Defense Industry Restructuring: Cost and Savings Issues (Testimony, 04/15/97, GAO/T-NSIAD-97-141)
GAO discussed the costs and savings associated with defense industry
restructuring, focusing on the: (1) Department of Defense's (DOD)
decision to pay restructuring costs; (2) process DOD uses to ensure that
paying restructuring costs is in the government's best interest; and (3)
amount and nature of costs that DOD has paid and estimates of savings it
has realized.
GAO noted that: (1) over the last several years, defense contractors
have attempted to become more efficient and competitive by such
activities as closing or combining facilities and eliminating jobs; (2)
DOD has always paid for its share of the costs of these activities when
they were undertaken as part of an internal restructuring by a single
contractor; (3) until July 1993, however, DOD did not pay for
restructuring costs on certain contracts transferred from one company to
another company as a result of a business combination; (4) at that time,
DOD changed its practice and began allowing restructuring costs to be
charged to these contracts as long as certain conditions were met; (5)
principally, such costs were allowed as long as projected savings
exceeded projected costs; (6) the dollar impact of this decision may be
less than some anticipated; (7) DOD estimates that only 10 percent of
the costs DOD had paid through September 1996 resulted from the change
in practice; (8) as of March 31, 1997, five combinations had gone
through a certification process that is required before DOD pays
restructuring costs; (9) GAO recently completed an evaluation of four of
the five certified combinations, as well as one additional combination
that DOD included in its reports to Congress: (10) overall, GAO found
that DOD estimated its share of projected restructuring costs was about
$755 million, while its estimated share of the savings resulting from
these combinations was at least $3.3 billion; (11) at the time of GAO's
review, the five business combinations had incurred about $849 million
for a wide range of restructuring activities, with about 10 percent of
these costs being for benefits and services to laid-off workers; (12)
services for laid-off workers were also being funded by federal grants
and through the contractors' normal overhead costs; (13) through
September 1996, DOD reported that it had paid $179.2 million in
restructuring costs while realizing $346.7 million in savings; (14) in
other words, for every $1.00 DOD had paid in restructuring costs, it
estimated savings of $1.93 had been realized; and (15) however, it is
extremely difficult to trace restructuring savings into reduced contract
prices because many factors other than restructuring activities affect
contract prices.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: T-NSIAD-97-141
TITLE: Defense Industry Restructuring: Cost and Savings Issues
DATE: 04/15/97
SUBJECT: Defense procurement
Department of Defense contractors
Defense cost control
Defense contracts
Defense industry
Overhead costs
Severance pay
Contractor payments
Contract costs
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Cover
================================================================ COVER
Before the Subcommittee on Acquisition and Technology, Committee on
Armed Services, United States Senate
For Release on Delivery
Expected at
2:00 p.m., EDT
Tuesday,
April 15, 1997
DEFENSE INDUSTRY RESTRUCTURING -
COST AND SAVINGS ISSUES
Statement of David E. Cooper, Associate Director, Defense
Acquisitions Issues, National Security and International Affairs
Division
GAO/T-NSIAD-97-141
GAO/NSIAD-97-141t
Defense Industry Restructuring
(707251)
Abbreviations
=============================================================== ABBREV
DCAA - Defense Contract Audit Agency
DOD - Department of Defense
FAR - Federal Acquisition Regulation
UDLP - United Defense Limited Partnership
============================================================ Chapter 0
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here this afternoon to discuss our work on the
costs and savings associated with defense industry restructuring.
The issue of whether the Department of Defense (DOD) should be paying
defense companies for restructuring costs associated with
acquisitions and mergers has been a controversial one·and one that is
not well understood.
Today, I will provide a brief overview of
-- DOD's decision to pay restructuring costs,
-- the process DOD uses to ensure that paying restructuring costs
is in the government's best interest, and
-- the amount and nature of costs that DOD has paid and estimates
of savings it has realized.
After this overview, I will provide details about each of these
issues.
OVERVIEW
---------------------------------------------------------- Chapter 0:1
Over the last several years, defense contractors have attempted to
become more efficient and competitive by such activities as closing
or combining facilities and eliminating jobs. DOD has always paid
for its share of the costs of these activities when they were
undertaken as part of an internal restructuring by a single
contractor. Until July 1993, however, DOD did not pay for
restructuring costs on certain contracts transferred from one company
to another company as a result of a business combination. At that
time, DOD changed its practice and began allowing restructuring costs
to be charged to these contracts as long as certain conditions were
met. Principally, such costs were allowed as long as projected
savings exceeded projected costs. The dollar impact of this decision
may be less than some anticipated. DOD estimates that only 10
percent of the costs DOD had paid through September 1996 resulted
from the change in practice.
As of March 31, 1997, five combinations had gone through a
certification process that is required before DOD pays restructuring
costs. We recently completed an evaluation of four of the five
certified combinations, as well as one additional combination that
DOD included in its reports to Congress. Overall, we found that DOD
estimated its share of projected restructuring costs was about $755
million, while its estimated share of the savings resulting from
these combinations was at least $3.3 billion. At the time our
review, the five business combinations had incurred about $849
million for a wide range of restructuring activities, with about 10
percent of these costs being for benefits and services to laid-off
workers. Services for laid-off workers were also being funded by
federal grants and through the contractors' normal overhead costs.
Through September 1996, DOD reported that it had paid $179.2 million
in restructuring costs while realizing $346.7 million in savings. In
other words, for every $1.00 DOD had paid in restructuring costs, it
estimated savings of $1.93 had been realized. However, it is
extremely difficult to trace restructuring savings into reduced
contract prices because many factors other than restructuring
activities affect contract prices. Due to the interest in this area,
we plan to further explore whether restructuring savings can be
traced to reduced contract prices.
I would now like to go back and discuss each issue in a little more
detail.
DOD'S DECISION TO PAY
RESTRUCTURING COSTS
---------------------------------------------------------- Chapter 0:2
Defense contractors are restructuring and consolidating to become
more efficient and competitive as defense business has declined over
the last several years. Contractors, whether or not they are
involved in an acquisition or merger, have been closing facilities
and disposing of assets; eliminating jobs; relocating employees; and
combining facilities and operations. The costs incurred for such
activities that are undertaken as part of an internal restructuring
effort can be charged to defense contracts as long as the costs are
allowable, allocable, and reasonable as required by the Federal
Acquisition Regulation (FAR).
Prior to July 1993, however, DOD did not permit contractors to charge
restructuring costs to flexibly priced\1 contracts that were
transferred\2 from one defense contractor to another as a result of a
business combination, such as a merger or acquisition. The rationale
was that DOD should not have to pay more for its contracts merely
because they were transferred from one contractor to another as a
result of a business combination.
In response to industry requests, and in an effort to encourage
consolidation in the defense industry and thereby reduce contract
costs, DOD changed its long-standing practice. On July 21, 1993, the
Under Secretary of Defense for Acquisition issued a memorandum
permitting contractors to charge restructuring costs to transferred
contracts if certain conditions were met. For example, contractors
could charge restructuring costs if it was determined that the
restructuring activities would likely result in overall reduced costs
to DOD. In other words, projected restructuring savings were to
exceed costs. The costs charged to transferred contracts also had to
comply with FAR requirements for allowability, allocability, and
reasonableness. For example, certain organization costs, such as
legal and consulting fees applicable to business combinations, cannot
be charged to a government contract.
Some believe that the July 1993 change added substantial costs to
DOD's contracts. That does not appear to be the case. Through
September 30, 1996, the Defense Contract Audit Agency (DCAA)
estimated that DOD had paid $179.2 million in restructuring costs.
We asked DCAA to determine how much of these costs resulted from the
change in practice. DCAA's work shows that the July 1993 change
added only $18 million, or about 10 percent, more in restructuring
costs than DOD otherwise would have paid. In other words, DOD would
have reimbursed most of these costs even if it had not changed its
practice. The 10 percent in additional costs, however, may not be
the same for future business combinations because of differences in
the factors that determine the percentage, including the mix of
flexibly priced and firm fixed-price contracts and the period of time
required for certification.
--------------------
\1 Flexibly priced contracts refer to a family of contracts under
which the total amount paid to a contractor is dependent on the
allowable costs the contractor incurs in performing the contract.
\2 The transfer of contracts from one contractor to another involves
a process called novation. The novation process requires a written
agreement executed by the buyer, the seller, and the government, in
which the government agrees to the transfer.
PROCESS FOR SAFEGUARDING THE
GOVERNMENT'S INTEREST
---------------------------------------------------------- Chapter 0:3
Congressional concerns about safeguarding the government's interest
in paying restructuring costs led to enactment of section 818 of the
1995 DOD Authorization Act (Public Law 103-337). Section 818
prohibits DOD's paying restructuring costs until a senior DOD
official certifies that projected savings are expected to exceed
restructuring costs and requires DOD to submit annual reports to
Congress that provide, among other things, information on the payment
of restructuring costs to defense contractors involved in business
combinations. Congress modified the authority for paying such costs
in section 8115 of the 1997 DOD Appropriations Act (Public Law
104-208) by requiring that projected savings exceed costs by a ratio
of at least two-to-one on business combinations occurring after
September 30, 1996.
In response to section 818, DOD issued regulations on the payment of
restructuring costs.\3
The regulations contain several features designed to protect the
government's interest. For example, contractors are required to
prepare proposals containing projected restructuring costs and
savings. DCAA is to audit the proposals and payment is to be
authorized only after a high-level DOD official certifies that the
projected savings should result in overall reduced costs to DOD.
As of March 31, 1997, five business combinations had gone through the
required certification process. These combinations were
-- the United Defense Limited Partnership (UDLP) between FMC
Corporation's Defense Systems Group and Harsco Corporation's BMY
Combat Systems Division,
-- Martin Marietta Corporation's acquisition of General Electric
Company's aerospace and other business segments,
-- Northrop Corporation's acquisitions of the Grumman Corporation
and the Vought Aircraft Company to form the Northrop Grumman
Corporation,
-- the merger of the Lockheed Corporation and the Martin Marietta
Corporation to form the Lockheed Martin Corporation, and
-- Martin Marietta Corporation's acquisition of General Dynamics'
Space System Division.
We examined the process used to certify four of the business
combinations and found that DOD complied with the restructuring
regulations. We did not examine Martin Marietta's acquisition of
General Dynamics' Space System Division because we were already
examining two other business combinations involving Martin Marietta.
For the combinations examined, the contractors submitted
restructuring proposals with projected costs and savings; the
proposed costs and savings were audited; and a senior DOD official
certified that the projected savings should result in overall reduced
costs to DOD.
The Defense Contract Management Command told us that 10 additional
business combinations either were in the certification process or may
result in restructuring proposals. Appendix II provides additional
information on these 10 combinations.
--------------------
\3 DOD issued interim regulations on the allowability of
restructuring costs effective December 29, 1994. After evaluating
public comments, DOD published the final regulations in the Federal
Register dated April 18, 1996. Section 818 required us to report on
the adequacy of the regulations, which we did in Defense
Restructuring Costs: Payment Regulations Are Inconsistent With
Legislation (GAO/NSIAD-95-106, Aug. 10, 1995).
AMOUNT AND NATURE OF ESTIMATED
RESTRUCTURING COSTS
---------------------------------------------------------- Chapter 0:4
As you are aware, we issued a report earlier this month\4 that
contains information on the projected and incurred restructuring
costs for five business combinations, including four of the five
certified business combinations, as well as Hughes Aircraft Company's
acquisition of General Dynamics Corporation's Missile Operations.
This combination did not have to go through the certification process
because payment of the restructuring costs was approved before the
1995 DOD Authorization Act was passed; however, we included it in our
review because DOD has included the combination in its restructuring
reports to Congress.
Overall, we reported that the projected restructuring costs for these
five business combinations totaled about $1.4 billion. Because these
costs will be allocated to all of the contractors' customers, DOD's
portion of these costs will depend on its share of the contractors'
total business base. Consequently, DOD's estimated share of the $1.4
billion totaled $755.2 million. Finally, we reported that the five
business combinations had incurred costs of about $849 million for a
wide range of restructuring activities, such as disposing of and
modifying facilities, consolidating operations and systems,
relocating workers and equipment, and eliminating jobs. We grouped
the costs into several broad categories to illustrate their nature
(see table 1).
Table 1
Incurred Restructuring Costs By Category
(Dollars in millions)
Category Amount
---------------------------------------------- ----------------------
Disposal and relocation of facilities and $452.7
equipment
Relocation of employees 100.0
Benefits and services for laid-off workers 88.9
Consolidation of operations and systems 81.4
Restructuring planning and implementation 57.8
Other 68.5
======================================================================
Total $849.3
----------------------------------------------------------------------
Disposal and relocation of facilities and equipment was the largest
category of incurred restructuring costs, amounting to over $450
million. Of the $88.9 million expended for benefits and services for
laid-off workers, almost 90 percent was for severance pay, about 6
percent was for the temporary continuation of health benefits, and
about 4 percent was for reemployment assistance.
We also found that services for laid-off workers were being funded by
federal grants. We identified about $48 million in Department of
Labor grants made either directly to contractors or to locations
where workers were laid off as a result of the business combinations.
These grants funded activities to help workers seek new employment
regardless of whether they were laid off as a result of a business
combination or normal downsizing.
Of the $48 million in Department of Labor grants, about $17 million
was awarded directly to Hughes and Martin Marietta. We recommended
in our April 1997 report that the Secretary of Defense obtain
information about significant federal grants made directly to defense
contractors and include the information in the DOD reports submitted
annually to Congress in response to section 818 requirements. We
believe including information about Department of Labor grants would
provide the Congress more complete information about federal funding
used to assist workers in connection with defense contractor
restructuring activities. In response to our recommendation, DOD
officials stated that they would meet with Labor officials to
determine how such information could be made available to DOD for
inclusion in its annual reports to Congress.
In addition to grant funds, contractors were providing some services
and charging them as normal overhead costs, rather than restructuring
costs. For example, UDLP operated an outplacement center where all
terminated employees, regardless of why they were laid off, could
obtain assistance in seeking a new job. UDLP spent $205,000 in
operating the center over a 3-year period and paid an additional
$109,000 to a consulting firm to assist mid- and senior-level
management officials seek new employment. UDLP charged these costs
to overhead rather than restructuring costs. Similarly, Northrop
Grumman and Lockheed Martin provided counseling and/or outplacement
assistance to help workers seek new employment and charged the costs
as overhead expenses rather than restructuring costs.
The process by which defense contractors are to be reimbursed for
restructuring costs differs from the typical contract payment
process. Normally, contractors are allowed to bill government
contracts during the same period they incur costs. That is not the
case with restructuring costs. Contractors are required to segregate
restructuring costs in their accounting records until the
certification process I described earlier is completed. After
certification, contractors can begin charging restructuring costs to
DOD contracts. Contractors are generally permitted to recover
restructuring costs over a 5-year period, but the recoupment period
may be shorter, depending on the terms negotiated between DOD and the
contractor.
As I noted earlier, the five business combinations we examined
incurred about $849 million in restructuring costs and these costs
will be allocated to each of the contractors' customers and paid over
a period of time.
--------------------
\4 Defense Restructuring Costs: Information Pertaining to Five
Business Combinations (GAO/NSIAD-97-97, Apr. 1, 1997).
AMOUNT AND NATURE OF ESTIMATED
RESTRUCTURING SAVINGS
---------------------------------------------------------- Chapter 0:5
DOD expects the consolidation and restructuring occurring in the
defense industry will reduce operating costs and thereby reduce
contract costs. However, estimating the savings DOD is likely to
realize from restructuring activities is difficult. Unlike
restructuring costs, restructuring savings are not recorded in a
contractor's accounting records. Therefore, neither the amount nor
the nature of the savings can be determined by reviewing the
accounting records. Consequently, savings must be estimated.
For four of the business combinations we examined, certified
restructuring savings totaled about $5.3 billion, of which DOD's
estimated share is $3.3 billion. These amounts do not include any
savings from the Hughes-General Dynamics business combination because
the combination occurred before Section 818 was enacted.
Consequently, there is not a certified amount of savings for that
combination. Additionally, these amounts do not include any savings
resulting from Martin Marietta's acquisition of General Dynamics'
Space System Division since it was not included within our review.
I would like to make the following three observations about
restructuring savings.
-- Certified savings are considerably less than the amounts often
reported in the media or proposed to DOD.
-- DOD estimated that it had realized net savings of $167.5 million
as of September 30, 1996.
-- It is extremely difficult to trace restructuring savings into
reduced contract prices.
Let me explain each of these points.
First, defense contractors, in announcing mergers or acquisitions,
generally provide initial estimates of savings expected to result
from the new business combinations. We have observed a tendency for
these initial estimates to be overly optimistic. For example:
-- In the case of UDLP, we found that the savings estimated at the
time of DOD's certification represented less than 15 percent of
the estimate FMC and Harsco originally presented to DOD.\5
-- In the case of Martin Marietta-General Electric, the savings
estimates used for certification purposes were about 56 percent
less than Martin Marietta's original estimate.\6
-- In the case of Lockheed Martin, the certified savings were less
than half of Lockheed Martin's initial proposal.
There are various reasons for such differences, including reductions
in estimated savings made by the contractors at the time they
prepared their restructuring proposals and negotiated reductions in
savings based on DCAA audits of the contractors' proposals. Further,
DOD limits savings for certification purposes to 5 years. In the
case of Lockheed Martin, excluding savings projected beyond the
5-year limit was the principal reason for the difference between the
amount Lockheed Martin initially proposed and the amount certified by
DOD.
Second, in terms of savings realized, DOD estimated that it had
realized net savings of $167.5 million as of September 30, 1996.
DOD's estimate was based on paying restructuring costs totaling
$179.2 million and realizing savings of $346.7 million. In other
words, for every $1.00 DOD has paid in restructuring costs, it
estimates savings of $1.93 have been realized. DOD officials noted
that savings may actually be higher because DOD reviewed only eight
contracts for the Hughes-General Dynamics business combination to
demonstrate that savings exceeded costs.
Finally, it is extremely difficult to trace restructuring savings
into reduced contract prices because many factors other than
restructuring activities affect contractor's operations and costs.
For example, changes in inflation rates, business volume, and
accounting systems, as well as subsequent restructurings and
unexpected events, all affect contract prices. When we attempted to
identify reduced contract prices resulting from the UDLP business
combination, we found differing views about the impact of the
restructuring. At the time of our review, the Army had awarded UDLP
only one new contract that was comparable to a contract awarded
before restructuring. For that case, we concluded that UDLP's
restructuring efforts contributed to a reduction in the contract
price, but we could not determine the precise amount. Due to the
interest in this area, we plan to further explore whether
restructuring savings can be traced to reduced contract prices.
--------------------
\5 Defense Contractor Restructuring: First Application of Cost and
Savings Regulations (GAO/NSIAD-96-80, Apr. 10, 1996).
\6 Our prior work on this combination covered the first eight
certified projects. See Defense Restructuring Costs: Projected and
Actual Savings From Martin-Marietta Acquisition of GE Aerospace
(GAO/NSIAD-96-191, Sept. 5, 1996). We updated this figure to
include all 13 certified projects.
-------------------------------------------------------- Chapter 0:5.1
Mr. Chairman, that concludes my statement. I will be glad to
respond to any questions you or members of the Subcommittee may have.
SELECTED INFORMATION ON COST AND
SAVINGS FROM FIVE BUSINESS
COMBINATIONS
=========================================================== Appendix I
(Dollars in millions)
Certified amounts\a Amount
---------------------------------------------- ----------------------
Costs $1,373.9
Savings\b 5,257.0
DOD share of certified amounts
----------------------------------------------------------------------
Costs 755.2
Savings\b 3,304.6
Status of September 30, 1996
----------------------------------------------------------------------
Restructuring costs paid by DOD 179.2
Estimated savings realized by DOD 346.7
----------------------------------------------------------------------
\a Does not include any costs or savings resulting from Martin
Marietta's acquisition of General Dynamics' Space System Division.
\b Does not include any savings from the Hughes-General Dynamics
business combination since the combination occurred prior to the
enactment of section 818 of the 1995 Department of Defense
Authorization Act. Consequently, there is not a certified amount of
savings for that combination.
STATUS OF SELECTED MERGERS
INVOLVING DEFENSE CONTRACTORS
========================================================== Appendix II
Date Status of
Acquirer Target firm combined restructuring proposal
-------------------- -------------------- ------------ ----------------------
Combinations currently with proposals in the certification process
--------------------------------------------------------------------------------
Westinghouse Norden Systems June 1994 Defense Contract Audit
Electric Agency (DCAA) audit of
proposal complete
Allied Signal Textron Lycoming October 1994 Awaiting completion of
DCAA audit
Hughes CAE Link December DCAA audit completed
1994
Litton Varo Night Vision June 1995 Awaiting completion of
division DCAA audit
Mergers that may result in restructuring proposals
--------------------------------------------------------------------------------
Northrop Grumman Westinghouse March 1996 Not applicable
Electronic Systems
Lockheed Martin Loral April 1996 Not applicable
The Boeing Company Rockwell's aerospace December Not applicable
and defense units 1996
Proposed mergers awaiting regulatory approval
--------------------------------------------------------------------------------
The Boeing Company McDonnell Douglas To be Not applicable
Corporation determined
Raytheon Company Texas Instruments' To be Not applicable
Defense Systems & determined
Electronics
Raytheon Company Hughes Electronics' To be Not applicable
defense business determined
--------------------------------------------------------------------------------
*** End of document. ***
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