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Some of the other interests of the committee involve special features of the new profit policy. For example, why won't the productivity reward clause tend to encourage high initial costs on defense contracts so that the contractors can later demonstrate alleged productivity improvements? Second, are the subcontractors correct in claiming that the new profit policy does not benefit them but will expose them to Defense Department contract scrutiny from which they have been exempt? What will be the different effects of the profit policy on high capital investment industries, such as shipbuilding, as opposed to low investment industries such as airframe makers or research and development (R. & D.) firms?

We don't expect final answers on a policy that was issued so recently. But we do want to know what expectations the Defense Department has and what it hopes to achieve by its new policy, and after 6 months or a year or even longer we can measure what is happening in defense industry against these goals that you may help us look for this morning.

Secretary Clements and General Stansberry, I want to thank you both for the open and cooperative attitude that you have shown to the committee and the staff in the development of this new profit policy. We appreciate your taking the time again today to answer our questions.

I see that you have a very short prepared statement, and I understand that you will deliver it orally, and a much longer statement.

The full longer statement will be printed in the record, and then I understand that General Stansberry has a brief statement he would like to make, too, when you conclude yours. So we are happy to have you proceed that way.

Mr. CLEMENTS. Thank you, Senator Proxmire. I also have with me Frank Shrontz, who is Assistant Secretary of Defense for Installations and Logistics under whose auspices this study was undertaken by General Stansberry. Also Dale Babione, who is the principal Deputy in Installations and Logistics, who has followed this study through the entire course during the past several months.

So I think that between the four of us who have been so intimately involved, we will be able to answer all of your questions and give you the information that you want.

I agree with you that in principle the final result remains to be evaluated. We will not have the answers as to how successful or unsuccessful the program will be probably for 2 or 3 years, and that is part of the plan, that we will monitor the results and see if we are obtaining the results that we had hoped for.

And I think your statement in that regard is exactly right. I know that you will continue to follow it in that regard, even though some of us won't be here, you will be. [General laughter.]

Senator PROXMIRE. I am glad to say that the people in Wisconsin have pretty good judgment. [General laughter.]

No; I was very lucky.

Mr. CLEMENTS. Particularly in the sense that there was no opponent, as I understand. [General laughter.]

Senator PROXMIRE. One of the best aspects of that election, since we have gotten into it, is I did have a good opponent. But this was an unusual election. You know, in the average campaign I have found

that the average incumbent spends about $500,000. I spent $177.23. I accepted no contributions at all. So it shows that it pays to be somewhat critical of the Pentagon. [General laughter.]

Mr. CLEMENTS. In Wisconsin. [General laughter.]
Senator PROXMIRE. Maybe not in Texas.

Mr. CLEMENTS. I insist on the last word, Senator.

Senator PROXMIRE. Maybe not in Texas. [General laughter.]

STATEMENT OF HON. WILLIAM P. CLEMENTS, JR., DEPUTY SECRETARY OF DEFENSE; ACCOMPANIED BY FRANK SHRONTZ, ASSISTANT SECRETARY OF DEFENSE FOR INSTALLATIONS AND LOGISTICS; DALE BABIONE, DEPUTY ASSISTANT SECRETARY OF DEFENSE FOR INSTALLATIONS AND LOGISTICS; AND BRIG. GEN. J. W. STANSBERRY, DIRECTOR, PROFIT 76 STUDY

Mr. CLEMENTS. Senator Proxmire, I am pleased to appear before this committee to discuss the new Department of Defense profit policy. This policy came about as a result of a 1-year study on the general subject of defense contractor earnings. The study, known as Profit 76, was chartered by me and was led by Brig. Gen. James W. Stansberry who is with me this morning.

We have been mindful for some time of the need to improve our profit policy. Many informed observers, including members of this committee, have pointed out what they believed to be shortcomings. The problems most consistently identified were overemphasis in our weighted guidelines on estimated contract cost as a profit factor and the absence of contractor investment as a meaningful profit determinant. We agreed that these problems might contribute to high cost and less than optimum investment levels by defense contractors. Thus, the overall goal of our profit study was to develop revisions in policy that would help achieve proper investment levels and associated reductions in cost.

In order to come to grips with these issues, we needed reliable data on actual defense contractor investment levels and earnings. We also needed to determine how these considerations were related to each other and to comparable commercial endeavors. Defense contractor financial and investment data was collected at the profit center level over a recent 5-year period and compared to Federal Trade Commission data on commercial durable goods manufacturers. We also sought informed judgment on profit issues across a wide spectrum of government and industry. We met with representatives of the accounting profession, the academic community, the General Accounting Office, the Cost Accounting Standards Board, the Office of Federal Procurement Policy, and many others. Throughout the course of the study we took great care to maintain a completely visible and open approach, culminating in a special advisory group review of our findings.

I would now like to briefly highlight what we have learned. Defense contractor profits, when measured on the basis of sales, are on the average lower than those generated in commercial endeavors; however, when measured on an investment basis they are somewhat higher. This relationship is traceable to a markedly low level of investment by defense contractors. In terms of production facilities, for example, commercial firms, on the average, invest more than twice the amount that defense contractors do on the basis of sales dollars. While there

are many reasons for this lack of investment, some are traceable to our procurement approach. In the past, we have not related profit to investment in a satisfactory way; nor have we allowed the cost of the capital requirement for investment to be reimbursed as a cost on defense contracts.

We have now set forth two important changes addressing this matter. The first provides that the amount of facilities investment will be recognized in the contracting officer's prenegotiation profit objective. The relative weight of this factor in the profit objective calculation is modest. In the future it will likely be increased after industry has had some opportunity to adjust its investment patterns. The second changes provides for the imputed cost of capital for facility investment, measured in accordance with Cost Accounting Standard 414; that is, the risk-free element of the total cost of capital will be considered an allowable cost on negotiated Department of Defense contracts. Procedures have been established so that on the average in our negotiated contracts, the prenegotiation profit objective takes into account and offsets the cost increase attributable to the imputed cost of facility capital. This offset provision is in line with the view expressed in Senator Proxmire's letter to Secretary Rumsfeld of May 27, 1976, on this subject.

We have taken special care in assuring successful implementation of our revised policy. General Stansberry and his team have briefed each of the service commanders charged with acquisition, and detailed training has been provided to over 3,000 government and industry personnel.

We believe that our policy changes are an important step forward in achieving our goal of encouraging contractor investment in cost-reducing facilities. Our new policy, combined with other procurement initiatives under way should act to strengthen the competitive industrial base and reduce Department of Defense acquisition costs.

Thank you very much, Senator, and we will explore these various aspects with you in whatever detail you want, and General Stansberry has a short statement.

[Complete statement of Secretary Clements follows:]

STATEMENT OF WILLIAM P. CLEMENTS, DEPUTY SECRETARY OF DEFENSE Senator Proxmire and members of the committee, thank you for the opportunity to discuss with you the new Department of Defense (DOD) profit policy. We have been mindful for some time of the need to improve our profit policy so as to help us accomplish a key objective of the Department of Defense-that we strengthen the defense industrial base. Today's sophisticated weaponry is expensive; therefore the industry which serves our defense needs must be as efficient and cost-effective as possible.

We have suspected for some time that the defense industrial base was suffering from a low level of private investment, and have suspected that low level is in part traceable to a relatively low level of profitability. It is axiomatic that business flourishes in an atmosphere which makes it possible to earn a fair level of profit. The rule is equally valid when business deals with the DOD, and it works to the Government's advantage for a number of reasons: It attracts good performers to do business with the Government. It makes for a healthy and competitive environment.

It enables contractors to invest in new and efficient plant equipment with ultimate reduction in cost.

In order to gain a detailed understanding of this matter, in May 1975 the Profit 76 study was chartered by me and led by Deputy Assistant Secretary Dale R. Babione and Brig. Gen. James W. Stansberry under the supervision of Assistant Secretary Frank A. Shrontz. The goal of the study was to develop any policy revisions considered necessary to encourage private investment in

cost-reducing equipment. The basic approach was to compare earnings and investment data between defense, and commercially oriented companies.

We sought widespread participation in the study throughout Government. The Military Departments became actively involved as did the Joint Logistic Commanders (JLCs). A high-level steering committee consisting of the Assistant Secretaries of Defense for both Installations and Logistics and Comptroller, as well as the Assistant Secretaries (I&L) of the Military Departments, exercised guidance and surveillance throughout the course of the study. We dealt extensively with representatives of the General Accounting Office (GAO), the Cost Accounting Standards Board, the Office of Federal Procurement Policy, and many other interested offices.

In any evaluation of investment and earnings, the key. to success is reliable data. Our collection and analysis of data was a carefully phased effort. First, we discussed in detail with industry, the GAO accounting firms and others the data elements required. We requested the participation of 133 major defense contractors that supply weapons systems and hardware. The data from the participating contractors was submitted to their certified public accountants (CPAs). The accounting firms of each participating company made a thorough, independent check of the collected data. Finally, the figures were further reviewed and analyzed by a CPA firm working under contract to the DOD. Ultimately our CPA firm received data from 76 companies. They rejected the data from 12 of the companies based on either their own review or that of the company's own CPA firm. The final analysis was then based on data from 64 companies (147 defense oriented profit centers) with an aggregate sales data for government business averaging $15.5 billion annually during the five year period from 1970 through 1974. As a result of the close coordination and comprehensive reviews, we obtained a high level of confidence in the data developed.

We also collected considerable data (8.5 billion annually) on the commercial operations of companies doing business with the DOD. This data, while valuable for certain purposes, was not considered sufficiently typical for all commercial endeavors for us to base prime earning comparisons on it, and it alone. Therefore, a second set of figures was constructed from the same five year sample period utilizing data routinely gathered by the Federal Trade Commission (FTC) on 5,000 corporations producing durable goods with aggregate average sales of $450 billion annually. We believe that the FTC data offers the best overall reflection of profitability in the commercial business world; for that reason, our comparisons are based primarily on that data.

I would now like to turn to our data analysis results. Looking at the return on sales, figure 1 displays the time trends of pre-tax profitability for commercial and Government profit centers and for the FTC durable good producers. As noted on the chart, the commercial profit centers reported a 5-year average of 17.1 percent, which is roughly 21⁄2 times the FTC durable goods average of 6.7 percent. The 5-year average of the Government oriented profit centers was 4.7 percent, which is 2 percent below the FTC average. This relationship of lower earnings on sales has also been noted in past profit studies.

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