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-- A formula has been devised for pricing each item based upon the depreciated value at the time the contractor requests that the Government acquire the individual capital investment(s).

An assessment of the impact on the make-or-buy structure and upon the competitive environment in the industry involved has been made.

These provisions for capital investment shall not apply if the contract is terminated for default. The Special Termination Buy-back provision has been authorized for use on three programs, the ammunition portion of the GAU-8, 30 mm cannon for the A-10, the B-1, and the F-16. As of June 30, 1977 North American Rockwell had made capital investments of approximately $16 million for the B-1 using the Special Termination Buy-back technique. This amount represents the maximum contingent liability and as of this date we have not determined how much of this equipment the government would re-purchase. Approximately $6.6 million of capital equipment has been bought under this provision to support the ammunition portion of the GAU-8 program. Although authorization to use the Special Termination Buy-back provision has been given to the F-16 program, as of this date no equipment has been purchased using this technique.

If the contract or program is terminated or funds are not provided in subsequent fiscal years to procure sufficient end items which would enable the contractor to recover his investment through the combination of investment incentives, and allowable depreciation costs pursuant to cost principles established in ASPR Section XV, the contractor through the contracting officer determines the equipment that he wants the government to re-purchase. Providing the contract provisions described above are met, and that it has become "...apparent that a contingent liability resulting from this technique will become an actual obligation, the Secretary (Service) shall be notified and immediate steps shall be taken to obtain sufficient funds to cover the obligation." ( Proposed ASPR 8-212(b)(6)].

6. Senator Proxmire: On page 8 of your prepared statement, you referred to

• pending ASPR revision which "will result in closer monitoring and control of contractor indirect costs." During the hearings, it was stated: "So what we are talking about is not any one particular part of the ASPR being changed so much as it is a charge to our people to do a better job of monitoring the day-to-day big program organization that we have throughout the United States." Besides the improved guidance to audit and administrative personnel, are any ASPR modifications under consideration which would deal with the question of indirect costs?

Mr. Church: We have provided for the record the proposed ASPR provisions for the monitoring of indirect costs. There are no other ASPR modifications under consideration at this time.

7. Senator Proxmire: In your prepared statement, you remark that the depart

ment is "encouraging the primes to make subcontractual arrangements which are no less favorable than those incorporated into the prime contract."

a.

In what ways do primes currently make arrangements less favorable than the terms in the prime contracts?

b. Is such harsh contractor treatment of subcontractors relatively

common?

C.

What effect would more favorable prime contractor treatment

of subcontractors have on contract costs? Mr. Church: Traditionally, the administration of subcontracts has been the sole responsibility of the prime contractor, the theory being that the Government has hired the prime to make business judgments and provide management services in selecting subcontractors and administering the contracts. Accordingly, the Government has claimed lack of privity. Because of this and the subcontractor's fear of attribution there is little documentation to substantiate the degree of harsh treatment received by subcontractors. We have reason to believe the problem may be real. Accordingly, we have initiated a study to determine the nature of the problem and the need for acquisition policy changes.

The preponderance of ways that prime contractors make arrangements with subcontractors less favorable than the terms in the prime contract usually hinge around the type of contract and the transfer of risk. For example, a prime contractor may have a cost type contract with the Government because of risk considerations, but the subcontractors who share many of the same risks are awarded subcontracts on a firm fixed price basis.

a.

Furthermore, prime contractors with escalation clauses in their contracts do not necessarily extend escalation provisions to the subcontractor level.

b. The frequency of harsh treatment cannot be assessed as discussed above.

c. Likewise, the same considerations prevent at this time a realistic assessment of cost impact of more favorable treatment of subcontractors. In any event, in adopting any new policies on subcontracting, consideration will have to be given to factors other than contract cost. For

example harsh treatment of subcontractors could be contributing to the diminution of the lower-tier defense supplier base, which in turn could be lessening competition, thereby causing higher prices, and creating an inadequate industrial mobilization surge capability. We have some indications of adverse trends with regard to the viability of the lower-tier defense supplier base and intend to study the matter.

8. Senator Proxmire: What is the 11kely effect on the industrial base

of extensive relocation of U.S. component production facilities in developing countries? Does the Department have plans to minimize negative effects of this relocation?

Mr. Church: Should an extensive relocation of U.S. component production facilities to developing countries take place, the DoD could find itself becoming fully dependent upon foreign sources of supply for parts and components of Defense systems. The enormous and rapidly growing labor surpluses in the developing countries offer to the multinational corporations an almost inexhaustible market for low cost production labor. Mexico, for example, will have to find almost three times the number of jobs for new young workers in each year between now and 1990 than it ever created in any previous year. Even with significant investment in cost reducing plant and equipment, U.S. industry will find it difficult to compete with these low cost labor markets. Additionally, the general absence of EPA/OSHA type restrictions in the developing countries offers a very favorable environment for low cost investment in production facilities by the multinationals. In our defense procurement, we have experienced a trend toward the relocation of production facilities to the developing countries for electronic parts and components. This trend has been particularly evident for those components which have been obsoleted in the commercial market (but still required for defense systems) by the rapid pace of technological change in the industry. The Defense Electronics Supply Center estimates for example, that of the 700,000 electronic items it manages, about 50 to 65% may be dependent upon foreign production sources (not exclusively in developing countries) to some degree. This dependency encompasses solid state products, passive devices and classes of electronic tubes.

The Department of Defense as well as other Government Agencies have been concerned about this trend for some time. During peacetime, we strongly encourage competition to strengthen the industrial base and reduce our defense material acquisition costs. If competition from foreign sources helps to achieve that goal, we are in favor of it. On the other hand, if foreign competition threatens our economic and political interests and adversely affects the viability of our domestic base to meet emergency defense requirements, then there is cause for concern. We have recognized the potential for injury to the defense related segment of the industrial base and have taken positive steps to minimize the negative effects of this potential. These steps include:

.

Provisions in the ASPR to protect critical defense industries
from foreign competition.

Buy American Act ASPR Clause 6-100
Restrictive Purchases for Preservation of Domestic Industrial
Base - ASPR Clause 1-2207

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