imposed by the Defense Authorization Act of fiscal year 1973 (Public Law 92-436)

We have an intensive program under way to review those specifications and standards which have a potential for high cost compliance and to eliminate those requirements which contribute to this potential. We are also tailoring the actual application of those documents to the systems being produced to reflect our minimum qualitative needs. We are actively participating with recognized industry standards organizations to promote the adoption of industry standards. To date, we have adopted almost 1,500 industry specifications and standards. We also have a very significant effort under way to increase the use of commercial, off-the-shelf products when such products adequately serve DOD's requirements. These efforts are in full consonance with the philosophy of S. 1264 which is pending before the Senate.

While we have concurred in the objectives of the bill, we must likewise be cautious in mandating the use of functional specifications without considering the minimum essential characteristics a product must meet. An unlimited application of this concept would run counter to our logistical support requirements and our efforts at standardization as a means of cost reduction. Overly broad definitions of "functional terms" and "performance specifications" would result in widespread spare parts duplication in our inventories. For example, there are approximately 4 million numbered parts in the defense supply system. A 10-percent duplication would result in an initial first-year increase of about $146 million in cost to the Defense Department.

Turning now to our efforts to better assure adequate sources of military supplies, we have instituted a program of initiatives to deal with this subject. These include: We have issued a directive to establish an "early warning system" for diminishing sources of materials and critical components and parts supply. We are seeking wider recognition of the potential of appropriations authorization under title III of the Defense Production Act to remedy materials shortages and deficiencies in production capacity. We are investigating the possibility of Government financing of dual or multiple sources of production for critical components during development-when the savings from the increased competition over the program life would pay back the initial qualification costs.

In addition to these initiatives, we launched our new profit policy to help strengthen the defense industrial base through the rewards of a fair level of profit. This policy, which was the subject of hearings before this committee last November, is intended to recognize and reward contractor investment in cost reducing production facilities through prenegotiation profit objectives and allowing for the imputed costs of facilities capital under Cost Accounting Standard 414. It is too early to determine the effect of this new policy on the level of investment in cost reducing facilities because of the lead time between the capital investment budgeting decision and the procurement and installation of the facilities.

We also recognized there were situations where the investment was so significant that profit motivated incentives would not be adequate

1 Defense Industrial Base: Department of Defense Profit '76, Part II, Hearings before the Joint Committee on Defense Production, November 18, 1976.

to provide the impetus for contractor investment. To respond to these situations, we initiated a study of investment policy to identify those factors which motivate contractor investment and the policy changes necessary to foster contractor motivation. A supporting investigation by the Logistics Management Institute revealed that defense oriented contractors reinvest at a level of about 6 percent of sales while comparable commercially-oriented contractors reinvest at a level of about 17 percent. The investment policy study concluded that the variation in investment decisions is influenced by a variety of reasons.

Chief among these is necessity-the need to have the capability to produce competitively in order to stay in business-rate of return, cash flow, competition and the perceived risks of investment. Of these, risk in relation to return on investment and cash flow proved to be the major factor; risk in defense procurement was perceived to be greater than in commercial business. This conclusion is based on the way the Defense Department conducts its business. Annual funding programs, program cutbacks and cancellations, schedule stretchouts, design change orders, changes due to advances in the state of the art and the lack of future business stability were singled out as being most contributory to risk in defense business.

We have other techniques that are on going which have been listed in the statement. These include the special termination buy-back technique and the manufacturing technology program, a program to address the efficiency of the investment that we now have in contractor's plant equipment, and to further encourage contractors to do better in that regard.

We have in the statement a summary of the status of the aircraft capacity study, which we undertook with the OMB. We are aggressively pursuing various means of implementing the results of that study trying to find ways to better that capacity and minimize the cost to the Department of Defense.

Some of the things include an aggressive implementation of ASPR policy and the examination of approaches to reduce potential excesses in capacity during the DSARC.

I would like to stress that I finally will offer some suggestions on how the Congress might assist achieving a more competitive and adequate defense industrial base.

The first of these would be to help us with the multiyear authorization of funds. The Senate bill S. 1264 proposes to give the statutory base for multiyear contracting, but beyond that we also need assistance in the multiyear authorization of funds to further enhance competition and to better set up continuity in production lines.

Let me say in summary we have found some problems in the industrial base, but we do find that the production base is responsive to our general procurement needs. The forthcoming report of the Rand Corp. study which looked at a selected segment of lower tiers in the defense industrial base confirms this finding. When the report is released, a copy will be provided to the committee.

I think that more or less summarizes and concludes my statement. I would be more than happy to answer any questions.

[The complete written statement of Mr. Church follows:]

PREPARED STATEMENT BY DALE W. CHURCH, DEPUTY DIRECTOR FOR ACQUISITION POLICY, OFFICE OF THE DIRECTOR OF DEFENSE RESEARCH AND ENGINEERING

Mr. Chairman and members of the committee, I appreciate the opportunity to discuss with you this morning how the procurement policies of the Defense Department affect the defense industrial base. My comments will address those aspects of our procurement policies which are directed toward obtaining the maximum competition in defense procurement and how our policies are oriented toward establishing and retaining adequate sources of production for military supplies. I will also touch upon two relatively recent developments which support these efforts; namely the promulgation of OMB Circular A-109 which provides Government-wide acquisition policies and S. 1264, a proposed Bill to provide one statutory authority for acquisition of all supplies and services for the Federal Government. I will also review for you the manner in which are implementing the findings of our recent study on capacity utilization in the aircraft industry. Finally, I will offer some suggestions as to how the Congress might assist in achieving a more competitive and responsive defense industrial base.

Concerning the maximization of competiton, I would first like to say that no part of the Government is any more aware of the need to maximize competition than the Department of Defense. We are constantly striving to improve our track record. In this regard, fiscal year 1976 statistics show that including price competition, technical and design competition, and follow-on contracts where the source of supply was initially selected by competition, approximately 57 percent of the dollar obligated were the result of competition. The other 43 percent in large part represented one-source solicitations where it is more difficult to obtain effective competition. Contracts for Government-owned contractor operated facilities, utility services, and development and production of complex, high cost weapons systems involving high capital investment and know-how, exemplify the types of procurement actions in this category.

It is in this latter area where we need to do more to introduce additional competition. Under Circular A-109 we are pursuing increased competition among qualified sources in the early stages of major system acquisition. Although we can envision an expanded competitive base for design and technical competition prior to the selection of the full-scale development contractor, we also recognize the difficulty of other potential prime contractors in bidding for the system production contract. The cost experience, know-how and investment of the development contractor gives him a strong competitive edge. Notwithstanding this, we are striving for increased competition through our high value spares breakout program, by acquiring production data packages and by assuring that the latest production know-how and technology are incorporated into the packages.

Additionaly, we are encouraging increased prime contractor use of competition at the subcontractor levels. The approaches we are exploring to encourage the primes to solicit greater competition at the subcontractor levels include: Where economical, encouraging the primes to "buy" rather than "make." Avoiding “lockins” and “data rights situations" which may result in sole source contracts. Encouraging primes to tailor subcontracts to reduce technical and administrative burdens. Where appropriate, encouraging the primes to make subcontractual arrangements which are no less favorable than those incorporated into the prime contract.

By the same token, we (the Government) are searching for ways to remove the disincentives in our procurement actions in order to encourage greater competition among prime and subcontractors. Among the efforts we are pursuing are: Increasing longevity of production through multiyear authorizations and contracts. Reducing or eliminating the specialized nature of military specifications and standards. Where feasible, accepting commercial practices and products.

We are stressing the increased use of the multiyear contracting technique, within our authority, to provide an assurance of program stability to prospective contractors. Aside from obtaining increased levels of competition we can anticipate reduced unit prices by reason of continuity of production and eliminaton of repetitive start-up costs. These efforts would be greatly enhanced if the Congress would look favorably upon multiyear authorization of funds for major programs and lifting the $5 million limitation on multiyear cancellation ceilings imposd by the Defense Authorization Act of fiscal year 1973 (Public Law 92-436).

We have an intensive program underway to review those specifications and standards which have a potential for high cost compliance and to eliminate

those requirements which contribute to this potential. We are also tailoring the actual application of those documents to the systems being produced to reflect our minimum qualitative needs. We are actively participating with recognized industry standards organizations to promote the adoption of industry standards. To date, we have adopted almost 1500 industry specifications and standards. We also have a very significant effort underway to increase the use of commercial, off-the-shelf products when such products adequately serve DoD's requirements. These efforts are in full consonance with the philosophy of S. 1264 which is pending before the Senate. While we have concurred in the objectives of the Bill, we must likewise be cautious in mandating the use of functional specifications without considering the minimum essential characteristics a product must meet. An unlimited application of this concept would run counter to our logistical support requirements and our efforts at standardization as a means of cost reduction. Overly broad definitions of "Functional Terms" and "Performance Specifications" would result in widespread spare parts duplication in our inventories. For example, there are approximately 4 million numbered parts in the defense supply system. A 10 percent duplication would result in an initial first year increase of about $146 million.

Turning now to our efforts to better assure adequate sources of military supplies, we have instituted a program of initiatives to deal with this subject. These include: We have issued a directive to establish an "early warning system" for diminishing sources of materials and critical components and parts supply. We are seeking wider recognition of the potential of appropriations authorization under Title III of the Defense Production Act to remedy materials shortages and deficiencies in production capacity. We are investigating the possibility of government financing of dual or multiple sources of production for critical components during development (when the savings from the increased competition over the program life would pay back the initial qualification costs). In addition to these initiatives, we launched our new profit policy to help strengthen the defense industrial base through the rewards of a fair level of profit. This policy, which was the subject of hearings before this Committee last November, is intended to recognize and reward contractor investment in cost reducing production facilities through prenegotiation profit objectives and allowing for the imputed costs of facilities capital under Cost Accounting Standard 414. It is too early to determine the effect of this new policy on the level of investment in cost reducing facilities because of the lead time between the capital investment budgeting decision and the procurement and installation of the facilities.

We also recognized there were situations where the investment was so significant that profit motivated incentives would not be adequate provide the impetus for contractor investment. To respond to these situations, we initiated a study of investment policy to identify those factors which motivate contractor investment and the policy changes necessary to foster contractor motivation. A supporting investigation by the Logistics Management Institute revealed that defense oriented contractors reinvest at a level of about 6% of sales while comparable commercially-oriented contractors reinvest at a level of about 17%. The investment policy study concluded that the variation in investment decisions is influenced by a variety of reasons. Chief among these is necessity (the need to have the capability to produce competitively in order to stay in business), rate of return, cash flow, competition and the perceived risks of investment. Of these, risk in relation to return on investment and cash flow proved to be the major factor; risk in Defense procurement was perceived to be greater than in commercial business. This conclusion is based on the way the Defense Department conducts its business. Annual funding programs, program cut-backs and cancellations, schedule stretchouts, design change orders, changes due to advances in the state of the art and the lack of future business stability were singled out as being most contributory to risk in defense business.

One of the most significant new policy changes being tested as a result of the investment policy study is the special termination buy-back technique. Under this technique, the economic risks associated with program instability can be reduced. In the event a procurement program is partially or wholly terminated, contractual provisions can provide for the contractor to sell specified capital investments to the government (if he elects to do so) for their unamortized value or some portion thereof. The criteria for employing this technique is very demanding. Its use is authorized only when the investment would not be

made by the contractor except to meet the requirements of the system involved and providing the contracting officer has determined that the government will save money if the contractor makes the specific investment. Currently, the technique is being used on the F-16 and A-10 programs,

Another action we are taking to improve responsiveness and increase competition in the industrial base is through the DoD Manufacturing Technology Program. This program is designed to improve and apply manufacturing techniques, processes, materials and equipment to provide for timely, reliable and economical production of Defense materiel. We view the DoD investment in this program as "seed money", to motivate industry to "pick up the ball" and apply the new technology in the production of Defense systems. Project results substantially reduce industry's implementation risks, and furnish incentives to the private sector to implement the new technology across the entire industry spectrum. In effect, the DoD Manufacturing Technology Program shares the cost and the risk of proliferating new technology throughout industry and expanding our competitive base.

I will now address the Aircraft Capacity Study and the actions we are taking to implement the study's policy alternatives for reducing extra capacity. The study shows that the industry is operating at about 40% of its capacity. This figure is derived by basing current industry performance on an efficient 1.4 shift 40 hour work week. (From a nominal one shift activity standpoint the industry is operating at 55% capacity.) Government and industry analyses and market projections on which the study was based indicated that extra capacity would increase in the near term, then improve by the 1980's primarily due to an upturn in commercial transport demand.

Estimates of the cost to the Defense Department of the extra capacity condition range between $300 and $500 million per year. For the most part, this cost consists of indirect labor, i.e., engineering, marketing and administrative personnel, retained in anticipation of and to enhance obtaining additional business. Twenty-five percent or less of the extra capacity costs is associated with underutilized plant and equipment.

The study further estimated that the realistic potential for savings resulting from reducing extra capacity was about $250 million per year while still retaining desired competition in each industry sector; i.e., two or three firms remaining viable to produce each type of aircraft.

The study identified 8 policy alternatives as those most feasible for reducing extra capacity. These varied in complexity from ones involving government action of a programmatic nature to those which would tend to evolve a different structural composition of the industry and a revised industry-government relationship. We have implemented several programmatic approaches, such as endeavoring to buy aircraft at more efficient production rates with buy-outs or termination of low rate production lines, phasing development and production procurements where militarily feasible to level industry activity, and favoring facilitization and sub-contractor arrangements which would make better use of existing resources. However, these approaches are not solely DoD prerogatives. For example, the Congress has not always agreed with the Defense Department on which production lines should be closed or what procurement rates, and even quantities, are needed.

In addition, we have directed the military departments to pay close attention during contract audits to idle facility and idle capacity costs as defined by the ASPR 15-205.12. Idle facility costs, with some exception, are not allowed nor are those resulting from chronic idle capacity.

A proposed revision to the ASPR has been developed which, when approved, will result in closer monitoring and contel of contractor indirect costs. Formal procedures will be followed and a government cost monitoring coordinator designated at locations where government procurement is expected to exceed $50 million.

We have constructed a generic checklist of potential capacity issues to be addressed in preparing for the Defense Systems Acquisition Review Council (DSARC) meetings at production milestone decision points. These milestone issues consist of pointed questions regarding program facilitization, use of government properties, industrial base requirements and procurement planning aimed at establishing the most economical program.

We have tabled the implementation of the more complex policy alternatives for a number of reasons. First, the study data are basically a year old and there are