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As requested by Senator Lawton Chiles, ranking minority member of the Committee on the Budget, United States Senate, this study examines multiyear procurement contracts already approved by the Congress and alternative strategies that could lead to greater savings through increased use of multiyear procurement. In accordance with the Congressional Budget Office (CBO) mandate to provide objective analysis, this paper contains no recommendations.

Wayne Glass of the National Security Division, Congressional Budget Office, prepared the study under the general supervision of Robert F. Hale and John D. Mayer, Jr. Neil Singer provided valuable assistance. Francis Pierce edited the manuscript.
 

Rudolph G. Penner
Director
July 1986
 
 

In 1982, the Congress enacted legislation that authorized the Department of Defense (DoD) to purchase major weapon systems and their components using a special type of multiyear contracting involving economic order quantities (EOQ). Under this concept the Department of Defense can enter into a contract committing it to purchase weapons over several years; moreover, the government provides money early in the contract to allow the supplier to purchase components--for example, landing gear for aircraft--in large, economical quantities in order to reduce overall program costs. Further, the government agrees to reimburse the contractor for certain costs if the contract is cancelled. In return for assuming this risk, the government expects savings of at least 10 percent over what it would have spent if it had negotiated a series of annual contracts for the same number of items. In 1987, DoD projects that 6.4 percent of its total obligational authority (TOA) for procurement will be under those multiyear contracts.

Greater use of multiyear contracting has been urged during the past several years by some outside of the Congress. Specifically, the President's Private Sector Survey on Cost Control (the Grace Commission) and the President's Commission on Defense Management (the Packard Commission) have recommended increased use of multiyear procurement. This study examines the advantages and disadvantages of multiyear procurement to date, and evaluates approaches for increasing its use.
 

ADVANTAGES AND DISADVANTAGES OF MULTIYEAR PROCUREMENT

The available data indicate that multiyear procurement is achieving its basic objectives. Multiyear contracts appear to have saved money. During fiscal years 1982-1986, the Department of Defense requested Congressional approval to enter into 59 multiyear contracts. Of these, the Congress judged that 40 met the strict criteria for multiyear funding. DoD projects $6.2 billion savings in TOA for these 40 contracts, relative to costs using annual procurement. Using a 10 percent real discount rate, DoD estimates $1.4 billion in present value savings from the 23 multiyear programs approved during fiscal years 1984-1986. (Data on present value savings have only been provided since 1984. Had a real discount rate in the range of 0 to 4 percent been used, present value savings would have been greater.) These savings occur largely because materials and components can be purchased more efficiently using economic order quantities early in the contract period, but savings may also stem from the reduced risk that a multiyear contract affords the contractor.

Savings cannot be estimated with certainty, however, since DoD never buys the same system under both annual and multiyear contracts. Moreover, none of the approved multiyear contracts has been completed through final delivery of all contracted weapons. Nonetheless, when the General Accounting Office (GAO) conducted audits of selected multiyear programs such as the Multiple Launch Rocket System (MLRS), the UH-60 helicopter, and the F-16 aircraft, it found that savings from purchasing materials and components in economic order quantities were approximately equal to those projected by the Department of Defense.

Multiyear programs also appear to entail fewer changes in numbers of weapons bought, both on an annual basis and over the life of the contract. This greater stability may minimize increases in weapons costs. As with savings, increased stability is difficult to assess, but multiyear programs have been stable according to several indicators. Of the 40 approved multiyear contracts, 39 were actually awarded and only two of these have had purchases over the life of a contract that differed from the planned contract amount. On an annual basis, the rate of quantity adjustments by the Department of Defense and the Congress for multiyear programs has been lower than for other procurement programs. During fiscal years 1982-1986, for example, quantities approved in the budget for multiyear programs were adjusted from planned levels 36 percent of the time as compared with 68 percent of the time for non-multiyear procurement programs.

The benefits of multiyear procurement have not, however, been achieved without disadvantages. Because the Department of Defense assumes the risk for purchasing material and components in economic order quantities at the beginning of a multiyear contract, more money must be appropriated in the first year of the contract than if the same program was executed using a series of annual contracts. Multiyear contracts also limit the government's flexibility to reduce the defense budget because the costs of cancelling a multiyear contract before it is fully executed can be high. In a period of sharp budget reductions, this means that programs with annual contracts might bear disproportionately large cuts. Indeed, the House Committee on Armed Services has thus far approved only two of the seven multiyear contracts proposed by DoD in 1987, citing the constrained budget environment for the next several years as its reason. The Senate Armed Services Committee, however, approved five multiyear contracts in 1987, citing potential savings as justification.

Multiyear procurement also prohibits one form of competition--annual competition between two or more contractors--that is another approach to achieving procurement savings. Analysis of savings attributable directly to annual competition has shown mixed results, however. A study by the Rand Corporation in 1983 concluded that in seven cases where two contractors competed annually, and where costs or savings could be estimated, four actually showed increased costs because of competition; costs to establish and qualify a second contractor and other added costs more than offset competitive savings. Moreover, multiyear procurement does not prohibit many types of competition. The government can award multiyear contracts to more than one contractor, or it can keep more than one contractor in the bidding until the multiyear award and then select one. Indeed, the Rand study suggests that competitive savings from such a winner-take-all competition are more frequent than from annual competition.
 

OPPORTUNITIES FOR GREATER USE OF MULTIYEAR PROCUREMENT

This study indicates that multiyear contracting for major weapon systems could be expanded beyond the level currently planned. In fiscal years 1982 to 1986, the use of multiyear by DoD increased gradually from 3.2 percent of its procurement total obligational authority to 11.9 percent. The level of multiyear has begun to decrease during 1986, however, and will fall to 6.4 percent during 1987 even if the Congress approves all the Administration's 1987 multiyear candidates. Thus, maintaining recent levels would result in more multiyear procurement than is now planned.

Differences among categories of procurement funds also suggest a potential for greater use. The Navy has used multiyear procurement less than the other services, seldom in ship construction and proportionately less than the other services for aircraft and missile procurement. The use of multiyear is also low in all the services' "Other Procurement" accounts, which buy smaller weapons and parts. Moreover, it is seldom applied to aircraft and missile modification programs, utility craft, and vehicles. Indeed, applying multiyear procurement to the purchase of smaller weapons may be one of the more promising ways to expand its use.
 

APPROACHES THAT WOULD INCREASE THE USE OF MULTIYEAR CONTRACTING

Of course, the Congress may wish to continue its current policy, reviewing only the candidates for multiyear procurement proposed by DoD. That would leave to DoD the choice of whether to expand the use of multiyear procurement. If, however, the Congress wishes to increase incentives for multiyear procurement without becoming involved in a case-by-case review of candidate weapon systems, it could adopt one of two approaches.

Approach I. New Production Programs

The first approach reflects the Packard Commission's recommendation that all programs approved for production be authorized for multiyear procurement, with separate contracts for periods of low-rate and high-rate production. To illustrate the effects of this strategy, Approach I assumes multiyear procurement for all new production programs scheduled to begin during fiscal years 1988-1989; this approach also assumes continuation of multiyear programs already approved plus approval of all the Administration's 1987 candidates. Under this approach, multiyear use would increase from 6.4 percent of DoD procurement TOA in 1987 to 10.8 percent in 1988 but would decrease gradually thereafter to approximately 7.9 percent in 1991. Nonetheless, levels for 1988-1989 would be higher than DoD's historical average of 8.2 percent during 1982-1986.

To achieve this level, DoD would have to commit an additional $23 billion in TOA to multiyear procurement during 1988-1989 (see Summary Table). Upfront costs associated with economic order quantities would increase by $900 million in 1988, while estimated savings based on past rates could increase by $2.7 billion during the period of the multiyear contracts. These increases would be relative to levels associated with multiyear contracts already approved plus programs proposed as multiyear candidates by the Administration for 1987. Estimates are based on results from the 40 programs already approved, but should be viewed as rough guides because of major uncertainties in the data.

Although savings might be expected under this approach, there would be some decrease in the flexibility the Department of Defense has to reduce its budget. The reduction in flexibility could grow sharply in the years beyond 1990 if all systems in production were put under multiyear contracts. Furthermore, this alternative might result in premature approval of some programs for multiyear procurement, since certain programs in low-rate production--all of which under this approach would be nominated for multiyear--might still have technical problems to be resolved. This risk, however, would be reduced if approval for multiyear procurement was delayed until the weapons system successfully completed operational tests and was approved for high-rate production. Indeed, one way to implement a version of this approach would be to have the Congress require that all programs approved for high-rate production also be proposed for multiyear procurement unless DoD submitted a report indicating why not.

Approach II. Setting a Goal

Rather than requiring that all new production programs be placed under multiyear procurement, the Congress could establish a goal for multiyear use. The goal could be stated as a percent of total obligational authority (TOA) for procurement. If DoD failed to meet the goal, it would have to report its reasons to the Congress.

For illustrative purposes, this alternative considers goals of either 15 percent or 20 percent in 1991, achieved through steady, incremental increases above the current level. Under this alternative, DoD would have to commit an additional $38.8 billion in TOA (for the 15 percent goal) or $55.1 billion in TOA (for the 20 percent goal) to multiyear procurement during 1988-1991 (see Summary Table). Additional upfront costs in 1988 would vary between $400 million and $900 million, while additional estimated savings over the lives of the contracts would range from $4.5 billion in TOA to $6.4 billion. Again, all estimates are relative to levels associated with approved multiyear contracts plus 1987 candidates.

Approach II would provide management focus on the use of multiyear procurement, while still permitting the use of case-by-case assessment to minimize the risk of inappropriate application. Other multiyear benefits would accrue in proportion to the level of additional use achieved. On the other hand, flexibility to reduce budgets could be more severely diminished than under Approach I during 1988-1989 because levels of multiyear procurement would be higher.

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