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The case for the $435 hammer.

the CASE FOR THE $435 HAMMER

"You want how much for abeer?!' asks the patron of a bar in the cartoon strip "Motley's Crew.'

"Four bucks,' the bartender replies.

Says the patron: "That must be the same outfitthat sells hammers to the Pentagon.'

Claw hammers, to be exact. The kind you buyat your local hardware store for between $7 and $10; billed to the Pentagon for $435 a piece. In the three years since the story broke, the $435 hammer has become synonymous with waste in the Department of Defense (DOD). From Beetle Bailey to Walter Mondale, everyone has expressed outrage at this apparent swindle. The hammer contract has been investigated by Congress, discussed during the 1984 presidential debates, and used as Exhibit A by politicians, journalists, and businessmen in their recent calls for military reform.

But here's the rub: the DOD didn't pay $435for a hammer. It's a good bet we paid too much for it (for reasons related in part to something called the equal allocation method and in part to larger problems in defense procurement). But the Pentagon didn't pay nearly $428 too much.

Hints of a rip-off

In 1981 the Navy decided to offer a sole-sourcecontract to the electronics company that manufactured the flight instrument trainer for the T-34C aircraft. That made the Simulation Systems Division of Gould, Inc., the lone provider of a comprehensive list of more than 400 different parts needed to keep trainers in the field in good repair. In June 1982, the Naval Training Equipment Center (NTEC) at Orlando, Florida, issued the contract. Of the items ordered, some were peculiar to the trainer and would have to be manufactured by Gould; others, known as "buy-and-sell items,' could be bought at an ordinary hardware store. Since the Gould plant is located on Long Island, the job of reviewing and negotiating Gould's proposal fell to the Defense Contract Administration Services Management Area (DCASMA) in Garden City, New York.

An outpost of the Defense Logistics Agency,DCASMA Garden City does a variety of tasks for the buying offices of the military. A man whom I shall call Dave Johnson, an administrative contracting officer there, was put in charge of the proposal. In November, his negotiating team brought Gould's price down from $896,011 to $847,000. This came close to the recommended price resulting from reports by an engineer, a price analyst, and a Defense Contract Audit Agency (DCAA) auditor. Johnson submitted his memo of negotiation and a contractual amendment to the Garden City Board of Review, whose five members saw nothing wrong with it. Then, after Gould had signed the amendment, he too signed it, making it legal and binding. The price it showed for the claw hammer was $435.

Why did no one protest? Because the equalallocation formula makes line item prices meaningless. Under this system the line item price does not reflect the item's true value. The equal allocation method calculates prices for large numbers of items in a contract by assigning "support' costs such as indirect labor and overhead equally to each item. Take a contract to provide spare parts for a set of radar tracking monitors. Suppose a monitor has 100 parts and support costs amount to a total of $100,000. Using the equal allocation method each part is assigned $1,000 in such costs, even though one item may be a sophisticated circuit card assembly, which requires the attention of high-salaried engineers and managers, and another item may be a plastic knob. Add $1,000 to the direct cost of the part and you get a billing price. This is what the government is billed, though not what the part is really worth--the circuit card being undervalued, the knob being overvalued. The need for billing prices arises because contractors want to be paid up front for items that are shipped earlier than others.

The problem with the equal allocation methodis that it's easier for contractors to overstate support costs when negotiating one price for all of these costs in a contract instead of haggling over them for each individual line item. And if the Pentagon doesn't know the real price it is paying for each spare part, it is also difficult for it to determine whether it is spending too much in support costs.

Few people are familiar with the price distortionscreated by this method. When the chief petty officer in the repair department of a naval air station in Florida saw the unit-price list for the T-34C trainer in 1983, he started asking how anyone in his right mind could have paid $435 for a common hammer. His inquiries led to press stories and investigations by a number of agencies including the Navy Audit Service which, on May 27, reported that the Gould contract contained "excess costs of about $729,000.'

These investigations led the Pentagon to announceon July 27 that Gould had overcharged the Navy "hundreds of thousands of dollars' for the hammer and other items under the same contract. Secretary of the Navy John Lehman sent a letter to Gould demanding repayment, and Secretary of Defense Caspar Weinberger gave notice that the DOD had to make "major changes' in its procurement of spare parts.

This would be a heartening example of the kindof internally generated reform the DOD so rarely makes except that the Pentagon was wrong. To begin with, the Navy Audit Service based its findings on Gould's original $1-million price list instead of the $846,000 list negotiated by Dave Johnson. The auditors calculated the "reasonable cost' of the parts to be $271,000 and subtracted it from $1 million to arrive at the $729,000 in excess costs. Even if they had subtracted the "reasonable cost' from the correct negotiated price, however, the audit would still have been wrong. The auditors figured the $271,000 by taking 114 buy-and-sell items--about 25 percent of the line items--and comparing Gould's prices with those of the DOD's own supply system. They found the difference in price to be about 369 percent. So, they calculated that every item in the contract, big or small, complicated or simple, was also overpriced by 369 percent. This approach was so wrong-headed you don't even have to understand the equal allocation method to know the results were off. No $729,000 refund should be made against an $847,000 contract when the contractor, as a DCAA audit shows, had bought almost $300,000 in materials alone.

Even though the Pentagon had flubbed theaudit, in August Gould agreed to make a good faith refund of $84,000. Gould Chairman William Ylvisaker knew the audit was flawed, but he wanted to placate Gould's most important customer and put a stop to the bad publicity which was causing a sharp decline in Gould's stock price. This proved to be a mistake. It confirmed the general suspicion of a rip-off, and it seemed to discourage analyses of the root causes of the hammer pricing by reporters. Shortly after Ylvisaker announced he would pay the $84,000, Newsday ran an article accompanied by a sidebar entitled "Would You Pay $435 for This?' next to a large photo of a claw hammer. In the sidebar, aerospace writer Tom Incantalupo gave a detailed explanation of the equal allocation method. Four days later The New York Times ran a similar article by James Barron in which he dvoted five paragraphs to the Gould hammer, and dutifully discussed the DOD's pricing system. But both pieces ended with suggestions that--the complexities of buying spare parts notwithstanding-- someone had ripped off the government.

Blackboard jumble

Reacting to the publicity, Congress quicklycompounded the Navy auditors' mistake. Leading the way was Iowa Rep. Berkley Bedell. During the first few months of 1984, Bedell called Johnson a number of times to discuss the hammer contract. He also visited the naval air station in Florida where the hammers were being used, and talked with both Navy and Gould officials. Bedell's staff director was dispatched to Garden City to study what went wrong. In spite of being named Small Businessman of the Year in 1964, Bedell had a problem fathoming the equal allocation method. In one long conversation, Johnson explained it in detail. Bedell said that he heard him, but had a mental block on the subject nonetheless.

Regardless of the block, Bedell spent the firstpart of 1984 working very hard at introducing spare parts amendments and educating his colleagues as to the outrageousness of parts overcharges, the Gould contract being his main example. His efforts won him praise from the press, including a June 13, New York Times article entitled "The Provocative Saga of the $400 Hammer.' An accompanying photo depicted him with a claw hammer in his right hand. The article by Steven V. Roberts recounted the tale of Bedell's introduction to the hammer contract ("I almost fell out of my chair') and his purchase for $92.44 of 21 tools billed in the contract for $10,168.56. The article began and ended with observations to the effect that, thanks to the hammer, people were finally starting to pay attention to the softspoken ten-year congressional veteran and former president of the Spirit Lake Kiwanis Club.

Other members of Congress applaudedBedell's efforts. Rep. Barbara Boxer of California, for instance, praised Bedell for having "taken the lead in this whole issue of spare-parts ripoffs.' There was only one problem: Bedell didn't understand the hammer contract.

The government simply didn't pay $10,000 for$92 worth of tools. It was billed that amount, but that was merely a bookkeeping procedure to create billing prices so that Gould could be paid as it shipped line items at different times during the contract. This didn't stop Bedell. The hammer was his ticket out of obscurity. He had the Navy Audit Service findings, and he had the smoking gun--Gould's $84,000 repayment. For almost as year after he first learned of the Navy's audit Bedell--in congressional debates, in speeches, and in the press--reiterated its findings. On May 2, 1985 The New York Times ran a frontpage story reporting Bedell's accusations that the $84,000 obtained from Gould "was only 11 percent of the refund the Navy auditors recommended.'

Bedell's persistence paid off, though not as hehad hoped. The Times article prompted the Navy to call together everyone involved with the Gould contract. At a meeting on May 17 at Cameron Station, Virginia, a representative of the Office of Naval Acquisition Support revealed that they had retracted the Navy Audit Service finding of a $729,000 overcharge. (No explanation was given for the reversal, perhaps acknowledging that the less said about this blunder the better.) Even the issue of fraud disappeared. An agent from the Defense Criminal Investigative Service, who grasped the equal allocation method better than FBI and GAO auditors had done in an earlier investigation, used a blackboard to persuade an official in the U.S. Attorney's office in New York that no charges should be filed against Gould for billing the government $435 for a hammer.

All that remains is to settle a DCAA auditprompted by DOD officials hoping to find justification for getting more than $84,000 back from Gould. This audit focused on whether Gould had been guilty of defective pricing--i.e., if it had violated the Truth in Negotiating Act by withholding information that would have reduced the overall contract price. The finding: Gould overcharged the government not $729,000 or $84,000, but $92,310.

Most likely this dispute will be settled for muchless than $92,310 or it will end up before the Armed Services Board of Contract Appeals. Either way, it has nothing to do with the price of the hammer. In fact, nobody with ever know what the hammer really cost, since Gould's accounting system is not set up to track individual line items. Certainly, though, it did not cost anywhere near $435. And just as certainly, the government will have spent well over $84,000 on investigating and explaining the hammer contract by the time it is finally put to bed.

The outrage over the $435 hammer could haveresulted in some procurement reforms, but that hardly happened. In 1984 the Pentagon did abolish the equal allocation method. But while the $435 hammer resulted from this method, other spare parts scandals were caused by more fundamental procurement problems. The toilet seats, ashtrays, and $7,600 coffee pots resulted from gold-plated specifications and the use of costly middlemen. The Pentagon did launch a potentially valuable drive to eliminate these middlemen from the spare parts business. In general, however, the response has been what John Kester, former special assistant to the secretary of defense, describes as Washington's prescription for all procurement ills--"more laws, more rules, more people checking on the checkers.'

DCASMA Garden City, for example, issued inApril 1985 an impressive "Procedure for Evaluation of Spare Parts' consisting of nine single-spaced pages plus a checklist and a chart. Its main innovation was to place at the center of an already cumbersome process a GS-11--a retired oil company executive with no DOD experience--to monitor all spare parts contracts.

More important, many of the major flaws inthe DOD procurement process remain untouched. For example, if the Pentagon did pay too much for the hammer, a key reason is that it gave Gould a sole source contract. In addition, there is still not enough emphasis on buying in bulk to reduce unit costs. The Navy Ships Parts Control Center (NSPCC), to select one buying office, issues orders for a large variety of spare parts with seemingly little regard for the advantages of quantity. An order for 56 circuit card assemblies will be followed six months later-- too late to be added to the first production run-- by an order for one or two or three of the same item at a relatively astronomical unit price.

This type of institutionalized failure in spareparts procurement, which illustrates David Packard's recent complaint that "there's been no effective long-range planning in the system,' simply does not elicit the interest and outrage that high-priced hammers or toilet seats or coffee pots do. Perhaps this is the greatest pity of the hammer controversy: it has given Congress and the press a nice warm feeling of indignation while distracting them--and the public--from deeper, more complex, less "newsworthy' sources of defense waste. The Pentagon continues to offer sole source contracts, refuses to punish corrupt or inefficient defense contractors, and allows disruptive inter-service rivalry to hinder military planning. [See Gregg Easterbrook's "Sack Weinberger, Bankrupt General Dynamics, and Other Procurement Reforms' on p. 33] We've all taken our cues from "Motley's Crew.' As one official at DCASMA Garden City wrote in a memo that reprinted two comic strips dealing with the

hammer: "When a subject makes the comic pages, it has become a serious matter indeed.'
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Title Annotation:investigation of Pentagon's procurement
Author:Fairhall, James
Publication:Washington Monthly
Date:Jan 1, 1987
Words:2472
Previous Article:Sack Weinberger, bankrupt General Dynamics, and other procurement reforms.
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