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entitled: 'Preliminary Observations on DOD Estimates of Contract 
Termination Liability' which was released on November 12, 2013. 

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GAO-14-107R: 

GAO:
United States Government Accountability Office: 
441 G St. N.W. 
Washington, DC 20548: 

November 12, 2013: 

Congressional Committees: 

Preliminary Observations on DOD Estimates of Contract Termination 
Liability: 

This report responds to Section 812 of the National Defense 
Authorization Act (NDAA) for Fiscal Year 2013, which mandates that we 
report to the congressional defense committees on the extent to which 
the Department of Defense (DOD) is considering potential termination 
liability as a factor in entering into and terminating covered 
contracts.[Footnote 1] Section 812 also mandates that DOD assess its 
relevant acquisition guidance and take appropriate actions to ensure 
that program managers for major defense acquisition programs (MDAP) 
are preparing estimates of potential termination liability for covered 
contracts.[Footnote 2] This is the first of two reports we plan to 
issue in this area for these committees. The second report, in 
response to a mandate in the Senate Report, 112-173, on the NDAA for 
Fiscal Year 2013, addresses program cancellations and will be issued 
in early 2014. To meet our requirement under Section 812, this report 
(1) describes the results of DOD's assessment, and (2) presents 
preliminary observations on termination liability estimates. 

To conduct this work, we reviewed DOD's assessment, in which DOD 
reviewed relevant acquisition guidance and collected information on a 
sample of six MDAPs. We also interviewed DOD officials responsible for 
conducting the assessment. In addition, we leveraged our ongoing work 
looking at program cancellations to further assess DOD efforts to 
consider potential termination liability. We interviewed DOD 
officials, obtained documentation on guidance and directives, and 
analyzed termination cost data for selected MDAP contracts terminated 
from 2004 through 2011. We are also collecting information on whether 
selected DOD programs have been requiring contract termination 
liability estimates before award and during the course of a contract. 
As part of our annual weapons assessment, we selected a non-
generalizable sample of weapons programs that represent Air Force, 
Army and Navy, that cover a range of platforms including aircraft, 
ships and satellites, and that represent programs in both development 
and production phases. We requested answers to a standard set of 
questions to determine how DOD officials consider termination 
liability costs prior to contract award and before contract 
termination, and to identify guidance used in making those decisions. 
We will report on these and other findings in our early 2014 report on 
program cancellations. 

We conducted this performance audit from July 2013 to November 2013 in 
accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives. 

Results in Brief: 

According to DOD, weapons programs generally receive estimates of 
termination liability from contractors, though there is no 
comprehensive guidance on how or when programs should require or 
consider termination liability estimates. DOD plans to include 
additional language to help ensure that program managers are aware of 
the need to consider termination liability before contract award and 
during the life of a contract in its next update of its acquisition 
management guidance.[Footnote 3] However, our preliminary observations 
show that while programs are receiving estimates of termination 
liability from the contractors, in some cases, DOD's ability to 
predict actual termination costs with these estimates appears limited. 
We will continue to monitor this issue and will report our final 
results in early 2014. 

Background: 

DOD may enter into one or more contracts with a prime contractor for 
the development, production, or maintenance phases of a major defense 
acquisition program. In some cases, during the period of performance 
of a contract, changed circumstances can require termination of the 
contract before it is completed. The Federal Acquisition Regulation 
(FAR) grants the government the right to fully terminate or partially 
terminate a contract for the government's convenience at any time 
during the performance of a contract and provides various termination 
for convenience clauses depending on the type and dollar amount of the 
contract.[Footnote 4] Terminating a contract for the convenience of 
the government is allowed because in some cases, termination of a 
contract is in the government's best interest. Even if the contractor 
is performing acceptably, the government can end its contractual 
obligation if it no longer needs the weapons or supplies provided 
under the contract because of a reduction in military force or the end 
of a war. However, the government is generally obligated, within 
certain limitations, to compensate the contractor for certain costs. 
Examples include the costs of disposing of inventory and negotiating 
with subcontractors. The FAR specifies these limitations and the 
categories of costs to which a contractor may be entitled when the 
government terminates a contract for convenience.[Footnote 5] To 
assist the government in budgeting for the potential incurrence of 
termination liability costs and in determining if the rate of funding 
for a contract is sufficient, DOD cost-type contracts may contain a 
requirement for the contractor to provide funding data, including 
potential termination liability estimates, by submitting Contract 
Funds Status Reports (CFSR) (DD Form 1586) at the end of each calendar 
quarter or contractor accounting period nearest the end of each 
quarter during the contract period of performance.[Footnote 6] 

DOD Found Termination Liability Estimates Are Being Considered but 
That Additional Guidance Is Needed: 

DOD provided us with its assessment of efforts to prepare estimates of 
potential termination liability for covered contracts. DOD reported 
program managers are preparing estimates of termination liability, 
though we found it was unclear whether program managers were 
developing their own estimates or using CFSR estimates. DOD determined 
based on its review that potential termination liability is a factor 
in decision making when terminating covered contracts and at certain 
points during the life cycle of a program. For example, DOD reported 
that all six MDAPs DOD reviewed considered potential termination 
liability estimates during the life of the contract. One of the six 
program offices reported that the office considered termination 
liability estimates before awarding the contract. According to DOD's 
assessment, in several instances program contracts required a CFSR 
from the contractor. Additionally, the DOD assessment found that cost 
estimators within DOD's Cost Assessment and Program Evaluation (CAPE) 
organization consider termination liability estimates when they 
conduct independent cost estimates.[Footnote 7] We were told by a CAPE 
official that potential termination liability is not the major focus 
of the independent cost estimates. According to DOD officials, CAPE's 
review is to determine cost risks associated with technology and 
schedule and their impact on a program's budget, and occurs only at a 
program's milestone decision points before a program can proceed to 
the next acquisition phase. CAPE might not review costs in the interim 
between these phases, which can last several years, and would not 
necessarily be aware of changes in cost estimates until the next 
milestone decision point. 

DOD found there is no comprehensive guidance on how or when programs 
should consider termination liability. Limited guidance is currently 
available in the Financial Management Regulation, Volume 2 and on the 
CFSR form.[Footnote 8] According to DOD officials, when they talked 
with program officials in their sample, none of the program officials 
expressed the need for additional guidance because they felt adequate 
training on contract termination is offered through the Defense 
Acquisition University. However, DOD officials told us they are 
drafting new guidance for the DOD 5000.02 instruction to help ensure 
program managers are aware of the need to consider termination 
liability before contract award and during the execution of a 
contract. A DOD official stated that the revised instruction would 
likely not be adopted before the start of 2014. DOD determined that no 
additional actions are needed to address the mandate. 

DOD's Ability to Predict Actual Termination Costs with Available 
Estimates Appears Limited: 

Through our ongoing work looking at termination liability and program 
cancellations, we found weapons programs generally received estimates 
of termination costs from contractors in the CFSR. However, this 
information did not necessarily enable DOD to predict the actual cost 
of terminating a contract. The cost data included in these reports are 
developed by contractors and are rough estimates of costs that would 
be necessary to liquidate all government obligations if the contract 
were terminated. These reports are provided to DOD on a quarterly 
basis. Because they are estimates and the various factors affecting 
termination liability change through the life of contract, they can 
fluctuate over time. Our past work found that DOD officials questioned 
the reliability of these estimates because they were provided by the 
contractors and were not given high priority for verification by the 
government.[Footnote 9] Some program officials we spoke with during 
our ongoing work were uncertain of how contractors arrived at these 
estimates, and were not aware of any additional information provided 
by contractors to support these estimates. Further, during our ongoing 
work we have learned that contractors may increase these estimates if 
termination of the contract seems probable. However, according to DOD 
officials, estimates of the termination costs can be useful for 
planning and budgeting decisions surrounding contract terminations. We 
will continue to monitor this issue and report our final results in 
our forthcoming report on program cancellations. In addition, our 
forthcoming report will include our findings from the questions we 
submitted to selected DOD programs about whether officials have been 
considering contract termination liability estimates before award and 
during the course of a contract. 

Agency Comments: 

We requested comments on a draft of this report from the Department of 
Defense, but none were provided. 

We are sending copies of this report to the appropriate congressional 
committees. We are also sending a copy to the Secretary of Defense. 
This report will also be available at no charge on our website at 
[hyperlink, http://www.gao.gov]. Should you or your staff have 
questions, please contact me at (202) 512-4841 or chaplainc@gao.gov. 

Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this report. Key contributors 
to this report were Katherine Trimble, Assistant Director; Ann Marie 
Udale, Peter Anderson, Maria Durant, Kristine Hassinger, Raffaele 
Roffo, and Matt Shaffer. 

Signed by: 

Cristina Chaplain: 
Director, Acquisition and Sourcing Management: 

List of Committees: 

The Honorable Carl Levin: 
Chairman: 
The Honorable James Inhofe: 
Ranking Member: 
Committee on Armed Services: 
United States Senate: 

The Honorable Dick Durbin: 
Chairman: 
The Honorable Thad Cochran: 
Ranking Member: 
Subcommittee on Defense: 
Committee on Appropriations: 
United States Senate: 

The Honorable Howard McKeon: 
Chairman: 
The Honorable Adam Smith: 
Ranking Member: 
Committee on Armed Services: 
House of Representatives: 

The Honorable Chairman: 
The Honorable Pete Visclosky: 
Ranking Member: 
Subcommittee on Defense: 
Committee on Appropriations: 
House of Representatives: 

[End of section] 

Footnotes: 

[1] Pub. L. No. 112-239 (2013). The NDAA does not define "termination 
liability", nor did DOD when conducting its assessment. For 
consistency with the Contract Funds Status Reports used by DOD, in 
this report we use the term "termination liability" to include costs 
incurred because of termination, as well as profit or fee owed. We do 
not include cost incurred for the work performed. 

[2] The Act defines a covered contract as a contract for the 
development or production of a major defense acquisition program for 
which potential termination liability could reasonably be expected to 
exceed $100,000,000. 

[3] Department of Defense Instruction 5000.02, Operation of the 
Defense Acquisition System (Dec. 8, 2008). 

[4] See, e.g., FAR §§ 52.249-2 and 52.249-6. 

[5] Under a fixed-price contract, the contractor is entitled to 
compensation for the work done, the preparations made for the 
terminated portions of the contract, profit on work done and 
preparations made by the contractor for the terminated portion of the 
contract, and the costs of settlement of the work terminated. FAR §§ 
49.201(a), 49.202(a), 52.249-2(f)-(g). Under a fixed-price contract, 
the government's liability is limited to the contract price plus the 
amount of settlement expenses. FAR §§ 49.207, 52.249-2(f). Under a 
cost-reimbursable contract, the contractor is entitled to compensation 
for the costs reimbursable under the contract for performance of the 
contract before the effective date of the termination, the costs of 
settlement of the work terminated, and a portion of the fee payable 
under the contract. FAR §§ 31.205-42, 49.305-1(a), 52.249-6(h). 

[6] The CFSRs supply funding data about defense contracts to program 
managers for: (a) updating and forecasting contract funds 
requirements, (b) planning and decision making on funding changes in 
contracts, (c) developing funds requirements and budget estimates in 
support of approved programs, (d) determining funds in excess of 
contract needs and available for deobligation, and (e) obtaining rough 
estimates of termination costs. 

[7] An independent cost estimate is conducted independently of the 
program office or defense agency. It is a full life-cycle cost 
estimate including all costs of development, procurement, military 
construction, and operations and support for a system. An independent 
cost estimate is required to be approved before a major defense 
acquisition program can enter the development phase or production 
phase of the acquisition lifecycle. 10 U.S.C. § 2434; Department of 
Defense Instruction 5000.02, Operation of the Defense Acquisition 
System Encl. 4, Table 2-1 (Dec. 8, 2008). 

[8] Volume 2 of DOD's Financial Management Regulation requires that 
programs with certain types of contracts submit termination liability 
estimates with their budget estimates. 

[9] GAO, Defense Contracting: Terminating Major Weapons Contracts for 
the Government's Convenience, [hyperlink, 
http://www.gao.gov/products/NSIAD-91-255] (Washington, D.C.: Aug.30, 
1991). 

[End of section] 

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