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The Costs and Benefits of Retail Activities at Military Bases October 1997

The military exchange system controls sales of general merchandise and consumer services at U.S. bases throughout the world. Although best known for its main retail stores (similar to department stores like Sears or J.C. Penney), its offerings cover the spectrum of consumer goods and services. Department of Defense exchanges run convenience stores, liquor stores, gas stations, garden shops, furniture stores, and home office-supply and computer stores. They also provide consumer services such as barbershops, florists, pay-telephone service, optical shops, tax-preparation services, and pet-grooming salons. In addition, the exchanges are responsible for providing fast-food outlets at DoD bases (including such national franchises as Burger King, McDonald's, Popeye's, and Dunkin' Donuts). At many bases, the exchanges have built small shopping malls to make on-base shopping more attractive to their customers.

The military exchange system generated sales of $9.2 billion in 1995, making DoD the 12th largest general retailer in the United States.⁽¹⁾ About 12 million U.S. citizens are eligible to shop in exchanges. That figure includes everyone eligible to shop in DoD commissaries (active-duty and retired military personnel and their dependents, and DoD civilian personnel and their dependents overseas) as well as exchange employees and members of the Selected Reserve and Individual Ready Reserve and their dependents. Exchanges employ approximately 78,000 nonappropriated-fund workers. Family members of active-duty personnel account for almost half of those workers, making the exchanges an important source of secondary income for military families.

DoD's exchanges, unlike its commissaries, are not part of a single agency. Instead, the department operates three distinct exchange systems. The Marine Corps system, which has 16 main stores and annual sales of about $600 million, is the smallest (see Figure 6). It operates in a relatively decentralized fashion, with the commander of each base controlling that installation's exchange facilities as well as its morale, welfare, and recreation programs. The Navy's exchange system, under the control of the Navy Exchange Command (NEXCOM), is larger and more centralized. In 1995, it had sales of almost $2 billion, distributed among exchange complexes at 122 bases. The Army and Air Force Exchange Service (AAFES), which serves both Army and Air Force bases, is by far the largest of the three. In 1995, it had sales of $6.7 billion and operated 224 main retail stores. Its exchange complexes include more than 10,000 distinct retail and service operations, ranging from Burger Kings to video stores.
 

Figure 6. Distribution of DoD Exchange Sales Worldwide, 1995

SOURCE: Congressional Budget Office based on data from the Department of Defense.

NOTE: Includes sales made by concessionaires.

Despite their separate management structures, the three military exchange systems share several features. They serve the same patron base; people who are eligible to shop at one exchange are eligible to shop at all others. Each system maintains exclusive control over the sale of goods and services to consumers at the bases it supports.⁽²⁾ Private cooperatives or retailers can sell goods and services on-base only with the approval of the exchange. In addition, although exchanges are nonappropriated-fund activities, each exchange system relies on in-kind support that DoD provides using appropriated funds. That support includes maintaining the outside of exchange buildings, transporting goods overseas, and providing free utilities at overseas stores.

The exchange systems also share the same three goals: to provide military personnel with a noncash benefit by selling goods and services at 20 percent less than commercial prices; to generate nonappropriated-fund earnings to support other MWR programs or to invest in the exchange system itself; and to ensure that service members have access to brand-name U.S. goods and familiar services at overseas or isolated bases.

The value of military exchanges depends not only on their ability to generate earnings but also on who shops in them and how much those patrons gain from their exchange privileges. Neither of those factors is easy to quantify.
 

Exchange Patrons in the United States and the Benefits They Receive

Exchanges in the United States sold $6.9 billion of goods and services in 1995, generating 75 percent of total exchange sales. Active-duty personnel and their family members appear to account for only about half of exchange sales in the United States. For example, AAFES estimates the following distribution for its U.S. retail sales: 45 percent to retirees and their family members, 50 percent to active-duty personnel and their family members, and 5 percent to reservists and their family members.⁽³⁾ (The percentage of sales going to AAFES employees and their dependents is very small, although in one location--the retail store for AAFES headquarters--employees account for 89 percent of sales.)⁽⁴⁾

Similarly, a survey commissioned by the Navy in 1989 indicated that about 40 percent of the shoppers in its largest U.S. exchanges were retirees and 5 percent were reservists.⁽⁵⁾ The percentage of sales going to retirees and reservists is likely to be greater than those figures indicate, however, because the survey was conducted before the defense drawdown reduced the number of active-duty personnel in the United States. Moreover, retirees are likely to account for a higher percentage of sales than of shoppers because they shop less often than active-duty personnel (since they must generally travel farther to reach exchanges) and because they tend to have higher income. In the Navy survey, 57 percent of retired customers reported annual income of at least $35,000, compared with only 23 percent of active-duty customers.⁽⁶⁾

Factors That Affect the Mix of Patrons

The proportion of sales made to active, retired, and reserve personnel and their families varies depending on the good or service being offered. On-base services (such as pay telephones, fast food, vending machines, and barbershops) generally attract active-duty patrons.⁽⁷⁾ Apart from any savings that those services offer, convenient access to them makes an important contribution to the lives of people living or working on-base. Retirees and reservists cite inconvenience as a major reason for not using those on-base services, although they may do so when they visit the base to use medical facilities or to shop at the commissary or at the exchange's main store.

Even within the main stores, different departments serve different populations. Unlike private retailers, exchanges perceive a need to be all things to all customers: a discount store that can offer low-cost children's clothing to junior enlisted personnel with dependents; a specialty store that can offer brand-name clothing to single, fashion-conscious service members; a source of household and garden supplies for senior enlisted personnel and officers who own their own homes; and a source of high-quality gift items to meet the needs of retired officers with discretionary income.

When the exchange systems decide what types and quality of merchandise to stock, they also help to determine their mix of patrons. Finding the right balance between discount store and upscale department store is a difficult task and a perennial source of controversy among exchange officials. That task is complicated by the fact that some of the most profitable merchandise (including upscale goods such as Lladro figurines, Coach handbags, and Villeroy and Boch china) is more attractive to retired officers than to active-duty enlisted personnel.

Although some enlisted customers feel that exchanges have the right mix of goods, others agree with the senior enlisted customer who noted, "Many military members, along with myself, do much of their shopping at stores such as Wal-Mart, trying to stretch a limited budget (getting the most 'bang for the buck'). I think modeling the discount store approach rather than being a miniature Sears would better meet the needs and desires of folk in the military."⁽⁸⁾ Only 53 percent of active-duty personnel surveyed by AAFES in 1994 thought the exchanges offered the merchandise they needed, compared with some 64 percent of retired personnel. In addition, 59 percent of active-duty personnel surveyed said that AAFES stores offered the right price range for them, compared with 71 percent of retired personnel.⁽⁹⁾

Patrons' Benefits from Shopping at Exchanges

DoD exchanges offer their customers below-market prices as a form of noncash compensation. For most goods, their policy is to provide savings of 20 percent relative to commercial retail prices in the United States, although some important goods and services--including fast food and gasoline--are usually sold at or near local market prices.

How Much Savings Do Exchanges Offer? The Congressional Budget Office's best estimate is that exchange prices may typically be 5 percent to 10 percent lower than commercial retail prices (including sales tax). That estimate is very uncertain, however. It is based on an informal assessment of the sometimes conflicting evidence provided by price surveys, average markups on goods in the retail industry, the perceptions and shopping patterns of exchange customers, and the concern with which exchange managers view their private-sector competitors.

Price surveys commissioned by the exchange systems find savings that are much greater than CBO's estimate. A 1993 survey comparing NEXCOM and commercial prices for 300 items at nine bases found average savings of 19.1 percent (which equates to 26 percent savings if commercial sales taxes are included).⁽¹⁰⁾ The survey even showed savings compared with discount stores: NEXCOM prices were 6 percent lower than Wal-Mart prices before sales tax.

Likewise, AAFES's 1995 annual retail price survey, which covered 317 items at 17 U.S. locations, found average savings of 20 percent compared with commercial stores (again before sales tax).⁽¹¹⁾ Actual savings varied depending on the type of commercial store: AAFES offered savings of 14 percent relative to discount stores and 25 percent relative to conventional department stores.

Other evidence, however, appears to contradict the results of those price surveys. For example, the results are inconsistent with actual markups in the private retail industry. The typical gross margin (the difference between sales revenue and the cost of goods, expressed as a percentage of sales revenue) for discount stores in the United States is about 25 percent (see Table 6). AAFES's margin for retail goods in the United States is about 20 percent, so it is unclear how it could offer pretax savings of more than 5 percent relative to typical discount stores. In fact, to the extent that large size permits Wal-Mart and other discount retailers to pay less for goods, their prices could be lower than those of the exchange systems.
 

Conventional department stores in the United States have an average gross margin of about 36 percent. Assuming that NEXCOM and AAFES can purchase goods for the same price as commercial department stores, their 20 percent margin might allow them to offer savings (before sales tax) on the order of 16 percent. That is a substantial figure, but it is well below AAFES's own estimate of 25 percent savings. Moreover, many of the goods bought at exchanges (including toiletries, automotive supplies, and compact discs) are not ones that most consumers would seek at a conventional department store.

A second problem with the exchange systems' price surveys is that their results are inconsistent with the perceptions of patrons. In 1994, only 31 percent of active-duty and retired Air Force personnel polled thought that AAFES prices were below those of other stores.⁽¹²⁾ About 43 percent thought they were roughly the same, and 27 percent thought they were higher. In addition, almost half felt that exchanges did not offer as wide a selection of merchandise as commercial stores.

As noted in Chapter 2, the way people shop contributes to the discrepancy between price surveys and customers' perceptions. Surveys that compare the price of an item at an exchange with the average price at a few nearby stores do not account for consumers' ability to compare prices among commercial stores, take advantage of sales, or go to those stores that typically offer the lowest prices (see Box 4 for more details about the weaknesses of price surveys).
 

The attitude of exchange managers in the United States toward private retailers also suggests that although exchanges offer savings on many kinds of merchandise, they do not have an overwhelming price advantage. In the words of three exchange officials:

The MCX's [Marine Corps exchange's] primary challenge is to maintain its share of market in the face of increased competition from category killers. It's becoming an increasingly difficult situation. Recent studies confirm that we have a Wal-Mart, Kmart, Circuit City, J.C. Penney, etc., within a 10-mile radius of all our stateside bases. . . . My experience is that there's a perception that the exchanges might not provide the best assortment or pricing.⁽¹³⁾

The NEX [Navy exchange] is struggling with a price perception. . . . We must drive the point home to our customers that the merchandise in the NEX is priced right against the competition. Base newspaper ads are being designed to shout about how well we are priced and what kind of savings we provide the military shopper.⁽¹⁴⁾

[In the past] you went to the exchange because it was there and you got good value. Now competition is nipping at us, and we have to pay attention to customer service.⁽¹⁵⁾

How Important Is Price? In general, price comparisons are probably less useful as a guide to the value of exchanges than they are of commissaries. Supermarkets typically carry a relatively standard selection of goods, and most customers have a primary store in which they make the majority of their purchases. By contrast, consumers routinely patronize more than one retail store for other types of merchandise, shopping around for value and selection. Exchange mini-malls cannot provide the same shopping experience and variety of goods as large civilian shopping malls with multiple, competing stores; as a result, the exchanges may have to offer below-market prices simply to continue attracting shoppers from off-base.

In evaluating benefits, it is also important to distinguish between the main retail stores that seek to attract off-base customers and those exchange activities--such as fast-food restaurants, dry cleaners, gas stations, barbershops, and convenience stores--that depend heavily on location and convenience for their value. Price comparisons may understate the benefits of those convenience-oriented activities to active-duty patrons who live and work on-base. For example, service members may highly value on-base access to gas stations and brand-name fast food even though such goods are typically priced at market levels.

Actual shopping patterns may best indicate the extent to which military personnel benefit from the selection, price, and convenience offered by exchange stores. Families of active-duty personnel rely on exchanges for about 30 percent of their general retail purchases, according to a 1993 survey by DoD's Defense Manpower Data Center. Those families would not shop at exchanges unless they received some benefit. Nonetheless, differences between the ratio of commissary to exchange sales in the United States and overseas high-light the fact that in this country, exchanges do not offer the same level of benefits as commissaries. Overseas, where all DoD retail activities have a distinct advantage over local stores, exchanges sell $2.60 of goods for each $1 sold by commissaries. In the United States, where exchanges struggle to compete against private retailers, the ratio of exchange to commissary sales is $1.40 to $1.

Moreover, the perceptions of both exchange managers and patrons suggest that a significant increase in prices or decrease in service in the main retail stores might sharply reduce sales. If that is true, it implies that the benefit patrons receive from exchanges (including the benefit of shopping in a uniquely military environment) is relatively modest. If large savings in selected "destination categories" of merchandise are what makes it worthwhile for many patrons to drive to an exchange to shop, those patrons must have alternative sources for many goods that are nearly as attractive as exchanges.
 

Exchange Patrons Overseas and the Benefits They Receive

Overseas exchanges sold $2.3 billion of goods and services in 1995, accounting for one-quarter of total exchange sales. (Those figures include sales made in regular exchange stores, sales by concessionaires, and sales at temporary facilities set up to support deployed troops in places such as Bosnia.) Although both NEXCOM and the Marine Corps operate some facilities overseas, the Army and Air Force Exchange Service accounts for 80 percent of overseas sales.

Like commissaries, overseas exchanges make an especially important contribution to the lives of U.S. military personnel and their families. Outside urban areas, overseas exchanges are sometimes the only reliable source of U.S.-style products, including music, videos, and newspapers. Moreover, overseas exchanges--which operate free from import, value-added, and other business taxes--provide greater savings than U.S. exchanges do.

Differences in the types of goods offered make international price comparisons inexact. Nonetheless, estimates of purchasing-power parity by the Organization for Economic Cooperation and Development indicate that if the prices for clothing, footwear, household goods, and books in exchanges are 5 percent to 10 percent below U.S. commercial prices (as CBO estimates), they are about 15 percent below commercial prices in the United Kingdom and 225 percent below commercial prices in Japan.⁽¹⁶⁾ In the case of heavily taxed goods, savings can be much greater. A gallon of gasoline that sells for $1.30 at commercial gas stations in the Washington, D.C., metropolitan area costs $3.10 at gas stations in Britain, $4.00 in Germany, and $4.40 in Italy.⁽¹⁷⁾

Despite offering large savings, many overseas exchanges have difficulty meeting the diverse needs of service members. Customer surveys indicate that although service members overseas rely more heavily on exchanges, they are less satisfied with the selection of goods and services those stores offer.⁽¹⁸⁾ Overseas, there are no local discount stores to provide a backup source of inexpensive, U.S.-style goods for junior enlisted personnel with families. Catalog sales by U.S. retailers are sometimes the only practical alternative to the exchange. As a result, the decisions that exchanges make about what range and types of merchandise to offer in overseas locations have a significant impact on the ability of enlisted personnel to maintain a standard of living comparable with what they would have in the United States.
 

NAF Earnings: An Additional Benefit of Exchanges

Besides providing savings to patrons, exchanges produce nonappropriated-fund earnings for DoD. Between 1980 and 1995, they generated an average of almost $500 million a year in nonappropriated funds (see Figure 7). Those earnings equal exchange receipts minus the cost of goods, NAF operating expenses, and depreciation. Over two-thirds of the earnings (an average of more than $300 million a year) were distributed as dividends to support MWR programs. The rest were retained by the exchanges for investment. NAF dividends and retained earnings do not appear in DoD's budget and can be spent without Congressional appropriations or authorizations and without creating a federal budgetary outlay.⁽¹⁹⁾
 

Figure 7. DoD Exchange Earnings Worldwide, 1980-1995

SOURCE: Congressional Budget Office based on data from the Department of Defense.

a. Marine Corps earnings for 1980 through 1987 were estimated by CBO based on sales.

The Use of Exchange Earnings to Support MWR Programs

Although DoD's practice of using exchange earnings to support MWR programs is now well established, it was initially questioned by some Members of Congress. In 1949, when growth in the exchange system attracted Congressional attention, a special subcommittee of the House Armed Services Committee examined DoD's justification for exchanges. The subcommittee agreed that exchanges were necessary to provide a convenient source of goods at military bases and to foster community life and morale. However, it disagreed with DoD's use of exchange earnings to support other MWR activities and with DoD's view that below-market prices were needed to make up for inadequate military pay. The subcommittee felt that Congressional appropriations would better meet those goals.

The subcommittee's concerns, however, were apparently outweighed by doubts about Congressional willingness to provide appropriated funds for the recreational programs that depended on exchange earnings. During the 1949 hearings, Congressman Carl Vinson, then Chairman of the House Armed Services Committee, noted that "we have to be realistic about this" and argued, "I doubt very seriously if this committee would be able to convince the Congress that we should buy golf courses and tennis courts and maintain them. . . . The only way [DoD] can swing them is to get some money from some other source."⁽²⁰⁾

Nonetheless, DoD's practice of using exchange earnings for other programs can make it difficult for the federal government to track resources. When the exchanges have a bad year, the decline in exchange dividends reduces the level of federal support for MWR activities even though that reduction is not evident in DoD's budget.

In addition, like all nonappropriated-fund earnings, exchange earnings raise issues of control. Supporters of the current system argue that any profits generated by exchange sales to service members are the "service members' money" and should be available--without the need for an authorization or appropriation--to provide MWR benefits to service members. Other observers argue that NAF earnings are federal resources and should be allocated using the federal budget process.

Like the grocery industry, the retail and service industries in the United States are extremely competitive. As a result, the apparent ability of military exchanges to earn profits while selling goods and services at below-market prices merits close scrutiny. How do they do it? And are the exchange profits that support MWR activities really a savings for taxpayers? A look at both the level and sources of exchange earnings provides insight into those questions.

The Level and Sources of Exchange Earnings

In 1995, the three exchange systems generated approximately $320 million in NAF earnings (see Figure 7). Earnings and sales were less than in previous years in part because of the effects of the defense drawdown. Exchange sales, which rose from modest levels after World War II, peaked during the Vietnam War and again during the late 1980s, only to dip sharply with the end of the Cold War (see Figure 8).
 

Figure 8. DoD Exchange Sales Worldwide, 1948-1995

SOURCE: Congressional Budget Office based on data from the Department of Defense.

NOTE: Does not include sales made by concessionaires.

a. Army and Air Force sales for 1949 through 1955 were derived from reported sales in 1948 and 1956, assuming a linear trend.

b. Marine Corps sales for 1949 through 1966 were derived from reported sales in 1948 and 1967, assuming a linear trend.

Although 1995 was a difficult year for military exchanges, their earnings still averaged 3.5 percent of sales--a performance that at first glance appears comparable with that of private retailers. In 1994, for example, both exchanges and private department stores had an average ratio of earnings to sales of about 4 percent.

Yet comparisons between exchanges and private retailers are misleading. An analysis of exchange earnings in different business areas shows that most earnings are not generated by the main retail stores. Instead, they come from a few business areas that particularly benefit from the exchanges' state and local tax-exemption and monopoly status on military bases. (See Box 5 for more details of how CBO estimated exchange earnings by business area.)
 

The most important source of exchange earnings is the fees that private firms, or concessionaires, pay for the right to operate on military bases. In 1995, concession fees constituted 36 percent of exchange earnings, although sales by concessionaires accounted for only 8 percent of the total value of goods and services sold by exchanges (see Figure 9).⁽²¹⁾ Concessionaires, which are selected by competitive bid, typically pay the exchanges 20 percent of their gross sales revenue. Those payments (net of the cost of any support that the exchanges provide) accrue to exchanges because of their monopoly over on-base sales.
 

Figure 9. Distribution of Exchange Earnings and Sales, by Type of Business, 1995

SOURCE: Congressional Budget Office based on data from the Department of Defense.

NOTE: Earnings estimates are net of allocated overhead.

a. Direct (nonconcession) sales of goods other than alcohol and tobacco.

b. Includes earnings transferred from the Navy Exchange Command's employee pension plan and earnings on funds that the Army and Air Force Exchange Service invested in its credit card program.

The single largest concession is pay-telephone operations, which alone account for 10 percent of total exchange earnings. Other services frequently provided by concessionaires include optical shops, flower shops, beauty shops, and gas stations. Concessionaires also operate fast-food franchises on Navy bases. In addition, exchanges permit some specialty retail shops (including those selling candy and gift items) to operate as concessions, provided that their merchandise does not compete with that offered by the exchange's main retail store.

In contrast, the exchanges' direct (nonconcession) sales of retail goods other than alcohol and tobacco accounted for 73 percent of exchange sales in 1995 but did not generate any earnings. Exchange earnings would have been $280 million larger if the exchanges' main retail stores, rather than losing money, had earnings equal to 4 percent of sales, as private retailers do. Instead, unprofitable main stores appear to be absorbing earnings generated by other business areas.

Why is there such a large difference in earnings between exchanges' concession operations and direct operations? Part of the answer could be differences in the ability of private and public managers to use resources efficiently. But at least some of the difference may arise because monopoly rights over on-base sales are more important for fast food and for consumer services that depend on convenience and location than they are for general retail sales. In the United States, the exchanges' main retail stores face direct competition from off-base general retailers (such as Wal-Mart and Target) and from the large discount specialty stores known as "category killers" (such as Circuit City and Toys R Us). Although the exchanges' general retail activities (direct sales of goods other than tobacco and alcohol) lost money in 1995, their fast-food, services, and vending activities had earnings equal to 8 percent of sales.

Alcohol and tobacco sales, in contrast to general retail activities, generate significant earnings for the exchanges. In 1995, they accounted for 10 percent of total exchange sales but 25 percent of total earnings. Sales of those goods benefit especially from the exchanges' exemption from state and local excise taxes (taxes that significantly raise the price of tobacco and alcohol in commercial stores).

Earnings from financial investments also benefit from the special status of exchanges. Most of those earnings reflect the return on assets held by the exchanges. Some of the financial earnings, however, come from an AAFES in-house credit card program that is financed, in part, with $700 million in borrowed funds. Some of the earnings of that credit card program should be attributed to the low interest rates at which AAFES can borrow--rates that reflect the implicit loan guarantees that the agency's federal status provides.

The basic pattern of profitable and unprofitable activities is the same for each of DoD's three exchange systems. Nonetheless, some differences exist among the systems. Concession income is especially important for the Marine Corps, accounting for half of total exchange earnings. Perhaps because of its small size, the Marine Corps exchange system relies heavily on concessionaires, which may help explain why it achieved a higher overall earnings-to-sales ratio than NEXCOM or AAFES. Tobacco sales, which are not permitted in commissaries on most Navy bases, are particularly important for Navy exchanges, where they account for 15 percent of earnings. (In 1996, DoD raised the price of tobacco sold in commissaries to equal the price in exchanges and assigned the earnings from those sales to the exchanges. As a result, tobacco sales are likely to become more important for AAFES in the future.)

That pattern of profitable and unprofitable activities may not be a new phenomenon. Although retail earnings were depressed in 1995 because the exchanges were still adjusting to the effects of reduced numbers of military personnel, many of the main retail stores did not generate significant earnings even before the force reductions. For example, if concessions (including pay telephones) and alcohol are excluded, AAFES's earnings as a percentage of sales declined gradually from almost 4 percent in 1980 to less than 1 percent in 1995. (The alternate measure, total reported earnings, is misleading because earnings shifted upward in 1987 and 1989 when AAFES took control, respectively, of telephones and liquor stores. Another upward shift in total earnings can be anticipated in 1997 from the transfer of tobacco sales.)

Patterns of exchange earnings must be interpreted cautiously, however. Attributing earnings to specific business activities is not entirely correct. Besides the problem posed by costs that are generated jointly by different business areas, earnings from some business areas may depend on sales in others. For example, the presence of subsidized commissaries nearby may attract shoppers to the stores that military exchanges operate. In addition, concession income may depend in part on sales by the main stores. Although a large part of concession income comes from telephones and (in the Navy) stand-alone fast-food outlets, other concessionaires providing services such as beauty shops and flower shops are frequently located in small malls next to the exchange's main store. Their profits depend in part on the main store's ability to attract customers.

Exchange managers also recognize that sales by main stores depend in part on alcohol and tobacco sales:

Cigarettes are historically an excellent destination department. People are going to drive to the exchange to buy cigarettes because the savings are significant. In order to get there, they'll more than likely drive by either a Kmart, Wal-Mart, Target, or some other mass merchandiser. Significant savings in select departments definitely gives us a leg-up on the competition. . . . Class Six beverages--spirits, wine, beer--are very, very good income producers. To AAFES customers, they represent another destination category, meaning that our price makes it worth driving to the store to make a purchase.⁽²²⁾

Exchange activities vary in their ability to generate NAF earnings for DoD and savings for patrons. Nonetheless, the military exchange system as a whole clearly benefits service members. It also benefits federal taxpayers by reducing the amount of cash compensation that DoD must pay in order to attract and retain a high-quality force. But what is the cost of that benefit?
 

The Cost of Exchanges to DoD and Society

DoD views its exchanges as a source of revenue. From a broader social perspective, however, exchanges depend on subsidies to survive. CBO estimates that exchanges received an economic subsidy, net of reported earnings, of approximately $1.1 billion in 1995 (compared with the $1.7 billion subsidy for commissaries). Exchange activities in the United States accounted for $850 million of that total (see Table 7).
 

That subsidy figure is substantial but not particularly surprising. In the United States, competition forces retail chains that sell general merchandise to use labor and capital relatively efficiently and to set prices just high enough to cover costs (including the required return on capital) in the long run. For a government-run system to sell goods at lower prices, it is likely to require a subsidy at least as large as the savings it offers to customers. If exchanges cannot use resources as efficiently as private firms, that subsidy could be even larger.

CBO's estimate of the economic subsidy takes into account exchanges' reported earnings, costs borne by DoD but not included in the income and expense statements of the three exchange systems, the forgone return on capital that is tied up in the systems, and tax revenue forgone because of their tax-free status. The figures in Table 7 are only rough estimates, and the subsidy will vary from year to year as the level of earnings rises or falls. The basic approach that CBO used to estimate the subsidy is outlined below; additional details and separate estimates of subsidy costs for the AAFES, NEXCOM, and Marine Corps exchange systems are provided in Appendix B.

DoD Costs That Are Not Reflected in NAF Financial Statements

The financial statements issued by the three exchange systems show only nonappropriated-fund income and expenses. They do not include the cost of the support services that DoD provides with appropriated funds. CBO estimates that those costs amounted to about $370 million in 1995, slightly more than the exchanges' reported NAF earnings. Those costs are not readily visible in DoD's budget, however. Unlike commissaries, exchanges do not receive an appropriation earmarked for their use; instead, exchanges rely on the military services to provide in-kind support using their own appropriated funds.

About $210 million of that $370 million in appropriated-fund costs can be traced directly to exchange operations, mostly overseas. In an effort to keep prices at overseas exchanges comparable with those in the United States, DoD policy authorizes the use of appropriated funds to pay for transporting exchange goods overseas (about $150 million in 1995) and to pay the utility costs of overseas stores. Other appropriated-fund costs that can be traced directly to the exchanges include some environmental cleanup costs at exchange gas stations and the salaries of the small number of military personnel assigned to exchanges.

In addition to those relatively direct costs, CBO estimates that individual bases provided exchanges with another $160 million in appropriated-fund support. The military base where an exchange is located typically pays for maintaining the exterior of the buildings that the exchange uses (including maintaining their heating and cooling systems, windows, and roofs). In addition, bases do not charge exchanges for the city services that they provide, such as utility lines, streets, garbage collection, and police and fire protection. At overseas exchanges, where scarce resources must be devoted to controlling black-market operations, the cost of police services can be significant. CBO estimated the costs of those less visible support services based on the square footage of exchange buildings and on the charges that the Defense Commissary Agency (a similar kind of enterprise) pays per square foot for those types of services. Their total cost equals less than 2 percent of exchange sales.

Forgone Return on Capital

The forgone return on capital is another cost of DoD's exchange system. If taxpayers did not have resources tied up in the exchanges' inventories, buildings, and cash balances, those resources could be invested in different enterprises that would earn a positive rate of return. (Box 6 discusses why the forgone return on the exchanges' capital is a cost to taxpayers rather than to service members.)
 

The three exchange systems reported combined NAF assets of $3.3 billion in 1995. That figure includes $1.7 billion in inventories of resale goods, $500 million in internal funds that are loaned to members through AAFES's in-house credit card program, and $1.2 billion in buildings and equipment.⁽²³⁾ Assuming that taxpayers could earn a 15 percent before-tax rate of return on equally risky commercial investments, they would expect a return of about $500 million annually on an investment of $3.3 billion.⁽²⁴⁾ (Approached from a different perspective, before-tax earnings for commercial department stores and specialty stores in 1994 equaled 6 percent of sales.⁽²⁵⁾ Applying that figure to the exchanges' direct sales of approximately $8.4 billion would also imply a before-tax return on capital of $500 million.)

Forgone Monopoly Rents

One of the most valuable assets of exchanges is their monopoly over retail sales at military bases.⁽²⁶⁾ One way to estimate the rents that taxpayers forgo by granting monopoly rights to the exchanges would be to add the concession fees that exchanges collect (about $120 million in 1995, after subtracting overhead costs) to the additional fees they could collect if they did not choose to operate most activities in-house. The CBO estimate shown in Table 7, however, includes only the rent on those monopoly rights that exchanges choose to auction to concessionaires (that is, actual concession fees). The value of the monopoly rights that exchanges choose to exercise themselves is unknown.

Forgone Tax Revenue

Exchanges, like commissaries, are exempt from state and local sales and income taxes. Thus, to the extent that exchange operations reduce the sales and profits of private retailers, they also reduce state and local tax revenue. Although not of direct concern to DoD or the federal budget, forgone tax revenue accounts for almost half of the exchanges' total economic subsidy. Based on U.S. sales data, CBO estimates that exchange activities in the United States resulted in $470 million in forgone state and local sales and excise taxes in 1995. (Exchange activities overseas were not assumed to result in any forgone U.S. state and local tax revenue.)

Forgone sales taxes account for about $370 million of that amount (based on an estimated average combined state and local sales tax rate of 7 percent). Forgone state and local excise taxes on tobacco account for another $50 million. (That estimate is based on exchange sales of tobacco in each state in 1995, the average effective state and local excise tax rate in each state, and a possible decline in sales because of the higher prices that customers would have to pay in commercial stores.) Forgone excise taxes on distilled spirits, wine, and beer may total another $50 million a year. However, for various methodological reasons (outlined in Appendix B), that figure should be viewed as only a rough estimate.

Because the $1.1 billion in forgone taxes, monopoly rents, and return on capital that exchanges cost each year does not appear directly in the DoD or federal budget, exchanges may appear to be a cost-effective form of compensation from DoD's point of view. As a result, the idea of fundamentally changing the current system could be unattractive to the department. Yet exchanges--and U.S. exchanges in particular--may not appear cost-effective when viewed from a perspective that takes into account their full economic cost.

The Economic Cost of U.S. and Overseas Exchanges

A cost comparison between U.S. and overseas exchanges is difficult because they share headquarters' expenses and because their combined operation permits economies of scale. Nonetheless, if joint costs and forgone return on capital are allocated in proportion to sales, the economic subsidy associated with a dollar of exchange sales in the United States appears to be nearly the same as that associated with a dollar of sales overseas (see Table 7).⁽²⁷⁾ Although overseas exchanges receive more appropriated-fund support, U.S. exchanges result in higher forgone taxes. In addition, host nations pay part of the costs of overseas exchanges, absorbing some expenses that might otherwise be paid by U.S. taxpayers.

Higher markups on overseas sales also tend to reduce the subsidy that overseas exchanges require. The average gross margin for AAFES exchanges abroad is 22.2 percent. That is 2.7 percentage points, or 14 percent, higher than AAFES's average U.S. margin. The exchange systems try to maintain uniform prices worldwide, yet managers in the United States--unlike those overseas--must frequently lower their prices to remain competitive. In addition, alcohol, tobacco, and gasoline purchased for sale by exchanges overseas, unlike similar goods purchased for sale in the United States, are exempt from federal excise taxes. That difference allows overseas exchanges to earn a higher markup while charging the same price as exchanges in the United States.

In overseas locations, the exchanges' ability to provide U.S. goods without paying import duties or value-added taxes gives them a large price advantage over their local competitors. As a result, overseas exchanges can attract customers even if they do not maintain the same quality of stores or provide the same selection of merchandise as exchanges in the United States.

Appropriated-fund support, together with their greater price advantage, helps explain why overseas exchanges have historically generated higher NAF earnings relative to sales than U.S. exchanges. Between 1980 and 1991, average earnings as a percentage of sales for AAFES exchanges were 7 percent in the Pacific, 5.5 percent in Europe, and 4 percent in the United States. For NEXCOM, the figures were 5.4 percent for overseas exchanges and 4.4 percent for U.S. exchanges. (Since 1991, however, AAFES has been struggling to adjust to reductions in the number of U.S. troops in Europe, and its NAF earnings there as a percentage of sales have fallen below the U.S. level.)
 

Issues Raised by the Exchange System

Exchanges offer numerous advantages to the U.S. military. Although not as highly valued by their patrons as commissaries, they still have many loyal customers. They provide goods and services at below-market prices and generate revenue that DoD can allocate to recreational programs that would otherwise be unlikely to receive taxpayer support. Overseas, they provide both U.S. goods and employment opportunities to service members and their families. They have also proved to be an effective way to supply basic products--videos, compact disc players, telephone service, and snack foods--to deployed troops.

In the United States, exchanges provide some goods and services (such as convenience stores, pay telephones, barbershops, and fast food) whose value depends on proximity to on-base housing and military workplaces. In addition, they provide large on-base retail stores that attract military personnel and retirees who live off-base. Although the practice of attracting off-base customers may be questioned, it allows exchanges to maintain on-base shopping malls that also benefit the active-duty personnel who live on-base.

Nonetheless, this overview of the exchange system has identified some problems. Many of them arise because of confusion about the nature of exchanges. In DoD's view, exchanges provide benefits to patrons and also operate as revenue-generating businesses. However, CBO's analysis indicates that although exchanges benefit current and former service members, they also generate hidden costs in the form of forgone taxes and forgone return on capital. Those costs are overlooked by the current NAF accounting system, which encourages exchange managers to act like businessmen, trying to increase sales and generate NAF revenue from their operations.

DoD's failure to recognize the total economic costs of exchanges is a problem because some of the activities most likely to generate NAF earnings--sales of tobacco, alcohol, and upscale merchandise--are not necessarily the activities that society would wish to subsidize or that are most closely related to DoD's warfighting mission. Moreover, some of the most profitable customers for the exchanges--officers and retirees--are not those whom taxpayers might wish to target for benefits.⁽²⁸⁾ If DoD was required to subsidize exchange sales from its own budget, exchanges might focus more on enlisted members stationed or deployed overseas, and the role of exchanges in the United States might be much smaller.

Another difficulty is that as long as DoD views the exchange system as a profit-making enterprise, it will have an incentive to expand the system despite the possible costs to taxpayers. Moreover, past declines in exchange earnings have prompted policy and legislative changes to boost earnings. Access to exchanges was expanded for retired reservists in 1990, and unlimited access was given to the Ready Reserve in 1991. The following year, exchange sales were further bolstered by the expansion of an in-house credit card program that relies in part on implicit federal guarantees. In 1996, DoD shifted control over all on-base tobacco sales to the exchanges, an action that could add over $60 million a year to their earnings. And this year, DoD improved the exchanges' ability to compete with private retailers by lifting many historical restrictions on the kinds of merchandise they can offer.

In an effort to maintain their sales volume despite a drop in the number of active-duty personnel, the exchanges are working to expand their sales to retirees and reservists.⁽²⁹⁾ If successful, that effort could reduce the cost-effectiveness of exchanges as a form of compensation. Advertising and merchandising campaigns that increase the amount sold to retirees do not increase the quality of the active-duty force. Moreover, the additional retirees (or active-duty personnel) who will be attracted to exchanges by those campaigns are likely to be people who are almost indifferent between exchanges and private stores. As a result, the additional sales will provide little benefit to the new patrons.

Both commissaries and exchanges benefit from their exemption from state and local taxes. But the size of the commissary system is limited by the Congress's need to appropriate funds to pay for labor and most other operating costs, whereas the size of the exchange system is not. Perhaps as a result, the exchange system has grown relative to the commissary system, in terms of sales, over the past 20 years. In 1974, total exchange sales were 1.4 times total commissary sales; by 1980, that figure was 1.5; and in 1995, it was 1.6.

The role that exchanges play in providing low-cost goods poses difficulties, in part because price subsidies encourage patrons to consume goods even if the cost of providing the goods exceeds their value to the patron. Difficulties also arise because the exchanges' multiple goals--offering below-market prices, providing access to affordable merchandise in overseas areas, and earning revenue--frequently conflict. That makes it difficult to hold exchanges accountable for their performance. If the exchanges' main retail stores in the United States do not earn a return, they can be justified on the grounds that they provide below-market prices. If overseas stores do not offer a good selection of low-priced merchandise, it is because the additional sales that a wider selection might generate would not justify the cost. If exchanges appear to encourage sales of tobacco and alcohol and excessive use of in-house credit cards, that contributes to earnings that support MWR activities.

Despite the best efforts of exchange managers to balance those conflicting goals, an environment without clear performance measures could lead to a corporate culture more intent on perpetuating itself than on serving the needs of service members. For example, although competition among stores benefits consumers in civilian shopping malls, exchange managers have little incentive to invite competition from other general retailers at military bases.

Overseas, exchange managers have no incentive to negotiate with host governments or local retailers in an effort to make local stores more accessible and affordable--for example, by exempting service members' purchases from value-added tax or by providing more convenient hours and access to interpreters. Yet better access to local stores may be the only practical way to ensure a high quality of life for service members in some locations. No matter how carefully exchange officials select the merchandise for their overseas stores, a single on-base store cannot rival the range and selection of goods available in urban European communities. Both the real benefits that the current exchange system provides and the difficulties that it presents need to be considered when evaluating alternative strategies for DoD's retail activities.

1. "Demographic Section," Exchange and Commissary News, vol. 33, no. 10 (October 15, 1996), p. 86.

2. That control does not apply to sales of commissary goods and those recreational services (golf courses, theaters, clubs) provided by MWR programs.

3. AAFES did not use survey data to calculate those figures. Instead, it estimated them based on the statistical relationship between the number of active-duty, reserve, and retired personnel living near its exchanges and the level of retail sales in the exchanges.

4. Army and Air Force Exchange Service, HQ Retail Store Customer Preference Survey (1995).

5. Those numbers are CBO estimates based on Navy Resale and Services Support Office, CRISP Report: Consumer Ratings and Impressions of Store Performance (prepared by Market Facts, Inc., 1990).

6. Ibid.

7. Army and Air Force Exchange Service, Food & Services Baseline Customer Preference Survey Results (commander's briefing prepared by EDS Management Consulting Services, September 19, 1995), p. 80.

8. Quoted in Army and Air Force Exchange Service, 1994 Baseline Customer Preference Research (commander's briefing prepared by Deloite & Touche, August 5, 1994), p. IV-24.

9. Ibid., pp. IV-29 and IV-41.

10. Reported to the Congressional Budget Office in a briefing by NEXCOM staff, February 29, 1996.

11. Army and Air Force Exchange Service, Price Comparison Survey, 1995: Final Reports (prepared by United Market Research, Inc., June 23, 1995).

12. Army and Air Force Exchange Service, 1994 Baseline Customer Preference Research, p. IV-28.

13. John Price, head of the retail services and operations branch of the Marine Corps Morale, Welfare, and Recreation Support Activity, quoted in Exchange and Commissary News, vol. 33, no. 10 (October 15, 1996), p. 63.

14. Robert McGinty, chief merchandising officer for NEXCOM, quoted in Exchange and Commissary News, vol. 33, no. 10 (October 15, 1996), p. 44.

15. The exchange manager at the National Naval Medical Center in Bethesda, Maryland, quoted in D'Vera Cohn, "Military Stores Armed for a Retail Battle: Smaller, Older Customer Pool and Discounter Competition Push PXs to Go Upscale," Washington Post, August 14, 1995, p. B1.

16. Organization for Economic Cooperation and Development, Purchasing Power Parities and Real Expenditures, vol. 1 (Paris: OECD, 1996), EKS Results, Table 2.11, p. 66.

17. Fawn Vrazo, "To Europe, U.S. Gas Prices Still Look Low," Washington Post, May 4, 1996, p. C2.

18. Navy Resale and Services Support Office, CRISP Report.

19. DoD does, however, submit a list of NAF construction projects to the MWR Panel of the House National Security Committee and the Personnel Subcommittee of the Senate Armed Services Committee for their approval.

20. Statement of Congressman Carl Vinson in House Committee on Armed Services, Hearings on Sundry Legislation Affecting the Naval and Military Establishments, hearings before the Special Subcommittee on Resale Activities of the Armed Services, H.A.S.C. No. 104 (1949), p. 346.

21. The estimate of concession earnings takes into account the cost of the overhead and support provided by the exchanges.

22. Terry Wagner, vice president of AAFES's merchandising group, quoted in Exchange and Commissary News, vol. 33, no. 10 (October 15, 1996), p. 54.

23. The $1.2 billion reported book value for buildings and equipment understates the value of the real property devoted to exchange activities, because all of the land and roughly two-thirds of the 55 million square feet of buildings used by exchanges are not NAF assets but are provided by DoD without charge. CBO did not attempt to place a rental value on those assets.

24. That $500 million estimate of the cost of capital does not reflect the budgetary savings that taxpayers would receive if exchange assets were sold. Although private-sector rates of return may be appropriate for policy analyses, Treasury bond rates are the appropriate rate of return for budget estimates. See Rudolph Penner, "Aspects of Budget Accounting and Scoring That Distort the Decision Process" (draft, Barents Group, Washington, D.C., November 15, 1996). For more information about the 15 percent before-tax rate of return, see Appendix B.

25. John A. Ronzetti, ed., FOR 1995 Edition: Financial & Operating Results of Retail Stores in 1994 (New York: John Wiley & Sons, 1995), pp. 6-9.

26. DoD's recent decision to transfer control of all tobacco sales at military bases to the exchange system illustrates the importance of accounting for the value of monopoly rights. Exchanges' earnings are expected to rise in 1997 because of their increased control over tobacco sales. However, the additional earnings will reflect an increase in the level of assets that exchanges hold, not a higher rate of return on their assets.

27. Those figures (the subsidy equal to 13 percent of sales in U.S. exchanges and 14 percent overseas) are rough estimates. CBO estimated NAF earnings in the United States and overseas based on reported earnings minus overhead costs allocated by sales. Transportation and utility costs paid for with appropriated funds were allocated to overseas exchanges, and forgone taxes were allocated to U.S. exchanges. Other appropriated-fund costs and the forgone return on capital were allocated based on sales. (Similar results are obtained when those costs are allocated based on square feet of buildings.) One difficult question is the extent to which U.S. and overseas costs are linked by common buying and distribution systems. Without a U.S. base to provide economies of scale, the costs of a DoD-run overseas system could increase.

28. See Cohn, "Military Stores Armed for a Retail Battle."

29. See Kristina Maze, "Coupons Target Those Set to Retire: Exchange Service Aims Promotion at 'Growing Segment'," Military Market (December 1996), p. 14.

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