The Relation between Cost Shifting and Segment Profitability in the Defense-Contracting Industry

Abstract

We test the conjecture from prior research that defense contractors' excess profitability in the 1980s stemmed from their ability to shift common overhead costs to government contracts that typically allow cost reimbursement or price renegotiation (Rogerson 1992; Thomas and Tung 1992; Lichtenberg 1992). Although we confirm prior evidence that defense contractors enjoyed abnormally high profitability on their government work in the 1984–1989 period (a period of relatively low competition for defense contracts), we find no evidence that this excess profitability is attributable to cost shifting. In addition, we find no evidence that the Top 100 defense contractors (firms that likely wield above-average market power) are able to use cost shifting to exploit a lack of competition in the industry. Our results suggest that, contrary to the conjectures in prior research, the unusually high profitability reported on government contracts in 1984–1989 is more likely attributable to nonaccounting explanations than to cost shifting.

Are Cost-Plus Defense Contracts (Justifiably) Out of Favor?

“…The main testable hypothesis is as follows: if the cost-shifting theory leads to the excess profitability of defense contractors, then one expects the highest profit in the mixed segment, where managers have the most opportunities to shift common overhead costs. In contrast with this expectation, McGowan and Vendrzyk (2002) either find that the government segments (not the mixed segments) significantly outperform the other two types or find no significant difference across the three categories, depending on the time period. Such evidence suggests that unusually high profitability for government segments is more likely due to nonaccounting explanations than to strategic cost allocation.…”

“…McGowan and Vendrzyk (2002) confirm that defense contractors enjoyed excess profit on their government work, yet find no evidence of common overhead cost-shifting. Specifically, they compare return on assets (ROA) among three types of segments within defense contracting firms: (1) commercial segments, (2) government segments, and (3) mixed segments.…”

Impact of Product Characteristics and Market Conditions on Contract Type: Use of Fixed-Price Versus Cost-Reimbursement Contracts in the U.S. Department of Defense

“…While defense contracting involves unique challenges (e.g., warzone acquisitions) and is governed by the Defense Federal Acquisition Supplement (DFAS), the same basic dynamics present in government contracting in general are also present in defense contracting (e.g., U.S. Government Accountability Office, 2012). Furthermore, the basic product characteristics and market characteristics that influence contracting in general should have similar effects on contracting by the DoD (Harmon & Scot, 2013;McGowan & Vendrzyk, 2002;Rogerson, 1994;Williamson, 1967).…”

Effects of Military Spending on the Profitability of Spanish Defence Contractors

“…There are three main reasons: the acquisition costs for defence supplies are frequently rearranged; reimbursement systems are the rule in defence contracting; and contractors are permitted to recover a portion of their R&D spending by including them as an allowable indirect expense on government contracts. Despite McGowan and Vendrzyk's (2002) attempt to verify this hypothesis, their final conclusion is that the higher profitability does not appear to have any connection with costrelated aspects.…”