Overhead Allocation and Incentives for Cost Minimization in Defense Procurement

Firms directly charge only a small fraction of their costs and allocate the rest across products in proportion to direct labor use. Such a practice creates a problem for defense procurement. This report concludes that firms' current overhead allocation methods create incentives for firms to systematically overuse direct labor on contracts where they believe that price will be fairly responsive to accounting costs and to underuse direct labor on contracts where they believe that price will be fairly unresponsive to those costs.