Overhead Allocation and Incentives for Cost Minimization in Defense Procurement

Defense firms typically produce a large number of products. The purpose of this article is to explain how two features of the current regulatory process create a significant incentive for these multiple-product firms to choose inefficient production methods. The first feature is that the marginal impact of accounting cost on price varies significantly among products. Prices for a defense firm's products are set according to a rather unique process that combines elements of both competition and cost-based regulation. Defense firms typically produce some purely commercial products and prices for these products are competitively determined. Aside from standard off-the-shelf items such as army boots, most defense products are purchased from a sole source and thus their prices are nominally cost-based. In reality, the negotiated price is likely to be affected by other factors as well. In particular, in cases where closer substitutes exist or where an alternative source might not be prohibitively expensive, the potential cost of these alternatives plays a role. The important consequence of this is that the negotiated price will not necessarily decline or rise by a full dollar when the projected cost of production declines or rises by a dollar. In more competitive procurements where the cost of alternatives plays a stronger role, changes in projected accounting cost are less important. The second feature of the regulatory process concerns the method that defense firms are allowed to use to calculate the cost of each product. Following traditional commercial accounting practices, only a relatively small fraction of costs are directly charged to products. The remaining costs are grouped together into overhead pools and allocated across products usually in proportion to directly charged labor use. These two features create the following incentive problem. Given the first feature, the firm would like to be able to assign more of its costs to well-funded sole source procurements instead of to more competitive procurements or commercial products. The second feature provides a method for accomplishing this task. Namely, the firm can increase (decrease) the amount of overhead allocated to a contract by increasing (decreasing) the amount of direct labor used on the contract. This means that the firm will have an incentive to engage in pure waste by padding direct labor usage on contracts with cost sensitive revenues. It will also have the incentive to distort its input substitution decisions between labor and other inputs by using too much (too little) direct labor on contracts with cost sensitive (cost insensitive) revenues. Two major types of input substitutes for labor exist. The first is capital. Thus, we would expect the firm to purposely under-capitalize production of products with cost sensitive revenues and over-capitalize production of products with cost insensitive revenues. The second possible input substitute is material. For many subcomponents of a weapon, a firm has the potential option of subcontracting production to another firm or making the component in-house. Subcontracting will result in higher direct material costs for the firm but lower direct labor costs. Thus, engaging in more in-house production is essentially a way of substituting towards direct labor and away from direct material. In particular, then, we would expect the firm to purposely engage in too much in-house production for its products with cost sensitive revenue and too much subcontracting for its products with cost insensitive revenue. An important point to note about this incentive effect is that it does not require the firm to report any cost projections untruthfully. That is, in the behavior predicted by this article, the firm does not make money by projecting that costs will be high (in order to get a high price) and then actually having low costs. The firm actually spends all of the money that is charged as a cost. The profit occurs through shifting the assignment of these costs. The importance of this point is that auditing is very poorly equipped to deal with this type of behavior. Auditing is relatively good at determining whether the firm actually spent as much as it projected. However, it is relatively poor at determining whether any expenditure that actually occurred was necessary. Braeutigam and Panzar (1989), Brennan (1990), and Sweeney (1982) have analyzed models of public utility regulation where the utility has commercial business segments. They make the general point that, depending upon how costs are allocated, the firm may have an incentive to distort its output and/or input decisions in order to shift overhead to the regulated sector. However, none of these articles analyzes allocation schemes based on direct labor or any other input base. Braeutigam and Panzar (1989) and Sweeney (1982) consider allocation schemes based on units of output under the assumption that comparable units of output exist across different products. Brennan (1990) considers allocation schemes where each product is allocated a fixed, invariant share of overhead. Thus all of the predictions of this article regarding the particular sorts of input distortions one would expect to see in defense procurement are new to this article. Furthermore, on a technical level, the model of this article is also somewhat different because it considers a multiple product case where products are not necessarily either perfectly competitive or perfectly regulated and the level of competitiveness varies from product to product.