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 su