The Impact Of Accounting Standards On Spiralling Aircraft Production Indirect Costs AUTHOR Major George V. Kuck, Jr. USMC CSC 1985 Subject Area Logistics EXECUTIVE SUMMARY Absolute overhead costs in the aircraft construction industry have increased since 1960. In the past several years the yearly increases have exceeded the rising rate of inflation. These increases may represent an underlying change in the economic structure of this key industry. The defense and economic policy questions raised have placed a burden on the Cost Accounting Standards Board. The require- ment for consistency of cost allocation runs counter to the perceived best interests of the individual contractors. As a minimum requirement there must exist among the DOD suppliers an acceptance of uniform and consistent cost allocation standards. The necessity of using the Government's huge purchasing power is presented and the apparent willing- ness of the current administration to play a positive role is applauded. THE IMPACT OF ACCOUNTING STANDARDS ON SPIRALLING AIRCRAFT PRODUCTION INDIRECT COSTS OUTLINE Until accounting standards are uniformly applied and enforced, indirect costs will continue to be a burgeoning problem resulting in excessive expenses being incurred during air- craft acquisitions. I. The spiralling costs of aircraft represent more than inflation and the costs of technological advances. A. There is increasingly negative publicity concerning apparent profiteering by defense contractors. B. Department of Defense (DOD) suspends General and Administrative expense reimbursements to General Dynamics Corporation. 1. General and Administrative is an example of an indirect expense. 2. Significance of indirect costs has received little notice within DOD. C. Indirect costs are as amorphous as direct costs are concrete in character. 1. Approximately one-third of the DOD price for weapon acquisitions is due to indirect costs or overhead 2. Variabilities of pricing and expected returns on investment impact on DOD contracting officers. II. Historically overhead has represented the cost of excess capacity. A. Clark recognized the complexity of indirect costs sixty-five years ago. B. There are many unanswered questions in the area of capacity as it relates to the defense industrial base. III. The Cost Accounting Standards Board (CASB) has led the effort to achieve a measure of control over overhead costs. A. Uniformity and consistency in accounting standards have been a quest of the CASB. 1. Generally accepted accounting principles have generally proved to be as amorphous as indirect costs. 2. Consistency is particularly important to establish. B. The DOD seeks consistency to support its cost control efforts. C. Inflation has been treated in several ways. D. The variability of cost assignments has proved to be a compounding problem. IV. The U.S. defense industrial base has been examined with particular interest taken in the shipbuilding and aircraft construction industries and their treatment of overhead. A. Policymakers must take note of the impact of overhead costs on likely procurement strategies. B. The overhead rate in the aircraft industry has been marked by significant growth. 1. The Naval Air Systems Command procures aircraft from an industry which may be subtly changing. 2. Efforts to capture the subleties have been thwarted by the lack of uniformity of application of indirect costs. V. The Government, because it operates in its procurements in an area where the adversarial relationship with contractors precludes an open exchange of the data necessary to support overhead cost control is forced to heavy handedly employ its purchasing power. A. Industry-wide accounting standards exist as the only way the Government can capably employ its purchasing power. B. The Reagan administration appears capable and ready to take the necessary actions. The acquisition cycle for major items of defense hardware involves the expenditure of huge sums of money. For example, the current cost of a frontline Navy fighter, the F-14, exceeds $24,000,000. A former Secretary of the Air Force compared the respective costs of a World War II fighter, the P-38, at $200,000, and the new F-15, at $15,000,000. Even after detailing the differential in procurement rates, technological advances, and the considerable impact of inflation, Mr. Mark was certain that those phenomena could not account for that factor of 100 [10:8-13]. The question being asked more and more often is - "What are we getting for all that money?" Today more than at any time in the past, defense expenditures elicit criticism from both anti-militarists and also from normally staunch supporters of defense spending. Increasing publicity, mainly negative, has kept defense expenditures in the public eye. Six hundred dollar hammers and six thousand dollar coffee pots are two examples of recent items in the press which have heightened public awareness of what is viewed as unconscionable profiteering by military suppliers. It is not difficult to draw the inference from such examples of corporate profiteering that govenment contractors are more interested in their balance sheets than in improving the level of national defense. Although these and other acquisition anomalies garner tremendous publicity, the area in which government contractors earn their most questionable profits came into public view on 4 March 1985. On that day, the Department of Defense (DOD) suspended general and administrative payments to the largest defense contractor, General Dynamics Corporation [14:5]. General and administrative expense is an example of the growing number of indirect costs which is finding its way into modern procurement contracts. A large portion of what the DOD pays for in its acquisition processes is in excess of the direct costs of labor, materials, and reasonable profit for the contractors. That excess is overhead or indirect costs. Kaitz [7] has suggested that a growing discontinuity between the trends in the cost of civilian and military goods may largely be explained by overhead as opposed to direct labor or direct material costs. The significance of overhead costs is broadly recognized within the DOD; however, that recognition has previously had little impact on controlling the continued increase in overhead costs [7:15]. Resolution of the myriad problems involved with controlling overhead costs will not occur until their nature is better understood, and also how indirect cost increases may possibly reflect internal changes in the substructure of the multi-tiered defense industrial base. In order to understand the difficulty in dealing with indirect costs, a basis for comparison must be established. This is where problems develop. As related in the definitions in Figure 1, indirect costs tend to be as amorphous as the direct costs tend to be concrete. It is this concreteness which facilitates estimation - and indirectly, control - of direct costs by industrial engineering methods. Click here to view image Of even more importance is that by virtue of their definition, direct costs can be more easily tracked during the production process. This ease of tracking Permits contracting officers to take steps to control the direct costs of acquisition contracts. In order to begin to understand the difficulties in dealing with indirect costs, a basis for comparison must be established. As related in the definitions in Figure 1, indirect costs tend to be as amorphous as the direct costs tend to be concrete. It is this concreteness which facilitates estimation of direct costs by general industrial engineering methods and their being tracked during the production process. The success enjoyed in the use of both parametric and nonparametric cost estimation is another result of the general tractability of direct costs. Given this robust nature of direct costs, it would certainly be advantageous to only have to deal with them. Unfortunately, on the average, two-thirds of all the in-plant costs in a typical manufacturer's cost center are indirect costs [5:35]. Even DOD accepts, according to the Deputy Secretary of Defense, Mr. Taft, that roughly one-third of the price the DOD pays for weapon systems is comprised of indirect costs [12:24]. The disparity is likely explained in the variability of pricing for labor and material input and expected differing return on investment. That such disparities exist exemplifies the problem DOD contracting officers face in sorting out a valid distribution of the prices contractors charge for their goods and services. Indirect costs are not something recently dreamed up by a cost accountant. They have been around as long as men have been involved in productive enterprise. The level of sophistication in their determination and application has taken on increased significance in recent history. Almost sixty-five years ago, Clark [3:12] arrived at a conclusion concerning overhead costs which may currently provide at least a partial explanation for the overhead problem. There is a deal of complexity in the attempts that are made to trace the untraceable costs or to assign them on a rational basis, or to discover the true added costs of added business, but at the bottom of these complexities lies a fact that is simple. That fact is unused productive capacity, or capacity of which full advantage is not taken. "Idle overnead", that great industrial sin, is simply the expense side of this unused capacity. The entire question of capacity as it relates to the defense industrial base, in general, and the aircraft construction industry, specifically, is one containing many unanswered parts. At the forefront,of establishing a degree of order in tracking and controlling overhead costs is the Cost Accounting Standards Board (CASB). The CASB, as established in 1971 by Public Law 91-379, has the responsibility for promulgating cost accounting standards designed to achieve uniformity and consistency in the cost accounting principles followed by defense contractors and subcontractors. Even though there has been obvious improvement in the level of accounting consistency and in the quality of data reported pursuant to the inclusion of the CAS (Cost Accounting Standards) clause in defense contracts, it is important to realize a serious shortcoming exists. There remains ample latitude for contractors' interpretations of the CASB guidelines so as to provide often murky waters in which to carry out rigorous cost analysis. "Generally accepted accounting principles" continue to provide a receptive milieu for unique interpretations of the CAS issued by the CASB; the inevitability of such interpretations has been recognized by the CASB in their policy statements. Cost Accounting Standards provide for the definition and measurement of costs, the assignment of costs to particular cost accounting periods, and the determination of the bases for the direct and indirect allocation of the total assigned costs to the contracts and other cost objectives of these periods. The use of Cost Accounting Standards has no bearing on the allowability of those individual items of cost which are subject to limitations or exclusions set forth in the contract or which are otherwise specified as unallowable by the Government. The Board recognizes that contract costs are only one of several important factors which should be involved in negotiating contracts. Therefore, the promulgation of Cost Accounting Standards, and the determination of contract costs thereunder, cannot be considered a substitute for effective contract negotiation. It should be emphasized that where Cost Accounting Standards are applicable, they are determinative as to the costs allocable to contracts. It is a contracting agency's prerogative to negotiate the allowability of costs which are allocated to contracts; however, the definition of what is a cost for purposes of negotiated defense contracts and how the amount thereof is to be allocated is a function of Cost Accounting Standards [4:F-2]. That prerogative to negotiate allowability of costs continues to be an Achilles heel for contracting officers attempting to control aircraft acquisition costs. Of the many areas studied by the CASB, certainly the topic most relative to this paper and to what the Government must eventually achieve is consistency. A strict adherence to common principles and form in the allocation of indirect costs by all Government contractors would provide researchers and, in turn, contracting officers, a stable empirical basis from which to derive the accounting ammunition to take on contractors on a more equitable basis. The consistent application of allocation principles remains a desirable goal for the DOD. Mr. Taft's entreaty on behalf of the DOD soliciting "...industry's early and active participation and cooperation with..." an initiative to establish principles of overhead cost control and of incentives for reducing overhead costs reflects that desirability [13:24]. Any steps which can be taken to control overhead costs promise to yield a concomitant reduction in the DOD's annual multi-billion dollar procurement expenditures. Unfortunately, such consistency in the allocation of overhead is not to be found within the confines of an industry and in many instances not even within the accounting systems of a single corporation. A view of the manner in which costs are allocated reflects the amorphous nature of indirect costs. Huefner [6] studied the CASB disclosure statements of 677 defense contractor profit centers. Table I [6:11-12] relates the treatment of specific cost items. This table graphically illustrates the variability with which costs are allocated in the defense industries. In conjunction with the several hundred available allocation bases, these allocative variabilities compound the cost allocation problem and mean the inconsistencies extant in overhead rates are even more intractable. The CASB, an outspoken zealot on the virtues of consistency, has recognized a concept of unlike circumstances in its attempts to establish greater uniformity in the allocation of overhead. This concept comes into play when it can be demonstrated that due to some prominent distinction between the circumstances of two profit centers it is patently unreasonable to expect them to handle an allocation of costs in a uniform manner. Given these obstacles, it quickly becomes a difficult struggle for the researcher or DOD contract monitor to capture the true nature of the behavior of indirect costs. It is necessary to address the considerable impact of inflation on indirect costs. A single set of composite overhead indices is often applied to overhead cost elements in order to bring those elements, which might have Click here to view image been derived over an inflationary (deflationary) set of data. Those data in turn provide more statistically stable results upon which to test the myriad of possible hypotheses relating overhead costs in just about any possible relationship a researcher might want to investigate. Actual overhead cost experience should provide the most logical index, but even that experience is probably not transferable beyond the expenses from which it is calculated. This shortcoming has not kept the Naval Air Systems Command (NAVAIR) from applying just such an actual overhead cost index to dissimilar expenses over varying years. Business Conditions Digest provides a widely utilized GNP implicit price index which again can be argued for or against based solely on perceived requirements for robustness. There are three broad areas which comprise the U.S. defense industrial base - shipbuilding, aircraft and missile construction, and the electronics industry. Within each of these areas the effects of growth in overhead costs have been noted. Vigrass [15] looked into the problem of an increasing overhead rate at the Newport News Shipbuilding and Drydock Company. His work provides a systematic approach to the study of overhead in the shipbuilding industry. Kaitz [7, 8 and 9] has extensively studied the U.S. shipbuilding industry and had analyzed the behavior of defense industries. A literature search failed to disclose any broadly oriented studies of overhead costs in the electronics industry. Apparently, for the electronics industry the impact of rapid technology growth precludes fixing the distribution of expenses. Rapidity of technology is apparently not a critical factor in fixing the expenses for the shipbuilding and aircraft construction industries. The aircraft industry, in relation to other U.S. industries is marked by high overhead costs. This suggests that long run savings may be generated by gaining a firm understanding of the indirect cost drivers. Based upon that knowledge, analytical judgments, with regard to the utilization of the industry in meeting U.S. defense goals, can be made. Certainly, the continuing rise in overhead costs with the attendant publicity will force policymakers to take a long searching look at those costs with the view either toward altering the defense aircraft procurement strategy or toward accepting the growth in costs and the deleterious impact of that on our defense requirements. As evidenced by the Reagan administration's determination not to pay General Dynamics Corporation's disputed overhead expenses [1:25], the course has clearly been established. The effect on the aircraft industry makeup and organization due to a change in procurement strategy away from maintaining a larger excess capacity would have profound effects. The policy questions engendered by any Government-fostered reorganization of the aircraft industry will be answerable only provided the depth of knowledge of overhead costs becomes thoroughly documented. During fiscal year 1979 NAVAIR procured nearly two billion dollars' worth of aircraft, spares, parts and ancillary equipment under cost reimbursement type contracts [12]. NAVAIR relied on cost analysis and cost control to ensure that those billions of dollars returned their fair share of military potential and that they did so at a fair and reasonable price. Basically, two types of costs were subjected to cost analysis - direct and indirect. There is a general concensus that cost analysis is capable of adequately predicting, monitoring and controlling direct costs. In the area of indirect costs, or overhead, the efforts to accurately predict, to track, and to control these costs have been much less successful. Table II, which was extracted from Kaitz [8:22] shows a 76 percent increase in the overhead rate for the aircraft industry during a sixteen year period. The rate depicted was determined using this formula: Click here to view image Although the table reflects the overhead rate only through 1976, the trend is clearly upward and nothing has occurred in the past nine years to improve that trend. The established significance, thus far, of indirect costs relative to total costs within the aircraft industry dictates that a greater effort be made to gain an understanding of the nature and behavior of the indirect costs. The literature search carried out in conjunction with this paper indicates a paucity of research being conducted in the area of "overhead." Further, there exists the possibility that the absolute increase in overhead costs may reflect possibly undesirable changes in the underlying structure of the aircraft industry. If this is the case, the policy questions to be answered necessitate a wide-ranging, in-depth knowledge of the behavior of indirect costs throughout the aircraft industry. Look for a moment at the environment in which indirect cost allocation arises. The lack of uniform cost accounting procedures and the idiosyncratic allocation systems within the aircraft industry are facts of life which must be accepted at face value. Huefner [6] documented this lack of consistency. It is imprudent to believe that industry members will voluntarily accept any rigid standardized accounting system which would allow the Government (and, coincidentally, competitors) to gain a firm understanding of their intra-corporate costs and allocations. The verity of this corporate reticence is adequately demonstrated by the level of security most corporations afford their accounting data, which they cloak with the mantle of proprietary information. Care must be taken to differentiate between costs which we could reasonably expect to have identified as overhead to a particular contract and those costs about which the allocation to a given contract may be characterized as fraudulent. Unfortunately, the application of a "doctrine of reasonableness" to what is in fact an adversarial relationship between buyer - in our terms, the Government and seller - in our terms - normally a publicly held profit-making corporation appears naive. The Government has been very clear, in some instances, concerning costs which they would not allow contractors to claim as overhead on given contracts. For example, Grumman Aerospace Corporation has been denied the right to allocate the costs of maintaining its Washington, D. C. office, which is primarily involved in lobbying activities, to Goverment procurement contracts for aircraft. However, in general terms whether specific cost items are allowable has been much less precisely handled. Usually the questionable items are recognized during contract analysis and upon discovery are adjudicated on a give-and-take basis between contractors and Government contracting officers. In the opinion of Kaitz and Associates, who have studied overhead extensively: "...lack of precision in defining costs leads to serious misunderstandings about the structure of U.S. industry and how it reacts to all manner and form of change. Further, this imprecision leads to a basic misunderstanding of the purpose served by overhead costs, and most specifically that portion of the overhead pool that is not dedicated to the output of a specific good or service." [7:21] Although the CASB is often characterized as having as its objective forcing all defense contractors to accept a desired commonality in their accounting systems, the Board has actually recognized that the various complex and diverse work done by defense contractors requires that their accounting systems reflect those differences [11:15]. Consistency, which the CASB does strive to obtain, necessitates that a contractor follow the same accounting methods over subsequent fiscal periods. However, a corporation which adopts consistent accounting methods places itself in jeopardy with regard to being forced to absorb certain costs that in the long term may adversely reflect on its profitability. While DOD is forced to purchase aircraft from corporations, which owe ultimate allegiance to their own continuing profitability, it is naive to believe that indirect costs can be controlled by requiring those contractors to adhere to anything less than industry-wide accounting standards. And those accounting standards must be both specific and all-encompassing. We have found that the accounting standards promulgated by the CASB are not meant to provide truly stringent and rigorous requirements that specific costs be allocated in a manner which facilitates their being consistently tracked over multiple accounting periods. Therefore, until the Government is prepared to take on the aircraft industry, using its tremendous purchasing power, to gain concessions, the chances for arresting the tremendous growth in overhead costs are slim. The current administration would appear to be taking the first steps toward toughening the Government's stand in aircraft procurement. BIBLIOGRAPHY American Notes, "A Defense Firm Picks Up the Tab", Time Magazine, February 25, 1985. Bedingfield, J. P., and Wright, H. W., Government Contract Accounting, Federal Publications, 1979. Clark, J. M., Studies in the Economics of Overhead Costs, University of Chicago Press, 1923. Cost Accounting Standards Board, "Restatement of Objectives Policies and Concepts", Federal Contract Reports, No. 681, Bureau of National Affairs, Inc., Washington, D.C., 1977. Guide for Monitoring Contractors' Indirect Cost," U.S. Government Printing Office, 1975. Huefner, R. J., Cost Accounting Policies: Some Empirical Evidence, State University of New York at Buffalo, 1975. Kaitz & Associates, An Analysis of Overhead Costs and Rates in the U.S. Defense Industrial Base, 1980. Kaitz & Associates, Building Naval Vessels: A Handbook of Shipyard Costs, 1980. Kaitz & Associates, The Capital Budgeting Policies of the U.S. Shipbuilding Industry: An Analysis of Defense Industry Behavior, October, 1979. Mark, H. M., "Productivity, Technology and the Illusion of the Free Lunch", Defense /80, August, 1980. Taft, W. H. , "Managing Defense Dollars Better", Defense/85, February, 1985. Soderberg, P. O., Procurement Contracting Officer's Guide to Cost Accounting Standards, M. S. Thesis, U. S. Naval Postgraduate School, 1977. Survey of Contracting Statistics, Headquarters Naval Material Command, September, 1979. "U.S. Suspends Paying General Dynamics Corp.", Wall Street Journal, March 6, 1985. Vigrass, D. H., Overhead at Newport News Shipbuilding, and Drydock Company, M. S. Thesis, U. S. Naval Postgraduate School, 1975.
