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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.
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
III. The Cost Accounting Standards Board (CASB) has led
     the effort to achieve a measure of control over overhead
     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
      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
      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.
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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
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
          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
      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
      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
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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
      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:
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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
      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
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.
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Huefner, R. J., Cost Accounting Policies: Some Empirical
     Evidence, State University of New York at Buffalo,
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.
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Survey of Contracting Statistics, Headquarters Naval Material
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"U.S. Suspends Paying General Dynamics Corp.", Wall Street
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     School, 1975.

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