Academic journal article Quarterly Journal of Finance and Accounting

Are Defense Contractors Rewarded for Risk, Innovation, and Influence?

Academic journal article Quarterly Journal of Finance and Accounting

Are Defense Contractors Rewarded for Risk, Innovation, and Influence?

Article excerpt

Introduction

The profitability of defense contractors has been investigated by many academic studies (Weidenbaum, 1968; Agapos and Galloway, 1970; Stigler and Friedland, 1971; Bohi, 1973; Rogerson, 1989; Lichtenberg, 1992; and McGowan and Vendrzyk, 2002). These studies mainly compare the profitability of segments or companies that had defense sales with the profitability of their commercial counterparts to determine whether defense contractors earn excessive profitability from defense business. The prior studies largely ignore the diversity of profitability among defense contractors. According to the Department of Defense (DOD), however, profits (markup) of defense contracts should depend on the risk assumed by a contractor, the difficulty of the task, the amount of contract cost, the source of resources, contractor past performance, and other factors (DFAIR, 1985, V-l). This objective suggests that the DOD makes a deliberate decision to vary the profitability of defense contracts. The decision may aid the DOD in achieving its desired purpose, a balance of protecting the interest of the taxpayer and enabling U.S. industry to achieve an equitable return for its involvement in defense business (DFAIR, 1985, E-1).

The purpose of this study is to investigate the factors that lead to diversity of profitability among defense contractors. A comparison of the average profitability of defense contracting firms (segments) with their commercial counterparts may not provide sufficient evidence for the reasonableness of defense contractors' profitabil= ity because defense business may be riskier (Weidenbaum, 1968; Stigler and Friedland, 1971) and/or more innovative (Rogerson, 1989) than commercial business. By investigating major factors that determine the profitability of defense contractors, this study can provide new light on the reasonableness of defense contractors' profitability. By examining whether the profitability of defense contractors is consistent with the intended objectives stated by the DOD, this study also provides useful evidence to evaluate the effectiveness of the DOD in implementing its stated profit policy.

This study uses a new method (relative to the prior research) to investigate the profitability of defense contractors. The percentage of defense sales to a firm's total sales is used as a main-effect variable for profitability of defense contractors while the factors that are hypothesized to cause the diversity of profitability among defense contractors are used as moderating variables. Such a method allows us to provide evidence on both the effect of defense sales on firms' profitability in a general sense and the incremental effects of the hypothesized factors on the diversity of profitability among the firms. Our results suggest that defense contractors assuming higher risks, being more innovation-oriented, and being more influential, can earn higher profitability from their defense business than other defense contractors, but that defense business in general seem to be less profitable than commercial business. The evidence implies that the profitability of defense contractors was reasonable with respects of rewarding risk and innovation. The DOD seems to have effectively implemented its stated profit policy.

Literature Review

Many studies have investigated the profitability of defense contractors. A study by the Logistics Management Institute for the DOD (1969) found that profitability of defense contracts was too low relative to that of commercial business. The study uses information voluntarily provided by defense contractors, which makes their results subject to self-selection bias, as the defense contractors with high profitability might choose not to participate. A study by the U.S. General Accounting Office (GAO, 1971) examines profitability of defense contracts for 74 large defense contractors. The study concludes that return on equity is generally not significantly different for defense contracts than for commercial business. …

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