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An Analysis of Risk and Return in the Defense Market: Its Impact on Weapon System Competition Author(s): Willis R.

Greer, Jr. and Shu S. Liao Reviewed work(s): Source: Management Science, Vol. 32, No. 10 (Oct., 1986), pp. 1259-1273 Published by: INFORMS Stable URL: http://www.jstor.org/stable/2631699 . Accessed: 26/05/2012 03:46
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MANAGEMENT SCIENCE Vol. 32, No. 10, October 1986 Printed in U.S.A.

AN ANALYSIS OF RISK AND RETURN IN THE DEFENSE MARKET: ITS IMPACT ON WEAPON SYSTEM COMPETITION*
WILLISR. GREER, JR.
AND

SHU S. LIAO

Naval Postgraduate School, Monterey, California 93943


With growing austerity pressures from the Administration, Congress, and the general public, the Government's procurement policy has called for increased use of dual-source competition as a means of reducing acquisition costs. In practice, however, this policy has produced mixed results. The cause seems to be an inadequate understanding of the peculiarities of competition in the Government's market. This paper examines the risk and return available in the defense market, and relates it to the industry's propensity to compete. The results show that intelligent observation of the industry's capacity utilization rate would contribute to the development of a more efficient acquisition policy. (DEFENSE SYSTEMS; COST BENEFIT ANALYSIS; GOVERNMENT PROGRAMS)

Profitsavailablein defense contractingand the effects of competition on weapon systemcost have been the subjectsof extensivestudy duringthe past two decades.The subject has recently attracted considerablepublic attention because of a rash of procurementscandals,such as $600 ashtrays,$800 toilet seats, at a time when the burgeoning federaldeficitbegs to be contained. This paper providesa systematicanalysis of the risks and return availablein the defense marketand their determinants. The generalconclusion is that the aerospace industry'scapacity utilization rate, which measures propensity to compete, has a significant impact on the variationof defensebusinessprofitability on the cost of and acquiringmajorweaponsystemsunderdual-source competition. The paper is organizedas follows: ?1 describesthe unique characteristics the of defensemarketand the policy issues involved in profitlimitationand weapon system competition. ?2 summarizes important prior research. ?3 examines the risk and profitability defensecontracting. modelsthe relationship of ?4 betweenweaponsystems costs and the aerospaceindustry'scapacityutilizationrate. ?5 is a validationof the cost estimationmodel. Finally, ?6 summarizesthe findingsof the study and suggests directionsfor futureresearchand policy making.
1. The Defense Market and Related Policy Issues

Defense marketsrun the gamut from totally free competition to a DOD-created market with one buyer and one or two suppliers.While a great many items are procuredin purely competitive markets,the vast majority of defense procurement dollarsare spentin a marketwherethe Governmentis the only buyerand the number of suppliers small.The Governmentexertscompletecontrolover the size and timing is of demandand, indeed, whetherthere will be a market.Productsusuallydo not even exist ex ante but, instead,are createdat the behest of the Government.Therefore, the amount of risk involvedin the defensebusinesshas often been consideredhigherthan in comparable commercialbusiness(Brownand Stothoff1976). Compoundingthe uncertaintiessuppliersexperienceover the Executivebranch's futureplansand Congressional appropriation processesis the heavyinvestmentneeded
* Accepted by Paul Gray; received August 28, 1985. This paper has been with the authors 1 month for 1 revision. 1259 0025- 1909/86/32 10/0000$01.25
Copyright ?) 1986, The Institute of Management Sciences

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WILLIS R. GREER, JR. AND SHU S. LIAO

to producemajorweapon systems.In fact, the availabilityof suppliersis often linked to the willingnessof the buyer to absorbat least part of the investmentcost required to developsuppliers. The uniquesettingof the defensemarkethas resultedin myriadlaws and regulations similarto profitlimitationsin regulated Unlike profitregulationof utilities, industries. however, the seemingly articulate defense contract profits policy often results in indeterminateprofit outcomes due to the extraordinary difficulties of cost/profit determination(Burns 1972). The widespreaduse of "buy-in"pricing strategiesalso contributes the complexityof defensecontractor to profitbehavior(Burns 1972;Dews et al. 1979). in Profitability the defensemarkethas been a particularly pungentissue duringthe last two decades.The fear that a high-risk,low-profitsituationcould convertdefense business into a "marketof last resort"-one in which only firms with considerable idle capacitywould choose to participate. This concernled to the issuanceof Defense ProcurementCircular(DPC) 76-3, which was intended to increase potential profit levels and to stimulatecapitalinvestmentby contractors. On the other hand, the "buy-in" practice and the Renegotiation Act provide for opportunities "excessprofits"(Burns 1972).This has been the targetof widespread press coverageand has led Congressand DOD to establisha policy of developinga second source of supply in an attemptto bring competitivepressuresto bear on the firstsource. is "Dualsourcing" not a radicaldeparture from long-standing procurement practice. Since 1809,Federalstatutes,regulations executiveordershaveconsistently and affirmed the position that procurementsmust, to the greatestpossible extent, be made on a competitivebasis.This positionhas been reaffirmed both by the currentAdministration and by Congress.' Governmentcontractshave been awardedto competing suppliersfor the sake of fairness,employment,or for otherpoliticaland social reasons(Rich 1977).Additional sourcesof supplyhave also been established enhancethe mobilizationbase. Current to policy on competition, however, finds its roots in the pursuit of financial savings.2 FormerSecretaryof Defense R. S. McNamara,in his reportto the Joint Economic Committeein 1965, said that the GAO had evidenceof dollarsavingson the orderof 25%or more when competitionwas introducedfor reprocurement an item which of had a sole-sourceprocurementhistory. Since then, this 25% saving figure has been quoted repeatedly Congressand the Departmentof Defense. by 2. Prior Researchon Profitability Price Competition and McNamara'sstatementdirectedpolicy makersand analysts'attentionto the issue of defensebusinessprofitability led to legislativeactions calling for expandeduse and of competition.Duringthe ensuingtwo decadesnumerousstudiesexaminedprofitsin defensebusinessand the effecton weapon systemcost of introducingcompetition. The firstcomprehensive study of profitability the defense marketwas conducted in by the GeneralAccountingOffice (U.S. Congress 1971), which reinforcedthe belief that contractors earned"excessiveprofit"from defense contracts.On the other hand, DOD's "Profit '76" study showed that defense business did not generatea return commensuratewith the risks involved (DOD 1976). The controversycontinued in
1 For example,the House and Senateconference agreement HR 4170, the "DeficitReductionAct of on 1984," significantly limits the use of noncompetitive in procedures Federalprocurement and establishes competition in advocates each agencyand each procuring activity. 2 PublicLaw 98-369, effective April 1, 1985.

RISK AND RETURN IN WEAPON SYSTEM COMPETITION

1261

other studies (Comptroller General 1977, 1979; Air Force Systems Command 1982; Simonson 1982; Perino 1983).

Resultsfrom studieson the actualeffectsof competitionon weaponsystemcost are equallycontradictory. findingssuggestthat competitionhas resultedin addednet The costs as often as it has producedthe desirednet savings.This bearselaboration. The unit price of a weapon system typicallyfollows a downwardsloping curve, as more units are acquired.Therefore, estimatingthe effectof price competitionrequires determination the slope of this price-reduction of curve.Conventional wisdomsuggests that the unit price of productswill drop when competitionis introduced.The price reduction has been attributedto two factors:(a) a one-time, probablyimmediate, reductionin the unit pricewhen competitionbegins(the "shift")and (b) an increased rate of price reductionbecause of a steeperprice-reduction curve under competition (the "rotation"). Numerous studies were conducted in the '70's in an attempt to determine the magnitude of the "shift" and "rotation" and the causal factors behind them.3 Unfortunately, resultshave been inconsistent.Many studieshave in fact identified the an unfavorable shift or rotation after competition is introduced.An assessmentby Archibaldet al. of the current state of the art seems to be regrettably close to the mark:
Current understanding of the competitive reprocurement process is meager. It would, for

example, be an understatement say that the determinantsof post-competition to price differences have not yet been identified. (Archibald al. 1981,p. 52) et

The Archibaldstudy raisestwo importantquestionsthat have not previouslybeen investigated: Under what circumstances (1) does competitionlead to productioncost reductions, profitreductions,or to some combinationof the two? (2) How does the to firm'sgeneralbusiness environmentand its investmentstrategyaffect the impact of competition? These two questionsare in fact related.We will show that when business slackensand idle productioncapacitygrows,prices tend to drop and profit margins weaken.
3. Risk and Profitability in the Defense Market

Much of the apparentcontradictionand confusion that surroundsthe profit issue can be attributed the difficultyof measuring profitability a portionof a firm's the of to business. The way corporate overhead and other common costs are allocated to divisions and contractsaffectsthe "cost" of a division's products,and thereforeits profits.Those familiarwith accountingpracticeswill note that allocationof overhead costs simplyredistributes profitsamong the varioussegmentsof the firm on a more or less arbitrary basis. Therefore,the amount of profitsearnedon defensebusinessis an essentially arbitrarynumber unless profit on commercial business is considered simultaneously. Another source of difficultyis that the various studies have been conducted at differenttimes. When competitive conditions change, profitabilitychanges, making comparisons throughtime problematic. A Hypothesis When the economy slackensand idle capacitygrows, real prices should drop and profitmarginsshould weaken.In other words,when demand falls, firms (particularly those with largerfixed costs) should engage in vigorousprice competitionto attract business.Any surplusof price over marginalcost can help offset fixed costs. On the
I

For a comprehensive survey of prior research see Archibald et al. (1981) and Greer and Liao (1984b).

1262

WILLIS R. GREER, JR. AND SHU S. LIAO

other hand, when the industryis busy and thereis sufficient businessto absorba large portion of capacity,the profitability defense business should approachparitywith of commercial business.Otherwise, contractors mighthave little incentiveto acceptDOD orders.Therefore, profitmarginson competitivelyawardeddefensebusinessshouldbe proportionately relatedto the use of the industry's productioncapacity.
Data

of Sinceaerospace firmsaccountfor the largest dollarpercentage defenseacquisitions, our study of defense market profitability concentrateson them. Two types of data were compiled:industryand corporate.The formerinclude capacityutilization(CU) ratesobtainedfrom the aerospacecomponentof the FederalReserveBoard'sIndustry CU Index. The corporatedata for 25 firms,includingreturnon sales (R:S),returnon net worth (R:NW), and the volume of DOD business,4were extractedfrom Value Line. This analysiscovers 1963 through 1982.
Disaggregation Regressions

As mentionedearlier,profitability a "portion"of a firm'sbusinessis subjectto of information changes whenallocationmethodsdiffer.Furthermore, sourceof financial no routinelyreportsthe aerospaceindustry'snet rates of returnon the specificsegments of interest-DOD vs. commercial.Only the amount of profitearnedby the firm as a whole is availablefor analysis.Therefore, was necessary use regression it to analysisas a disaggregation tool. For each of the 20 years,individualfirms'percentages defensebusinesswereused of as an independent variable, and the two profitabilitymeasures were treated as dependentvariables.Thus, 20 regressionsof the form Y = a + bX were produced, trackingreturnon sales as a function of "percentof defensebusiness"throughtime. All 20 values of "b" were negative,indicatingdefensebusinesshas a negativeimpact on a firm'soverallreturnon sales. Another20 regressions the same form trackedreturnon net worthas a function of of the same independentvariable.This time 15 of the 20 valuesfor "b"werenegative. The remainingfive werepositive,but not statistically significant. Therefore patterns the were consistent. Each regression equationwas next evaluatedat X = 0 (100%commercialbusiness) = 100 (100%defensebusiness).The ratio of the latterto the formeryields the and X relativeprofitability defense business to commercialbusiness, as indicatedby the of respectiveprofitability measure.For example, the returnon sales equation for 1973
was Y = 13.3
-

0.094X. At X = 0%, the estimated return is 13.3% for commercial

business;for 100%defensebusiness,the estimatedreturnis at Y = 13.3 - 0.094(100) = 3.9%. The ratio of return on sales (R:S) is 3.9%/13.3%= 29.3%. This ratio "neutralizes" effects of allocatingcommon costs across commercialand defense the contracts. To help reducethe volatilityintroducedby the accountingprincipleof periodicity, and to widen the time perspectiveassociatedwith the industry'splanninghorizon,a resistanttime series smoother was applied, followed by a simple Hanning running average(Velleman1980).The finalresultsare shownin Table 1, alongwith the indices of aerospaceindustrycapacityutilizationdiscussedearlier. A summaryreviewof Table 1 data might be helpful.The profitability figuresshow the estimatedreturnon defense business as a percentageof the estimatedreturnon
4Value Line reports translates "defense into whichin this case roughly "government business," business," sincethe only othersignificant business fromNASA,whichusesthe samerulesand regulations is government as DOD.

RISK AND RETURN IN WEAPON SYSTEM COMPETITION TABLE 1 Relative Profitability of Defense Business and Capacity Utilization Year 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 R:S 29.7% 34.4 41.8 48.5 50.8 48.9 41.6 30.2 21.6 18.8 19.1 23.2 35.5 53.7 67.4 71.1 67.0 60.2 57.0 56.9 R:NW 99.2% 94.8 92.4 91.7 91.3 89.5 85.2 75.5 64.7 60.6 63.5 74.1 92.4 109.1 115.0 106.1 88.2 79.3 79.3 79.3 CU 83.0% 83.7 86.0 88.3 89.1 87.0 80.0 72.2 69.3 69.7 70.7 71.3 71.7 72.2 74.8 79.1 81.2 80.6 78.1 73.9

1263

commercialbusinessfor the aerospaceindustryin each of the 20 years.The returnon sales figuresfor defense businesswere considerably lower than those for commercial business.This might be consideredacceptabledue to the fact that a portion of the investmentneeded to performon defense contractsis financedby the government. How much lower a returnis acceptable a questionthat remainsto be answered. is Akin to profit regulationin public utilities, relativereturn on net worth (R:NW) provides a more meaningful comparison of profitability.Using this measure, the defense business also has been less profitablethan its commercialcounterpart.The to periodbetween 1976 and 1978 is an exception.This can be attributed DPC 76-3, which was issuedto boost contractors' profitpotential.
Associative Analysis

During the 20 years included in this study, the aerospace industry's capacity utilizationrate hit a peak in the mid 1960's. The same period also produceda high businessprofitability). to point in defensebusinessprofitability compared commercial (as The periodduringwhich DPC 76-3 was in effect producedanotherprofitability peak. The low point for both the industry'scapacityutilizationand the relativeprofitability from defensebusinesswas in the early 1970's.Figure 1 depictsthese phenomena. To test the hypothesis that relative profit margins are related to the industry's capacity utilization,the statisticalsignificanceof the relationshipsbetween capacity utilizationand relativedefensebusinessprofitability shownin Table 1 was analyzed. as A regression equationof the generalform: Profitability(R:S or R:NW)=f(CU) was derivedfor each of the profitability measures.Two sets of data were used, one includingall 20 years and one excludingthe period contaminatedby the DPC 76-3 profitpolicy change.The resultsare as follows:

1264

WILLIS R. GREER, JR. AND SHU S. LIAO

CQ~~~~~~~~~~~~ 0~~~~~~~~~~~
o

F-1

-I

|LEGEND 2 '
S

~R:-~~~~~
65 ra 0 65 70 70

YEAR
75

0R:NW
~~~~80
85

YEAR
FIGURE 1.

Profit Ratio and CU.

Equation 20 Years (1976-1979 included): R:S=-35.0+ 1.01 CU R:NW = 12.6 + 0.95 CU 16 Years (1976-1979 excluded): R:S = -54.1 + 1.17 CU R:NW = -50.5 + 1.65 CU

T-ratio 1.84 1.98 3.08 7.51

R2

F-test
3.39 3.92 9.50 56.45

15.8% 17.8% 38.7% 80.1%

Several observations can be made. The regressions constitute strong statistical support for the hypothesis that the relative profitability of defense business is proportionately related to the industry's capacity utilization rate. The coefficients for the independent variable CU are positive and their T-ratios are statistically significant at the 5% level or higher in all four cases. The analysis using only 16 years of data (excluding the four years contaminated by DPC 76-3) provided a much better statistical fit than the result using all 20 years of data (see Figure 2). R:NW showed a better association with CU than did R:S, which is consistent with the observation made earlier that return on net worth is a more meaningful indicator of relative profitability. A more general conclusion can also be drawn from the above analysis. As measured by return on net worth, the profitability of defense business is usually lower than that of commercial business, but the two approach parity when the industry is busy. Risk/Return Analysis The preceding analyses showed that defense business has in general been less profitable than its commercial counterpart. But a question arises as to whether the return in defense business is commensurate with its risk level. In general, a firm subject to profit limitations should be permitted to earn at a rate equal to that of firms in unregulated industries with comparable risks (Cootner and Holland 1979).

RISK AND RETURN IN WEAPON SYSTEM COMPETITION

1265

CQ

o
0

0-

C2 -

~
---~~~~~G

EO-CEr

C;d

~ ---E ~

LEEN

60

65

70

75

80

85

YEAR
FIGURE 2.

Profit Ratio and CU.

Risk may be defined and measuredin severalways. One view is from inside the firm-through the eyes of management.This risk perspectiveconcernsitself with the volatility of earnings. Managementmust budget cash flows and exhibit appealing picturesof stableprofitgrowth.These tasks are made easierif earningsare stableand predictable than if they are volatile.All thingsequal, managementwould preferstable of returns.Earlierwe estimatedthe profitability business from the commercialand equations for returns on net worth. The defense sectors using 20 disaggregation estimates(commercialand defense) standard deviationsof the two sets of profitability werecalculatedas indicationsof their volatility.The resultswere 3.2%for commercial businessand 4.2%for defensebusiness,indicatinghighervolatilityof profitsfor defense business.This finding is consistentwith the observationthat contractorsseek profit paritywith commercialbusinesswhen the industry'sproductioncapacityis pushed. To study risk throughthe eyes of the financialmarkets,the "PriceStabilityIndex" (PSI) reportedby Value Line was used as a measure of total risk-the volatility of returnsin the equities market. The most recent PSI for each of the 25 firms was regressed againstthe firm's"percentdefensebusiness"figurefor the same period.The regression analysisyielded a coefficient("b") of -0.38, with a T-ratioof -2.68. The at T-ratiois significant the 1%level and the negativevalue of the coefficientindicates that, if a firm's percentageof defense business were to rise by 10%,its PSI would declineby about 3.8 points. Therefore, total risk, as seen throughthe capitalmarket's eyes, is also higher for defense than commercialbusiness. This finding is consistent Board'ssurveyresults(Brownand Stothoff 1976). with the Conference Finally,we replacedthe total riskmeasurewith one for systematicrisk,the so-called "beta", for each firm and ran another regressionanalysis. (Again the data were extractedfrom Value Line.) Here the coefficientlacked statisticalsignificance.This means the amount of defensebusinessdone by a firm should not have an impact on to its cost of equity capital. This may be attributable the fact that the Government typicallyprovidesa portionof the funds neededfor majorweaponsystemscontractors throughgovernmentfurnishedequipment,progress payments,etc.

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WILLIS R. GREER, JR. AND SHU S. LIAO

What Makes Defense Business Attractive?

The observedlower rate of returnand higher risk for defense business relativeto commercialbusinessmay seem inconsistentwith the fact that firmsindeed do pursue this market. Several hypotheseshave been offered to explain firms' willingnessto participate. One hypothesisis that, since a portion of the investment needed to perform on defense contractsis financed by the government,return on investment for defense businessmay be higherthan for commercialbusiness.This is not a directlytestable hypothesis,though,as it is impossibleto determinethe actualcapitalused on a given contract, which is almost always under-reimbursed the government (Simonson by 1982).Our findingon the relativereturnon net worthalso refutesthis argument. An alternativeexplanationis that managementmay seek objectives other than maximumreturnin defensebusiness.The most widely held view is that management is willing to accept lower return and higher risk in order to take advantage of from defensecontracting. technologytransferred Majorweapon systemsdevelopment is always at the leading edge of technology. Securing a defense contract gives a the participant technologicaladvancesit needs without financingits own costly R & D projects.This view is best summarized Fox (1974, pp. 449-450): by
Profitis not a defensecontractor's concernwhenbiddingon or conducting development only a or production program. Defensecontracts soughtto coverpayrolland overhead are costs,and to providecompanypersonnel with the opportunity developtechnicaland managerial to skills usefulin futurecommercial defensebusiness. and

From the viewpointof profitmaximization,the most logical explanationof participation in defensebusinessis to absorba portion of a firm'soverheadburden.Given the allowableaccountingpractices,securingdefensecontractsmakesit possiblefor the contractor shift a significant to portion of overheadto defensecontracts,thus making its commercialbusinessmore competitive.Thereare empirical(Greerand Liao 1984a) as well as anecdotal5evidences to suggest that defense contracts tend to bear a disproportionate portionof corporateoverhead. Finally, it is sometimes suggested that firms gain marketing advantagesfrom If Government contracts. the firmcan build a state-of-the-art defensesystem,it "must" be capableof buildinga good commercialproduct. 4. WeaponSystems Cost Variationand CapacityUtilization The precedinganalysesshowed that the profitability defense business is closely of associatedwith the industry'scapacity utilizationrate. Given the multitude of laws and regulations limitingthe profitcontractors make on governmentcontracts,one can might wonderhow it is possible to have varyinglevels of profit.To understandwhy this is possible,it is necessary understand forward-pricing to the systemused in defense contracting. The vast majorityof defense acquisitiondollarsare spent on items requiringstateof-the-arttechnologies, i.e., items which did not exist or must undergo constant redesignto incorporate new technology.Whetheracquiredusing a cost-plus,firm-fixed price or other type of contract,a bid price must be submittedwell in advanceof the actual work. The basis for bid price determinationnecessarilydepends on the often highly uncertainestimatedcost to performthe contractedwork. When the industry
I DoD officials and procurement analysts often complain that contractors "set up a production process that is inefficient" (Archibald et al. p. 55). It is counter-intuitive that a profit seeking producer would deliberately set up an inefficient production process. In reality, it is the disproportionate overhead burden allocated to defense contracts that causes the observers to misinterpret the process as inefficient.

RISK AND RETURN IN WEAPON SYSTEM COMPETITION

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has ample idle capacity,a firm may be so eagerto compete for a contractthat it will base its bid on a cost figurewhich it may only have a small chance of achieving.On the other hand, if the economy improvesand the industrygets busier,the same firm may not be willingto accepta contractunlessit has a much betterchanceof achieving the estimatedcost. Anotherinterpretation that when the economy slackens,firms(particularly is those with largerfixed costs) tend to engagein vigorousprice competition.In orderto win contracts,genuinely competitivebids must be submitted.On the other hand, when the industryis busy, a firm may increaseits bid price in anticipationof a reduced amount of competition.In either case, variationsin the bid price simply reflectthe level of risk the firm is willing to take under differentmarket conditions. In this section,we analyzeempiricalevidencesupporting view of the defensemarket. this Competition Major WeaponSystemsMarkets in To addressthe policy issue of weapon system competition, one must partition defenseacquisitionsinto three categories.The firstincludesitems with very high unit costs but acquiredin low quantities,such as new generationsof aircraftsand ships. Except for the initial design and development, no effective competition has been established theseitems.Therefore, for acquisitions understandably been conducted have in a sole sourceenvironment. At the other end of the spectrumlies low value, high volume partsand tools which normallyare procuredcompetitively.However,the total dollar value of items in this categoryis relativelysmall comparedto that of majorsystems. The middle categoryof goods procuredby DOD includes relativelyhigh unit cost but high volume items such as missiles and sophisticated electronicequipment.This is the categoryto which the policy issues of competitionapply. Many items in this categoryare acquiredon a sole-sourcebasis, but many others are procuredfrom two suppliers.This kind of monopsony versus duopoly scenariois referredto as "dualsourcecompetition". As mentionedearlier,conventionalwisdom suggeststhat the unit price of products will drop when competitionis introduced.However,the recent researchdone on the known historiesseems to suggestthat dual sourcinghas resultedin added net costs as often as it has producedthe desirednet savings.In this section we will examine the cause of this apparentcontradiction. Historyof Dual-SourceCompetition Seven majoracquisitionprograms have been dual sourcedafteran initial periodof sole-sourceprocurement. These systemsare the most sophisticated weaponsthat have been acquiredundercompetitivecontracting. The numberof contractsfor each system rangesfrom six to sixteen.These seven programs yieldeda total of 87 annualbuys, of which 39 were awardedcompetitively.Extracting useful price data from each contract file requireslengthystudy. Fortunately, they have been the subjectof severalprevious studies, and verifiableprice data are available.It is reasonableto say that the data used here represent entirecensus of dual-sourced the majorweaponsystemsfor which verifiable pricedata are available. Hypothesis Consistentwith our findingsregarding defensebusinessprofitability, hypothesis our is that effective competitive pressure exists only when the aerospace industry is "hungry".In other words, under the forward-pricing system, the price of goods acquired DOD (andcontractors' by profits) varieswith the industry's capacityutilization rate.Net savingsare possibleonly when capacityutilizationis low.

1268 A Preliminary Check

WILLIS R. GREER, JR. AND SHU S. LIAO

First,as a simple preliminary check of the hypothesis,the data reportedin Table 2 were assembled.The programsavings (loss) data were taken from an earlier study (Beltramoand Jordan 1982). The capacityutilizationfiguresare simple averagesfor the aerospaceindustryduringthe competitivephase of each procurement program. By examiningTable 2, the readercan confirmthat in only three of the seven cases studiedwerethe price savingssufficiently largeto more than offsetincreasedcosts due to the lost economies of scale and the added front-endinvestmentsrequired.In each of the three"savings" less cases,industrycapacityutilizationaveraged than 80%during the dual-sourcephase of the procurement.When a loss resultedcapacityutilization was runningabove 80%. This preliminarycheck tends to support the general hypothesis.Net savings do appearto have resultedfrom competitiononly when capacityutilizationwas relatively low. Indeed, implementationof dual sourcingwhen capacity utilization was higher than about 80%seems to have been, in retrospect, unwise.
Empirical Analysis

Encouraged the resultsof the preliminary by analysis,we went aheadwith the actual The unit pricesof the 87 annualbuys were modelingof a price estimationprocedure. fittedwith a regression model of the followingform:
P=
kQaCUcedMefN.

"P" is the averageprice per unit for the buy. The "Q" term represents "algebraic the midpoint" quantity associatedwith a particularbuy as used in the learning curve model.6 CU, again, representsthe aerospaceindustry'scapacity utilization rate in percentage, while "k", "a" and "c" are parameters. In addition,since the savingspotentialdependson theform of competitionin effect, two dummy mode variables were added; 0 M = 1 if the buy was underdual sourcing, otherwise; 0 N= 1 if competitionwas winner-take-all, otherwise. The parameter M is "d", for N it is "f". Raisingthe constant,e, to the resulting for causesa parallelshiftin the log form of the learningcurve.A nonzeroparameter power
TABLE 2

A Preliminary Hypothesis Check


Procurement Program TOW Rockeye Bomb Bullpup AGM-12B Savings or (Loss) Due to Competition 26.0% 25.5 18.7 Average Capacity Utilization During Dual Source Phase 63.5% 70.9 76.2

Shillelagh Missile
Sparrow AIM-7F MK-46 Torpedo Sidewinder AIM-9D/G

(4.7)
(25.0) (30.9) (71.3)

87.0
81.6 91.6 82.3

6 Note that the learning curve model used in contracting follows the incremental average cost concept, or the so-called Crawford's model (as opposed to the cumulative average cost concept or Wright's model). In

otherwords,the unit priceof a "lot"is associated with the algebraic midpointof the lot.

RISK AND RETURN IN WEAPONSYSTEMCOMPETITION

1269

value would mean a downwardshift in the sellingprice takes place if a given form of competition is in effect. As mentioned earlier, competition would not be effective unless the capacityutilizationrate is low. Based on Table 2 data, an 80%utilization M rate seems to be a convenientand logical break-point.'Accordingly, was set to 1 only if CU < 80%. Sincethese weaponswere procuredunderdual sourcing,separatemodels werebuilt for each of the two contractors.Moving through the seven programsproducedan as arrayof statistically significantestimatesfor the parameters shown in Table 3. Interpretation The resultsareconsistentwith our observations existingtheories.The coefficients and for the learningterm are all negativeand reflectslopesrangingfrom a steep 76%curve to a flat 99%.The coefficients the capacityutilizationterm are all positive,which is of consistentwith our hypothesis that, otherthingsbeingequal,highercapacityutilization rates drive up the price the Govemnment must pay for major weapon systems.Also consistentwith our hyothesisis the fact that the coefficientsof the two competition mode terms are negative,indicatingcompetitionwas indeed an effectiveprice reducer whenthe propensityto competeis strong.Our definitionof this condition is a period when the industry'scapacityutilizationrate is below the normal level, i.e., 80%.The coefficientsfor winner-take-all competition were found to be higher than those for dual source competition,indicatingthat the formerhas been more effectivethan the latterin generating price savings. To summarizethis section, when the industryCU is below the 80%normal level, introducingcompetitionto a major systemsacquisitionresultsin price savings(joint
TABLE3 cients Learning, & Coeffi for CapacityUtilization Competition Source Original Program Sidewinder Bullpup Tow Shillelaghi MK-46 Rockeye Sparrow a ns -0.354 6.74 -0.040 1.97 -0.391 107.1 -0.219 2.43 -0.241 5.29 -0.315 3.04 c 8.123 1.91 ns 2.950 7.22 1.250 8.04 ns 1.096 1.88 ns d ns -0.275 3.07 -0.127 4.85 na na na ns f na na -0.854 26.21 na na na na -0.122 3.01 -0.013 4.01 -0.389 6.96 a ns -0.174 2.77 -0.371 10.49 SecondSource c ns ns ns d -0.526 6.31 ns ns f na -0.514 2.07 na

Insufficient observations ns 5.90 13.66 5.05 3.37 na na ns na na na

=not

Note:Coefficients shownin boldface; are T-ratios shownbeloweachcoefficient; = not significant; are ns na to applicable the program.

7The 80%utilizationrate seems to be the generally accepted"standard" "normal" or volume. See, for example,Johnson(1978, pp. 498-500, 505-507).

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WILLIS R. GREER, JR. AND SHU S. LIAO

effect of low CU and competitionpressure,M or N) which may be sufficiently large to offset the front-endinvestmentsof introducinga second supplierand the loss of economies of scale by splittingthe quantityamong two sources.On the other hand, introducinga competitor most likely will not pay off if CU is tight. Splitting the quantitymeansforegoneeconomiesof scale.The positiveparameter CU also means of higherprices.Furthermore, neitherof the price reducers, or N, will have any effect M whenCU is abovenormal.Thesefactors jointly explainwhy net losseswereexperienced in four of the cases studied. 5. CapacityUtilizationas a Cost EstimationTool To be of benefit to Congressional and DOD policy makers,the findingsreported above must be usablein makingacquisitiondecisions.From an economic perspective, the question is whether the Government should spend large sums of resourcesto develop a second source in hopes of reaping savings from price competition. The robustness our model must be evaluated. of
Current Cost Estimation Practice

Determiningthe slope of the learningcurve is the backboneof currentparametric cost estimationmodels. Recent attemptsto improvecost estimationhave focusedon addinga productionrate term to the learningcurve (Smith 1980; Womer 1979). To test the relative strengthsof estimating a program'scost with the learning-curve/ production-rate model versus our model, we derivedthe coefficientsfor the learning and productionrate terms alone using a model of the followingform:
P=
kQaRb

where "Q" is the lot midpoint as mentioned earlier,"R" representsthe production rate and "k", "a" and "b" are parameters.If the parametersare negative, P is a downwardsloping curve as Q and R increase,reflectingthe effects of economies of scale. The model was fitted to each of the seven programsand the median value of the statisticallysignificantparameterswas derived. This resulted in the following equationsfor the learning/rate models:
P=kQ-0313R-0 183

(for the original source), (for the second source).

P = kQ-0323R+0560

The positive exponent for rate term in the second source model may at first seem odd. One possible explanationis that the second source might have been facilitized for a lower productionrate than the originalsupplier,and while it might therefore be more efficientat lower productionrates,it becomesless efficientas ratesrise. For comparison,the median values for the explanatory variablesof our model are as follows:8 P= kQ-? .278CU+1.250C0.201MCO.8e4N (original source), P= kQ-0174cu+5475eO.e26McO.514N (second source).
Testing the Models

Due to the limitednumberof majorweaponsystemswhich havebeen dual sourced, no holdout samples are availablefor model validation.The only data availablefor While not ideal are testingthe model'sperformance the ones used for the derivations.
8 The rate term was also considered in our analysis. However, it became statistically insignificant when the capacity utilization term was added to the model. Other studies reporting nonsignificant rate term include Alchian (1963) and Hirsch (1952).

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as a research procedure, it does provide an indication of the ability of the methodically derived models to accommodate accurately the individualities of these seven programs. It will also provide an indication as to whether our model is superior to current cost estimation practices. The basic strategy of the test was to use each model to project at the onset of procurement what the total procurement cost "would be" for each of the seven programs, then to compare the actual cost to the forecast. Our criteria for comparison include means and standard deviations of both the arithmetic and absolute errors as measured by the percentage of cost underrun or overrun from projected cost. To place each model on an equal footing, it was assumed that the price, quantity, production rate and smoothed capacity utilization were all known for the first buy. This enabled "k" to be evaluated, as it was the only remaining term. We further assumed that the values of the independent variables could be forecast with accuracy. This insured that we were testing the models, and not the accuracy of the inputs. Now consider the summary of the results given in Table 4. Clearly, the learning/ capacity utilization model has outperformed the learning/rate model. The average arithmetic and absolute errors are both lower for the learning/capacity utilization model than for the learning/rate model. In addition, the lower standard deviations (shown in parentheses) indicate the program-to-program variations of actual from forecast cost are lower with the former. We view this outcome as additional support for our hypotheses. But there are additional insights to be gained from the research, and which also bear elaboration. 6. Implications and Conclusions A vast amount of research has been done on public utility price determination. But, until now, little systematic empirical work has been done on the forward pricing system in defense contracting.9 Most research on defense business profitability and savings from competition has produced results which are contradictory. This study examined the defense contract pricing issue in a systematic manner, using a theoretical framework as a guide to formulate hypotheses. The results clearly show that contractor profitabilityvaries with the aerospace industry's capacity utilization, and that the price the Government has paid for major systems reflects this variation. The study also shows that defense business has generally been less profitable than commercial business even though the risk level is higher. Several explanations as to why contractors continue to participate in defense business despite low return and high risk were discussed. The suggestion that defense business bears a disproportionate share of contractors' overhead seems to be logical. This
TABLE 4 Summary Results of Performance Tests Arithmetic Error Percentage Learning/Rate Model: Average (Standard Deviation) Learning/Capacity Utilization Model: Average (Standard Deviation) Absolute Error Percentage

27.2 (93.1) 4.0 (38.2)

64.3 (68.6) 30.6 (19.8)

The one possibleexceptionis Gansler's work(1980).

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suggestion,along with other findingsin this study, can offera logical explanationfor many of the perplexing questionsfacingacquisitionanalysts.For example,production costs should decreasewith cumulativequantitiesproduced,suggesting that an original producershouldbe able to win a competitiveawardhandsdown. Many analystswere puzzledby the fact that originalproducersfrequentlylose in the biddingfor an item that is reprocured competitively(Archibaldet al. 1981). Some suggestthat a profitmaximizingproducermight set up a productionprocessthat is inefficient; then when this producerfaces competitionfrom a second source, he seems unable to shift to a more efficientproductionprocess(Zusmanet al. 1974). This seems counter-intuitive both theoreticallyand empirically.It is difficultto imagine why a profit-maximizing firm would deliberately up an inefficientproductionprocess. Furthermore, set there are many other cases when the originalproducercontinuedto be the winningbidder. A more logicalexplanationis that, undercurrentlaws, contractors have a certain still degreeof flexibilityin shiftingoverheadcosts. When the industryis busy, a contractor sees no need to shift some of the overheadcosts from defensecontractsand, therefore, remains"inefficient" and content to be the high bidder to maximize profit. On the otherhand,when the industry's is low, most contractors CU would shifttheiroverhead in orderto win the contract. We view our contributionas one of separating myths from the facts of weapon the systemcompetitionand providingexplanations analytical and tools for policy analysts. It is unfortunate that many majoracquisitiondecisionswere made on the basis of the myth that competingmajorweapon systemsshould producesignificantsavingsto the government.This study used data from three differentsourcesand producedresults that clearlycall for modifyingthis viewpoint. Severalconclusionswhichhaveimplications both policy-makers cost analysts for and can be drawn.First, the profitability defense businessclearlyis lower than that of of commercialbusiness in the aerospaceindustry.What causes this is not clear, but a logical interpretation that "losses"sufferedwhen "buyinginto" programshave not is been sufficiently offsetby "excessprofits"duringthe productionphase. A relatedconclusion is that an inter-temporal analysis of profit is necessaryif an appropriate profitpolicy is to be adopted.A case in point is DPC 76-3, a policy change basedon the resultsof the "Profit'76" study,which happenedto examinethe defense industrywhen it was in poor shape. As a consequence,profitswere abnormallyhigh during 1976-79, as shown in Figure 1. On the other hand, GAO's "Profit'71" study examinedthe defensemarketat the heightof the VietnamWar.The conflictingresults were inevitablebut can easily be explainedby our findings. Knowledge of the state of capacity utilization in the defense industry can be importantinformationfor correct managementof the acquisitionof major weapon systems under competition.Such knowledgecould contributeto the efficientuse of public resources as well as having a stabilizing effect on the economy. Shifting procurement funds from periodsof "boom"to "slow"periodswould not only make it possibleto reduce procurementcosts, but would also have a moderatingeffect on the cyclical variationwhich has plagued the industry. Many social programshave followed this method of funding. Based on our analysis,this method would prove beneficialto the Governmentas well as the industry. In view of our ongoingdebatesover federaldeficitand defensespending,we see our researchas a timely contributionto better managementof the financial resources entrusted to our Government, and to attendant efficiencies in the procurement
process.10
Support fromthe Officeof Naval Research NavalAir SystemsCommandCost AnalysisDivisionis and gratefully acknowledged.
10

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References
Air Force Systems Command, "Profit Study '82," summary report, Andrews Air Force Base, MD, undated. ALCHIAN, "Reliability of Progress Curves in Airframe Production," Econometrics, 31 (1963), 679-693. A., ARCHIBALD, A., A. J. HARMAN, A. HESSE,J. R. HILLER K. M. AND G. K. SMITH,"Factors Affecting the Use of Competition in Weapon system Acquisition," R-2706DR&E, Rand Corporation, February 1981. BELTRAMO, N. AND D. W. JORDAN,"A Brief Review of Theory, Analytical Methodology, Data, and M. Studies Related to Dual Source Competition in the Procurement of Weapon Systems," Headquarters, Naval Material Command, August 1982. "The Defense Industry: Some Perspectives from the Financial BROWN,J. K. AND G. S. STOTHOFF, Community," Report No. 693, The Conference Board, 1976. BURNS,ARTHUR E., "Profit Limitation: Regulated Industries and the Defense-Space Industries," Bell J. Economics and Management Sci., 3, 1 (Spring 1972), 3-25. Comptroller General of the United States, "GAO Review of Profit '76," 17 February 1977. , "Recent Changes in the Defense Department's Profit Policy-Intended Results Not Achieved," Report to the Congress, 8 March 1979. COOTNER, P. H. AND D. M. HOLLAND, "Rate of Return and Business Risk," Bell J. Economics and Management Sci., 1, 2 (Autumn 1970), 211-226. Department of Defense, Profit Study Group, "Profit '76 Summary Report," December 1976. DEWS, E., G. K. SMITH, A. BARBOUR, E. HARRISAND M. HESSE, "Acquisition Policy Effectiveness: Department of Defense Experience in the 1970s," R-2516-DR&E, Rand Corporation (October 1979). Fox, J. R., Arming America: How the U.S. Buys Weapons, Harvard University Press, Cambridge; 1974. GANSLER, J. S., The Defense Industry, The M.I.T. Press, Cambridge, December 1980. GREER, JR., WILLIS R. AND SHU S. LIAO,"Cost Analysis for CompetitiveMajor Weapon Systems Procurement: Further Refinement and Extension," Naval Postgraduate Technical Report 54-84-023, September 1984a. , "Competitive Weapon Systems Procurement: A Summary and Evaluation of Recent AND Research," National Contract Management J., (Winter 1984b), 37-47. HIRSCH, W. Z., "Manufacturing Progress Functions," Rev. Economics and Statist., 34 (1952), 143-155. JOHNSON, H. T., "Management Accounting in an Early Multidivisional Organization: General Motors in the 1920's," Business History Rev., (Winter 1978), 490-517. PERINO, G. H., JR., "What Price Defense? Profit and Profitability in Defense Industry," Program Manager, (May-June 1983), 32-36. RICH,M. D., "Congress and Competition," paper presented at Joint National Meeting of TIMS/ORSA, May 1977. SIMONSON, R., "Misconceptions of Profit in Defense Policy," National Contract Management J., (Winter G. 1982). SMITH,C. H., "Production Rate and Weapon System Cost," Army Procurement Office, APRO 80-05, November 1980. U.S. Congress, House of Representatives, "Defense Industry Profit Study of the General Accounting Office," March 1971. VELLEMAN, "Definition and Comparison of Robust Nonlinear Data Smoothers," J. Amer. Statist. Assoc., P., (September 1980). N. WOMER, K., "Learning Curves, Production Rate and Program Costs," Management Sci., (April 1979). ZUSMAN,M. ET AL., "A Quantitative Examination of Cost-Quantity Relationships, Competition During Reprocurement, and Military vs. Commercial Prices for Three Types of Vehicles," Institute for Defense Analyses, 1974.

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