Defense Profit Policy and Capital Investment

by Rachel Schmidt

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Since 1964, the Department of Defense (DoD) has used its Weighted Guidelines (WGL) method to formulate an objective profit level for defense contracts prior to entering into price negotiations with firms. Initially, the WGL system resulted in objective profit rates that were largely proportional to total contract costs. It has been argued that under these circumstances, defense firms have little incentive to invest in cost-reducing capital equipment. Since 1976, however, DoD has revised the WGL system several times so that ex ante profit is based, in part, on the value of facilities and equipment employed on a contract. DoD has devoted considerable attention to these WGL policy changes on the premise that ex ante profits are a major impetus for capital investments. This Note examines the implementation and effectiveness of WGL policy changes using a multiple regression framework on more than 5,000 defense contract observations from fiscal years 1978, 1983, and 1988. The author finds that some aspects of WGL policy — particularly guidelines regarding the return on capital portion of research and development and service contract profits — were not implemented fully by DoD. Furthermore, she concludes that during the 1980s, numerous factors provided a positive climate for defense capital investments and that changes in WGL profit policy were only a minor investment incentive for defense contractors.

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