An Economic Framework for Analyzing DoD Profit Policy

by William Rogerson

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The Department of Defense (DoD) purchases many one-of-a-kind items that involve advanced specialized technology, so the DoD often procures items from a sole source. When competition does not determine one, the DoD must try to set a fair price based on anticipated production cost. A complicated set of regulations, collectively referred to as profit policy, is used to calculate a "profit" for the contract. This report provides an economic analysis of the regulations used to calculate the profit. It argues that profit actually consists of many conceptually distinct components, each performing a distinct economic function, and provides an overall framework in which to understand the function of profit in the procurement process. Many costs of production are not recognized in government accounting regulations. The author shows that there are also other categories of unrecognized costs. While the regulations explicitly identify one small subcategory of profit payments (payment of profit for specific observed actions of the contractor, such as implementing a more accurate cost-estimating system) they do not explicitly acknowledge the most important subcategory of such profit payments — payment of economic profit to provide firms with an incentive to innovate. The author argues, therefore, that profit policy regulations should be analyzed in the context of an economic theory that explicitly identifies the economic functions of profit.

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