Incentive Versus Cost-Plus Contracts in Defense Procurement

Abstract

IN I966 Robert McNamara claimed that the introduction of incentives in defense contracts, especially with respect to cost variables, caused roughly a io% reduction in total weapons procurement costs relative to comparable outcomes using cost-plus contracts.1 This claim provoked considerable debate over the realism of such savings.2 The arguments that a cost incentive contract will lead to lower procurement costs boil down to the following. First, if there is a cost overrun under an incentive contract, the government will be obliged to pay only part of it. Second, since the firm will have to pay a portion of any cost overrun, it will undertake cost efficiencies to avoid a reduction in profit level. It is argued that the firm would not otherwise undertake to realize such efficiencies since there are no market pressures of competition to force it to do so. Third, it is an empirical fact, noted by many observers, that cost performance relative to target costs has improved as stronger incentive measures have been introduced.3 The validity of the theoretical and empirical claims of the proponents of incentive contracting have been attacked by the following counterargument. Although it is possible that production efficiency has increased, it does not follow automatically that the total cost to the government has been reduced relative to what it would have been under a simple cost-plus contract. There are three basic reasons for this. First, while it is true that costs have improved relative to target costs (under incentive contracts), it is possible that the target costs themselves have been inflated relative to what they would have been under a cost-plus contract.4 Second, incentive contracts offer higher 'going-in' profit rates (i.e. negotiated target profits) as well as higher 'comingout' profit rates (i.e. final profits).5 Thus, production efficiencies under the