The Role of Cost-Plus Contracts and Target Costing in Wartime: A Case Study from World War II

 

Introduction

During periods of conflict, particularly in large-scale wars like World War II, governments face immense pressure to ramp up production of military supplies, weapons, and equipment. The urgency and scale of such demands often make traditional fixed-price contracts impractical due to the unpredictability of costs. This is where cost-plus contracts come into play. These contracts guarantee that manufacturers are reimbursed for their costs and receive a fixed profit margin, thus ensuring rapid production without the financial risk associated with fluctuating material, labour, and overhead expenses. This method proved vital in World War II, particularly in the U.S., where it allowed for unprecedented military expansion. A key example is the production of the B-17 Flying Fortress by Boeing.

Understanding Cost-Plus Contracts
Cost-plus contracts are agreements where a contractor is paid for all incurred costs, plus an additional amount for profit. This structure includes:

• Direct Costs: Such as materials and labour directly involved in production.
• Overhead Costs: Indirect expenses like administrative costs, utilities, and depreciation.
• Profit Margin: A fixed percentage or fixed amount added to the total costs as profit.

The Boeing Example: Aircraft Production During WWII
One of the clearest applications of cost-plus contracts during World War II was in the U.S. aircraft manufacturing sector, particularly with companies like Boeing. In the early 1940s, the U.S. military required thousands of aircraft to fight in both the European and Pacific theatres. The production of bombers such as the B-17 Flying Fortress was critical to the success of the U.S. Air Force.

However, the costs associated with building these planes were highly uncertain. Factors such as material shortages, changing labour demands, and unforeseen production challenges meant that fixed-price contracts would have been risky for Boeing and other manufacturers. The cost-plus contract eliminated this uncertainty. Boeing was reimbursed for all its production expenses and received a guaranteed profit, typically a percentage of the total cost. This allowed Boeing to focus on increasing production speed and quality without worrying about cost overruns.

For instance, if Boeing estimated that the production cost of a B-17 bomber would be $300,000, the U.S. government agreed to pay that amount, plus a fixed percentage profit, say 10%. Even if production costs rose to $350,000 due to unforeseen issues, the government would cover those costs, and Boeing would still receive a $35,000 profit based on the 10% margin.

Advantages of the Cost-Plus Method in Wartime

1. Incentivizes Production: By removing the financial risks, cost-plus contracts incentivize manufacturers to produce at full capacity without fear of losses from cost overruns.
2. Accommodates Unpredictability: War often creates volatile markets for raw materials and labour, and the costs of production can vary widely. A cost-plus contract accommodates these fluctuations, ensuring production continues even when costs are unpredictable.
3. Speeds Up Procurement: Governments can quickly engage contractors, knowing that any unexpected costs will be covered. This is crucial in wartime when delays could mean losing strategic advantages.
4. Encourages Large-Scale Projects: Major projects, such as building fleets of bombers or ships, involve complex logistics and high risks. The cost-plus system allows for large-scale mobilization of resources without requiring manufacturers to bear the full financial burden.
5. Assured Profit for Contractors: Manufacturers are more willing to invest in war production because their costs are covered, and they are guaranteed a profit. This secures long-term partnerships between the government and industries crucial to the war effort.

Disadvantages of the Cost-Plus Method
While the cost-plus contract system helped facilitate rapid production during World War II, it was not without criticisms:

1. Lack of Incentive to Control Costs: Since contractors were reimbursed for all costs and still earned a profit, there was little incentive to control or reduce spending. This occasionally led to inefficiencies and waste.
2. Potential for Overpricing: Contractors might inflate costs, knowing they would still be reimbursed, leading to potential abuse of the system.
3. Administrative Burden: Cost-plus contracts often require extensive record-keeping and audits to ensure that all expenses are legitimate, which can lead to administrative challenges for both the government and contractors.

Overcoming the Disadvantages of Cost-Plus Contracts
To address these issues, governments and contractors can adopt several strategies to improve cost control and reduce inefficiencies:

1. Incentive Clauses for Cost Reduction: One solution is to include incentive clauses that reward contractors for meeting cost-saving targets. For instance, if a contractor reduces production costs below a certain level, they could receive a bonus or a higher profit margin. This encourages contractors to minimize costs while still adhering to the contract terms.
2. Auditing and Monitoring: Governments can establish more rigorous auditing and monitoring systems to ensure that contractors are not inflating costs or overspending unnecessarily. Periodic audits and stricter expense approval processes can reduce the likelihood of waste and overpricing.
3. Target Cost Contracts: Another alternative is to move towards target cost contracts with shared savings. In these contracts, the government and contractor agree on a target cost, and if the contractor manages to reduce costs below the target, both parties share the savings. This creates a win-win scenario, incentivizing cost control.
4. Fixed Profit Margins: Instead of using profit percentages based on actual costs, the government can offer fixed profit margins. This way, contractors have no incentive to increase costs, as their profit will remain constant regardless of how much they spend.
5. Progressive Penalties for Cost Overruns: Governments can also introduce penalty clauses that apply when costs exceed certain thresholds. If costs rise above a pre-determined limit, contractors could face reduced profits or other penalties, encouraging them to keep costs under control.
6. Collaboration and Transparency: Establishing a collaborative relationship between governments and contractors, where transparency and communication are prioritized, can help prevent overpricing and inefficiencies. Both parties need to align their interests toward the common goal of cost efficiency.