The excessive profits of defense contractors: Evidence and determinants
| Date | 01 March 2012 |
| DOI | https://doi.org/10.1108/JOPP-12-03-2012-B004 |
| Pages | 386-406 |
| Published date | 01 March 2012 |
| Author | Chong Wang,Joseph San Miguel |
| Subject Matter | Public policy & environmental management,Politics,Public adminstration & management,Government,Economics,Public Finance/economics,Texation/public revenue |
JOURNAL OF PUBLIC PROCUREMENT, VOLUME 12, ISSUE 3, 386-406 FALL 2012
THE EXCESSIVE PROFITS OF DEFENSE CONTRACTORS:
EVIDENCE AND DETERMINANTS
Chong Wang and Joseph San Miguel*
ABSTRACT. A long controversial issue that divides academics, government
officials, elected representatives, and the U.S. defense industry is whether
defense contractors earn abnormal or excessive profits at the expense of
taxpayers. Using an innovative industry-year-size matched measure of
excessive profit, we demonstrate three findings. First, when compared with
their industry peers, defense contractors earn excessive profits. This result is
evident when profit is measured by Return on Assets (ROA), Return on
Common Equity (ROCE), and Profit Margin Ratio (PMR). The evidence of
excessive profit is less consistent if profit is measured by Operating Margin
Ratio (OMR). Secondly, defense contractors’ excessive profit is more
pronounced after 1992, consistent with the conjecture that the post-1992
significant industry consolidation enabled superior profitability due to both
the improved bargaining power and increased political influence of the newly
combined firms. Finally, defense contractors’ excessive profitability
increases with poorer corporate governance, as measured by the duality of
the Chief Executive Officer (CEO) and the Chairman of the Board.
INTRODUCTION
A long-standing controversial issue that divides academics,
government officials, elected representatives, and the defense
industry is whether U.S. defense contractors earn abnormal or
excessive profits at the expense of taxpayers. The Aerospace
Industries Association (AIA), the premier association representing the
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* Chong Wang, Ph.D., and Joseph San Miguel, Ph.D., are Assistant
Professor, and Professor, respectively, Graduate School of Business & Public
Policy, Naval Postgraduate School. Dr. Wang’s research interest is in
financial accounting and corporate finance. Dr. San Miguel’s primary
research interest is strategic enterprise management.
Copyright © 2012 by PrAcademics Press
EXCESSIVE PROFITS OF DEFENSE CONTRACTORS: EVIDENCE AND DETERMINANTS 387
nation’s best known names in the aerospace and defense industries,
has consistently insisted that “Defense industry profitability lags
significantly behind its industrial peers (p.3, AIA 2010).” On the other
hand, a General Accounting Office (GAO) report in 1980s found that
defense contractors normally earned a higher return on assets (ROA)
than their commercial counterparts. The primary metric used by AIA is
operating margin, measured as operating profit (earnings before
interest and tax or EBIT) as a percentage of sales. In 2009, the
Institute for Defense Analysis (IDA) issued a U.S. Department of
Defense (DoD) sponsored report, “Defense Department Profit and
Contract Finance Policies and Their Effects on Contract and
Contractor Performance”. The IDA report confirms that the operating
margin of the defense industry is lower than that of other sectors.
However, the profit is “adequate” to sustain defense industry firms
because they enjoy a more favorable financing structure under which
the firm has much less of its own capital invested.
One might expect that as a more independent and relatively free-
of-conflict-of-interest source of research, the academic literature
should have provided more concrete and scientific evidence on this
critical issue. Unfortunately, this is not the case. First, for whatever
reason, there is a long history of avoidance of military-related
research among academics. As a result, studies in this field are quite
limited. Secondly, the already limited studies on this topic stopped at
the 1990s, leaving a blank for almost two decades. Early evidence on
the issue of excessive profits is mixed. For example, Weidenbaum
(1968) argued that defense profits are excessive. Bohi (1973) used a
sample of 36 defense contractors and concluded that “there is no
evidence for arguing that defense business is any more or less
profitable than nondefense business in general (p.728).” Agapos and
Galloway (1970) stated that “There is almost no evidence that
aerospace firms in contemporary America are able to reap unusually
large or excessive profits (p. 1103).” Stigler and Friedland (1971)
documented that the profit rates of top defense contractors
substantially exceeded those of comparable nondefense companies.
In summary, there was no consensus among academics in 1960s
and 1970s.
The studies in the 1980 s and 1990s are less divided in that
generally they support the proposition that defense industries earn
higher profits than their non-defense peers. (Carrington, 1986;
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