U.S. Government Begins Using Cost-Plus Contracts Summary

  • Last updated on November 10, 2022

By offering cost-plus contracts to business firms, the U.S. government ensured that high-quality war materials were delivered to war agencies on time during World War I.

Summary of Event

During World War I, in some cases the United States changed the usual method of awarding government contracts on competitive bids because that method was found to be inexpedient given factors related to the urgency of wartime demands. Cost-plus contracts were formally legalized by the National Defense Act of 1916, although they had been in limited use for several years. The major feature of cost-plus contracts is that contractors are reimbursed for all costs and are also paid a profit, either fixed or a percentage of cost, by the government. Because profits were guaranteed under such contracts, contractors could deliver war materials on time, in sufficient quantities, without having to worry that speeding up orders would cost them more. Cost-plus contracting[Cost plus contracting] Contracts;cost-plus[cost plus] Manufacturing;cost-plus contracting[cost plus contracting] [kw]U.S. Government Begins Using Cost-Plus Contracts (1914) [kw]Cost-Plus Contracts, U.S. Government Begins Using (1914)[Cost Plus Contracts, U.S. Government Begins Using (1914)] [kw]Contracts, U.S. Government Begins Using Cost-Plus (1914) Cost-plus contracting[Cost plus contracting] Contracts;cost-plus[cost plus] Manufacturing;cost-plus contracting[cost plus contracting] [g]United States;1914: U.S. Government Begins Using Cost-Plus Contracts[03500] [c]Government and politics;1914: U.S. Government Begins Using Cost-Plus Contracts[03500] [c]Business and labor;1914: U.S. Government Begins Using Cost-Plus Contracts[03500]

Markets for materials and labor were in a state of uncertainty during the war period, making it difficult for business firms to bid for contracts on the basis of fixed prices. Contractors argued that the government should assume the risk of wide fluctuations in wages and material prices and that it should guarantee profits to manufacturers in the form of cost-plus agreements. Production of war materials was new to many firms, and experimentation with production in untried fields made it difficult for them to estimate costs. It therefore made sense to employ cost-plus contracts for goods that the government needed urgently.

Cost-plus contracts basically take two forms: The buyer pays costs plus either a fixed fee or a percentage of costs. Under the fixed-fee Fixed-fee cost-plus contracts[Fixed fee cost plus contracts] type, the buyer reimburses the contractor for all costs actually incurred to perform a job in accordance with the contractual terms and in addition pays a fixed fee to the contractor. The contractor’s fee remains the same whether the final actual cost of the work turns out to be lower or higher than both parties expected when the contractual agreement was signed. Only when there is a change in the scope of the work (for example, an increase in the square footage of a building being constructed) can the fee be changed. Under cost-plus-percentage-fee contracts, Cost-plus-percentage-fee contracts[Cost plus percentage fee contracts] the buyer reimburses the contractor for all costs actually incurred to perform the job in accordance with the contractual terms and in addition pays the contractor a fee in the amount of a specific percentage of the costs. The contractor’s fee thus changes in direct proportion to the actual costs incurred.

One of the earliest known uses of cost-plus contracts by the U.S. government occurred in 1914, a few years before the United States became involved in World War I. The U.S. Navy found that it was difficult to estimate the costs of production for experimental projects in naval gunnery. When production requires experimentation, cost-plus contracting is attractive to both the manufacturer and the government. Such contracting is also attractive during periods of war, when costs of materials and wages are unpredictable. Using cost-plus contracts does, however, require an assumption that manufacturing firms will behave with integrity and adopt sound cost accounting systems.

The construction division of the Quartermaster Corps of the U.S. Army used 250 cost-plus contracts in 1917, with an outlay of about $300 million. In awarding these contracts, the government tried to select contractors with experience, integrity, and the ability to complete large construction projects. Government leaders agreed with business leaders that in times of war the government should bear the brunt of any hazards caused by the emergency conditions, including the financial risks involved in such contracting. Construction engineers of high repute recognized cost-plus contracting as a proven method of efficient compensation for emergency work. It saved time and allowed big construction companies to start work quickly without waiting for detailed plans, and it also allowed the government to select contractors based on reliability and experience rather than awarding contracts to possibly incompetent companies only because they submitted the lowest bids. In addition, cost-plus contracting allowed contractors to be free from worries about profit, so they could instead concentrate onspeedy execution of quality work under wartime conditions.

The ordnance department of the U.S. Army entered into cost-plus contracts for a large portion of the total amount contracted out in 1917, which was $1.75 billion. In 1918, naval construction contracts were awarded to the five largest private shipyards to build lighter vessels such as submarine chasers, destroyers, and minesweepers. These contracts were for costs plus a fixed profit. In the summer of 1917, orders for twenty-two thousand Liberty motors, used in aircraft, were placed with six different companies under cost-plus-fixed-profit contracts.

U.S. government agencies used cost-plus contracts freely during World War I despite the fact that doing so had some major drawbacks. On one hand, critics asserted that because the government reimbursed all costs plus a profit, contractors had no incentive to control costs. Enormous cost accounting Cost accounting systems were needed to figure out actual costs (for example, calculation of overhead or research expenses), and disputes arose regarding the calculation of costs. Producers who lowered costs also lowered their profits on contracts that called for profits to be calculated as a percentage of costs. This meant there was a premium on inefficiency. On the other hand, contractors were unhappy that the profit percentages were small. In addition, some businesses that were not awarded contracts complained of favoritism on the part of the government.

Responding to these criticisms, the U.S. Congress prohibited the use of cost-plus contracts for housing facilities in May, 1918. In July, 1918, the purchase of all standard articles required by the five main War Department bureaus was consolidated under one purchase division. As a result of this reorganization, all cost-plus contracts were rejected. By that time, businesses involved in the war effort were able to forecast costs, and they preferred bidding to having their products commandeered. The Poindexter Bill of May, 1919, Poindexter Bill (1919) prohibited cost-plus contracts in any government contracting, but the law applied only to contracts with profits calculated as a percentage of costs and not to cost-plus contracts with fixed profits.

Significance

One of the major impacts of the U.S. government’s use of cost-plus contracts was increased cooperation between the government and private enterprise. Traditionally, the relationship between the two had been one of distrust and antagonism. War contracting taught the government the importance of working with business. The government also recognized the contributions of large businesses to economic development. War contracting resulted in the government’s receiving voluntary cooperation from the three major professions of engineering, accounting, and law. Members of these professions rendered exemplary service in the final settlement, liquidation, and cancellation of these cost-plus contracts.

During the World War I years, many American businesspeople became millionaires thanks to cost-plus contracts. At the same time, the wages of millions of workers rose rapidly. This huge increase in purchasing power fueled economic expansion. Because of war needs, many commercial manufacturers were not free to make commercial goods; this reduced the supply of both necessary and luxury products and increased the manufacturers’ profit margins. In some cases, the government had to use its commandeering authority to keep prices under control to protect the public and the war effort. A committee of the War Industries Board War Industries Board was in charge of fixing prices on such goods as chemicals, medical supplies, textiles, leather, rubber, machinery and tools, and metals such as iron, steel, and copper. One of the greatest impacts of the war contracting experience as a whole was the evolution of price control mechanisms to keep supplies of food, fuel, and other crucial materials flowing during wartime.

Another impact of the use of cost-plus contracting during World War I was the increased stature gained by accounting Accounting;professional development as a science and a profession. The government and businesses needed accounting services to establish costs, monitor business practices, and settle claims. Cost accounting methods and practices increased in importance, and contracts between industry and the government became more precise and scientific in character. Wartime contracting also helped introduce greater standardization into the manufacturing process. Precise technical measurements were included in the formal specifications contained in the contracts, and this influenced production processes, often leading to reductions in costs. When the war was over, manufacturers were able to use the standardization techniques they had learned in commercial production.

In large part because of the cost-plus contracting used during World War I, accounting came to be recognized as more than just bookkeeping. Both industry and government realized that cost accounting reports can be useful in guiding the efficient administration of large manufacturing plants. During World War I, the U.S. Navy used cost accounting reports to understand how best to distribute labor in such plants. Cost accounting reports provide information that can help manufacturers control costs, eliminate inefficiencies, and secure greater output. Following World War I, cost accounting became a vital tool for industrial management.

In using cost-plus contracting during World War I, the U.S. government also faced the major problem associated with such contracting: Contractors had no incentive to control costs, and in some cases this led to waste and inflated costs. Cost accountants played a large role in determining correct unit costs, and better cost accounting systems were designed, but no satisfactory solution was found for this vexing problem.

Several additional problems are inherent in cost-plus contracts. When contractors are paid full costs plus a fee, the fee can be either too low or too high when measured as a percentage of investment in plant, inventories, and working capital. For example, a 5 percent fee on full costs can generate a higher annualized return on investment than a 10 percent fee if the project is completed very rapidly. A related problem in cost determination is allowance for depreciation. If replacement or current costs, rather than the purchase price of an item, are used to calculate depreciation, that can inflate production costs to a great extent. In the early twentieth century, the U.S. Navy insisted on using historical costs to compute depreciation allowances. Both of these problems illustrate issues of the time value of capital; that is, value may depend on when something is used.

Another impact of cost-plus contracting relates to the extraordinary profits made by manufacturers and the excess-profits tax imposed by the federal government. The Revenue Act of 1917 provided for graduated income taxes and an excess-profits tax. Specifically written into the cost-plus contracts used during this period was the provision that federal income taxes and excess-profit taxes were not to be considered part of manufacturing costs and hence would not be reimbursed by the government. An indirect refund of taxes was considered to be against public policy and beyond the powers of various war agencies of the government.

For all of its problems, cost-plus contracting remained a regular part of government procurement. After World War II, various defense projects and space research projects employed cost-plus contracting, as firms were unwilling to take the risk of costs that could be much higher than anticipated. Examples of seemingly wasteful expenditures proliferated, such as hammers and toilet seats costing hundreds of dollars each, but the system made many projects feasible and worthwhile for private contractors. Cost-plus contracting[Cost plus contracting] Contracts;cost-plus[cost plus] Manufacturing;cost-plus contracting[cost plus contracting]

Further Reading
  • citation-type="booksimple"

    xlink:type="simple">Aljian, George W., ed. Purchasing Handbook. New York: McGraw-Hill, 1958. Provides useful information for purchasing agents in government and private industry. Chapter 16 gives a good summary of various types of cost-plus contracts. Easy to read.
  • citation-type="booksimple"

    xlink:type="simple">Baruch, Bernard M. American Industry in the War. New York: Prentice-Hall, 1941. Describes the various facets of the industrial mobilization for war and the experience of the U.S. War Industries Board in 1917-1918. Chapter 6 gives a good summary of the price-fixing activities of the board, which followed the principle of cost plus reasonable profits.
  • citation-type="booksimple"

    xlink:type="simple">Crowell, Franklin J. Government War Contracts. New York: Oxford University Press, 1920. Discusses contractual relations between the U.S. government and private firms during World War I. Chapters 2-4 describe the evolution of cost-plus contracts. A readable, reasonably concise history of contractual accounting and government contracting.
  • citation-type="booksimple"

    xlink:type="simple">Cuff, Robert D. The War Industries Board: Business-Government Relations During World War I. Baltimore: The Johns Hopkins University Press, 1973. Describes the motives and methods of businesspeople in government work and the nature of the relationship between business and government during World War I. Chapter 8 details the price-fixing process and describes how the board arrived at fair prices for various commodities. Includes an excellent reference list.
  • citation-type="booksimple"

    xlink:type="simple">Farquhar, Francis P. “Accounting for Cost of Naval Vessels Under Cost-Plus-Profit Contracts.” Journal of Accountancy 29 (July, 1919): 180-189. Describes shortcomings of cost-plus-percentage contracts and traces the evolution of cost-plus-fixed-profit contracts. Useful for researchers.
  • citation-type="booksimple"

    xlink:type="simple">Kelley, Arthur C. “Cost Analysis of a Cost-Plus Contract.” Accounting Review 17 (October, 1942): 370-376. An in-depth analysis of the problems involved in administering a cost-plus contract program. Suggests a system for cost control and unit cost determination.
  • citation-type="booksimple"

    xlink:type="simple">Miranti, Paul J., Jr. Accountancy Comes of Age: The Development of an American Profession, 1886-1940. Chapel Hill: University of North Carolina Press, 1990. Highlights major events in the history of the accounting profession in the United States.
  • citation-type="booksimple"

    xlink:type="simple">Previts, Gary John, and Barbara Dubis Merino. A History of Accountancy in the United States: The Cultural Significance of Accounting. Rev. ed. Columbus: Ohio State University Press, 1998. Chronicles the history of the accounting profession in the United States, from the colonial period to the late 1990’s. Addresses accountancy from social, economic, and political perspectives. Chapters 5 and 6 cover the eras immediately before and after World War I. Includes bibliography and index.
  • citation-type="booksimple"

    xlink:type="simple">Shillinglaw, Gordon. Managerial Cost Accounting. 5th ed. Homewood, Ill.: Richard D. Irwin, 1982. Chapter 21 provides the theoretical rationale for cost-plus contracts by government with defense contractors.

American Institute of Accountants Is Founded

United States Establishes the War Industries Board

U.S. Congress Imposes a Wartime Excess-Profits Tax

McKinsey Founds a Management Consulting Firm

Ultramares Case Establishes Liability for Auditors

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