Government Contracting:

Using Cost of Capital to Assess Profitability

NSIAD-91-163: Published: Aug 16, 1991. Publicly Released: Aug 16, 1991.

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Pursuant to a congressional request, GAO: (1) evaluated the effectiveness of the government's current method of assessing contractors' profitability levels; and (2) identified other methods that might better identify appropriate levels of defense contractors' profitability.

GAO found that: (1) government use of the return on assets measure to assess the profitability of defense contractors is beneficial because it recognizes how government financing can affect contractors' levels of profitability, but it fails to distinguish between firm- and segment-level risk, which can vary significantly; (2) the cost-of-capital measure, used along with other financial measures, would eliminate the requirement that defense contractors' profitability be compared solely with that of other companies, thereby reducing concerns about whether firms are comparable; (3) using both accounting measures would provide a more valid picture of a company's financial health, since each measure considers a different side of the balance sheet; (4) studies comparing the profitability of government contracts with that of commercial durable goods manufacturers could provide useful information on appropriate profitability levels, but several of the studies used inappropriate groupings that could have distorted the results of the conclusion drawn from such a comparison; (5) if appropriate segment-level data were collected, the cost of capital could be computed for groups of defense industries as a principal indicator of the return required by those groups over time; (6) policymakers could assess defense profitability trends and determine when changes to policies or other regulations were needed to ensure that individual industry groups had adequate profitability levels over time if cost of capital were used in conjunction with return on invested capital; and (7) the framework of data for assessing the relationship between risk and profitability is not in place, because financial data are not publicly available on a recurring basis for just those segments of a company that perform government work.

Matter for Congressional Consideration

  1. Status: Closed - Not Implemented

    Comments: There has been no indication that Congress plans to take action on the recommendation.

    Matter: Congress should enact legislation to require government contractors to annually report segment-level financial data to enable policymakers to measure the profitability and the cost of capital for assessing the financial health of the defense industry.

Recommendation for Executive Action

  1. Status: Closed - Not Implemented

    Comments: DOD has stated that it will not take action on this recommendation.

    Recommendation: The Secretary of Defense should develop procedures to add the cost-of-capital concept to its analytical framework for assessing the profitability levels of the defense industry over time. This implementation would require that the data, specific to the segment doing defense work in each company, be gathered on a recurring basis.

    Agency Affected: Department of Defense


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