It Destroys Incentive to Cut Defense Costs

CONTRACT RENEGOTIATION

RENEGOTIATION is a threat to national security." With this flat accusation the defense contractors' National Security Industrial Association took dead aim at an old enemy entering the congressional battlefields once more: the highly controversial Renegotiation Act of 1951, which is before the House Ways and Means Committee for renewal this year. In its role as examiner--and judge--of thousands of defense contractors annually, the Government's Renegotiation Board since 1952 has ruled that the suppliers have made some $700 million in "excessive profits." In doing so, say businessmen, it has seriously hampered effective procurement and demoralized large segments of vital industry.

The main argument for keeping the act on the books is that defense equipment has become so complex, and changes so fast, that past production and cost experience are not enough to forecast and avoid exorbitant profits. The Government, say renegotiation advocates, needs a watchdog agency to take a long legal second look at every major defense contract. While contractors go along with this, they argue that renegotiation decisions are so capricious that what are considered normal profits for one contractor are called excessive for another.

Renegotiation's bitterest enemies are the planemakers, whose defense-produced net income is rarely more than 3% of sales. Nevertheless, during fiscal 1957, the Board ruled they had made $33.6 million in excessive profits. Boeing has been ordered to give back $27.5 million (less tax credit), and lesser amounts are demanded from North American, Douglas, Lockheed and most of the others. The planemakers maintain that the Renegotiation Act is unconstitutional because it levies what amounts to a tax without a rate--and thus deprives the taxpayer of due process. The law provides no formula to measure excess profits. Instead, the board considers such items as the risk involved, the company's efficiency and any other "factors considered important by the board."

One major consideration is corporate net worth. In 1952, for example, the board noted that Boeing Airplane Co. made a return on "beginning" net worth of about 93%, ruled that it had excessive profits of $10 million. Boeing President William McPherson Allen calls such a yardstick "callously fallacious." He and other planemakers argue that net worth does not reflect the greatest asset of any company: its know-how team of engineers, manufacturers and administrators. Moreover, it neglects the many profitless years of costly drawing-board development, design and prototype testing.

No one knows when the standards applied by one of the three regional boards will stick. For example, in Boeing's case, a regional board ruled that the company had not made excessive profits on its defense work. Shortly after, the statutory board in Washington reviewed the case, decided that Boeing owed the Government a refund on $10 million in excessive profits, or approximately 20% of its pre-tax earnings in 1952. To make things worse, it takes up to 3 1/2 years before profits are audited and a decision reached. Thus no company can confidently pay out funds for either dividends or new research--the money might be called back tomorrow.

The planebuilders' strongest argument against renegotiation is that it destroys the incentive to cut costs that the Government is working hard to instill in its contractors. The Government offers contractors 20-c- of every dollar they manage to save under the contract price of an item. But no sooner is the incentive payment dispensed than it can be demanded back as excessive profit. As Boeing's Allen says: "By all odds the most unenlightened aspect of the whole renegotiation mess is that it ignores how good a job you're doing--how many dollars per pound you're saving the Government by beating cost figures." In seven years of producing B-47 and B-52 jet bombers and KC-97 tankers, Boeing saved $131.5 million on their anticipated prices--and got aggregate incentive profits of some $25 million--or $9,900,000 net after taxes. Yet for all this top performance the U.S. Government charged Boeing with $27.5 million in excessive profits for three of those years. Says Allen: "It is a case of one agency of Government arbitrarily negating the incentive for economical production established by another branch of Government."

The one recourse for industry is an appeal to the Tax Court. In fiscal 1957, 26 of the Renegotiation Board's 58 orders were appealed.

Few thoughtful businessmen want to do away with renegotiation entirely. Rather, they would like to see the act amended to exempt incentive contracts and to make it mandatory to show contractors all data and information used as a basis for determining excessive profits. With such amendments, business might be able to live with the Renegotiation Act.

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