Approximation of the Cost Effect from Business Base Changes

Abstract

Cost analyses often ignore the effects of changes in the business base in estimating the costs of large development and production programs. These effects, however, may be significant, not just for the program being changed, but also for other programs produced by the same contractors. Indeed, these effects are important when dramatic reductions occur in the defense budget. The pattern of inter-locking subcontracted arrangements causes the business base effects to ripple through the defense industrial base and complicates assessment of the effects of program scope changes. This paper presents a coarse method for approximating the implications of program scale changes on both prime and major subcontractors that is relatively easy to apply.

The method begins with budget profiles that form a base case for the programs of interest and for the other programs in the industrial sector. From the base case, we estimate contractors' revenues, specifically variable (direct plus variable indirect) costs and fixed costs. The model indicates how the fixed costs may be reallocated for revised budgets. If fixed costs equal 15 percent of the firms' variable costs, which is about the historical average for several defense firms, our model suggests budget reductions result in cost increases totaling about 20 percent of the budget reduction in the remaining programs produced by the same contractors. This cost effect occurs in the first year of a change; data indicate that the effect rapidly diminishes as we project into the future.