The Excessive Profits of Defense Contractors: Evidence and Determinants

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.