The Effect of Costing Rule on Cost Structure in the Korean Defense Industry

This paper investigates the cost structure in the Korean defense industry. Managers in the defense industry tend to have incentive to manage earnings because the costs incurred in the production process of defense articles are reimbursed. With the emphasis on labor costs (especially direct labor costs) as a means of earnings management, this research focuses on labor costs among the cost components of manufacturing costs and examines the cost structure of the defense industry. After examining the institutional characteristics of the Korean defense industry, such as defense article contracts that are favorable to the reimbursement of costs and computation methods that emphasize labor costs (Ratios, profit rate), this paper directly compares the labor costs of between the defense sector and the commercial sector of defense industry firms. We find that in the defense industry of Korea, the ratio of direct material costs and indirect production costs to the total manufacturing costs of the defense sector is lower than those of the entire defense industry firms as well as the commercial sector, whereas the ratio of direct labor costs of the defense sector is higher than those of the entire defense industry firms as well as the commercial sector. These findings indicate that the incentive to automate production is low in the defense sector and that labor costs are the primary component of the cost structure. From the regression analysis using labor costs, direct labor costs, and indirect labor costs in order to compare the cost structures between the defense sector and the commercial sector, we document that the labor costs ratios (direct labor costs ratio, indirect labor costs ratio) of the defense sector are statistically significantly higher than those of the commercial sector. We also found that the coefficients of direct labor costs ratio are larger than those of the indirect labor costs ratio. These findings imply that the direct labor costs ratio is a core component in the composition of the cost structure of defense industry firms. This paper enlarges related literature by comparing costs structures between defense sector and commercial sector of defense industry using detailed costs data limited in prior studies. It also contributes to academics as well as practices by providing direct evidence that managers of defense industry have strong incentive to adjust costs structure using labor costs in order to get more reimbursed from the government.