Cost Shifting Activities in the Korean Defense Industry and their Determinants

This study empirically examines the cost shifting hypothesis of defense industry, which is one of the most regulated industries in Korea. The defense companies have incentive to shift costs from commercial sector to defense sector in order to maximize their earnings. In previous literature, approaches to the cost shifting activity were made indirectly by considering only discretionary accruals or certain cost components, such as labor costs, overhead costs, and pension expenses. However, this study utilizes a Yetman(2001) model that estimates ‘cost shifting amounts’ as an aggregate measure that considers all cost components regarding cost shifting activity. This paper also examines factors that affect the cost shifting amounts. The results of this paper are as follows. First, the cost shifting activity in the Korean defense industry follows an inverted-U shaped curve with the proportion of defense sector sales to total sales. Second, result shows that the cost shifting amounts is higher under the cost plus contract consistent with our prediction. This is because the cost plus contract reimburses all costs that occur in the production process of defense articles and facilitates the exercise of discretion, which defense company can exploit to increase earnings and receive more compensation by shifting costs from commercial sector to defense sector. Third, the improvement of defense acquisition policy were found to have a negative relation with the cost shifting amounts. This can be understood that, following the political costs hypothesis, the improvement of defense acquirement policy will strengthen the monitoring and control of the regulator. This will act as a high level of political costs to defense contractor, which will relatively deter cost shifting activity. Fourth, the independence of the board was found to have a negative relation with the cost shifting amounts. This implies that outside directors will monitor and control the firm by blocking cost shifting which can be regarded as irrational behavior. Fifth, the industry concentration was not found to have a significant relation with cost shifting activity. This is consistent with McGowan and Vendrzyk(2002) that the high profitability of defense industry, when competition is low, is not from cost shifting. This paper seeks to overcome the limitations of prior studies. It also extend the scope of existing literature by providing factors that affect cost shifting activity.