Economic Approaches to Overhead Costs an Application of Multiproduct Cost Theory,

An important element of military production cost is the overhead cost component. At the elemental level, overhead costs represent costs that are indirect - in other words, costs that cannot be unambiguously assigned to more than one product. To the extent that detailed cost accounting can make reasonable allocations of these costs, they are unimportant. However, many of the contractors that produce military hardware also produce similar hardware for commercial applications within the same division. This is good in that it enables them to exploit significant economies of scale. Unfortunately, this also creates ambiguity in the assignment of overhead costs between military and commercial production. Even if a correct allocation rule for every indirect cost of military production is known, it is impossible to calculate the exact amount of overhead cost assigned to military production. This paper addresses some of the most important of these problems and examines how they have been dealt with in the literature. These issues include the relationship between accounting data and economic cost information, selection of appropriate functional forms, and trade-offs between detail and statistical validity. Several recent applications of this methodology to the telecommunications industry are discussed, along with current research efforts in the area of naval jet engine production. The paper concludes with a discussion of the general applicability of this approach to other military settings.