An analysis of defense procurement policy in Korea: Selection, cost accounting, and profit policies

This dissertation deals with some major issues in defense procurement policy--selection, cost accounting, and profit policies--with special reference to Korea. Chapter II provides a factual introduction, discussing the history of the Korean weapons industry and current defense procurement regulation.; The first study, "Selection Policy: Quality vs. Quantity Decision in Defense Procurement," focuses on one aspect of the weapons selection decision, the quality/quantity mix choice. This analysis was motivated mainly by the literature's partial treatment of the issue, tending to emphasize the bureaucracy as sole instigator of excessive quality, also known as gold plating. The research question is "What are the origin and tendency of gold plating with different decision-making structures?" Resistance and benefit-generation by the bureaucracy and different patterns of reaction to them by different political principals, either the president or the legislature, are set up as sources of the differences among selection choices. The analysis shows that the president is generally more successful than the legislature in realizing her/his preferred choice. Under a parliamentary system, the bureaucracy can take advantage of its position as first mover and promote its preferred choice better than under the president-dominated system. However, resistance option may hurt the bureaucracy, because it could lessen the flexibility of the gate-keeping committee, which tends to align itself with the bureaucracy.; The second study, "Behavior of Korean Defense Firms Under the Current Regulatory Cost Accounting Policy," is motivated by a research question, "What incentives does Korean defense cost accounting regulation offer to Korean defense firms?" Little in the literature deals with the incentive impact of a regulation stipulating how various cost categories are to be allocated and aggregated. The analysis shows that to reduce indirect costs, contractors attempt to substitute in-house production for sub-contracting and promote activities dedicated solely to the production of a specific product. Government audits do not appear to be a solution for the problem, because unless the auditor investigates the appropriateness of a contractor's input choices, the audit will not change the contractor's tendency towards suboptimal behavior. Furthermore, the audit may promote abuse and waste because it may provide incentives for contractors to embellish their cost reports by incurring additional actual costs. Empirical evidence is needed to complete the argument.; The third study, "Profit Policy," seeks to develop a theoretically correct and practical profit policy for Korean defense procurement. It employs a simple model to evaluate cash flows and identifies as components of a correct profit policy unrecognized economic costs such as financing cost, the contract risk premium, and facilities capital use cost. This cash flow valuation model identifies an arguably correct form of the contract risk premium, the reason for preferential treatment of small sized firms, and the unusual implications of depreciation costs. On practical plane, the application of correct formulas for calculating the financing cost and contract risk premium is advised. Since detailed cost information on Korean contractors is not available, a test of the proposal in practice is a needed complement to this work.