Regulation and Incentives: The Behavior of Korean Defense Firms Under the Regulatory Cost Accounting Policy

The question of how a firm might change its economic behavior with regulatory cost accounting methods (not pricing method) has yet to be fully answered in the literature. The question posed in this paper is, “What are the characteristics of the incentives that the Korean Defense Cost Accounting Regulation offers to Korean defense firms?” The firm’s behavior in terms of technology choice, input choice, sub-contracting versus in-house production decision, diversification, organizational structure, and investment decisions are examined. It is shown that it is in the interest of a Korean firm to distort its behavior not only because of the way the regulation relates profit to the total cost, but also because of the way in which the price is related to each cost category. The main incentive effects of the current cost accounting regulation are that firms make a sub optimal cost mix decision in such a way that (1) firms reduce sub-contracting and increase in-house production, and (2) activities dedicated only to a concerned product production line substitutes for possible alternatives, such as joint operations and joint facility utilization. The impact of these incentives is unlikely to be confined to the manufacturing input choice decisions. It also reaches decisions regarding organizational structure, diversification, and investment. Even under circumstances where firms are subject to governmental audit, the above incentive effects hold. In addition, under the audit, firms may embellish their cost reports by incurring additional actual costs to retain a reasonable relationship between reported and actual costs. This results in waste and/or abuse of resources, in addition to the given sub-optimal cost mix.