Question

The price the government pays for standard weapons purchased from military contractors is determined by a pricing method called “historical costing.” Historical costing allows contractors to protect their profits by adding a percentage increase, based on the current rate of inflation, to the previous year’s contractual price.

Which of the following statements, if true, is the best basis for a criticism of historical costing as an economically sound pricing method for military contracts?

• A. The government might continue to pay for past inefficient use of funds.
• B. The rate of inflation has varied considerably over the past twenty years.
• C. The contractual price will be greatly affected by the cost of materials used for the products.
• D. Many taxpayers question the amount of money the government spends on military contracts.
• E. The pricing method based on historical costing might not encourage the development of innovative weapons.

Answer 1

The correct option is A The government might continue to pay for past inefficient use of funds.

Option (a)

If the original contractual price for the weapons purchased incorporated an inefficient use of funds, then, since historical costing merely adds to the original price, it preserves these inefficiencies. An economically sound pricing method should at least allow the possibility of reductions in price as such inefficiencies are removed. Hence, A is the best answer. Because historical costing responds to inflation, B and C are consistent with the economic soundness of historical costing-the rate of inflation and costs that are reflected in inflation. D offers no grounds for questioning the economic soundness of historical costing in particular. Historical costing applies to standard weapons only, not to the innovative weapons that are mentioned in E.