Although under the circumstances the cost-plus contract was a necessity and its advantages were many, nevertheless the form was endowed with an inherent weakness (from the Government’s standpoint) most difficult to overcome. In a lump-sum contract the profit of the contractor increased according as he was able to keep down his costs. If his costs ran too high, he faced actual loss. In the cost-plus contract of the simplest form—cost of production, plus a percentage of the cost as profit—it was just the other way. The higher a producer’s costs, the greater his profit; and though a producer might not deliberately seek to augment his costs, yet if he were relieved of the necessity of maintaining a normal business wariness, bargaining for his raw materials, and resisting wage advances, the best interests of the Government might not be served. There is no question that the elementary form of cost-plus war contract in the early months of the war added considerable impetus to the procession of higher costs of living, higher wages, and higher costs again in the vicious circle. It was to retard this tendency, to add an inducement to the producer to control and keep down his costs, that the Government evolved the many modifications and refinements of the cost-plus contract.
At several points in these narratives we have called attention to the train of evils which followed the attempt of the War Department in 1917 to conduct its enterprise in the production of munitions with an organization feudal in character and, one might almost say, in antiquity. Five virtually independent bureaus—the Ordnance Department, the Quartermaster Department, the Corps of Engineers, the Signal Corps, and the Medical Department—and, later, after the creation of the Construction Division, the Air Service, and the Chemical Warfare Service, eight, set forth to procure their own war supplies as competitors, each determined to attain its own ends at the expense, if necessary, of the others. This plan of operation soon drew up near the edge of disaster, as factories and the more accessible industrial districts were overloaded with war contracts by the undirected distribution of the Government’s business, and transportation both on rail and ocean was nearly throttled by the congestions of freight at various seaboard and inland terminals.
Here again, in considering the war contracts, we stumble once more across the trail of this faulty organization. The war contracts were practically as diverse in their provisions and types as the Government’s contracting agencies were numerous; and here it should be noted that some of the main procurement bureaus were in turn subdivided into smaller purchasing agencies, each of which drew its war contracts according to its own lights. About all the early war contracts had in common were the legal provisions protecting the Government against fraud and graft. There was no such thing as a standard contract, and no uniformity anywhere. The Government was being obligated in contracts to the tune of billions by contracting officers almost out of touch with the responsible heads of the administration.
The Government was soon forced to take cognizance of this state of affairs. In the spring of 1917 the Secretary of Commerce convened the so-called Interdepartmental Conference to consider the war contracts—the first attempt to bring harmony into the confused business situation. To the conference came the representatives of the various departments, boards, and administrations interested in contracts, and to the sessions of the conference also the opponents of the cost-plus contract brought their objections to it. There were those who held it almost solely responsible for the great increase in costs of all sorts during 1917.
It was soon evident to the conferees, however, that the cost-plus contract had come to stay in the war business, regardless of its obvious dangers and disadvantages. If an evil, it was a necessary one. True, the Government could still go into fixed-price contracts for the procurement of many important war supplies. These were such supplies as food, clothing, and tools—commodities essentially like those produced and consumed in time of peace. The producers of these commodities were not perplexed by costs; their facilities and processes were ready to begin production; and therefore the War Department could, and did until the end of hostilities (except when shortages made it necessary to deal with single responsible manufacturers in order to gain early deliveries), procure such supplies on fixed-price contracts let after competitive bidding. But such supplies, although they bulked large in the cash balance, contributed little to the solution of the main munitions problem. It was in the production of artillery, of airplanes and airplane engines, of ammunition, of explosives, even of buildings in which to house the war department enterprises, that the cost-plus contract had become a necessity.
There was no way of telling in advance what would be the costs of producing these more important supplies. Many of them were of types and designs entirely new to American manufacturing experience. It was hard enough for the government agents to induce manufacturers to undertake these contracts even on a cost-plus basis. Had the War Department attempted to advertise the specifications of such a mechanism as the French hydropneumatic recuperator, it would never have received a bid. The only possible terms on which any sane manufacturer would take such a contract would be the payment of his costs, plus a profit.
Many of the contracts for the more difficult sorts of supplies were bound to continue over an extended period before all the deliveries could be made. It was often impossible for such contractors to make commitments in advance for all their raw materials. Therefore they faced a rising market and prices which they could not predetermine. They also faced almost certain increases in the wages paid to their employees; yet here again they could not anticipate what these increases would be. The costs of a maker of optical instruments for the Army depended partially upon what he should have to pay for optical glass, but the glass was to come from a new war industry which had not yet begun production and therefore could not estimate what it would charge for glass. With its designs for war implements the War Department did the best it could, founding its specifications upon the latest and best information at its command. Yet so rapid was the evolution of war materials resulting from their intensive use that sometimes the Department found a design obsolete before its production was fairly begun. Its designers therefore made changes in the specifications at the factory, and these changes involved heavy manufacturing costs. Every contractor knew that his work was to be subject to such changes in the specifications; yet no one could foretell whether changes would be made or what they would cost.
These purely manufacturing considerations were enough in themselves to explain the prevalence of the cost-plus contracts. Another element was the time required to prepare specifications and advertise for bids—time not to be spared in war. But there was still another reason to account for the cost-plus contract, a reason in war finance, even more cogent. The successful prosecution of the war meant that practically the entire industrial equipment of the United States would have to be devoted to the production of war supplies. Before the war only large concerns with great financial resources were able to put through great government projects in which the delivery dates were far removed from the dates of starting the work. A war contract often involved a tremendous preliminary expenditure of money in factory expansion and in commitments for raw materials. The Government’s practice was to pay for supplies only upon their delivery. Under such conditions the small manufacturer could not work for the Government. In normal times, perhaps, the possession of a government contract might have enabled him to finance his operation through the banks in the usual way, but with every manufacturer needing special financing, the effect upon the banks was to make them less liberal in their commercial loans. The banks had their own solvency to look out for first.
The cost-plus contract proved to be one of the solutions of this problem. Most of the cost-plus contracts provided that the War Department could pay the manufacturing costs as they accrued, in installments. Thus, by securing partial advance payments from the Government, the small producers, and the large, too, were able to finance their projects and even to take advantage of the cash discounts in their purchases of raw materials. Naturally, the War Department was careful to make such arrangements only with contractors of recognized probity, men who were deserving of confidence, but who often lacked working capital to enable them to become successful producers of war supplies.[6]
The Interdepartmental Conference, far from disapproving or attempting to abolish the cost-plus contract, recognized its necessity, but registered a preference for forms of it which best protected the interests of the people and of the Government. The elemental cost-plus contract obligated the Government to pay manufacturing costs, plus an agreed-upon percentage of the costs as profit. Costs included not only the charges for labor and materials, but also certain overhead and depreciation charges. This contract form was vicious in principle, and the Conference did not approve it. Meanwhile various contracting officers of the Government had been improving the cost-plus contract with provisions which either removed the tendency for the contractor to increase his costs or added inducements to him to keep his costs down. One of these improvements was a cost-plus form providing for a fixed profit to the contractor, regardless of what his costs might be. This form removed the incentive to increase costs. A still further refinement made it of material advantage to a contractor to keep down his costs and penalized the man who was careless about costs. In this form the Government agreed to pay all costs and a fixed profit, but the contract also fixed in advance an estimated unit price for the product, this price being known as “bogey,” a term borrowed from the ancient and honorable game of golf. If the contractor succeeded in holding his costs, plus his fixed profit, under the unit bogey price, he was paid a share of the saving. If, however, his costs and profits ran above bogey, then he was penalized a percentage of the excess, the penalty being subtracted from his fixed profit when the War Department came to pay for the supplies. This form not only put a premium upon plant efficiency, but it stimulated the speed of production; for the briefer the factory processes, the smaller the costs, as a rule, and the sooner the contractor would get his money. The Interdepartmental Conference approved both these forms.