The price the government pays for standard weapons purchased from mili

We need to find the answer choice that is the best basis for a criticism of historical costing as an economically sound pricing method for military contracts. Before we do that, let's make sure we understand what exactly "historical costing" is:

• "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 add a percentage increase (based on the current rate of inflation) to the previous year's contractual price. In other words, instead of simply charging last year's price, the contractor's can charge the government last year's price PLUS a percentage increase to adjust for inflation.
• "Historical costing allows contractors to protect their profits." - For example, if they charged a certain price last year and since then there has been significant inflation, charging the same price would actually mean lower profits for the contractors. Instead, the contractors can charge last year's price PLUS an extra amount to make up for the inflation.

Historical costing clearly protects the contractors profits from inflation. But does that mean that historical costing is an economically sound pricing method for military contracts? We need to find an answer choice that could serve as a basis for a criticism of historical costing as an economically sound pricing method for military contracts. In other words, we need something that suggests that historical costing might NOT be an economically sound pricing method for military contracts.


What if last year's contract was a bad deal? For example, what if the contractor used inefficient methods and thus included unnecessary costs when determining the prices? Without historical costing, the use of more efficient methods should drive down this year's prices. But with historical costing, even if the contractor uses more efficient methods, prices will increase with inflation.

Thus, the government might continue to pay for past inefficient use of funds. (A) represents a possible problem with historical costing, so keep this one.


With historical costing, the percentage increase is based on the current inflation rate. It doesn't matter whether the inflation rate is changing. The changes to the prices will reflect the variations in the inflation rate. Choice (B) does not represent a problem with historical costing, so eliminate this one.


Of course the contractual price will be affected by the cost of the materials. If the cost of the materials increases with inflation, historical costing will allow the prices to increase accordingly. Choice (C) does not describe a problem with historical costing, so eliminate this one.


Whether a pricing method is economically sound does not depend on how taxpayers feel about government spending on military contracts. The government might use the most economically sound methods, and taxpayers could still question the total amount that the government spends on military contracts. Choice (D) is irrelevant and can be eliminated.


Just because a contractor's profits are protected by historical costing does not mean there is no incentive to innovate. Contractors would still have incentive to come up with new and better weapons. If they don't, their competitors certainly will.

More importantly, the passage specifically talks about standard weapons, not innovative weapons. The government might use historical costing for standard weapons contracts and other pricing methods for innovative weapons. In that case, it wouldn't matter whether historical costing encourages the development of innovative weapons.

Choice (A) is the best answer.