Two types of contracts are commonly used when private firms contract to provide services to governmental agencies: cost-plus and fixed-price contracts. The cost-plus contract allows the contracting firm to recover the costs associated with providing the product or service plus a reasonable profit. The fixed-price contract provides for a fixed payment to the contractor. When a fixed-price contract is used, the contractor’s profits are based on its ability to control costs relative to the price received.
In recent years, a number of contractors have either been accused, or found guilty, of improper accounting or fraud in accounting for contracts with the government. One deceptive accounting technique that is sometimes the subject of audit investigations involves cases in which a contractor is suspected of shifting costs from fixed-priced contracts to cost-plus contracts. In shifting costs from the fixed-priced contract, the contractor not only influences costs assigned to that contract but also receives a reimbursement plus an additional amount on the costs shifted to the cost-plus contract.
a. Why would a company that conducts work under both cost-plus and fixed-price contracts have an incentive to shift costs from the fixed-price to the cost-plus contracts?
b. From an ethical perspective, do you believe such cost shifting is ever justified? Explain.