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Profitability gains of Korean defense firms: Technological progress or cost shifting?

Summary This study identifies the influential factors for profitability gains of Korean defense firms by applying Stochastic Frontier Analysis (SFA) to the 1990–2005 production data. The conventional perception that defense firms enjoy extra profits through cost shifting is tested against the improvements of X‐efficiency through technological progress and managerial achievements. This study tests cost‐shifting hypothesis in the defense industry based on efficiency measurement methodology. The hypothesis states that there exists an incentive for a defense firm to manipulate cost by shifting input cost or reallocating labor, from commercial to defense, especially by mixed type firms that operate in both the commercial and the defense sectors. To test the hypothesis, the difference in mean technical efficiency between the commercial and the defense parts is estimated by collecting the data that can be divided into purely commercial and purely defense data. The mean technical efficiency of the defense part is not significantly higher than that of the commercial part. This result suggests that the high efficiency reported in mixed type firms is not likely attributable to cost shifting. However, this result indirectly investigates cost shifting, but does not exclude other sources of cost manipulation, such as pure cost padding or cost misreporting.