Rules on the profits arms companies can make on more than £8bn of contracts with the government each year will be renegotiated, in one of the most sweeping reviews of defence acquisition for decades.
The new Single Source Regulations Office — set up by the Ministry of Defence in January as an independent regulatory body — will announce at the end of this month that it will scrap existing guidelines, which have been in place unchanged since 1968.
These cover all defence contracts between the government and single companies and were created to try to ensure fairness in the absence of market competition.
The current formula, which allows for a margin of 10.6 per cent, is calculated based on an average of profits earned by a selection of UK listed businesses. It also permits contractors to charge significant further “contingency” costs.
“The world has changed since 1968 and we need to start looking at things differently,” SSRO chairman, Jeremy Newman told the Financial Times in an interview.
“Back in the 60s and 70s, the Ministry of Defence’s buying was much simpler. The profit benchmark against manufacturing made a lot of sense. Today they buy a whole range of goods and services, a whole host of different sorts of contracts, some of which bear little resemblance to industry and manufacturing. The world is also a lot more global.”
The SSRO was set up by the last government as part of a package of measures to overhaul defence acquisition. The MoD’s procurement practices have long been the subject of considerable concern in Whitehall, but successive governments have failed to reform.
Both the MoD and private sector have so far proved reluctant to engage with the new regulatory regime: just three of 61 single-source contracts awarded this year have fallen under the SSRO’s remit because the others were classified as extensions or amendments to existing contracts, Mr Newman said.
“It’s far less than we were expecting . . . but we anticipate it will change in time. The longer it takes you to transition to the new regime the longer you are losing out on the benefits.”
Eventually, the government intends all £8bn of its annual spending on single-source defence contracts will be overseen by the regulator, and hopes this will bring significant benefits for taxpayers.
“The MoD have a target that we should be saving them [about] £200m a year,” Mr Newman said.
In reality, the figure could be far greater.
Anecdotal evidence from the past five decades indicates companies have been earning anywhere between 12 and 22 per cent margins on single-source contracts, Mr Newman said.
As well as scrapping contingency allowances, the SSRO’s proposed rules, which will be put out for public consultation on September 25, will insist that companies end the practice of charging profit at multiple stages of individual contracts.
“We are introducing guidance on what we call ‘profit on cost once’,” Mr Newman said. “Most defence contractors are large businesses that are vertically integrated and at the moment they add that 10.6 per cent profit on stuff as it goes through every level of the food chain.”
Even bigger savings should flow from also enforcing more discipline on costs being charged in contracts.
Mr Newman said “flabby” labour rates, costs because of bad workmanship and high central overheads — including tabs for entertainment picked up by the government — were widespread in the procurement process.
“I have been to see a number of sites. Do I think they could be manufacturing more efficiently? Yes I absolutely do, and I think the incentive for them to do so has been lacking.”
It would be reasonable to expect a 10 per cent reduction in costs, Mr Newman said. However, he stressed that the process had to be mutually beneficial for industry and government.
“Now the MoD budget is protected, there is greater incentive for it to bear down on costs . . . before the money was just going to go to the Treasury once it was saved. But now the MoD knows that money they get back could go to fund other projects . . . and if it does, that’s good for the defence industry too. It means that everything becomes more efficient and there isn’t an overall reduction in defence spending. Hopefully, the whole thing will become a virtuous cycle.”
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