Consultation outcome

Review of single source baseline profit and capital servicing rates methodology and adjustment guidance 2016

This consultation has concluded

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Detail of outcome

Baseline profit and capital servicing rates methodology 2017/18

Under the Defence Reform Act 2014 (the Act), the Single Source Regulations Office (SSRO) is required annually to review the figures used to determine the contract profit rate for pricing qualifying defence contracts (QDCs) and qualifying subcontracts (QSCs). Section 19(2) of the Act requires the SSRO to provide the Secretary of State with its assessment of the appropriate baseline profit rate, SSRO funding adjustment and capital servicing rates for that year.

When publishing its updated methodology for calculating the single baseline profit rate for 2016/17 the SSRO stated that it would work towards having multiple profit rates in future, for adoption first in 2017/18. The SSRO published a consultation paper on 8 July 2016 covering the planned introduction of multiple baseline profit rates and the SSRO funding adjustment. The consultation closed on 18 August 2016.

The SSRO has today published its response to the issues raised in the methodology consultation this year. These included how the SSRO identifies the comparable companies whose profits are analysed in setting the baseline profit rate; the data it uses; and the ability of others to replicate the approach taken. We have also published a chart pack setting out detailed analysis relevant to specific issues.

While respondents mostly supported the principle of multiple rates there were mixed views about the SSRO’s proposals. The SSRO maintains that a single baseline profit rate does not allow for the diversity of products and services covered in single source contracts. An approach involving multiple rates would contribute to enhancing the credibility of the single source regime while providing more appropriate returns for contractors that are fair and reasonable and represent value for money for taxpayers. The SSRO is continuing with the work needed to recommend multiple rates for 2017/18, including further discussions with the Ministry of Defence, and will publish further information in due course.

In light of the responses to the consultation we are reviewing the content of the methodology and guidance publications to increase further the level of transparency for stakeholders about the approach we take. We will republish these in January 2017, alongside our recommendations to the Secretary of State.

Original consultation

Summary

Multiple profit rates on contracts could save MOD millions

This consultation ran from
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Consultation description

Taxpayers and the Armed Forces could be saved millions if multiple profit rates are introduced for defence contractors, the new Ministry of Defence regulator has found.

The margin on some contracts could be reduced by almost two-thirds, the Single Source Regulations Office has said in launching its consultation on Multiple Profit Rates.

On one exclusive ‘single source’ agreement the SSRO discovered it could save the taxpayer £8.4 million if a 4 per cent ‘construction’ profit rate was used on a building deal awarded an 11 per cent margin.

Companies who now enter exclusive ‘single source’ contracts with the Ministry of Defence receive a fixed profit rate of 8.95 per cent. No discretion is made between those who build highly complex weapon systems or those who clean barracks.

Clive Tucker, the SSRO’s Interim Chairman said:

It is the SSRO’s view that having a number of baseline profit rates for different activities would better reflect risk and reward.

A contract to build a missile or submarine does not compare to one to clean an office or construct a facility. Some contracts carry little risk and we argue should not be rewarded with high profit margins.

The consultation document is part of the SSRO’s significant reform to the ‘Yellow Book’ guidelines that date back to 1968. Previously profit rates were determined from too broad a range of companies not relevant to defence and with widely varying margins. These included pharmaceutical firms with margins of more than 20 per cent or tobacco companies with profits of 30 per cent. It also included food companies such as Tesco’s with a margin of less than 3 per cent.

The independent defence watchdog last year examined profit rates of both defence and civilian companies to find a fair method of charging.

The multiple profit rates would be calculated using the new 2016/17 transparent methodology with a more appropriate and more international range of companies

The SSRO has in its new consultation suggested six different categories for single source contracts.

Under one of the categories, ‘develop and make’, a separate profit rate will be awarded to companies that manufacture equipment to order – such as the Astute submarine or Brimstone 2 missile. This includes purchase of long-lead items, systems integration and upgrade, along with research, design and development of intellectual property.

A different rate will be calculated for firms that ‘provide and maintain’ kit. This includes items where the contractor owns assets or contract work that covers servicing MOD equipment, such as RAF Hawk jets. Similarly ‘asset hours’, such as flying hours on a leased aircraft should be included as well as training.

A ‘composite rate’ is proposed for projects that combine both ‘develop and make’ and ‘provide and maintain’. It will be a mean average of the two.

Substantial savings could be made if a ‘construction’ category is available. Profit rates across the construction industry are around 4 per cent. Under the current agreed Baseline Rate of 8.95 per cent firms building docks and warehouses are in some cases making double the civilian sector profit.

Similarly firms that have been enjoying sizeable profits for ‘ancillary services’, such as cleaning, gardening or IT support services should receive a lower margin.

“An appropriate reward for the routine work carried out under these contracts should be differentiated from more complex activities,” the consultation document said.

Mr Tucker said:

In situations where the activity is complex the reward should properly be greater.

The sixth category is labelled ‘zero rate’ mainly for military charities who are not permitted or do not wish to make a profit. It could also apply when a contractor feels a zero rate is appropriate.

Mr Tucker said:

Setting a fair baseline profit rate is critical to maintaining the credibility of single source procurement.

Single source suppliers derive significant advantages from long-term contracts with HM Government that stem from the 10-year planning horizon set out in the defence equipment plan which accompanied the SDSR. By its own admission, last year was a prosperous* one for the defence sector, and we want to make sure that industry receives a fair and reasonable return for its work.

The SSRO will submit its recommended rates to the Secretary of State for Defence in January next year.

*ADS publication: ‘UK Defence Outlook 2016’

NOTES

  1. The consultation is open from Friday 8 July to Thursday 18 August.
  2. A contract is a Qualifying Defence Contract (QDC) if the Secretary of State for defence purchases goods, works or services for defence purposes, and the contract is not the result of a competitive process and has a value of £5 million or more.
  3. Contracts with a foreign government, for the purpose of intelligence activities, for the acquisition, management or maintenance of land/buildings, and contracts made within the framework of a cooperative international defence programme are excluded.
  4. The 8.95 per cent profit rate compares favourably with Western Europe defence companies, which have an average profit of 7.26 per cent and North America with 8.28 per cent.
  5. The SSRO has already saved the taxpayer and MOD £13.4 million by, among other actions, bringing the baseline profit rate down from 10.70 per cent to 8.95 per cent. A further £61 million of costs are currently being challenged.
  6. Single source contracts represented 53 per cent of new MOD contracts worth £8.3 billion in 2014/15

Under the Defence Reform Act 2014, the SSRO is required annually to review the figures used to determine the contract profit rate for pricing single source defence contracts.

Section 19(2) of the Act requires the SSRO to provide the Secretary of State with its assessment of the appropriate baseline profit rate, SSRO funding adjustment and capital servicing rates for that year.

When publishing its updated methodology for calculating the single baseline profit rate for 2016/17 the SSRO stated that it would work towards having multiple profit rates in future, for adoption first in 2017/18.

Regulation 11(5) requires the SSRO funding adjustment to be zero until 31 March 2017 and, on or after 1 April 2017, the rate published in the London Gazette in accordance with section 19(4) of the Act.

The SSRO has published a consultation paper covering the planned introduction of multiple baseline profit rates and the SSRO funding adjustment.

Alongside the consultation document, it has published examples to illustrate the direction of travel of the ‘Baseline profit and capital servicing rates methodology’ and ‘Guidance on adjustments to the baseline profit rate’ documents. The updated sections of the two guidance documents are highlighted.

This is a public consultation, which is open to anyone with an interest in the SSRO’s two statutory aims of obtaining good value for taxpayers’ money and a fair and reasonable return for industry. We also welcome comments from people or organisations with a particular interest in defence (non-competitive) procurement. The consultation will close on 18 August 2016. Following our consideration of responses to the consultation, we will publish the final guidance document by the end of October 2016.

Documents

Published 8 July 2016
Last updated 29 September 2016 + show all updates
  1. Consultation response published
  2. First published.