Review of single source contract profit rate methodology 2015
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Single source contract profit rate calculations in 2016/17
The Secretary of State for Defence announced on 14 March 2016 that, for 2016/17, the baseline profit rate for qualifying single source defence contracts will be 8.95 per cent. This figure is a three year rolling average: assessing profits across three years smooths out the impact of any year-to-year changes. The equivalent figure for 2015/16 was 10.60 per cent.
This baseline rate is the starting point for agreeing the profit rate for each contract – it is not the actual profit rate which will be achieved. For each individual contract, adjustments can be made to take account of factors such as risk, performance incentives and capital servicing rates. On 24 March 2016 the SSRO published new guidance on how companies and the Ministry of Defence should calculate those adjustments.
The profit rate was decided by the Secretary of State following a recommendation from the SSRO. It was calculated using a new methodology, published by the SSRO in January. The changes to the methodology are the most far-reaching since the 1960s and follow a review last year, and a consultation running from 25 September 2015 until 20 November 2015.
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 and capital servicing rates. Single source procurement represented around 53 per cent of new MOD contracts in 2014/15 and the MOD spent approximately £8.3 billion on single source contracts that year.
The major change is that the baseline profit rate has been determined by considering the profit rates achieved by a more international and a more appropriate range of companies. Previously only companies headquartered in the UK were considered and some with little or no relevance to defence were included.
The SSRO was intending to recommend a number of baseline profit rates for 2016/17, including two main activity types, ‘develop and make’ and ‘provide and maintain’. It was also considering rates for specific categories of work that would not fall into these two broad categories, such as ancillary services, and a composite rate for ‘develop and make’ and ‘provide and maintain’, to address contracts that had significant elements of both activity types.
However, before the finalisation of the SSRO’s proposals, the Secretary of State issued statutory guidance that the methodology used to calculate profit rates for UK single source contracts should result in setting a single baseline profit rate in 2016/17. Although the SSRO recommended only one baseline profit rate this year, it will work towards having multiple profit rates going forward from 2017/18.
The new methodology identifies comparable companies in two categories of activity: ‘develop and make’ and ‘provide and maintain’. A three-year rolling average of the profit range for each set of categories is then determined, and the baseline profit rate is the average of the two. As in previous years, the profit level indicator used will be net cost plus (also known as return on total cost).
Capital servicing is not accounted for in the baseline rate but will be included in calculations for the actual rate for individual contracts. Three rates will be set for calculating capital servicing: for fixed capital, positive working capital and negative working capital. The methodology which will be used to calculate these remains largely unchanged, but includes the use of more appropriate corporate bonds.
Baseline profit and capital servicing rates methodology (updated March 2016)
Guidance on adjustments to the baseline profit rate - March 2016
Original consultation
Consultation description
The changes proposed are the most far reaching since 1968.
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 and capital servicing rates. Single source procurement represented around 53 per cent of new MOD contracts in 2014/15 and the MOD spent approximately £8.3 billion on single source contracts that year.
The most radical new measure is the proposal that there should be different baseline profit rates for different types of work.
This consultation is open to anyone with an interest in single source defence procurement. Please respond by 20 November 2015.
Documents
Last updated 24 March 2016 + show all updates
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Baseline profit methodology updated & Q&A document uploaded
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Response to consultation published
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Consultation outcome published
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First published.