New method for calculating profit rate on single source defence contracts announced by SSRO
The regulator for single source UK defence contracts has announced how it will calculate the profits that contractors will be allowed to make on such contracts.
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 baseline profit rate itself is due to be announced by the Secretary of State for Defence by mid-March and will apply to new qualifying contracts signed from 1 April 2016.
The main change is that the rate will be 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, including some with little or no relevance to defence.
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 an instruction 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.
Explaining the changes, Jeremy Newman, Chair of the SSRO, said:
Our aim is to recommend to the Secretary of State a profit rate which strikes the right balance between delivering a fair return for industry and ensuring value for money for the taxpayer. Following our recent consultation, this new methodology is more appropriate than the previous arrangements, with a comparator group that is significantly better than that used under the previous ‘Yellow Book’ approach.
In the past a single baseline rate has been set. We believe that there should be different baseline rates for different kinds of activity. We were keen to introduce this change now but the statutory guidance issued to us by the Secretary of State instructed us to recommend a single rate for a further year. Although we will recommend only one baseline profit rate this year, we will work towards having multiple profit rates in future, for adoption first in 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.
Full details are available on our website.
Published: 21 January 2016