New defence regulator recommends reduced profit rate for contractors, and launches tighter rules on £6 billion of MOD annual spend.
The newly established regulator overseeing Ministry of Defence’s (MOD’s) single source procurement of defence assets and services  has discharged its first 2 core responsibilities. In its first action, the Single Source Regulations Office (SSRO) proposed a reduction in the 2015 baseline profit rate paid to defence contractors by the MOD in single source defence contracts. The SSRO then published new guidance on what costs are ‘allowable’ under such contracts, following a first principles review of the existing framework.
Baseline profit rate
The SSRO is required annually to review the figures used to determine the baseline profit rate and contract profit rate, which the MOD uses to price its single source contracts with defence contractors . The SSRO must also publish the review and make an annual recommendation to the Secretary of State for Defence on whether the profit rates should be adjusted.
In 2015 Contract Profit Rate, published on 23 January 2015, the SSRO recommends a baseline profit rate of 10.60 % for 2015, a 0.10 % reduction on the rate for 2014. The 2015 baseline profit rate as a percentage of cost of production in 2013/14 is 9.88 %, down from 10.92 in the previous year.
Under the existing ‘Yellow Book’ regime, which the SSRO replaces, the rates were calculated annually by the Review Board for Government Contracts, using the principle of ‘comparability’ with the prevailing profit rate across UK industry as a whole. As the SSRO was not in a position to develop a new methodology for determining the rates in its first months of existence, it agreed that the review board should develop the 2015 baseline profit rate and capital servicing allowances (one of the adjustments to the baseline profit rate). The SSRO Board has endorsed the review board’s recommendation, having received adequate assurance about the process and data used to produce the rates.
The Chair of the SSRO, Jeremy Newman says:
The SSRO’s main objective is to ensure good value for money for the taxpayer on single source procurement, while ensuring that defence contractors receive a fair price. Our first action has been to recommend that the Secretary of State should reduce the baseline profit rate paid to contractors. We thank the review board for its work and for providing the SSRO with access to its processes and data. We will now start our fundamental review of the principles and methodologies that have been used for many years, including the principle of comparability.
The Single Source Cost Standards: statutory guidance on allowable costs, published on 26 January 2015, establishes what costs can and can’t be recouped from the MOD by defence contractors. The guidance will be used by the MOD and contractors when determining whether costs are allowable under qualifying defence contracts and qualifying sub-contracts. The Defence Reform Act 2014  states that allowable costs must be: “appropriate, attributable to the contract, and reasonable in the circumstances”. In the event of a disagreement, the SSRO can be asked to determine whether a cost is allowable.
The SSRO’s new guidance is principles, rather than rules, based. It sets criteria for what costs are generally allowable and not allowable and specifically addresses areas that will not withstand public scrutiny. These include expenditure on: bad debts, civil penalties, entertainment, charitable donations, political subscriptions, sponsorships, discounts and penalties for poor performance.
Jeremy Newman, Chair of the SSRO, says:
The SSRO’s new guidance on allowable costs will assist the negotiation process, and help to ensure fair contract prices between the MOD and contractors. Pricing large, lengthy and complex contracts is a difficult task. Our job is to help both parties be clear about whether costs are allowable. Without exception, contractors have engaged positively during the development of the guidance, even when they disagree with us. I think they have respected the engagement we have given back to them. If everyone understands the basis on which they are contracting, we can deliver savings to the public purse and ensure the UK retains the capability to develop our armed forces’ requirements now and into the future.
The SSRO has a newsletter on its website providing further information about the organisation’s recent work, plans and priorities.
 The Defence Reform Act 2014 established the independent, arms length body from the Ministry of Defence to regulate single source procurement of defence assets and services. The Single Source Regulations Office (SSRO) was established by section 13 of the Act in June 2014.
 The baseline profit rate is common across all single source contracts and is the starting point for determining the contract profit rate to be applied in the pricing formula, after a series of adjustments have been made to the baseline profit rate. A full description of this process can be found in the SSRO’s 2015 Contract Profit Rate.
 Defence Reform Act 2014 (Section 20(2)(a)- (c))
Published: 30 January 2015