Statutory guidance

Guidance on the baseline profit rate and its adjustment (version 7)

Published 15 March 2021

Versions of this guidance

This is version 7 of the guidance on the baseline profit rate and its adjustment which applies to contracts agreed on or after 1 April 2021. It is a legal requirement to have regard to this guidance, which supersedes all previous versions.

The table in Appendix A highlights changes that have been made from the previous version of the guidance.

The publication and application dates of versions of this guidance are shown below.

Version number	Date published	Applies to contracts agreed on or after
7	15 March 2021	1 April 2021
6	16 March 2020	1 April 2020
5	18 March 2019	1 April 2019
4	15 March 2018	15 March 2018
3	15 March 2017	15 March 2017
2	24 March 2016	24 March 2016
1	26 March 2015	27 March 2015

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1. Introduction

About the contract profit rate

1.1 Section 15 of the Defence Reform Act 2014 (the “Act”) and regulation 10 of the Single Source Contract Regulations 2014 (the “Regulations”) require that the price payable under a qualifying contract be determined in accordance with the formula:

(Contract profit rate ×Allowable Costs)+Allowable Costs

1.2 The contract profit rate (CPR) is expressed as a percentage mark-up on Allowable Costs.

1.3 Section 17(2) of the Act and regulation 11 of the Regulations require that the CPR for any qualifying defence contract must be calculated by taking the following six steps:

1.4 In accordance with section 30 of the Act, Part 2 of the Act and the Regulations “apply to qualifying sub-contracts (and to sub-contractors) as they apply to qualifying defence contracts (and to primary contractors).” This means that the six steps also apply to calculating the contract profit rate for qualifying sub-contracts.

About this guidance

1.5 Section 18 of the Act provides for the Single Source Regulations Office (SSRO) to issue guidance in relation to the steps set out in section 17(2).

1.6 This document contains the guidance to be used when determining:

• Step 1 - baseline profit rate;
• Step 2 - cost risk adjustment;
• Step 3 - profit on cost once adjustment;
• Step 4 - SSRO funding adjustment;
• Step 5 - incentive adjustment; and
• Step 6 - capital servicing adjustment.

1.7 The SSRO has provided separate guidance that will assist the contracting parties to determine the Allowable Costs of a contract.

Application of this guidance

1.8 This is statutory guidance issued by the SSRO under section 18(1) of the Act. It applies to all qualifying defence contracts (QDCs) and qualifying sub-contracts (QSCs). This document updates the version published in March 2020 to include:^{[footnote 1]}

a. the baseline profit rate, SSRO funding adjustment and capital servicing rates that apply for the financial year commencing 1 April 2021.

b. minor changes that:

• explain the pricing formula and refer to the SSRO’s guidance on Allowable Costs;
• restructure the guidance for each step around three standard headings: ‘basis’, ‘application’, and ‘determination’;
• set out how the guidance on each step applies to qualifying sub-contracts;
• promote POCO definitions from the appendix to the main body of the document and minor corrections to the POCO adjustment worked example;
• provide additional references to other SSRO guidance and methodology documents, and remove the guidance on contract profit rate referral procedures that is now provided in self-contained referrals guidance; and
• make stylistic changes to capitalisation and the approach to referring to the Secretary of State.

1.9 It is a legal requirement to have regard to this guidance when applying the six steps. This document provides guidance on the adjustments to make to the baseline profit rate when determining the contract profit rate for all QDCs and QSCs in respect of which the time of agreement (as defined in regulation 2(1)) is on or after the date this guidance takes effect. The SSRO has provided separate guidance that will assist the contracting parties to determine the time of agreement for a particular QDC or QSC.^{[footnote 2]}

Statutory reports

1.10 In relation to any QDC, (or QSC), the primary contractor (or sub-contractor) must provide statutory reports as described in Part 5 of the Regulations. The SSRO has provided separate guidance that will assist defence contractors with preparing and submitting the reports required.^{[footnote 3]}

Regulation 23(1) requires a contract pricing statement be provided for the QDC within one month of the initial reporting date.

1.11 As stated in regulation 23(2)(d) the contract pricing statement has to describe the calculation made under regulation 11 to determine the contract profit rate. This includes all adjustments that were made under steps 1 to 6 as detailed in this guidance document.

Relevant records

1.12 In relation to a QDC, regulation 20 requires the primary contractor to keep ‘relevant records’. In the case of a QSC, it is the sub-contractor who is so required. Section 23 of the Act defines relevant records as accounting and other records (whether in hard or electronic form) which the primary contractor or sub-contractor, as the case may be, ‘may reasonably be expected to keep’ and ‘which are sufficiently up-to-date and accurate’ for use by the Secretary of State for specific purposes, such as verifying certain matters relating to the price payable under a QDC or QSC. Such matters may include the calculation of the contract profit rate.

Opinions and determinations

1.13 The Act and Regulations make specific provision for opinions and determinations by the SSRO on the appropriateness of a cost risk adjustment (step 2), profit on cost once adjustment (step 3), or capital servicing adjustment (step 6). The Act also makes general provision for opinions by the SSRO on any matter in relation to qualifying contract or proposed qualifying contract on a joint referral. For further information, please refer to the SSRO’s guidance on referrals.^{[footnote 4]}

Key terms and definitions

Allowable Costs	A term used for the costs incurred to deliver a QDC or QSC. Costs must be appropriate, attributable to the contract and reasonable in the circumstances to be considered Allowable.
Baseline profit rate (BPR)	Section 17(2) of the Act and regulation 11 require that the contract profit rate for any qualifying defence contract must be calculated by applying six steps. The first step requires taking the baseline profit rate which has been determined by the Secretary of State.
Capital employed (CE)	The total amount of capital used for the acquisition of profits or the capital investment necessary for a business to function. The SSRO defines this as the sum of fixed and working capital.
Capital servicing adjustment	A term used to refer to fixed capital servicing adjustment and positive or negative working capital servicing adjustments collectively.
Cash and cash equivalents	A term used for current assets comprising receivables from other sources, short-term investment of money, and cash at hand and at bank.
Cost of production (CP)	A cost incurred by a business when manufacturing a good or providing a service before financing charges (interest). It is calculated as: cost of production = operating revenue (turnover) – operating profit/loss [EBIT].
CP:CE ratio	The ratio formed by dividing a contractor’s cost of production by its capital employed. This ratio can be used at the company level or can be used to attribute a proportion of the contractor’s capital employed to individual contracts.
Current assets	A company’s balance sheet items that represent the value of all assets that can reasonably expect to be converted into cash within one year.
Current liabilities	A company’s balance sheet items that represent debts or obligations that are due within one year.
Defence Reform Act 2014	The primary legislation applicable to QDCs.
Fixed capital	The total capital outlay that is invested in fixed assets, that stay in the business almost permanently – or at the very least, for more than one accounting period. The assets are considered fixed in that they are not used up in the actual production of a good or service but have a reusable value. Fixed capital investments are typically depreciated over a number of years.
Fixed capital servicing adjustment	An adjustment that accounts for the cost of debt which is attributed to investment in fixed capital.
Fixed capital servicing rate	The cost of servicing medium-term to long-term (i.e. more than one year) debts.
Negative working capital	A term used when the working capital number is negative. It results when a company holds less current assets than its current liabilities.
Negative working capital servicing adjustment	An adjustment that accounts for the rate of return (interest earned) which is attributed to investment in negative working capital (i.e. depositing creditors’ cash on fixed-deposit accounts).
Negative working capital servicing rate	The rate of return (interest earned) on short-term (i.e. up to one year) bank deposits.
Positive working capital	A term used when the working capital number is positive. It results when a company holds more current assets than its current liabilities.
Positive working capital servicing adjustment	An adjustment that accounts for the cost of debt which is attributed to investment in positive working capital.
Positive working capital servicing rate	The cost of servicing short-term (i.e. up to one year) debts.
Qualifying defence contract (QDC)	Those contracts that fall within the scope of the Act and the Regulations, and that the Secretary of State has not exempted from being a QDC. In such contracts an allowance for profit is calculated by reference to the baseline profit rate applicable at the time of pricing.
Qualifying sub-contract (QSC)	A QSC is a contract between a primary contractor and another contractor or between a sub-contractor and another contractor where it meets the definition laid down in section 28 of the Act and has been assessed and notified as a QSC pursuant to the procedure under section 29 of the Act.
Secretary of State	The title typically held by cabinet ministers in charge of Government departments. In practice, authority to act on behalf of the Secretary of State for Defence on matters relating to single source contracts is often delegated to junior ministers and officials within the Ministry of Defence. The Act also provides for the Secretary of State to authorise any person to exercise specified functions under the Act.
Single Source Contract Regulations (SSCRs)	Secondary legislation in the form of a Statutory Instrument, enabled by the Act.
Single Source Regulations Office (SSRO)	The independent non-departmental public body established under the Act, with wider powers and remit than the Review Board.
Working capital	A measure of both a company’s efficiency and current/shortterm (up to one year) financial health. It indicates how much capital a company uses in its day-to-day activities.

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2. Baseline profit rate (step 1)

Basis of the Baseline Profit Rate

2.1 Section 17(2) of the Act, and Regulation 11(2), set out the requirement for the baseline profit rate as the first step in determining the contract profit rate to be applied in the pricing formula:

“Take the baseline profit rate which is in force at the relevant time”.

2.2 The relevant time should be the time of agreement, as defined in regulation 2(1). The SSRO has provided separate guidance that will assist the contracting parties to determine the time of agreement for a particular QDC or QSC.^{[footnote 4]}

Application of the Baseline Profit Rate

2.3 The calculation of a contract profit rate must begin with a baseline profit rate.

Determination of the Baseline Profit Rate

2.4 Section 19(1) of the Act requires the Secretary of State to determine the baseline profit rate for each financial year.

2.5 The SSRO is required annually to review the figures used to determine the contract profit rate for pricing single source contracts. Section 19(2) of the Act requires that, for each financial year, the SSRO must provide the Secretary of State with its assessment of the appropriate baseline profit rate for QDCs. The SSRO has published information on its methodology to aid those who may wish to scrutinise or replicate the approach taken.^{[footnote 5]}

2.6 Section 19(4) of the Act states that the Secretary of State must publish the baseline profit rate for each financial year in the London Gazette, no later than 15 March in the preceding financial year. The baseline profit rate in force for the financial year commencing 1 April 2021 are:^{[footnote 6]}

Category	2020/21 baseline profit rate
Baseline profit rate	8.31%
Baseline profit rate to apply to contracts between the Secretary of State and a company wholly owned by the UK Government and where both parties agree	0.057%

2.7 The Secretary of State’s determination for the financial year commencing 1 April 2021 included a second baseline profit rate in addition to the SSRO’s recommended rate. As required by section 19(6) of the Act the Secretary of State has explained the reasons for the difference in the London Gazette notice, which is available at: https://www.thegazette.co.uk/notice/3760612.

2.8 That notice explains that the second baseline profit rate will only apply to qualifying defence contracts where:

a. the contract is between Secretary of State and a company incorporated under the Companies Act that is wholly owned by the UK Government; and

b. both parties to the contract agree that it should apply.

2.9 The guidance in this document pertaining to steps 2 to 6 applies irrespective of which baseline profit rate is taken. The SSRO intends to consult on whether any further revisions are required to its guidance and will publish an update in due course.

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3. Cost risk adjustment (step 2)

Basis of the cost risk adjustment

3.1 Section 17(2) of the Act, and regulation 11(3), set out the requirement for the cost risk adjustment:

“Adjust the baseline profit rate by an agreed amount which is within a range of plus or minus 25% of the baseline profit rate, so as to reflect the risk of the primary contractor’s actual allowable costs under the contract differing from its estimated allowable costs”.

3.2 Section 30 of the Act sets out that “[the Act] and single source contract regulations apply to qualifying subcontracts (and to sub-contractors) as they apply to qualifying defence contracts (and to primary contractors)”. In the case of a qualifying sub-contract, the calculation of the cost risk adjustment is agreed between the sub-contractor and the contracting authority, rather than the Secretary of State, and this guidance must be modified by reading references to the Secretary of State as the contracting authority and references to the contractor as the sub-contractor.

Application of the cost risk adjustment

3.3 The calculation of the contract profit rate must include application of the cost risk adjustment, although the legislation is clear that permissible range of adjustments includes a zero adjustment. The purpose of this guidance is to provide a consistent approach for contractors and the Secretary of State to follow when agreeing a cost risk adjustment.

Determination of the cost risk adjustment

3.4 The cost risk adjustment guidance is principles-based rather than rules-based.

Regulated pricing methods

3.5 Regulation 10(2) states that the parties to a qualifying defence contract may agree which regulated pricing method is to be used for that contract. The parties can also agree a different pricing method for defined components of the contract (regulation 10(3)).

3.6 There are six regulated pricing methods that the parties to a qualifying defence contract may decide to use, as set out in regulation 10(4) to 10(11). All regulated pricing methods use either an estimate or actual Allowable Cost base.

General approach

3.7 Contractors and the Secretary of State must have regard to the following approach and principles when negotiating the cost risk adjustment to the baseline profit rate. The terms and conditions of each individual contract should always be considered when determining the adjustment.

3.8 The purpose of the cost risk adjustment is to incorporate into the contract profit rate an addition or deduction to reflect the risk that the contractor’s actual Allowable Costs in delivering the requirement will differ from the estimated Allowable Costs included in the contract price. While one factor will be the proportion of actual versus estimated costs included in the pricing method, other factors also drive risk. The adjustment should be agreed by considering the principles stated at paragraph 3.17.

3.9 For qualifying defence contracts that are based on the cost-plus or estimate-based fee regulated pricing methods (refer to regulation 10), the cost risk adjustment should be minus 25 per cent, because actual Allowable Costs are used to determine the costs to be paid, although the Secretary of State and the contractor should always have regard to the principles at paragraph 3.17.

3.10 For all other regulated pricing methods, the adjustment may vary from minus 25 per cent to plus 25 per cent, depending on the risk of actual Allowable Costs differing from estimated Allowable Costs, using the following guidance and the principles stated at paragraph 3.17.

3.11 Subject to the considerations of the regulated pricing method, the starting point for the appropriate cost risk adjustment is that none should apply. A positive or negative cost risk adjustment should apply where it can be reasonably justified and evidenced.

Negative adjustment

3.12 A negative adjustment should be made where the Secretary of State and the contractor agree there is a lower (or no) risk of actual Allowable Costs differing from estimated Allowable Costs.

3.13 For example, this may be justified where there are risks that are well understood and for the large part mitigated.

3.14 The SSRO recognises that for some defence contracts most of the cost risk associated with one or more sub-contracts is held by, or assigned to, the Secretary of State. It is appropriate to recognise these circumstances when agreeing a cost risk adjustment. The cost risk adjustment should reflect the reduced risk of the primary contractor’s actual Allowable Costs under the contract differing from its estimated Allowable Costs, thus recognising the reduced risk held by the prime contractor associated with the sub-contract(s).

Positive adjustment

3.15 A positive adjustment should be made where the Secretary of State and the contractor agree there are higher risks of actual Allowable Costs differing from estimated Allowable Costs.

3.16 For example, this may be justified where the risk is held by the contractor, and not the Secretary of State, and where the risks are not well understood and/or cannot managed in the Allowable Costs because they are not in the control of the contractor and therefore cannot be mitigated.

Principles to consider

3.17 The contractor and the Secretary of State must have regard to the following principles (which are not exhaustive) when determining the cost risk adjustment. The adjustment should:

a. only consider uncertainties that impact on Allowable Costs;

b. give consideration to the contract pricing method (refer to 3.9 and 3.10);

c. not take into account risk that should be managed in estimated Allowable Costs;

d. be based upon an assessment of the extent to which actual Allowable Costs may vary from estimated Allowable Costs, both positively and negatively;

e. take into account the relative likelihood of actual Allowable Costs being over or under estimated Allowable Costs;

f. take into account the extent to which the probability and expected impact of cost risk has been mitigated, eliminated or transferred to another party, for example through insurance or where sub-contract risk is ‘passed through’ to a party other than the prime contractor;

g. take into account the extent to which cost risk should be covered through Allowable Costs;

h. reflect and draw upon the overall approach to risk assessment such as risk allocation, management, and risk registers (and be recorded in the risk register);

i. not take into account uncertainty resulting from force majeure, for example an unforeseeable natural disaster; and

j. be based on reasonable documented assumptions and/or evidence.

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4. Profit on cost once adjustment (POCO) (step 3)

Basis of the POCO adjustment

4.1 Section 17(2) of the Act, and regulation 11(4), set out the requirement for the POCO adjustment:

“Deduct from the amount resulting from step 2 the adjustment determined in accordance with regulation 12 (“the POCO adjustment”), so as to ensure that profit arises only once in relation to those Allowable Costs under the contract that relate to the price payable under any group sub-contract (including any further group sub-contract)”.

4.2 This adjustment ensures that if a party to a qualifying defence contract enters into a group or further group sub-contract then profit arises only once in relation to Allowable Costs included in the group or further group sub-contract price.

4.3 Section 30 of the Act sets out that “[the Act] and single source contract regulations apply to qualifying subcontracts (and to sub-contractors) as they apply to qualifying defence contracts (and to primary contractors)”. In the case of a qualifying sub-contract, the calculation of the POCO adjustment is agreed between the sub-contractor and the contracting authority, rather than the Secretary of State, and this guidance must be modified by reading references to the Secretary of State as the contracting authority and references to the contractor as the sub-contractor.

Application of the POCO adjustment

4.4 The POCO adjustment applies in the calculation of a contract profit rate if, at the time of the agreement^{[footnote 7]}, the primary contractor is party to, or proposes to enter into, a group sub-contract^{[footnote 8]}.

4.5 Regulation 12(2) sets out that the POCO adjustment is zero if the Secretary of State is satisfied that the Allowable Costs of the qualifying defence contract have already been decreased by an amount equal to the attributable profit on all group and further group sub-contracts.

4.6 Regulation 12(3) sets out that, where the Secretary of State is not satisfied that the allowable costs have been adjusted to remove an amount equal to the attributable profit, a POCO adjustment may be agreed. The purpose of this guidance is to provide a consistent methodology for contractors and the Secretary of State to follow when agreeing a POCO adjustment.

4.7 The diagram below demonstrates when a POCO adjustment should be made.

Determination of the POCO adjustment

4.8 The information upon which the POCO calculation is constructed is likely to be held by the prime contractor and their group sub-contractors and not the Secretary of State. In such cases, in order for the parties to reach an informed agreement as to the POCO adjustment:

a. the prime contractor should propose the POCO adjustment to the Secretary of State, supported by the facts, assumptions and calculations relied upon; and

b. the Secretary of State should scrutinise those matters and request any further information required to form a view as to the amount by which the contract profit rate must be decreased in order to exclude attributable profit that has been included.

4.9 The table below demonstrates the process that contractors and the Secretary of State must have regard to when agreeing the POCO adjustment amount. Please refer to paragraph 4.10 onwards for a glossary of the terms used. And please refer to Appendix B for a high-level worked example of the process to aid users.

Stage	Process	Calculation (see Appendix B)
1	Document the expected contract supply chain, identifying all the group subcontracts and further group subcontracts to which the POCO adjustment applies. Note the total Allowable Costs (used for the purposes of the pricing formula) for each contract.
2	Calculate the contract profit rate (before the application of step 3 (POCO) and step 6 (CSA), where applicable) for the primary contract (CPRP). Calculate the attributable profit rates for each group sub-contract and further group sub-contracts) identified at stage one (CPRSi).	CPRP CPRS1 CPRS2 …… CPRSi
3	Multiply total Allowable Costs identified at stage one for the primary contract (ACP) by its contract profit rate (before the application of step 3 (POCO) and step 6 (CSA), where applicable) (CPRP) calculated at stage two. Multiply total costs identified at stage one for each group sub-contract and further group sub-contract (ACSi) by their respective attributable profit rates (CPRSi) calculated at stage two. The result is the profit for the primary contractor (πP) and the attributable profits of each group sub-contractor (πSi) (net of POCO adjustment and CSA where applicable).	ACP x CPRP=πP ACS1 x CPRS1 = πS1 ACS2 x CPRS2 = πS2 … … … … ACSi x CPRSi= πSi
4	Sum the profits calculated at stage three to determine the total group profit (net of POCO adjustment and CSA where applicable). This comprises the profits of the primary contractor (πP) and the sum of all attributable profits for all group sub-contractors (ΣπS).	πP + πS1+πS2+πS3…=πP + ΣπS =Σπ
5	Note the total Allowable Costs of the primary contract (ACP) and subtract from it the sum of the attributable profits for all group subcontract (ΣπS) calculated at stage two.	ACP -ΣπS = AC*
6	Multiply the value calculated at stage five by the primary contract profit rate (CPRP) derived at stage two. This gives the target profit that the group should receive from the QDC (net of primary contract CSA).	AC* x CPRP = πT
7	Subtract the total group profit from stage four (before the application of step 3 (POCO)) and step 6 (CSA)) from the target profit from stage six. This is the reduction to the price that will result from the step 3 POCO adjustment.	πT - Σπ = POCOR
8	The POCO adjustment is the POCO reduction (POCOR) divided by the total Allowable Costs for the primary contract identified at stage five. This is the step 3 adjustment, which will result in a reduction to the profit (or zero if no profit has been charged at lower levels).	POCOadj=POCOR / ACP
9	Apply all adjustments (steps 1 to 6) to calculate the contract profit rate (CPR) which is applied to the total Allowable Costs associated with the primary contract. Cross check the calculated price to expectations.	ACP + (ACP x CPR)

Glossary of POCO terms

Group sub-contract

4.10 As set out in regulation 12(5), “group sub-contract” means a contract:

a. where the price payable under which includes an amount of profit; b. which is made between the primary contractor and any person associated^{[footnote 9]} with the primary contractor; c. where the value of which is no less than £100,000; d. where the award of which was not the result of competitive process (as defined in regulation 59 or 60); and e. where the goods, works or services to be provided under the contract are necessary to enable the performance of the qualifying defence contract.

Further group sub-contract

4.11 As set out in regulation 12(6), “further group sub-contract” means a contract:

a. where the price payable under which includes an amount of profit;

b. which is made between two or more persons, each of which is associated^{[footnote 9]} with the primary contractor or a group sub-contractor;

c. where the value of which is no less than £100,000;

d. where the award of which was not the result of a competitive process (as defined in regulation 59 or 60); and

e. where the goods, works or services to be provided under the contract are necessary to enable the performance of a group sub-contract or further group sub-contract.

Attributable profit

4.12 As set out in regulation 12(7) to (8), the “attributable profit” is:

a. where all of the output of a group sub-contract or further group sub-contract is necessary to enable the performance of the qualifying defence contract, all the profit element in the price payable under that group sub-contract or further group sub-contract; or

b. where only part of the output of a group sub-contract or further group sub-contract is necessary to enable the performance of the qualifying defence contract, that part of the profit element in the price payable under that group sub-contract or further group sub-contract which relates to the output necessary for that performance.

However, attributable profit does not include:

a. any capital servicing adjustment made under step 6 of regulation 11; and

b. any profit which is received by a person which is not associated with the primary contractor.

Group sub-contractor

4.13 As set out in regulation 12(10), a “group sub-contractor” means a person with which the primary contractor makes a group sub-contract.

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5. SSRO funding adjustment (step 4)

Basis of the SSRO funding adjustment

5.1 Section 17(2) of the Act, and regulation 11(5), set out the requirement for the funding adjustment.

“Deduct the SSRO funding adjustment which is in force at the time mentioned in step 1”

5.2 The relevant time should be the time of agreement, as defined in regulation 2(1). The SSRO has provided separate guidance that will assist the contracting parties to determine the time of agreement for a particular QDC or QSC.^{[footnote 10]}

Application of the SSRO funding adjustment

5.3 A contract profit rate must include the SSRO funding adjustment.

Determination of the SSRO funding adjustment

5.4 Section 19(1) of the Act requires the Secretary of State to determine the SSRO funding adjustment for each financial year.

5.5 The SSRO is required annually to review the figures used to determine the contract profit rate for pricing single source contracts. Section 19(2) of the Act requires that, for each financial year, the SSRO must provide the Secretary of State with its assessment of the appropriate SSRO funding adjustment for qualifying defence contracts. The SSRO has published information on its methodology to aid those who may wish to scrutinise or replicate the approach taken.^{[footnote 11]}

Section 19(4) of the Act states that the Secretary of State must publish the SSRO funding adjustment for each financial year in the London Gazette, no later than 15 March in the preceding financial year.

5.6 The SSRO funding adjustment in force for the financial year commencing 1 April 2021 is:^{[footnote 13]}

2021/22 SSRO funding adjustment

0.057%

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6. Incentive adjustment (step 5)

Basis of the incentive adjustment

6.1 Section 17(2) of the Act, and regulation 11(6), set out the requirement for the incentive adjustment:

“Where the Secretary of State determines that the amount resulting from step 4 should be increased so as to give the primary contractor a particular financial incentive as regards the performance of provisions of the contract specified by the Secretary of State, increase that amount by an amount (“the incentive adjustment”) specified by the Secretary of State, that amount not to exceed two percentage points.”

6.2 This document provides guidance for the Secretary of State to use when determining when to apply the incentive adjustment to a qualifying defence contract and what to consider when setting the adjustment between zero and two percentage points.

6.3 Section 30 of the Act sets out that “[the Act] and single source contract regulations apply to qualifying subcontracts (and to sub-contractors) as they apply to qualifying defence contracts (and to primary contractors)”. In the case of a qualifying sub-contract, the determination of the incentive adjustment is made by the contracting authority rather than the Secretary of State and this guidance must be modified by reading references to the Secretary of State as the contracting authority and references to the contractor as the sub-contractor.

Application of the incentive adjustment

6.4 It may be desirable for the Secretary of State to include a positive incentive in certain circumstances. The incentive adjustment is not automatic and will be applied exceptionally in the determination of a contract profit rate.

Determination of the incentive adjustment

6.5 The incentive adjustment guidance is principles-based rather than rules-based.

6.6 The inclusion of an incentive adjustment is at the Secretary of State’s discretion. When considering whether to apply an incentive adjustment the Secretary of State should have regard to the following principles:

a. The incentive adjustment can be applied to any QDC using any regulated pricing method. The incentive adjustment must relate to the performance of the contract to which it applies.

b. The incentive adjustment must be used for delivering performance on a contracted performance metric. The contract should be priced on the basis that a contractor will deliver the performance specified in the contract.

c. The incentive adjustment must relate to performance enhancements which benefit the Secretary of State. The additional value delivered to the Secretary of State through the achievement of incentivised elements must be tangible and demonstrable.

d. The incentive adjustment must be within a range of up to two percentage points. A positive incentive adjustment will not be applied to all QDCs and is not an entitlement.

e. The link between the incentive adjustment and performance must be simple and measurable. The criteria for achievement must be measurable and set objectively.

f. The link between the incentive adjustment and performance, and the criteria for achievement and payment must be clearly stated in the contract. This includes:

i. the required level of performance;

ii. how it will be demonstrated;

iii. when it will be measured; and

iv. if incentivised performance is delivered, when incentive payments will be made.

6.7 The incentive adjustment must not be linked to legislative obligations. An incentive adjustment must not be given for compliance with the Act, Regulations, or other legislative obligations.

6.8 The incentive adjustment should not be linked to a reduction in the Allowable Costs of the contract. Reducing Allowable Costs of a contract should be rewarded via the chosen regulated pricing method.

6.9 Subject only to this guidance and the maximum incentive adjustment of two percentage points provided for in regulation 11(6), the Secretary of State can determine the amount of an incentive adjustment and when to apply an incentive adjustment to a QDC.

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7. Capital servicing adjustment (step 6)

Basis of the capital servicing adjustment

7.1 Section 17(2) of the Act, and regulation 11(7), set out the requirement for the capital servicing adjustment:

“Take the amount resulting from step 5 and add to or subtract from it an agreed amount (“the capital servicing adjustment”), so as to ensure that the primary contractor receives an appropriate and reasonable return on the fixed and working capital employed by the primary contractor for the purposes of enabling the primary contractor to perform the contract.”

7.2 Regulation 11(8) requires that:

“In agreeing the capital servicing adjustment, the primary contractor and the Secretary of State:

a. must have regard to the capital servicing rates in force at the time of the agreement;

b. must not apply any adjustment in respect to any costs of the fixed and working capital employed by the primary contractor which are Allowable Costs under the contract; and

c. may use an average fixed and working capital for any business unit which is likely to be performing the primary contractor’s obligations under the contract.”

7.3 The SSRO has provided separate guidance that will assist the contracting parties to determine the time of agreement for a particular QDC or QSC.^{[footnote 14]}

7.4 The three capital servicing rates published by the Secretary of State that are in force for the financial year commencing 1 April 2021 are:[^15]

Item	Rate
Fixed capital	3.27%
Positive working capital	1.33%
Negative working capital	0.65%

7.5 Section 30 of the Act sets out that “[the Act] and single source contract regulations apply to qualifying subcontracts (and to sub-contractors) as they apply to qualifying defence contracts (and to primary contractors)”. In the case of a qualifying sub-contract, the capital servicing adjustment is agreed between the sub-contractor and the contracting authority, rather than the Secretary of State, and this guidance must be modified by reading references to the Secretary of State as the contracting authority and references to the contractor as the sub-contractor.

Application of the capital servicing adjustment

7.6 The calculation of the contract profit rate must include consideration of the capital servicing adjustment, although it is clear that the permissible adjustments include a zero adjustment. The purpose of this guidance is to provide a consistent approach for contractors and the Secretary of State to follow when agreeing a capital servicing adjustment.

7.7 In the calculation of the baseline profit rate (step 1) the comparator company data is adjusted to remove the effect of capital servicing and so sets a baseline upon which Step 6 can be applied for a contract. This process is set out in SSRO (2019) Single Source Baseline Profit Rate, Capital Servicing Rates and Funding Adjustment Methodology.

Determination of the capital servicing adjustment

7.8 This guidance sets out the approach that should be followed to calculate the capital servicing adjustment using a ratio of capital employed to the total cost of production (CP:CE ratio) of a relevant unit of business which is likely to be performing the contractor’s obligations under the contract (the CSA calculation).

7.9 The next sections of the guidance set out the calculations of capital employed and of cost of production, which are required for the CSA calculation. The diagrams after that guidance set out the four computations to be performed. A simple worked example is described at Appendix C to this guidance.

7.10 The CSA calculation ensures the contractor receives an appropriate and reasonable return on the fixed and working capital employed by the contractor for the purposes of enabling it to perform the contract. On this basis borrowing costs should not form part of Allowable Costs.

7.11 The CSA calculation assumes that the capital intensity of the unit of business (that is the ratios of its fixed and working capital to its cost of production for a given period) is equivalent to the capital intensity of the contract. This assumption is a reasonable estimate because a unit of business will normally perform many contracts of a similar nature under similar conditions and it is therefore reasonable to expect that the QDC or QSC will be performed on the same basis with equivalent capital requirements.

7.12 The contractor and the Secretary of State must use the information of the unit of business which they agree is most relevant to the contract. This may be a subsidiary company, division, business unit, or site location, and is selected based upon professional judgement. If reliable information cannot reasonably be isolated to a unit of business the information of the contractor’s business as a whole may be used.

7.13 The calculation has two components: the capital employed and the cost of production. Both components should be derived from the same financial records or should be adjusted to ensure they are on the same basis. For example, if cost of production is derived from the information supplied during the course of the assessment of cost recovery rate claims, such as financial or management accounts, then components of capital employed, for example manufactured inventory, may need adjustment to ensure they are valued on the same cost basis.

7.14 Regardless of which financial periods are described in the records from which data is drawn to determine the capital employed and cost of production, the capital servicing rates to which the relevant parties must have regard are those in force at the time of the agreement, not those relating to any other period.

Calculation of capital employed

7.15 Capital employed is the debt and equity necessary for a unit of business to function. Directly calculating this may be difficult because a unit of business may not separately report the debt and equity necessary for a business to function from other debt and equity. Capital employed is instead indirectly calculated with reference to the equal and opposite balance sheet items for which more granular information is available.

7.16 Capital employed should be computed as the total assets less total liabilities, excluding interest-bearing liabilities, of the business unit.

7.17 Capital employed is the average capital employed over the same period used to determine cost of production. At a minimum this is the average of the opening and closing position.

7.18 The capital employed is adjusted to remove elements that are not part of normal operations, are equivalent to debt, or would not result in an appropriate result if included in the calculation. These adjustments seek to achieve a result that, when taken with the cost of production as a ratio, approximates the capital intensity of the contract as closely as is practicable.

7.19 The initial definition of capital employed is total assets less total liabilities, except for interest-bearing liabilities. The following items should then generally be excluded:

a. items not representing capital employed in normal operations, for example:

i. goodwill, brands and customer lists acquired in a business combination;

ii. fair value adjustments that did not require additional input of capital, for example, the upward revaluation of tangible and intangible assets;

iii. investments in shares and securities;

iv. loans to or from other companies, including non-trading balances with group entities;

v. assets held for sale and idle assets not required for the normal operation of the business; or

vi. cash that exceeds the amount required for normal operations. Normal operational requirements might include holding cash for the purpose of meeting liabilities included in the calculation of capital employed;

b. items that are indirect ways of raising capital that should be treated as debt equivalents, for example:

 i. deferred tax assets or liabilities; or

 ii. retirement benefit surpluses or obligations; and

c. other items whose inclusion would not result in an appropriate step 6 adjustment.

7.20 Where cash is held in a group pooling arrangement outside the balance sheet of the unit of business used for the calculation, a value of cash required for normal operations of the business unit may be included as an element of capital employed.

7.21 Exceptional further adjustments may be agreed with the Secretary of State if they can be reliably estimated and have a material impact on the result. Any adjustment will depend on the information available and the specific circumstances of the contract being delivered.

Examples of such situations are:

a. where a pervasive change is expected to occur that will affect the capital employed of the unit of business; or

b. where considering the timing of a significant transaction during the period will give a more precise average.

Fixed and working capital

7.22 To calculate the split of capital employed between fixed and working capital employed a contractor should identify balance sheet items that are fixed in nature; this will generally include items that are held for more than one year. This ‘fixed capital value’ figure is subtracted from the capital employed and the balance is the ‘working capital value’, which may be positive or negative.

7.23 Adequate justification should be provided to support the calculation of both fixed and working capital. In determining what type and standard of information is required, the relevant parties should take a proportionate approach considering:

a. the specific requirements and circumstances of the contract;

b. the materiality of particular components of the calculation; and

c. what it is reasonable to expect would be available.

Calculation of cost of production

7.24 Cost of production is the cost incurred by the functioning of a business before financing charges.

7.25 Where the period to which the cost of production relates is not one year, an equivalent annual value should be computed because the capital servicing rates to which the CP:CE ratio is applied are an annual rate of return.

7.26 The initial definition of cost of production is operating revenue less operating profit/loss. The following items should then generally be excluded:

a. borrowing costs;

b. costs related to items excluded from capital employed; and

c. costs whose inclusion would not result in an appropriate Step 6 adjustment.

7.27 Where exceptional adjustments have been made to capital employed in accordance with paragraph 7.21, a corresponding adjustment to cost of production may be required.

*The capital servicing rate can be positive or negative.

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Appendix A: Changes from previous version

A.1 The table below highlights changes from version 6 of the guidance to this version.

References in footnotes have also been updated to include web links to the documents referenced.

A.2 The table does not include stylistic or trivial changes.

Section/paragraph 2020 v6	Section/paragraph 2021 v7	Change made
1. Introduction	1. Introduction
	1.1 to 1.2	Added
1.1 to 1.4	1.3 to 1.6	No change
	1.6	Added
1.5	1.7	Revised
1.6	1.8	No change
1.7	1.9	Revised
1.8 to 1.9	1.10	No change
1.10	1.11	No change
	1.12	Added
Key terms and definitions	Key terms and definitions
	Secretary of State	Added
2. Baseline profit rate	2. Baseline profit rate
2.1 to 2.2	2.1 to 2.2	No change
	2.3	Added
	2.4	Added
2.3	2.5	Revised
2.6	2.6	No change
	2.7 to 2.9	Added
3. Cost risk adjustment	3. Cost risk adjustment
3.1	3.1	No change
	3.2 to 3.3	Added
3.2 to 3.15	3.4 to 3.17	No change
4. POCO adjustment	4. POCO adjustment
4.1	4.1	No change
4.2	4.2	Revised
	4.3	Added
4.3	4.4 to 4.6	Revised
4.4 to 4.7	4.7 to 4.9	No change
Table	Table	Revised
Appendix B	4.10 to 4.13	No change
5. SSRO funding adjustment	5. SSRO funding adjustment
5.1 to 5.3	5.1 to 5.5	Revised
5.4	5.6	No change
6. Incentive adjustment	6. Incentive adjustment
6.1 to 6.2	6.1 to 6.2	No change
	6.3	Added
6.3 to 6.4	6.4	No change
6.3	6.5	No change
6.6 to 6.9	6.6 to 6.9	No change
7. Capital servicing adjustment	7. Capital servicing adjustment
7.1 to 7.3	7.1 to 7.3	No change
7.5	7.4	No change
7.4	7.5	Revised
	7.6	Added
7.6 to 7.26	7.7 to 7.27	No change
8. Opinions and determinations	See 1.6	Deleted
Appendix A	Appendix A	Revised
Appendix B	4.10 to 4.13	No change
Appendix C	Appendix B
C.3	B.3 to B.4	Revised
Appendix D	Appendix C	No change

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Appendix B: Worked example of POCO adjustment

B.1 To calculate what the POCO adjustment is, apply the stages that have been described in the main body of this document.

B.2 The diagram below reflects Stage 1 of the methodology, with profit applied at the supplier’s rates at each level. These figures are used in the calculations that follow.

Expected contract price

B.3 The diagram below reflects the expected price of the contract if profit on allowable sub-contract costs is only applied once as per section 15 of the Defence Reform Act. This is determined by:

• removing attributable profit from the group and further group subcontracts directly;
• consolidating the remaining SC2 and SC3 totals into SC1;
• consolidating the remaining SC1 total into the primary contract; and
• applying the contract profit rate for the primary contract (CPRP) to the consolidated total to determine the expected profit.

B.4 Note that a CSA is not part of attributable profit. The values for CSA are taken from the diagram under B1 rather than being calculated from the adjusted sub-total.

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Appendix C: Worked example for capital servicing adjustment

C.1 The worked example shown below incorporates the four main computations that need to be followed in order to determine the capital servicing adjustment in step 6 of the contract profit rate.

C.2 To aid the worked example shown below we have provided the following illustrative information:

1. Total capital employed:

• Example a): £4,000,000;
• Example b): £4,500,000;
• Example c): £2,500,000; and
• Example d): (£1,000,000).

1. Fixed capital:

• Examples a), b), and c): £3,000,000; and
• Example d): £1,500,000.

1. Working capital (by way of calculation i.e. total capital employed less fixed working capital):

• Example a): £1,000,000;
• Example b): £1,500,000;
• Example c): (£500,000); and
• Example d): (£2,500,000).

1. Cost of production: £6,000,000 (in all four examples).

This worked example uses the following published capital servicing rates for 2021/22:

• Fixed capital servicing rate: 3.27%;
• Working capital servicing rate for positive working capital: 1.33%; and
• Working capital servicing rate for negative working capital: 0.65%.

	Example (a)	Example (b)	Example (c)	Example (d)
Computation 1
CP: CE ratio calculation:
(a) Fixed capital	£3,000,000	£3,000,000	£3,000,000	£1,500,000
(b) Working capital	£1,000,000	£1,500,000	-£500,000	-£2,500,000
(c) Total capital employed	£4,000,000	£4,500,000	£2,500,000	-£1,000,000
(d) Total cost of production	£6,000,000	£6,000,000	£6,000,000	£6,000,000
(e) CP:CE ratio (d/c)	1.5	1.3	2.4	-6.0
Computation 2
(f) Fixed capital as a proportion of capital employed (a/c)	0.75	0.67	1.20	-1.50
(g) Positive Working Capital as a proportion of capital employed (b/c)	0.25	0.33	-	-
(h) Negative working capital as a proportion of capital employed (b/c)	-	-	-0.20	2.50
Capital servicing rates (published annually. 2021/22 rates used for this worked example)
(i) Fixed capital servicing rate	3.27%	3.27%	3.27%	3.27%
(ii) Positive working capital servicing rate	1.33%	1.33%	1.33%	1.33%
(iii) Negative working capital servicing rate	0.65%	0.65%	0.65%	0.65%
Computation 3
Fixed capital servicing allowance (f x i)	2.45%	2.18%	3.92%	-4.91%
Positive working capital servicing allowance (g x ii)	0.33%	0.44%	-	-
Negative working capital servicing allowance (h x iii)	-	-	-0.13%	1.63%
Capital servicing allowance “x”	2.79%	2.62%	3.79%	-3.28%
Computation 4
Capital servicing adjustment for step 6 (“x”/e)	1.86%	1.97%	1.58%	0.55%

1. A guide to the changes which have occurred from the previous version is provided in Appendix A. ↩

2. SSRO (2020) Reporting guidance on preparation and submission of contract reports – Version 9, paragraphs 3.9 to 3.32, available at https://www.gov.uk/guidance/contract-and-supplier-reporting-defcars-and-associated-guidance. ↩

3. SSRO (2020) Reporting guidance on preparation and submission of contract reports, available at https://www.gov.uk/guidance/contract-and-supplier-reporting-defcars-and-associated-guidance. ↩

4. SSRO (2020) Reporting guidance on preparation and submission of contract reports – Version 9, paragraphs 3.9 to 3.32, available at https://www.gov.uk/guidance/contract-and-supplier-reporting-defcars-and-associated-guidance. ↩ ↩²

5. SSRO (2021) 2021/22 baseline profit rate, capital servicing rates and SSRO funding adjustment methodology, available at https://www.gov.uk/government/publications/2021-contract-profit-rate. ↩

6. Figures for earlier years are available in the London Gazette. ↩

7. The SSRO has provided separate guidance that will assist the contracting parties to determine the time of agreement for a particular QDC. See SSRO (2020) Reporting guidance on preparation and submission of contract reports – Version 9, paragraphs 3.9 to 3.32, available at https://www.gov.uk/guidance/contract-and-supplier-reporting-defcars-and-associated-guidance. ↩

8. Refer to paragraph 4.10 for the definition of ‘group sub-contract’. ↩

9. As set out in section 43(3) of the Defence Reform Act 2014, one person is “associated” with another if they are group undertakings in relation to each other, where “group undertakings” has the meaning given by section 1161 of the Companies Act 2006. ↩ ↩²

10. SSRO (2020) Reporting guidance on preparation and submission of contract reports – Version 9, paragraphs 3.9 to 3.32, available at https://www.gov.uk/guidance/contract-and-supplier-reporting-defcars-and-associated-guidance. ↩

11. SSRO (2020) 2020/21 baseline profit rate, capital servicing rates and SSRO funding adjustment methodology, available at https://www.gov.uk/government/publications/2020-contract-profit-rate. ↩

12. SSRO (2020) Reporting guidance on preparation and submission of contract reports – Version 9, paragraphs 3.9 to 3.32, available at https://www.gov.uk/guidance/contract-and-supplier-reporting-defcars-and-associated-guidance. ↩

13. Figures for earlier years are available in the London Gazette. ↩