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Multiple profit rates on contracts could save MoD millions

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Taxpayers and the Armed Forces could be saved millions if multiple profit rates are introduced for defence contractors, the new MoD 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 (the consultation will run from 8 July to 18 August 2016) 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 ‘design 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.

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