Defence Market Overview

In the last few years there has been considerable Merger and Acquisition (M&A) activity within the Defence industry, particularly amongst the large US contractors. The deals most of note in the past years have been;

These transactions have impact for the UK Defence market in three main dimensions;

  1. The resultant business combinations are all major suppliers to the Ministry of Defence (MOD). Changes in composition of these businesses will directly affect the products and services which are accessible to MOD.
  2. Through the changes in scale the internal cost structures will be materially impacted. As globally integrated businesses these changes will indirectly alter the price which MOD pays.
  3. The Defence industry is segmented into tiers, with Tier 1 suppliers being the prime contractors who directly conduct business with MOD. The reduction in available Tier 1 suppliers to MOD increases the probability that single source procurement programmes will be required.

With the global defence supply chain becoming concentrated the need for MOD procurement through the Single Source Contracting Regulations (SSCR) will become more prevalent. A significant proportion of both the total contracts placed by MOD and MOD spend with the Top 10 Suppliers fall within the bounds of the SSCR.

The present SSCR were introduced in the Defence Reform Act 2014 (DRA) and resulted from an independent review of single source pricing regulations conducted by Lord Currie and published in 201. These regulations replaced the prior regime, known as The Yellow Book.

The history of non-competitive price regulation in the UK

The non-competitive contracting environment in the UK can be segmented into three periods;

  1. The pre-1968 period
  2. 1968 to 2014
  3. Post 2014

Price controls grew from concerns over First World War (WW1) profiteering and the need to maintain industrial capacity in the inter-war years. With the 1930’s rearmament concerns grew over excess profits which led to the McLintock Agreements of 1936 to 1941. These agreements were designed to not only guard against profiteering but also provide incentives for efficient production.

From the end of the Second World War (WW2) until 1968 contracts were agreed upon the basis of “fair and reasonable prices” with the Ministry of Defence possessing the necessary technical and accounting competency to be able to assess the validity of quotes provided from contractors and negotiating the fair and reasonable price point.

This period came to a close following two cases of contractors earning excessive profits (Ferranti and Bristol Siddeley Engines (BSE)) and the introduction of the Government Profit Formula and Associated Arrangements (GPFAA or “Yellow Book”). The main issues from the two cases were that of asymmetrical access to information, the Governments rights to access contractor cost records, the adequacy of profit rates and definition of excess profit.

The GPFAA stayed in place for a considerable amount of time and were subject to regular review and revision. The final of these was the Currie report of 2011. There had been substantial change in the UK Defence industry in the time between 1968 and 2011, including consolidation in the supply chain and less dependence on MOD as a sole customer, as well as reduction in MOD’s competence to be an intelligent customer.

The Currie Report

Lord Currie of Marylebone authored an independent report into the single source pricing regulations used by the Ministry of Defence at the request of Conservative/Liberal Democrat Coalition Government with publication coming in October 2011.

In review of the operation of the Yellow Book arrangements it was identified that post costing has been used sparingly. The was seen as being the result of a reduction in financial analysis skills at MOD Cost Assurance and Analysis Service (CAAS) which also had the impact of diluting MODs ability to be an intelligent customer. Decentralised budget management had led to an inability to compare across programmes and over time, further weakening this capability. As information asymmetry is a key failing of the defence market resolution of this facet is an understandable aim of the report.

It was also highlighted that the GPFAA had led to a focus on appropriate profit rate rather than efficient pricing and therefore attention was only paid to 10% of the contract price (this being representative of the profit element). While the recommendations have a defined process for contractors to use when making a contract proposal it’s not clear that this will resolve what is in effect an MOD cultural and capability issue. The report made five key recommendations to improve the efficiency of MOD single source procurement together with the establishment of the Single Source Regulations Office (SSRO) to oversee their introduction and ongoing management. These five recommendations were;

  1. Open book accounting
  2. Uniform reporting arrangements across projects and companies
  3. Incentivising of efficiency
  4. A new system for overhead reporting and monitoring
  5. A richer approach to the treatment of risk and return

The first two recommendations can be seen to be concerned with transparency and enablement of MOD becoming an intelligent customer, as well to develop an understanding of available capacity in the industrial base. These are solutions which appear to be reasonable to ensure that information asymmetries between MOD and industry are minimised in the single source environment.

The third recommendation, strengthening efficiency incentives, was further segmented in two ways;

  1. Having an equal balance of pain/gain share on Target Cost Incentive Fee (TCIF) contract types and only using these contracts where appropriate. This would avoid situations where benefits accrue to MOD and act as a disincentive to contractors delivering efficiencies. Unconscionable profit provision should also be relaxed.
  2. Through intelligent customer capability apply more pressure on contractors to be efficient.

For the final recommendation, the report sets forth that the Yellow Book arrangements were overly simplistic in only having two available profit rates, one for risk work and one for non-risk work although the risk rate could be adjusted for risk factors. While this might hold merit it is not clear that the solution implemented by the SSRO has resolved the perceived issue. The SSCR prescribe a 6-step process that allows for a narrow adjustment (+/- 25% of the Baseline Profit Rate) for risk factors and up to 2% profit mark up for incentivisation.

The Single Source Contract Regulations

The stated aim of the SSCR is that MOD receive Value for Money (VFM) and that industry receive a fair and reasonable return for the work conducted. The DRA sought to achieve this by establishing the SSRO and introducing thresholds at which a contract becomes a Qualifying Defence Contract (QDC) or Qualifying Sub Contract (QSC) dependent on whether the contract is direct with MoD (QDC) or another contractor who has a QDC with MoD (QSC). The values for QDCs and QSCs are set at £5m and £25m respectively, after which price regulation is a statutory requirement.

The price regulation is multi-faceted and broadly incorporates; statutory guidance on allowable costs for inclusion in the contract, defined profit formula to arrive at the contract profit rate, open book reporting obligations and auditing rights, and the right for price adjustment in the event of excessive profit or loss by the contractor. Contravention of these regulations can lead to penalties being imposed by the SSRO on a scale dependent on size of contract, with the maximum penalty being £1m.

Under the DRA there is a statutory obligation to periodically review the effectiveness of the regulations and the latest review was published on 14th June 2021. Crucially, according to the DRA this review is limited to the operation of the single source regime and any refinement that can be made within the framework rather than the considering whether the SSCR themselves remain necessary or are achieving the aim of delivering a balance in VFM and a fair and reasonable return for industry.