Understanding a different ‘holy trinity’: procurement and British defence policy, part 2: Cost

DR ED HAMPSHIRE

In my previous post I discussed the problems faced in defence procurement deriving from one of the members of the procurement trinity: ‘capability’. This post will now turn to the second element of this trinity: cost.

It is the cost escalation of projects that unsurprisingly most exercises the Treasury when it reviews the Ministry of Defence’s spending plans. Almost all defence projects seem to rise in cost at a faster level than planned, leaving policy-makers and staff officers with difficult decisions about prioritisation, reduction in project size and even cancellation.

One important factor to recognise is that defence procurement spending is subject to something called, in the Treasury jargon, the ‘relative price effect’. In essence that means that all things being equal, defence procurement will inevitably rise faster than inflation. Time and space are at too much of a premium in this post to explain this in detail here, but one of the elements that causes the relative price effect is the increasing cost of producing the same capability as an opposing threat increases over time. In short, much more money needs to be spent in order to do the same thing today compared to say, twenty years ago, because your potential enemy has improved their defences and their weaponry in order to stop you. Defence economists have estimated that this aspect of the relative price effect causes increases in the procurement budget by approximately 5% a year.

 

When officials and staff officers are faced with an escalating procurement budget, for whatever reason, they have a number of options. At level of an individual project, costs might be unobtrusively and almost invisibly pushed into the future when negotiating with a contractor over a particular sub-system or piece of equipment. As purchases of such equipment increasingly come with an attached maintenance contract with the same company, the easiest approach would be to negotiate a lower initial purchase price with the contractor, but at the cost of a much more restrictive and inflexible maintenance contract over the equipment’s service lifespan. On the surface, money has been saved, but in practice, the cost has been pushed from those staff officers dealing with procurement, to those staff officers in the slightly less sexy area of managing ongoing upkeep. They will have to deal with a maintenance contract that is not fit for purpose without renegotiation or expensive work-arounds.

Since the 1990s, procurement has meant to operate on a whole-of-life concept where conceptual work, assessment, demonstration, manufacture, in-service life and finally disposal (known as the CADMID cycle) are all equally taken account of, but in practice older attitudes can remain, and in the end, if costs need to be controlled, pushing the problem into the future – bringing in our third element of the procurement trinity: time – can be a way to keep everyone happy (for the moment).

Another way of saving money quickly when costs escalate is to reduce the project’s production run. This ‘salami slicing’ approach has the inevitable effect of increasing the individual cost per item, be it a rifle, fast jet or frigate. The newly shrunk production run has the same development costs as before, contracts might have to be renegotiated, and more significantly the cheapest units in the procurement (those produced last, when early glitches have been ironed out) are the ones that have been cancelled. The difference in cost between the first in the production line and the last can be substantial. For example in 2012 it was expected that the last Astute class nuclear submarine would cost £300m, nearly a fifth the cost of the fourth boat (£1448m – see appendix. 4, p. 39). This is an extreme example and partly reflected recent changes in the schedule of production for the class, but unit costs at the end of production run which are less than half those at the start are not uncommon.

This sheds an interesting light on one of the major decisions of the 2015 Strategic Defence and Security Review: the planned order of 13 Type 26 frigates will be reduced to 8, and in the place of the cancelled ships, the MoD would investigate building 5 cheaper vessels instead   (p. 31) However, the cheapest Type 26s have just been cancelled, whilst the first of the new Type 31s (as they have been informally dubbed) will be the most expensive of what would anyway be a short and therefore in itself expensive production run. It seems distinctly possible that the Type 31s will no cheaper than the cancelled Type 26s they will replace unless they are significantly less capable and not much more than enhanced offshore patrol vessels.

Other factors can increase costs dramatically: over-ambitious requirements using new technology can be a significant aspect of this. As described in the previous post, aiming for the best can add a hugely disproportionate amount to a project. The changing of requirements by staff officers either too late in the design process or too often can increase costs exponentially, as well as more mundane matters of effective cost control and the types of contract under which a contractor is operating.

The use of ‘cost plus’ contracts (which used to be widespread in the 1970s) for the most complex procurement projects could also escalate costs: the contractor would be permitted to pass on any development overspends onto the Ministry of Defence, thus providing an incentive for routine overspending. ‘Cost plus’ contracts are now used much more sparingly and with a wider range of controls and cost control measures are much more effective, but cost escalation is still a significant issue within contemporary defence procurement: by 2009 it was estimated by the National Audit Office that the total defence procurement programme was on course to overspend by over a huge £36bn over the next ten years  (p. 4). Although much of this overspend was apparently dealt with during the 2010 SDSR, as we have seen the recent 2015 SDSR might have added new opportunities for long-term overspending.

As has been seen, it is surprisingly easy for the costs of procurement projects to escalate. In my previous post I showed how pushing for too great a capability leap can multiply costs, as can multiple changes in requirements. Reduction in production runs is a way to reduce or at least control costs at the expense of capability, but the result is much higher unit costs. In a similar way, the reduction in sub-system purchase costs at the expense of inflexible or inflated maintenance and support contracts, is another way in which capability is traded in order to control costs. This trading away of capability has therefore been partially hidden through the pushing the costs incurred forward in time. This therefore brings us to the subject of my next post, and the last element of the procurement trinity: time.

Image: HMS Ambush Arriving at HMNB Clyde, via flickr.

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