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Editorial: Refine Requirements

Oct. 30, 2012 - 02:19PM   |  
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Over the past three decades, 82 governments have required some form of direct or indirect industrial compensation in return for defense purchases, known as offsets. The value of these packages, according to the U.S. Commerce Department, is about 70 percent of the value of the original contract.

One offsets expert estimates accumulated global offset obligations will total $500 billion by 2017, 60 percent of which will be held by U.S. industry.

Some governments want their national firms to build or develop support capabilities for what will serve under their flag, while others require far more elaborate — and wholly unrelated — profitable enterprises to be established, such as paper mills, fish farms, tourist destinations and, increasingly, enterprises in the training, education and health sectors. They are increasingly looking for medium- to long-term relationships via joint ventures and other investments to cement relationships beyond the original purchase.

Shifting obligations to non-defense activities poses a risk to defense companies, since it introduces too many variables and firms often lack the expertise to fully mitigate risk.

Sometimes, these indirect offsets aren’t preferred by governments, but are encouraged by companies as more genuine contributors to the economy. Direct offsets, on the other hand, tend to steer toward indirect governmental subsidization due to a lack of economies of scale.

Offsets have always been regarded by defense contractors as a necessary evil. Companies have been all-too-willing to climb the promissory ladder to win business in an ever-more competitive international market. What began as demands to build parts or all of a given defense system that was being purchased became increasingly expansive and expensive, until many nations ultimately demanded their economies receive equal value in offsets for a given purchase.

Executives now fear the accumulated mass of these promises may be increasingly difficult to deliver and will expose any company that fails to meet those obligations to punishment in a highly competitive market.

What to do? For starters, companies have been partly to blame for ultimately agreeing to governments’ demands, thereby encouraging other countries to be bolder in their requirements. But insistence by these governments on offsets, direct or indirect, leaves little wiggle room: companies must satisfy the demand or lose business.

Ideally, contractors — or their national trade groups — would come together to hammer out global offset rules to establish precisely what constitutes acceptable or unreasonable industrial-compensation packages. Europe has a code of conduct to limit offset requirements, and the Aerospace Industries Association is working with counterparts to lobby India to adjust its staunchly pro-offset defense procurement policy.

That is easier said than done in this buyer’s market, and no nation or company is willing to entirely trust their competitors to follow the rules. As spending drops in America and Europe, competition in international markets is red-hot. Defense companies first must get smarter about the deals they strike and get help from specialists to mitigate their long-term risks. Some will have to negotiate with their customers for some manner of relief from set stipulations and demands and take strategic risks while trying to mitigate losses.

Governments, however, bear the blame. Often their offset requirements are wholly out of sync with their true national economic and industrial interests. Here, Australia’s industrial participation model is a guide, aimed at enhancing strengths the nation already has instead of taking a scattershot approach.

This will prove a long and difficult project, but it’s absolutely vital if contractors are to avoid being financially strangled by contracts once hailed as major victories, now turning into albatrosses.

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