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British defense companies see profits cut on sole-source deals

March 15, 2017 (Photo Credit: Phil Noble/WPA Pool via Getty Images)
LONDON — British defense companies are facing a 16 percent cut in the baseline profit rates they can earn on contracts awarded without competition, Defense Secretary Michael Fallon has told Parliament.

The latest clampdown will see profit margins for 2017 squeezed to 7.46 percent compared with last year’s figure of 8.95 percent. It’s the third year in a row baseline profit margins have been cut by the Ministry of Defence — in 2014/2015 the figure stood at 10.7 percent.

Britain hands out hundreds of uncontested, or single-source, contracts to industry. In 2015, that accounted for £11 billion (U.S. $13.5 billion) of procurement, with BAE Systems being the main beneficiary due to its big naval and combat aircraft contracts.

The £31 billion program being led by BAE to build the Royal Navy’s new Dreadnought-class Trident missile submarines will be single-source, as will a major deal to build Type 26 frigates, which is due to be signed early this summer.

Europe’s largest defense contractor said it recognized the role of the Single Source Regulations Office in providing value for U.K. taxpayers and a fair return to industry but said it would also ensure shareholders got a fair shake as well.

In a statement, BAE said its contracts with the MoD are “mostly bespoke due to their complexity and the level of risk involved. The baseline profit rate is used as a basis for negotiations. BAE Systems will ensure its shareholders earn a fair rate of return reflecting the scale, complexity and risks the company bears delivering some of the most technically challenging engineering projects in the world."

"I am today announcing that I have set the baseline profit rate for single source defence contracts at 7.46%, in line with the rate recommended by the Single Source Regulations Office," Fallon said in a written statement to Parliament.

The decision to cut again the baseline rate brought an angry response from ADS, Britain’s main industry lobby group.

“The U.K. defense industry is disappointed by the decision to further reduce the baseline profit rate for single-source defense contracts,” ADS CEO Paul Everitt said. “The methodology and rate is out of step with key international comparators and does not support the MoD’s stated intention of incentivising risk transfer and outstanding performance."

"The current approach risks long-term investment in the U.K. defense industry and the long-term, high-value jobs it supports,” he said.

In a further squeeze on companies, the defense secretary also announced further reductions on capital servicing rates for fiscal 2017/2018.

The MoD said in a statement it was making sure “big business does its part to support an efficient and economical defence budget.” The money saved would be reinvested in defense, it said.

One of the tasks of the SSRO is to recommend the baseline profit rate at which deals can be done. It is only the starting point, and contract negotiations frequently result in a higher profit rate.

The SSRO was set up in 2014 as part of reforms to the procurement process here. Aside from recommending profit rates, the organization also provides scrutiny of contracts for things like non-allowable costs.

For the moment at least, the SSRO’s mandate does not extend to foreign military sales and other government-to-government deals. Amendments to that exclusion and numerous other potential changes are the subject of a review expected to be complete later this year. 
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