LONDON — The Single Source Regulations Office (SSRO) was created last year by the previous government to rewrite and regulate the terms and conditions under which the British Ministry of Defence and industry agree on non-competitive contracts. The new principles being put in place by the independent regulator scrap an outdated, nearly 50-year-old set of terms and conditions known as the Yellow Book, governing about £8.5 billion (US $13.1 billion) a year of equipment and support spending.
To the outside world the SSRO is likely one of the least known of the government's reforms aimed at spending the MoD's £34.9 billion budget more wisely. But the office has already set tougher rules on allowable costs and has the full attention of British industry chiefs as it sets out proposals for public consultation on the SSRO's next big initiative — shaking up the way profit margins will be set beginning next April.
US Foreign Military Sales and government-to-government deals fall outside the SSRO's remit.
Jeremy Newman was appointed the first chairman of the SSRO in July 2014. A former CEO of accounting and business advisory firm BDO, he is also a past chairman of the Government Audit Commission.
Q. You have revised rules for what industry can claim as an allowable cost. What's the next major initiative for the SSRO?
A. The next big piece is around the profit rate for qualifying defense contracts. At the moment a single industry-wide rate, currently 10.6 percent, was calculated by the Review Board for Government Contracts, approved by the defense secretary and published in the Yellow Book. The basis of the calculation of that number has been broadly unchanged since the 1960s. However, the landscape for the UK economy and the defense economy in particular is fundamentally different, so we are proposing to calculate the profit rate on a different basis. Our final thinking is not determined, a public consultation period starts Sept. 25, but it is inconceivable that the new profit rate methodology will be the same as has been used. We are independent regulators so the principle is to deliver value for money for the taxpayer as well as a fair and reasonable return to contractors. To achieve that, we are going to change the basket of industries we use to calculate the rate for defense. We're also proposing that different contract activity types have their own rates rather than a one-size-fits-all approach.
Q. How was the rate calculated?
A. The Yellow Book Review Board looked at the average profit made by every listed company weighted by reference to their market capitalization. Certain companies were excluded, like natural resources, regulated business and those not headquartered in the UK. The board came up with the average profit rate those companies in the basket made and said "that's our recommendation."
Q. Why the need for change?
A. The basket of industries is out of date for a fair comparison to today's defense industry and the single-source sector in particular. So the concept which will form the basis of the public consultation will involve a methodology which sticks with comparability but changes the basket we compare it to. The proposals will also cover the concept of multiple comparators for different parts of the industry rather than just one, the inclusion of businesses not headquartered in the UK, and exactly what are the sort of businesses relevant for comparison with today's defense contractors.
Q. What type of industries will be removed from the comparison basket?
A. We have done an analysis of what drives the set profit rate at the moment and looked at the margins of particular types of businesses and how big their market capitalization is, because that drives the rate set for single-source contracts. For example, the defense industry expressed concern about Tesco's low profit margin pulling down the rate. But what they haven't looked at is what generates the highest profit margin. The biggest weighting comes from tobacco and pharmaceuticals; they make an enormous margin. I've struggled to see why a profit margin you can make on a tobacco business has any relationship to what you make in defense. If I did nothing more radical than say "I am going to drop tobacco companies out," it would have a substantial impact on the profit rates set. So what we are proposing is we will take out companies that are simply not comparable anymore. Tesco will no doubt drop out at the bottom end, and equally so will tobacco businesses at the top end.
We are also looking slightly wider than the UK for companies to be included. What effectively we are going to say, I think, is that Western European and North American companies have a broadly similar market in terms of profit and labor rates and where they provide a useful comparison should be included.
Q. How else might your proposals reform the current set-up?
A. Defense contractors are not homogeneous. A contract to build a submarine is not the same as a contract to maintain a dockyard or clean an office. We are not looking at a single type of business here. So we are thinking of the defense sector in more detail than just setting a single profit rate. We are looking at different types of contract and potentially a different profit rate for various types of work.
Q. How many sectors are you looking to break the baskets into?
A. The likely recommendation is six but I can't be sure. Let's say several. By splitting into different types of contracts, we will look for comparable companies for each of those types, be it manufacturing, maintenance, training, support, ancillary or whatever.
Q. Can you say more about the different contract types that might be impacted?
A. We need to recognize that some contracts are effectively cost-plus, where the contractor has little if any risk. Compare this with, say, a contract for a new missile, where there is some research and development and there is a risk whether the technology will work, or it may be that there is a fixed-price contract so the cost risk sits with the contractor rather than the MoD. They are fundamentally different.
Q. Which has the potential to impact industry most, profit margin changes or the new allowable-costs guidance?
A. Profit is a smaller element of the total contract value than the allowable costs, but it's also more visible. Some of our guidance on cost may have a substantial impact, but it's likely to be hidden because people won't necessarily know what would have been charged in different circumstances. There is, though, a potential profit impact in our allowable-cost guidance. We are preventing contractors passing items up through the food chain and adding a profit margin each time. Now we are saying you can only take a profit on that once. The cost guidance in the long run will have the biggest impact; it is potentially quite far-reaching.
Q. The first qualifying defense contract under the new regime has been agreed. What lessons did you learn?
A. The first lesson was that not everybody understands our guidance, so we have worked to improve that. Industry was still including some non-allowable costs, which they have subsequently removed. The MoD is challenging them on that, making sure enough has been removed. I think it's understanding, for example, that when we say no contingency, we mean no contingency unless they actually need that expenditure, in which case it becomes an allowable cost. What we mean about faulty workmanship, and the definition of rework versus faulty workmanship — it's a big issue for the MoD. It's a big number in a lot of these contracts.
Q. Have you been asked to look at other departments that have single-source contracts?
A. I have been asked by others, like the Treasury, and my response was to let us learn to walk before we can run. Are there lessons from what we do here? Yes, but I would like to deliver proof of concept before I have that conversation.
Q. Some say contract negotiations using the Yellow Book favored the companies rather than the customer. Will the balance of power change under the new rules?
A. We have no direct input into contract negotiations. The answer, though, is probably not yet, but over time it will because issues like having an allowance for contingency, having a contingency for reworks will just get taken off the agenda because our guidance how these issues should be dealt with is clear. Whether industry will try and tip the see-saw back, I can't say. But by providing clarity on certain kinds of cost, we take the issue off the negotiating table. Secondly, because of the analysis we will be doing in providing greater clarity and benchmarking, I hope it will allow the MoD to become better negotiators and better customers. Thirdly, if MoD thinks industry is taking advantage of a situation, they can refer the matter to us to issue a binding determination. There is already anecdotal evidence that the prospect of something being referred to the SSRO has led to the contractor rethinking how they want to negotiate.
Equally, industry has rights to come to us as well if they think the MoD is being unreasonable. Contractors have said to me that although I may think the new rules are tougher on them, they like it as it stops arbitrary conversations with the MoD that go along the lines of, 'we don't like this, knock 10 percent off.' When asked what the logic was, they say, 'we just want 10 percent off.'
Q. How much money do you think the SSRO will save the MoD?
A. We have not expressed a view on that, but the MoD has said they think it could be around £200 million.