02 May 2009

Defence Materiel: DMO gunning for efficiency?

An article by John Kerin in the Australian Financial Review, 28 April 2009 (p. 13), DMO gunning for efficiency, raises a number of issues that require careful consideration. If implemented, the proposed measures will certainly change the DMO’s relationship with Australian defence industry. The question is whether or not that will be for the better. In commenting on the article I would acknowledge that it might not reflect with absolute accuracy the position or direction of DMO, but in the interests of contributing to an important public debate I offer the following observations on the words as they appear on the printed page:

(1) Industry profit margins will be slashed and contractors more likely to be dumped for poor performance.

- Why would we want to slash industry profit margins? Does DMO know what the profit margins of its suppliers are, and if so, how? Costs and margins are usually closely guarded by private sector entities, amongst other reasons because it is fatal to any commercial negotiating position to have the other party know how low you can go. Government officials tend to fill in this lack of knowledge by assuming (resentfully) that all companies are making money hand over fist.

- Defence’s approach to defence industry needs to be based on a clear understanding that the industrial support base which can build, maintain, upgrade, modify and test and evaluate our defence equipment is a fundamental part of our defence capability. The only way Defence can rely on these companies being there when they are needed is to ensure that they can conduct their business on a profitable basis, which in commercial terms means enough profit to ensure that they do not decide that the game is not worth the candle and exit that particular sector of industry.

- The importance of the industrial base is acknowledged in proposition (6) below, which refers to priority areas of defence industry being singled out for special assistance. Hopefully these will not be the same areas as those that are to have their profit margins slashed.

- Dumping contractors for poor performance will be fun. Any attempt to dump contractors during the contract period will end up in the courts. Dumping a contractor at the end of a contract will be tricky as well. The work will have to be re-tendered under Commonwealth procurement rules. Will the dumped company be told it is not eligible to bid? If not, what if the advantages of incumbency enable it to frame the most convincing and cost-effective tender?

- Do we want a system that is contoured around the possible need to sever a relationship from time to time? Would not our efforts be better spent planning for and ensuring successful relationships with industry, which might require a different approach to contracting altogether?

(2) Shorter term contracts will be instituted in a bid to claw back greater savings for taxpayers as contractors realise productivity improvements.

- This sounds very nice but short term contracts can cut both ways. Through-life support for major platforms is complex and expensive, and usually involves significant learning curves. Why would a company make significant investments in plant, equipment, buildings and workforce skilling against a 3-5 year planning horizon? Isn’t there a danger that short term contracts will turn out to be productivity limiting rather than productivity enhancing?

- As noted in Defence industry: delays are costly, DMO can take years to get a Request for Tender (RFT) out, and aside from the enormous cost of tendering under the best of circumstances it costs industry further large sums of money to have bid teams under-employed as a result of delay in issuing the RFTs – to the point where some large and highly capable companies have lost interest and decided not to bid. If the assured life of the contract is to be reduced, the risk-reward calculus would require every tendering company to raise its prices in order to be sure on average that it recovers the cost of more frequent bidding.

- And if DMO is struggling to get the RFTs out under current arrangements (the first Abrams tanks arrived in Australia in September 2006, the tender for their through-life support closed last Thursday 30 April 2009), how confident can we be that it will be able to manage the higher volume of tenders and evaluation in the new dispensation? When it comes to the point, will we see lazy rollovers of existing contracts rather than prompt recruitment of a new contractor? Is that what happened with the F-404 engine for the FA/18 Hornets?

(3) [DMO CEO] Dr Gumley enlisted contractors in cutting $230 million, or 5 per cent, from the $4.6 million equipment operating budget in the past 12 months. The cost of operating defence ships, vehicles, aircraft and weapons systems was slashed as part of a broader Rudd government cost-cutting drive.

- Is the second sentence literally true – the cost of operating these platforms was reduced? How was that achieved? Cheaper fuel, cheaper or less materials, fewer man-hours, deferral of “non-essential” work? Or does it simply mean that the contractors were told (“enlisted”) to find savings and whether they did or not they were paid less? Is this a part of what the acrimony between DMO and ASC is about?

(4) The DMO chief believes that further taxpayer savings can be made because defence companies have been able to realise bigger profits on long-term contracts (10 to 15 years) after instituting on the job improvements to weapons production or refining maintenance and sustainment processes.

- That is what Commonwealth procurement processes are all about. There is a very prescriptive, costly and time consuming process of submitting a tender for any given project.

: The services to be provided must be costed in great detail and all of the information provided becomes part of the basis for the contract between the Commonwealth and the successful bidder.

: Each bidder must try to bid a price that is high enough to be profitable, but low enough to have a good prospect of winning.

: Upon signing the contract, the successful tenderer accepts the risk that costs might prove higher than expected, i.e., the risks of making a loss.

: It is a corollary of this way of doing business that if the successful contractor can find ways of reducing cost while performing the contract to the required standard, then the rewards accrue to the contractor.

- Presumably it is not in the mind of DMO within this framework to share the contractors’ risks of making losses. If DMO wants to share in the benefits of process improvement, perhaps it should consider genuine risk-sharing relationships as recommended in the previous Government’s Defence Industry Policy Statement of 1998, which noted (p. 25) that such arrangements involve forming longer-term relationships with industry, after an appropriately rigorous selection process.

(5) A switch to standard three to five-year contracts with the option for a series of rolling 12-month extensions will mean the DMO is not locked into long-term contracts and has greater flexibility to dump a supplier it is not satisfied with.

“Long-term contracts don’t always work well for the [DMO] because – unless you can get productivity improvements written into a contract after a few years – the contractor can work out how to do things better, but the customer doesn’t get any benefit,” Dr Gumley told an industry conference.

“Where we’re heading is that a lot of contracts in the future will be, say, for three years and if you perform well in year one you’ll get a fourth year.

“This rolling series of extensions on a two to three-year lead time works out such that we’ve got a chance to switch supplier if the productivity improvements aren’t being delivered.”

- Not much to add to previous comments except to repeat that the customer should be prepared to share in the risks as well as the rewards, which points in the direction of some sort of open-book alliance contracting, perhaps with the assistance of a customer’s engineer.

- The reference to a “rolling series of extensions” intensifies the dangers of lazy rollovers, with a loss of value for money for the taxpayer. This system raises the risk of an increasing volume of work that has not really been competed adequately, and raises important probity issues. At what level and on what rigorous, equitable and transparent basis will it be decided that contractor performance has been satisfactory and the contractor can be granted an extension to a short-term contract without having to compete for it?

- Successions of one-year rollovers will do nothing to encourage productivity enhancing investments or process improvements.

(6) The [Defence White Paper] will ... nominate areas of the defence industry that are considered strengths to be singled out as priority areas singled out for special assistance.

- See comments at (1) above. I agree completely that there are areas of defence industry that we must ensure are available in Australia to support the Australian Defence Force. But the idea of special assistance seems at odds with the objective stated at (1), and implicit in some of the others, of “slashing corporate profits”.

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