Leveraging the Defence Buy
© 2014 FrontLine Defence (Vol 11, No 3)

The government’s recently announced Defence Procurement Strategy has led some critics to argue that including economic benefits to Canada in evaluating company bids will drive up the price of defence acquisitions. This critique, emanating from people who have never sat in a company boardroom or been held accountable for pricing strategies, is based on flawed assumptions about how the defence industry actually works.

To have an intelligent discussion on this subject we need to understand the costs and risks that drive pricing decisions for defence companies. The major costs that are factored into a company’s bid price relate to project-specific research and development requirements, associated engineering and product development, marketing (including very expensive bid and proposal costs), and finding and managing extensive supply chains attached to complex defence programs. These are real costs that must be recovered to make any project worthwhile from a business perspective.

Pricing risk is equally important – and usually more of an art than a science. Chief among these is project risk. Consider, for example, the risk associated with a project like the Royal Canadian Air Forces’ Fixed Wing Search and Rescue procurement. In that case, companies have invested millions of dollars into a project that was announced a decade ago but has yet to generate a final request for proposal and is still years away from any revenue flow.

Or consider the risk when the Department of National Defence (DND) commits to a project, strings companies along for years, asks for and receives bids, and then cancels the project at the last minute. The recent flushing of the Army’s Close Combat Vehicle (CCV) is an excellent example. The need to re-compete the ­Integrated Soldier Systems Program, and start over on the Joint Support Ships are further examples.

Other risks that companies routinely price into defence bids include shifts in exchange rates and project schedule delays. The latter are legion in this country.

The ability of firms to deliver on the precise specification DND asks for is also a huge risk. DND is notorious for generating specifications for equipment that has never been designed or built anywhere in the world and tests the boundaries of physics. When a defence company is faced with delivering on a capability that is still an engineering dream, it drives costs through the roof and has a direct bearing on price. Such over-specification often results in a unique product which likely cannot be sold anywhere else in the world. As a result, development costs cannot be spread over other projects in other countries, which is usually how defence firms amortize and recover costs while remaining competitive on individual programs.

These are the costs and risks that have a major influence on price. By contrast, and contrary to those critical of a defence procurement strategy for Canada, satisfying domestic economic objectives, which are required of bidders on defence contracts everywhere in the world, are rarely if ever a subject in bid pricing discussions. They are, however, discussed at the leadership level in the context of strategic market positioning, expanding supply chains to reduce risks and costs, and long-term investments – which often manifest in price reductions to the customer.

One element of the government’s leveraging policy is technology transfers from foreign to domestic companies. This does constitute a cost to the companies involved. But those costs can be mitigated by, for example, requiring the company that receives the transferred technology to sell it back to the original equipment manufacturer at a discounted price in exchange for a world product sales mandate. This has been done in Canada in the past such that the government benefited from economies of scale and paid no premium for the cost of technology transfer.

Requirements to involve Canadian firms in supply chains has also been criticized as something that will increase price. This is a myth which assumes Canadian defence companies, which on average derive half of their revenue from sales in highly competitive and protected foreign markets, are uncompetitive on price. If Canadian defence companies were not internationally price competitive they wouldn’t be in business.

The government’s decision to leverage defence acquisitions to advantage Canada is long overdue and brings us into line with our NATO allies and defence trade partners elsewhere. The policy will deliver important and long-lasting economic returns to this country while growing our defence industrial base in a manner that serves Canada’s sovereign interests without compromise to the operational requirements of Canada’s Armed Forces.

If leveraging increases the price the government pays for defence products and services it will be because people on one or both sides of the ledger (in government and/or industry) are not doing their job. There is no legitimate reason why we can't achieve a win-win-win for Canada’s military, the government, taxpayers, and Canadian workers.

Dave Stapley was formerly a senior executive in the aerospace and defence sector, responsible for corporate-wide, international market strategy and business operations in Canada, the U.S. and the United Kingdom.
© FrontLine Magazines 2014