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Issues in Defence Costing
Costing is one of the foremost weakest links in the defence procurement process. The Defence Procurement Procedure (DPP), which applies to all capital acquisitions for the armed forces, requires cost estimates to be prepared at two stages: first, when a procurement proposal is sponsored by the user Service Headquarters (SHQ), and subsequently before the opening of the commercial offers. The purpose of working out the cost estimates at each of these two stages is different, but the challenges faced by the costing community across the SHQs and the Ministry of Defence (MoD) are the same. MoD has responded to this challenge by increasing the number of cost accountants drawn from the Indian Cost Accounts Service (ICoAS). They are top class professionals, but they cannot be expected to operate in a policy vacuum and deliver the intended results. It is a matter of some concern that this vital aspect has not received as much attention as it deserves.
What is the purpose of costing and is it unavoidable?
The purpose of the first stage of costing is to examine the affordability of an acquisition proposal. Ideally, this should entail assessing the financial implications of various options. It is, however, doubtful if that is done. Typically, the user SHQ sponsoring a proposal works out the financial implication of only one chosen option to acquire the requisite capability. As per the prescribed procedure, SHQs are required to prepare a statement of case (SoC) indicating the one-time as well as the recurring cost of acquisition, the basis of costing, and the base year with reference to which such costs are estimated. The sponsoring service is also required to confirm that funds will be available to make contractual payments over the entire delivery period which usually spreads over several years. This is to ensure that the government does not assume a financial obligation that it cannot meet. The need for the first-stage cost estimation is, therefore, unquestionable. The proposal moves through various committees in HQ Integrated Defence Staff and MoD based on this SoC.
The cost of acquisition is estimated again just before the opening of the commercial offers. This estimate could be higher or lower than the initial cost estimate, depending on the movement of prices since the time the proposal was approved in principle (in MoD parlance, this is referred to as Acceptance of Necessity, or AoN). The estimate worked out at this stage serves as a benchmark with reference to which the reasonableness of the commercial offers is assessed by the contract negotiation committee. It should not be necessary to set a benchmark in multi-vendor cases because in a competitive environment vendors would normally quote their best price. The DPP, however, requires a benchmark to be established in all cases, probably because the competition is generally very limited. Considering this fact, the need for benchmarking, as a means of ensuring the reasonableness of the commercial offers, cannot be viewed as unnecessary.
Challenges in costing
The biggest challenge faced at both of these stages is the virtual absence of a laid down methodology for costing. There is very little, if anything, in the DPP to guide the personnel in the SHQs working out the first-stage cost estimates. There are no standard guidelines to ensure uniformity in costing across various SHQs. This lack of attention to detail in the DPP is partly because of the ubiquitous tolerance for the disconnect between the first stage cost estimation and the actual costs incurred subsequently for acquisition, operation and maintenance of the equipment.
It is arguable, but experience shows, that not much importance is attached to the initial cost estimates. To the best of one’s knowledge, no formally sponsored proposal is ever turned down on the grounds that the basis of cost-estimation is faulty or that it is financially unviable. From the financial point of view, the determining factor is an indication in the SoC that funds are or will be available. This certification is more of a formality than a means of assessing the affordability of the acquisition proposal in the long run. This is evident from the fact that the DPP requires the sponsoring SHQ merely to confirm that funds are available to make any payment that may become due in the current year and that the requirement for future years has been included in the five-year plan. This is inherently problematic as the yearly outlays never match the requirement projected in the five-year plans.
There is another challenge associated with the first stage costing. In some cases, the initial cost estimate indicated in the SoC becomes outdated by the time the AoN is accorded to start the tendering process. Ideally, in such cases, the initial cost estimate should be revised to make sure that the AoN is given based on the estimate that is current and, therefore, more realistic. But this is not a standard practice followed in all the cases, probably because the DPP does not contain a specific provision for mandatory revision of the initial cost estimate in such cases.
These snags in the system are glossed over in the hope that the problem will take care of itself when the second-stage cost estimation is carried out before the opening of the commercial bids for benchmarking the reasonableness of the commercial offers. This is somewhat delusionary because those responsible for determining the benchmark face similar challenges as the ones faced at the initial costing stage. The DPP does not contain the methodology of costing/benchmarking in any manner of detail. While the Defence Procurement Manual (DPM) of 2009 does contain some details, these too fall short of a clearly defined costing methodology and, in any case, leave many loose ends untied. This drawback has slipped into the DPP and the DPM, as indeed in procurement manuals of the Defence Research and Development Organisation (DRDO) and the Ordnance Factory Board (OFB), primarily because the General Financial Rules (GFR) on which all these manuals are based also do not contain any detailed guidelines on costing methodology.
All the aforesaid procurement manuals merely suggest that the cost estimates may be prepared using the Budgetary Quote (BQ) obtained from the prospective vendors, Maximum Retail Price (MRP) shown in the brochures, Last Purchase Price (LPP) of the same or similar product purchased in the past, or by carrying out a Professional Officers’ Valuation (POV). The Manual for Procurement of Goods, 2017 issued by the Ministry of Finance (MoF) permits the procuring agencies to rope in internal and external costing agencies or, as a last resort, make a rough assessment based on the opportunity cost of not using that item at all. These two methods are, however, not followed in defence. There is a certain amount of tentativeness about all the aforesaid approaches to costing as none is backed by a clearly articulated methodology.
This makes the task difficult for the costing community and the cost estimates prone to being questioned. To illustrate, let us assume that in a given case it is decided to adopt the POV method which entails analysis based on costs of various components, such as the raw material, labour and overheads. This would require component-wise data which the private sector companies, both Indian and foreign, may not be prepared to part with. Even if this data were to be available, the costing community will need to decide the margin of profit to be considered while estimating the product’s cost. Unlike the practice followed in some other countries, there is nothing in defence contracts that binds companies to provide access to their costing data. There are also no guidelines, much less a law, that could be invoked to decide what kind of profit margin could reasonably be taken into account for the purpose of costing. It is indeed surprising that despite these constraints this approach is often adopted in some cases for working out cost estimates.
Let us consider another situation where LPP is to be adopted as the basis for costing. In this case too, the costing community will have to deal with several questions: How should the LPP be escalated to make a realistic assessment of what the equipment is likely to cost now? What escalation factor should be adopted? If the country from where the equipment is to be imported uses multiple inflation indices, such as the Wholesale and Consumer Price Indices used in India, which inflation index should be used? Most defence manufacturing companies source components and assemblies from other countries. The question of which index to use would become more complex in such a situation. There may be a situation where the prices are believed to have come down since the previous purchase. In such situations, the costing community will have to grapple with questions such as by what factor to deflate the LPP so as to arrive at a realistic current price. These issues assume greater significance where the last purchase was made several years earlier.
Ramifications of costing
Costing is not a science but a method whose efficacy depends on the application of well-developed accounting techniques, access to relevant data and information, standardised guidelines to be followed by the costing community and, in some cases, legislative backing that binds the vendors to provide access to their books of account/costing data and regulates the margin of profit that vendors could rightfully build into their costs. Costing errors could result in an unaffordable procurement programme being sanctioned, contract being awarded at a price higher than what would be reasonable, cost and time overruns, and default on contractual commitments. It is, therefore, important to pay greater attention to the system of costing followed by the MoD.
Are costing issues unique to defence procurement in India?
It may be reassuring that the issues highlighted above are not unique to India, but that should not reinforce complacency. Some countries like the UK have made earnest efforts to improve costing efficiencies in defence procurement. The effort is led by the Cost Assurance and Analysis Service (CAAS), which estimates the “cost of a product or service in advance of the activity being undertaken when contracts are to be placed non-competitively’ by investigating ‘the company tender detailing the quoted direct and indirect costs together with estimating allowances, risk and profit.” This function is performed with the full realisation that “Estimating uncertainty, allowances and risks are a key consideration when estimating the cost and agreeing (to) a fair and reasonable price for a contract”, and that ‘The main uncertainty is contained within the basic estimate and is linked to issues such as escalation, breaks in production, tail-off cost, design growth, loading or capacity, warranty or guarantee, over provisioning and insurance excess.”1
These are the kinds of issues that bedevil the costing of defence acquisitions in India. It would be a good idea to link up with CASS and see if the methodology (including tools, techniques, models, principles, etc.) developed by it could be used in India with or without our culture-specific customisation. Somewhat similar functions are probably also performed by the Director of Cost Assessment and Program Evaluation (CAPE) in the office of the US Secretary of Defense. It would be worthwhile to also study the system followed by CAPE and pick up elements from its system that may be of help in improving the system of costing in India.
Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.