SSRO: A fair and reasonable profit?

21 December 2016

 

The profit suppliers can include in the price of single source contracts has changed since the introduction of the new single source regime. The new methodology used by the Single Source Regulations Office (SSRO) has reduced substantially the baseline rate recommend to the SofS, and the statutory regime means this now has legal force. These changes have made suppliers believe their profit is under attack, despite the original policy aims expressed by Ministers in Parliament. This blog considers how suppliers can make a healthy profit under the constraints of the new regime.

It will be hard to change how the SSRO calculates the profit rate. Their youth and sensitivity means they are likely to stick to their guns for a while, and it is hard for SofS to publically support higher profits against the advice of a new regulator. There is no objective reasonable baseline profit… what is reasonable to some may be excessive or derisory to others. A wide range of baseline profit methodologies can be defended, and today’s 8.95% baseline profit is not that different from the 9.89% lifetime average of the previous methodology. In any event, a change to the methodology can only be affected through lobbying, which will either succeed or it won’t. What happens if it doesn’t?

Suppliers could try to exempt their contracts from the regime. However this requires the agreement of the Secretary of State, and large contracts will also be under the watchful eye of Her Majesty’s Treasury, so this is unlikely to meet with widespread success.

The first real lever is a supplier’s approach to risk. Today’s 8.95% baseline profit rate can be increased by a quarter, up to 11.19%, if a supplier takes on cost risk. This depends on the commercial model… firm or fixed price contracts are higher risk than pain/gain share or cost-plus. Under the old regime, the incentive was to minimise risk, passing as much as possible to the MOD. This reduced the apparent cost of the contract, making it ‘affordable’ so long as the MOD’s retained risk wasn’t properly costed. This practice now comes at a cost to suppliers – the more you are prepared to commit to your price, the more profit you can make.

The second lever is performance. The profit rate can be increased by up to 2% in exchange for performance targets. This is at the MOD’s discretion, and the regulations limit its use “to give… a particular financial incentive as regards the performance of provisions of the contract”. The more suppliers are prepared to commit to performance, and the more that performance really matters to the customer, the stronger the justification and chances of accessing the uplift. For a firm price contract, this means the profit could be as high as 13.19%.

The last lever is efficiency. Given that costs are around 90% of the price, a small percentage reduction in the cost base can make a big difference to the outturn profit. A 2% reduction in the cost base on the above example would give an outturn profit of 15.5% (on cost). This works in synergy with the first lever – the firmer the price, the more any benefits will flow to a supplier’s bottom line. It also works well with the second: if a supplier is prepared to invest in real spend-to-save initiatives, where the benefit of baked in savings outweigh the cost of investment, there is a strong argument for a positive risk adjustment.

In summary, the new regime has adjusted some long-standing incentives. A supplier who treats all single source work as a low-risk ‘cash cow’ is likely to find their profits dwindling – possibly as low as 4.5% for cost-plus contracts. On the other hand, a supplier who is prepared to stand by their contracted price and performance, and who focusses on efficiency and performance, will be able to earn generous double digit profit rates. This may require some cultural change, not least from the MOD, but this approach chimes with the wider trends across MOD and Government - a more commercial DE&S, greater financial accountability from the Commands, and a post-Brexit Government focussed on productivity and UK PLC.

 

Andrew Godfrey | Commercial Risk and Assurance
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