Problems of Costing in Defence Procurements

The disputation over the price India will pay for the 36 medium multi-role combat aircraft, the contract for which was signed in 2016, brings into focus the vulnerability of the process of estimating the cost of acquiring defence equipment, many of which are highly complex systems of systems.

The procedure followed by the Ministry of Defence requires the cost to be estimated first at the initial stage of the procurement proposal for the purpose of obtaining approval for starting the tendering process. The process is repeated just before the opening of the commercial offers with a view to determining an up-to-date and more realistic cost – or, the benchmark price – with reference to which a view could be taken by the contract negotiation committee about the reasonableness of the lowest price quoted by a vendor.

The benchmark price could be different from the initial cost estimate because, in many cases, the negotiation stage is reached several years after in-principle approval. But an error at either of these two stages has serious implications. If, for example, the cost of an equipment that can be procured at Rs 500 crore were to be wrongly estimated as Rs 1,000 crore at either of these two stages, a vendor quoting even Rs 900 crore would appear to have made a very reasonable offer.

While the importance of costing cannot be gainsaid, it is arguably the weakest link in the defence procurement process. This has largely to do with the absence of a policy framework as also the fact that the tools and techniques required for application of costing methods to defence procurements are either non-existent or not adequately refined. There is some irony in this, since costing, as a discipline, is fairly developed.

Various government regulations place the onus of ensuring the reasonableness of the cost of procurement squarely on the procuring agency. While some broad guidelines have been prescribed by the Ministry of Finance that can be followed for discharging this responsibility, these guidelines have many loose ends, especially in the context of defence procurements.

The procedures governing capital and revenue procurement in defence broadly refer to three methods of costing: Budgetary Quote (BQ)/Market Survey (MS), Last Purchase Price (LPP) and Professional Officers’ Valuation (POV). Each of these has severe limitations.

The BQ/MS method, for example, is more appropriate for the purpose of initial cost estimation rather than benchmarking. But, more to the point, the budgetary quotes are generally inflated and, therefore, need to be deflated to arrive at a realistic cost. The problem is that there is no standard rule for the deflation factor to be adopted.

The LPP method presents its own problems. Firstly, this method works best if there is a like-to-like comparison between the equipment bought previously and the one for which the cost is to be estimated. Often this is not the case. Therefore, the LPP has to be adjusted to accommodate the difference between the two, which is a challenge in itself.

Even if the previous and proposed purchases of an equipment are comparable, the LPP may still require to be adjusted on account of inflation during the years since the previous contract was concluded. Again, there is lack of clarity on which inflation indices are to be used for this purpose, especially if the system is being procured from abroad and the seller is sourcing the components of the system from a number of other countries. This method cannot anyway be adopted if no LPP is available or if the equipment to be procured is an upgraded version of, or happens to be materially different from, the system for which the LPP is available.

The adoption of the POV method, which is the last resort, is also dependent on the availability of extensive databases and component-wise break down of the system to be procured.

The biggest challenge faced by procurement personnel is to take a call on the extent of variation, with reference to the estimated cost and benchmark price, that can be accepted while negotiating with the lowest bidder. The fact of the matter is that the entire process of costing is ridden with lack of clarity as regards the standard method of costing, if any, as well as the tools and techniques for the application of these methods. The problem is aggravated by the absence of extensive price databases.

The brunt of these difficulties is borne by the Services Headquarters which is where the costing is generally done with or without the help of the cost advisors in the Ministry of Defence. This is a bit unfair, considering that the onus of costing is on the Contract Negotiation Committee (CNC) and not the services alone.

Several steps need to be taken to address the issue of costing. To begin with, there is a need for the Ministry of Defence to standardise the methods and refine the process of costing in defence thus ensuring that the entire acquisition team collectively decides the method to be adopted in each case at the initial stage of cost estimation as well as at the stage of benchmarking before the commencement of commercial negotiations.

While standardising the methods, the ministry could also consider the possibility of adopting the method of deciding on the reasonableness of the commercial offer by seeking its justification from the vendor. It should be possible to adopt this method if the matrix for assessing the reasonableness of the offer is indicated in the Request for Information/Request for Proposal.

It is equally important to consider the possibility of seeking information through the Request for Information (RFI), especially from foreign vendors, relevant for benchmarking, such as the system break down and the inflation indices applicable in the countries from which vendor is likely to source the components.

Standardisation of the costing methods and refinement of the tools and techniques will work only if databases are maintained by the ministry on price and other factors such as inflation indices that impact costing. The Management Information System (MIS) Cell of the Acquisition Wing in the ministry will need to be enabled to take on this responsibility.

The cost and effort required for creating and maintaining these databases could possibly be minimised by making use of the products and tools that are available commercially from external sources which provide continuously updated data on prices of various components of complex defence systems as well as spares, culled out from contracts concluded by other countries.

The use of external sources is permitted by the existing procurement procedure, though probably this provision has hardly ever been invoked. Use of the products and tools available in the market do not carry the risk of the confidentiality of the process being compromised as the costing can continue to be done within the ministry.

Authentic information available from external sources should make it possible for the ministry to also enlarge the scope of the Fall Clause by making the vendor commit to not charging a price that is higher than the price at which the same equipment is sold by him to some other country.

Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.