Review Board for Government Contracts (Hansard, 5 June 1986)

§ Mr. Brooke

The review board in its report on the fouth general review proposed that the triennial reviews of the target profit rate should be supplemented by limited annual reviews so that changes in the rate of return elsewhere in the economy and in other economic circumstances can be reflected more quickly in the profit rate. The review board submitted the second of these interim reviews to the Treasury in January.

The board recommended that the target rate of profit should be 13 per cent. on capital employed in semi-CCA terms, with an assumed average CP/CE ratio of 2.40 to 1. The semi-CCA basis of the profit formula allows for historic cost figures to be adjusted by the inclusion of current cost based depreciation and fixed asset values; and 608W the average cost of production to capital employed (CP/CE) ratio is used in determining the components of the profit formula applicable to risk and non-risk work (that is the rates of return allowed on capital employed and cost).

In its first annual review the board found that, although there were not sufficient data to support the view that Government profit formula work generally required less capital than contractors' other work, there were some significant divergences in individual cases arising almost entirely from a small number of large and exceptional projects, both defence and non-defence. The board recommended that these divergences should be addressed by negotiating more relevant units for the calculation of contractors' individual CP/CE ratios rather than by adjusting the target rate of return in the profit formula. To avoid distortion by the exceptional projects until more relevant units are established and start to affect negotiations on individual CP/CE ratios, the board has again recommended, in its second annual review, that a transitional adjustment should be made to the average CP/CE ratio. Specifically, the board recommended that the observed ratio of 2.32 to 1 should be increased to 2.40 to 1.

Progress has been made with the introduction of more relevant units, but it is not certain that this action alone will eliminate the exceptional problems reported by the board. The Government and industry have therefore asked the board to conduct a further study of capital employed as part of the fifth general review which will take place later this year. Meanwhile, it is essential that the overstatement of capital employed already identified by the board should be reflected in the profit formula. Accordingly, after careful consideration, and following representations from industry, the Government have decided to leave unchanged the formula introduced on 1 May 1985. The target rate of profit will therefore remain at 12 per cent. on capital employed on a semi-CCA basis, and the components of the profit formula applicable to risk and non-risk work will also be unchanged.

Copies of the review board report have been placed in the Library.