Executive summary of the review of Canada’s contract cost principles and profit policy
Public Works and Government Services Canada (PWGSC) engaged PricewaterhouseCoopers (PwC) to review the methodology for determining contract price using Canada's contract cost principles and PWGSC's profit policy. The policies apply to several types of procurement but are particularly relied on in defence procurement, which was the focus of this study. The review had three objectives:
- identify the issues related to Canada's contract cost principles and PWGSC's profit policy
- provide recommendations on how Canada can best address the issues
- provide recommendations related to a "management framework" which specifies how PWGSC can effectively manage the risks around application of the policy on a government-wide basis
Several factors contributed to the initiation of this study. Canada's current guidance is old and has not kept pace with the evolving procurement landscape in Canada and internationally. Large-scale procurement is moving to include new models including performance-based contracting, which measures a contract's effectiveness by looking at "value for money and price" versus looking at "cost and profit." Canada's sustainment initiative is the vehicle under which performance-based contracting is being studied for implementation.
Several reviews were performed prior to this one, including a recent study by the Canadian Association of Defence and Security Industries (CADSI), which provided several observations and recommendations. This work provided a foundation for the current study.
The review involved:
- a review of the guidance (that is, section 1031-2 of the Standard Acquisition Clauses and Conditions Manual and the Supply Manual)
- consultation with federal government and industry stakeholders to understand how the guidance is being applied and to get perspectives, namely on what is working and what is not
- a comparative review of defence procurement practices in the United Kingdom, Australia and the United States, as well as other similar sectors, to identify practices that may work for Canada
- recommendations for potential revisions to the guidance or application
This review was undertaken as a project within the interdepartmental sustainment initiative. The sustainment initiative aims to align the interests of the Government of Canada and industry to maximize value-for-money and optimize performance in military equipment maintenance and engineering programs. The study took into account the objectives of the sustainment initiative and the Minister's mandate to modernize procurement practices and recognizes efforts already underway in this regard.
Public Services and Procurement mandate
This study started before the 2015 general election and concluded after. On November 13, 2015, the new administration released mandate letters for each departmental minister which identified new departments and policy objectives. PWGSC becomes Public Services and Procurement Canada (PSPC). This study and its recommendations are closely aligned to one of the priorities outlined in the mandate letter for PSPC to:
"Modernize procurement practices so that they are simpler, less administratively burdensome, deploy modern comptrollership, and include practices that support our economic policy goals, including green and social procurement."
It is therefore obvious that where changes to the content and application of guidance are required, this is supported at the highest level of government. It is also clear that the ability of National Defence to deliver on its Minster's mandate, including coordinating the CF-18 fighter aircraft replacement competition and the National Shipbuilding Strategy with PSPC, will require use of developing practices.
The guidance and its application
The study identified a number of consistent themes related to the current guidance and, importantly, its application. These arose from both government and industry. The observations also highlighted application problems, and some went so far as to consider the structure of government as being a factor, in particular, that Canada has more than one department involved in defence procurement (unlike the other jurisdictions, which have one point of accountability). In terms of the written guidance, stakeholder groups agreed that the rules for allowable costs in SACC 1031-2, are sensible and only required some minor changes to clarify interpretation. The main issues were related to the Supply Manual's basis for the calculation of profit rate, which is seen as rigid and over-prescriptive in content (and application). In particular, the ranges of profit rate identified are not tied to any market information (as they are in the United Kingdom) and are seen as arbitrary. In addition, the mechanism is not sophisticated enough to recognize and reward commercial and technical risk transfer, where this would be an advantage for the Government. As a result, industry essentially "games" the guidance provided (which is understandable) and is not incentivized to invest in value and lower prices. The contractual forms available link profit and cost and therefore, industry is actually incentivized to increase costs, in some cases. The guidance does not mitigate this through incentivization, painshare/gainshare mechanisms or through the use of technical validation of cost estimates and incurred costs. Technical validation of solutions does not generally involve military industrial specialists who can price the Government's specification, like industry would, identify a "should cost" of variations proposed by bidders and evaluate the effectiveness of supply chain arrangements. As a result, Canada is relying on the bidders to provide the costs and technical input, without impartial scrutiny.
The current rules do not provide guidance on the use of performance-based contracting, which is being used increasingly in the United Kingdom and Australia. Performance-based contracting does not consider profit, but rather price, value and incentivization. In terms of application, it is appreciated that the core guidance should be principle-based to provide sensible flexibility for interpretation. It was suggested that practitioners Footnote 1 need some help in the form of an application manual (the United States' Procurement, Guidance and Information [manual] was cited as an example), so that there is consistency of outcomes, because currently, individual projects can get treated quite differently.
A comparative analysis with the United Kingdom, Australia and the United States
The study involved a review of the written guidance in similar jurisdictions and consultation with practitioners in these countries. Although the suites of documentation and language varied, the principles related to allowable costs were similar and would be applied for sole-sourced and competed arrangements. One notable difference between the jurisdictions is in the application of fixed price contracting. In the other jurisdictions reviewed, fixed prices are negotiated based on a rigorous review of pro-forma costs. In Canada, less rigour is applied; however, the price is adjusted after the contract is closed such that any profits above the negotiated level are clawed back. A second notable difference relates to the profit rate calculations. The profit rate in the United Kingdom starts from a market sample and adjusts against this, using logical steps which would be able to consider risk transfer at a performance-based contracting level. Australia does not have any guidance on profit instead focusing entirely on performance-based contracting, where value is continually incentivized through applying key performance indicators against an agreed price. The United States has extensive guidance and defined profit rates by type of contract, but there is latitude in how this is applied, as exercised by the procurement contracting officer. The United States and United Kingdom have clear mechanisms for incentivization, and this is never for just delivering to the base requirements, as we understand can happen in Canada. In Australia, incentivization is managed by key performance indicator performance over 100%, and this is then monetized. In the United Kingdom it would be linked to a specific need like delivering ahead of timetable.
There are some key structural and application differences. The other jurisdictions have one point of accountability and decision making, either a department, like the United Kingdom (Defence Equipment and Support) and Australia (Capability Acquisition and Sustainment Group) or a person, like the United States (the procurement contracting officer). In addition, there are some specific differences such as the United Kingdom's use of an independent regulator (Single Source Regulations Office) to adjudicate on disputes and provide compliance reports, if requested by government or industry. The United Kingdom and Australia have used public-private partnerships (PPP) for defence solutions (PPPs are used in Canada but not for defence) and have always needed to have guidance which can cope with this delivery model (which is an advanced form of performance-based contracting). If Canada wants to be able to use different types of delivery models for defence, the guidance needs to be modified to cover these contract structures.
Procurement practices in other sectors
The study looked at how capital intensive solutions were procured in other sectors in Canada and the other jurisdictions. It was noted that in many cases these solutions would be exposed to a thin market at some stage of the procurement, and even if a competition were possible at some stage, the process may lapse into a sole-sourced situation. The key focus in all cases, was to make sure that the assets and services ultimately procured are value for money and affordable. Strategies to achieve this included the establishment of a public sector comparator, or "should cost," which is the Government's own costed response to the specification and can be used to sense check suppliers' responses. Another common approach is to hold a competition for an initial contract using an exemplar project, select the contractor and then tie them to exemplar project rates for future solutions. Variations on this include just using the contractor as a procuring agent with incentives to procure future contracts. Sharing third party revenue by selling excess capacity to parties outside the arrangements has been used extensively in other industries and jurisdictions and can help deal with variable demand. An example would include the United Kingdom selling heavy-lift air transport capacity to its allies, as it does with the Future Strategic Transport, PPP.
Key in all complex procurement situations is to keep market interest. This is because specific areas like energy, transport and healthcare (like defence) will have consolidated industries and thin markets. It is important to shape the offering using market testing, which helps ensure the specification can be met at a price where a deal can be closed based on the pricing submitted at tender without major negotiations. This has the added benefit of retaining market interest and enabling vendors to invest in well-thought-out and competitive proposals, a necessity given the risk transferred under these types of contracts. As the procurement proceeds, the development of high quality specifications and clear direction is vital, combined with professionalism from the authority. If the procurement ends up in a sole-sourced situation, a "should cost" is very useful to sense check proposals. To do this, the authority requires a military industrial understanding to make reliable assessments.
Recommendations have been developed against the findings in each of these areas. It is recognized that they are at a high level and could be split into groups of distinct actions, but this is intentional, as this report is about establishing a direction. We offer the following recommendations for consideration:
- Some specific terms in SACC 1031-2 should be changed and more instruction on application given
- The Supply Manual requires substantive changes to overcome significant shortcomings
- An application manual should be created to assist government practitioners
- The Government needs to improve its access to military industrial specialist support
- Practitioners need to recognize the limitations of the guidance and consider alternatives Footnote 2
- A protocol for enhanced coordination between the departments should be developed
- A management framework for sole-sourced contracting is required; this may include a regulator
Learn about our response
Read our response to each recommendation.
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