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Op-Ed: Supply and demand economics in defence industry – Time to rebalance

Australian defence CEOs are told to get their local companies ready for the wave of defence work, present their clever ideas and government will help them upskill their business and win defence business, however, more needs to be done, explain Chris Williams, managing director of HIFraser, and Mike Kalms, defence and space industry lead partner at KPMG Australia.

Australian defence CEOs are told to get their local companies ready for the wave of defence work, present their clever ideas and government will help them upskill their business and win defence business, however, more needs to be done, explain Chris Williams, managing director of HIFraser, and Mike Kalms, defence and space industry lead partner at KPMG Australia.

The 2020 federal budget – more money for Defence innovation grants, supplier readiness, skilling grants, manufacturing grants and more. Since 2016 we’ve had a raft of supply-side economics initiatives available to both primes and SMEs. 

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Supply and demand economics

The supply-side initiatives offer grants and funding to invest scarce time and resources into market entry and/or capability development activities. The supply-side money and incentives are important and are working for primes and SMEs alike. 

The supply side is working and is not the issue. The issue is with the demand side.

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So, what’s the problem?

The government's demand-side economic incentives are clear for the primes with the $275 billion spend on Defence. Note that Australian owned SMEs can rarely quote directly for the $275 billion, so the only path available to the majority of Australian owned SMEs to win a piece of the $275 billion is through the primes.

Clearly there are plenty of programs to upskill and push companies into defence industry, but what is creating the demand and pulling the Defence ready Australian SMEs into Defence programs. The ultimate measure of which is the flow of purchase orders from the $275 billion to Defence ready Australian SMEs.

How is the demand side being stimulated?

Many would argue that our Australian industry content (AIC) and Sovereign Industry Capability Priorities (SICP) create demand from the overseas primes for AIC. In addition, we have been told that AIC the five pillars announcement strengthens AIC.

So, what is the issue? The issue is the assumption that the ‘incentives policy style’ that works so well on the supply side will work on the demand side, too. History has shown that it doesn’t.

Five pillars measure AIC, but do not create demand for Australian industry content

Let’s look more closely at the five pillars announcement. The defence sector applauded the government’s recent AIC announcements of the new ‘five pillars’ approach to supporting defence industry, which encompasses:

  1. A new and enhanced AIC contractual framework;
  2. An independent AIC audit program;
  3. Commonwealth Procurement Rules (CPR) guidelines update;
  4. Centre for Defence Industry Capability (CDIC) review and its implementation; and
  5. Australian Standard for Defence Contracting (ASDEFCON) review.

This new five pillars approach is certainly a step forward and will be valuable for measuring AIC commitments for future defence programs. The five pillars framework does not create demand for AIC in Defence programs.

We recommend that the five pillars change from measuring AIC using revenue, to measuring AIC using cost or local industry activity (LIA). The critical difference is that measuring revenue does not tell government whether the AIC revenue was spent in Australia.

In fact, previous programs have shown that a prime's 100 per cent AIC revenue spend on a Pty Ltd can result in only a small percentage of LIA. This occurs when a prime spends the AIC revenue on their offshore supply chain through a Pty Ltd setting up a thin supplier model.

What happens prior to AIC being measured by the five pillars?

The key issue with AIC is that the motivation of primes ‘flips’ as they move from tendering to delivering. We’ve discussed this in previous blogs, but to recap: during the business winning phase primes are all about getting ‘more local content’ to create a tendering point of difference. 

Lots of road shows, vibrant discussion on the art of the possible, exploration of technology transfer, promises to look at how local manufacturing and services companies can be folded into mature global design and supplier arrangements, and the golden carrot of export opportunities.

Post contract award the prime narrative changes to risk, schedule and budget (as it inevitably must). As a result the well-meaning discussions pre-contract award are now seen by the prime and CASG in a different light. Local SME suppliers are no longer ‘win themes’, they are ‘delivery risk’.

Incentivise supply, police demand

The issue with the demand side economics is not the lack of incentives for the primes, it’s the lack of response options for the SME and government when a prime (inevitably) decides with CASG that the risk of pursuing the local content option is too great. Or perhaps more ominously, there is lower risk in awarding the tendered local content to the prime's home country supply chain (thereby supporting another nation’s sovereign interests, especially in the COVID-19 world).

When a prime calls a local SME post-contract award and says, “sorry mate we’ve decided that we are not proceeding with your AIC or SICP work package”, two questions immediately come into play for the SME:

  1. What can I do about it?
  2. How long have I got?

Right now the answer to question one is, go to your minister or CASG project sponsor and seek redress. But there are not many success stories (think here about ARAFURA RHIB AIC outcome). Various conflicted parties are invited to write briefs, explain decisions, recommend actions but it all feels very unsatisfactory because all parties have vested interests.

The prime that made the decision is unlikely to want to change it, CASG wants less risk and they’re unlikely to force a change, government wants AIC and will push for change but will be nervous about dictating an outcome. 

It’s all quite predicable for the seasoned SME owner, they know where this course of action ends up – being listed as a ‘difficult Australian SME’.

The second question around time is equally important. History has shown that even the best founded SME AIC/SICP proposal that is not incorporated in batch one, hull/vehicle one is unlikely to be realised later in the build program. Speed is of the essence.

Arbitration for Australian owned companies AIC/SICP proposals

In our view, government should consider a rapid independent arbitration option for Australian owned companies SICP and AIC proposals. 

When a prime makes a decision to back away from an Australian owned company AIC or SICP plan to the detriment of a sovereign outcome, then a rapid independent arbitration should be available as a remedy. Government would have sole discretion to call for it – as the funder it would be their right.

This option would be the same as the current right of a prime to challenge CASG on a major contract award decision (introduced in 2017 as part of the First Principles Review) modelled on the US system. Given primes get a right of challenge – why not Australian owned SMEs?

Such arbitration would have to occur within a short window (we imagine weeks – not months) so as to ensure that the project does not unduly suffer or stall while supplier decisions are reviewed. 

And where the supplier decision cannot be reversed – this may occur when visibility of the change from a local provider to an international supplier is slow – then compensation to the impacted SME and to the Commonwealth (due to any sovereign loss) is part of the remedy (particularly considering that CASG is paying a 20-40 per cent premium for AIC on some Defence programs). That would be an attention-grabbing policy change.

We propose that the AIC/SICP arbitration function logically rests within the minister's five pillars announcement and clearly fits within the remit of the CASG Head of AIC.

To what end?

A change like this would drive an evolution in AIC – not a revolution. Many defence primes effectively think capability and jobs now and will easily move into this new mindset. 

But there will be parts of our Australian defence industry base that will be forced to move from thin overseas-owned supplier structures with little more than an ABN, to engaging with agile, innovative Australian owned SMEs who at their core are creating local capability and jobs.

Remember, AIC was built for a different time. It has worked well to date but has important blind spots that aren’t aligned with contemporary community thinking. It can be gamed. In our previous blog we listed seven ways Defence and its prime contractors come to ‘comfortable arrangements’ that support the intent of a project but come at the cost of local content. 

Sensible people look at how they are getting measured and make sensible decisions.

In summary the ideas in this article are relatively straight forward:

  • The policy framework employed on the supply side of the defence sector does not work equally well on the demand side. We need different tools to ensure defence demand is accurately targeting the government's stated goals of sovereignty and jobs.
  • Stronger tools beyond incentives – policing demand side behaviours is required particularly in the post-contract award phase. Arbitration for Australian owned companies AIC and SICP proposals is offered as an idea here – nested within the minister’s recently ‘five pllars’ announcement.
  • Implement the five pillars model measuring AIC actually spent using Australian local industry activity (LIA), and not simply assuming that 100 per cent of the revenue line AIC measure is spent in Australia.

This article was co-authored by Mike Kalms, KPMG Australia’s defence industry lead partner, and Chris Williams, managing director, HIFraser.

Op-Ed: Supply and demand economics in defence industry – Time to rebalance
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