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Aviation History
1964
1964 - 2001.PDF
26 FLIGHT International, 2 July 1964 THE PRICING OF MILITARY AIRCRAFT... order to maintain a reserve of design and production capacity for strategic purposes, the Government allocated contracts on a cost-plus basis. With the onset of rearmament and the resulting rise in the demand for military aircraft, the Air Ministry and the aircraft industry negotiated an agreement (the McLintock Agree- ment of 1936) whereby an attempt was made to determine fixed prices for production contracts. Under the 1936 scheme the agreed minimum rate of profit on aircraft contracts was 5 per cent of estimated costs; but there was no maximum profit rate. In the case of new types of aircraft, where costs and prices could not be estimated on the basis of past experience, the 1936 agreement arranged for the initial deliveries of such new types to be paid for at actual cost plus an agreed rate of profit. However, once sufficient experience of the cost trend was available, a fixed-price production contract was to be negotiated. With the increasing demand for military aircraft during the late 1930s it became necessary to prevent firms .earning excessive profits from Government aircraft orders, and consequently the original McLintock Agreement was revised in July 1939, when the Forbes Formula was introduced. The Second Report of the Public Accounts Committee, published in 1940, mentioned that ". . . the object of this formula is to scale-down the rate of profit with due regard to the amount of the contractors' capital employed, to the volume of his turnover and certain other factors."2 In other words, the Forbes Formula emerged because it was felt that if profits were related to production costs in the inflationary circumstances of rearmament, firms would earn high profits. Also, under the 1939 scheme, there was to be no minimum profit percentage. Differing profit rates The basic Forbes Formula is still used to determine the profit rate which is to be paid on military aircraft development and production work. Broadly, the profit which is allowed on a Govern- ment order is calculated on the basis of a percentage figure multiplied by the ratio of capital employed to cost of production or turnover in a given year. For the purpose of the Forbes Formula, turnover (excluding profit) and cost of production seem to be regarded as identical. However, since the capital employed on development projects is, by its very nature, "turned over" far less frequently than the capital employed on production work, there are separate profit rates for development and production contracts. With military aircraft development contracts, the capital employed in a given year by a typical airframe firm will consist of:— (a) Work in progress, less any progress payments against that work. (b) The "stock" capital employed on research and development. This will consist of the percentage of stock issues to the R & D contract over total issues from stock in the year, multiplied by the stock balance at the end of the year. (c) Fixed assets devoted to R & D. The cost of production for R & D work will consist of the actual recorded cost of all development work, namely, materials, labour, overheads and any other purchases incurred in a given year.3 The basis for profit calculations is that where the ratio of capital employed to cost of production is 1:1 the firm is awarded 7A per cent which will be applied to the cost of the work. [74% + £] = Forbes Formula = P = cost of Production [estimates for production contracts] C = capital employed With production contracts, the airframe firm takes the total capital employed at the end of the financial year (fixed assets and working capital) less any items included in the R & D capital em- p'oyed, and compares this total, in ratio, with its estimated cost of production less the R & D cost of production. In other words, all items not included in the R & D ratio are included in production work for profit purposes. It should be emphasized that the Forbes Formula provides only a basic profit percentage for development and production work. Extra percentages may be added to this basic figure where the contract involves an element of risk or where it is desired to reward efficiency. These extra percentages may be as much as 2 per cent in either case, provided that this does not bring the total percentage profit to more than 15 per cent on the capital employed. Using the Forbes Formula, together with cost estimates, it is possible for the MoA to obtain an estimate of the price to be paid for a given number of production aircraft. But this is not the end of the matter. Given this estimate of costs and profits, the Director of Contracts at the Ministry then has some idea of what is a fair price to pay for each aircraft; but the firm will probably have a some- what different idea of what is a fair price. It is at this point that the Ministry and the firm begin their process of bargaining, with the former trying to obtain the lowest price and the latter striving to negotiate as high a price as possible. The present contractual arrangements for military aircraft are by no means beyond criticism. One of the basic problems with the present pricing system involves the method of calculating the capital employed on a particular project. In the Minutes of Evidence to the 1956 Report on the Supply of Military Aircraft, a leading Ministry witness admitted that "We are not able to calculate,, the capital employed on that particular project. We take the| capital employed by the Company as a whole."4 This obviously; presents difficulties where the airframe firm is producing more than3 one product for customers other than the Government. Favouring the inefficient ? A second problem involving the Forbes Formula concerns turnover. The airframe firms claim that in so far as a high rate of turnover is pritna fade a sign of efficiency, the Forbes Formula rewards the inefficient. For example, it is argued that a firm which turns its capital over once per year will receive a 7J per cent profit rate on the capital employed; but a firm which turns the same capital over twice per year will receive a profit rate of only 3| per cent. To some extent this criticism seems to be justified, but it must not be forgotten that, in addition to the profit rate resulting from the basic Forbes Formula, the Ministry can award an additional 4 per cent for risk and efficiency. Moreover, with fixed-price production contracts the price is based upon cost estimates. Theoretically, the fixed price only allows a maximum profit rate of 15 per cent on the capital employed, but once the price is fixed the firm has every incentive to reduce its actual costs below the estimates, since it is allowed to retain the whole of any difference. In fact, in the early 1950s "... the average profit for aircraft firms as a whole on Ministry of Supply fixed-price pro- duction contracts was 18 per cent."5 Apparently, the Ministry maintains that firms are allowed to retain the difference between actual and estimated costs because it has no means of determining the actual costs! What suggestions can be made about the pricing of military aircraft contracts ? In the field of development contracts, greater use should be made of the target system, with effective enforcement of target criteria. Briefly, the target-cost contract is a variant of the cost-plus type of development contract. The firm is required to meet some target, either a particular circumstance, such as the first flight of a new aircraft, or a given date, say the first flight of the P.I 154 by mid-1966. The firm is paid the actual costs incurred on the project plus a fixed fee provided that it meets its stated targets. In the event of failure to meet the target, the Ministry can refuse to pay the fixed fee. More effective enforcement of target criteria would obviously lead to disputes regarding the achieve- ment of targets, and consequently it might be necessary to establish an arbitration commission consisting of representatives of the industry and the Ministry. A more elaborate type of target contract might introduce a system of bonus and penalty profit percentages. After all, it must be remembered that development contracts are generally risk- free, in the sense that all the firm's actual costs will be recovered. The rate of return on all development contracts could be related to the basic Forbes Formula. In addition, there should be a system of bonus and penalty percentages, based on clearly defined criteria. (2) Public Accounts Committee 2nd Report (1940), pages 20-21. (3) This applies to cost-plus percentage contracts. For cost-plus-flxed-fee contracts the fixed fee is calculated on the basis of estimated costs, although the firm will receive actual costs. Fixed-price pro-duction coKracts, however, are based on cost estimates. (4) Minutes of Evidence, page 37. (5) 1956 Report, Supply of Military Aircraft—Minutes «f Evidence,page 298(f).
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