On 1 April 2018 revised guidance from the Single Source Regulations Office (SSRO) on Allowable Costs came into effect (2018 Guidance). This 2018 Guidance replaces the guidance from July 2016 (2016 Guidance) and will be the applicable guidance for all qualifying contracts entered into on or after 1 April 2018.
The Defence Reform Act 2014 (Act) states that both the UK Ministry of Defence (MoD) and its single source contractors must have regard to the applicable SSRO guidance on Allowable Costs in determining whether costs are Allowable under their qualifying defence contracts and qualifying subcontracts (Qualifying Contracts). The SSRO Allowable Costs guidance is therefore very important and should be considered to be part of the single source legislative framework.
The Act requires that Qualifying Contracts are priced on the basis of Allowable Costs meaning that such costs must be Appropriate, Attributable to the relevant contract and Reasonable in the circumstances (the AAR Test). The AAR Test applies to all costs under a Qualifying Contract including labour costs, cost of materials, sales, marketing and third party costs, R&D costs and costs associated with loss and poor performance.
This article focuses on what the new 2018 Guidance says in respect of three categories of costs which are the subject of regular debate between MoD and industry: costs associated with rework and wastage, faulty workmanship and the costs of insurance to cover poor performance.
Rework and Wastage
Under the 2016 Guidance, the costs of rework and wastage may be Allowable if they meet the AAR Test. Such costs have to be "agreed between the contractor and the MoD based on the expected level of rework and wastage given the nature of the contract in question". The 2016 Guidance also states that if rework is required due to faulty workmanship or breach of contract, then the costs of such rework will not be Allowable. We comment further on the faulty workmanship exclusion below. Industry had a number of concerns with the 2016 Guidance, and particularly felt that there was a lack of clarity as to what level of rework and wastage would be considered reasonable. Whilst the 2016 Guidance gave some broad principles illustrating what is meant by AAR, it did not give any specific guidance on what level of rework or wastage might be reasonable.
Under the 2018 Guidance this position has not fundamentally changed – the costs of rework and wastage remain Allowable if they meet the AAR Test. However, the SSRO has tried to address industry concerns, and the guidance in respect of what a Reasonable level of rework or wastage may be has been embellished, nonetheless it remains limited.
The SSRO recognises, and the 2018 Guidance now provides, that no production or manufacturing process is likely to be completely effective and it may not be economical to achieve zero rework or wastage. What will be a Reasonable level of rework or wastage will depend on the information available and the specific circumstances of the contract, including that:
- contractors should have adequate quality control and monitoring systems in place to be able to identify the level and, if material, the causes of reworks and wastage. There should be plans in place to reduce costs through learning curve and efficiency gains; and
- once the parties have considered the information available and the specific circumstances of the contract, including how they compare to other contracts, a judgement can be made about whether costs are Allowable.
The 2018 Guidance therefore seems to focus more on the quality management systems that a contractor has in place to: (i) assess levels of rework and wastage; (ii) understand what is causing each instance of rework and wastage; and (iii) take steps to address the causes.
It should also be noted that neither the 2016 Guidance nor the 2018 Guidance distinguishes between "direct" rework costs (the costs of the rework itself) and "knock-on" costs arising as a consequence of such rework (e.g. delay costs). If a rework cost does not meet the AAR Test there is therefore a risk that both the direct and consequential costs of such rework will not be Allowable.
As stated above, under the 2016 Guidance, if rework is required due to faulty workmanship then the costs of such rework will not be Allowable. This position has been the subject of much debate between the MoD and industry. This is because industry argue that in some cases, particularly in more complex programmes, a certain level of faulty workmanship is reasonable and to be expected. In a competitive fixed or firm price contract, a contractor may well price into its fixed price a certain risk contingency for fixing faulty workmanship defects in accordance with its obligations under the contract.
The 2018 Guidance does change this position, and crucially the sentence in the 2016 Guidance which stated that compensation for faulty workmanship would not be an Allowable Cost has been removed. The 2018 Guidance also then anticipates that in some circumstances faulty workmanship costs may be Allowable:
"Costs associated with faulty workmanship may be Allowable where both parties are satisfied that faulty workmanship cannot be avoided because of the complexity or lack of maturity of the process being undertaken and the AAR test is met. These costs may be re-classified as reworks in some circumstances."
However, other faulty workmanship costs will remain not Allowable – those "where the fault has occurred due to poor skills, training, systems or materials that the contractor has in place or has purchased."
As with the remainder of the 2018 Guidance on rework and wastage, the focus is on the systems the contractor has in place to assess faulty workmanship and what is causing it. For faulty workmanship costs to be Allowable, the contractor will still need to prove that they are AAR: something that may remain difficult given the lack of prescriptive rules on what AAR means.
What do these changes mean?
In all cases the onus remains on the contractor to demonstrate that the relevant costs do satisfy the AAR Test. The likelihood of satisfying the MoD that such costs are Allowable is likely to increase where:
- Rework costs have been agreed because a complex manufacturing process is being undertaken or a product is being manufactured for the first time, i.e. the contractor can demonstrate that in certain circumstances rework costs cannot be avoided given the complexity of the product being manufactured.
- A contractor can demonstrate that such costs will reduce future costs through efficiency gains or it being part of a learning curve.
- A contractor can demonstrate that the rework costs have been incurred because of a re-specification or a change in design by the MoD.
- A contractor can demonstrate that the costs do not exceed what might be expected to be incurred in the normal delivery of a QDC or QSC.
We continue to recommend that the Qualifying Contract sets out in as much detail as possible those costs which are agreed at the outset as being Allowable and meeting the AAR Test, so as to mitigate the risk of any challenge by the MoD at a later date. The MoD and the contractor could also pre-agree the process that the contractor will follow to assess causes of rework. We further recommend that if a Qualifying Contract refers to certain costs as being not Allowable, it is clear whether this is intended to cover both direct and consequential costs.
Whilst from a commercial perspective being specific in the contract on any agreement regarding Allow-ability of costs is helpful, ultimately if the MoD challenges a cost, it will be a question of fact as to whether the cost is Allowable (based on the DRA, SSCRs and 2018 Guidance) regardless of what is written in the contract.
Insurance for 'poor performance'
The third category of costs which are often the subject of discussion are those associated with insurance for poor performance. The SSRO's position on this and the new 2018 Guidance have not changed, which will not come as welcome news to contractors. The 2018 Guidance restates that it would neither be Appropriate nor Reasonable for a contractor to be paid to cover against its own poor performance in delivering the contract. Accordingly, contractors will continue to be unable to recover their costs of insurance associated with faulty workmanship, defective parts or breach of contract.
The 2018 Guidance unfortunately remains unclear as to specifically which insurance policy costs this would disallow. By way of example, contractors would usually purchase contractors all risk and product liability insurance as part of an overall risk management strategy. These insurances provide protection to a contractor against damage arising from faulty workmanship or supply of a defective product and would often be business wide i.e. would not be specific to the QDCs or QSCs. The MoD benefits from these insurances being in place, as without them a contractor may well request MoD indemnities. Industry is therefore concerned if the costs of such insurance policies are not Allowable.
Once again we recommend being clear in the Qualifying Contract as to whether the MoD and contractor have agreed that certain insurance premium costs are considered to be AAR and therefore Allowable under the contract. As set out above, this would provide commercial comfort only, and ultimately it is a question of fact as to whether an insurance premium cost is Allowable.