A composite package comprising of tax holiday/incentives, deemed export status etc., for the entire range of defence manufacturing will have a bearing on successful execution of the 'Make' projects, but more crucial will be the funding & financial planning of these projects as this will require a deliberate value judgments by the MoD...
The 'Make' category was evolved in 2006 to entail development of futuristic systems based on indigenous research and design. It is disconcerting that despite the efforts that went into evolving a consensual model for 'Make' projects, not a single contract has got concluded so far. Two projects - the Battlefield Management System (BMS) and the Tactical Communication System (TCS) - seem to have gained some traction of late and a big-ticket project for development of the Futuristic Infantry (FICV) is also making some progress, but it is difficult to predict the future of any of these projects.
Concerned at the slow movement of the projects categorized as 'Make' projects, MoD came up with the draft of a revised procedure in 2013 which was further tweaked earlier this year. These drafts were circulated by MoD for obtaining feedback from a few selected stakeholders but before any further step could be taken, an experts' committee was set up to make recommendations for evolving an appropriate procurement policy framework. The committee, which submitted its report in July 2015, has not recommended any change in the basic architecture of the 'Make' procedure but has made a few recommendations with reference to the draft paper circulated by MoD earlier this year.
Considering that this committee had extensive consultation with the industry and other stakeholders, the revised procedure drafted by the ministry and the recommendations made by the committee should take care of all possible drawbacks in the existing policy as well as the procedure for execution of the 'Make' procedure. However, one of the recommendations made by the committee regarding incentivising of the Indian industry could come in the way of immediate promulgation of the revised procedure.
The committee has recommended that the Indian Production Agencies (IPAs) participating in the 'Make' schemes may be given tax incentives by way of categorizing their share of 20 per cent in the development cost as expenditure on R&D and that '300% weighted tax deduction of such development cost should be considered against 200% given by the Department of Science and Technology'. This could obstruct early promulgation of the revised procedure because the matter does not fall within the purview of the MoD. Secondly, considering that the government has expressed its intention of lowering the corporate tax and reviewing various incentives available under the Income Tax Act, the Ministry of Finance (MoF) would find it tough to allow weighted deduction for R&D expenditure that is a good 100 per cent more than what is available for other scientific projects.
This is not to suggest that there is no case for providing incentives to the defence industry. However, giving tax breaks, exemptions and incentives to the defence industry is not the only financial issue that has a bearing on successful execution of the 'Make' projects. There are at least three other macro issues that need attention.
Financial Planning for the 'Make' Projects
The latest draft of the 'Make' procedure envisages feasibility study for every project identified as a potential 'Make' project by way of the first step in execution of such projects. The feasibility study is required to include recommendations on, inter alia, MoD's long-term interest in development of indigenous capabilities and the cost estimates for prototype development as well as the cost of the subsequent procurement of the equipment, when developed, under the 'Buy (Indian)' category.
These feasibility studies are required to be carried out by the HQ Integrated Defence Staff (HQ IDS) or the Service Headquarters (SHQs) but neither of them has the professional expertise to carry out the cost-benefit analysis which is an important component of any feasibility study. The existing guidelines have a provision for engaging consultants for carrying out such studies but in the absence of a mechanism to ensure accountability, engagement of consultants will be fraught with enormous risk. This is equally applicable in the case of outside agencies engaged for the purpose.
Secondly, no defence company will be keen on any project under the 'Make' procedure unless the project is commercially viable. The commercial viability does not depend merely on funding of the prototype development but also on subsequent assured procurement of the equipment from the agency that succeeds in making the technically acceptable prototype. This, of course, raises the question as to what happens to the other Development Agency (DA), especially if that DA is also on the verge of developing a prototype, but we will let that question pass for the moment.
Uncertainties surrounding the completion of the prototype stage and subsequent procurement of the equipment require a very flexible system of financial planning which MoD has not prepared itself for. This systemic drawback has led to many a project, albeit not under the 'Make' procedure, being forsaken midway because of the funding issues. Rolling back of procurement of the medium multi-role combat aircraft programme is a case in point. Any apprehension if a 'Make' project meeting a similar fate could result in lukewarm response to the requests for Expression of Interest (EoI).
Thirdly, it is no secret that practically in all capital acquisition programmes the final cost turns out to be substantially higher than the initial estimate made while seeking the Acceptance of Necessity (AoN). It is also no secret that little expertise is available with MoD for working out the life cycle cost of various equipment, weapons systems and platforms. If this problem is being faced even in respect of 'Buy' and 'Buy and Make' programmes where the imponderables are not too many, one cannot even imagine how this problem is going to be overcome in relation to the 'Make' projects that are contingent upon numerous imponderables.
Funding of the 'Make' projects
The proposed 'Make' procedure contemplates selection of the Development Agencies (DAs) on the basis of the evaluation criteria comprising the commercial strength of the prospective agencies and their capabilities in technology, R&D (research and development) and indigenization as claimed by them in response the EoI. Each of these criteria comprises several parameters. For example, the R&D criterion has three parameters: R&D expenditure as a percentage of the total turnover on strategic/defence systems; the existing R&D infrastructure, the infrastructure projects in progress and those planned in the next three years; and, total number of patents translated into products in the subject field and the total number proposed to be utilized for the project. In theory, this sounds good but evaluation of the response based on these complicated criteria, some of which are prone to over-projection by the respondents, will always be open to being challenged.
Secondly, the draft 'Make' procedure provides that 'depending on the requirement of the DAs in terms of development of technology and indigenous content, the IPMT could consider and recommend a cost variation up to 25% among the DPRs submitted by the two DAs, as compared to the lower of the two'. Presumably, it means that the difference in the projected cost of the two DAs cannot be more than 25 per cent. The situation could become very tricky if there is a substantial difference between the costs projected by the short listed DAs, and the DA with the higher projected cost is not prepared to bring down the cost to within 25 per cent of the cost quoted by the other DA. This is not an unlikely scenario if the DA quoting the lower costs is a Defence Public Sector Undertaking (DPSU) or the Ordnance Factories Board (OFB). In any case, no DA would agree to lower the projected cost to less than 25 per cent over the cost projected by the other DA. This could stupefy the IPMT negotiating the cost with the DAs.
Thirdly, the 'Make' procedure provides for funding of the development cost to the extent of 80 per cent by the MoD. The existing procedure provides for release of funds based on the recommendation of the Integrated Project Management Team (IPMT) in accordance with the schedule of release of payments linked to achievement of milestones given in the contract. This has to be seen with reference to the provision in the draft 'Make' procedure that the following criteria would be applied to determine whether, and up to what extent, the costs incurred by the DAs shall be payable out of the public funds:
- Cost allowability
- Cost allocability
- Cost reasonableness
- Terms of the contract
Though the draft 'Make' procedure elaborates how these criteria are to be applied, it would be naive to believe that these could be applied with scientific precision and that those responsible for applying them would not need to take a subjective call.
Take, for example, what the draft 'Make' procedure says about cost reasonableness. It says that 'a cost is reasonable if it would have been incurred by (a) prudent entity in the course of competitive business. To be reasonable the cost must be: (i) generally recognized as an ordinary or necessary cost of business; (ii) follow sound business practices; (iii) comply with Central, State, local laws; and (iv) be consistent with the Development Agency's established business practices. The determination of reasonableness of a particular cost shall depend on all the relevant facts and circumstances concerning the costs; and the decision of the Ministry of Defence in this regard shall be final'.
This would require the MoD officials to make value judgements that they have simply not been trained for. This concept of allowability, allocability and reasonableness seems to have been borrowed from the Defence Contract Audit Agency (DCAA) that provides audit and financial advisory services to the Department of Defence and other federal entities responsible for acquisition and contract administration in the United States of America. The agency, which has more than 5,000 professionals working for it, operates under the authority, direction, and control of the Under Secretary of Defence (Comptroller)/Chief Financial Officer. Though an organization of that size is not required in India, at least as of now, a motley ad hoc group of officials with no exposure to financial management of such projects will be a poor substitute for DCAA.
Management of the Prototype development Contracts
The draft 'Make' procedure provides that 'the financial sanction for development of the project, taking the total approved prototype development costs into account, would be obtained by the Acquisition Wing/SHQ as per the delegation of financial powers for capital expenditure from time to time'. Thus, depending on the cost of the project, the sanctioning authority could be the Secretary, Defence Minister, Finance Minister or even the Cabinet Committee on Security.
The projects will be funded from the budget head 'Make Procedure Prototype Development Account' to be operated by the SHQ. The payments will obviously be made by the Defence Accounts Department based on the sanctions accorded by the Principal Staff Officers at the SHQ who will accord such sanctions on the recommendation of the IPMT, which 'at every phase/sub-phase of the project will also assess the project on the relevance of continuing the project with respect of time and cost overruns, operational requirements, availability of same/similar equipment or technology'.
IPMT will also be responsible for recommending cost overruns up to 10 percent. The Vice Chiefs at the SHQ concerned will have the authority to approve time overrun up to 20 per cent of the timeline envisaged in the DPR, beyond which the power will rest with the Defence Production Board. Needless to say, these authorities will act on the basis of the recommendations of the IPMT.
If one looks at the totality of the procedure, at least six agencies SHQ, HQ IDS, IPMT, Acquisition Wing, Defence Production Board, and Defence Acquisition Council would play an important role in steering of the 'Make' projects in one capacity or the other with the central and sustained role being played by the IPMT. A look at the composition of the IPMT as envisaged in the draft 'Make' procedure will be enough to frighten anyone familiar with the existing disjointed monitoring mechanisms in MoD. This is what the draft 'Make' procedure says:
“Once AoN is accorded for acquisition under “Make” category, the Acquisition Wing/SHQ will constitute an Integrated Project Management Team (IPMT) headed by a SHQ Rep, consisting of representatives from SHQ, HQ IDS, DRDO, DDP, DGQA/DGAQA/DGNAI, Advisor (Cost) and MoD (Finance)/IFA and other experts as considered necessary. Each SHQ shall have a Project Management Unit (PMU), having a team of officers, who will be responsible for overseeing and implementing the Make projects relating to that Service so that there would be continuity of leadership and accumulation of institutional knowledge gained under these projects. The PMU may also have experts from practitioners in Finance, Legal and technical domain. Representative of SHQ will function as Member Secretary of IPMT and shall be posted for a minimum period of preferably three years to provide continuity. The officer can be assigned one or more projects of similar nature. Expenses for hiring the services of experts/consultants shall be met by the SHQ concerned.”
Officials drawn from various departments and organizations with no expertise or previous experience of managing such projects and working under the administrative control of different authorities can hardly be expected to constitute a cohesive team, especially since each one of them would be a part of the IPMT for a finite tenure.
Most of the equipment is not going to be procured through the 'Make' procedure in the near future. It would not cause any harm if review of this procedure is delinked from the larger issue of revision of DPP 2013 based on the recommendations of the experts' committee. It might, in fact, be helpful in the long run if some more thought is given to make the procedure simpler and pragmatic and appropriate permanent structures are created to steer the 'Make' projects from their commencement till fruition. An India-specific model could be evolved by studying in greater details the functioning of the DCAA and DCMA.
(The writer is former Financial Advisory (Acquisitions) and Additional Secretary and Member, Defence Procurement Board, MoD)