Cost risk adjustment (step 2)

3.1

Section 17(2) of the Act, and regulation 11(3), set out the requirement for the cost risk adjustment:

“Adjust the baseline profit rate by an agreed amount which is within a range of plus or minus 25% of the baseline profit rate, so as to reflect the risk of the primary contractor’s actual allowable costs under the contract differing from its estimated allowable costs”.

3.2

Section 30 of the Act sets out that “[the Act] and single source contract regulations apply to qualifying subcontracts (and to sub-contractors) as they apply to qualifying defence contracts (and to primary contractors)”. In the case of a qualifying sub-contract, the calculation of the cost risk adjustment is agreed between the sub-contractor and the contracting authority, rather than the Secretary of State, and this guidance must be modified by reading references to the Secretary of State as the contracting authority and references to the contractor as the sub-contractor.

3.3

The calculation of the contract profit rate must include application of the cost risk adjustment, although the legislation is clear that permissible range of adjustments includes a zero adjustment. The purpose of this guidance is to provide a consistent approach for contractors and the Secretary of State to follow when agreeing a cost risk adjustment.

3.4

The cost risk adjustment guidance is principles-based rather than rules-based.

Regulated pricing methods

3.5

Regulation 10(2) states that the parties to a qualifying defence contract may agree which regulated pricing method is to be used for that contract. The parties can also agree a different pricing method for defined components of the contract (regulation 10(3)).

3.6

There are six regulated pricing methods that the parties to a qualifying defence contract may decide to use, as set out in regulation 10(4) to 10(11). All regulated pricing methods use either an estimate or actual Allowable Cost base.

General approach

3.7

Contractors and the Secretary of State must have regard to the following approach and principles when negotiating the cost risk adjustment to the baseline profit rate. The terms and conditions of each individual contract should always be considered when determining the adjustment.

3.8

The purpose of the cost risk adjustment is to incorporate into the contract profit rate an addition or deduction to reflect the risk that the contractor’s actual Allowable Costs in delivering the requirement will differ from the estimated Allowable Costs included in the contract price. While one factor will be the proportion of actual versus estimated costs included in the pricing method, other factors also drive risk. The adjustment should be agreed by considering the principles stated at paragraph 3.17.

3.9

For qualifying defence contracts that are based on the cost-plus or estimate-based fee regulated pricing methods (refer to regulation 10), the cost risk adjustment should be minus 25 per cent, because actual Allowable Costs are used to determine the costs to be paid, although the Secretary of State and the contractor should always have regard to the principles at paragraph 3.17.

3.10

For all other regulated pricing methods, the adjustment may vary from minus 25 per cent to plus 25 per cent, depending on the risk of actual Allowable Costs differing from estimated Allowable Costs, using the following guidance and the principles stated at paragraph 3.17.

3.11

Subject to the considerations of the regulated pricing method, the starting point for the appropriate cost risk adjustment is that none should apply. A positive or negative cost risk adjustment should apply where it can be reasonably justified and evidenced.

Negative adjustment

3.12

A negative adjustment should be made where the Secretary of State and the contractor agree there is a lower (or no) risk of actual Allowable Costs differing from estimated Allowable Costs.

3.13

For example, this may be justified where there are risks that are well understood and for the large part mitigated.

3.14

The SSRO recognises that for some defence contracts most of the cost risk associated with one or more sub-contracts is held by, or assigned to, the Secretary of State. It is appropriate to recognise these circumstances when agreeing a cost risk adjustment. The cost risk adjustment should reflect the reduced risk of the primary contractor’s actual Allowable Costs under the contract differing from its estimated Allowable Costs, thus recognising the reduced risk held by the prime contractor associated with the sub-contract(s).

Positive adjustment

3.15

A positive adjustment should be made where the Secretary of State and the contractor agree there are higher risks of actual Allowable Costs differing from estimated Allowable Costs.

3.16

For example, this may be justified where the risk is held by the contractor, and not the Secretary of State, and where the risks are not well understood and/or cannot managed in the Allowable Costs because they are not in the control of the contractor and therefore cannot be mitigated.

Principles to consider

3.17

The contractor and the Secretary of State must have regard to the following principles (which are not exhaustive) when determining the cost risk adjustment. The adjustment should:

1. only consider uncertainties that impact on Allowable Costs;
2. give consideration to the contract pricing method (refer to 3.9 and 3.10);
3. not take into account risk that should be managed in estimated Allowable Costs;
4. be based upon an assessment of the extent to which actual Allowable Costs may vary from estimated Allowable Costs, both positively and negatively;
5. take into account the relative likelihood of actual Allowable Costs being over or under estimated Allowable Costs;
6. take into account the extent to which the probability and expected impact of cost risk has been mitigated, eliminated or transferred to another party, for example through insurance or where sub-contract risk is ‘passed through’ to a party other than the prime contractor;
7. take into account the extent to which cost risk should be covered through Allowable Costs;
8. reflect and draw upon the overall approach to risk assessment such as risk allocation, management, and risk registers (and be recorded in the risk register);
9. not take into account uncertainty resulting from force majeure, for example an unforeseeable natural disaster; and
10. be based on reasonable documented assumptions and/or evidence.

SSRO Determination: In 2016 the SSRO issued a determination on the appropriate cost risk adjustment. Link to full referral