Wednesday, May 29, 2024

Life Cycle Costing For Military Procurements

By Air Marshal  Anil Chopra (r) 

Air Mshl. Anil Chopra (r), DG CAPS

Life cycle cost (LCC) is truly representative of the total cost of an aircraft through its life cycle. It is usually used for estimating the cost-effectiveness of an aircraft design. For enabling LCC estimation at an early stage, LCC models have been evolved by different countries. Object-oriented and hierarchical approaches are used for LCC modelling. The cost estimation is mostly based on a bottom-up approach. Most models are T generic, and can be customised and applied for estimating the costs of other aircraft systems. Nowadays, most military assets are generally appraised at the acquisition stage on the basis of LCC. 

While India is gradually building its own military-industrial ecosystem, the bulk of its military equipment remains of foreign origin. Most purchases have been through government-to-government deals. For a long time India did not have the luxury to make choices. But after India began competitive bidding and detailed evaluations, the approach to LCC evolved. The Mirage 2000 and MiG 29 were bought around the same time. The Mirage was much more expensive based on initial cost. After some years of operations, the Indian Air Force (IAF) did its own internal study to look at LCC for the two types. 

LCC Models

LCC is defined as the sum of all recurring and non-recurring (one time) costs over the full span of planned utilisation period. LCC includes the costs of procurement, installation, operation, maintenance and also factors in the residual or salvage value recoverable at the end of useful life. It is thus the cost of ownership over the full life. The LCC model in different forms has been adopted since the 1980s by Austria, Germany, Iceland, the Netherlands, Switzerland and the United States. Australia has a Parliamentary Act mandating the use of LCC for all public procurements. The concept is known by various names such as LCC, cost of ownership (COO) and the total cost of acquisition (TCA).

Single-Stage Two-Bid System

For years, for capital procurements in India, the ‘Single-Stage Two-Bid System’ system has been followed. Both the technical and commercial bids were submitted simultaneously. The technical aspects were subjected to detailed evaluation following which commercial bids of only those that were technically compliant were considered by the Contract Negotiation Committee (CNC) for determination of the ‘lowest bidder,’ popularly known in the corridors of power as the ‘L1’.

L1 Model

The L1 was determined on the basis of ‘procurement cost’ of items contracted. Although this process ensured induction of the cheapest equipment, it did not address the issue of very high cost of operation over its life-cycle which depends on the type of technology and design philosophy. Employment of better technology and design would reduce operating costs over the life-cycle of the equipment. In our personal life, when we want to buy a car we don’t look at only the initial cost, we go into details of running expenditure such as fuel consumption, cost of spares, repair and servicing facilities across the country, etc. That is one of the reasons why diesel cars were so popular in India in spite of higher initial cost. That is what lifecycle cost (LCC) model is all about.

LCC Models Evolve In India

More than 19 internationally reputed vendors have responded to the Indian Government RFPs with the TCA model. No vendor has raised any issue or expressed lack of clarity on the subject. The LCC analysis is carried out using the defined procurement objectives, cost drivers, established parameters, escalation methodology, discounting rate, etc. The methodology is stated upfront in the RFP. The Indian Defence Procurement Procedure (DPP) has been gradually moving towards LCC since 2002. A committee was formed by the Ministry of Defence (MoD) in 2007 with members from MoD (Finance) and the Air HQ to suggest a suitable model for the medium multi-role combat aircraft (MMRCA) case.

Broad TCA & TCO Models 

Total cost of acquisition (TCA) is an accounting concept that includes all the costs associated with buying goods, services, or assets. Generally, it is the net price plus other costs needed to purchase the item and get it to the point of use. The other costs could include research, transportation, and preparation and installation costs. The Total cost of ownership (TCO) is a financial estimate intended to help buyers and owners determine the direct and indirect costs of a product or service. It is a management accounting concept that can be used in full cost accounting or even ecological economics where it includes social costs. TCO includes repairs, overhauls, replacements, ship and re-ship, and opportunity costs. 

LCC Model Used For MMRCA 

It was decided that all major elements that were quantifiable, verifiable and relevant be included to generate the LCC figures. The TCA model was mentioned in the MMRCA RFP. Finally all the determinable factors, including the operating cost and MTB-linked warranty were included. The TCA model proposed for determination of the L1 vendor was approved by the Secretary (Defence Finance), Defence Procurement Board (DPB) and the Defence Acquisition Council (DAC) for inclusion in the MMRCA RFP (for the first time) issued in August 2007. While considering the heavy-lift helicopter procurement case in February 2009, the DPB directed that all ‘applicable elements’ of the MMRCA TCA model may be used for all future aircraft procurements. This has become the norm since then.

While the TCA model was used for the first time in MMRCA RFP, the contract for procurement of basic training aircraft (BTA) was the first case to fructify using the TCA model. The BTA case using the TCA model was accorded ‘no objection’ by the Ministry of Finance (MoF) and the Cabinet Committee on Security (CCS) approval in May 2012, thereby validating the TCA model. Based on the experience gained and suggestions of MoF, it was decided to include the TCA model for all major weapon system procurements that are being processed for inclusion in the DPP.

Elements Of TCA As Applied To MMRCA

TCA includes direct cost of acquisition, cost of total technical life (TTL)-based reserves, cost of time between overhauls (TBO) mean time between failures (MTBF)-based reserves, cost of inspection level servicing, cost of repair level servicing and overhaul, basic operating costs and cost of transfer of technology (ToT). The types of spares include daily use spares such as consumables, line replaceable units (LRUs) and items like nuts, bolts, filters, fuses, etc. 

Intermediate level spares are used for rectification of the LRU up to card level. Depot level requires spares for major servicing and repairs. TTL and TBO-based reserves include components with specified life after which they need to be mandatorily replaced such as engine, pumps, gear boxes, cartridges, etc. If an aircraft has a TTL of 10,000 hours and engine TTL is 5,000 hours, two engines will be required in the lifetime.

MTBF-based reserves relate to items which are not lifted but will have to be replaced on failure. The MTBF provided by the vendor forms the basis for these reserves. Manufacturer recommended list of spares (MRLS) caters for scheduled and unscheduled servicing and maintenance for the first five years after induction. The vendor is bound by ‘adequacy of spares’ clause and a ‘buy back’ clause in case of under/over assessment of spares required.

The direct cost of acquisition includes aircraft, weapons, support and handling equipment, MRLS for five years, tools and testers up to intermediate level servicing, initial training of personnel, training aids and publications. Cost of TTL-based spares include all mandatory replacement items up to stipulated life. Cost of spares for intermediate level is included in the MRLS, so only man-hour cost has to be factored in. Cost of depot level servicing over the entire life includes man-hours and spares and the amortised cost of infrastructure required to be set up at the repair depot. The operating costs are essentially for fuel.

MMRCA TCA included seven elements. For all subsequent cases only five elements were involved as cost of MTBF-based reserves and cost of ToT were not applicable. MMRCA case was originally for 126 aircraft to be operated from five to six different locations requiring a large inventory of spares and reserves. MTBF-based reserves are low in all other cases as the numbers and locations are fewer and the platforms are less complex.

LCC In DAP 2020

DAP 2020 focuses on simplifying the Defence Acquisition Procedure and institutionalising monitoring mechanism with concurrent actions using digital technologies & data base for selection of best equipment in a transparent and competitive manner giving adequate opportunities to capable vendors. The aim of the Defence Acquisition Procedure (DAP) is to ensure timely acquisition of military equipment, systems and platforms as required by the Armed Forces in terms of performance, capabilities and quality standards, through optimum utilisation of allocated budgetary resources.

The Offsets clause would be applicable for Buy (Global) categories of procurement where the estimated AoN cost is ₹ 2000 crore or more. An Indian Vendor participating in the Buy (Global) category would be required to meet minimum 30% Indian Content (IC), failing which such vendor would be required to discharge offsets as applicable in the case.

The OEM shall provide the estimated LCC of the product and the basis thereof. Factors such as operational hours/year, MTBF, requirement of maintenance spares, mandatory replacements during preventive maintenance schedules etc. may be considered for arriving at life cycle cost. OEM shall also provide all the details like Operating cost, Maintenance cost, Overhaul cost, training cost etc. per squadron of aircraft, required to estimate the Life cycle cost of the aircraft.

The Seller will acknowledge that the Buyer shall be free to explore other global sources and design & manufacturing ecosystem prevailing in India, to optimise the life cycle costs and improve the performance of the platform/ equipment/ system being provisioned under the contract.

L1 Determination

For fair comparison, the cost of bids need to be brought to a common ‘date and currency’. As per DAP, all bids are to be compared as on the date of opening of the commercial bids. Therefore, for TCA, all costs are brought to their ‘net present value’ (NPV) as on the ‘bid opening day’. The vendor with the lowest NPV of TCA emerges as the L1. Since the request for proposal (RFP) seeks a ‘firm and fixed’ cost, to calculate NPV, all the future cash flows for the entire contract period need to be ‘discounted’ to bring them to their ‘present value’ through the discounted cash flow (DCF) method. The prevalent ‘lending rate’ by Central and state governments is used as the ‘discounting rate’. Early payments will result in higher ‘present value’ in comparison to the same amount with delayed payment.

The vendors quote cost for a ‘base year’ (stated upfront in the RFP) along with an ‘indices based escalation formula’. These costs are ‘escalated’ to their ‘present value’, as on the ‘bid opening day’, using the escalation formulae. Similarly, cost of TTL-based reserve and ‘D’ level servicing is quoted for a base year and these are escalated to their ‘present value’, as on the ‘bid opening day’. Vendors only provide ‘man-hours’ for ‘I’ level servicing and its ‘present value’ is computed using the man-hour rate (MHR) prevalent in India on the bid opening date. The ‘fuel consumption’ is determined during the flight testing and the ‘present value’ of operating cost is computed using the ‘fuel rate’ prevalent in India on the bid opening date.

Hence, all elements of TCA are at their ‘present value’ as on the bid opening date. The vendor with the lowest NPV of TCA emerges as the L1. Direct acquisition costs are validated by the Technical Evaluation Committee and during flight and maintenance evaluation, and validated by the Cost Negotiation Committee (CNC). Certified manuals, component log cards, servicing task cards are also studied. The contract includes all ‘specifications’ and ‘cost parameters’ quoted by the vendor. The contract also includes a specific clause stipulating that subsequent revenue contracts would be mutually finalised on the basis of these reference cost parameters and escalation formulae. To bind the vendor to the mean-time-between-failure (MTBF) data provided by him, the contract includes a strong MTBF- linked warranty for 10 years with a bond of five per cent the contract value.

TCA-based L1 determination will result in significant cost saving over the life of the aircraft. Besides binding the vendor to the DCA, as in the conventional model, the TCA model goes a step further to provide the cost parameters and specification of all elements with a strong MTBF-linked warranty. Thus, the TCA model provides a much better visibility and price discovery for future revenue contracts as compared to the conventional DCA model. TCA model will obviate situations wherein an aircraft inducted with low initial cost, has very high operating and maintenance expenditure. The TCA model is a ‘scientific method’ of procurement decisions.

Enhanced Performance Parameters (EPP)       

EPP are those parameters that enhance the capability of the equipment, vis-à-vis the operational, technical, maintainability/ergonomic parameters; a SQR may not contain EPP in all cases. Inability to meet the EPP does not preclude vendors from being eligible for the bidding/bid evaluation. However, if a vendor claims to have equipment meeting the EPP as specified in SQR and RFP, then they must provide details of the same in their technical bids, which have to be tested for compliance during the FET itself. Equipment successfully meeting the EPP parameters will be awarded a credit score of up to 10%, for evaluation of L1, with each individual attribute not exceeding a credit score of up to 3%, as approved by the AoN according authority. In case procurement involves EPP, then the EPP and their credit scores need to be explicitly detailed in the RFP. In such cases, if the equipment supplied by a vendor does not have the EPP, then the commercial quote of the vendor, for the purpose of L1 determination, remains as it is. 

In cases where a vendor’s equipment meets the EPP, the commercial quote will be multiplied by a credit factor less than 1 and greater than or equal to 0.9, based on the additional technical score assigned for the EPP, as detailed in the RFP. For example, if a vendor quotes ₹ 10 crore for an equipment and meets a certain EPP for which an additional credit score of 2% is being provided, then the commercial quote of this vendor will be considered for L1 determination purpose only, as ₹ 9.8 crore (10 crore multiplied by 0.98) and not ₹10 crore; however, for all purposes other than L1 determination, the value of the commercial quote will be considered as ₹ 10 crore only.  

Splitting Source Of Supply

In cases, where it is decided in advance to have more than one source of supply, specific approval will be taken in AoN for ratio of splitting the supply between (first lowest bidder) L1 and (second lowest bidder) L2 vendors, provided L2 vendor accepts the price and terms and conditions quoted by/negotiated with the L1 vendor, and the same will be pre-disclosed in the RFP.

Comparative Statement Of Tenders (CST) & Declaration Of L1 Vendor 

The CNC would prepare a CST for evaluating the offers and determine the lowest acceptable offer (L1 Vendor). Declaration of the L1 Vendor will be done by the CNC at a predetermined date and time, previously intimated to these vendors. Such vendors or their authorised representatives will be permitted to be present during the opening of the commercial bids.  

Negotiations With L1 Vendor

The RFP in multi-vendor cases should clearly lay down that no price negotiations would be carried out with the L1 vendor once the reasonableness of the price quoted by the vendor is established. Once the commercial offers are opened and the price of the vendor is found to be within the benchmarked price, there should be no need to carry out any further price negotiations.  

Negotiations With L2 Vendor

If the bidder, whose bid has been found to be the lowest evaluated bid withdraws or whose bid has been accepted, fails to sign the procurement contract as may be required, or fails to provide the security as may be required for the performance of the contract or otherwise withdraws from the procurement process, the Procuring Entity shall cancel the procurement process. Provided that the Procuring Entity, on being satisfied that it is not a case of cartelization and the integrity of the procurement process has been maintained, may, for cogent reasons to be recorded in writing, offer the next successful bidder an opportunity to match the financial bid/negotiated price of the first successful bidder, and if the offer is accepted, award the contract to the next successful bidder at the financial bid/negotiated price of the first successful bidder, subject to reasonability of the price bid being established by the CNC. 

Negotiations In Cases Of Splitting Of Source Of Supply 

In cases, where specific approval has been taken in the AoN to have more than one source of supply, ratio of splitting the supply will be pre disclosed in the RFP and negotiations will be done with both the L1 and L2 vendor, provided the L2 vendor agrees to accept the price and terms and conditions quoted by/negotiated with the L1 vendor.  

Life Cycle Support Contract (LCSC)  

The CNC would also negotiate the terms of Life Cycle Support Contract along with the Main Contract, where applicable, and would finalise the assured supply of information on product/technological improvement, modifications and upgrades; obsolescence management and life time purchases: and an illustrated spares price catalogue with base price and pricing mechanism for long term. LCSC would be signed along with the Main Contract and would clearly stipulate the obligations of the vendor towards provisioning Life Cycle Support for the equipment.

The CNC Report  

The CNC will document the selection of vendors using a formal written recommendation report addressed to the relevant approval authority. It should comprehensively elaborate the method of evaluation and the rationale for the selection made. Vetting of the Draft Contract may commence once the L1 vendor is declared. The CNC will finalise the Draft Contract before seeking CFA approval taking into consideration any other issues that may arise during the course of CNC. The CNC report should also contain the Draft Contract Document, duly vetted by all the stakeholders. 

The report must be complete in all respects and should be checked by the members of the CNC. All CNC members should sign the recommendation report, in the interest of probity and accountability, as evidence that they concur with the process adopted and the ultimate selection made. Any dissenting view, including the reasons for the same, should also be documented. The CNC Report would include, a brief background to the requirement; composition of the CNC; an explanation of the commercial evaluation process, selection criteria and commercial evaluation matrices, if used; brief description of different phases of the commercial negotiation process; the draft contract document, duly vetted by all the stakeholders; and the summary of the recommendations. 

To Summarise

Military equipment is very expensive. They take years of research and development to be operationalised. Security of any nation being paramount, nations are willing to spend large sums. As large sums are involved, there is greater public and audit scrutiny. Value for money becomes the mantra. As game-changer technologies disturb the status quo, obsolescence sets in. Typically an aircraft fleet may operate for over 40 years. This requires spare and upgrade back up. Any life cycle costing has to factor in such long periods. Defence acquisition procedures have been evolving globally. LCC is being factored by all countries. India being a developing country and yet a major arms importer, the LCC becomes more significant.    

About The Author

Air Mshl. Anil Chopra (r) is the Director-General of the Center For Airpower Studies (CAPS)

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