UK defence inflation and cost escalation

Abstract

The UK experience with defence inflation and cost escalation is described and analysed. Evidence is presented and policy solutions are reviewed. Optimism bias is a source of cost escalation and this bias is analysed with game theory and public choice models. The key facts remain, namely, that defence inflation exceeds the GDP deflator, and despite various reforms, cost escalation continues.

Keywords:

• Defence inflation
• Cost escalation
• Optimism bias
• Contracting

JEL Codes:

• H56
• H57
• L10
• L51

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ A chain-linked Laspeyres price index relates the price of a basket of goods and services to the price of a similar basket in a previous period, not a fixed base period. Quantities are fixed, hence resulting in a measure of a pure price change (MoD 2014b).

² The GDP deflator is often used as a measure of inflation in the UK economy (MoD 2014b).

³ Inflation indices and discount rates provide information on monetary values over time.

⁴ Alternatively, input indices might be used based on labour and materials inputs using official statistics.

⁵ MoD guidance suggests the use of output-based Producer Price Indices for manufacturing industry and the use of other indices published by the National Statistics Office. Similar guidance is provided for Input indices, comprising labour, materials and fuel (e.g. average earnings indices; price index numbers of materials and fuel purchased). Where input indices are used, MoD requires an NVE of 20–30%. MoD guidance also states that in negotiating VOP arrangements, the search for undue precision should be avoided (MoD 2011a).

⁶ The US studies are reviewed since they are some of the few published studies on the causes of cost escalation.

⁷ Learning curves for the US sample were estimated at an overall average of 89%, meaning that a doubling in annual procurement led to an 11% decrease in unit costs.

⁸ For the UK, less than 5% of the 165 projects over the period 2004–2009 were cancelled. Similarly, of the 40 projects which passed Initial Main Gate for the period 2004–2009, only one was cancelled (Gray 2009, 100, footnote 56).

⁹ The average tenure of project leaders has decreased since 2003 from about three years to under two years (Gray 2009, 183).

¹⁰ Firm and fixed-price contracts usually outperform other types of contracts in terms of cost overruns. However, firm and fixed-price contracts are likely to include a greater contingency for risk in their original estimates, so they may not represent best value for money even if they show smaller cost overruns (Gray 2009, 131, 142).