Profit on cost once adjustment (step 3)

Contents: This section of the SSRO's guidance describes the profit on cost once adjustment, step 3 of the contract profit rate.

Basis of the POCO adjustment

4.1

Section 17(2) of the Act, and regulation 11(4), set out the requirement for the POCO adjustment:

“Deduct from the amount resulting from step 2 the adjustment determined in accordance with regulation 12 (“the POCO adjustment”), so as to ensure that profit arises only once in relation to those Allowable Costs under the contract that relate to the price payable under any group sub-contract (including any further group sub-contract).”

4.2

This adjustment ensures that if a party to a qualifying defence contract enters into a group or further group sub-contract then profit arises only once in relation to Allowable Costs included in the group or further group sub-contract price.

4.3

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 POCO 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.

Application of the POCO adjustment

4.4

The POCO adjustment applies in the calculation of a contract profit rate if, at the time of the agreement, the primary contractor is party to, or proposes to enter into, a group sub-contract

SSRO guidance: Time of agreement

4.5

Regulation 12(2) sets out that the POCO adjustment is zero if the Secretary of State is satisfied that the Allowable Costs of the qualifying defence contract have already been decreased by an amount equal to the attributable profit on all group and further group sub-contracts.

4.6

Regulation 12(3) sets out that, where the Secretary of State is not satisfied that the allowable costs have been adjusted to remove an amount equal to the attributable profit, a POCO adjustment may be agreed. The purpose of this guidance is to provide a consistent methodology for contractors and the Secretary of State to follow when agreeing a POCO adjustment.

4.7

The diagram below demonstrates when a POCO adjustment should be made.

Flowchart setting out the requirements of paragraph 4.4 to 4.6. — When a POCO adjustment is made.

Determination of the POCO adjustment

4.8

The information upon which the POCO calculation is constructed is likely to be held by the prime contractor and their group sub-contractors and not the Secretary of State. In such cases, in order for the parties to reach an informed agreement as to the POCO adjustment:

the prime contractor should propose the POCO adjustment to the Secretary of State, supported by the facts, assumptions and calculations relied upon; and
the Secretary of State should scrutinise those matters and request any further information required to form a view as to the amount by which the contract profit rate must be decreased in order to exclude attributable profit that has been included.

4.9

The table below demonstrates the process that contractors and the Secretary of State must have regard to when agreeing the POCO adjustment amount. Please refer to paragraph 4.10 onwards for a glossary of the terms used. And please refer to Appendix B for a high-level worked example of the process to aid users.

Stage	Process	Calculation
1	Document the expected contract supply chain, identifying all the group subcontracts and further group subcontracts to which the POCO adjustment applies. Note the total Allowable Costs (used for the purposes of the pricing formula) for each contract.
2	Calculate the contract profit rate (before the application of step 3 (POCO) and step 6 (CSA), where applicable) for the primary contract (CPR_P). Calculate the attributable profit rates for each group sub-contract and further group sub-contracts) identified at stage one (CPRS_i).	CPR_P CPRS₁ CPRS₂ …… CPR_Si
3	Multiply total Allowable Costs identified at stage one for the primary contract (AC_P) by its contract profit rate (before the application of step 3 (POCO) and step 6 (CSA), where applicable) (CPR_P) calculated at stage two. Multiply total costs identified at stage one for each group sub-contract and further group sub-contract (ACS_i) by their respective attributable profit rates (CPR_Si) calculated at stage two. The result is the profit for the primary contractor (π_P) and the attributable profits of each group sub-contractor (π_Si) (net of POCO adjustment and CSA where applicable).	AC_P x CPR_P = π_P AC_S1 x CPR_S1 = π_S1 AC_S2 x CPR_S2 = π_S2 … AC_Si x CPR_Si= π_Si
4	Sum the profits calculated at stage three to determine the total group profit (net of POCO adjustment and CSA where applicable). This comprises the profits of the primary contractor (π_P) and the sum of all attributable profits for all group sub-contractors (Σπ_S).	πP + π_S1+π_S2+π_S3…=π_P + Σπ_S = Σπ
5	Note the total Allowable Costs of the primary contract (AC_P) and subtract from it the sum of the attributable profits for all group subcontract (Σπ_S) calculated at stage two.	AC_P -Σπ_S = AC*
6	Multiply the value calculated at stage five by the primary contract profit rate (CPR_P) derived at stage two. This gives the target profit that the group should receive from the QDC (net of primary contract CSA).	AC* x CPR_P = π_T
7	Subtract the total group profit from stage four (before the application of step 3 (POCO)) and step 6 (CSA)) from the target profit from stage six. This is the reduction to the price that will result from the step 3 POCO adjustment.	π_T - Σπ = POCO_R
8	The POCO adjustment is the POCO reduction (POCO_R) divided by the total Allowable Costs for the primary contract identified at stage five. This is the step 3 adjustment, which will result in a reduction to the profit (or zero if no profit has been charged at lower levels).	POCO_adj = POCOsub>R / AC_P
9	Apply all adjustments (steps 1 to 6) to calculate the contract profit rate (CPR) which is applied to the total Allowable Costs associated with the primary contract. Cross check the calculated price to expectations.	AC_P + (AC_P x CPR)

Glossary of POCO terms

4.10

As set out in regulation 12(5), “group sub-contract” means a contract:

where the price payable under which includes an amount of profit
which is made between the primary contractor and any person associated with the primary contractor
where the value of which is no less than £100,000
where the award of which was not the result of competitive process (as defined in regulation 59 or 60); and
where the goods, works or services to be provided under the contract are necessary to enable the performance of the qualifying defence contract.

4.11

As set out in regulation 12(6), “further group sub-contract” means a contract:

where the price payable under which includes an amount of profit
which is made between two or more persons, each of which is associated with the primary contractor or a group sub-contractor;
where the value of which is no less than £100,000
where the award of which was not the result of competitive process (as defined in regulation 59 or 60); and
where the goods, works or services to be provided under the contract are necessary to enable the performance of a group sub-contract or further group sub-contract.

4.12

As set out in regulation 12(7) to (8), the “attributable profit” is:

where all of the output of a group sub-contract or further group sub-contract is necessary to enable the performance of the qualifying defence contract, all the profit element in the price payable under that group sub-contract or further group sub-contract; or
where only part of the output of a group sub-contract or further group sub-contract is necessary to enable the performance of the qualifying defence contract, that part of the profit element in the price payable under that group sub-contract or further group sub-contract which relates to the output necessary for that performance.

However, attributable profit does not include:

any capital servicing adjustment made under step 6 of regulation 11; and
any profit which is received by a person which is not associated with the primary contractor.

4.13

As set out in regulation 12(10), a “group sub-contractor” means a person with which the primary contractor makes a group sub-contract.

Appendix B: Worked example of POCO adjustment

B.1

To calculate what the POCO adjustment is, apply the stages that have been described in the main body of this document.

B.2

The diagram below reflects Stage 1 of the methodology, with profit applied at the supplier’s rates at each level. These figures are used in the calculations that follow.

Expected contract price.

B.3

The diagram below reflects the expected price of the contract if profit on allowable sub-contract costs is only applied once as per section 15 of the Defence Reform Act. This is determined by:

removing attributable profit from the group and further group subcontracts directly;
consolidating the remaining SC2 and SC3 totals into SC1;
consolidating the remaining SC1 total into the primary contract; and
applying the contract profit rate for the primary contract (CPRP) to the consolidated total to determine the expected profit.

B.4

Note that a CSA is not part of attributable profit. The values for CSA are taken from the diagram under B1 rather than being calculated from the adjusted sub-total.

Expected contact price. — Expected contract price.

Note: The annotations on this page are applied to underlying text taken from version 7.2 of the Contract profit rate guidance, available at ssro.gov.uk. Errors or ommisions can occur, or updates may not be reflected. Always check the source document.