Capital servicing adjustment (step 6)

7.1

Section 17(2) of the Act, and regulation 11(7), set out the requirement for the capital servicing adjustment:

“Take the amount resulting from step 5 and add to or subtract from it an agreed amount (“the capital servicing adjustment”), so as to ensure that the primary contractor receives an appropriate and reasonable return on the fixed and working capital employed by the primary contractor for the purposes of enabling the primary contractor to perform the contract.”

7.2

Regulation 11(8) requires that:

“In agreeing the capital servicing adjustment, the primary contractor and the Secretary of State:

1. must have regard to the capital servicing rates in force at the time of the agreement;
2. must not apply any adjustment in respect to any costs of the fixed and working capital employed by the primary contractor which are Allowable Costs under the contract; and
3. may use an average fixed and working capital for any business unit which is likely to be performing the primary contractor’s obligations under the contract.”

7.3

The SSRO has provided separate guidance that will assist the contracting parties to determine the time of agreement for a particular QDC or QSC.

7.4

The three capital servicing rates published by the Secretary of State that are in force for the financial year commencing 1 April are:

7.5

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 capital servicing 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.

7.6

The calculation of the contract profit rate must include consideration of the capital servicing adjustment, although it is clear that the permissible adjustments include 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 capital servicing adjustment.

7.7

In the calculation of the baseline profit rate (step 1) the comparator company data is adjusted to remove the effect of capital servicing and so sets a baseline upon which Step 6 can be applied for a contract. This process is set out in SSRO (2019) Single Source Baseline Profit Rate, Capital Servicing Rates and Funding Adjustment Methodology.

7.8

This guidance sets out the approach that should be followed to calculate the capital servicing adjustment using a ratio of capital employed to the total cost of production (CP:CE ratio) of a relevant unit of business which is likely to be performing the contractor’s obligations under the contract (the CSA calculation).

7.9

The next sections of the guidance set out the calculations of capital employed and of cost of production, which are required for the CSA calculation. The diagrams after that guidance set out the four computations to be performed. A simple worked example is described at Appendix C to this guidance.

7.10

The CSA calculation ensures the contractor receives an appropriate and reasonable return on the fixed and working capital employed by the contractor for the purposes of enabling it to perform the contract. On this basis borrowing costs should not form part of Allowable Costs.

7.11

The CSA calculation assumes that the capital intensity of the unit of business (that is the ratios of its fixed and working capital to its cost of production for a given period) is equivalent to the capital intensity of the contract. This assumption is a reasonable estimate because a unit of business will normally perform many contracts of a similar nature under similar conditions and it is therefore reasonable to expect that the QDC or QSC will be performed on the same basis with equivalent capital requirements.

7.12

The contractor and the Secretary of State must use the information of the unit of business which they agree is most relevant to the contract. This may be a subsidiary company, division, business unit, or site location, and is selected based upon professional judgement. If reliable information cannot reasonably be isolated to a unit of business the information of the contractor’s business as a whole may be used.

7.13

The calculation has two components: the capital employed and the cost of production. Both components should be derived from the same financial records or should be adjusted to ensure they are on the same basis. For example, if cost of production is derived from the information supplied during the course of the assessment of cost recovery rate claims, such as financial or management accounts, then components of capital employed, for example manufactured inventory, may need adjustment to ensure they are valued on the same cost basis.

7.14

Regardless of which financial periods are described in the records from which data is drawn to determine the capital employed and cost of production, the capital servicing rates to which the relevant parties must have regard are those in force at the time of the agreement, not those relating to any other period.

Calculation of capital employed

7.15

Capital employed is the debt and equity necessary for a unit of business to function. Directly calculating this may be difficult because a unit of business may not separately report the debt and equity necessary for a business to function from other debt and equity. Capital employed is instead indirectly calculated with reference to the equal and opposite balance sheet items for which more granular information is available.

7.16

Capital employed should be computed as the total assets less total liabilities, excluding interest-bearing liabilities, of the business unit.

7.17

Capital employed is the average capital employed over the same period used to determine cost of production. At a minimum this is the average of the opening and closing position.

7.18

The capital employed is adjusted to remove elements that are not part of normal operations, are equivalent to debt, or would not result in an appropriate result if included in the calculation. These adjustments seek to achieve a result that, when taken with the cost of production as a ratio, approximates the capital intensity of the contract as closely as is practicable.

7.19

The initial definition of capital employed is total assets less total liabilities, except for interest-bearing liabilities. The following items should then generally be excluded:

1. items not representing capital employed in normal operations, for example:
1. goodwill, brands and customer lists acquired in a business combination;
2. fair value adjustments that did not require additional input of capital, for example, the upward revaluation of tangible and intangible assets;
3. investments in shares and securities;
4. loans to or from other companies, including non-trading balances with group entities;
5. assets held for sale and idle assets not required for the normal operation of the business; or
6. cash that exceeds the amount required for normal operations. Normal operational requirements might include holding cash for the purpose of meeting liabilities included in the calculation of capital employed;
2. items that are indirect ways of raising capital that should be treated as debt equivalents, for example:
1. deferred tax assets or liabilities; or
2. retirement benefit surpluses or obligations; and
3. other items whose inclusion would not result in an appropriate step 6 adjustment.

7.20

Where cash is held in a group pooling arrangement outside the balance sheet of the unit of business used for the calculation, a value of cash required for normal operations of the business unit may be included as an element of capital employed.

7.21

Exceptional further adjustments may be agreed with the Secretary of State if they can be reliably estimated and have a material impact on the result. Any adjustment will depend on the information available and the specific circumstances of the contract being delivered. Examples of such situations are:

1. where a pervasive change is expected to occur that will affect the capital employed of the unit of business; or
2. where considering the timing of a significant transaction during the period will give a more precise average.

Fixed and working capital

7.22

To calculate the split of capital employed between fixed and working capital employed a contractor should identify balance sheet items that are fixed in nature; this will generally include items that are held for more than one year. This ‘fixed capital value’ figure is subtracted from the capital employed and the balance is the ‘working capital value’, which may be positive or negative.

7.23

Adequate justification should be provided to support the calculation of both fixed and working capital. In determining what type and standard of information is required, the relevant parties should take a proportionate approach considering:

1. the specific requirements and circumstances of the contract;
2. the materiality of particular components of the calculation; and
3. what it is reasonable to expect would be available.

Calculation of cost of production

7.24

Cost of production is the cost incurred by the functioning of a business before financing charges.

7.25

Where the period to which the cost of production relates is not one year, an equivalent annual value should be computed because the capital servicing rates to which the CP:CE ratio is applied are an annual rate of return.

7.26

The initial definition of cost of production is operating revenue less operating profit/loss. The following items should then generally be excluded:

1. borrowing costs;
2. costs related to items excluded from capital employed; and
3. costs whose inclusion would not result in an appropriate Step 6 adjustment.

7.27

Where exceptional adjustments have been made to capital employed in accordance with paragraph 7.21, a corresponding adjustment to cost of production may be required.