The Russian Ministry of Defense is attempting to pour old wine into new wine bags

13.01.2012 — Analysis

The RF Ministry of Defense has announced that in 2012 arms and military equipment will be supplied according to the new rules. Defense Minister Anatoly Serdyukov believes that due to the transparent pricing mechanism manufacturers will be able to perform contracts on time, and the army will be technologically rearmed. In the meantime, the manufacturers have informed the RusBusinessNews columnist that they do not have any definite information regarding the essence of changes. The ongoing campaign aimed at winning contracts for 2012 demonstrates that hardly anything has changed in the system of government defense orders, while it is too early to talk about large-scale modernization. More than that, if the existing model of purchasing is going to be retained, the government order for supplies of arms and military equipment is doomed to fail in the new year.

Three government agencies are involved in the process of setting prices for military products in Russia: the Ministry of Defense defines the initial price of the contract, the Federal Tariff Service defines the profit margin, and the Ministry of Economic Development is responsible for the deflator index. The work of these three organizations lacks coordination: For several years they cannot arrive at the decision which of them is in the driver's seat in establishing the unified regulatory framework governing the process of the government defense order.

Until recently, the price for military products has been defined by estimation of industrial costs and company profits. Back in 2006, the Federal Tariff Service decided that the minimum profit margin would be 5%, whereas the maximum profit margin would be equal to 20%. The appointment of Anatoly Serdyukov as the Minister of Defense ushered in the army reform that affected purchasing prices for arms and hardware. The military authorities began to set preliminary contract prices, which were often adjusted downwards at the end of the year based on the actual costs of manufacturing companies. Manufacturers were no longer interested in fulfilling government defense orders: The analysis of the RF Ministry of Industry and Trade showed that from 2008 to 2010 the profitability of military contracts decreased by 25-30%.

Mikhail Pogosyan, the president of the United Aircraft Corporation, OJSC, speaking during the hearings at the Public Chamber of Russia, warned that the rates offered by the Ministry of Defense were not efficient, as the ministry did not take into account a number of costs. The production cost does not include insurance payments for testing of aircraft equipment, design supervision of manufacturing to assure quality, expenses on special-purpose equipment required for research and development work, expenses on payment of royalties to design engineers developing new models through their own efforts, etc. As a result, the target profitability of 11.5% goes down to 4.7% during the development of aeronautical products. When the vehicles and equipment are supplied, the profit margin can sometimes be negative.

Repair and maintenance of military aircraft are also unprofitable: A large-size order cannot be fulfilled without expansion of production in a number of areas and investment in re-equipment; however, the existing legislation prescribes that manufacturers must spend not less than 40% of the relevant funds from their own sources. Under such conditions, no upgrading can be talked about: According to M. Pogosyan, the profit margin required for expanded reproduction should be at least 15%.

The barrage of criticism from manufacturers forced the Ministry of Defense to embark on development of new rules for making orders for military products. Anatoly Serdyukov stated that manufacturers would be allowed to plan for a 20% profit margin for their own products and 1% - for purchased products. At the same time, the minister stipulated the following condition: The received profit must be spent on upgrading of production, improvement of performance characteristics of weapon or on increasing of labor efficiency. Behind the scenes representatives of the Ministry of Defense talked about their readiness to agree to a 35% profit margin, provided that enterprises disclose the actual production cost. The new model was approved by Russian President Dmitry Medvedev; however, no official document has been issued so far. Nevertheless, half a year ago, A. Serdyukov informed that the pricing mechanism would be transparent; thus, contracts will be signed with all suppliers of military products by the end of December.

The reality turned out to be different from the minister's forecast. Vladimir Schelokov, the general director of the Union of Defense Industry Enterprises of the Sverdlovsk Region, in his conversation with the RusBusinessNews columnist assumed that the situation with government defense orders would remain obscure till February. The Ministry of Defense has not given any clarification regarding the new procedure of signing contracts. Manufacturers do not understand the algorithm of implementation of the announced initiatives. V. Schelokov has heard nothing about a 35% profit margin.

The representatives of the Almaz-Antey Concern, OJSC, told the RusBusinessNews columnist that the defense authorities had agreed to sign long-term contracts for supply of hardware requiring long-time manufacturing and to make advance payments so far. Experts are not willing to overestimate the significance of these moderate initiatives.

Ivan Grachev, a deputy of the RF State Duma, pointed out the fact that the prices for electrical energy for Russian manufacturers exceeded the American prices in 2010. According to him, if the US government intends to retain the current prices for energy commodities and raw materials for the next 15 years, the Russian government is planning to increase them two times in the next 10 years. The Ministry of Defense does not take into account industrial inflation in contracts for military products, though, based on the official data, the inflation is 24% a year. Consequently, not to lose their competitiveness, Russian manufacturers have to cut down investment, thus jeopardizing the entire manufacturing industry and driving it into collapse.

Experts do not show any enthusiasm about the officials' proposal about a 20% profit margin. Alexander Brindikov, head of the advisory group at Rosoboronexport, OJSC, speaking during the hearings at the Public Chamber of Russia, said that the proposed solution would have an adverse impact on cooperation among enterprises, which took so much effort to be restored after the chaos of the 1990s. The new formula, in fact, will bring the industry back to the times of subsistence economy. However, the main concerns are that the military authorities, while imposing archaic relationships on the domestic market, demonstrate an absolutely different behavior on the international market.

According to A. Brindikov, no one required any profit margin when Israeli unmanned aerial vehicles were supplied to Russia. No questions were asked about profit margins of the French manufacturer of Mistral helicopter transport ships; the negotiation agenda included only the price. The expert thinks that the same scenario should be used by the Ministry of Defense in its relationships with Russian manufacturers. It will require a complex contraction system, but it should be done: Military contracts are far from being simple in other countries as well.

In Russia manufacturers hardly ever participate in development of laws pertaining to the contracting system. According to Oleg Bochkarev, a representative of the RF Military and Industrial Commission, the Ministry of Defense suppresses industry administratively. Employees of the military Department for Pricing Policy, taking advantage of the fact that enterprises show different labor input and overheads, set, at their own discretion, prices that are profitable only to them.

Sergei Dovguchits, the director of the Department for Development of the Defense Sector at the RF Ministry of Industry and Trade, thinks that the military authorities should motivate manufacturers in developing new products by compensating them for part of the incurred costs and by distributing risks between the customer and manufacturer. However, such practice does not exist: The experience of 2011 and the launched campaign for signing contracts for 2012, as he says, have not evidenced soundness of the statements made by the Ministry of Defense regarding incentives for modernization of industry and expanded reproduction of military products. The participants of the meeting at the Public Chamber are sure that if the existing practices for awarding contracts remain unchanged, the government defense order for 2012 is going to repeat the failure of 2011.

Vladimir Terletsky