Filling the hollow middle in Australia’s defence industry

Ever since Covid-19 started cutting a swathe through global supply chains, countless column inches in Australia have been devoted to the need for sovereign manufacturing capabilities as a defence against future disruptions. To its credit, the federal government has heeded these calls and is supporting the development of Australian industry capability, particularly in the defence sector, with a heavy focus on small to medium-sized enterprises (SMEs).

This focus on domestic capability and the various forms of assistance from different levels of government are both welcome and necessary, particularly in the context of the economic downturn. However, a number of issues are working to hold back Australia’s defence manufacturers and prevent them from making the leap from SME to major player.

At the top of the list—ironically—is the focus on SMEs, followed closely by the Defence Department’s aversion to risk and the nature of the bidding process itself. Reforms in these areas will go a long way towards taking Australia’s defence manufacturing sector to the next level.

Australia’s defence manufacturing industry is shaped like an hourglass: there are a large number of small firms at the base, a smattering of mid-sized companies in the centre, and large foreign primary contractors at the top. The problem with this structure is that a collection of small supply chain companies doesn’t constitute a sovereign defence industry capability. While these firms provide essential products, at best they can supply projects run by larger players from overseas. What we need is a number of local primes that can integrate and sustain complex capabilities. Unfortunately, our current arrangements work against such developments.

At the moment, we have a situation where incentives for defence companies dry up as they grow larger, which can leave them in a precarious position and have the perverse outcome of discouraging them from taking on workers or even bidding for contracts they would be capable of delivering if it meant hiring more staff. Too big to be small, but too small to be big, they are trapped in the middle of the hourglass. If these firms are going to achieve the economies of scale that will allow Australia to have a truly sovereign defence industry capability, they will need to be encouraged to grow to that next level.

Distorting incentives are just one factor holding back our defence manufacturers. Another is a culture of risk-aversion within Defence that predisposes decision-makers towards having foreign primes oversee programs, with a reluctance to appoint local companies to take on larger projects.

This can result in absurd situations where a foreign prime is imposed on top of Australian companies that already have the capability, equipment, knowledge and experience to deliver projects in their own right. Defence’s efforts to mitigate any risk involved with having a smaller company deliver the product or service come at considerable cost to local firms and to taxpayers.

Examples abound of companies that have done everything the government has asked of them by investing in local jobs and local high-end technology and gearing their businesses for export. But in many cases they have found themselves ineligible for government incentives on the one hand, and untrusted to deliver by Defence on the other. Despite the difficult situation they find themselves in, companies are reluctant to complain publicly for fear of biting the hand that feeds them.

Finally, bidding for defence contracts isn’t cheap, and firms can be left significantly out of pocket following an unsuccessful campaign. Again, this counts against mid-sized domestic companies that are fully able to deliver the proposed capability but lack the financial firepower to compete in the bidding process with large foreign primes. While writing off a million or so dollars on a failed bid might be uncomfortable for a foreign prime, it can be ruinous for a mid-sized local manufacturer. That’s without taking into account the lost productivity as staff are taken away from their profit-making activities to work on the bid. Of course, on the flip side is the fact that winning a major program could be transformative to an Australian company, its workers and its supply chain.

The answer could be a subsidised bidding process, where the government underwrites the costs of qualified Australian companies and the funding is paid back by the successful bidder, while unsuccessful firms reimburse the government an amount that’s calculated based on how far they progressed in the bid. This would decrease the financial risk of bidding for programs and increase the pool of Australian companies bidding for, and winning, work.

As has been pointed out ad nauseam over the past six months or so, Australia needs to boost its manufacturing capabilities as a hedge against future supply-chain disruptions. If we are to be successful in this endeavour, it’s time for government policy to catch up with defence industry developments. We need to increase the width of the hourglass and create local primes that can partner with global industry and provide us with the best of global technology that can be built, integrated and sustained here.

That’s what a sovereign defence manufacturing sector looks like.