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26 Mar 2014|

Financial planning?

Over the past two decades, Defence has staggered from one budget crisis to the next, trying to afford the unaffordable.

Of the five White Papers issued between 1976 and 2009 for which ex post fact evidence is available, only the Howard Government’s 2000 effort was funded as planned. All the rest ended up delivering substantially less money than promised. To make matters worse, for most of the period in question, Defence was planning beyond its means anyway, by systematically underestimating both its acquisition and recurrent costs. Thus, even if promised funding had been forthcoming it would’ve been inadequate for the task. Defence’s plans were damned twice over.

In practice, there’s little that can be done to force governments to keep their commitments; politicians routinely break promises. On the other hand, it should be possible to curtail the habit of underestimating costs. With a new White Paper underway, now’s a good time to start.

The problem is hardly unique to Australia; one of the ‘key drivers’ of the UK’s 2010 Levene inquiry into structure and management of the Ministry of Defence was ‘the Department’s over-extended programme’. It was no mistake that Lord Levene mentioned ‘affordable’ or ‘affordability’ 32 times in his report. Overly optimistic planning leads to wasteful cycles of overinvestment followed by underinvestment as financial reality overtakes military fantasy.

Levene’s solutions for the United Kingdom are largely built around improved governance and accountability. But while such approaches are likely to be valuable to Australia in the longer term, the clock is already running on the 2015 White Paper; we need practical measures now to ensure that the resulting plan for the ADF is affordable.

The good news is that we aren’t starting with a blank spread sheet. Over the past decade, Defence has made steady progress in understanding its current and future costs. The sorts of egregious underestimates of acquisition costs that appeared back in the 2001 Defence Capability Plan (DCP) are much rarer today. At the same time, the ongoing refinement of Defence’s budget has led to a better understanding of recurrent costs than in the past. These are firm bases upon which to build.

Nonetheless, the government should treat Defence’s cost estimates with great caution. Two interplaying factors predispose the organisation to systematically underestimate its costs.

Firstly, Defence’s civilian and military leaders are positive ‘can-do’ optimists. Nothing out of the ordinary there—most large organisations are led by similarly incautious souls who got to where they are by doing rather than naysaying (helped by a survivorship bias towards those who are lucky enough not to fail at a prior point in their career and are hence unjustifiably confident).

Second, and more importantly, moral hazard comes into play within Defence. Proponents of individual projects—for example the RAAF seeking a new fleet of aircraft—have an incentive to underestimate costs so as to get the project on the books irrespective of whether it’s affordable. Once a project is in the DCP it’s difficult to dislodge without political cost, and the problem of funding it becomes the taxpayer’s rather than the Air Force’s. For exactly the same reasons, industry has equally strong incentives to systematically underestimate future acquisition and support costs when answering initial queries from Defence.

The government needs to protect the taxpayer’s interests against the twin onslaught of self-delusion and deception. And it’s not simply a matter of worrying about the cost of projects in the DCP. To be affordable, the next White paper will need to take into account the cost of not just acquiring but of crewing and operating all of military capabilities in the ADF, along with their attendant administrative overheads, now and into the future. This means building a detailed model of the Defence budget.

An effective model of the defence budget would combine bottom-up estimates of the cost of individual activities—such as maintenance programs and acquisition projects—with projected trends in key cost drivers such as personnel expenses, foreign exchange rates, equipment and facilities maintenance costs. Critically, the model shouldn’t be designed to deliver a single estimate but rather to capture the spread of possible future costs given the inherent uncertainties and credible ranges for economic trends.

In some way or form, Defence will already have many of the building blocks of such a model—if only to support the annual budgeting process. But to guard against a conspiracy of optimism again delivering an unaffordable plan for the ADF, the government should ensure that the model is comprehensive and credible. There’s no shortage of consulting/accounting firms which could both assist Defence with the development of the model and warrant its robustness to the government.

Defence could also benefit from external help to understand the cost of its major programs. One way to do this would be to get independent cost estimates for the top 30 projects by value in the DCP, including the personnel and operating costs associated with new capabilities—an area that the 2011 Rizzo Report found wanting. Apart from helping to guard against conscious and unconscious internal biases, independent advice would inject additional technical rigour into the process. Estimating the cost of major projects (defence or otherwise) is a technical exercise, so outside help would certainly come in handy. To get a feel for the complexities, have a look at this 2005 study by the RAND Corporation on the UK government’s carrier project or this 2008 NASA Cost Estimating Handbook.

Amid the heady discussion of defending Australia against the myriad uncertainties of the Asian century, the question of reliable costing can easily be dismissed as a sideline. Who can be bothered with financial niceties when there’re issues of grand strategy to be discussed? Let’s hope the government can be bothered. As the Levene Report observed, reliable financial planning ‘is not a distraction from providing the capability the country needs; it is an essential enabler to it’.

Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user Images Money.