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Proposal for a Practical Offset Procedure

The author analyses the progress on offset provisions in present context and suggest some practical suggestions for achieving the objectives.

The Defence Procurement Procedure states that the key objective of the Defence Offset Policy is to leverage capital acquisitions to develop Indian defence industry by (i) fostering development of internationally competitive enterprises, (ii) augmenting capacity for Research, Design and Development related to defence products and services (iii) encouraging development of synergistic sectors like civil aerospace, and internal security. The Offset procedure has been revised several times over the past decade but it is questionable if the offset procedure has actually achieved the objectives that were set out for it.

Status of Offset Contracts
The total value of the defence offsets contracted in the last few years is valued around $ 4.8 billons. The Indian Air Force (IAF) has signed contracts worth approximately $3.615 billion (Rs 19884.7 crores), the Indian Navy (IN) worth $843.73 Million (Rs 4636.5 crores) and the Indian Army (IA) worth $24 Million (Rs 132 crores). IAF procurements have generated 80% of all offsets, with naval procurements accounting for the other 15% whereas army procurements have yielded 5% so far. These aspects are represented in the figure below.

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The activity wise spread is depicted in the chart below with manufacturing taking up 55 percent of offsets. Within manufacturing the aerospace segment have maximum offset. The major areas of offset realization are:
•    Sub contracts involving supply of fuselage, cabins, radome, tail cone, data link etc (56%)
•    Engineering projects & project management (5%)
•    Overhaul and repair facilities (15%)
•    Simulators and training facilities (17%)
•    Ground Handling/Support Equipment (7%)

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The Offset contracts were expected to be worth about US $ 22 billion (Rs 11,000 crore) in the 11th Plan (2007-12). Concluded figures, though much lower than planned, are still encouraging considering the delays inherent in contract conclusion. In addition, contract worth over $ 1 billion (Rs 5,000 crore) are at Commercial Negotiation Committee (CNC) stage and over $ 7 billion (Rs 35,000 crore) are also under process. There is over 40 offset contracts (with global armament firms who have bagged or about to clinch Indian defence deals) worth over Rs 50,000 crore under negotiation. More than 35 Indian companies, both in public and private sector would derive offset business benefits.

India aims to attract investment worth $30 bn in the defence sector over next 10 years. The cumulative market for offsets alone is expected to be almost US $ 68 bn by the end of the 13th Plan (2022) or approximately $ 130 bn by the end of the 14th Plan (2027).

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Whilst the offsets contracts look impressive the execution has woefully lagged. Between the period from 1 Jan 2008 to March 2014, only 50% of the committed offsets have been discharged. Interviews with OEMs have revealed that all OEMs are in uniform agreement that the offset contracts are not executable because of a variety of impediments and lack of pragmatism and practicality in the formulation of the procedures.

This article seeks interventions in the procedure to make Offsets deliver on the objective.
The basic metric for the success of Offsets in the Indian context is to see a visible improvement in national capability in terms of skill development along with the national capacity in terms of productivity, quality and delivery schedules to merge with the global supply chain. As can be seen so far most offsets are “Built to Print” or “Local Purchase in India” items that is more of the same thing. Also such jobs are already executable from the available industry pool and hence no real additional capacity or capability has been created. There are, of course, exceptions where major investments have been made for bringing Indian industry into the aero structure global supply chain and these have been successful. So, unless “Built to Specifications” items begin to take up most of the order books there is really no skill enhancement.

The core debate in this context is whether offsets should be buyer demanded or vendor driven. Clearly a buyer demanded offset well designed to meet a specific capacity or capability gap is best. However, since offsets are not part of the commercial value of the offer the OEM discharges offsets that create least turbulence in his supply chain. Therefore, offsets could find some place in the bid evaluation matrix if offsets are to genuinely contribute towards national aerospace and defence industry growth.

Second, offsets must be kept simple and avoid unnecessary complicated mathematics and accounting algorithms. The present set of “equations” that are required to meet with offset conditions are summarised below, where the subscript for each offset refers to the sub-para of the “avenues for discharge of offset Obligation” as given in the defence offset guidelines (eg . O3A refers to Offsets discharged under Para 3(a) of the guidelines.
Thereafter, the OEM has to meet the compliance conditions of each offset discharge avenue under the relevant sub paras of Para 3 of the guidelines as stated below:-

O3A + O3B + O3C + O3D > 0.7* OF
O3D > 0.4*Investment in Kind for Eqpt
O3c > 0.1*Buy back of products and services
For O3A eligible value will be :-
V3A = Tc  (CIC + CR) subject to indigenous content certified by CFO
Where
V3A is Value of offsets under para 3(a)
Tc is the total cost
CIC is indigenous content cost
CR is royalty cost

When such calculations have to be performed for 30 IOPs spread over 7-8 years the futility of this unnecessary complex exercise should become evident. An example for a simple case of 4 Vendors with one each IOP is tabulated below to illustrate the complexity of offsets allocation by the OEM and its monitoring by DOMW.

Offset Program (% Contents)

Year1234567Total
Vendor 1   0.03  0.09  1.23   3.1    0.57   1.24   0.01  6.27
 Vendor 2  0.9  0.8  0.8   0.8   2.8    0.8   0.2   7.1
 OEM  1.2   0   1.7    1.8    1.9    2     2.5   11.1
 Vendor 3   0.01   0.03   2.5   2.6   0.39   0   0  5.53
 Total 2.14  0.92   6.23   8.3    5.66   4.04   2.71   30

The Table below further elaborates on the effect of multiplier (M) and contract values (V) to make the monitoring process even more complex.
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After these calculations are performed the condition of “proportionate work share content” has to be met which are shown in the last column of the above table:-
(O3A + O3B + O3C + O3D) /OF> VT1/P
Where VT1 = Vendor 1 workshare
And P = Total Program Cost

This situation is in the simple case when there are three Tier 1 Vendors and the OEM. Imagine the complexity of these rules should there be 16-20 Tier 1 Vendors with some vendors having a workshare content of about 1.875%-3.015%!! Obviously, these procedures must be simplified more for the good of the DOMW than the OEM!

Offsets are a cost to the OEM. Also, it is well known that the time period from RFP issue to award of contract is generally indefinite and may well last as long as 7-8 years and typically may take about 5 years to conclude contract on average. Therefore, requiring OEMs to submit technical and commercial proposals “normally three months from the date of submission of the main technical and commercial proposals” is absurd since by the time these proposals are evaluated tectonic changes in technology (manufacturing and materials for example and Moore's law for electronics apply) and vendor profiles (merged, acquired, renamed or liquidated) would have occurred rendering the initial proposal outdated and usually unimplementable. Also, during the execution of the contract itself further changes in technology and vendor profiles may also occur. Therefore, there is good sense in keeping the execution of offset contracts flexible. The requirement to furnish the undertaking as a sina quo non for continued participation of the vendor in the procurement process should be adequate to proceed with the acquisition case.

Unless offsets have a commercial “value” in determining the L1 vendor there should be really no requirement for all vendors to submit technical and commercial offsets proposals. Only the L1 vendor should require to submit not just the offset proposal but the purchase orders on the Indian Offset partners. Ofcourse the offsets structure should be aligned with the offset procedures enumerated in the current Defence Procurement Procedure and not the DPP under which the RFP was initially issued. This would also reduce the needless workload on the DOMW in futilely evaluating offset proposals of all bidders; compress the acquisition time frame; and, make offset proposals aligned with the current and better developed offset policy and defence procurement procedures.

Offsets must remain the sole responsibility of the OEM alone. So long as the offset requirements are clearly and unequivocally complied with details such as participating partners and vendors, respective workshare etc are inconsequential and do not add any value to creating robust business or industry in India and are counterproductive to the stated objective simply because they do not provide the scale that can support sustainable business operations.

The OEMs in-house direct material and direct labour component would rarely exceed 25-30 % of the cost of the aircraft. The balance 70-75% would be sourced from Vendors. Usually there may be at least 70-100 Tier 1 vendors to a modern aircraft OEM. As an example the communications package of a typical transport or utility aircraft is worth only about 1.85% by value of its total cost. This 1.85% may be spilt between 3-4 vendors supplying various specialist equipment. Now as per the extant guidelines the offset share would be about 0.22-0.43% of the total cost for each communications equipment vendor. But say the supplier, whose share in the aircraft is only 0.21% but his equipment are also on other aircraft operating not only in India but in the region, seeks to make a major investment to set up say manufacturing in India which requires say 2.1% of the offset package is not encouraged to do so since the amount of 1.89% (2.1-0.21) is not helpful to the OEM in meeting his total offset requirements and hence this restriction would cause the nation to perhaps lose a manufacturing facility since the offset would be inadmissible. This salami slicing rigorous accounting approach to offsets should be done away with and the OEM should be held accountable finally for the total offset obligation irrespective of workshare and vendors issues. The point is that OEMs and the DOMW must have the flexibility to leverage offsets to deliver meaningful sustainable business cases which caters to not only the domestic but also to the global market and thus boost manufacturing in India. Also, monitoring many many small values offset contracts, because of the restriction of Tier 1 vendor and workshare limits, is a needles burden on DOMW.

Another example to illustrate the point could be say in the case of an aircraft OEM where the OEM has won a contract and is now fulfilling his offset obligations. To convert this into an opportunity the OEM may decide to leverage his obligations and consolidate the activities of one of his Tier 1 Vendors to “make in India” not only products specific to the program but to the entire product range of the OEM. Now if the Tier 1 vendor is not a vendor to the specific product he becomes ineligible and once again an opportunity to create a facility of global scales earning valuable foreign exchange and job creation is lost. The following are proposed:-

a. Tier 1 Vendor to the OEM should be company specific and not program/product specific.
b. No limitation of workshare content in establishing vendor content in offsets.
c. Banking of offset credits should be tradeable between OEMs.
d. Offset proposal should only be sought from the L1 vendor.
e. The offset discharge option must be more flexible to allow for technology upgrades and business environment and both OEM and DOMW must commit to a best effort basis for meeting the key objectives of offsets.

In conclusion, the offset guidelines may derive best value if the guiding principles are pragmatic. The first principle is to abandon a clerical and accounting approach but instead embrace a capability and capacity building approach. This would require the offsets to be buyer demanded and not vendor driven. The associated principle could be to adopt a consolidated approach to offsets as a national industrial development requirement in which case the offset proposal would be evaluated commercially and banked offset credits could be traded between OEMs. The second principle should be to avoid complexity and introduce simplicity and this may be achieved by reducing the complexity of conditions, intricate sub conditions and difficult formulae. This would mean that once the offset requirements have been communicated to the Vendor the execution options are left to the DOMW and OEM on a “best effort” basis.

Monitoring would still be undertaken by the DOMW as hitherto but would be a lot less complex more transparent and less intricate than the present situation. The third principle should be to reduce infructuous work on both the Vendor and Buyers side (if commercial consideration of offsets proposals are not acceptable), and therefore offset proposals must only be sought from the L1 vendor though “undertaking” to fulfill offsets requirements would need to be provided by all participating vendors.

Essentially, unless there is a sense of bonding and trust between the buyer and the seller offsets will not achieve the desired aim of rapid industrialization. Fortunately, Buy and Make Indian categorization is on the rise and hopefully offsets will soon belong to a bygone era. But as argued in an earlier article Buy and Make Indian is unlikely to succeed unless the DNA of the DPP is dramatically and purposefully changed from it's present Buy Global to a “make in India” focus. Until then keep offsets pragmatic to be achievable.

Cmde Sujeet Samaddar, NM (Retd.)

Cmde Sujeet Samaddar, NM (Retd.)

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