Putting Numbers on Capabilities: Defence Inflation vs. Cost Escalation

This article was external pageoriginally publishedcall_made by the external pageEuropean Union Institute for Security Studiescall_made in external pageIssue Brief No.27call_made on 24 July 2015.

Imagine a world without weapons: no battle tanks, no combat helicopters, no nuclear submarines – a world at peace, presumably. This world might soon come true if we believe what US aerospace businessman Norman R. Augustine famously pre-dicted in 1983, namely that “in the year 2054, the entire [US] defence budget will purchase just one aircraft”. Very little has changed since then: costs for defence equipment are still skyrocketing while, in parallel, defence budgets have largely slid into a downward spiral. The world, however, has hard-ly become more peaceful – especially in Europe’s neighbourhood. As a result, a better understand-ing by policymakers of the relation between (crip-plingly) expensive capabilities and complex secu-rity challenges appears to be much in need.

Spiralling costs

The assumption that the defence sector suffers from comparatively higher inflation rates and cost escalation than the general economy is hardly new. In 1983, academics Kirkpatrick and Pugh found that the unit costs of UK combat aircraft had in-creased by more than 8% per year since the end of the Second World War. Pugh later updated this estimate to be 10% for the period between 1952 and 1976, and 11% between 1955 and 2005. Following these early findings, much research has been conducted on defence costs – with differing results.

While more recent studies find that cost escalation figures are lower than early empirical work sug-gested, all of them provide evidence that above-average cost growth is a persisting and universal phenomenon that affects a large variety of military equipment. Cost increase is generally believed to be lowest (1%-4%) for main battle tanks, small arms and frigates, and highest (6%-11%) for transport and fighter aircraft, infantry fighting vehicles, and submarines.

The consequences are already visible: expenditure for both equipment procurement and research and development (R&D) has fallen in real terms since 2006, but spending on R&D has seen the more dramatic decrease – by 12% more than equip-ment procurement and by 35% in total. Likewise, spending for R&D as a share of total investments has declined proportionally to defence equipment procurement expenditure. This has practical impli-cations, too: procurement programmes are smaller, and order books – as seen with Europe’s A400M transport aircraft and the F-35 Joint Strike Fighter – are shrinking. As a result, keeping military equip-ment cutting-edge is increasingly tough and bur-dens already tight budgets.

Differing concepts – and results

Despite the obvious importance of spiralling equip-ment costs for European defence planning, the phe-nomenon is little understood. Defence inflation, cost escalation and cost growth are the terms which are mainly used to describe price variations in the de-fence sector. They do not measure the same factors, however, and the conclusions which follow from them tend to differ.

Defence inflation as it is currently measured (by the UK Ministry of Defence, for instance), gives the in-crease in prices for all goods and services covered by the defence budget. In contrast to output inflation in-dicators, such as the GDP deflator, defence inflation is an input measure, which holds constant the quan-tity and quality of the goods and services included. Because it does not account for productivity and effi-ciency gains, it generally displays higher growth rates than general inflation indicators. Cost growth, on the other hand, arises through overoptimistic forecasting and planning, as well as changing requirements dur-ing the development and production phases of a spe-cific defence project. Last but not least, cost ­escalation occurs if new generations of weapon systems are purchased in reaction to a changing security environment.

Cost escalation and cost growth

Most research to date has centred on cost escalation and cost growth of military equipment – and the driv-ing forces behind them. There are a number of factors which contribute to cost increases in the defence sec-tor. One is the imperfectly competitive structure of the defence market, which features only a few num-bers of suppliers and typically only one main cos-tumer, the defence department. Others include the relative value of defence equipment, which has to be superior to those of potential rivals, and the continu-ous struggle to acquire (costly) cutting-edge military equipment. Lastly, preferential arrangements favour-ing national industries also tend to distort prices.

Recent defence projects show evidence of these nega-tive forces. Initially set to cost €20 billion, quarrels over extra requirements for Europe’s A400M Atlas programme (as well as the quest for preferential in-vestment decision which led to the establishment of a European engine consortium) meant that the project is now running years behind schedule and €10 bil-lion over budget. To keep costs within specified lim-its, European governments cut the size of the project from a total of 196 ordered transport aircrafts to 174, thus further driving up unit costs.

Cost escalation of weapon systems is not an exclusive-ly European problem: military planners on the other side of the Atlantic are racking their brains over how to control the same inefficiencies and cost increases of acquisition programmes, too. A 2014 report by
the US Government Accountability Office showed that almost half (42%) of the major weapon acquisi-tion programmes of the US Department of Defence in 2013 experienced an increase of unit costs by 25% or more – and a schedule overrun of 28 months on average.

Do figures hide more than they reveal?

Countermeasures have already been taken to face up to these challenges. The 2009 EU defence pro-curement directive and the European Commission’s 2014 roadmap ‘A New Deal for European Defence’ aim to increase cooperation between member states, promote competitiveness, and reduce national pro-tectionism and the fragmentation of defence markets in Europe. Some positive effects can already be seen. The introduction of a common licensing system, for instance, now facilitates the transfer of defence-relat-ed goods between member states.

More collaborative projects in development, pro-duction and maintenance of weapon systems, so the logic goes, are key to ensuring that European defence remains credible. Cooperation promises savings through economies of scale, shared develop-ment, production and maintenance costs, as well as through the common use of training and logistical fa-cilities. And yet, duplication of weapon systems and the fragmentation of the defence market still persist. Overall, European states have almost four times the number of platforms and systems in use than the US and some remain reluctant to forge closer and deeper cooperation.

If Augustine’s prediction is in any way accurate, how-ever, inefficient weapon programmes will become unaffordable from a financial perspective and risky from a security point of view in the long run. After all, a world in which security threats have become more diverse and diffused does not offer a choice be-tween quantity and quality. Matching numbers with capabilities is a necessity: sending a naval ship to fight pirates in the Horn of Africa is of little use with-out the helicopters needed for the operation – and a single aircraft obviously cannot be present in two theatres at a time.

That said, cost escalation hype can easily lead to false conclusions and uncoordinated efforts in the pursuit of savings. The problem runs deeper and requires more complex responses than cost escalation figures may indicate. Cost escalation estimates are essen-tial for European military planners to determine the programming and budgeting of defence equipment. They provide information on the likely cost growth of weapon systems and are crucial in attempts to an-ticipate how many new capabilities can be acquired with the resources available. Yet, because cost escala-tion estimates do not take quality changes into ac-count, they do not provide any information on how effective the purchased capabilities are, whether they make a nation more secure and whether they are able to thwart the threats which they are intended to tack-le. In short, such figures show absolute price changes of weapon systems but do not disclose their relative value and effectiveness. In fact, research conducted for the UK Ministry of Defence and the latest figures of a study by Hove and Lillekvelland reveal that once changes in characteristics and quality are adjusted for, cost escalation estimates tend to fall.

For example, a 2009 report by RUSI shows that al-though the size of the UK fleet of combat aircraft has shrunk by 40% in absolute terms since the end of the Cold War, those of Russia and China have fallen by more than 70%. Hence, UK air capabilities in-creased in relation to those of the other two pow-ers. The variation in the number of deployable and sustainable forces is another indicator which pro-vides some insight into military efficiency: absolute numbers of military personnel of the 27 European Defence Agency (EDA) states decreased by 26% be-tween 2006 and 2013, but the share of deployable land forces increased by almost 12%, and that of sus-tainable land forces by almost 3%.

Measuring defence output

Getting a better sense of the relative effect of capabili-ties, the security which military equipment provides and, more broadly, the benefits of spending on de-fence would obviously be valuable for defence analy-sis, planning, programming and budgeting – but it is also of interest to the general public. Yet there are several difficulties with the construction of an output measure for defence, something which has hindered the development of such an indicator so far.

Clearly, measuring peace, national interests, the pro-jection of power and the protection from terrorist at-tacks with numbers is a tricky undertaking. Equally problematic is how to measure the added value of defence expenditure, a process which would re-quire determining the costs and consequences of not spending on defence – i.e. measuring the counterfac-tual. Another problem is that the performance of de-fence services is always relative: capabilities not only need to be assessed against the changing capabilities of and threats posed by potential rivals, but their efficiency also depends on the capabilities of allies when they are used in common operations. Due to these difficulties, the only publicly available defence inflation measure in Europe – used by the UK – fol-lows the input=output convention which measures defence output according to the volume of input and does not take quality changes or relative effectiveness of capabilities into account.

Despite these obstacles, recent advancements through the calculation of quality-adjusted cost escalation figures demonstrate that progress in this direction might be cumbersome but is not impossible. From a practical viewpoint, the Capability Development Plan produced by the EDA – which addresses capa-bility challenges based on future scenarios – is just as valuable. Ultimately, while measuring defence per-formance is a remote goal, a rational assessment of defence capabilities in their respective security en-vironments, backed up by thorough defence plan-ning and efficient procurement, is essential. That is, as long as it remains uncertain that tomorrow’s world will be peaceful.