Abstract
The aim of this study is to numerically evaluate the performance of three schemes in incentive contracts used by the Japan Ministry of Defense for its procurement of defense equipment: Two schemes that had previously been used and one scheme that is currently being used. We formalized the transaction between the Ministry of Defense and a supplier as a principal-agent model and compared the effectiveness of providing an incentive for the supplier to exert effort for its cost reduction to the benefit of the general public in Japan. In a simple numerical study, we specified the probability distribution of the amount of cost reduction per unit and fixed the effort level so that we could interpret whether the supplier chooses to exert effort or not on cost reduction. As a result, it was found that changes in the schemes that have been made did not clearly improve the welfare of the general public and that the incentive scheme currently being used is always the best one among those three schemes.
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Notes
In the standard theory of contracts, the incentive for effort is measured with a parameter that indicates how much additional reward the principal should pay to the agent, depending on the outcome of the agent’s effort, and the main problem is to find \(\alpha\) or \(\beta _t\) (\(t=1, \ldots , k\)) that maximize the MOD’s objective function.
Note that in this model, the transaction conducted between the MOD and the supplier will not be implemented when the realized amount of cost reduction per unit (value of x) does not reach the committed amount of cost reduction per unit \(c_p\).
FMS is a procurement method for purchasing equipment, etc., and services from the U. S. government based on the Mutual Defense Assistance Agreement between Japan and the U.S.
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Acknowledgements
The authors wish to thank Rei Goto, Toshihiko Nanba, and Yasuhiro Ohta for their helpful comments on an earlier draft of this work. This paper is based on the MBA thesis of the first author submitted to the Graduate School of Business Administration at Keio University. The views expressed are purely those of the authors and may not in any circumstances be regarded as stating an official position of the Japan Ministry of Defense
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Appendices
Appendix A: Procurement of Defense Equipment
Below, we describe more about three incentive schemes noted in Sect. 2.2 in detail.
1.1 Procurement Methods
In the Ministry of Defense (MOD), the Acquisition, Technology & Logistics Agency (ATLA) handles in a centralized manner the procurement of major items (firearms, guided weapons, ships, aircraft, etc.) in accordance with the “Instructions for Procurement of Equipment and Services (Soubihin Tou oyobi Yakumu no Chotatsu Jisshi ni Kansuru Kunrei, in Japanese).” This procurement accounts for about one-third of all defense-related spending. The methods for selection of contract partners (suppliers) are categorized as follows.
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Open competitive bidding: Contract details and bidding conditions are publicly announced and an unspecified number of qualified parties participate in the bidding.
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Closed competitive bidding: A selected number of parties are invited for bids if they meet specific contract conditions, and the contract details and bidding conditions are directly notified to them.
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Private contracts: When the nature or purpose of a contract does not permit competition, or when competitive bidding is impossible due to an urgent need, or where competitive bidding is considered disadvantageous, or when otherwise stipulated by law, regulations, etc., the government may conclude a contract with a single, designated suitable party, selected according to specified conditions, after negotiations.
The Accounting Law stipulates that, in principle, procurement should be subject to competition, but a substantial amount of defense equipment is procured through private contract. Procurement of defense equipment does not lend itself to competitive bidding processes because of the requirements for special specifications and advanced technologies, and also because of applicable legal and regulatory restrictions.
The expected contract value is calculated in advance as a price estimate by the contracting officer, for use as a reference in negotiating the contract. The expected contract values serve as a kind of yardstick, or upper limit price, for anticipating the approximate successful bid price, as well as to calculate an appropriate and reasonable figure to ensure the most economical procurement within a given budget. There are two methods of calculation for this: the market price method and the cost accounting method.
Typically, the market price method is based on the idea that the market value of an item is represented by the price agreed upon by a seller and a buyer in a competitive market. The cost accounting method is used in more difficult cases, when the market price method cannot be effectively applied; it calculates production cost by adding up expenses for each component of production and then adds an appropriate profit margin on top of the cost.
In principle, the contract price should be fixed at the time of contract conclusion, but in some cases, depending on the nature of the contract, it may not be possible to finalize the contract value when the contract is initiated, or it may be inappropriate to do so. For this reason, three types of contract methods are utilized, as follows, according to conditions.
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Fixed contract: The amount to be paid to the counter party is fixed, as per the contract value.
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Semi-fixed contract: The amount to be paid is fixed within a range of contract values, in accordance with predefined criteria.
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Approximate contract: The amount to be paid is to be determined at a later date, according to predefined criteria. It is used when it is deemed inappropriate to use either of the preceding two contract types.
1.2 Statistics of the Past Results
Actual results of defense equipment procurement for FY2019 are shown in Tables 10, 11, and 12. Ignoring FMS (Foreign Military Sales), private contracts are used for the biggest (highest value) procurements, with a value of 900 million JPY per contract.Footnote 3 Similarly, excluding FMS, contracts priced using the cost accounting method account for about 70% of total procurement by value. Furthermore, contracts exceeding 200 million JPY in value account for about 92% of total contract value.
1.3 Incentive Contracts for Defense Equipment
According to the Equipment Procurement and Construction Office (EPCO) of the Ministry of Defense [4], in 1999 the Ministry of Defense (formerly the Defense Agency) established the Cost Improvement Proposal Scheme, aimed at reducing defense equipment procurement prices. It was described as “a scheme for realizing reduced procurement prices by increasing suppliers’ motive (incentive) to lower costs by offering to pay them a portion of any cost-savings they achieve when they reduce their costs by their efforts.” In 2002, this Cost Improvement Proposal Scheme was extended and renamed the Incentive Contract Scheme. The EPCO of the Ministry of Defense [4] has claimed that under the scheme, “private companies that take advantage of their technological invention or manufacturing expertise receive 50% of the cost reduction they achieve through proposals able to cut procurement costs as a technology proposal fee paid over 5 years.” The scheme required the supplier company to make a commitment to the method and amount of cost reduction in its production before commencing cost-saving measures. However, in the first 9 years of the scheme only two cost reduction proposals were submitted, worth a total of approximately 27 million JPY in savings.
According to the EPCO of the Ministry of Defense [4], in 2008, the scheme was changed to encourage greater use by suppliers, by expanding its scope to include any systematic initiatives by suppliers, adding “various kinds of cost reduction efforts, such as capital investment and production management improvements” to the existing proposal requirements. Furthermore, losses in profits due to the reduced production costs as a consequence of how the cost accounting method works would be compensated by separate payments. Additionally, for procurement over 5 years of the scheme, it became possible to make weighted allocations of the cost improvement proposal fee, if within the range of 50% of the amount of price reduction within the applicable period (e.g., for the same volume each year, 90%, 80%, 50%, 20%, 10%, respectively). As under the previous scheme, suppliers were required to commit (make a pledge) to the method and amount of cost reduction in its production before commencing their cost-saving efforts. According to the Ministry of Defense [5], the scheme was utilized twice in the first 2 years following the introduction of the scheme.
As the EPCO of the Ministry of Defense [5] relates, in 2013, the scheme was modified to further encourage its active use by suppliers. The change in scheme related to an incentive fee. “To motivate companies to try and reduce costs, when a company proposes a cost reduction measure based on a technology that was not considered at the time the contract was concluded and the proposal is adopted, a portion of the cost-savings is added to the contract price after cost reduction as an incentive fee.”With this change, something was added to the previous method, under which the supplier committed to the method and amount of cost reduction in its production before commencing the cost-saving work; that is, the supplier first demonstrates the production cost reduction method before commencing the cost-saving work and then after the event must verify the actual cost-savings or report on the actual cost reduction achieved.
Furthermore, as shown in Table 13, the incentive fee rate was increased (e.g., average of 80% over 5 years for a company pledging to cut production costs by up to 5%, as opposed to 50% previously), and the period of application of the scheme was extended by 1 year for each year that the amount of cost reduction exceeds 10% of the original production cost. It was also noticed that under the previous scheme, since there was no promise of a contract after the fact, even when production cost was reduced, no large-scale production cost reductions necessitating large initial investments were made by suppliers. It was therefore decided that for a commitment to a production cost reduction exceeding 20% during the scheme application period, a private contract would be awarded to the supplier. According to EPCO of the Ministry of Defense [6] the number of applications under the current scheme is increasing, as can be seen in Table 14.
Appendix B
1.1 Derivation of (26)
The numerator of (25) is
and its denominator is
where \(A=\alpha C_BQ + \sum _{i=1}^{k}(\beta _i+\alpha )c_p Q_i - (1+\alpha ) c_p Q\). Recall that \(\psi ^{''}(e)=1\). Then, we have
where \(D=\left[ S(Q)-(1+\lambda )((1+\alpha )(C_B-c_p)Q+\sum (\beta _i + \alpha ) c_p Q_i)\right]\).
1.2 Derivation of (35)
The numerator of (34) is
and the denominator is
where \(A=\alpha C_BQ + \sum _{i=1}^{k}(\beta _i+\alpha )c_p Q_i - (1+\alpha ) c_p Q\). Recall that \(\psi ^{''}(e)=1\). Then, we have
where \(E=\left[ S(Q)-(1+\lambda )((1+\alpha )(C_B-c_p)Q+\sum (\beta _i + \alpha ) c_p Q_i)\right]\).
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Kasai, M., Watanabe, N. A Simple Numerical Evaluation of the Incentive Contracts for Japan’s Defense Equipment. Rev Socionetwork Strat 15, 575–596 (2021). https://doi.org/10.1007/s12626-021-00090-9
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DOI: https://doi.org/10.1007/s12626-021-00090-9