16.7 The next chapter focusses on project initiation and implementation processes within DND according to three lines of enquiry: program management, project management and feedback processes.
16.8 To fulfil its roles and carry out its tasks, DND operates a wide variety of sophisticated weapon systems involving large fleets of vehicles, ships and aircraft. Although the funding available to DND to buy the equipment it needs is limited, DND has the largest capital program of all government departments.
16.9 At the time of our audit, there were approximately 550 major capital projects in the 15-year plan of the Defence Services Program with a total cost of $63 billion in 1990 constant dollars. Industrial development initiatives are usually attached to major capital projects costing over $100 million, a category called major Crown projects. There are about 70 of these major Crown projects in the Defence Services Program. DND is responsible for the majority of federal major Crown projects potentially subject to industrial development initiatives. If current trends continue, there could be as much as $30 billion in industrial development initiatives attached to DND projects.
16.10 The life cycle of major capital projects consists of four phases: initiation, implementation, in-service, and disposal. For most of the larger projects, the complete life cycle is usually more than 20 or 30 years. The initiation phase can be critical in obtaining value for money. During this phase, the need for the project is established, the procurement and industrial development strategies are set, proposals from contractors are sought, contracts are signed and project management processes are established. If things go wrong at this stage, the repercussions are likely to affect the project throughout its entire life cycle.
16.11 Procedures for implementing the government's procurement policy involve several departments. Essentially, DND establishes the need for the project, provides the operational and technical specifications and sets funding and scheduling priorities. The Treasury Board Secretariat provides general policies and guidelines for all aspects of procurement. The Department of Supply and Services assists in developing a procurement and contracting strategy and is responsible for managing the contracting process. The Department of Industry, Science and Technology, the Atlantic Canada Opportunities Agency, the Department of Western Economic Diversification and the Federal Office of Regional Development (Quebec) are responsible for industrial and regional development initiatives to be attached to major capital projects.
16.12 As soon as a large DND capital project is identified as an operational requirement for inclusion in the Defence Services Program, these departments begin to influence the procurement strategy. By the time the project has progressed through DND's Defence Program Management System to the point where Treasury Board approval (and Cabinet approval where necessary) is being sought, the procurement strategy and the bidding and contract adjudication processes have generally been agreed to by departments and industrial development initiatives have already had a major impact on the procurement strategy. The initiatives may also have affected the overall cost and scheduling of the project.
16.14 The primary focus of our overall audit was on the extent to which value for money was achieved in procurement. In this part of our audit, we examined the approach adopted by federal departments and agencies to implement the government policy concerning industrial development initiatives attached to DND major capital projects. We examined each of the six projects from the standpoint of procurement strategy, industrial development initiatives and the bidding and bid assessment processes as they affected DND. We did not conduct audits of industrial or regional development programs of other government departments, but kept our focus on the effects of industrial development initiatives on DND projects. We examined the industrial benefits expected or actually achieved in relation to the costs. We also conducted interviews with chief executive officers and other senior executives of 28 Canadian defence contractors to obtain their perspective on the manner in which these initiatives are currently being pursued.
16.16 Our report on industrial development initiatives in 1984 included concerns about overlap in departmental roles and responsibilities and the lack of clearly defined objectives, policies and plans in the management of industrial offsets. We also noted that non-military objectives, including industrial benefits, complicated and constrained DND equipment projects. In 1985, the Standing Committee on Public Accounts recommended that non-military objectives be identified in Part III of the Estimates and that their attainment be monitored and reported. In 1987, we noted that the recommendation concerning reporting to Parliament had been implemented, but the costs of achieving industrial benefits were not being reported.
16.17 Our 1987 Report included concerns about the need to define "Buy Canadian" goals and objectives and to specify the premium that would be paid to purchase from Canadian rather than foreign suppliers. These concerns with non-military objectives extended beyond just identifying and reporting them. It also included their cost, their impact on project objectives and the consistency of their application in the competitive process. We noted that, to a great degree, these non-military objectives were directed towards satisfying the objectives of other departments, such as the Department of Regional Industrial Expansion, but their costs were charged against DND's budget. We recommended that, where it is reasonable to do so, the direct and indirect costs associated with achieving non-military and strategic sourcing objectives should be reported in Part III of the Estimates.
16.18 In 1987, we also noted that four of the contracts we reviewed involved sole-sourcing to a Canadian supplier, thus by-passing the competitive process and specific Treasury Board contract regulations. We requested analyses to support the decision to sole-source, but the information we were given did not include any cost-benefit, economic or financial analyses to support the decision. We recommended that decisions to by-pass the competitive process be supported by a full justification in the contract file that would specify the costs, benefits and risks of doing so in comparison to the national benefits expected.
16.19 In addition to these three audits of DND projects, in our 1991 audit of the Department of Supply and Services, we reviewed management practices relating to the use of procurement in major Crown projects as an instrument for achieving industrial and regional development and other related government objectives. The focus of the audit was primarily on non-DND projects. We recommended that the Department of Industry, Science and Technology should, within its mandate, evaluate the effectiveness of the application of its policies and practices in achieving industrial development through procurement. Industry, Science and Technology agreed with our recommendation.
16.21 The Defence Production Sharing agreement and the Defence Development Sharing agreement with the United States were concluded about 30 years ago, in part to compensate Canadian industry for large military contracts going to U.S. manufacturers. In 1963, the Defence Production Sharing Agreement was amended to include a provision for a rough balance of trade over the longer term.
16.22 In addition to funding from the federal departments responsible for industrial and regional development and other forms of federal assistance, Canadian defence manufacturers are often granted provincial and municipal assistance of one kind or another. In 1959, Canada created the Defence Industry Productivity Program (DIPP) to provide cost-shared repayable contributions to foster, among other things, the continuity of research and development in Canada's defence industry. DIPP funding to Canadian manufacturers of defence equipment between 1979 and 1990 amounted to $1.8 billion.
16.23 Between 1976 and 1986, it became commonplace to seek "offsets" (now called "indirect benefits") in major defence procurements from foreign manufacturers, although often there were also some direct industrial benefits claimed in these contracts. An "offset" involved the purchase of Canadian manufactured goods and services, an investment or a technology transfer that was unrelated to the actual product being purchased by the government. The contractor was expected to deliver the equipment specified in the contract at the stated price and, at the same time, to undertake procurement, investment or technology transfer in Canada to an estimated value that often equalled or exceeded the total cost of the contract.
16.24 The results of one study commissioned by the government indicated that, during this period, Canada developed administrative policies and processes for these offsets programs that were much more complex and expensive than those in other developed countries, for example, Belgium, Denmark, Australia, the United Kingdom, the Netherlands and Sweden. United States government policy states that federal funds are not to be used to finance offsets. The U.S. also views certain offsets for military exports as economically inefficient and market-distorting.
16.25 In 1985, the Ministerial Task Force on Program Review Concerning Government Procurement (the Nielsen Task Force) reported that no one associated with the procurement process seemed to have a clear idea what industrial benefits the government was trying to achieve. It felt that the problem was not a lack of objectives but a multiplicity of overlapping, competing objectives that conveyed confusing signals to both government and industry. The report stated that the government's expectations had tended to be unrealistic and misdirected and that, in some cases, there had been gross overstatements of expectations of what would ultimately be achieved by these procurements in terms of incremental economic activity in Canada. There was growing dissatisfaction among departments, particularly DND and the Department of Transport, that their operational needs were being jeopardized by ad hoc, third-party decisions of other departments. According to the Task Force, regional distribution, technology transfer and investment benefits had been much lower than expected. Moreover, the Task Force was concerned that existing policies may have been inadvertently signalling that short-term benefits were preferred over long-term, lasting benefits.
16.26 The report called for a reassessment of government policies on the basis of certain considerations, including the following. The government's expectations of securing 100 percent offsets had been unrealistic. The benefits acquired had been much lower than expected and had mostly been of short-term value to Canada. The costs of achieving industrial benefits had been substantial. The emphasis on offsets had become a trade irritant with the United States and Europe while producing marginal long-term benefit to Canada.
16.28 This new government policy makes it clear that federal objectives in procurement start with the pre-eminence of best value for money in the fulfilment of operational requirements. Essentially, this means obtaining the equipment that meets the operational requirements in the most cost-effective manner.
16.29 Secondary to this objective is the need to review procurements from the standpoint of long-term industrial and regional development opportunities, emphasizing benefits of lasting value that assist Canadian firms to become competitive in domestic and world marketplaces.
16.30 Where promising procurement strategies are identified that conflict with the concept of best value for money in the fulfilment of operational requirements, but at the same time are considered to be cost-effective from an industrial and regional development standpoint, these strategies are to be developed as sourcing options for the review of ministers prior to issuing requests for proposal to private sector contractors. Costs are to be estimated when possible, and the submissions to ministers are to include a source of funds where significant cost premiums are anticipated.
16.31 Where industrial and regional development opportunities have been included in a major capital project, the increased costs due to the industrial development initiative are to be shared between the project-sponsoring department and the department responsible for industrial development, but with the latter playing a significantly larger role in supporting those industrial benefit activities not directly associated with the project-sponsoring department's overall mandate. For DND major capital projects, DND is to fund any requirements considered essential to national security (for example, those related to creating and maintaining a defence industrial base). The costs of any industrial development initiatives not considered essential to national security are to be shared by DND and the departments responsible for industrial and regional development, with the latter providing a significantly larger share.
16.32 Where there are incremental costs involved in achieving a specific benefit, it must be demonstrated that the activity generated by the procurement is sustainable and has a clear prospect of becoming commercially viable; that the socio-economic benefits are sufficient to justify the extra cost of the procurement; and that the benefits would not be forthcoming in the absence of government assistance.
16.33 The new policy has been interpreted by officials as emphasizing the need to seek cost-effective, direct industrial benefits related to the actual system or product being purchased by the government. Although indirect benefits unrelated to the actual system or product being purchased (previously called "offsets") can still be proposed, the primary effort is to be focussed on direct benefits. Both direct and indirect benefits could include "production effort", or the Canadian content value of goods and services; technology transfer that is exploitable in terms of access to world markets; and investments that result in sustainable industrial and regional development.
16.35 The new government policy lays out a framework for achieving value for money in meeting operational requirements, while at the same time seeking industrial development opportunities that are long-term and sustainable and result in products that are competitive in domestic and foreign markets. While this new policy has the potential to produce high-quality initiatives of great value to Canada, it also poses a significant implementation challenge for government officials.
16.36 The procurement approach that is being used to implement the new policy, however, is much the same as the approach prior to 1986. Most of the burden of identifying and proposing specific industrial and regional development initiatives in major Crown projects continues to be placed on the shoulders of the private sector, rather than residing in the federal departments responsible for industrial development initiatives. This is achieved by including the requirement that bidders propose industrial and regional benefits in requests for proposal, along with price and technical suitability in meeting operational requirements.
16.37 The approach also continues to be structured to reward the firms whose proposals maximize industrial benefits. Today, the emphasis on direct benefits means that foreign firms, which are often the only ones with the manufacturing capability for large military equipment, but whose facilities are not normally located in Canada, may be precluded from supplying complete weapon systems or from bidding directly.
16.38 A variety of approaches has been used to achieve greater direct participation by Canadian industry. In some cases, Canadian companies are set up as prime contractors to complete the final assembly of equipment designed and manufactured abroad. Canadian firms are also being set up to integrate these weapon systems. As well, offers are made to use as many components from Canadian sources as possible. While Canada has areas of industrial strength, the components supplied by Canadian firms for the projects we examined were often of relatively low technology. They may or may not have been price-competitive with similar components available on the international market and often required considerable additional design and testing to integrate them successfully into the original product.
16.39 Successful foreign manufacturers of major defence systems already have complete production processes. They often have amortized the costs of investment, design, project management and start-up over large production runs and may also have achieved economies of scale. This makes for a highly competitive marketplace. Where a contract for manufacture or final assembly is awarded to a company, whether in Canada or elsewhere, that has never designed and manufactured high technology defence systems or products, there are bound to be higher costs and greater risks.
16.40 Firms doing business with government have no choice but to conform to the procurement approach defined by the terms and conditions of the request for proposal. To do otherwise would ensure that their bids would be unsuccessful.
16.41 Exhibit 16.2 is a conceptual diagram that portrays the fundamental issue in government procurement policy in the area of industrial development initiatives attached to major capital projects. Any cost to the Crown and industry of undertaking an industrial development initiative must be more than offset by the returns on this investment in the form of enhanced productivity that enables goods to become internationally competitive. The value of this enhanced productivity can be estimated by the expected profits from future international and domestic sales over some reasonable horizon. The same principles would apply to any country engaging in industrial development of this type.
16.42 In areas where Canadian firms are already competitive, there may be little or no additional costs associated with their involvement in a project. Also, if a defence requirement is so unique that no other comparable product can be provided by a foreign firm, it may be just as cost-effective to build it in Canada. In most cases, however, direct Canadian participation would require investment in such areas as product design, infrastructure establishment or labour force development. When a decision is taken to make investments of this type, analysis should be carried out to ensure either that the short-term and long-term benefits justify the investment, or that any unique capabilities are cost-justified.
16.43 Estimating these costs and returns would be quite simple in some cases and considerably more complex in others, particularly where the operational requirements include certain unique capabilities for meeting Canada's special military needs that would have to be weighed against the cost of meeting them. In complex programs it may be difficult to obtain precise selling prices from alternative manufacturers, and future estimates of sales and potential market share may be subject to varying degrees of certainty. Nevertheless, government policy requires analyses of the costs and the future returns. Judgment will have to be exercised as to the level of resources needed for these analyses to provide a reasonable assurance of value for money. We realize that this work can be difficult in the more complex procurements, but we believe that it can and must be done.
16.46 In August 1988, DDGM submitted an unsolicited proposal to the Minister of National Defence to build 200 LAVs for the Canadian Militia. The proposal stated that, due to a production gap following their order for 759 LAVs for the U.S. Marines, there was a serious danger that their defence operations could be closed by their parent corporation, which would result in the loss of 375 jobs in the London area. They also indicated that their future looked bright with a strong possibility of export sales of thousands of vehicles.
16.47 The procurement approach that was originally being adopted to meet DND's operational requirement was to acquire tracked vehicles, which would be compatible with the equipment used by the Regular Force units with which the Militia was expected to serve. Concern was expressed that the MILLAVs had limited ability in rough terrain or deep snow and that differences in training approaches would affect operational effectiveness. As well, the MILLAVs were more expensive initially than the tracked vehicles, and the process of introducing them quickly into DND operations resulted in disruptions in maintenance and training. These initial costs may be offset against the increased cost of operating tracked vehicles depending on usage rates. In October 1988, however, the Minister of DND, with the support of the Chief of the Defence Staff, responded that he would seek the support of his colleagues for the purchase of the GM vehicles.
16.48 The industrial benefits commitments in the contract amounted to $91.5 million, the exact amount of the prime contract. Sixty percent of this represents the Canadian content of the vehicle. The rest is offsets in the form of acquisition of other Canadian products by GM. Company officials advise us that the offsets commitments will be exceeded by over 200 percent.
16.49 The CF-5 Avionics Upgrade project. Canadair Ltd. of Montreal, Quebec, produced the CF-5 fleet in the late 1960s. In 1984, DND recommended that the aircraft have an avionics upgrade to replace unsupportable avionics and to make it a more suitable transition trainer for the highly sophisticated CF-18 aircraft. ( see photograph )
16.50 In 1986, a consortium including Bristol Aerospace of Winnipeg was found to have the best overall bid for the systems engineering support and airframe repair and overhaul contract for the CF-18. As events unfolded, however, the contract was awarded to Canadair, the leader of the consortium that had ranked second, since it was judged that downstream technology transfer could be better done through Canadair.
16.51 In January 1987, one month after the signing of the CF-18 contract, it was announced that industrial support activities for the CF-5 would be transferred from Canadair to Bristol, to achieve a more equitable distribution of aerospace procurement. This decision resulted in additional costs to the Crown because of the transfer of tools and technical documentation to Bristol; additional contract costs for the prototype and production contracts; delays and the learning curve at Bristol; loss of efficiency because other repair work could not be done at the same time as this upgrade work, as originally planned; and additional government assistance in support of international marketing studies and prepositioning investments.
16.52 There are no contractual commitments for industrial benefits associated with this project. Nevertheless, the 1992-93 Part III of the Estimates reports $34 million of production effort, offsets and technology transfer. These costs had been identified prior to the decision to sole-source the contract to Bristol, when it was assumed that the Crown would acquire major components of the upgrade and provide them to the contractor as government-furnished equipment. As a result of our audit, Industry, Science and Technology officials have advised DND that no further reporting of industrial benefits against this project need be made in Part III of the Estimates.
16.54 In the case of the HLVW, UTDC Inc. of Kingston, Ontario, assembled trucks using components provided by Steyr of Austria for the major elements such as the engines, transmissions and axles, as well as other components and assemblies that were to be provided by Canadian manufacturers and suppliers. This included items such as cargo boxes and handling equipment, as well as a range of lower technology items. Some of these were licensed from foreign firms, and some others involved primarily the assembly of components supplied by foreign firms. Component suppliers had to design their products and then put in place the necessary production processes. UTDC's overall responsibilities involved ensuring compatibility between the various components, assembly, systems integration and project management. ( see photograph )
16.55 In the case of LLAD, Oerlikon Aerospace Inc. of St. Jean, Quebec, was responsible for the assembly of the major components of the Air Defence Anti-Tank System (ADATS), part of the LLAD system, and systems integration of the entire LLAD system. A few of the elements of the ADATS, such as the radar, are being supplied by Canadian firms under licence from foreign firms.
16.56 In the CPF case, Saint John Shipbuilding Limited of Saint John, New Brunswick, assumed responsibility for the design, hull construction and assembly of state-of-the-art frigates. Paramax of Montreal, Quebec, a major sub-contractor to Saint John Shipbuilding, is designing a systems integration package that is viewed as being at the leading edge of technology. ( see photograph )
16.57 Each of these three projects involved a substantial investment by the firms and by the Crown to bring them to their current state. This included the need to either substantially upgrade or establish the necessary plant or equipment, hire and train a skilled labour force, undertake necessary design, develop a systems integration package, and manage the project. As well, federal government project management costs are greater for these complex developmental projects than is normally the case for off-the-shelf buys. In all three cases it was concluded that unique Canadian operational requirements precluded an off-the-shelf acquisition from foreign suppliers, although in the HLVW and CPF cases there were similar weapon systems in production or being designed at the time the decisions were taken.
16.58 As Exhibit 16.2 indicates, investments for industrial development are recovered through the profits from future sales. The companies involved in these three projects have been marketing their products internationally but, with a few exceptions, have not yet been successful for a variety of reasons. The international market for defence equipment is very competitive, export restrictions limit the markets to which certain Canadian defence products can be sold, and larger industrialized nations usually prefer to build their own systems. Canada's domestic market is small, and the changing international situation has created further pressures on the defence acquisition budget.
16.59 While there are advantages to Canada from building systems here rather than buying them from foreign suppliers - reduced unemployment and increased utilization of industrial capacity - there is considerable debate about the significance of these benefits and how they should be valued in cost-benefit analyses. Treasury Board and Industry, Science and Technology cost-benefit manual guidelines indicate that while these benefits might accrue to a particular region or industry, they can be offset by equal or greater disadvantages to other regions or industries.
16.61 Canadian participation in the project consisted of supplying about $4.5 million (U.S.) of components normally supplied by Canadian firms to Lockheed U.S. for this type of aircraft. Another $12 million (U.S.) is work undertaken in Atlantic Canada to install components needed to meet DND's operational requirements. We were informed by officials at Lockheed that this work did not entail any greater costs than it would have if done by Lockheed at its U.S. plant.
16.62 Offsets amounting to $90 million (U.S.) were committed: $40 million (U.S.) in the form of purchases from Western Canada and the Atlantic provinces; and $50 million (U.S.) in the form of the possible supply of Canadian components for the planned U.S. Navy acquisition of the P-7 anti-submarine warfare aircraft. The P-7 project has now been cancelled, and company officials advise us that they are trying to find alternatives to meet these commitments.
16.64 First, there was no long-term strategy regarding industrial development initiatives for any of the projects to guide the selection of an appropriate procurement approach. As we point out later, the chief executive officers of Canadian defence suppliers felt that it would be useful to begin the development of a strategy for Canadian industry participation in these projects well before the bidding process begins.
16.65 Second, none of the procurement strategies that were adopted was supported by a thorough analysis of the costs, benefits and potential risks. Alternatives, such as joint ventures with other nations, were not assessed. Where unique operational requirements were involved, no assessment was made to compare the costs involved in meeting these requirements with the cost of equipment already available or being designed.
16.66 Third, although the bids were adjudicated on the basis of price, technical suitability and industrial benefits, it was often not made clear in the request for proposal how these factors would be weighed in the final decision or what characteristics the industrial development initiatives needed to be acceptable.
16.67 Fourth, decisions to use procurement for immediate national or regional needs, to produce in Canada a unique operational capability, or to Canadianize components can involve substantial costs. In the cases we looked at, these costs ranged from the costs of simply administering industrial benefits for off-the-shelf procurements to up to 20 percent of the total project costs. When viewed over the 15-year Defence Services Program, which involves major Crown projects totalling over $50 billion, these costs could amount to several billions of dollars.
16.68 Fifth, in the cases we examined, the amount of long-term, competitive industrial activity that has resulted from the industrial development initiatives has, so far, been quite limited. A number of the sub-contractors that were chosen to produce components for the various products are now out of business. Despite strong marketing efforts by the prime contractors and major sub-contractors, few additional sales have yet been secured, although some promising prospects are being pursued.
16.69 Sixth, in some cases the pursuit of industrial development initiatives has affected the approach taken to meet DND's operational requirements and the scheduling of projects, or has affected regular operations. As well, because the additional costs of industrial development initiatives are now borne by DND, the funds available for other operational requirements are reduced. On the other hand, the desire to obtain equipment that exceeds existing or planned capabilities elsewhere in the world leads to substantial investments for the design and production of the equipment.
16.70 Seventh, the amount of validation or audit of the benefits achieved against the contractual commitments seems low.
16.71 Eighth, the information that is reported in Part III of the Estimates needs to be significantly improved. There is no indication of the costs involved for industrial development initiatives, and accountability for the expenditures is not clear. The industrial benefits that are reported in Part III of the Estimates for these projects are largely the Canadian content of certain industrial activities, which are further categorized as "direct" or "indirect". Direct Canadian content is simply the value of Canadian content in the product being bought by DND and would not be viewed as benefits in the sense expected by government policy. Indirect Canadian content reflects the value of future anticipated sales of the product being bought, or the Canadian content of other non-project related goods or services (offsets) that the prime contractor will arrange to be bought, from Canadian firms. The actual net benefit to Canada of these offsets has not been defined, and in many cases, the anticipated future sales have not materialized. To a lesser extent, the other direct and indirect benefits claimed involve the value of technology acquired and the value of investments made by foreign firms in Canada.
16.73 Although most CEOs believe that major Crown projects can present opportunities for industrial development, they are very concerned about the way the process is being implemented. In large measure, what the CEOs would like to see happen is exactly what is required in the government's procurement policy.
16.74 The feelings of industry leaders about industrial development are both very strong and quite consistent. Although a few of the people we interviewed were positive about their own experiences in this area, most were very critical about the current approach. A few firms told us that they have seriously considered dropping out of dealings with government to avoid the problems created by the current implementation process. Some CEOs argue that Canada would be better off if it stopped including industrial development initiatives in government procurements. Most believe that such initiatives are an inevitable part of the process, but want them to be better managed. At the very least, they would like the criteria against which these initiatives will be assessed to be clearly and completely described before the bidding process and not changed during the competition.
16.75 In our 1987 Report, we recommended that departments identify the costs associated with industrial development initiatives, where it is reasonable to do so. Responses from government officials suggested that for projects then in progress it was not possible to determine these costs. We asked CEOs whether they believed it would be possible to determine the cost of supporting industrial and regional goals. Most agreed that these costs could be determined and strongly believed that they should be. Many of them are concerned that companies are being encouraged to do things that do not make good economic sense and that there is no thorough analysis of whether or not a proposed industrial development initiative is reasonable.
16.76 Most of the CEOs felt that the current approach to these initiatives was defeating their original intent. Many believed that they actually reduced the competitiveness of Canadian companies or industry sectors. In some cases, foreign firms are encouraged to establish capacity that competes with existing firms located in Canada, some of which were encouraged by the government to be in that market area in the first place. Sometimes, staff are displaced and the original firm withdraws from the market area due to a lack of orders. In other cases, firms are required to break up efficient operations, which reduces their overall competitiveness. Some CEOs believe that firms already located in Canada are actually at a disadvantage because they cannot offer new investment or technology transfer. Other examples of what was often described as "policy schizophrenia" include the refusal to approve export permits for products that were developed using federal resources and the unwillingness to use products developed with federal support.
16.77 Canada's defence requirements in peacetime are usually so small that it does not make economic sense to set up a production capability to serve just this market or to expect a number of Canadian firms to compete for this market. International markets are very competitive, and countries with larger demands usually supply their own needs. This problem is growing as the demand for defence equipment drops in response to declining defence budgets around the world. In this highly competitive market, most CEOs feel that Canada needs a clear industrial strategy and a stable defence policy to guide industrial development initiatives. In the opinion of a number of CEOs, government officials need to consider entirely new approaches. One example of the kinds of things that could be considered is the possibility of concluding strategic deals between nations in which another country might supply an entire weapon system, but would agree to buy a competitive Canadian product.
16.78 CEOs identified examples of what they felt to be successful industrial development initiatives. When asked to identify the factors that made them successful, the usual responses were that the initiative did not compete with existing Canadian production effort; that it made good economic sense; and that the product was needed in Canada and competed successfully in foreign markets.
16.79 The view was often expressed that by the time a contract reaches the request for proposal stage it is really too late to generate strong industrial development initiatives. Most believe that earlier planning is needed and that mechanisms should be established to allow this to occur on a regular basis. Many suggested that industry should be involved in identifying meaningful industrial development opportunities. There is a strong view in the private sector that we need a fundamental review of how industrial development initiatives in government procurements are managed and that we should look at different approaches to gaining benefits from procurement.
16.80 In summary, the CEOs consistently suggested that there was a need for a longer-term approach to this area, better planning, and rigorous analyses of the costs and benefits of any initiatives.
16.82 The costs of any industrial development initiatives not considered essential to national security are to be shared by DND and the departments responsible for industrial and regional development, with the latter paying a significantly larger share. Both DND and the department(s) sponsoring the industrial development initiative would have obtained the funds to pay for any extra costs involved from programs clearly identified for this purpose in their respective departmental Estimates. This would have ensured that funding for industrial development initiatives would be properly approved by Parliament. Appropriate arrangements could then have been made for the proper tracking and monitoring of these initiatives. Unfortunately, this process was not followed in any of the six projects we reviewed.
16.83 The approach to industrial development initiatives used for the projects we audited was basically the same as the one used prior to the 1986 policy, even though the expectations of the policy are more demanding and present greater risks. The new emphasis on direct benefits resulted in production or assembly in Canada by firms that had never undertaken projects of this type or complexity. It continued to be clear to bidders, however, that their chances of winning a contract improved if the industrial benefits offered were maximized.
16.84 Firms were asked to identify and propose industrial development initiatives, which they would include in their bids. Any additional costs associated with the procurement strategy would be reflected in the prices they submitted. Government officials assessed these industrial development proposals from the standpoint of their likelihood of being achieved. Without information on the costs of these initiatives, and in the absence of overall objectives and strategies, they could not assess them against the objectives of the procurement policy.
16.85 This situation is carried through to existing monitoring and reporting arrangements. Monitoring and audit is done against the commitments made in the contracts, and commitments and results are reported in Part III of the Estimates. These reports give the impression of extensive industrial development occurring in Canada as a result of these procurements. In fact, the direct benefits reported are primarily the Canadian content of the products acquired, and these benefits can be seen as increasing due to things like cost overruns, inefficient production arrangements, layers of subcontractors adding costs and profits, and higher overheads. As the Nielsen Task Force reported, the benefits expected from indirect initiatives such as offsets can be unrealistic.
16.86 None of the procurement strategies in the projects examined was officially justified by DND as essential to the development of a Canadian defence industrial base capable of sustaining an expansion of the Canadian Armed Forces, if and when needed. However, in some cases, the final documents in the procurement process indicated that the "Buy Canadian" strategy would support the development of a defence industrial base. Had this been given officially as a primary reason for favouring a Canadian supplier, it would have constituted a DND operational requirement. According to the government procurement policy, all costs, whether for the equipment or for the enhancement of the industrial base, would then have to be borne by DND. Under the government policy, industrial development initiatives attached to DND projects not related to operational requirements or the defence industrial base would be funded primarily by the sponsoring industrial development departments. Given that the Canadian Armed Forces have been operating for decades under a "forces-in-being" concept, without any plans for significant expansion, any references to a need to develop a defence industrial base for Canadian military reasons would be particularly difficult to justify.
16.87 Our audit indicates that there is a need to establish a better way to manage the relationship between operational requirements and industrial development objectives. The current process generates an adversarial posture between departments, rather than a co-operative one, and has created considerable concern in the private sector. We believe that if responsibility and accountability were clearly defined, and better processes established to discuss tradeoffs between meeting operational requirements in the most cost-effective manner and achieving cost-effective industrial development that is long-term and sustainable, greater overall value for money for the Crown could be achieved.
16.88 Near the end of our audit, in June 1992, Treasury Board approved the chapter of its Procurement and Project Management volume that deals with Procurement Review. If implemented as written, this policy should address many of our concerns.
Department of National Defence's response: DND fully supports the essence of this recommendation.
16.90 The Department of National Defence, in co-operation with the departments responsible for industrial and regional development, should start from the standpoint of meeting operational requirements in a cost-effective manner, regardless of where suppliers are located. Given this baseline, the departments responsible for industrial and regional development should, after consulting with the Canadian private sector, identify opportunities to take advantage of recognized competitive Canadian sources of supply or to establish new Canadian sources of supply. These should be subjected to an adequate analysis of costs, benefits and impacts on DND operational requirements and scheduling. This analysis should consider costs, if any, of developing Canadian industry to a competitive position, the risks associated with pursuing these initiatives and the benefits to be derived, especially those of a long-term and sustainable nature. The departments should then recommend cost-effective options to officials and, if necessary, to ministers, along with a source of funding, prior to issuing requests for proposal.
Department of National Defence's response: DND fully supports starting all equipment acquisition projects from the baseline of meeting operational requirements in a cost-effective manner. We also fully concur with the balance of the recommendation, that a comprehensive analysis of the costs and benefits associated with industrial development opportunities be implemented in each instance where they are being considered, and that a source of funding be identified.
16.91 Alternatives should be assessed to ensure that adequate resources are devoted to planning, analysis, validation and audit of industrial development initiatives. This could include recognizing incremental resource requirements as part of the total project costs presented to decision makers.
Department of National Defence's response: The Department agrees that adequate resources must be available to ensure that the planning, analysis, validation and audit of industrial development initiatives may be effected competently. Any incremental cost of these resources should be identified as a cost associated with industrial projects, to be funded from the appropriation of the department sponsoring the industrial development initiative.
16.92 To encourage accountability in the pursuit of industrial development initiatives of lasting value through DND procurements, officials should consider ways of implementing the government procurement policy requirement that any incremental costs of these initiatives be shared by DND and the departments responsible for industrial and regional development.
Department of National Defence's response: DND would consider sharing incremental costs in those instances where they contribute to the development of strategic defence industrial base requirements.
16.93 The departments sponsoring industrial development initiatives should adequately monitor and audit them. The costs and results of these initiatives should be fairly and accurately reported to Parliament in Part III of the Estimates, with a view toward achieving consistency in presentation over time.
Department of National Defence's response: DND fully supports the essence of this recommendation.
Department of Industry, Science and Technology's overall response to the recommendations: The Department of Industry, Science and Technology agrees with the thrust of the recommendations and is undertaking a number of initiatives that will deal directly with them.