Part 4: Funding shortfalls

• Introduction
• Background
• Funding shortfalls quantified
• Efforts to address the funding shortfalls
• Our overall conclusions
• Recommendations

Introduction

4.1
In this Part we identify shortfalls in funding for 3 important aspects of the LAV project. These include:

• spare parts for the LAVs;
• the Logistic Support Agreement that the Army has entered into with General Dynamics to secure support services for the LAV; and
• a moving target range for LAV gunnery training.

4.2
We examine how the funding shortfall has been addressed by the Defence agencies, and assess the likely effect on the LAV project.

Background

What are spare parts?

4.3
Spare parts include components that wear out over time, and rotables. Rotables are larger components that can be replaced when they fail, and can then be repaired by Army technicians (for example, a gearbox).

4.4
The spare parts required to operate and maintain the LAVs represent a significant capital cost to the LAV project, and an ongoing operational cost to the Army.²⁷

What is the Logistic Support Agreement?

4.5
The Logistic Support Agreement is a contract between the Army and General Dynamics. For an annual fee, General Dynamics provides the Army with support services throughout the 25-year life of the LAVs. The agreement allows the Army to purchase other services²⁸ as required.

4.6
An important feature of the Logistic Support Agreement arrangement is that it is designed to facilitate knowledge transfer from General Dynamics to the Army, so that the Army can improve its technological expertise.

What is a moving target range?

4.7
A moving target range is a training facility that would allow LAV crews to practise manoeuvring while firing at static and moving targets.

4.8
The Army does not currently have a moving target range – such a range is required to test the full capacity of the LAV gunnery system, and to ensure that crews are fully trained.

Funding shortfalls quantified

Spare parts

4.9
Insufficient funding was allocated for the purchase of spare parts at the outset of the LAV project. The Defence agencies recognised this before signing the contract in January 2001, and obtained additional funding to increase the total capital budget for spare parts to $11.351 million.

4.10
However, there was still a shortfall between the amount required for spare parts and the amount available in the LAV project budget.

4.11
In July 2003, the Army informed the Chief of Defence Force that it would be impossible to have the first LAV battalion at the directed level of capability by December 2005 “if the spare parts pool is not in the $25-$30 million range”.

4.12
Based on the amounts quoted in paragraphs 4.9 and 4.11, a capital-funding shortfall of about $14-19 million is indicated.

Logistic Support Agreement

4.13
An outline of what a Logistic Support Agreement might cover was included in the prime contract29, and funding was allocated for negotiation of the final agreement. However, at the time the prime contract was signed, no funding was provided for either the annual fee associated with the agreement or the costs for provision of other services.

4.14
In June 2002, the Army, for the first time, budgeted an amount of $400,000 a year to cover the expected cost of the Logistic Support Agreement. This figure was reached after discussions between the Army and General Dynamics.

4.15
The Logistic Support Agreement was signed in October 2003, and the NZDF subsequently provided additional funding for the 2003-04 and 2004-05 years. The total cost of the agreement for each year from 2003-04 to 2008-09 is shown in Figure 8 below. There is a shortfall of at least $1.7 million a year for 2005-06 and future years.

Figure 8
Projected costs of the Logistic Support Agreement

* Funding has been secured for costs of other services.

4.16
While the value of the shortfall in funding for the Logistic Support Agreement is not significant when compared to the overall cost of the LAV project, it does illustrate that the original budget for the LAV project did not provide for some items important to the introduction into service of the LAVs.

Moving target range

4.17
Funding for the moving target range was not included in the original LAV capital budget approved by Cabinet. The Defence agencies have not been able to explain why the moving target range was not included, although they indicated that it is likely to have been an attempt to limit the overall costs of the LAV project.

4.18
In February 2003, the Army put forward a proposal to include funding for the moving target range in the NZDF’s Capital Programme (Minor)30 for the financial year ended 30 June 2004. The Army’s proposal stated the cost of the moving target range as $4.1 million.

4.19
The Chief of Defence Force decided that, while the moving target range was a high priority, competing priorities meant that funding would not be available until 2004-05. Funding of $2.409 million for the construction of the moving target range was allocated for 2004-05, and $1.655 million was allocated for the purchase of the required equipment in 2005-06. The moving target range is scheduled for completion in December 2006.

Efforts to address the funding shortfalls

Spare parts

4.20
After reviewing and reducing the list of required spare parts, the NZDF and the Army considered alternative ways of increasing funding for spare parts to the $25-30 million range required by the Army. These alternative funding options included:

• outsourcing ownership of LAV spare parts³¹;
• use of the LAV project contingency fund³²;
• putting forward Budget Initiatives for 2004-05;
• funding spare parts from the NZDF rotables budget³³;
• using proceeds from the sale of the M113 fleet³⁴; and/or
• using compensation for an increase in LAV weight to purchase spare parts³⁵.

4.21
While the NZDF and the Army have been thorough in their consideration of other sources of funding for spare parts, efforts to incorporate these sources of funding into a workable solution have, at times, been hampered by confusion and error.

4.22
Work to address the spare parts funding shortfall took place between January and November 2003. On 7 November 2003, the Chief of Defence Force wrote to the Chief of Army setting out how the Army was expected to address the spare parts funding shortfall. He stated that under the proposed funding solution, the Army would be able to have funding for spare parts of up to $30 million³⁶ by late-2005.

4.23
There was evidence of poor communication and a lack of clarity around the status of the proposed funding solution. In addition, aspects of the solution were inaccurate. For example:

• Dollar amounts did not reconcile with the actual funding available.
• There was confusion between the MoD and the NZDF about whether the weight compensation for the LAVs was being negotiated in Canadian or New Zealand dollars.
• It was proposed that the Army contribute to the funding solution by making operating savings. The use of operating funding to purchase capital items would have been unlawful without Parliamentary authority, and this is a matter that would have required consultation with the Treasury. We saw no evidence of the NZDF consulting with the Treasury before proposing this solution.

4.24
Although the solution proposed in November was evidently inaccurate, the Chief of Army reported to the Executive Capability Board in December 2003 that he understood that proposals for the funding for spare parts had been resolved. However, in February 2004, the Chief of Army sent the Chief of Defence Force an alternative solution to the funding shortfall³⁷ for spare parts.

4.25
The Army’s alternative funding solution included the same estimate of $7.8 million for weight compensation as used in the Chief of Defence Force’s correspondence on 7 November 2003. As noted previously (see paragraph 4.20 and footnote 35), the actual amount of weight compensation agreed between the MoD and General Dynamics was $4.75 million. This amount was agreed on 13 February 2004, the same date that the Army sent its alternative funding solution to the Chief of Defence Force³⁸.

4.26
In our view, the Army’s alternative funding solution should have included a more accurate estimate of the likely amount of weight compensation. This information could have been obtained from MoD (Acquisition) staff.

4.27
We were informed in August 2004 that the Defence agencies consider that funding for spares has been resolved to a satisfactory outcome. They expect that the anticipated funding levels will allow the Army to reach its December 2004 and December 2005 goals for the LAV project. The Army is satisfied that there is sufficient funding available for spare parts for current motorisation training and operation, for the first 2-3 years.

Logistic Support Agreement

4.28
In our view, an allowance should have been made for the potential financial implications of the Logistic Support Agreement much earlier than June 2002.

4.29
Signing the prime contract without defining exactly what the Logistic Support Agreement would cover put General Dynamics in a strong position to negotiate the terms of the final Logistic Support Agreement. The Army Risk Register notes that –

… leverage to negotiate the Logistic Support Agreement was significantly eroded by the signing of the Prime contract with only a ‘statement of principles’ negotiated as part of the Prime contract.

4.30
As shown in Figure 8 on page 39, the NZDF approved funding of $1 million for the Logistic Support Agreement in 2003-04 and $2.1 million in 2004-05. The NZDF’s 2004-05 budget initiatives also sought operating funding for the Logistic Support Agreement of $2 million a year for each financial year from 2005-06 to 2008-09. This bid was not successful.

4.31
The Army has not yet secured funding for the ongoing cost of the Logistic Support Agreement from 2005-06 onwards. We have been told that the NZDF’s forward budgeting, operational planning, and prioritising process will manage the cost of the Logistic Support Agreement. The Defence agencies expect that some of the operating savings related to the withdrawal of the M113 fleet will be able to be applied to the Logistic Support Agreement.³⁹

Moving target range

4.32
The current lack of a moving target range affects the ability of LAV crews to become competent in firing at moving targets – a skill that is required by the Employment Contexts included in the NZDF 2004/2005 Output Plan.

4.33
Without a moving target range, the Army’s training of LAV crews to fire at moving targets is limited to using computer simulators.⁴⁰

4.34
In a deployment situation, there are 2 options for managing the skill limitations that exist between the directed level of capability and the operational level of capability. These are:

• that the skill limitations are reported to the Minister at the time of deployment, and the LAVs’ mission may be tailored to fit the available skills; or
• the skills required are built up to the required level during the preparation for the operational level of capability (as was done with the East Timor deployment) by using the facilities of an overseas partner.

4.35
Currently, the Army plans to meet the directed level of capability milestones for December 2004 and December 2005, but to a lower level than would be the case had the LAV crews trained on a moving target range.

4.36
The cost of the moving target range is small in comparison to the overall cost of the LAV project. However, the exclusion of the moving target range from the original capital budget approved by Cabinet now means that the limitations will need to be managed as outlined in paragraph 4.34 if the LAVs are to be deployed operationally. These limitations will continue until the moving target range has been completed (scheduled for December 2006) and sufficient LAV crews have been able to train on the facility.

Our overall conclusions

4.37
The funding shortfalls that we identified were not large when compared to the overall cost of the LAV project. However, the respective Army and MoD Risk Registers noted that these 3 issues posed risks to the introduction into service of the LAVs, and to the ongoing effectiveness of the LAVs that were purchased.

4.38
In our view, more accurate estimates of the cost of these items should have been made in the original LAV project budget. It is inappropriate that the introduction of a large capital investment, such as the LAVs, should be put at risk by an initial failure to adequately provide for relatively small aspects of the project.

4.39
We are satisfied that Defence agencies have put a lot of effort into finding a solution to these funding shortfalls, in line with the Government’s direction that no additional capital funding would be allocated to the LAV project.

4.40
However, the absence of a complete financial assessment of all aspects of the LAV project has led to funding for some important items being underestimated, or not incorporated at all, in the project budget. This has caused difficulties for the Defence agencies during the introduction-into-service part of the project.

4.41
For future acquisitions, a full assessment of all of the financial implications of a project should be undertaken, as we advocate in Recommendation 2. Though we recognise that an assessment of this nature will include an initial degree of uncertainty around funding estimates, we consider that a regular review process could be used to manage this uncertainty.

4.42
The Capability Management Framework requires a formal consultative process with other Government departments in regard to submissions for Cabinet approval, and provides guidance for preparation of a business case. This guidance states that it “may be critically important” to seek “an independent review of the case by technical and finance scrutineers”.

4.43
We consider that – for major military capability acquisition projects, such as the LAV project – financial and technical analysis undertaken to support proposals to Cabinet should be independently reviewed.

Recommendations

27: The initial purchase of a pool of spare parts to support any capability is made from the capital funding allocated to the project by the Government. This initial purchase establishes an inventory (sometimes referred to as the ‘spares pipeline’), which is maintained by using operational funding to replace items from the ‘pipeline’ as they are used for ongoing maintenance.

28: Other services include technical support, training support, and engineering changes.

29: The main contract signed in January 2001 between the Government and General Dynamics for the purchase of 105 LAVs.

30: The NZDF is responsible for managing approval for the funding of minor capital project bids, such as the moving target range.

31: This option was ruled out, as it represented a significant increase in cost over the life of the LAVs.

32: The LAV project budget includes $14.15 million set aside as contingency funding for any unforeseen risks that may arise. Throughout 2003, the Chief of Defence Force indicated that any unexpended contingency funds would be returned for re-allocation to other high priority defence projects.

33: The NZDF has a budget for the purchase of rotables. Additional funding of $2.6 million was added to the LAV spare parts budget in July 2003 for the purchase of LAV rotables.

34: The M113s are being replaced by the LAVs.

35: Compensation for an increase in LAV weight, and the associated increase in maintenance costs, was agreed between General Dynamics and MoD (Acquisition) on 13 February 2004. The compensation is in the form of a $4.75 million credit on the initial spare parts procurement.

36: This figure included:

• $14.2 million as the original project budget for spare parts (rather than $11.351 million as stated in paragraph 4.9);

• an additional $3 million a year for 2 years in funding from the NZDF rotables budget;

• $7.8 million in anticipated funding from General Dynamics as compensation for an increase in the weight of the LAVs; and

• a requirement for the Army to make $2 million a year savings from its operating baselines.

37: The alternative solution included:

• Initial project funding of $11.8 million;

• $2.6 million from the NZDF rotables budget in 2003-04 and $3 million from rotables in 2004-05 and 2005-06 respectively;

• an estimated $7.8 million from General Dynamics in weight compensation; and

• $1.5 million from sale of the Army’s M113 fleet.

38: The Army notes that funding for spare parts of $25-30 million will enable a LAV battalion to be at directed level of capability by December 2005. The agreed amount of weight compensation is still within the range of funding that the Army says is required.

39: This will be in addition to any proceeds received from the potential sale of the M113s. Any such proceeds are earmarked for additional spares.

40: It was always the Army’s intention to use computer simulators for the training of LAV crews. However, on their own, the simulators are not sufficient to equip the crews with all the skills required.