12. Profit for conventional non-competitive contracts is defined by the Government Profit Formula that is published, usually annually, by the Review Board for Government Contracts. The formula produces a percentage figure that is applied to the estimated costs agreed for the contract and this provides a return to contractors that is equal on average to the overall return earned by British Industry. However, application of the Government profit formula to PPP/PFI contracts may not be appropriate due to the SPV structure, which will fall into the unreasonably high or unreasonably low category under the profit formula, and to the approach taken to profit by the PPP/PFI contractor.
13. The PPP/PFI contractor may seek to approach profit on the basis of one of the Internal Rates of Return (IRR) quoted in the contract. There are often a number of IRRs quoted in PPP/PFI contracts. In simple terms the IRR on PPP/PFI arrangements equates to profit on conventional contracts plus an element to cover the cost of risk associated with the PPP/PFI arrangement. The MOD position on this approach is that the contractor would not normally be entitled to the same rate of IRR on changes as on the original PPP/PFI contract. The reason for this being that the risks for changes will seldom be as high as the level of risk perceived at the time of contract award. For example the design risk for the facility as a whole will have been removed or considerably reduced. The Notice to Proceed for each Change will state whether that Change is to be included in the VfM Review.
14. There is no central policy on agreeing profit rates for PPP/PFI Changes. As a result, unless specific provision has been made in the PPP/PFI contract for the level of profit to be charged for future changes, commercial staff will seek to negotiate a profit level for all changes under the contract, or on a case by case basis. In agreeing the level of profit commercial staff will consider:
• whether the Government Profit Formula is relevant to the SPV contractor (this is unlikely);
• what risks the SPV is taking and if these are different to those present when the original PPP/PFI contract was signed (see paragraph 17, below);
• what elements of the price the SPV profit should be applied to. Profit should generally not be applied to sub-contract profit when the SPV and sub-contractor is part of the same group. SPVs may apply profit to sub-contract costs34 when it can be demonstrated that the SPV has provided some added value or taken an additional risk (see paragraph 18 below);
• a risk rate of profit calculated on the basis of the Government Profit Formula for the sub-contractor, plus a percentage for the additional risk or value added by the SPV.
15. As a fundamental principle SPVs should be able to include in their price a cost for the risks they take for implementing changes to PPP/PFI arrangements. There are two major factors that need to be considered when agreeing the risks to be included in the SPV profit. These are:
• the risk may not rest with the SPV but with a sub-contractor.
• the cost associated with a risk may be associated with an element of the price build up (e.g. labour) rather than the SPV profit.
16. An understanding of where the contractor should be including the costs for each type of risk will therefore enable a structured approach to agreement of rates to be applied. To facilitate this understanding attached at Appendix A Part 2 to this PFU guidance is a list of risks with details of where the cost for these risks are likely to be applied by the SPV. As can be seen most risks are likely to be associated with an element of the price build up rather than the SPV profit. Whilst Appendix A Part 2 may not cover all risks associated with change, it provides a basis for establishing how additional categories of risks may be viewed.
17. Whatever method is employed to determine the rate of profit, care should be taken to ensure that the SPV profit for work sub-contracted to organisations within his own Group reflects the added value or additional risk being taken by the SPV.
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34 'Costs', in this context, is taken to mean all a sub-contractor's outgoings in relation to a task, including overheads, handling charges etc but excluding profit.