3.3 The selection of the contracting approach appropriate to the risks and challenges of a programme can set the groundwork for successful delivery. This is especially important given the frequent absence of competition to put downward pressure on costs. For all contract types, the Department may also incur additional costs if it chooses to change its requirements during the contract period. The Department uses a range of contracting approaches in its portfolio of major equipment programmes. It tailors its commercial approach according to programme requirements, sectors and suppliers. Certain types of contract predominate:
• Contracts where the Department pays the allowable costs incurred by the supplier, plus a profit percentage ('cost plus'). Since this approach only permits the Department to monitor costs and profits, rather than incentivising the supplier to minimise costs, the Department seeks to limit such arrangements to the design phase of major programmes, where scope and parameters are still under development. An extreme example is the Type 26 frigate, where approval for manufacture, and a move to a more cost-controlled contract, was delayed while the Department worked with the supplier to make the overall programme affordable. The programme was due to spend four years on a 'cost plus' contract at the design and development phase, at a cost of £158 million, but instead this lasted more than seven years, at a cost of £853 million.
• Contracts which incentivise suppliers and the Department to do what is necessary to deliver within the target cost. This differs from a 'cost plus' approach as it offers suppliers a financial incentive to deliver below target cost, with both parties sharing the financial risks of failing to achieve it. Historically, high-profile contracts of this type have incurred cost overruns, for example the Astute attack submarine programme and Queen Elizabeth Carriers. Such contracts move away from the Department's standard model of costing programmes on the basis of the 50th percentile (that is, the programme's cost model indicates that the actual cost has an equal chance of being higher or lower than the estimate). For the Type 26 frigate, the negotiated target cost was at the 85th percentile, and for Astute Boat 5, the 76th percentile. This means that there is more scope in these cases for costs to increase without penalty to the suppliers than would normally be the case.
• Contracts where the supplier agrees to meet the requirement for a set, all-inclusive price, or where variation is limited to an element for inflation. These firm-fixed price contracts are desirable for the Department when budgetary pressures increase the need for certainty over costs. We have seen several examples where this approach has controlled costs to date, such as the Crowsnest and Spearfish programmes, although future increases cannot be ruled out given the problems encountered in both cases. This type of contract means that the supplier will bear the risk of failing to accurately cost the work.