The Shape of New Zealand's Defence - A White Paper (November 97)
Annex B
Defence as a Business
The Defence Force has 15,796 employees, assets of $3.5 billion, and an annual operating budget of about $1.4 billion. By New Zealand standards it is a big business. It also has some unique characteristics that have a bearing on its funding and financial management.
Defence is capital intensive, with a large inventory of military equipment, supporting infrastructure and a vast array of supply items. However, the return on this investment cannot be judged solely on its present day utility. By its very nature, defence is a contingent service provided to Government. the Defence Force is equipped, manned and trained to apply military force in combat. The military capabilities must be maintained, even when, as at present, there is little prospect of their use in actual combat. For defence, the bottom line is performance in a future conflict.
Defence funding decisions are long term investments. The military must train most of its own people and it can take years to achieve the required level of proficiency. Military equipment typically takes many years to acquire and its operational life can be measured in decades. At the same time, defence is an area of rapidly developing technology, and a programme of new equipment acquisitions together with upgrades and refits for existing equipment, is the norm. Provisions must be made for on-going investment to ensure that operational effectiveness is maintained. A "whole-of-life" approach is required that takes into account all of the downstream life-cycle costs.
The Cost Drivers
Since 1990, accrual accounting has replaced cash accounting within the public sector in New Zealand. Financial accounts reflect expenses when they are incurred and revenue when it is earned, regardless of when the actual cash transactions take place. As well, all assets and liabilities are accounted for on a balance sheet. For these reasons, accrual-based financial reports and budgets give a more complete picture of financial activity during a reporting period and of the overall financial position of an organisation than is provided by cash accounting alone.
Personnel costs are the highest proportion of operating expenses. These costs are driven higher by the significant training load associated with high attrition rates which have been climbing since 1994. The average attrition rate of the NZDF is currently around 14% Personnel is also an area where there is little flexibility to absorb changes in funding levels. Defence has to undertake its own training for most of its personnel and this a long term investment; it can take a decade or more before people reach the proficiency required to take on senior roles. The operating component includes such items as fuel, equipment maintenance and spare parts, an other consumables such as food and clothing. In general terms these expenses can be considered to be the cost of the activities undertaken by people: training, exercises and operations. Together with personnel, these costs make up almost 58% of the operating budget.
Distribution of Operating Costs 1997
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Distribution of Operating Costs 1997
- Personnel - 36%
- Capital Charge - 28%
- Depreciation - 14%
- Operating - 22%
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Capital is a significant component of the costs because of the large amounts of military equipment, supporting infrastructure and inventory held by the Defence Force. Capital acquisition is funded through a depreciation allowance that is based on the value and depreciable life of fixed assets held by the NZDF. Depreciation is currently about 14% of the NZDF's operating expenses. The other expense associated with capital investment is capital charge that is assessed to reflect the cost to Government of its capital investment in Defence. It makes up 28% of operating expenses and is the second largest cost component after personnel.
Some 95% of the total costs cannot be easily changed in the short term. These fixed costs include personnel costs, capital charge, depreciation and the operating costs associated with significant equipment and property holdings which cannot be disposed of easily. The costs that can be changed in the short term are those consumables associated with training activities such as ammunition, fuel, rations, travel costs, and repairs and maintenance. These variables constitute only 5% of the total costs. Unanticipated funding cutbacks or cost increases can only be absorbed in the short term by cutting back on these variable costs. The result will be less of the training and exercising necessary for the NZDF to maintain its operational effectiveness. Although the variable costs may be marginal in financial terms, they are critical to achieving and maintaining operational effectiveness.
Technological change and heavy reliance on overseas suppliers will mean that the cost of replacing major equipment will rise faster than the general rate of inflation. In addition, because the depreciation funding regime does not include an allowance for the impact of inflation, it will not even be able to keep up with cost increases brought about by general inflation. For all of these reasons, depreciation alone will not be sufficient to sustain the required level of capital investment. Because of this, there will be a need from time to time for capital injections to augment the depreciation account.
The "lumpiness" of large capital acquisitions will also result in a need for capital injections by the Government, but they could be compensated for by re-payments through a series of subsequent capital withdrawals. Alternative funding arrangements, such as leasing, are being investigated as a possible way of better managing cashflow and the NZDF's balance sheet when dealing with large capital purchases.
