This Web page has been archived on the Web.

1991 Report of the Auditor General of Canada

Main Points

19.2 The government's policy defines its national objectives with respect to the procurement process. It confirms the pre-eminence of operational requirements, competition, fairness and accessibility as the cornerstones of government procurement. Second priority is given to long-term industrial and regional development, and third to other national objectives. By incorporating industrial and regional development requirements into the procurement process, the government's goal is to create long-term, sustainable economic activity in Canada that results in goods and services which are internationally competitive (19.7 to 19.11 and 19.14).

19.3 Canada is not alone; other countries also use procurement as an instrument for industrial and regional development and other related government objectives. To the extent that foreign governments incorporate domestic industrial and regional development objectives in their procurement process, the Canadian government may find it necessary to have certain requirements to develop and protect some industries where governments are usually the major customers (19.21 to 19.23).

19.4 A number of reviews carried out within government have contributed to changes in policies and practices. Achievement of specific industrial and regional development benefits targeted under procurement contracts has been monitored and reported. However, there has not been a formal evaluation of the effectiveness of using the procurement process to achieve long-term industrial and regional development objectives (19.24 to 19.26).

19.5 Before the government awards procurement contracts to suppliers without competition or with limited competition, for the purposes of industrial and regional development, domestic preference, or other related government objectives, more attention should be given to the following factors to minimize contract performance risks such as cost overruns and delays (19.27 to 19.69 and 19.81 to 19.107):

• assessing the selected suppliers' technical, managerial, and financial capabilities;
• providing the selected suppliers with the required technical assistance, where cost justified;
• ensuring that suppliers' estimates of contract cost and time of delivery are realistic, taking into consideration their capabilities;
• ensuring that, where feasible, the research and product development portion of procurement projects is satisfactorily completed and tested before the actual engineering and production begin; and
• considering the suitability of awarding fixed price contracts for work that involves significant research and development where the specifications are not firm.

Procurement and National Objectives

19.8 Canadian practices with respect to national objectives in procurement have attracted attention because of a number of large procurement contracts entered into by the federal government since the mid-1970s. In some industries, the capabilities of Canadian suppliers were not well developed. It was believed, however, that multinational corporations could be persuaded to establish facilities in Canada or transfer technology to Canadian partners as a condition of procurement contracts. Canada developed explicit policies and mechanisms, based initially on the concept of short-term economic offsets and subsequently more focussed on long-term industrial and regional development.

19.9 The general policy developed by the Department of Industry, Science and Technology provides overall direction to all government departments involved in the procurement process. It defines the federal government's national objectives with respect to the process and confirms the pre-eminence of operational requirements, competition, fairness and accessibility as the cornerstones of government procurement. Second priority is given to long-term industrial and regional development, and third priority to other national objectives. This general policy applies to all government procurement regardless of its value.

19.10 This chapter deals with the procurement process in the Department of Supply and Services (DSS) as it concerns industrial and regional development and other related government objectives. Issues related to the government's competition objective are discussed in Chapter 18. Operational requirements and other national objectives are excluded from the scope of this chapter.

19.11 In relating procurement issues to industrial and regional development objectives, we report our observations under two headings:

• procurement for major Crown projects, each of which has an estimated cost of over $100 million; and
• procurement contracts with an expected cost of less than $100 million, and the application of domestic preference policies.

Major Crown Projects

19.13 In evaluating suppliers' proposals for major Crown project contracts, an "Industrial and Regional Development Benefit" is defined as a commitment by a supplier to carry out a particular type of business transaction or other economic activity as part of a procurement contract for the projects. Four general types of benefits are considered eligible transactions:

• production effort - the extent of Canadian content of goods and services produced as a result of the procurement contract;
• technology transfers - the importation of new proprietary technology or licences by a Canadian company. The technology must be exploitable in terms of access to world markets or to specified regional areas;
• investment - the development of a facility or project through direct investment in Canadian industry; and
• other long-term indirect economic benefits (such as offsets).

19.15 Operating departments, jointly with DSS, the Department of Industry, Science and Technology and, recently, the Atlantic Canada Opportunities Agency and the Department of Western Economic Diversification, plan and administer major Crown projects through interdepartmental committees which they chair. The operating department leads the project and focusses on its operational and technical aspects. The Department of Industry, Science and Technology and the Atlantic Canada Opportunities Agency and the Department of Western Economic Diversification play the primary role in planning and monitoring the industrial and regional development requirements. DSS participates in formulating procurement plans and strategies and administers the project contracts. Key decisions are approved by Cabinet.

Audit Objectives and Scope

19.17 We examined procedures for risk management as a part of procurement planning activities and reviewed the following areas:

• procurement and industrial and regional development practices in other countries;
• procedures for evaluating and reporting policy application effectiveness; and
• procedures for management of contract performance risks, both in terms of project costs and schedules.

19.19 This year's review included the following Department of Transport projects:

• The Radar Modernization Project, a $620 million competitively awarded contract to modernize the radar and display site systems in airports across Canada. This project was nearing completion at the time of our audit.
• The Microwave Landing System, a project to develop and install microwave landing guidance systems in airports across Canada. The government is planning to award the main contract, without competition, to a selected supplier. Negotiations were being carried out for the main contract at the time of our audit; the estimated total cost is $450 million.
• The Canadian Automated Air Traffic Control System, a $700 million project to replace the information handling systems for air traffic services across Canada. The main contract had recently been competitively awarded at the time of our audit.

Observations

Other countries also use government procurement to achieve industrial and regional development and other related government objectives

• Certain government contracts may be restricted to domestic suppliers, often on the basis of national security. For example, the United States prohibits procurement of certain foreign products by its Department of Defense; the Department must give preference to American suppliers for research and development contracts; and U.S. Navy ships must be built in American shipyards using American components.
• Preference is given to procurement from small domestic suppliers in the United States in accordance with The Small Business Set Aside legislation. In addition, price premiums are allowed to domestic suppliers, under its Buy American legislation, which allows a 6 percent price premium for domestic products. This premium can be raised to 12 percent to favour small businesses in regions of high unemployment. Reciprocal agreements exempt certain countries, including Canada, from the provisions of this latter legislation.
• Foreign suppliers may be required to provide trade offset benefits to compensate for foreign content in their government contracts, as is the case in Australia.

19.23 To the extent that foreign governments incorporate domestic industrial and regional development objectives in their procurement process, the Canadian government may find it necessary to have certain requirements to develop and protect some industries where governments are usually the major customers. However, such requirements and trade barriers in other countries contribute to the difficulties facing Canadian industries attempting to penetrate foreign markets.

Procedures are needed for evaluating the effectiveness of the application of government policies and practices in achieving industrial development through procurement

19.25 There has been monitoring and reporting by the Department of Industry, Science and Technology on the achievement of specific industrial and regional development benefits targeted under contract to prime contractors of major Crown projects. However, there has not been a formal program evaluation of the effectiveness of using the procurement process to achieve long-term industrial and regional development objectives.

19.26 A formal evaluation would assess the extent of the long-term industrial and regional development benefits actually achieved through major Crown projects procurements. Among other things, it would assess the long-term viability of the business activities established in Canada as a result of these projects. An important consideration would be examining ways to enhance the ability of these businesses to compete, in the long term, in export markets. Potential barriers include differences in product specifications, domestic procurement preference policies in other countries, and recent trends toward reduction in new defence spending worldwide.

More effort is needed to minimize contract performance risks such as cost overruns and delays

19.28 The competitive process, which is one of the cornerstones of the government procurement policy, normally minimizes performance risks by providing an opportunity to fully assess the technical, financial and managerial capabilities of competing suppliers, then awarding the contract to the most capable at a competitive price. Moreover, private sector prime contractors legally assume performance risks through the contractual terms and conditions. We found this to be the case in two of the projects examined -- the Radar Modernization Project and the Canadian Automated Air Traffic Control System Project. However, we found that contract performance risks are likely to be relatively greater when, for industrial and regional development or other related government objectives, the government:

• directs the awarding of a contract to a specific prime contractor without competition, as in the Microwave Landing System and related Toronto Island Airport projects which are described in Cases 1 and 2;
• mandates a regional distribution target of contract expenditures which has the potential to significantly constrain the prime contractor's choice of subcontractors, as in the Space Station Project described in Case 3; or
• requires the prime contractor to use a specific subcontractor, as in the Canadian Navy's Tribal Class Destroyer Update and Modernization Project described in Case 4.

19.30 While such efforts contribute to reducing contract performance risks, we believe that, when contractors are selected by the government for the purpose of industrial and regional development or other related government objectives without the benefit of the competitive process, more effort is needed, before awarding contracts, to ensure that the risks are minimized. Such circumstances require giving more attention to assessing suppliers' technical, financial and managerial capabilities, providing suppliers with technical assistance, as needed and where cost justified, and ensuring that the contract terms and conditions are realistic, taking into consideration the capabilities of the supplier. They also require that the research and product development part of the project be completed, where feasible, in advance of production, and other measures to ensure that government operating requirements are met at reasonable cost and without delay.

19.31 The following cases illustrate some of the contract performance risks that are partially attributable to the use of procurement to achieve industrial and regional development and other related government objectives, and the efforts made by government officials to mitigate their impact.

Case 1. Microwave Landing System

19.33 The government's Science and Technology Contracting-out Policy encourages the fullest possible participation by Canadian industry in government sponsored research and development in science and technology, to stimulate industrial innovation, help Canadian industries become internationally competitive, and thus provide additional benefits to the Canadian economy.

19.34 In April 1989 the procurement plan for the microwave landing system major Crown project, developed by DSS and the departments of Transport and Industry, Science and Technology, recommended competition among Canadian-based suppliers, with a requirement for industrial and regional development benefits emphasizing direct Canadian participation in engineering development and manufacturing. The procurement plan noted that "a sole-source contract would not allow selection of a contractor based on product quality, price and delivery, nor would it ensure that industrial and regional benefits would be optimized."

19.35 In August 1989 the government directed that a certain supplier, subject to demonstration of its capabilities in this field, become the prime contractor for the project. This choice was intended to help in the development of high technology and employment in a certain region of Canada. The intention of the government was to issue a contract in 1990, with deliveries of the required equipment beginning in 1992-93. A smaller contract had already been directed by the government, without competition, to the same supplier for similar but more limited technical work at the Toronto Island Airport, as an opportunity to demonstrate its capabilities in this type of technology. However, the supplier has experienced difficulties in performing this smaller contract, and expressed concerns that development work for the major Crown project will be more extensive and costly than anticipated by the government and that the financial risks could be significant.

19.36 The government now estimates that delivery of the first equipment for the major Crown project is not likely before 1995. At the time of our audit, the Department of Transport was carrying out a review of its options in light of recent cost and time estimates and the performance difficulties encountered in the smaller contract described in Case 2. The review identified two options which would comply with the Department of Transport's operational requirements. The first is to award the contract for a full scale Phase I development of the microwave landing system in Canada to the supplier designated by the government. The second option is to open the requirements for Phase I of the major Crown project to competition. According to Department of Transport files, the second option is less expensive and offers a more flexible approach to project implementation planning. However it would not be consistent with the government directive.

19.37 In August 1991 government officials advised us that the review was complete and that the Department of Transport intends to award the contract for the major Crown project to the supplier designated by the government, subject to this supplier's satisfactory installation and testing of the equipment for the Toronto Island Airport contract described in Case 2 and also subject to Treasury Board's effective approval and successful contract negotiation.

Case 2. Toronto Island Airport

19.39 In May 1987, the government directed that a certain supplier be awarded, without competition, a contract for the Toronto Island Airport system. The decision was taken to provide this supplier with an opportunity to demonstrate its capabilities in this field. Substantial financial and technical risks associated with this directed contract had been identified and communicated by DSS and Department of Transport officials.

19.40 In May 1987 DSS began the acquisition process and negotiated the contract with the supplier. DSS' financial assessment of the supplier, at the time, indicated high financial risks to the government.

19.41 In December 1987, another domestic company announced the purchase of this supplier. This was perceived by government officials as alleviating the financial risks to the government associated with contracting directly with this supplier for the Toronto Island Airport equipment. In March 1988 a contract was issued to the supplier, without competition, for a fixed price of $2.4 million, and a delivery date of June 1989. A performance guarantee was provided by the supplier's new parent company.

19.42 In the spring of 1990, the parent company declared bankruptcy. The supplier subsequently made an assignment for bankruptcy.

19.43 In August 1990, a consortium considered purchasing certain assets of the bankrupt supplier. In accordance with a memorandum of understanding between DSS and the consortium, the consortium agreed to pursue the objective of making the supplier a modern electronic facility that specializes in ground navigation equipment thereby becoming the Canadian centre of excellence for the design, development and production of microwave landing systems including the related world product export mandate. The government also agreed to negotiate, on a sole source basis, with the supplier for the procurement of the first phase of the microwave landing system major Crown project referred to in Case 1. Subsequently the consortium purchased the assets of the supplier and rolled them into a new entity.

19.44 The memorandum of understanding also provided that the original contract for the Toronto Island Airport would be terminated by mutual consent, and a new contract would be entered into with the supplier. The government had paid approximately $1 million for some of the work completed under the original contract. The new contract was to be on a cost-reimbursable basis until a firm fixed-price contract could be negotiated. An interim contract with a limit of $3.2 million has been issued. The supplier currently estimates the costs to complete the work at $7.5 million, bringing the total estimated cost of the project to a potential $8.5 million.

19.45 The supplier is now projecting that the work originally planned for 1989 will not be completed until 1992. In the meantime, the government leased similar equipment to meet the urgent operational requirements of the Toronto Island Airport at a cost of $1 million to April 1991.

19.46 At the time of our audit, DSS hired an independent consultant to review the supplier's ability to complete the contract successfully. The consultant was also directed to assess the cost of completing the contract, and the feasibility of the schedule for completion and installation.

19.47 Subsequent to our audit, the consultant reported to the government that, with regard to project control and technical capability, the supplier was above industry average and that the supplier should be able to complete the contract within the estimated $7.5 million. The consultant also reported that there would probably be a slight slippage in delivery and expressed concern that the planned level of software testing prior to system testing could have a significant negative impact on the completion date. In addition, the Department of Transport informed us that the contract for the completion of the work has been negotiated on a final price basis of $7.1 million and that Treasury Board has approved it.

19.48 Our analysis of Cases 1 and 2 indicated that:

• Before research and development contracts are awarded, without competition, to specific suppliers for industrial and regional development or other related government objectives, more attention should be given to ensuring that project costs and time estimated by the suppliers are realistic, taking into consideration their technical and financial capabilities.
• The practice of awarding fixed-price contracts for work that involves significant research and development, where the specifications are not firm, should be reconsidered.

Case 3. Space Station Project

19.50 The government's Science and Technology Contracting-out Policy encourages the fullest possible participation by Canadian industry in government-sponsored research and development in science and technology to provide additional benefits to the Canadian economy.

19.51 Canada's interest in the Space Station Project centres on the use of the station's facilities and the accelerated high technology space research and development the project would bring to the Canadian private sector, universities and federal and provincial research centres. Throughout, a major emphasis of the government was on spreading the benefits across the various regions of Canada.

19.52 In 1986, the federal government announced its $3 billion expenditure plans for all components of its space program, including the Space Station Project, a Radar Remote Sensing Satellite System and the federal contribution to the funding of the Mobile Communication Satellite. The government indicated that taking part in all projects related to the space program was expected to create more than 100,000 person-years of employment and up to $8 billion in benefits to the private sector by the year 2000. A supplier was designated by the government, without competition, as the prime contractor for the Space Station Project. The expected regional distribution of government expenditures for all space program projects was to be 10 percent each for the Atlantic provinces, the Prairie provinces and British Columbia and 35 percent each for Quebec and Ontario.

19.53 Setting a regional percentage distribution for space project expenditures involved certain risks; limited amounts of the kinds of work involved had been carried out in Canada outside of Ontario and Quebec, particularly in Atlantic Canada. In May 1988, Treasury Board requested that a report be prepared on plans for attaining the regional distribution targets. The government-designated prime contractor was asked to establish an industry team of senior executives from space companies across Canada expected to participate as major subcontractors in the space projects.

19.54 The team assessed the capabilities of private sector companies and, in November 1988, proposed targets which, together with additional space expenditures, were similar to those previously announced by the government. These were approved by Treasury Board in March 1989. The team also proposed a number of measures that would provide flexibility in how the targets were to be met:

• The regional distribution percentages of expenditures would be applied to the total value of the industry team commitments, not to the individual contracts.
• Other high technology work anticipated by the prime contractor, but not directly related to the space projects, was included. This accounted for a significant proportion of the allocation for a certain region of Canada, where there was the least space-oriented industry.
• For the Space Station, Radar Remote Sensing Satellite System and the Mobile Communication Satellite projects, regional targets were made conditional on the technology being available in Canada and on the regional suppliers being competitive in price, schedules and technical capability.

19.56 In January 1990, the prime contractor and the Canadian Space Agency agreed on the principles to be incorporated in a memorandum of understanding. At the time of our audit, the memorandum had not been finalized.

19.57 Our analysis indicated the following:

• Although the government did not solicit competitive bids for the prime contract for this important high technology major Crown project, it designated a highly capable Canadian space technology supplier to be the prime contractor.
• Despite the difficulties involved in allocating some high technology space contracts to suppliers in certain parts of Canada, the government's designated prime contractor and its potential private sector subcontractors developed a realistic procurement plan. The plan recognizes that achieving government targets for regional distribution of some space projects is conditional on the availability of the space technology and the regional suppliers being competitive in price, schedule and technical capabilities.
• We believe that the government and the private sector suppliers are making reasonable initial efforts to meet government industrial and regional development objectives. However, the space projects are still at an early stage and the ultimate success of these initial efforts in meeting government objectives cannot yet be determined.

Case 4. Tribal Class Destroyer Update and Modernization Project

19.59 This year we determined that there is no further delay in DSS contract financial audits of the TRUMP project. Our comments on the DSS contract audit function are included in Chapter 18 of this report. We also reviewed the history and progress of the TRUMP project to determine whether delays and cost overruns are still a concern.

19.60 The TRUMP project, to upgrade and modernize four Canadian Navy destroyers, was first presented to the government in 1977. The project involves a mid-life refit and replacement of old equipment with modern capabilities, specifically anti-aircraft and anti-missile area defence and a new command and control system.

19.61 The government's Shipbuilding Policy requires that most government ships be built, modernized or repaired in Canadian shipyards. In 1983, in an attempt to distribute its projects among shipyards in several regions of Canada, the government required that the shipyard portion of the TRUMP project be given to a specific shipyard in a certain region not already involved in other major government shipbuilding projects, providing that a satisfactory contractual arrangement could be negotiated between the TRUMP prime contractor and the specific shipyard.

19.62 In 1984, a contract for the project definition phase was awarded to the lowest bidder. In 1986, this phase was completed and DSS awarded the prime contract, without competition, to the same contractor. The government stated that this decision was made in the national interest, to accelerate the contract award process, place work with the then-ailing Canadian shipbuilding industry, and avoid placing contracts with prime contractors already involved in other major government shipbuilding work.

19.63 The prime contract was placed with certain conditions imposed by the government. The conditions were that the shipyard work for the first two ships was to be placed with a specific shipyard, and the shipyard work for the remaining two ships was to be competed within the Canadian shipbuilding industry. The prime contract was also governed by a target/ceiling incentive arrangement with a ceiling price of $946 million (1984 dollars) and was subject to economic and foreign exchange adjustments. The contract gave the prime contractor total responsibility for the project. Under conditions set out in the prime contract, the government assumed responsibility for non-performance of the shipyard.

19.64 The shipyard portion of the work for two of the ships was subcontracted to the shipyard designated by the government, for a ceiling price of $115 million (1984 dollars). In 1988, the prime contractor held a competition for the remaining two ships. The same shipyard won this bid, partly because of the experience and knowledge gained from work on the first two ships and partly because of the incremental costs of having the work carried out elsewhere. The ceiling price of the shipyard subcontract was then increased to $235 million (1984 dollars) covering all four ships. The shipyard obtained a $20 million performance bond and a $20 million commercial labour and material payment bond on each of the ships. The government, under conditions set out in the prime contract, continued to be responsible for the non-performance of the shipyard for all four ships.

19.65 By 1989 several disputes had arisen among the parties. Through late 1989 and 1990, DSS attempted to negotiate a settlement with the prime contractor. A settlement offer was made by DSS in December 1990 which included certain relief to the prime contractor in the areas of costs and schedules. However, the parties failed to reach a settlement. This proposed settlement did not include the projected cost overrun by the shipyard, being negotiated separately between the federal government and the government of the province where the shipyard is located. It was understood during the negotiations that the prime contractor would be relieved of the shipyard cost overruns.

19.66 By April 1991 the cost of the TRUMP contract, including economic adjustments and contract changes and amendments, had increased to $1.3 billion. Both the shipyard work and the combat system are late and the project has fallen behind schedule by 18 to 24 months. On 11 April 1991 the prime contractor launched a lawsuit against the government, the shipyard and other subcontractors claiming damages of $750 million.

19.67 In June 1991, DSS and the prime contractor signed a memorandum of understanding setting the principles on which the dispute would be settled by the end of August 1991. The memorandum calls for the suspension of the litigation against the government, the shipyard and all other major subcontractors. It also called for a major restructuring of the current contractual arrangements among the parties. Negotiations between DSS and the prime contractor continued and separate negotiations between the federal government and the government of the province where the shipyard is located also continued. The actual amount of increase in costs is dependent on the outcome of the negotiations and final settlement.

19.68 In July 1991 the federal government reached a separate agreement in principle with the provincial government where the shipyard is located, whereby the two governments would fund the cost overrun of the shipyard contract, currently estimated at $135 million.

19.69 Since the settlement between DSS and the prime contractor will be finalized after our audit, we have limited our analysis to the following comments:

• There are potential performance risks, in terms of cost overruns and delays, when the government requires the prime contractor to use a specific subcontractor, without competition, for the purpose of industrial and regional development or other related government objectives.
• When the government guaranteed the performance of the shipyard, a major subcontractor, it introduced an abnormal element into its contractual relationship with the prime contractor, who was supposed to have total project responsibility. This contributed to the ensuing prolonged disputes and the resulting financial arrangement with the government of the province in which the shipyard is located.

Domestic Preference Policies

19.71 Procurement contracts with a value between $2 million and $100 million, amounting to $3 billion annually, are reviewed by the Procurement Review Committee. The Committee is chaired by DSS and includes representatives from central agencies, policy departments and key operating departments. Its objective is to obtain lasting benefits from the federal procurement activity, extending beyond the immediate impact of the procurement expenditure itself, toward the economic and social development of Canada.

19.72 Most of the DSS procurement policies built up over the years in pursuit of national objectives are designed to provide preference to Canadian suppliers, and support the Canadian content in federal government procurement that is exempt from the provisions of international trade agreements. These domestic preference policies generally apply to procurement contracts valued below $100 million. Some of these policies could also apply to major Crown projects at the discretion of the interdepartmental committee of the particular major Crown project. They include the Shipbuilding, Science and Technology Contracting-out, Priority Groups, Area Buy, Canadian Content Premium and Canadian Value Added Profit policies.

19.73 The Shipbuilding Policy limits competition on most government shipbuilding contracts to Canadian shipbuilders.

19.74 The Science and Technology Contracting-out Policy encourages the fullest possible participation by Canadian industry in government-sponsored research and development in science and technology, to stimulate industrial innovation, help industries become internationally competitive, and thus provide additional benefits to the economy.

19.75 The Priority Groups Policy limits competition for government procurement to domestic suppliers whenever possible. The policy places suppliers in four groups: Canadian-based manufacturers and service providers; Canadian-based agents providing after-sales service; other Canadian-based agents; and all others, including foreign manufacturers and governments. If there are three or more suppliers within the first category, competition is limited to that group. Competition is opened up to the other groups, in order of priority, until a minimum of three potential suppliers have been identified.

19.76 The Area Buy Policy provides for acquisition of goods and services by regional DSS offices from businesses located in the regional office's immediate area. The majority of these acquisitions are of a low dollar value and are commercially available off the shelf.

19.77 The Canadian Content Premium Policy and the Canadian Value Added Profit Policy are designed to encourage industrial development in Canada by rewarding suppliers for the extent of domestic content in products supplied to the government. The Canadian Content Premium Policy assigns a penalty of 10 percent of the foreign content in products to the bid price when competing bids are evaluated. The winning bid is the bid with the lowest adjusted price. The Canadian Value Added Profit Policy is applied in sole source, non-commercial contracts and provides for a higher profit for Canadian materials content, for Canadian research and development, and for subcontracting in certain regions of Canada. Such profit is restricted to a maximum of 5 percent of the costs of any contract to which it applies.

Audit Objectives and Scope

Observations

Procedures are needed for evaluating the effectiveness of the Procurement Review mechanism in achieving domestic preference policy objectives

19.80 Furthermore, an internal DSS audit noted that a large percentage of the projects reviewed by the Procurement Review Committee were sole source where there was clearly only one supplier that could deliver the goods or services. There is limited opportunity to obtain additional industrial and regional benefits in such cases, which still take the Committee about four weeks to decide. The internal audit recommended that sole source contracts referred to the Procurement Review Committee should only be reviewed on a sample basis, to improve the efficiency of the procurement process.

More effort is needed to minimize contract performance risks

19.82 During our review of a judgmental sample of procurement contracts valued at $400 million, three cases came to our attention where the impact of such performance risks could be significant. Cases 5, 6 and 7 illustrate these risks and the efforts made by government officials to minimize their impact.

Case 5. Shipborne Integrated Communication System

19.84 Since the Science and Technology Contracting-out Policy encourages the fullest possible participation by Canadian industry in government sponsored research and development in science and technology, competition for the SHINCOM development contract was limited to domestic suppliers. The contract was won by a supplier in February 1982. It was for a fixed price of $6.3 million, with a delivery date of July 1984. This contract represented an ambitious project for this supplier and a departure from its previous line of business, the production of individual hardware components for avionics and flight instruments.

19.85 The product was delivered in July 1985, a year behind schedule, and was accepted with a list of deficiencies. The supplier had incurred cost overruns and, since this development contract was for a fixed price, had to absorb the extra costs.

19.86 While the supplier was working on the development of the SHINCOM system, the Canadian Patrol Frigates major Crown project started. In 1983, project specifications called for a communications system with features identical to those of the SHINCOM system. In February 1984, before the SHINCOM system development contract was completed, a subcontractor in the Canadian Patrol Frigates project awarded the supplier a fixed price contract for $2.8 million for the engineering of the SHINCOM system. This included production drawings and the design of manufacturing methods and test procedures. Delivery was expected for August 1985. Five years later it was still not complete; some system documentation had to be revised before the client department accepted it. Again the supplier had to incur unspecified costs exceeding the value of the contract.

19.87 In July 1986, with the development contract and the engineering contracts not completed, a subcontractor in the Canadian Patrol Frigates project awarded another fixed price contract for $24 million to the supplier for the production of six SHINCOM systems. The expected delivery date for the first system was March 1988; it was delivered in November 1989 with an agreed-on deficiency list. It has now been installed and is functioning, although there are still deficiencies. The supplier's estimated loss on this contract alone amounted to $18 million.

19.88 Subsequently the supplier obtained three more fixed price production contracts. One of these was for the production of four SHINCOM systems for the Tribal Class Destroyer Update and Modernization major Crown project and was awarded by the project prime contractor. Another, awarded directly by DSS, was for 14 compact versions of the SHINCOM system for retrofit to smaller Canadian warships. The third, awarded by the subcontractor in the Canadian Patrol Frigates project, was for production of six more SHINCOM systems.

19.89 With a full order book, but somewhat limited by its capital base and size, the supplier began to look for a partner. In 1988, it was bought 100 percent by a foreign company; in 1989, the new parent company was taken over by another foreign company. In September 1989, the new management reviewed all contracts. Cost overruns on SHINCOM and other contracts, along with changes in accounting policies, had resulted in a net loss of $72 million.

19.90 In late 1989, the new management examined the situation and held meetings with government officials. Management had determined that $40 million was needed above the agreed contract prices to complete the work in progress on government-related contracts. It also asked for a relaxation of the SHINCOM specifications. At the time, the new owner was considering various options.

19.91 In April 1990, the supplier went into bankruptcy. One of the contributing factors was the cost overruns on SHINCOM contracts. The appointed trustee entered into an agreement with DSS to continue limited work on various contracts. It took nearly six months before the bulk of its assets were sold to another company in October 1990. DSS then entered into a cost reimbursable contract with the new owner to identify what was required to fix SHINCOM systems deficiencies, complete some of the systems in progress and prepare a plan and cost estimate for completing the rest of the systems. DSS is planning to have the new owner complete the remaining work on a fixed price contract. The government will pay the remaining costs for SHINCOM system work beyond the amounts in the contracts between the supplier and the Canadian Patrol Frigates and Tribal Class Destroyer Update and Modernization project contractors.

19.92 Our analysis indicated that:

• When the development contract for the SHINCOM system was awarded to this supplier, the need to meet the shipbuilding and refit schedules of the two major Crown projects left too little time to allow for the orderly development of the system.
• A simple, fixed price contract for the development of a unique and complex system did not provide an arrangement that was flexible enough to allow for coping with the design and other problems that had to be resolved before the engineering and production activities could begin.

Case 6. Procurement of Direction-finding Equipment for Airports

19.95 Some of the development work had already been completed by the Department of Transport, but the successful supplier would have to complete work on the design and bring it to the production stage. A proposal from a domestic supplier containing the lowest bid - for $1.8 million - the lowest predictable life-cycle costs and the highest Canadian content, was selected as the winning bid.

19.96 However, the supplier, at that time, had limited prior experience with this type of equipment. Because of this, and because the contract involved considerable development work, DSS considered the risks to be high. To minimize these risks, it divided the contract into two parts, the first for completion of the design and production of a prototype system, and the second an option for the production of 20 systems. The option would be exercised only after the first system had successfully passed all design approval tests and operational field trials.

19.97 Tests on the first system revealed that it contained some unacceptable design weaknesses. On the basis of analysis performed at the time, DSS and the Department of Transport extended the delivery date of the prototype, and the Department of Transport also decided to provide the supplier with technical assistance. In early 1988, the supplier delivered an acceptable prototype and the government exercised its option to purchase the 20 remaining systems. The supplier subsequently obtained another contract to provide the Department of Transport with 40 more systems.

19.98 In this case, the government recognized the risks and took steps to minimize them. The contract was structured so that the development work was completed and approved before production began. The client department provided additional technical assistance to the supplier when it was experiencing product design difficulties.

Case 7. Procurement of Crash Firefighting and Rescue Vehicles

19.100 DSS and the Department of Transport expressed concerns that Supplier B might not have the necessary capabilities to perform the work. As well, Transport officials had expressed their preference for awarding the entire project to Supplier A, who it was believed had the appropriate expertise.

19.101 In deciding to split the requirement between the two suppliers, the government sought to achieve other objectives; namely, to reduce the risk of late delivery, create a second source of supply, encourage technological development and create additional employment opportunities. As a result of splitting the contract requirement, the total contracted price for all the required vehicles was $22.1 million instead of $20.3 million, the amount originally bid by Supplier A.

19.102 The Treasury Board approved the contract with Supplier B on the condition that:

• prior to the award of the contract, Supplier B have in place engineering expertise and experienced production management staff acceptable to the Minister of DSS;
• the contract with Supplier B contain a clear provision for termination should this expertise and staff not remain in place for the duration of the contract, or should the first production vehicle fail to pass the required tests and inspection; and
• further Treasury Board approval be sought if it was proposed to make advance payments to Supplier B.

• Department of Transport and DSS officials continued to express doubts that Supplier B had the engineering, production or project management expertise to complete the contract satisfactorily;
• Supplier B's performance on a different but related contract for the design and production of certain equipment for the Department of Transport was still in question; and
• a consultant had been hired by DSS in early September 1986 to determine whether Supplier B had the engineering design capability and expertise required for the design, development and manufacture of the required vehicles.

19.105 In May 1987, Supplier A's initial contract for 34 vehicles was increased to include the entire requirement for 68 vehicles, for a total cost of $21.3 million. This was approximately $1 million higher than Supplier A's initial bid to complete the 68 vehicles.

19.106 Subsequent to our review of this case, Supplier B informed us that, in its opinion, it had the full capability to complete the work and that it had to terminate the contract due to difficulties with government officials at the time. We did not verify this opinion.

19.107 Our analysis indicated that:

• This project involved product development as well as production work. To minimize the contract performance risk in such projects, the project could have been divided into two phases -- the first phase for product and prototype development and the second phase for actual production. The production phase could then have been competed and divided between two suppliers.
• In its quest to achieve industrial and regional development or other related government objectives in the procurement process, the government may decide to award a contract to a supplier who, in the opinion of government officials, might not be able to complete the contract. In such a case, it should decide, before awarding the contract, whether it is prepared to provide the selected supplier with technical assistance, as required and where cost justified, to enable it to successfully perform the contract obligations.

Certain aspects of domestic preference policies are complex to administer and may conflict

19.109 The complexity of the Priority Groups Policy and its distinction between groups based on the type of supplier, rather than the product supplied, inhibits the efficiency of the procurement process. Also, supplier organizations are increasingly diversified, with both manufacturing and foreign agency operations. Criteria for determining what constitutes manufacturing, and thus inclusion in the first priority group, have varied within DSS.

19.110 Policies may also conflict with each other in some areas. For example, the Area Buy Policy may result in domestic agents located in the regions, who import goods from foreign manufacturers, being given preference over Canadian manufacturers located elsewhere. This conflicts with the Priority Groups Policy, which is intended to give Canadian manufacturers preference.

There is a need for an evaluation of the cost effectiveness of the policy of giving preference to domestic agents

19.112 DSS policies state that, for procurement over $2 million, "when extra costs are involved, it must be demonstrated that the benefits justify the extra cost, and either the benefits would not accrue to the Canadian economy without support or the procurement exploits a strategic opportunity". For procurement under $2 million there is no comparable departmental policy. The policy does state that where, based on the procurement officer's product knowledge and past experience, the prices do not represent fair value to the government, the officer should cancel or reject all bids. This determination should be fully supported in the contract file.

19.113 We were not able to identify, in the DSS system, all contracts issued to preferred domestic agents. In our opinion, such information is vital if DSS is to evaluate the cost effectiveness of this domestic preference policy in contributing to the national objectives of the government.

19.114 In the absence of agent information in the DSS system and to try to estimate the incremental cost to Canada of this preference policy, we examined a judgmental sample of contracts for spare parts valued at $60 million. We selected a product line in which domestic agents, who import their products from foreign sources, seem to be particularly active as suppliers to the Canadian government.

19.115 Our review of the information submitted by the agents and included in the DSS files indicated that the prices paid by DSS to these agents include approximately 16 percent to cover the agents' administrative costs and profits. There is a need for an evaluation of the incremental costs and benefits of applying this domestic preference policy.

19.116 DSS Initiatives A review is currently under way by DSS to streamline and rationalize the various domestic preference policies.

19.117 At the time of our audit the Department proposed a new Priority Groups Policy with only two groups; the first is to include Canadian manufactured products or services, and the second all others. The effect of the proposed policy would be to eliminate the practice of giving preference to domestic agents. DSS also proposed the discontinuance of the Canadian Content Premium Policy and the Canadian Value Added Profit Policy.

General Recommendations

19.119 Before the government awards procurement contracts to suppliers without competition or with limited competition, for the purposes of industrial and regional development, domestic preference, or other related government objectives, more attention should be given to the following factors to minimize contract performance risks such as cost overruns and delays:

• assessing the selected suppliers' technical, managerial, and financial capabilities;
• providing selected suppliers with the required technical assistance, where cost-justified;
• ensuring that the suppliers' estimates of contract cost and time of delivery are realistic, taking into consideration their capabilities;
• ensuring that, where feasible, the research and product development portion of procurement projects is satisfactorily completed and tested before the actual engineering and production begin; and
• considering the suitability of awarding fixed price contracts for work that involves significant research and development where the specifications are not firm.

19.121 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. The scope of the evaluation should be decided by the Department of Industry, Science and Technology and be feasible.

DSS' response: DSS recognizes that competition is one of the cornerstones of the government procurement policy and is attempting to achieve the objectives of competition, fairness and accessibility in support of the objectives of its client departments. The Department has put in place a number of initiatives designed to foster competition such as open bidding and the Advanced Contract Award Notices advertised through the Procurement Opportunities Board and the Government Business Opportunities publication.

DSS will continue to provide client departments with specialized advice, assistance and services in the contracting area and will ensure that all procurement activities are carried out in accordance with Government contracting regulations and policies.

In conjunction with client departments and other agencies, DSS will continue to minimize contract performance risk by assessing the selected supplier's technical, managerial and financial capabilities, ensuring that supplier's estimates of contract cost and time of delivery are realistic, and selecting the most suitable type of contract particularly when research and development is involved and specifications are not firm. The Department will continue to ensure the optimum approach to contracting is followed when research and product development forms a portion of the work.

As noted by the Auditor General, DSS has undertaken an internal analysis of domestic preference policies. This analysis has resulted in the development of a new simplified priority groups policy. The new policy gives preference to Canadian goods and services rather than making distinctions between the types of suppliers.

Department of Industry, Science and Technology's response to recommendation contained in paragraph 19.121: The Department is in agreement with this recommendation.

Treasury Board Secretariat's response: The Treasury Board Secretariat is in the process of reviewing and updating its procurement management policy. One of the objectives of this review is to establish a better framework for the analysis and evaluation of proposals to use procurement as an instrument for industrial and regional development, that will promote the use of procurement in a selective, judicious and cost effective manner. The proposed framework would include criteria for evaluating project performance risks.