The defense sector has many characteristics that are unique to its market due to its national security exemption to most international trade agreements. Amongst those characteristics is a firm set of offset (or industrial participation) agreements that are often required of prime contractors.. With approximately 130 countries participating in defense offset agreements, it’s important to note that these terms differ per location. Moreover, it’s important to acknowledge the growth in usage of these offsets and how this can affect your supplier relations.
Since the end of the Cold War, Western markets have been downscaling on their defense spending. In the US, the adaption of the Budget Control Act of 2011 saw a decrease in military spending up until 2021. On the flip side, continents such as Asia and South America have increased their defense investments by a compound rate of 5-10% per year. Despite the varying economic climates, one thing reigns true: defense spending still commands a respectable portion of these countries’ GDPs.
With this in mind, every country approaches its offset strategy differently with its own set of rules. In most cases, these regulations are there to support the local economy and maximize long term socio-economic benefits to the buying country.
Although adhering to offsets may seem like a contractual burden, there are many ways for organizations to start utilizing them to their benefit, as a strategic objective. Defense offsets can be used to promote international growth, partner on unique innovations, while developing a sustainable, diverse supply chain. In this article, we will unpack what you can expect from a basic offset agreement and how you can start crafting an effective strategy to change this obligation into a win for your company.
What is a Defense Offset?
Put simply, defense offset agreements are a set of agreed-upon terms in which the seller - or prime contractor- adheres to providing local benefits to the pertaining country of the sale. In other words, the seller will agree to buy the local products or services with the intention of growing the country’s economy. For the defense market where the money is of a significant amount, this can be a huge Foreign Direct Investment win for the country of the buyer.
Offsets can be viewed as a legal trade practice that is widely used in both the aerospace and military industries, where they typically become an integral part of a standard “terms and conditions” in the purchasing country’s contract. However, each country designs their rules , based on the country’s immediate and long term objectives. In most cases, it can be generalized that many look to require 50-100% of the Total Contract Value spent locally with a particular focus on defense and ongoing innovations. Most countries also desire R&D transactions that generate long term impacts to the country.
Ways to Build a Strong Defense Offset Practice:
Globalization within the defense market continues to grow and with this brings an increase in offsets (and industrial participation). More often than not, we are seeing offsets become a strategic tool in relation to contractor and supplier relations. While some may think of offsets as a tax burden or a “pay to play” task that must be done, offsets are essential for international growth and can provide the company a serious local advantage. Following a holistic and well-structured supply chain enables organizations to incorporate these offsets as an advantage instead of a limitation.
To avoid mitigating any types of risks, here are a few ways for an organization to adhere to an advantageous offset strategy:
Contextualize the Agreement
All good business decisions require thorough investigations and evaluations of proven methodologies. Despite the fact that some offsets have been built and repeated for years, a thorough review can reveal any potential gaps in the agreement and therefore possible risks for your organization. Even with limited offset experience, being able to alleviate risks and fully knowing how you can efficiently fulfill contractual obligations will pay off in the long run. It is important to have your specific sourcing and partnering plan in place well ahead of time in signing a contract with the local government.
Confirm International Alignment
Before signing any contracts, for a business to fully utilize the power of offsets, they should confirm if the agreement is in line with the company’s overall goals. In an international market, contractors are warned to avoid contracts that disrupt other units of operation or even limit certain areas of growth. Offset proposals are there with the proposed purpose of supporting local business development. Even so, adhering to your company’s set of growth initiatives, global sourcing partnerships, and socio-economic footprint cannot be ignored. Ensuring that the offset strategy is consistent with a company’s overall game plan can lead to higher functioning capabilities. It is important to understand and estimate your forecasted “Cost of Credits” ahead of signing a contract, to know how much it will ultimately cost you to achieve your offset obligations.
Consider the Regulations
Contracts are subject to deviating variables where the minimum offset requirements are subjective. Organizations need to consider these factors when optimizing their strategies for particular deals. For example, you can expect India to offer multipliers of up to 3x for the technology in the domestic production and export fields.
Know Who You are Engaging With
Defense companies who are operating in international markets run the risk of coming into contact with different stakeholders and diverse cultures. Generally speaking, offsets have had a bad reputation in the past for being linked to corruption in the sector. A common example of this happening is bribing public officials to sign off on offset credits before any real fulfillment has been completed.
The bad PR and potential legal storm that corruption can bring to an organization aside, this goes beyond the final dollar. Increasing an organization’s integrity, accountability, and transparency should reign in international agreements. Setting up offset frameworks that define performance delivery and a robust code of conduct makes up the cornerstone of an effective defense agreement.
The Bottom Line
Without the potential of outsourcing or going to a cheaper supplier, many companies view defense offset agreements as a costly compliance. While this may be true, the longer-term effects say otherwise. With the high-value investments coming in from defense spending, businesses are delivering significant development opportunities that position them as a strategic and preferred partner.
Showing investors that your organization goes beyond the triple bottom line bodes well for business growth as well as extending your international growth. Procurement directors are urged to follow offsets that are bound by a robust set of regulations that establish clear responsibility and social accountability. But most of all, its critical to bring socio-economic thinking and offset strategies to the corporation’s most strategic level planning, as they can be seen as a real opportunity for long term growth.