Defence investment cost escalation - a refinement of concepts and revised estimates

This report explores the topic of investment cost escalation (ICE) – the increase in unit costs beyond inflation between generations of a weapon system. One aim of this report is to clarify important concepts. We make a distinction between cost escalation and cost growth. Where cost escalation refers to long run increase in cost, for example from F-16A/B to F-22A, cost growth is a project specific term, indicating cost increases within a specific project. Cost escalation is the sum of intragenerational and intergenerational cost escalation. Examples of these two types of cost escalation are cost increases from F-16A/B to F-16E/F (intragenerational) and from F-16E/F to F-22A (intergenerational). There are several sound reasons as to why cost escalation exists. The concept of relative effect says that to counter the weapons of an adversary, we must upgrade our weapons to at least their level. As this requires sophisticated technology, the result is an increase in costs relative to general inflation. Advanced technology also carry risks of further cost increases if new technology is more difficult to develop than originally thought. The power of suppliers and buyers are also of significance – as there are few suppliers and few buyers of military equipment, the relative negotiating strength can influence cost growth. If a string of mergers and acquisitions increase supplier power, cost escalation could be a persistent phenomenon. Previous studies all confirm investment cost escalation as a phenomenon, and generally find higher rates on more advanced systems with low rates of production. We conduct a similar study and find similar results. We then isolate the part of the price that can be explained by characteristics such as development in range, weight, displacement, speed, total production quantity and other variables. Controlling for these variables, we find a lower investment cost escalation. The table below summarizes our main results. The table shows annual unit cost escalation for various types of weapon systems using only time as an explanatory variable and using characteristics and total production quantity as explanatory variables. Weapon system n Explanatory variables Only time Characteristics Transport aircraft 7,4 % 3,1 % Fighter aircraft 7,0 % 3,9 % Infantry fighting vehicle 5,2 % 2,1 % Artillery vehicles 4,5 % Submarines 4,5 % 1,7 % Fast attack craft 3,6 % 0,5 % Helicopter 2,5 % 0,6 % Frigates 2,4 % 0,8 % Main battle tank 2,1 % 1,1 % Small arms 1,2 %