The objective of the audit was to assess the adequacy of Defence’s processes, including compliance with the Financial Management and Accountability Act 1997 (FMA Act), the Financial Management and Accountability Regulations 1997 (FMA Regulations), and relevant Commonwealth and Defence procurement requirements, to select the capability solution recommended to the Government to satisfy the requirements of AIR 8000 Phase 2.
1. AIR 8000 Phase 2 is a major capital acquisition project which aims to provide a light tactical fixed wing aircraft capability to the Royal Australian Air Force (Air Force) to replace the DHC-4 Caribou. The Caribou served as Air Force’s primary light tactical transport aircraft for 45 years until its retirement in 2009, and was noted for its versatility and ability to operate from short rudimentary airstrips. The replacement aircraft are expected to undertake a similar role while providing Air Force with useful payload capacity, good range, and in-theatre survivability from a range of threats.
2. Replacing the Caribou has a long history. As part of an earlier project, AIR 5190, Defence conducted a tender process in the late 1990s but found no suitable solutions at the time. Instead, the Caribou’s service life was extended through to 2009. A further project to replace the Caribou, AIR 8000 Phase 2, was included in the 2004 Defence Capability Plan (DCP) and began in 2004, but it was not given priority until mid-2011. At that point the project was accelerated, resulting in the Government approving a capability solution in May 2012.
3. Following government approval, Defence entered into a Foreign Military Sales (FMS) agreement with the United States (US) Government to supply 10 C-27J aircraft, configured in the same way as those in service with the United States Air Force1, at a cost of AUD$882.4 million.2 This acquisition was approved as a direct source procurement: that is, one that does not require an open tender. Defence also entered into a AUD$58.1 million contract with the aircraft’s Italian manufacturer, Alenia Aermacchi (Alenia) for the Intellectual Property (IP) rights to the aircraft.
4. During a Parliamentary hearing on 29 May 2012, Senator the Hon. David Johnston expressed concerns as to whether this acquisition complied with the requirements of the Financial Management and Accountability Act 1997, given that an open tender was not conducted, and whether the acquisition represented value for money.
5. Subsequently, on 31 May 2012, Senator Johnston wrote to the Auditor-General outlining his concerns about the procurement processes adopted by Defence for this project and whether the capability solution option selected would deliver value for money. Senator Johnston requested that the ANAO undertake a performance audit of the project. The Auditor-General agreed to Senator Johnston’s request on 11 July 2012, and scheduled this audit.
Audit objectives and scope
6. The objective of the audit was to assess the adequacy of Defence’s processes, including compliance with the Financial Management and Accountability Act 1997 (FMA Act), the Financial Management and Accountability Regulations 1997(FMA Regulations), and relevant Commonwealth and Defence procurement requirements, to select the capability solution recommended to the Government to satisfy the requirements of AIR 8000 Phase 2.
7. The scope of the audit encompassed the research and analyses undertaken by Defence to inform its recommendation to the Government to approve the selection of the US variant C-27J, under an FMS arrangement with the United States, as the capability solution to satisfy the requirements of AIR 8000 Phase 2.
8. As part of an accelerated approval process, the Australian Government provided combined pass approval3 in May 2012 for the direct source procurement of the Royal Australian Air Force’s replacement for the Caribou light tactical fixed wing aircraft, which had been retired in 2009. The replacement aircraft, a variant of the C-27J as operated by the United States Air Force, would be procured under an FMS arrangement4 with a total approved acquisition budget of $1.403 billion. Defence subsequently entered into a contract with the US Government for the purchase of 10 US variant C-27J aircraft and associated equipment on 4 May 2012.5 The US variant C-27J was selected in preference to a commercial version of the C-27J, and another aircraft type, the Airbus C-295.
9. Overall, Defence’s processes to select the US variant C-27J met relevant Commonwealth legislative and procurement requirements applicable at the time. Defence conducted a direct source procurement process in compliance with the Commonwealth Procurement Guidelines (CPGs). Based on Defence’s assessments, there was a reasonable basis for government to select the US variant C-27J as a better value for money option than the commercial version of the C-27J, and the Airbus C-295. Nevertheless, the department’s advice to government during the earlier phases of the procurement did not cogently establish the case for undertaking a direct source FMS procurement, and there were also shortcomings in Defence’s handling of relations with industry during the course of the procurement.
10. Following a request for additional information by government on the aircraft options to further inform its decision making, in October 2011 Defence approached the commercial suppliers of the C-27J and the C-295 to obtain further price, availability and capability data to compare against information sought from the US Government on the US variant C-27J option. Defence’s approach to industry did not transparently communicate the status of the procurement process, and resulted in a misunderstanding by the commercial suppliers that Defence had initiated an open procurement process, rather than collecting additional information for government decision making in the pursuit of a direct source procurement. In that respect, Defence’s approach did not have sufficient regard to the expectation in government procurement that suppliers will be treated in a fair and transparent manner.6 Defence has acknowledged the lack of clarity attending its approach to industry and has amended its processes so as to improve communication with industry in the future.
11. By way of background, the option to pursue a direct source procurement was available to Defence under the applicable Australian Government and Defence procurement framework. The Government’s Mandatory Procurement Procedures that were in place at the time7 were designed to encourage competition and, therefore, enhance value for money outcomes. However, there was a general exemption clause from these requirements in a number of circumstances, including national security.8 This exemption was, and continues to be used9 by Defence in the procurement of the majority of its military specific equipment, including the C-27J.10
12. Notwithstanding this exemption available to Defence, the department was required to promote the proper use of Commonwealth resources11 and consider value for money, which the CPGs described as the core principle applying to all Australian Government procurement. Value for money involves a range of considerations, including cost, fitness for purpose, the performance history of prospective suppliers, the relative risk of proposals, and flexibility to adapt to change over the life cycle of the acquisition.12 Reflecting these considerations, Defence based its recommendation for a direct source acquisition of the US variant C-27J through an FMS contract on the following departmental assessments:
- the aircraft price offered by the US Government for the US version C-27J could not be matched by the commercial supplier of the C-27J (Raytheon) and this price was only available until June 2012 when the US contract with the supplier of the US variant C-27J (Alenia) was due to expire;
- by accelerating the acquisition process, and reducing the risk of schedule delays by exercising the FMS option, Defence could retire its ageing C‑130H fleet of transport aircraft in 2013, avoiding increasing support costs13;
- the Airbus Military C-295 did not meet several essential capability requirements, including interoperability requirements with other ADF aircraft logistics systems14;
- the US variant C-27J was the only Military Off The Shelf (MOTS) option available15, incorporating ballistic protection, electronic warfare protection, and communications systems that provided battlefield survivability and interoperability with other ADF platforms and the US16;
- the commercial C-27J option offered by Raytheon could not offer substantial benefits over and above those offered by the US variant available under FMS arrangements; and
- the cost to industry of participating in a full tender process was high and Defence assessed (based on previous research and the most recent information received from commercial sources) that the commercial suppliers could not compete with the FMS offer in any case. Defence further considered that conducting a tender would have taken several months and resulted in the loss of the competitive aircraft price available through FMS until 30 June 2012.
13. As discussed in paragraph 9, Defence’s assessments, when taken together provided a reasonable basis to select the US variant C-27J as a value for money option. However, in advice to government in September 2011, and April 2012, seeking approval to proceed with the acquisition of 10 US variant C-27J aircraft, Defence did not cite, for the benefit of Ministers, the legislative basis for a direct source procurement provided by paragraph 2.7 of the CPGs, or cogently present some core advantages of the US variant C-27J, namely its ability to carry the standard ADF cargo pallet, and its interoperability with Defence’s other two fixed wing cargo platforms; the C-130J and C-17 aircraft. There was also scope to strengthen the case for the procurement by clearly outlining the benefits of an FMS acquisition, which can offer the potential to lower risk by taking advantage of: the US’s superior purchasing power; proven capabilities; the ability to share the costs of upgrades and modifications; and a platform that is interoperable with the US.
14. Defence has acknowledged there would have been merit in highlighting the importance of the logistics advantages of the C-27J in its advice to government, to inform decision makers of the full range of considerations which formed the basis of Defence’s longstanding preference for the C-27J. Given the long timeframes, cost and complexity of major Defence projects, it is important that advice to government on procurement decisions clearly identifies the key points to consider and the cost of various options to assist Ministerial decision making.17
15. Defence has further acknowledged limitations in its approach to industry in the course of developing its April 2012 advice to government. Following consideration of Defence’s advice in September 2011, which included concerns about the planned cancellation of the US C-27J program, the Government indicated a wish to keep open its options, and a strong desire for reassurance that there was a compelling case for the direct source procurement of the US variant C-27J. The Government’s decisions prompted a previously unplanned approach by Defence to two commercial suppliers in October 2011, to supplement its existing knowledge of the commercial C-27J and C-295, to compare with the information that was being sought from the US Government on the US variant C-27J.
16. Defence’s correspondence of 26 October 2011 to the commercial suppliers (Raytheon as an agent of Alenia for the commercial C-27J, and Airbus for the C-295), advised them that the information requested would be used to inform first-pass consideration by government; advice which could reasonably be interpreted as implying that the project was in the early stages of development and that a solicitation activity would be undertaken in the future when more detailed information would be sought. The Government’s public announcement on 10 May 2012 that a decision had been made to acquire the US version C-27J through FMS, prompted criticism from industry that the correspondence from Defence had been misleading.18
17. The ANAO has not made any formal recommendations for administrative improvements, noting: that the approval and procurement processes have mostly concluded; and Defence’s advice regarding the introduction of revised processes for future approaches to industry during the capability requirements phase. Nevertheless, the audit underlines the importance of: cogent advice to government on procurement options; and fair and transparent dealings with potential suppliers by government agencies when undertaking procurements.
Selecting the capability solution for AIR 8000 Phase 2 (Chapter 2)
18. The C-27J has been the preferred capability solution for AIR 8000 Phase 2 since the inception of the project in 2004, due to its greater performance, load carrying capacity and interoperability with Air Force’s existing cargo fleets.19 By the time the US Defence Department selected a modified version of the C‑27J in 2007, Defence had developed a strong preference for the C-27J over the Airbus C-295, and in particular the US variant C-27J based on the additional upgraded ballistic protection, electronic warfare and communication systems included in this aircraft.20
19. While Defence developed detailed and robust capability definition documents (Preliminary Operational Concept Document and the Preliminary Functional Performance Specification Document)21, it did not finalise these documents prior to moving into the acquisition phase of Air 8000 Phase 2. Defence also did not obtain robust data as a basis for estimating whole-of-life costs for the three aircraft options. Defence instead estimated whole-of-life costs on the assumption that they would be two-thirds of the running cost of a C-130J aircraft. While Defence has advised that time constraints relating to the accelerated acquisition of the US variant C-27J in 2011 precluded the use of robust data, AIR 8000 Phase 2 had been running for several years prior to the accelerated process, providing Defence ample opportunity to source this data.
20. In seeking government approval in April 2012 to purchase the US variant C-27J, Defence did not emphasise some core capabilities of the US variant C-27J; in particular, its interoperability with Air Force’s C-130J and C‑17 fleet; and its ability to carry the standard ADF cargo pallet. Rather, Defence emphasised other potential capabilities of the aircraft such as its ability to carry the Nary Special Operations vehicle. While the aircraft’s potential to transport the Nary vehicle was relevant, the core role of the C-27J is as a cargo aircraft, operating in the context of a wider ADF logistics and transport framework.
21. The shortcomings in the quality of Defence’s advice to government were partly attributable to AIR 8000 Phase 2 not undergoing a DMO Gate Review22 until 11 July 2012, some two months after contract signature. While DMO requires that a Gate Review be conducted before a proposal goes forward to government for approval23, Defence advised that the Gate Review for AIR 8000 Phase 2 was postponed due to the time constraints involved in meeting the US deadline of FMS contract signature by June 2012.
Compliance with relevant Australian Government and Defence procurement requirements (Chapter 3)
22. Defence pursued an accelerated acquisition strategy for the procurement of 10 US variant C-27J through a direct source FMS arrangement from July 2011. Defence advised that it pursued the direct source option on the basis that the two commercial options could provide no reasonable prospect of providing better value for money that the US variant C-27J sourced through an FMS process. In September 2011, Defence advised its then Minister on the strategy, who then sought the then Prime Minister’s approval to approach the US Government to obtain cost, availability and schedule information on the possible acquisition of the US variant C-27J. While approving the approach, the Prime Minister also requested the development of alternate options and acquisition strategies, noting that the US C-27J program may ultimately be reduced or cancelled. The Prime Minister indicated that commercial information on the alternate options, ‘akin to first pass’, would be considered by the Government.
23. This resulted in an unplanned approach to industry, and Defence’s letters to the commercial suppliers could reasonably be read as implying that the acquisition process for AIR 8000 Phase 2 was at a pre-first pass stage, stating that the purpose of the request was to ‘support the Government First Pass considerations.’ The letters gave no indication that Defence was considering accelerating the approval process, nor that Defence hoped to finalise an FMS contract by June 2012. In this context, Defence’s approach to industry did not transparently communicate the status of the procurement process.
24. Further, the commercial suppliers were not provided with the key capability requirement documents that Defence’s Capability Definition Documents Guide states should be fully developed for the solicitation stage. Defence has acknowledged the limitations of its approach to industry on this occasion, and in the course of the audit amended its Defence Capability Development Handbook so that future approaches to industry follow a more formal procedure.
25. Defence evaluated the industry responses and compared them to the US offer. The information provided by the commercial suppliers reflected the request made by Defence, and was of a lower quality than the information provided by the US in respect to the US variant C-27J. Defence advised that it adopted this approach on the basis that it was seeking to confirm that the commercial options had no substantial benefits over the US variant. Defence was confident of the adequacy of this process to confirm its understanding of the relative merits of the various aircraft, developed over time, without conducting a formal tender process. Defence further advised that it was cognisant of the significant costs associated with developing second pass quality proposals, and wished to avoid having commercial suppliers commit to developing second pass data for this acquisition, when there was no reasonable prospect of them providing a better value for money option. That said, the commercial suppliers were led to believe they were engaging in the early stages of an open procurement process, when in fact they were providing supplementary information to confirm Defence’s position to pursue a direct source FMS procurement of the US variant C-27J.
26. Based on this evaluation, Defence advised government that the US variant C-27J provided the lowest cost and lowest risk option for AIR 8000 Phase 2. However, no risk management process was undertaken by Defence during the acquisition process, contrary to Defence internal guidelines. The possible cancellation of the US C-27J program also presents additional risks to this acquisition in the future as several key advantages of the FMS acquisition may be negated.24 Nevertheless, the possible cancellation of the US program had not been settled at the time of the Australian decision to procure the aircraft, and debate regarding cancellation has continued in the US since then.
Final approvals and value for money (Chapter 4)
27. Based on Defence’s April 2012 advice, the Government approved the purchase of 10 US variant C-27J aircraft through an FMS arrangement with the US Government on 16 April 2012 and the FMS contract was signed on 4 May 2012. The total contract values are:
- FMS contract with the US – $882 502 873; and
- intellectual property contract with the aircraft’s manufacturer Alenia Aermacchi – $58 160 025.
28. In examining the value for money achieved by this acquisition, the ANAO found that in terms of cost, the procurement process adopted by Defence for AIR 8000 Phase 2—which compared tender quality information from the US Government (in respect to the US variant C-27J) to first pass data from the two commercial suppliers (in respect to the commercial C-27J and C‑295), in itself provided a relatively limited basis for comparison between the three options. However, Defence has advised that it also had regard to other cost information on the various aircraft, acquired over the course of Project Air 8000 Phase 2. The comparison of FMS and commercial offers is inherently difficult, and without the benefit of tender quality documentation for the commercial offers, becomes even more so.
29. The Australian Government procurement policy framework does not limit the determination of value for money to cost.25 FMS acquisitions can offer value for money by making available proven capabilities adopted by the US. FMS can also reduce risk and provide an opportunity to take advantage of the US’s superior purchasing power; the ability to share the costs of upgrades and modifications; and a platform that is interoperable with the US. In this regard the ANAO observed that the US variant C-27J:
- allowed Defence to secure a discounted price for the aircraft, contributing to the value for money of the acquisition;
- not only offered interoperability with the US variant C-27J fleet, but also with Air Force’s existing C-17 and C-130J fleets; satisfying the fitness for purpose criterion of paragraph 4.4 of the CPGs;
- provided ballistic protection, electronic warfare protection, and communications systems that enhanced battlefield survivability and interoperability with other ADF platforms and the US, also satisfying the fitness for purpose criterion of paragraph 4.4 of the CPGs;
- removed the risk of Defence having to integrate flight control and electronic warfare systems into the aircraft, decreasing the risk of the acquisition in line with paragraph 4.4 of the CPGs; and
- provided a relatively short timeframe to achieve Initial Operating Capability26, allowing Air Force to retire its ageing C-130H fleet of aircraft earlier and achieve savings, contributing to the efficiency of the acquisition.
30. Taken together, these considerations provided a reasonable basis to select the US variant C-27J as the value for money option.
Summary of agency response
31. Defence’s covering letter in response to the audit is reproduced at Appendix 1. Defence provided the following formal response to the audit report:
Defence acknowledges the findings detailed in this audit report on AIR 8000 Phase 2—C-27J Spartan Battlefield Airlift Aircraft and notes that the ANAO has not made any formal recommendations. Of particular note is that:
- The Financial Management and Accountability Act 1997 was not breached by Defence during the procurement process for the C-27J Spartan Battlefield Airlift Aircraft;
- The chosen C-27J Aircraft constituted the best value for money for the Commonwealth when all factors were considered;
- The basis for a direct source procurement and articulation of the core advantages of the US variant C-27J could have been more cogently presented; and
- Defence's engagement with industry, in this instance, could have been improved.
The approval and procurement processes for this project have mostly concluded. Defence has introduced revised (and improved) processes for future approaches to industry. As noted in the Audit Report, Defence has amended the Defence Capability Development Handbook to ensure that all future solicitation with industry, throughout the requirements phase of the capability life cycle, follows a more formal procedure to ensure the status of procurements are transparently communicated.
 In this report the modified C-27J aircraft Australia is purchasing under this FMS arrangement are referred to as the US variant C-27J.
 FMS is the means by which the Australian Government, through the Defence Materiel Organisation (DMO), procures defence-related goods and services from the US Government. FMS procurement helps to achieve standardisation and interoperability with US Defence Forces and can lower costs by creating access to economies of scale for acquisition and sustainment.
 Defence major capital acquisition projects undergo a staged government approval process that generally involves at least two passes. The first pass submission describes broad solutions to meet an identified capability gap and is presented to the relevant government approving authority. The second pass involves a detailed and rigorous acquisition business case for each capability option approved at first pass. The information provided to the government approving authority at second pass is more detailed and of a higher standard of accuracy. The approval of an individual project may be ‘tailored’ to take into account the particular circumstances. This can include varying the number of times it is considered by government—that is, the number of passes. In the case of AIR 8000 Phase 2, second pass approval was brought forward and agreed at the same time as first pass approval in what is known as ‘combined pass’ approval.
See paragraph 4.4 for a more detailed explanation and examination of the two pass approval process.
 The FMS program can be used to procure materiel and services for both acquisition and sustainment projects with items purchased directly from the US Government through its Security Assistance Program. Defence Instruction (General) LOG 4–3–002, Procurement of Materiel and Services from the United States of America under the Foreign Military Sales Program, 1 October 2010, p. 1.
 In January 2012 the US cancelled future orders of the C-27J and announced plans to divest the aircraft. However, a debate over the future of the C-27J is continuing in the US.
 The CPGs highlighted the need for proper use of Commonwealth resources, which includes ethical use. Paragraph 6.18 of the CPGs observed that: ‘Adopting an ethical, transparent approach enables business to be conducted fairly, reasonably and with integrity.’
 On 1 July 2012, the Commonwealth Procurement Rules (CPRs) replaced the CPGs. The CPRs reflect the CPGs in that they also require procurements to represent value for money for the Commonwealth, and encourage competition in procurement. The Additional Rules in the CPRs have now replaced, and largely reflect the Mandatory Procurement Procedures in the CPGs.
 Paragraph 2.7 of the CPGs stated:
Nothing in any part of these CPGs prevents an agency from applying measures determined by their Chief Executive to be necessary: for the maintenance or restoration of international peace and security; to protect human health; for the protection of essential security interests; or to protect national treasures of artistic, historic or archaeological value.
Applying such measures does not diminish the responsibility of Chief Executives under section 44 of the FMA Act to promote the proper use of Commonwealth resources. Proper use means efficient, effective, economical and ethical use of Commonwealth resources that is not inconsistent with the policies of the Commonwealth.
 This exemption was retained in the CPRs.
 The use of the exemption is further articulated in the Defence Procurement Policy Manual (DPPM).
 Under section 44 of the FMA Act. See footnote 8.
 Commonwealth Procurement Guidelines 2008, paragraph 4.4.
 The 2012-13 Defence Portfolio Budget Statements reported that the savings to be achieved from the early retirement of the C130H fleet were forecast to amount to some $251 million over the period 2012-13 to 2015-16.
 The C-295 was considered unable to achieve the required level of interoperability mainly due to the smaller diameter of its cargo compartment and its inability to transport the standard sized cargo pallet used by Air Force on its C-130J and C-17 aircraft. Further, the C-295 was considered unable to carry a range of ADF vehicles, while the C-27J had the capacity or potential to do so.
 The use of Commercial Off The Shelf (COTS) and MOTS products has been promoted by Defence as a risk mitigation measure in response to a recommendation by the Defence Procurement and Sustainment Review (Mortimer Review) in 2008.
 Defence noted that at the time, another key advantage identified for the US variant C-27J was that the US Air Force planned to conduct certification work for the aircraft which could be relied on by the ADF.
 The April 2012 advice to government contained two different cost comparisons for the aircraft’s acquisition, and estimated whole-of-life costs based on another type of aircraft (the C-130J), even though the manufacturers possessed data on the whole-of-life costs for the C-27J and C-295.
 Airbus stated that ‘despite Airbus expending considerable resources responding to enquiries and requests for rudimentary information, we are concerned that the outcome may have been pre-determined from the start.’ Airbus Military public statement, see http://www.asiapacificdefencereporter.com/articles/235/AIRBUS-MILITARY-E... [accessed 19 September 2012, see also http://www.flightglobal.com/blogs/asian-skies/2012/05/full-text-of-airbu... [accessed 19 September 2012].
 Defence has advised that while an earlier project Air 5190 had found the C-27J to be developmental, the value for money of the C-27J improved, as the cost risk associated with its developmental nature decreased over time as the aircraft matured.
 Defence noted that at the time, another key advantage identified for the US variant C-27J was that the US Air Force planned to conduct certification work for the aircraft which could be relied on by the ADF.
 The purpose of the Operational Concept Document (OCD) and Functional Performance Specification (FPS) documentation is discussed in paragraphs 2.6—2.10. By February 2009, Defence had developed a comprehensive set of requirements which were documented in the Preliminary OCD and the Preliminary FPS. However, these documents remained in preliminary form and final versions were not available when Defence sought pricing data in the second half of 2011 and when seeking government approval in May 2012.
 Gate reviews form part of DMO’s internal assurance framework for capital acquisition projects. The results of Gate Reviews inform DMO’s advice to Defence and government as to a project’s health and outlook. These reviews are the most searching and critical internal review that major Defence acquisition projects are subjected to in the ordinary course of capability development and acquisition. Since mid-2011, it has been DMO’s intention to conduct Gate Reviews at a number of key milestones in the project lifecycle, from DCP entry to delivery of equipment and development of a Materiel Acquisition Agreement. In particular, Gate Reviews are regarded as mandatory at three key stages: before first-pass and before second-pass consideration by government, and before contract signature. See ANAO Audit No. 52, 2011-12, Gate Reviews for Defence Capital Acquisition Projects.
 Defence Materiel Instruction (Executive) 00-0-009, Gate Reviews for DMO Projects, Version 1.0, 3 May 2012, p. 6.
 These risks include the inability of Defence to share the costs of through-life sustainment; aircraft upgrades and training with the US.
 See paragraph 12 for discussion of the other considerations which may inform a value for money assessment.
 Initial Operating Capability is the minimum number of aircraft, associated equipment, and training provided to personnel to deliver a capability to Air Force.