Photo/IllutrationA C-2 transport aircraft of the Air Self-Defense Force (Asahi Shimbun file photo)

Skyrocketing costs in the unit price of an Air Self-Defense Force transport aircraft Japan is trying to produce on its own are shining a spotlight on the whole process of procurement, from cost accounting to cost management.

When the Defense Ministry first placed orders for the C-2 in fiscal 2011, each aircraft was priced at 16.6 billion yen ($150.2 million), according to government sources.

Since then, the cost has risen by 7 billion yen, or 40 percent. The ministry intends to acquire two of the aircraft this fiscal year.

Despite calls to switch to an alternative model, ministry officials clung to the argument that soaring costs were inevitable in light of rising prices for components and other factors.

According to insider documents and sources involved in the project, the unit price of the C-2 fell slightly to 16.5 billion yen in fiscal 2012, but has since risen sharply. It is currently priced at 23.6 billion yen.

The Finance Ministry took the unusual step of suggesting to the Defense Ministry in April, the start of the new fiscal year, that replacing the C-2 with a more cost-effective model "should perhaps be considered as an option.”

The proposal was made by a subcommittee of the Finance Ministry’s Fiscal System Council.

A spokesperson for Kawasaki Heavy Industries Ltd., manufacturer of the C-2, declined to explain the reason for the price hike, saying “it is a contractual matter.”

A Defense Ministry official explained that soaring costs for the C-2’s engines, which are purchased from the United States, and the weaker yen on foreign exchange markets were partly to blame.

But experts point to structural problems in the defense industry, where the principle of competition barely exists because of the limited availability of companies that can undertake such projects.

The price assessment for the C-2 relies on a system called “cost calculation method,” whereby the contractor’s profit is added to the prime cost, including that of materials and labor.

Part of the prime cost, including processing expenses, is calculated on the basis of documents and materials prepared by the manufacturer. Some experts suggest that is an open invitation for soaring costs as contractors have few incentives for suppressing the prime cost.

LAX COST MANAGEMENT

This has spurred rising calls within the government for more thorough cost management efforts ahead of a revision late this year to National Defense Program Guidelines.

Markets have limited coverage in the defense industry because it is such an exclusive club, so “market prices” are often nonexistent.

This means the Defense Ministry has to rely on the cost calculation method.

“We don't accept contractors’ statements without question,” said a Defense Ministry official. “We check them scrupulously.”

One government official remains unconvinced.

“Prices ought to drop in the stage of mass production because of rising plant worker skills and growing work efficiency,” the official said. “The steep price hike we are seeing is not something that we can explain to taxpayers, although there are variation factors, such as foreign exchange rates.”

The Defense Ministry has put expensive items of its mainstay defense equipment, including the C-2, under a framework called “project management,” which consists in managing a “life-cycle cost,” or the total cost covering all five stages of (1) design (2) research and development (3) mass production and deployment (4) operation and maintenance, and (5) scrapping.

Although the system was introduced to ensure reasonable costing, the life-cycle cost per unit of the C-2 has risen from 43.2 billion yen in fiscal 2009 to 60.7 billion yen under a projection released last August. The cost per unit per year has almost doubled from about 1.1 billion yen in fiscal 2009 to 2 billion yen in the current plan.

“Cost management has obviously failed,” the government official said.

Revised National Defense Program Guidelines and a new Mid-Term Defense Program are scheduled to be drawn up late this year. The National Defense Program Guidelines outline the shape of Japan’s defense capacity over the coming decade or so, whereas the Mid-Term Defense Program defines, among other things, goals for the development of key defense equipment over a five-year period.

Putting the cost calculation method under constant review would likely make it more precise and enable more effective project management, experts say.

The Defense Ministry is now discussing new contractual terms with manufacturers to curb the surging costs for C-2 aircraft, a senior ministry official said June 27.

The ministry is weighing the option of a contract with a joint venture of makers involved.

Kawasaki Heavy Industries is currently listed as the primary contractor. According to ministry sources, KHI is responsible for final assembly of the aircraft using components manufactured by other companies, including the main wings and vertical tail fins made by Subaru Corp. and backward fuselages supplied by Mitsubishi Heavy Industries Ltd.

The C-2 transport aircraft is 44 meters long from nose to tail and has a wingspan of 44 meters. It stands 14 meters high. Development of the model began in fiscal 2001. The C-2 has about three times the payload, and about four times the cruising range of its predecessor, the C-1. The development cost was in the region of 250 billion yen.

Budgets have been set aside for 13 C-2 aircraft through fiscal 2018. Five has so far been deployed at the ASDF Miho Air Base in Tottori Prefecture.

The C-2 aircraft is designed to transport troops and equipment during a military contingency in Japan as well as supplies in times of disaster. It is also intended for use overseas in U.N. peacekeeping operations and humanitarian aid missions.