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17 September 2017

Lack of confidence: breaking the unbreakable

Danylo Sytnikov Vice-president of UA.RPA

"To have technologies developed, the existing industry relations should be improved, and new industry relations should be implemented. It has been a long while since Ukraine left behind the ideologically biased method of forced developments widely practised in the Soviet Union. However, our country has not yet switched to capital market relations."

Republished from Obozrevatel

Lack of Confidence: Breaking the Unbreakable

The defence industry of Ukraine craves for reforming of the old financial system of military products procurement. The motivations for engineers and developers existing in Ukraine bring about bitter disappointment and bewilderment, kill enthusiasm and the wish to strive for the benefit of the native country. At the same time, dozens of Ukrainian private companies and organisations producing or developing defence and dual-use products successfully manufacture exported products, and they are interested in thriving of the Innovation Development Platform in our country.

Basis Linked Innovations

The state of innovations in the defence industry can be reliably evaluated if linked to a certain basis only. When assessed on the basis of defence industry development in the NATO states, or even in neighbouring Russia, we can surely say that the condition of innovations is currently pitiful. However, if compared to 2013, the current development of innovations in Ukraine encourages optimism and deserves high esteem. First of all, Ukraine, its core defence industry operator (Ukroboronprom), private companies, are now passing the way which took twenty-five years for other countries to complete after the Soviet Eastern Coalition collapsed. Remembering the events from our history, we just cannot expect the easy way. Still, on the positive side, the innovations presently implemented in the Ukrainian Army and in the country’s defence industry are aimed at specific solutions in a certain place – in the warfare area.

Laws of Progress

To have technologies developed, the existing industry relations should be improved, and new industry relations should be implemented. It has been a long while since Ukraine left behind the ideologically biased method of forced developments widely practised in the Soviet Union. However, our country has not yet switched to capital market relations.

What is the problem? As a private company in our country, you will encounter a restricted profit margin and restricted wages for employees. If you wish to cooperate with the Ministry of Defence, you are sure to face the military acceptance procedure. Technically, it’s a progressive novelty that has been already adopted by many countries. Actually, high-risk products, when human lives are concerned, should be subject to some special acceptance. But, the financial acceptance … is connected with certain problems. The primary problem is the restricted profit margin for materials. Do you know that the permitted profit margin for materials is only 1%? And that for human resources is 15%. These are actual current figures.

So, if your company is a developer having no own manufacturing plant, nor powerful production facilities, like Boeing or our Ukroboronprom, and you make attempts to sell something to governmental agencies, your profit margin would be about 2-2.5%, while your innovations are financed at your own expense, investments may not be taken into account in determining of the product prime cost, and no account may be taken of the inflation. The question is whether someone is willing to take efforts with the profit margin of 2.5%. Most chances are that you would be engaged in R&D just in the same way it was 25 years ago at an ordinary company in Ukraine, and earn from the process rather than from the final product.

Despite the acceptance procedure, the system still has innovations: Ukraine is, probably, one of the global leaders in such directions as air defence, armoured vehicles, and machinery modernisation, due to foreign trade rather than selling of products for the domestic consumer in the war. The implementers of innovations in the network of Ukroboronprom challenged the system, since foreign trade contracts are not subject to profit margin restrictions. Nevertheless, our domestic market that needs development has emerged. To save innovations in the country, developers should be given the opportunity to return investments and earn profits for further innovations.

Ukrainian Engineers and Designers: One Soldier Does Not Make a Battle

Engineers or designers in the Ukrainian defence industry do not compete with their western colleagues, since teamwork and global business consolidations are on the way. At the major US arms exhibition (2016 AUSA), I noticed that only 2 exhibition pavilions were sufficient to locate all of the military industry exhibits. Exhibitors included major corporations, like LockheedMartin, Textron, BMSystems, NorthropGrumman and other corporations that acquire small companies and get enlarged thereby. The US experience may be demonstrated by the following scenario: university teams create products and, later, are taken over by large networks. In Ukraine, we also should focus on teams and their working conditions rather than certain engineers. Presently, the only option of such teams’ development is engagement of the western finance. However, this is not the best way to keep on innovations in the country.

From Idea to Product; Venture Fund Experience

Based on my own experience of venture capital management, I may conclude that no individual, even the nuttiest inventor, can work in the defence industry system independently, since such system is sophisticated, intricate and combines engineering, management, marketing, certification, design documents, etc.

In Ukraine, private companies have no legal ways to earn from project development. Applying to the Ministry of Defence in attempts to get the governmental financial support of a project is not a way out either, since you’ll be bogged down in papers for nearly a year and a half. No team will wait for so long.

The only option that remains available is approaching western funds and universities in search of moneys. In my opinion, this is not the best solution to support our developers. The last example is quite illustrative for me. Can the country producing 10-15% of the global software work for the Ministry of Defence? No, for the reason further detailed. Suppose, you create something unique, for instance, an identifying system for unmanned aerial vehicles, and want to sell it to the state. Such creation took two years and consumed the efforts of five programming engineers having the average monthly salary (in our outsourcing companies) of about two thousand US dollars. So, you would spend, in total, about two hundred thousand US dollars. Then, you sign a contract with the Ministry of Defence, and the Ministry compensates approximately eight thousand US dollars only. The reason is in the calculation which is based on the average salary in the place of development, and the project implementation period. You sign such contract for several months only, and you will be compensated the amount invested in those several months only. The software title passes to the Ministry of Defence, and the software developers loose their rights to the relevant product, and earn nothing from it.

In this case, I cannot blame the military acceptance procedure, as the governmental mechanism stems from the lack of confidence. When the mechanism of state-run companies was effective, such lack of trust was well justified. But, since private companies have emerged, the acceptance problem has to be somehow tackled.

In August, a new financial document, Decree No. 517 (Pricing for Defence Products, Work and Services) dated August 08, 2016 and signed by the Prime Minister was passed. It changed the profit margins. Now, the profit margin of 5-30% is applied instead of 1-15%. However, the problem is not ultimately solved. Actually, companies are now supposed to earn 6-7%, and no investors are expected for such projects. Therefore, there is an urgent need in fundamental changing of the financial system of the military acceptance procedure.