The Ministry of Defence may need to dip into its contingency funding to cover planned costs as inflation cuts the department’s spending power, its permanent secretary has warned.
"When set against the assumptions which underpin our Spending Review settlement and forward plans, high inflation will reduce our spending power over the SR period [up to 2023-24] and beyond," David Williams said.
In a letter to MPs on the Public Accounts Committee – which also revealed the department sees a 7.5% cut to its staff budget as "manageable" – Williams said “volatile” inflation made it difficult to give a precise estimate of how badly the MoD could be affected.
But he said there were two major risks to the department’s spending on contracts.
“Firstly, there is the risk of price increases although, to an extent, our commercial mechanisms protect us from this in the short term,” the letter, written on 6 September and published last week, said.“Secondly, there is the risk of schedule delay feeding through as labour shortages, supply chain bottlenecks and shortage of materials bite. This could reduce spend in the short term with financial pressure to follow in later years.”
Inflation has risen to almost 10% from around 4% in October 2021, when the last spending review took place.
The department has brought forward some costs and is keeping its work “under constant financial review” in a bid to limit the impact of financial pressures, Williams said.
This could include using contingency funds if it needs to, which include £5.9bn for the 2020-2030 Equipment Plan over a 10-year period and £4.1bn for research and development, plus more “on top of this”, he added.
Contingency funding was built into the equipment plan to allow for unexpected cost increases to equipment projects, or to get delayed projects back on track.
Williams said “forward purchase of foreign exchange” – buying foreign currency for a specific future date at a predetermined exchange rate – will also help. The perm sec told the MPs in June that the “most” of the department’s foreign exchange was covered for the financial year for this reason – meaning it could also protect the MoD from the pound’s tumble following the new chancellor’s turmoil-inducing “‘mini-budget”’.
Williams said recently agreed pay settlements – the armed forces received a 3.75% rise this year – “will limit financial risks”. However, he warned of "knock-on risks" associated with offering staff a real-terms pay cut, which he said could make it difficult for the department to recruit and retain staff.
Unions are still negotiating with the MoD over pay for civil servants, however. Last month PCS rejected the department's offer of 12.58% over the next three years, including 3.75% this year. The union is demanding a 10% increase this year and also slammed the "unacceptable" changes to terms and conditions that would have been included in the deal.
The other key civil service unions, the FDA and Prospect, have chosen to ballot their members over the offer.
Perm sec sets out thinking on MoD staff cuts
Williams also revealed the department had worked out how much staffing spend it is prepared to cut as part of the government’s plans to cut 20% of its workforce.
This summer, departments were asked to model 20%, 30% and 40% reductions in their headcount.
But Williams said rather than focusing on staff numbers, the MoD had instead focused on the cost savings it could make.
He said the department could cut its staff budget by 7.5% and still deliver on its commitments. Williams did not spell out how many jobs might need to go to achieve this.
“Defence framed its Civil Service 2025 response to reinforce the workforce cost envelope approach (rather than full-time equivalent) as our contribution to this exercise, whilst recognising that a significant proportion of our civilian workforce is supporting the IR and operations.
“As I indicated, the department illustrated a 7.5% reduction – which we judged to be manageable while delivering the outputs set for us in the  Integrated Review – as well as the progressive impact of potential higher levels of reduction.
“We await to see how this exercise will be taken forward across government this autumn.”
While the government develops its plans, which were kickstarted by former prime minister Boris Johnson but have been backed by new PM Liz Truss, Williams said he is “keen we use the work as a catalyst for improvements in how we run and manage the department”.
This will include using digital transformation, automation and increased sharing of services to make the department more efficient, Williams said.
Williams was responding to a request from PAC chair Meg Hillier to set out how the MoD would deal with soaring inflation as well as the government's planned headcount reduction.