Why the Modi government's defence pricing policy is not as bad as it looks

An advance air defence interceptor missile is launched from Wheeler Island off the Dhamra coast in the eastern Indian state of Orissa December 6, 2007. India successfully tested two surface-to-surface nuclear-capable Prithvi missiles against each other from separate military ranges on its eastern coast to evaluate their air defence capability, according to the Indian military. REUTERS/Indian Military/Handout (INDIA). EDITORIAL USE ONLY. NOT FOR SALE FOR MARKETING OR ADVERTISING CAMPAIGNS. - GM1DWTIPJSAA

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26 Aug, 2025 12:21

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At first blush, the new defence pricing policy announced by the government earlier this month seems to discourage production. The policy, which proposed margin cuts, seems to be at odd with government rhetoric.

For instance, not long ago, finance minister Arun Jaitley, who had also held the defence portfolio earlier, wrote in a blog: “Indigenous defence production or defence industrial base are the essential components of the long-term strategic planning of a country.”

The new defence pricing policy has proposed to cut profit before tax margins for all defence public sector undertakings for all new orders. The margin would reduce to 7.5 percent on manufactured equipment compared to 12.5 percent now. For spare & services, profitability margins remain unchanged at 10 percent. The rationale given for the new defence pricing policy was to bring uniformity among state-owned units.

Defence companies trading on the bourses, especially Bharat Electronics Ltd (BEL), took a beating after the announcement. BEL has lost nearly 30 percent, or about Rs 8,000 crore of its market capitalization since September 4.

BEL’s management tried to pacify the market saying that the impact will be small and not affect current business, but that hasn’t worked. Now that the dust has settled, there seems to be a consensus among analysts that the impact will be lower than feared.

A Citi report points out that the profit margin allowed under the old policy was a maximum of 12.5 percent, which was not always achieved. Further, the treatment of overheads between the old and new policies gives enough room for BEL to hang on to its margins.

A positive that is being ignored by the market is that under the new regime, the company earns 7.5 percent margins on bought out components and value added, while earlier margins were only on the value added. Bought out components are those parts which are produced by suppliers and there is no value addition at BEL’s end. These are essentially traded goods on which a 7.5 percent margin is pretty high.

Though the overall impact of the new policy on companies such as BEL seems to be neutral at best and marginally negative at worst, the fact that the government decided to cut margins gives the impression that the move is done to cut down cost. This, in turn, suggests that companies would not be making enough money to research newer state-of-the-art products.

In effect, the government’s stress seems to be on ‘Make in India’ and not on ‘Innovate in India’ which would not augur well on the long run. But this is not the case.

A look at the way Indian defence production is structured brings clarity. Presently there are 41 ordnance factories across the country, nine defence PSUs, at least 200 private sector license holder companies and a few thousand small and medium enterprises that support the bigger companies. This is where the manufacturing takes place. The government policy is meant only for PSUs.

These manufacturing companies work on the products that are researched and developed by more than 50 defence laboratories of DRDO, the only government-supported R&D agency in the country. DRDO’s efforts are both towards indigenization as well as developing new products. Its skill set has increased with time.

Jaitley in his blog highlights the evolution of the defense industry in the country. At the turn of the century the country largely depended on imports but now 40 percent is indigenously produced. In some cases, indigenization is more than 70 percent as in case of T-90 tank, Infantry Combat Vehicle (BMP III) and some missiles.

But more than indigenisation, the bigger story in defence is the work DRDO has done in developing own systems like Akash missile, Advanced Light Helicopters, Light Combat Aircraft, Pinaka missiles, various radars among others. While the hard work in developing these products has been done, the government’s intention of mass producing these goods has to be done at the lowest possible cost.

A cost-plus basis with a thin margin that would cover overheads and leaves some profit on the table is the thinking behind the government’s current policy. This, however, does not mean that research on new products will stop. DRDO also benefits from this production as it generally receives 4 percent royalty for domestic sales and 6 percent for exports.

While the move of bringing down cost is credible as the bill to the exchequer would be lower, government’s decision also creates an opportunity for exporting arms to other countries. The government had announced earlier that it wanted to start exporting missiles by 2022, low-cost manufacturing bases would go a long way in achieving this goal.