Transaction costs have to be paid for

Ronald Coase, a Nobel Prize-winning economist, died last week. Way back in 1932, when he was 21, he did some research into why it was that companies did not use pricing and markets to organise themselves internally even though they relied on pricing and markets being the best way to operate an economy. (See this article for the importance of this theory for the development of the internet.) The answer, he found, is that using an “internal market” brings with it transaction costs. To have an internal market a company (or other organisation) would need to spend money and resources negotiating contracts and passing invoices between divisions and units. Much easier, then, to manage an organisation by some form of command and control regime. In the public sector we have seen various flavours of internal markets and they are still in place, notably in the NHS. I'm sure the government and others would claim that the greater efficiency of suppliers that results from competition outweigh the transaction costs and perhaps they are right. (If anyone can point me to recent research which addresses this issue I'd be very grateful.)

What's on my mind, though, is a slightly different point. In a competitive market there has to be scope for losers as well as winners. We can see that because some businesses just don't get off the ground and because even successful companies can lose their market share (Nokia, for example). How can you have room for losers in an internal market without incurring waste? In particular, when the market is for public services upon which, say, vulnerable people rely, what happens if their provider is the equivalent of Nokia--once upon a time the best provider but now falling behind the performance of others? There's nothing the recipients can do: they don’t have true customer power because they don’t pay for the service (at least they don't pay the provider directly and have the option to take their money elsewhere) and the long term contract the provider has with the public authority means there isn't an immediate threat of competition to perk up their performance. I think this is because having incurred the transaction costs of procuring the contract the public authority will be reluctant to incur additional transaction costs in ending it early unless the performance is abysmal.

I think what this points me towards is the importance of good contract management for the duration of a contract. Good contract management can represent the service users and also prevent the public authority from getting in to a position where it even has to think about terminating the contract and incurring all the costs that would involve.

I think public authorities are also coming around to this view. Certainly I find myself more often talking with my clients about contract management than I used to. I suspect this reflects the maturity of the outsourcing market in two ways. First, public authorities and providers both understand the commercial issues relating to the contracts and are able to reach workable agreements much more readily than they used to. Second, public authorities who’ve reviewed their experience of contracts over the last, say, 10 years will often recognise that they have not felt in full and proper control of their contracts and that they ought to have invested in contract management skills from the outset.

I think what this means is that if an organisation wants to use contracts, whether for an internal market or externally, it is important that they recognise that good contract management will be a significant transaction cost and they need to be willing to pay for it.

Benchmarking: an incentive to improve, a distraction or a red herring?


In the question and answer session of the presentation I gave a couple of weeks ago I was asked how I thought a process of benchmarking should fit into the annual budgeting process. I gave an answer at the time but I don't think I expressed my view as well as I could have so I thought I would have a go in writing.

The question was posed to me in terms of unit costs: if we are preparing our budget for a service how should we take into account the fact that our neighbours or peers deliver the service for a lower (or higher) unit cost? On the face of it this seems like a good idea and I'm sure there must be some sound theories to support it. My answer to the group, though, was sceptical, borne from experience rather than theory.

I think that the "information" a public sector organisation gets from such benchmarking is unhelpful. I think carrying out a benchmarking exercise is "busy work"; it feels like you're doing something positive but in practice you're using up a lot of resources and getting very little in return. They say you don't fatten a pig by measuring it. Well, benchmarking is the equivalent of trying to fatten your pig by measuring someone else's.

I've been involved in numerous benchmarking activities over the years (it was a key feature of the Audit Commission's work in the 90s and 00s) and the first problem is agreeing common definitions so that the information is at all comparable. The development of accounting standards and financial reporting standards has no doubt improved the consistency of treatment by public bodies, but that does nothing for the second, and bigger, problem: that public managers will cling to favourable comparisons and find reasons to criticise unfavourable ones. (I once has a manager who was very quick to claim successes were the result of his management but failures were the result of external factors beyond his control. Sound familiar?) If you want an academic reference for this, Demeere et al (2009), writing about the use of activity-based costing in healthcare, said:

"... healthcare managers might argue about the accuracy of the models estimated costs and pro"tability rather than address how to improve the inef"cient processes, unpro"table products, and considerable excess capacity that the model has revealed."

Demeere et al actually touch on the potential negative consequence of benchmarking: complacency. If a public manager's unit costs (or whatever) are good they do not need to try harder; if they are poor, they might try hard to make a defence but they can avoid the need to improve their service.

Many aspects of public management these days are informed by or developed from private sector practice. Do private sector organisations benchmark with each other? Perhaps, but it seems unlikely that an organisation could benchmark with competitors directly so they are more likely to use competitors' prices as the benchmark. They may ask themselves, Can we sell our product for the same price as the competition and still make an adequate return? If the answer is no then they either have to find a way to make their product more cheaply, charge a higher price and compete on the basis of quality/design or cease to produce the product. If the answer is yes then that's great, but it would not stop them from seeking efficiency improvements in order to improve their gross profit margin.

How does that compare with a public service? Well, there are some services where charges are made but generally there is not a market because public bodies usually have a monopoly on the service in some geographic area. But there are some areas where there are comparable private sector providers whose prices could be used as a signal. Except, how many local authorities would compare the unit costs of their schools with fee-paying private schools, or compare their access-for-all leisure centres with members-only private gyms? "They're not offering the same things as us," would be the cry so of course our unit costs are different from theirs.

So, based on my experience, what would I recommend? In my view the answer is much easier to find than carrying out benchmarking exercises because the organisation already has it. The answer is to compare our own unit costs over time. This avoids all the problems of alternative accounting treatments, geogrpahical differences in prices, etc. and it builds on the idea that however good a service is the managers should strive to improve it. I'm sure that if all the time and energy spent carrying out benchmarking work and then defending or criticising the results was spent on improving services the benefit for the public would be significantly improved.



Demeere, N., Stouthuysen, K., & Roodhooft, F. (2009). Time-driven activity-based costing in an outpatient clinic environment: Development, relevance and managerial impact. Health Policy, 92(2-3), 296–304. doi:10.1016/j.healthpol.2009.05.003

Local government needs to rethink its attitude to outsourcing

I think the following is a thought-provoking piece from the Guardian's website by John Tizard . Local authorities—and other public sector bodies—do need to think about what it is they want in terms of service and then work out how to get it. Times change and a key aspect of public service is the frequency of politicians, national and local, making changes. In some ways outsourcers can be more flexible than in-house staff and in other ways less flexible.

Perhaps now more than ever flexibility is needed in outsourcing contracts. There are ways of getting such flexibility, but to my mind it gets back to the issue that, despite 30 years of using private sector providers, there is a remarkable lack of commercial skill and knowledge within public sector organisations. Such skills are needed for two reasons. First, to be able to procure an outsourced provider that meets the organisations needs now and in the future and, second, to know when outsourcing is the wrong answer.

Double dip recession, calls for all Whitehall departments to prepare further cuts, the Comprehensive Spending Review brought forward to 2013, demographic growth, government borrowing remaining high – the financial prospects for local authorities are bleak.

Councils may have managed to balance their budgets for 2012-13 and for the remainder of the current spending review period (provided that they are not asked to find more savings), but are they ready for the next phase of austerity?

Given the immediacy of the cuts following the spending review and financial settlement in 2010, I suppose it was not surprising that few local authorities reached for genuinely radical changes over the last two years. They did not rush to outsourcing if they had not already commenced a procurement process before the autumn 2010.

It was a logical and rational position for local authorities to adopt. Traditional outsourcing arrangements take time to weave through complex and protracted procurement processes that cost large sums of money, consume senior officer time and rarely deliver immediate savings. Many of the savings that had been made by some earlier outsourcing of services such as back office or support services were no longer available, as councils themselves had become more efficient.

During a period of uncertainty, it's simply imprudent to lock up significant tranches of a local authority funding within inflexible contracts. The truth is that evidence of the success of outsourcing has been mixed at best.

Over the last few decades, local government has used outsourcing to the business sector for a number of reasons: to secure savings; to gain investment; to offer choice to users; to attract innovation and productivity improvements through competition; to address under-performance; and to transfer difficult management decisions outside the council.

These reasons vary both from authority to authority and also sometimes within the same councils between different servcies. This apparent inconsistency is understandable and appropriate, as outsourcing should only be pursued when and where it will add value.

These actions must be explained to the public. Outsourcing has not always been a success in adding public value, and those lessons need to be learned. Over two decades the scope of outsourcing and the services it involves has changed dramatically. In some ways, there has been a major move on from Compulsory Competitive Tendering (CCT) - but in others, regrettably, there hasn't.

Faced with the stark prospect of having to make even deeper cuts in the future, are we likely to witness a significant expansion of outsourcing to private companies? It is worrying to note that some local authorities are returning to some of the worst elements of CCT, more concerned purely with driving costs down then about quality or the terms and conditions of public servants. This will undoubtedly lead to long-term problems.

Thankfully, others are seeking strategic partnerships to both reduce costs and improve services, help manage demand for services, and to invest in wider social and economic objectives. Of course, these goals are not always compatible – especially when the overriding desire is to reduce spending. But attempting to reach them does require a new approach to partnership and collaboration between local authorities and the outsourcing industry. This requires constructive dialogue and a willingness by all parties to change their behaviours.

Local authorities are right to want greater transparency and accountability from providers. They should always want good terms and conditions for people delivering public services. However, local authorities should also be considering a wider selection of responses to their financial and policy imperatives, other than purely outsourcing. There has to be a role for in house provision, a greater role for the voluntary and community sector, for employee and user co-operatives, for partnerships with other authorities and the wider public sector, and other roles for business including in-sourcing.

The risk of blinkered thinking and lack of planning is that some councils will pursue a default and automatic outsourcing to the business sector believing it to be a panacea for their budget problems, or indeed for ideological reasons. Others will ignore the option for the exact opposite reasons.

Local government has to change, and change dramatically – in what it does and how it secures the results required by local people, communities and businesses. It has to be more open and transparent. It needs to be more fleet of foot. Set against that context, the old model of outsourcing has little to offer to meet these challenges. My prediction is that, over the coming years, the traditional outsourcing model will be left behind – so will be some of the current outsourcers.

Both providers and local authorities need to wake up to the new paradigm. They must reject simplistic options.

John Tizard is an independent strategic advisor and commentator on public policy and a member of the Guardian local government network editorial advisory panel


Collaborate to improve value for money


Many of us would intuitively agree with the truism that two heads are better than one but that doesn't mean that we work that way. In the public sector there are often tens or even hundreds of organisations that carry out similar functions to each other but in different localities. Despite 20 or 30 years of talking about sharing services, in one way or another, little happens. Whilst most public bodies have the power to work with others they are not obliged to do so. That is not always the case, though.

Over the last year I have been working with Lincolnshire Police. In the UK police forces are expected to collaborate with each other in order to save money. This is not so relevant for routine policing but neighbouring forces can share in the savings made when specialist services are combined into a single team. There are examples of this all over the country.

I recently discovered that the Welsh Assembly has passed an act (acts are called measures, though, in Wales) that requires Welsh local authorities to collaborate with each other with a view to improving the overall efficiency and effectiveness of local government services. The measure is not prescriptive about which services to collaborate on or the form of the collaboration: these decisions are left to the local authorities to work out together.

One aspect of any collaborative arrangement that has to be resolved is what form the collaboration should take. In legal terms this could range from informal arrangements through delegation from one authority to another, a formal contractual arrangement to a joint venture company or joint committee. Recently the Welsh Local Government Association commissioned Trowers and Hamlins to give general legal advice on the pros and cons of the various collaborative arrangements that are available to local authorities. This guidance has just been published on the WLGA's website.

I mention this partly because I contributed to the document in terms of the financial implications of each of the possible arrangements. I also mention it, though, because it might be useful to managers in local authorities outside of Wales. The exact nuances of the law might be different—and any local authority, in Wales or elsewhere, should get specific legal advice on their specific proposals and not rely on the contents of a general report—but in broad terms the report can help decide which forms of collaboration might be suitable and which are not.

Minor roadworks


I live in the north west corner of Derbyshire where there aren't major roads or motorways. Over the last few weeks I have come across roadworks on lots of the local roads. Not major roadworks, just one of those machines that scrapes off the top few centimetres of the road surface so that it can be replaced with fresh, smooth tarmac. However, I am sure that I won't be seeing any more of these small schemes next week, or again until next March because it is the end of the financial year.

If I were being cynical I would suggest that these works were only being done to make sure that the budget for 2011/12 was as fully spent as possible. That might be the case but I don't know because I don't have the budgetary control report for Derbyshire County Council. What I do know, though, is that public managers still measure their importance and their success by how much money they spend. Until a few years ago the value of public service as measured in national statistics was deemed to be equal (exactly equal) to how much was spent. So, spending more on the roads (or in hospitals, schools, libraries, wherever) meant more value was created. That's changed now (but I won't go into the detail here) but for many managers it is still the case that if they spend more on their service, they deliver more outputs and that must mean they deliver more value for the public. Sounds fair enough, doesn't it?

If I were being more positive, though, I could suggest that these schemes are taking place now because the council's managers operate in the same way that most people do when faced with a deadline; they leave things until the last possible minute to start and then finish just in time.

Whatever the reason, there are several hundred metres of improved roads all around my neighbourhood and, as a cyclist I value it because it will make my riding in the summer a bit faster and a lot smoother and more comfortable. If they hadn't done it no value would have been created but the question is, would more value have been created if they spent the money on something else?

Interim Judgement

I've fallen out of the habit of writing for this blog and have been telling myself for weeks to write a new post. The furore about senior public sector managers being hired through service companies rather than as employees is something I really ought to write about. So I have ... By posting a comment on their blog entry. Here's what I wrote:

I am an accountant and I work as an interim manager through my own limited company. Without getting too technical about it, the potential for reducing my tax bill is not that great, not since the Inland Revenue introduced IR35. Prior to that people working through companies could pay themselves minimal salaries and take the rest of the money as dividends, upon which income tax is paid but not national insurance. Even with that device, you have to pay corporation tax on the profit before you can take the dividends.

There are other possible tax advantages one could implement. Eg the company could employ the interim’s spouse or offspring and thus take advantage of two or more people’s personal tax allowances, reducing the interim’s total tax paid at the higher rates. Dare I say it, this is something MPs have been doing with office allowances for years.

I think I should also mention the reason such companies are attractive to employers, especially for hiring interims: it reduces their liability as an employer. As far as the council or other body is concerned they have a service contract. That means they are not responsible for employment duties such as the working time directive, they don’t have to make national insurance contributions, they don’t have to pay for holidays, they don’t have to apply their equal pay scheme to the position, they can fire the person without having a long winded investigation and disciplinary hearing, and so on. They also don’t have to allow the person to join the pension scheme and thereby they can save themselves the pension contributions.

The downside is VAT is payable on the service contract. Local government and ministries don’t worry about that because they can reclaim it from the treasury. The picture is different in the NHS and I’d be surprised if the witch hunt uncovered the same sort of arrangements in the trusts and PCTs.

To see the full blog post and other comments go to