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Contracting Out In The Public Sector

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Analyzing existing literature, this paper seeks to determine the primary factors considered in deciding whether to contract out public services and to evaluate the determinants of success in contracting out these services. Based on this information, this paper explores which public services can be contracted out and which factors could either motivate or act as a barrier in further contracting.

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Contracting Out in the Public Sector

Contracting out public services remains one of the most popular forms of public-private partnerships in America today. Through contracts with private sector companies, government agencies can reduce expenditures, improve efficiency, and sometimes provide higher quality public services than they otherwise would be able to provide. In fact, some municipalities in the United States have contracted almost all public services out, earning these cities the designation of “contract city” (Segal, 2012). Sandy Springs, Georgia became a model for “contract cities” when it incorporated in 2005 and outsourced nearly all public services to Colorado-based engineering firm, CH2M Hill (“Here’s how to do it”, 2012). With CH2M Hill’s contract set to expire in 2011, Sandy Springs went even further by breaking apart its services and soliciting competitive bids, saving the city even more money in 2012. As a contingency, the city even awarded secondary contracts to losing bidders as an insurance policy in the event the winning bidder failed to meet the city’s expectations (“Here’s how to do it”, 2012). While Sandy Springs has experienced great success with private sector contracts, its model does not always equal a recipe for success. Under a similar contractual setup, the city of Maywood, California relied on neighboring city, Bell, to provide most of its public services until a corruption scandal led to the collapse of the agreement (Vives & Elmahrek, 2018). Shortly thereafter, Maywood contracted with ECM Group, Inc., a company under federal investigation for corruption in El Monte, California during the same time period. The city of El Monte later released an audit accusing ECM of falsifying time sheets and billing reports (Vives & Elmahrek, 2018).

According to Vibes and Elmahrek, during that same year, a state auditor found issues with Maywood’s governance and fiscal management, revealing that the city was $15 million in the hole with money owed to the city’s creditors (2018).

As demonstrated by these examples, contracting out may or may not serve as an effective solution in reducing expenditures, increasing efficiency, and ensuring the quality of public services. However, when carefully designed, implemented, and managed, contracts for the provision of public services can be a useful tool to governments looking for the best way to provide these services to society. This paper presents a literature review to analyze the factors considered in deciding whether to contract out public services and to evaluate the determinants of success in contracting out these services. Using this information, the paper seeks to ascertain which public services can be contracted out and which factors could either motivate or act as a barrier in further contracting.

Review of Literature – Determining Whether to Contract

In determining whether contracting could provide a tangible benefit in the delivery of public services, there are several factors to consider. The foremost factor in contracting is the potential cost savings, and according to Ferris and Graddy, there are three primary sources of cost savings: economies of scale, sector differences in the cost of labor, and competition (1986). Prager adds two additional variables to the mix: scope economies and organizational economies (1994). Prager defines economies of scope as combining activities among services to create a “jack of all trades” to cut costs (1994). He posits that contracting out should be considered when a government entity cannot realize economies of scale, cannot take advantage of economies of scope, or when an entity is too large or complex to be managed effectively and contracting some services would allow the entity to focus on its most critical functions (Prager, 1994). While these principles address production costs, Globerman and Vining highlight two types of contract-related costs that are relevant in decision-making: bargaining and opportunism costs (1996). Bargaining costs center on contract negotiations, monitoring of contract performance, and the cost of disputes should a party to a contract fail to hold up its end of the deal.

Opportunism is defined as “behavior by a party to a transaction designed to change the agreed terms of a transaction to be more in its favor (Globerman & Vining, 1996, p. 578).” Globerman and Vining also provide a model for determining the total amount of bargaining and opportunism costs based on three major factors: task complexity, contestability, and asset specificity (1996). As demonstrated by these articles, the evaluation of potential cost savings requires an analysis of many more variables than just the reduced labor cost typically associated with the private sector. According to Domberger and Jensen, sometimes the costs of contracting are large enough to offset the potential benefits, and when this occurs, the delivery of services in-house is ideal (1997). If contracting does represent a cost savings, there are a number of other factors that can support efforts to contract out public services. A political environment that encourages a smaller government is likely to support the contracting of public services (Boyne, 1998). This support is reinforced when the agency’s governing body has a high level of control and/or the head of the agency shares the governing body’s beliefs (Jeffrey, Sergio, Jay Eungha, & Deil, 2005). An agency’s positive prior experience with contracting provides support for the contracting of additional public services (Kodrzycki, 1994).

Furthermore, the greater the agency head’s education and/or experience with the private sector, the greater the support for contracting (Jeffrey, Sergio, Jay Eungha, & Deil, 2005). Significant increases in population can also support contracting out for public services. Termed “overload hypothesis,” governments can become overwhelmed during periods of rapid population growth, prompting the use of contracting to meet service needs (Greene, 2002). Conversely, there are several factors that can hinder efforts to contract out public services. Public employees are generally averse to the idea of contracting out for fear of layoffs, lower pay, and reduced benefits. In addition, public sector unions representing these employees are strongly opposed to contracting out (Fernandez, Lowman, and Rainey, 2002). Another hindrance to contracting out could be the preferences of constituents and citizens, who may prefer in-house delivery of services as they may perceive the government to have a stronger commitment to quality through this delivery channel. In addition, subgroups such as those with low incomes have been shown to prefer a larger role for government and oppose the contracting out of public services (Ferris and Graddy, 1986). One factor where the impact is less clear is public sector accountability. Mulgan argues that contracting inevitably reduces government accountability through the lack of direct control; however, accountability may be increased as it relates to improved clarification of objectives and standards (1997). According to Jeffrey, Sergio, Jay Eungha, & Deil, the perception of reduced accountability is the result of a misunderstanding of the difference between responsibility and accountability (2005). They argue that responsibility is transferred when a service is contracted out; however, accountability for the service remains with the government. In fact, the authors feel that contracting can enhance accountability by incorporating specific standards and strong monitoring of contract performance (Jeffrey, Sergio, Jay Eungha, & Deil, 2005).

Managing Contracts for Success

Once a government entity has decided contracting out would provide a tangible benefit in the delivery of public services, there are several steps that must be taken in structuring, implementing, and managing a successful contract. Prager notes that selecting a contractor is often a complex process given the role competition and collusion play in the competitive bidding process (1994). Despite the risk of collusion among bidders, competition must not be taken for granted as this is a primary source of cost savings and other benefits gained through contracting (Prager, 1994). Another major consideration Prager points out is the number of contractors used to provide services. Some firms choose to accept multiple bids to reduce collusion; however, other firms prefer to minimize the number of contractors to develop more intensive relationships (Prager, 1994). In addition to seeking out the lowest cost bid, firms should also consider a contractor’s past record, reliability, and their capacity (Prager, 1994).

Contract structuring is also a complex process with many variables to consider. The Federal Deposit Insurance Corporation (FDIC) has issued comprehensive guidance regarding the management of risk associated with contracting out to third parties (2008). While the guidance is specific to financial institutions, it lists topics important in structuring any contract including: scope, cost and compensation, performance standards, reports and auditing, confidentiality and security, monitoring of complaints, contingency plans, dispute resolution, and liability limitations (FDIC, 2008). One of the most important aspects of ensuring a contract’s success is defining specific performance standards with which a government entity can measure a contractor’s performance in providing a public service. A lack of specific performance standards can lead to reduced quality according to the “quality shading hypothesis” when a contractor’s incentive to reduce costs surpasses its incentive to maintain quality (Domberger & Jensen, 1997).

Using the defined performance standards and reporting and auditing provisions set forth in its contracts, a government entity should perform comprehensive monitoring to ensure success. Prager posits that monitoring is made up of two components: financial monitoring and technical monitoring (1994). Financial monitoring involves auditing to ensure contractors are paid according to the contract and to uncover potential errors or fraud, while technical monitoring involves the review of the quantity and quality of services provided under the contract (Prager, 1994). Depending on the complexity of the service being contracted, the cost of monitoring can be significant; however, the cost of not monitoring can be even higher (Prager, 1994). DiscussionUsing the framework provided in the literature, almost any public service could be contracted out. In order to successfully contract out a public service, there must be a tangible benefit (i.e., cost savings or increased quality), support from external and other factors (i.e., political environment, viewpoint of agency head, or prior positive experience with contracting), and a mechanism in place to provide for effective management of the contract. Assuming these conditions are in place, the quantity or level of public services available for contracting is at the discretion of the government entity considering such a project. As demonstrated by Sandy Springs, Georgia, a government entity can use contracting out to provide nearly all public services and successfully meet the needs of its citizens. Its success in meeting these needs depended on the conditions mentioned above. The municipality received significant cost savings as a benefit of contracting out (“Here’s how to do it”, 2012).

External factors such as the conservative political environment, views and experience of those in charge, and the high income level of citizens provided additional support for contracting (Segal, 2012). Furthermore, government leaders had the technical expertise to effectively manage its contracts, which is evidenced through its strategy to award losing bidders secondary contracts in the event the winning bidder fails to deliver services as promised (“Here’s how to do it”, 2012). On the other hand, Maywood, California represents a failure in the use of contracting for public services. According to Segal, the town “flirted with bankruptcy and lost insurance coverage for its public workforce” in 2010 (Segal, 2012, para. 23). According to a city council member in 2012, the cost of providing services increased, while the quality went down (Segal, 2012). In 2016, state audits revealed issues with Maywood’s governance and fiscal management and noted debts of over $15 million (Vives & Elmahrek, 2018). In considering the conditions for success noted in the literature, the city’s cost savings in contracting services out is questionable and the quality of service provided is inferior. Furthermore, the city government lacks the expertise needed to successfully manage its contracts. The city council did not perform adequate due diligence when it contracted with ECM Group, Inc for services in 2016, which has been involved in other federal corruption investigations, and was recently named in a warrant related to Maywood’s most recent political scandal (Vives & Elmahrek, 2018). While these are only two examples of the results of contracting out, they do support the conditions for success mentioned throughout the literature. Ultimately, the amount or level of public services that can be contracted out depends on the discretion of the government entity considering contracting. Assuming all of the conditions in supporting contracting are present, contracting out provides a useful tool to government entities looking to achieve cost savings, increase the quality of services, or improve efficiency in providing public services. While government entities may initially experiment with more simple contracts, further and more complex contracting may be motivated through positive experiences.

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