Outsourcing in the public sector often results in overspends and, sometimes, outright failure. So how can you spot when a contract is heading towards ‘financial distress’?
The recent Public Accounts Committee report on outsourcing identified the risk of public sector contract failure as ‘the most important public policy issue of our time’.
With public spending on goods and services now more than £187bn a year, the reality is that many of those contracts become financially ‘distressed’. The level of this financial ‘distress’ has been quantified by the European Services Strategy Unit. It estimates that over half of these contracts show cost overruns with an average overspend of 30% against plan.
But distressed contracts can be predicted before the cost of fixing them becomes disproportionate to the underlying contract value.
This shouldn’t be a surprise because there are common features to distressed contracts. The challenge is for the finance, commercial and programme directors to jointly identify these and put mitigation actions in place.
When looking at the public sector, three key questions can predict a potential distressed contract during the procurement phase:
- Did the preferred bidder offer a significant price reduction towards the end of the procurement?
- Does the contract contain fixed-price arrangements?
- Do the requirements include development of bespoke goods or services?
If the answer to each of these is ‘yes’ then the contract is at higher risk of becoming a distressed contract. This is particularly true for complex and technology contracts where development and price risk was supposed to have been ‘transferred’ to the private sector.
It’s important to understand the commercial and financial imperative from the supplier perspective. A supplier needs each new revenue stream to generate a minimum profit margin, cover overheads and support cash flow targets. Having staked so much resource, cost and internal reputation on the bidding process over 12-18 months, winning becomes key: suppliers may offer a drop in headline price in order to secure the contract.
In the excitement of the final stages of negotiation, a reduction in price is often seen as a triumph by the procurement team. But how many teams consider the operational and commercial implications of a price drop? Why should you assume that nothing changes in the supplier’s cost of delivery?
In reality, a drop in the fixed price tends to mean that the supplier will look to reduce investment in services as a means to reducing costs, thereby protecting their target profit margin. The opportunity to generate a market-rate profit is not unreasonable, but the responsibility rests with the government customer teams to understand the implications of this behaviour.
There are a number of supplier behaviours post the contract award that may impact service delivery and directly lead to cost overruns and delays.
- One example is the supplier pushing for primacy of their solution over the customer requirements. The supplier is seeking to reduce their delivery obligations by diluting the customer requirements. Areas targeted for dilution will typically be those that are more complex and therefore critical to realising benefits.
- Another example is a flurry of contract change notes after contract award. The supplier is incentivised to create ‘sell-on’ opportunities through identifying ‘gaps’ in their solution or by overtly seeking funds to cover the ‘best and final offer’ price reduction. Suppliers will encourage fragmented customer teams to raise their own change requests to increase functionality, resilience or operational benefits. This is particularly relevant where parties have agreed higher day rates and profit margins for ‘additional services’ compared to those for ‘core services’.
- The supplier will also drive down its costs by minimising peripheral services such as financial reporting, governance activities and open-book obligations. These are critical to alerting the government customer to delays and cost overruns.
The trick to managing these issues tends to be found in the financial model. Cash is key for the supplier, so an intelligent customer must regularly ‘read’ the supplier’s financial model pre- and post-contract award and monitor the changes between each version. The challenge is ensuring that there are the skills and expertise within the public sector to grapple with these. Even the simplest of financial models can predict cost and schedule overruns.
In the event that a contract starts to show signs of becoming ‘distressed’, use formal governance channels to flag the issue. The likelihood is that individual teams have not made the connection so collating the evidence at a pan-organisation level enables the accountable officer to determine the appropriate intervention.
Commentators have suggested that we’re experiencing the biggest wave of UK outsourcing since the 1980s, but more must be done to tighten controls and manage performance on public sector contracts. Given there is little political appetite to bail out distressed contracts, it’s time to ‘follow the cash’, improve services and secure a better deal for the taxpayer.
Deborah Downey is a director in Deloitte’s government advisory team advising on outsourced public sector contracts
