Public service outsourcing: profit capping is in the public interest

13 Apr 15
There are strong reasons for profit capping and sharing in outsourcing deals, including bolstering moves to introduce universal accounting standards for all public service contracts. However, there will also be challenges that need to be overcome.

When Ed Miliband announced at the start of the general election campaign that a Labour government would cap the profits for firms with NHS outsourcing contracts there were the predictable responses from some providers and commentators.

The concept is a sensible and workable one, provided that certain conditions prevail and that the public sector has the necessary commercial acumen and skills. The idea seems to be to apply the rule to individual contracts and projects rather than to a company’s total public contracting. Of course profit in this context usually means net financial contribution to the company by individual contracts and projects.

The idea is simple: for any given contract providers would be contracted to return any profit that is made above a stated threshold. An alternative approach, which is already, applied in some public service and business to business outsourcing contracts is to introduce a profit sharing arrangement. Again the idea is simple – if profits rise above a stated threshold the provider is required to share the excess profit with the public sector client to pre-determined proportions, which may be 50-50 or some other balance, which could alter as the level of profit exceeds the threshold.

Companies, including some of the leaders in the sector, are willing to enter into profit sharing arrangements, so why not into contracts with profit caps? Profit sharing can be an incentive for client organisations to work with their contracted providers to achieve productivity and efficiency increases, which can be positive. However, it can also lead to complicate behaviours and weak client management, which is very unattractive.

The simplicity of profit capping and sharing may morph into complexity when the ideas are actually introduced into procurements and contracts. But nevertheless, they are very workable and in the public interest.

The purpose of such arrangements is to ensure the public sector is not paying excessive and possibly unnecessary levels of payments to the outsourcer – but it is reasonable and indeed essential to allow a company or charity to make a profit in order to make a return on investment and create surpluses to re-invest. 

Such arrangements could also potentially reduce public concern about and opposition to outsourcing of public services to the business sector. They can also ensure that more money is available to spend on direct service delivery rather than returns to the outsourcer’s shareholders and/or senior executives.

Indeed, there is no reason why profit capping should be confined to NHS clinical services or the NHS. It and profit sharing could become the norm for all public service outsourcing.

If governments and other public sector bodies want to contract on the basis of either profit capping or profit sharing or perhaps a combination of the two, there are certain conditions that must apply.

There will have to be universal accounting standards and disciplines for all public service contracts (perhaps above a certain value but certainly when profit capping or sharing apply) which not only address the accounts for the contract but which also capture all financial transactions with and money flows between the contracted project and the company involved and its subsidiaries. There would need to be agreed means of allocating company overhead and management costs to a specific project.  

It would be too easy to sub-contract to a subsidiary or to charge for inputs from the company in ways that bolstered the overall company profit but depressed the declared profits or returns to the company for a particular contract. These accounts would need to be subject to independent audit by the public sector client’s internal auditor and external auditor. They would need to be published in a timely and accessible form too. The same applies when the public sector has a joint venture with a business sector provider.

It would also be necessary to ensure that profits or surpluses on specific public service contracts were not being depressed by payments of significantly high salaries or bonuses to senior executives. Indeed any system staff profit share would need to be agreed as part of the contract with the public sector.

One of the biggest challenges that the proposal to impose a profit cap and profit sharing arrangements relates to setting the level of the cap or threshold. The level would need to reflect the level of investment required from the provider, the risks being transferred to the provider and the market benchmarks – the latter being particularly relevant where there are non-public sector markets available for providers as for example for facilities management or IT services. There would need to be an understanding of the relationships between profit and quality of service and employment conditions and for these to be recognised in the contract.

There would presumably, therefore, be different thresholds for different markets and different services. Over time these may converge but it would be wrong to presume that they would.

It will also be important to understand what various levels of threshold will have on different providers so as not to discourage quality providers from the market leaving less competent bidders to dominate markets. 

Understanding all these commercial issues will require a level of commercial sophistication that is not always available in the public sector especially for small procuring bodies. It would be possible for the public sector to build this capacity and to deploy on a shared basis.

If there is to be a real understanding the supply side in public service outsourcing it would be desirable for the creation of a database of all significant contracts, including levels of performance and financial returns. Such an initiative would complement profit capping and add to transparency.

There have been suggestions that the imposition of profit capping may be unlawful under UK and EU competition and public procurement legislation. Provided that all suppliers have to bid and contract on the same basis there should be no serious legal obstacle to the policy and its practical application.

If there is to be more public service outsourcing there is a strong public interest case for profit capping and/or profit sharing.  Governments and the wider public sector need to recognise this.

  • John Tizard
    John Tizard is an independent strategic adviser and commentator on public policy and public services. He works with a range of public, private, third, union and academic organisations. He now holds several non-executive, trustee and chair roles in the VCS and arts sectors. He was a senior executive both at Capita and Scope, and is a former joint council leader

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