Increasingly when governments decide to test the market for the best price and quality for delivering a particular service, in-house units also are given the opportunity to bid for the contract. Based on the Indianapolis and Phoenix approaches, this model of public-private competition sometimes is referred to as "managed competition."

Introduction

When setting up a public-private competition program, public officials need to take great pains to create a level playing field between in-house public units and outside private providers.

Achieving such "competitive neutrality" requires three major changes:

• Determining the real in-house costs of delivering the public service.
  
  
• Removing all special privileges and tax and regulatory exemptions now enjoyed by public providers that give them an unfair advantage over private firms.
  
  
• Providing public units with greater flexibility in procurement, personnel and remuneration so they can effectively compete with the private sector.

Full-Cost Accounting

Few governments know how much it costs to fill a pothole, do a building inspection or clean out the sewers. In fact, most governments don’t know how much it costs to deliver many public services. Without such data, it is impossible to conduct fair competitions.

Before agencies can make an informed decision about competitive contracting, they must first identify the total cost of in-house service. The task is not an easy one. Often, the cost of a single good or service is shared by several departments or activities, so administrators must decide how much of the cost to allocate to each part of the organization. Professor E.S. Savas of Baruch College/City University of New York, notes that public agencies routinely underestimate their true costs by as much as 30 percent.

Many public agencies lack a consistent methodology for reporting costs. A survey of the contracting practices of 120 cities, counties and district governments nationwide found that half the respondents had no formal method for analyzing and comparing costs. Common mistakes in estimating total costs include:

• cross-subsidizing;
  
• failing to allocate overhead;
  
• improperly depreciating capital assets;
  
• ignoring cost of capital; and
  
• excluding or underestimating costs such as pension plans, legal fees, insurance and administration.

Part of the difficulty is inherent in the nature of the task. As Jonathan Richmond of MIT’s Center for Transportation Studies has observed:

Cost analysis is art, not science. In complex organizations, large numbers of assumptions must be made about how costs which are incurred are to be allocated to various parts of the organization. Many costs are shared by a number of services, and there is often no one obvious way of assigning them to their sources.

Cost often is an important consideration in the privatization decision, and officials should be aware of the true cost of both in-house and contracted services. Without an accurate assessment of total costs, public officials face difficulty determining the most cost-efficient provider of a given service. Computing the cost of service delivery is a complex accounting endeavor, and there is no "cookbook" method that will eliminate all subjective evaluations.

A. Why Total Cost?

When private businesses decide to expand operations or undertake a new service, they ask, "Should I make or buy the additional output needed?" Standard business practice directs that the additional cost of providing the service in-house (also called marginal cost) should be compared to the cost of purchasing the service outside. In private business, this is a sensible method for minimizing total cost.

But government agencies do not operate in the private sector with the same competitive pressures as private business. They often maintain excess productive capacity or overhead and allocate resources inefficiently. For this reason, public-sector estimates of the marginal cost of expansion often are unrealistically low. To better assess the relative efficiencies of public and private service, the total cost or fully allocated cost of both should be compared. Total cost is the sum of the direct and overhead cost of providing a particular service.

B. Beware of These Common Mistakes

• Cross-subsidizing. Costs of the target department often are borne by other departments in the same agency and not reported as a department expense. When determining costs, be on the lookout for in-house units attempting to subsidize the part of their operations that must compete with private firms from protected parts of the unit. In several cities, for example, solid waste pickup has been broken up into quadrants, some subject to competition and some reserved for in-house operation. On several occasions, private firms have argued that the low bids offered by city units are the result of cross-subsidization. The best way to guard against this is to bring in an objective third party to determine the department’s true costs.
  
  
• Failing to Allocate Overhead. Indirect costs, or overhead, such as insurance, utilities, facilities, and administration, are often shared by many departments within an agency. A portion of these costs should be allocated to the target department or service based on its use of overhead support.
  
  
• Understanding Capital Requirements or Replacement Reserves. Assets such as buildings, computers and heavy equipment lose value over their lifetime. They wear out or become obsolete and eventually are dumped, sold, overhauled or replaced. The cost of this loss in value is the asset’s depreciation cost, which usually is calculated as the value of the asset plus interest divided by the asset’s useful life (in years), less its salvage value, if any, when sold. Depreciation costs, or replacement reserves, must be figured into the total cost of a particular activity.
  
  
• Ignoring the Cost of Capital. Interest expense on borrowed funds and debt also must be included in any calculation of total costs.
  
  
• Excluding or Underestimating Costs. A catch-all category, costs may be excluded or underestimated because of oversight, accounting practices that don’t fully allocate cost, cross-subsidizing, or the desire to make a particular service appear more cost-effective than it actually is. Underestimating costs is especially likely when making projections of future costs. Key areas include underfunded pensions, employer-paid benefits, liability and legal costs, and administration costs.
  
  
• Failing to Account for Higher Service Levels. When calculating costs, make sure you are comparing "apples to apples" within what you are asking the contractor to provide. It would not be fair to compare a higher level of service from a contractor with what you might be spending in-house for a lower quality of service. Therefore, it may be necessary to cost-out what the in-house provider would have to spend to deliver this defined performance level.

C. Comparing Costs

When deciding whether to competitively contract for a particular service, additional costs must be considered. Total In-House Costs should be compared to:

   Contractor Cost + Contract Administration Cost + Conversion Cost (Amortized) - New Revenue

• Contractor Cost: This is the price charged to the agency for performing a service.
  
  
• Contract Administration Cost: This can include the costs of bidding, contract negotiations, and any other cost the agency would not have incurred had it not contracted for service. The cost of monitoring and evaluating performance is incurred by in-house and contract providers alike and therefore should not be viewed as part of the additional cost of contract administration.
  
  
• Conversion Costs: Sometimes a public agency will incur one-time conversion costs when it switches from in-house to contract service, such as legal fees or employee incentives. Or the provider may require certain changes in existing facilities before it can begin service. If these costs are paid by the public agency, they should be included in the total contract cost on an amortized basis.
  
  
• New Revenue: Some contracting will create new revenue for the public agency. New revenue should be deducted from the total cost of contract service for comparison to the cost of in-house service. Revenues may be the result of government asset sales, income from operations, or new tax revenues generated by the private contractor.
  
  
• Foregone Tax Revenue: Private contractors pay taxes. They pay corporate income tax, property tax, sales tax, user fees and other taxes, which accrue to the public. Public-sector providers pay very few, if any, of these taxes. When public-sector agencies are used to provide particular services, the public experiences a net loss in tax revenue over that which would be realized if the services were provided by tax-paying private enterprise. Public officials should consider tax revenue in the decision of whether to contract for services. Governments in New Zealand and Australia assess a tax equivalency charge to public units in managed competitions.

Note: Other factors, such as performance, are important when making decisions about who will provide a service. However, it is important to fully understand the financial picture when weighing options, so that cost implications can be correctly evaluated.

The Importance of Competition

None of the cost efficiencies of private or public providers will last in the absence of competition. Private enterprises often provides lower-cost services because competition forces them to keep close watch on their expenditures. Likewise, competition from private providers forces public providers to control their costs. The issue isn’t public vs. private; it’s monopoly vs. competition. Competitive markets can lead to efficient operations in both the public and private sector.

Removing Special Privileges

Some governments have unfairly tilted the playing field against the private sector by exempting in-house units from the requirement of submitting sealed, blind bids. Several cities have made it a practice of allowing in-house units to put together their bids after being shown the best bids from the private sector. In addition to corrupting the competition process, such an approach is likely to significantly reduce future cost savings from competition. The reason is that if private firms feel as though they’re being used by politicians only to obtain concessions from in-house units, they soon will decide it’s not worth the trouble and expense of putting together serious contract bids. The result will be less competition.

In an effort to try to create as equal a standing as possible between public units and private companies, the New Zealand and Australian governments require competitive neutrality between the public sector and private sector. To the extent possible, all protections and special privileges that public units usually enjoy over private firms have been removed. Public-service entities have been "commercialized" and are required to pay taxes (or a tax equivalent), comply with regulations imposed on private firms, institute accrual-based and full-cost accounting, and carry a capital charge on their books.

To ensure a fair bidding process, conduct an arms-length relationship between the public entity administering the competition and the unit bidding on the contract. The particular bidder, whether a public or private entity, should be held to the same performance standards and be subject to the same financial penalties and incentives.

Freeing Public Units from Onerous Regulations

To be competitive with private firms, government units need to be relieved of many of the regulations and bureaucratic procedures that decrease their productivity. For instance, a road maintenance crew in Indianapolis complained that it took a week to get supplies from the city’s purchasing department, while private firms can be confident of receiving necessary supplies the next day. Unless government units are given more autonomy when governments institute competition, they are being forced to operate in both worlds — the entrepreneurial and the bureaucratic.

In New Zealand, individual agencies now have the power to hire, fire, pay, promote, reduce (or eliminate) job classifications and negotiate collective bargaining contracts. Control over procurement and financial management also have been devolved down to the agencies.

Additional Resources

• How To Compare Costs Between In-House and Contracted Services, Lawrence Martin, Reason Foundation, How-To Guide No. 11, March 1993.
  
  
• Privatization: The Key to Better Government, E.S. Savas, (Catham: Cathum House Publishers, 1987).
  
  
• Rightsizing Government: Lessons from America’s Public-Sector Innovators, William D. Eggers, Reason Foundation, How-To Guide No. 11, January 1994.
  
  
• Total Costing for School Transportation Service: How the San Diego City Schools Missed the Bus, Janet R. Beales, Reason Foundation, Policy Study No. 199, December 1995.