Outsourcing: A Primer for Public Sector Organizations

The Town of Lilidotter (a disguised name), like many municipalities in the northern hemisphere, contracts with private vendors to remove snow from its streets in the winter. The Town of Forenna in Italy (a disguised name) contracts with private vendors to pick up and dispose of its trash. The team responsible for the “Big Dig” in Boston Massachusetts (not a disguised name) contracted with multiple vendors for a massive project designed to replace an overhead transit system with an underground one, and when cost overruns and performance failures were revealed, the project faced a plethora of lawsuits (Exhibit 1). In addition to public sector organizations, private sector companies contract with vendors in a variety of circumstances, ranging from staffing a call center in Bangladesh to purchasing paper clips from Staples. In his business autobiography, Jack, Jack Welsh described how General Electric contracted with a vendor to produce component parts for its aircraft engines. If these parts failed to function as specified, the consequences would be catastrophic. OUTSOURCING DEFINED In general, the term that is used to describe these relationships is “outsourcing,” a term that refers to a decision not to “do it yourself,” but to rely on others. Outsourcing is a strategy used by many public sector organizations (PSOs) in industrialized countries in an effort to provide high quality public services at low cost. The underlying theory is that, by contracting with a private sector vendor to provide services (and sometimes goods), a PSO can take advantage of the vendor's considerable experience and economies of scale. In addition, outsourcing’ popularity in PSOs is related to the growing emphasis on entrepreneurship in managing public services so as to stem the growth of the public sector and exert greater control over spending.1 Many of the PSOs we discuss in this paper are local governments (LGs), where the topic of outsourcing has received considerable attention in the public policy and public management literature for almost three decades. During that time, many LGs have undertaken a wide variety of outsourcing initiatives, including such disparate activities as animal control, air traffic control, legal services, fire protection, trash collection, health care, snow plowing, building maintenance, bill collection, data processing, street cleaning, street repair, and recycling. In Italy, where we conducted much of our research, extensive local government reforms that began in 1990 have created an impetus toward outsourcing. At present, some 27 percent of Italian local services are provided by privately owned companies, and 40 percent are outsourced to companies owned by the public sector.2 PROBLEMS WITH OUTSOURCING Unfortunately, outsourcing has not always achieved a PSO’s goal of high quality services at reduced cost. In part, this is because some PSOs have not managed their vendors as well as they might have. Indeed, according to some observers, a PSO frequently becomes seduced by a vendor's alleged competence to provide high quality services with a relatively small (or no) incremental investment in infrastructure assets. As a result, the PSO’s managers fail to identify the (frequently hidden) costs that the PSO will incur in conjunction with the outsourced activity.3 In part, a PSO’s “transaction costs” in outsourcing are caused by the information asymmetry that exists between it and its vendor. In addition, however, the PSO’s senior managers frequently fail to consider the risk associated with an outsourcing decision. This risk has been addressed in terms of (a) increased dependence on external suppliers, resulting in a potential loss of control over essential activities, (b) greater difficulty in cost management when there are adversarial relationships, (c) loss of essential competencies in the public entity, (d) loss of control over suppliers of the resources (inputs) needed to conduct the outsourced activity, and (e) loss of flexibility in response to the needs of the citizenry.4 In short, outsourcing sounds easy in principle, but it can be disastrous in practice. WHY OUTSOURCE? A common feature that characterizes the decision to outsource is senior management’s desire to provide an entity’s (a PSO’s or even a private sector company’s) customers with the same level of service and quality as if the entity had produced the product or service itself, but to do so at a lower cost. In some instances, the desire may actually be to provide a higher level of service or quality. To paraphrase Jack Welsh, General Electric Company’s legendary CEO, “why should we produce something in our back room when another company produces it in its front room?” Back room or front room -- how does a manager decide? Is the decision cost based? Is it made in an attempt to improve quality or service? Should customer reactions be incorporated into the thinking? How should a company prepare itself for a return to internal production if an outsourcing arrangement does not work out as planned? What level of skill or expertise is required, and how easily can it be obtained? In short, an outsourcing decision is not an easy one. Indeed, it is much more complicated and strategic than often is thought. The purpose of this book is to describe these complications and provide senior PSO managers with some guidance in how to think about an outsourcing decision. Although the primary focus is on public sector organizations, there is considerable applicability to private sector entities as well. ORGANIZATION OF THE PRIMER Each chapter is discussed briefly below. The Table of Contents shows the major headings of each chapter. As mentioned above, the Appendix contains solutions to the practice cases. Chapter 1 puts outsourcing into the context of what is known as “the New Public Management Paradigm.” This chapter is somewhat theoretical, and could be skipped by readers not interested how outsourcing fits into a context designed to improve a government’s effectiveness and efficiency. The two cases at the end of the chapter are designed to illustrate the difficulty of (a) achieving generational equity and (b) using shadow prices as a means to improve efficiency. Chapter 2 puts outsourcing in the context of what is known as the “four governance model” of public administration. It also discusses outsourcing risk, and presents a model for assessing that risk and selecting an appropriate governance model to manage it. Chapter 3 discusses the financial aspects of outsourcing. It focuses on some of the techniques that a public sector organization can use to assess how its costs will change if a particular service is outsourced. Chapter 4 looks at how a PSO’s management control system needs to be designed (or redesigned) to accommodate outsourced services. As we argue in Chapter 2, a well-designed MCS is a key element in managing high risk outsourcing. s this chapter emphasizes, to exclude these entities results in a management control system that only partially addresses the issues that an entity needs to consider on an ongoing basis. Chapter 5 contains three in-depth case studies about outsourcing in municipalities in Italy. The focus is on trash collection, but the implications extend well beyond trash collection, and, indeed, well beyond Italy.