State and local governments contract out for over $100 billion in services annually.[1] The reason most frequently given for contracting out is to reduce the cost of service delivery.[2] For public officials to make informed judgments about contracting out, valid comparisons need to be made between the costs of in-house and contracted service delivery.

Cost is not the only consideration for public officials making the decision between public and private service provision. Issues such as service quality, managerial flexibility, the likelihood of labor actions, the extent of competition among providers, and other factors must be scrutinized as well. Cost is simply one component—although an important one—in the decision matrix.

Attempting to compare the costs of in-house and contract service delivery is difficult. One major national study suggests that the cost of in-house service delivery is frequently underestimated by as much as 30 percent.[3] Case-study evidence also suggests that the cost of contract service delivery is often underestimated as well, due to a failure to properly account for such costs as contract administration and monitoring.[4]

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.”[5]

The failure of governments to accurately compute the costs of in-house and contract service delivery is also related to the absence of a consistent methodology that ensures all relevant costs are included in the analysis. In a recent survey of the contracting out practices of 120 cities, counties, and special district governments nationwide, 50 percent of the respondents reported having no formal methodology for conducting cost comparisons.[6]

This guide provides a structured approach for making cost comparisons between in-house and contract service delivery that will be applicable to most state and local governments. The approach outlined here is based on: 1) mainstream public financial management thinking; 2) the best identified practices of federal, state, and local governments; and 3) a desire to keep the process as simple as possible while ensuring a high degree of validity. Though no set of accounting guidelines, however standardized or well-designed, can totally eliminate subjective judgments, this guide provides a useful framework for assessing the costs of public service provision versus contracting out.

Determining the total cost of in-house service delivery is discussed first. The next section considers the cost of contract service delivery. The issue of which in-house costs—"fully allocated" or "avoidable"—to use in comparing costs with contract service delivery is then addressed. As part of this discussion, a format is presented to display and compare cost data between in-house and contract service delivery. Finally, the relatively new phenomenon of in-house government departments bidding against contractors is discussed. Throughout this guide, an in-house service being considered for contracting out is referred to as a "target service."