What about those instances in which a government has decided to undertake a new service? Should a public entity take on the service, or should it be contracted out? Often, an existing public department will seek to perform the service and bid against private contractors. This form of competition between the public and private sector is becoming increasingly common. Making valid cost comparisons between bids and proposals submitted by in-house departments and contractors requires that appropriate in-house costs are considered, and that contractor bids and proposals are adjusted to reflect the total cost of contract service delivery.
A. Appropriate In-House Costs
A business entity intending to take on a new service has the choice to either provide the service in-house or to contract out for it. In business accounting this is termed a "make or buy" decision, and standard business theory calls for the additional cost (also known as marginal or incremental cost) of providing the service in-house to be compared to the total cost of purchasing the service. In a competitive business, this is the proper course of action to minimize total cost.
But what is sound business practice is not necessarily prudent for government entities, which do not operate in a competitive environment. For this reason, state and local governments desiring to promote public-private-sector competition may find that basing in-house bids and proposals on fully allocated costs comes closer to creating a "level playing field." This is because, unlike a competitive enterprise, a public provider often maintains excess productive capacity. Business accounting theory assumes an efficient allocation of resources, and this assumption is often not valid for monopolistic public providers. The existence of surplus capacity in public providers tends to make estimates of the marginal cost unrealistically low. Assuming that an in-house department has surplus capacity and bids to perform a new service using incremental cost rather than fully allocated cost, it is difficult to imagine many scenarios in which a private-provider cost would appear competitive.
This is true even for private providers that are far less expensive. The practice of comparing in-house marginal costs with the total cost of contracting has the practical effect of precluding private contracting. Therefore, in the case of new or significantly expanded service, governments wishing to promote competition should compare the fully allocated costs of the government agency against the total cost of the contracted service.
Suppose a large new public building was being constructed, and the government was deciding whether to contract out for maintenance or to expand their janitorial staff. Let us suppose that it was calculated that the fully allocated cost of in-house provision in those buildings currently serviced came to $10 per unit area, and that the total cost of contracting for services, including contract administration, came to $8 per unit area. The public provider may contend that only the marginal costs of service provision, which may be $6 per unit area, should be considered since the additional service will not increase overhead. In essence, this argument is a claim that while the cost for janitorial services in all other public buildings is $10 per unit area, in this new building the cost will be only $6 per unit area. The public provider should be required to bid based on fully allocated costs, which should be compared against the total contracting costs.
The only occasion in which it makes sense to consider marginal costs for a new or expanded service is when the extent of the privatization is extremely small. Otherwise, fully allocated in-house costs should be compared to total contract costs.
Furthermore, it is best to have in-house costs calculated by a disinterested third party, rather than the department seeking the contract. This third party can either be another governmental agency or an outside consultant.
B. Adjusting Contractor Bids and Proposals
A contractor's bid or proposal costs, of course, only represent part of the total cost of contract-service delivery. A contractor's bid must be adjusted (as described previously) to include: contract administration costs, one-time conversion costs and any off-setting revenues.