Checks and Balances: Accounting for Costs

An accurate analysis of the costs of providing government products or services is one of the most important steps in the privatization process.

But all too often the true costs of government services are understated—by as much as 30%—according to a Reason Foundation study.

Privatization should rarely be done for its own sake. If government can use scarce economic resources to provide superior services at lower cost than competitors, then privatization may offer no advantage. But all too often the true costs of government services are understated—by as much as 30%—according to a Reason Foundation study.

In the United States, public-private contracting is a $100 billion annual business and growing. As more units of government embrace privatization, it is vital that they avoid pitfalls such as failing to properly analyze contracting opportunities.

There is little consistency in the accounting methods used to measure important costs at various levels of government, according to How to Compare Costs Between In-House and Contracted Services, a jointly published study of the Reason Foundation and the Mackinac Center for Public Policy. "In a recent survey of the contracting out practices of 120 cities, counties, and special district governments nationwide, 50% of the respondents reported having no formal methodology for making cost comparisons," the study states.

The lack of an accurate, widely recognized method of cost analysis may contribute to problems including paying too much for services and bids being unnecessarily lost by private bidders.

Good stewards of the public purse use estimating techniques that accurately account for all costs.

The "total costing" (sometimes called "full cost") method of accounting for in-house (government) expenses "is the sum of its direct costs plus a proportional share of organizational overhead, or indirect costs." Direct costs include the obvious: wages, benefits, and leases. The proportional share costs may include utilities that are paid for by one department and used by many. The total cost method can yield a division of expenses per employee, which permits an easier breakdown of department costs.

Government officials and managers seeking to accurately compare government costs with bids from outside firms must incorporate in their analyses the costs listed below.

Redirected Costs: One department or agency may charge to other departments the expenses that they incur for pension costs, janitorial services, payroll administration, and others. This can give the false appearance of lower than actual costs.

Shared Costs: Electric utility costs for an entire department may be paid for by one department. However, if electricity costs are not accounted for on a department basis, any analysis of departmental operational costs would be understated.

Depreciation Costs: The value of assets depreciates over time. Good faith efforts must be made to account for losses (or gains) in value and future replacement costs of government assets (if any).

Apparent Cost Advantage: Privatization is often dismissed on infrastructure projects because municipalities may enjoy the cost advantage of using tax-free bonds. Despite the advantage to government entities, private-sector firms are often able to underbid and outperform their public sector counterparts.

Marginal Cost: Financial analysis may wrongly compare the cost of providing the last additional unit of a government service (marginal cost) to the total cost submitted by the private sector agency. Comparing government’s marginal cost to a private firm’s average (or total) cost usually causes a wide—but false—discrepancy between the two.

Future Costs: The future cost of government pension funds are often ignored in cost analyses because a payout may not be required for years. Still, future payments to current workers are liabilities and must be included in honest analyses.

Private Bidders Cost Government, Too

Government cannot manage its private contracts for free. Officials must plan for contractor costs (what the contractor charges), administrative fees (bidding, negotiating, handling invoices, contract evaluation and monitoring), one-time conversion charges (if necessary), and less "new revenue." "New revenue" deserves special mention.

New Revenue

New revenue is the estimation of the taxes that will be paid to the state and/or local units of government by the private entity as a result of its contract with the government. If government continues to provide a service instead of contracting it to a private firm, that government may have to forgo future tax revenue generated by the firm.

Tax revenue should be estimated and factored into the cost of maintaining public-sector duties by subtracting it from the total costs of the private provider. In Britain, the sale of state-owned enterprises turned once tax absorbing (£50 million per week) government agencies into private, taxpaying (£55 million per week) entities. Clearly, new revenue estimates should play a major role in determining the opportunity cost of maintaining public agencies.

Total cost accounting is probably the most accurate way to compare costs of public and private sector organizations. It should be adopted at all levels of government to help avoid inaccurate cost-benefit analyses. Only when government’s true costs are known can it be determined if privatization is the best option.