Transaction costs have to be paid for

Ronald Coase, a Nobel Prize-winning economist, died last week. Way back in 1932, when he was 21, he did some research into why it was that companies did not use pricing and markets to organise themselves internally even though they relied on pricing and markets being the best way to operate an economy. (See this article for the importance of this theory for the development of the internet.) The answer, he found, is that using an “internal market” brings with it transaction costs. To have an internal market a company (or other organisation) would need to spend money and resources negotiating contracts and passing invoices between divisions and units. Much easier, then, to manage an organisation by some form of command and control regime. In the public sector we have seen various flavours of internal markets and they are still in place, notably in the NHS. I'm sure the government and others would claim that the greater efficiency of suppliers that results from competition outweigh the transaction costs and perhaps they are right. (If anyone can point me to recent research which addresses this issue I'd be very grateful.)

What's on my mind, though, is a slightly different point. In a competitive market there has to be scope for losers as well as winners. We can see that because some businesses just don't get off the ground and because even successful companies can lose their market share (Nokia, for example). How can you have room for losers in an internal market without incurring waste? In particular, when the market is for public services upon which, say, vulnerable people rely, what happens if their provider is the equivalent of Nokia--once upon a time the best provider but now falling behind the performance of others? There's nothing the recipients can do: they don’t have true customer power because they don’t pay for the service (at least they don't pay the provider directly and have the option to take their money elsewhere) and the long term contract the provider has with the public authority means there isn't an immediate threat of competition to perk up their performance. I think this is because having incurred the transaction costs of procuring the contract the public authority will be reluctant to incur additional transaction costs in ending it early unless the performance is abysmal.

I think what this points me towards is the importance of good contract management for the duration of a contract. Good contract management can represent the service users and also prevent the public authority from getting in to a position where it even has to think about terminating the contract and incurring all the costs that would involve.

I think public authorities are also coming around to this view. Certainly I find myself more often talking with my clients about contract management than I used to. I suspect this reflects the maturity of the outsourcing market in two ways. First, public authorities and providers both understand the commercial issues relating to the contracts and are able to reach workable agreements much more readily than they used to. Second, public authorities who’ve reviewed their experience of contracts over the last, say, 10 years will often recognise that they have not felt in full and proper control of their contracts and that they ought to have invested in contract management skills from the outset.

I think what this means is that if an organisation wants to use contracts, whether for an internal market or externally, it is important that they recognise that good contract management will be a significant transaction cost and they need to be willing to pay for it.

Interim Judgement

I've fallen out of the habit of writing for this blog and have been telling myself for weeks to write a new post. The furore about senior public sector managers being hired through service companies rather than as employees is something I really ought to write about. So I have ... By posting a comment on their blog entry. Here's what I wrote:

I am an accountant and I work as an interim manager through my own limited company. Without getting too technical about it, the potential for reducing my tax bill is not that great, not since the Inland Revenue introduced IR35. Prior to that people working through companies could pay themselves minimal salaries and take the rest of the money as dividends, upon which income tax is paid but not national insurance. Even with that device, you have to pay corporation tax on the profit before you can take the dividends.

There are other possible tax advantages one could implement. Eg the company could employ the interim’s spouse or offspring and thus take advantage of two or more people’s personal tax allowances, reducing the interim’s total tax paid at the higher rates. Dare I say it, this is something MPs have been doing with office allowances for years.

I think I should also mention the reason such companies are attractive to employers, especially for hiring interims: it reduces their liability as an employer. As far as the council or other body is concerned they have a service contract. That means they are not responsible for employment duties such as the working time directive, they don’t have to make national insurance contributions, they don’t have to pay for holidays, they don’t have to apply their equal pay scheme to the position, they can fire the person without having a long winded investigation and disciplinary hearing, and so on. They also don’t have to allow the person to join the pension scheme and thereby they can save themselves the pension contributions.

The downside is VAT is payable on the service contract. Local government and ministries don’t worry about that because they can reclaim it from the treasury. The picture is different in the NHS and I’d be surprised if the witch hunt uncovered the same sort of arrangements in the trusts and PCTs.

To see the full blog post and other comments go to

Competing for public audits

What does the OFT’s announcement that the audit market should be investigated by the Competition Commission mean for the audit of public organisations? When Eric Pickles announced in August 2010 that the Audit Commission would be abolished he stated that public organisations should be free to choose their auditors. One possibility is that the Audit Commission's own audit arm (formerly known as District Audit) could be floated off in some form to compete with the existing audit firms. I believe that Pickles's department has hired some management consultants to advise on how that might happen.

The abolition of the Audit Commission is, in its way, a classic piece of Conservative market deregulation. My personal view is that, generally speaking, market regulations were imposed by governments for good reason and deregulation makes things worse for most people, whilst allowing a few to make a lot of money. There are too many cases of deregulation resulting in a bad deal for consumers (eg price rises) if not worse (Enron-type frauds and scandals). Once local authorities and NHS trusts are in a position to choose their own auditor I am sure that the larger ones—the county councils, London boroughs, metropolitan boroughs, major acute hospitals—will receive suits from the 'Big Four' as well as some of the smaller firms. The process will be a beauty parade. The codes of practice that set out what comprises the audit of a major organisations means all the firms will provide the same service so the client organisation will pick the one they fancy. In the first year or two they might also get a good discount on the fee.

What the practice of the FTSE 350 companies shows is that once an audit firm is hired they very rarely are replaced. I suspect that's because there's little incentive. All the firms do more or less the same thing and charge more or less the same fee so why would a client organisation spend the time and trouble to have a new beauty parade every five or seven years? And if a new firm were selected as a result there would then be an element of disruption as the new auditors found out all they needed to know about the client's business and accounting system and so on. It's rather like changing your bank. Even if you could get a cheaper deal from a different bank, it would have to be a very significant improvement on your current deal for it to be worth the trouble of moving all your direct debits and all the rest of it.

Whilst the larger public organisations can look forward to being enticed by the Big Four audit firms I doubt that the smaller district councils, the ones whose budgets are still £10–20million and so are substantial organisations in their own right, will. They might see much the same effect, though, from the small and medium-sized audit firms who would be happy to have a regular income from organisations that will pay their bills and never go bust.

If the Audit Commission's audit division is floated off as a stand-alone organisation (New District Audit, perhaps?)then I expect it would compete for all shapes and sizes of audit. Its unique selling point would be its specialism in public sector audits and I expect that it would win some of the business. Prior to the Audit Commission's creation, local councils could choose between being audited by the District Audit or by a 'professional auditor'. (Back then hospitals were not part of trusts and the whole of the NHS was audited by the Exchequer and Audit Department, which was renamed the National Audit Office in 1983).  When local government was reorganised in 1974 202 boroughs had moved over to the professional audit, while 119 use the District Audit (Coombs and Edwards, 2004: 82). (There were 21 others who used the antiquated system of electing local people as auditors, a practice which I don’t think the secretary of state, or anyone else, is proposing to reinstate.) So back then the private sector held about 2/3 of the local government audit market. During its tenure the Audit Commission has favoured its own auditors with about 70% of the market. Would a stand-alone ‘New District Audit’ be able to hang on to 70% of the market. I doubt it. At least, I doubt it in terms of fees. There are about a thousand principal councils and NHS bodies currently audited by the Audit Commission (and many thousands more parish councils). The New District Audit might be able to win 70% of them as clients but the professional firms will focus on the bigger, more valuable clients and I can well imagine that they might secure 70% of the fees. And once they are in they’ll be very difficult to replace.

Reference: Coombs and Edwards, (2004) The audit of municipal corporations—a quest for professional dominance. Managerial Auditing Journal, 19(1), 68-83.

"Expect multiple train crashes"

Here is a terrific article by Polly Toynbee from yesterday's Guardian. As someone who has experience of negotiating contracts under European procurement directives I can't see how doubling the number of commissioning bodies will reduce bureaucracy. If the government think that a standard form of contract will simplify matters they only have to look at the experience under the Private Finance Initiative (PFI) to see how much is spent on lawyers and other advisors to make the standard contract fit each project's specific requirements. Let's face it, even changing the names of the parties in a standard contract will take some time and money to complete. Whilst I suspect that law firms and management consultants might have a difficult time in short term as public bodies take in the scale of cuts they have to make the chances are that new opportunities such as the reorganisation of the NHS will provide a significant income stream. Will all of this result in an NHS that is better value for money?

GPs are doctors, not accountants

Ann Robinson wrote an interesting article for The Guardian on 12 July (available here) setting out her view that GPs should not be expected to be accountants. I agree with that, and with much of the sentiment of Ann's article, but I differ in a couple of respects. Firstly, anyone who is responsible for spending public money should be accountable for their decisions. That means that they have to learn how to manage the money they are entrusted with. This doesn't mean that they have to be able to draw up a statement of accounts (that should be left to accountants who enjoy that sort of thing) but it does mean having an understanding of the financial constraints they work in, knowing what they want to buy (or sell) and how much it will cost.  They ought to be able to get a monthly financial report from their accountant and the should seek (and listen to) the accountant's advice albeit that the final decision and the accountability is theirs 

My second point is that commissioners and accountants are not the same thing. As I understand it, Andrew Lansley's proposals are for GPs to form consortiums and through these determine how health needs in their local area are met. There will still be a need for accountants to "keep the books" for the consortiums and presumably provide advice if a consortium is running the risk of its expenditure exceeding the approved budget. Even without seeing the detail of the proposals I find it difficult to imagine the government would not require the consortiums to set annual budgets and provide regular reports to the Department of Health of their spending against their budget. That smacks of bureaucracy but, whilst bureaucracy is oft-regarded as negative, the fact of the matter is that bureaucratic structures are good at control. And the government needs to control NHS spending tightly because a 1% over-spend would put a £1billion-a-year hole in their plans.