Does outsourcing make sense?

More and more public services in Britain are outsourced to the private sector. But does this really deliver the quality and cost savings claimed? Matthew Partridge investigates.

What happened?

G4S recently admitted that it will not be able to provide the agreed number of security staff for the Olympics. Because of this, the government had to provide 3,500 troops and police to make up the shortfall. According to The Daily Telegraph, G4S claims that it will now have to take a loss of "up to £50m on the £284m contract" and the share price has fallen sharply. Meanwhile, Scotland Yard commanders are said to be "seething" as it is still not clear how many extra troops and police may end up being deployed, but apparently up to 20,000 uniformed personnel could be involved. As a result of the debacle, the spotlight is now firmly back on the wisdom or otherwise behind the government's policy of subcontracting public services to the private sector.

Is outsourcing widespread?

Yes. "Britain is in the grip of the biggest wave of outsourcing since the 1980s", according to the Financial Times. Equity research group Jefferies estimates that more than £4bn-worth of contractsis due to be tendered this year. The Economist notes that this even extends to areas such as the army and policing, previously considered core services only to be performed by the state. Although many police forces have been outsourcing administration and IT jobs for some time, there are now plans to delegate core tasks, such as case preparation, hiring and staff management. "Chief constables might become fully fledged commissioners of policing services, drawing on a mix of private firms and sworn constables, depending on the task."

How is outsourcing being justified?

David Cameron has argued that "there's a simple logic to all this: with more freedom and openness comes more creativity and innovation. And with competition comes the pressure to keep up with the best." In other words, outsourcing should be a win-win situation for both taxpayers and shareholders. As the US magazine Governing puts it: "if someone is willing to fix streets or put out fires for less money, that should be a plus for a government's bottom line". David Walker also argues in Prospect that outsourcing can help cut bloated public-sector salaries, many of which were agreed before the recession.

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Any evidence that it works?

Governing magazine estimates that the US city of Philadelphia saved $275m by privatising key services. Jeremy Stafford, the head of outsourcing company Serco, has claimed that Britain and the US should take the model further. "In India, two healthcare organisations run on sound business principles and provide affordable healthcare in a public system, without being dependent on the state." Three years ago even usually sceptical journalist Polly Toynbee wrote in a piece for Serco's Ethos magazine that "hospital consultants' waiting lists plummeted when a few independent treatment centres were set up nearby. Suddenly, long waiting lists for hip and cataract operations fell because patients had a choice."

So G4S is an exception?

Outsourcing also has many detractors. The main criticism is that providing a public service and making a profit are conflicting aims. The private sector's focus on costs drives down quality, resulting in what The Guardian's Neil Clark calls "trying to do everything on the cheap". Worse, the selection process is frequently flawed, argues Polly Toynbee in The Guardian. "Only a small caucus of giant companies has the capability to bid." Meanwhile, the government lacks the ability to negotiate effectively. "With a third of Whitehall civil servants cut, their already doubtful ability to write clever contracts weakens further. Local authorities are even more prone to bamboozlement." It is also hard to penalise poor performance. "Most contracts are too complex to re-let, so 80% never change supplier." The Scotsman's Tom Miers believes the whole premise is flawed. "It doesn't work because the essential discipline of competition is removed. Profits are retained while risk is transferred to the taxpayer."

Have there been other notable failures?

Many. The most notorious sub-contracted British project tried to create a single IT system for the NHS. Despite payments of £12.7bn to various IT firms, the system was eventually scrapped. Governing magazine notes that Maywood, a small Californian city, outsourced almost all its services to nearby Bell City. However, a scandal forced it to cancel the contract, leaving Maywood "to fend for itself and find new contractors". David Hall notes in the FT that a comprehensive review in Denmark throws severe doubt on whether it ever really works [see below]. The G4S fiasco will only shake confidence further.

The lessons from Denmark

Professor Ole Petersen of the AKF institute in Denmark recently reviewed a large number of studies on the outsourcing of Danish government services between 2000 and 2011. He found that, in the short run, "contracting out provides minor cost savings". However, these were offset by large "administrative, legal and transaction costs", and a possible reduction in quality. He suggests that outsourcing should be limited to routine administrative services. Even when outsourcing is proven to work, "it is not the private companies but the competitive situation itself that creates cost savings when lower prices from contracting out are achieved. In several cases, significant savings were also achieved by the in-house tender and studies show that the difference between the public sector and private sector alternatives diminishes over time."

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri