NAO report and PAC grilling – G4S, Serco, Atos and Capita on the barbecue?

The UK’s National Audit Office published two reports last week. One looks at the work the Cabinet Office are doing to manage the top suppliers to government; the other which we’ll consider today looks in detail at four major suppliers of outsourced services to government (Atos, Capita, G4S and Serco) – it’s called “Memorandum on the role of major contractors in the delivery of public services(download via link).

G4S and Serco are of course currently facing criminal investigations into accusations that they cheated in terms of reporting and overcharged on Ministry of Justice contracts.

The report looks at three questions.

• Is there sufficient competition in contracted-out public services?

• Can we see whether contractors’ profits reflect a fair return?

• How can we know whether contractors are delivering?

It’s an unusual report for NAO because it really doesn’t provide any direct conclusions, let alone recommendations. So for example, it does not attempt to answer the first question about competition – there is some interesting analysis and NAO commentary, then five “areas for further exploration” are suggested. I know these are big questions to answer in a short report, but it makes this section somewhat unsatisfying – I felt like I’d had the tasty amuse-bouches but not the Michelin-starred meal we normally get from NAO!

We may come back to the other two questions at some point but the heart of the report is an NAO investigation into the second question above, the profits made by the firms from UK government business. And this is where matters get very interesting and counter-intuitive. The firms appear to have cooperated reasonably well in providing data, so NAO have been able to look at profits made from the public sector generally and then try and analyse UK central government specifically.

What that seems to show is that margins are not excessive. The four contractors have generally had low profit margins compared to the FTSE 100, for instance. Their good PE ratios imply the market expects growth, which they have delivered over the last years, but margins don’t appear particularly high. At individual contract level, much depends on how you treat overhead allocation, inevitably, but it is hard to argue that gross margins of 10-15% on average are excessive. However that does conceal some big differences - G4S was making gross margins of “between 0 and 32 per cent” on various contracts.

Indeed, a more subtle picture emerges. At individual contract level, more than one supplier explained that they lose money in the early days of the contract, and aim to make that up (and more) through the lifetime, largely through reducing their costs. That won’t be a surprise to experienced procurement people of course. Bid low to win, and then make your money on efficiencies you generate through the contract – but also through contract additions, changes, or extensions. That’s an age-old strategy in many industries, and it appears that major outsourced services is one of them.

Now the downside of this strategy for the buyer and the service user is clear. The supplier starts delivering the contract with an unsustainable financial position. They simply have to find ways of increasing margin. Now that could be through win:win activities – work more efficiently or find innovative ways of delivering the service.

But there are other ways of increasing margin. Cut staff salaries and benefits. Reduce service levels (and hope no-one notices / complains). Or even cheat in terms of reporting performance to attract more revenue or performance bonuses. Maybe (without pre-judging the results of the current investigations) this is the driver behind what we have seen happening recently. Suppliers under pressure because contracts are not making money, whilst individual managers are bonused on hitting overly challenging targets. That could lead to inappropriate behaviour.

Anyway, later today (November 20th) the firms will be grilled by Patricia Margaret Hodge and the parliamentary Public Accounts Committee about the findings. Expect some fireworks... and we’ll come back to what the NAO report means for government buyers shortly.

Voices (6)

  1. Dave Orr:

    Please don’t forget all the spend in Local Government or PFI…..

    Here is a good example:

    http://ukcampaign4change.com/2013/11/19/police-sap-systems-significant-security-weaknesses/

    Pay “top dollar” for “World Class IT” to IBM for South West One and get a poorly configured setup for SAP (says auditor) using the cheapest shared option (see some expert comments below article).

    And…does anyone believe that profit margins are accurately stated when multi-national suppliers can move costs up and down their supply chain?

    So, energy suppliers appear to make 5% net profit margin at the retail end, yet their internal generation division could be making much higher margins to supply the retail division.

    Peter: Follow the money!

  2. John Diffenthal:

    I’m not a lawyer, but if a company invoices for a service that hasn’t been delivered, and does so for long periods I’m tempted to think that it’s fraud.

  3. Gordon Murray:

    Patricia Hodge wil certainly be interesting to watch and an indication that procurement is now centre stage. It’s certainly a novel way for PAC to grab attention – I wonder who drafted the contract.

  4. MG Man:

    I’m pleased they are being grilled by Patricia Hodge. I used to like her in Rumpole and then in that Amanda thingy where she is the bossy mother!

    1. Peter Smith:

      OK, OK, I meant Margaret Hodge!! Although as you and Gordon have pointed out (thanks by the way), Patricia would perhaps be more entertaining!

  5. Dan:

    And of course, there’s G4S who have overcharged by £24m. And thats just what they’re admitting to. It would have been interesting to see what NAO would have seaid about that in the report. They were just too quick to publish it.

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