Europe Articles and Perspectives

Not everything the UK government has done in terms of procurement has been leading-edge, and certainly not everything has worked perfectly. But what we can say is that the UK has tried a lot of different procurement ideas, and has probably been an early adopter in many areas. That includes bringing private sector expertise into public procurement, collaborative buying initiatives, use of category management processes, involving private finance in complex long-terms construction transactions, outsourcing complex services delivered to the citizen (welfare to work or social care), or adoption of some aspects of eProcurement.

Currently, one of the hot topics in recent years for UK public procurement is whether public sector contracts should habitually make more use of “open book” contractual provisions. That follows some scandals and problems where suppliers were found to be over-charging the government customer, and the subsequent feeling that buyers need to have much better visibility of suppliers’ cost structures and financial situations.

Open book contracts are used mainly where the payment mechanism for the supplier is going to be cost plus or some variant of that mechanism. So the buyer pays a set of agreed actual costs incurred by the supplier, plus some sort of margin to cover overheads and profit. The “open book” requirement enables the buyer, in theory at least, to see that a fair price is being paid.

To illustrate this, let’s go back to my first role in Purchasing, buying raw materials for a global food company. But soon after, I was also given responsibility for our “contract packing” operations.

Our main supplier had been set up by an ex-employee of our firm, with the blessing of the CPO, because there were apparently not enough good suppliers or capacity in the market to meet our needs. Contract packing is used when the manufacturer wants to sell product in non-standard packs – maybe for special holiday products (like Christmas “selection boxes”).  That packing work could not be easily handled on automated production lines, so was outsourced to a largely manual hand-packing operation. 

The contract agreed by my bosses was open book and cost plus in nature. This meant that whatever this supplier spent in direct costs, mainly labour, we would cover the costs – plus an agreed margin. Once I got to grips with this, a number of obvious questions presented themselves.

Firstly, why on earth had we agreed a contract of that nature, which seemed very unbalanced from a risk point of view?  (We took all the risk of cost overruns or inefficiencies.) The reasons given related to the fact that the operation had been set up primarily to meet our needs, and indeed the founder might not have been prepared to proceed if we had not provided him with what was in effect a guaranteed profitable business.  Cost plus ensured that he made a decent profit, whatever happened, and independent of whether he managed to find business beyond that work we provided to him.

Cost plus also meant that we could very much dictate what the firm did, without endless arguments about changes of specification, or volume, which tended to be pretty volatile when it came to these seasonal products.  Whatever we asked the firm to do, they did it, and we paid up.

It also arguably protected us from negative market price movements. If capacity was really limited in the market, additional demand might force up prices well beyond genuine costs plus a reasonable margin – in economic terms, suppliers might make super-profits. The cost plus and open book arrangement protects the buyer against such a possibility.

Looking at that situation, it highlights both the positives but also the negatives of open-book and cost plus.  If the buyer wants to retain considerable flexibility and be able to dictate the supplier’s behaviour (and therefore cost structure), it may be sensible for the buyer to take the whole risk and work on that basis. It is also useful where there is a very limited market and little recourse to a competitive route to determine the price; it is no surprise that the industry that probably uses these mechanism most often is defence and military contracts, where often there will be little open competition to determine a “fair” market price. 

On the other hand, the negatives are clear too. There is little incentive for the supplier to drive greater efficiency, as whatever direct costs they incur are covered. Indeed, the higher the direct costs, the greater the total margin payment in most cases. There may be little incentive for the provider to seek other business, or they may use the cost plus arrangements to fund or subsidise work for other buyers, who might even be competitors of the firm who are paying under the cost plus deal!

There is also a major incentive for the provider to lie about their true cost structure, to inflate the real costs and receive higher payments. At one time, it is likely that many firms operating under these processes kept two sets of books, one that might be shown to clients (or indeed to tax authorities or other regulators) and one that reflected the true figures. However, it is likely to be more difficult to do this now, when everything is systemised and automated.

So true cost plus contracts, supported by open-book arrangements, need to be used with caution. They can be useful in certain cases, and even with their imperfections, they may be the best route – in some military contracts for instance. But they can easily create the wrong incentives for suppliers, and require a lot of work for buyers.

But there are also occasions when open-book principles might be used outside the cost-plus environment. We might look at using the open-book route during the bidding and tendering process, for example, or when it comes to managing contractual changes and new requirements. Perhaps we will return to those cases another day.

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