Contracting out has become a popular method of simultaneously reducing government expenditures and improving the efficiency of government services.(1) Proponents of privatization can point to the apparent satisfaction of most government decision makers in achieving the dual aims of economy and efficiency, which in turn has spurred on new contracting-out initiatives.(2) Such Structural Changes in government operations can be highly beneficial and deserve to be emulated, provided that these initiatives have been properly evaluated and their limits thoroughly understood. Unfortunately, in the case of contracting out, the benefits have been trumpeted loudly while its weaknesses have been muted. To some extent, this imbalance reflects the absence of a systematic treatment of the advantages and hence the limits of outsourcing. In this article, which supports outsourcing as a vital financial tool in the hands of government authorities, I examine contracting out in a private sector context to determine the sources of its alleged cost-savings. This will facilitate abstracting the essential lessons that can be transferred from the private sector to the public sector. One conclusion will emerge quite dearly: Contracting out is not a panacea. Indeed, at times, instead of stemming the flow of budgetary red ink, it will intensify the hemorrhage. Contracting Out in the Private Sector A business firm can acquire the resources it needs for producing its output by producing them itself, acquiring them from the marketplace on an ad hoc basis, or turning to designated suppliers. The firm will typically buy an input on the market when that resource is not unique and is readily available at acceptable prices. However, the options narrow to contracting out versus self-production when the firm anticipates supply constraints, unacceptable pricing, or unique specifications. It is this constrained choice--produce in-house or out--that needs to be understood. In fact, no private business firm is so integrated that it produces all the resources it uses. Companies typically out for physical inputs, intermediate or component products, and services used in producing the few goods or services in which the firm specializes. Furthermore, because the typical business firm is geared up for undertaking a limited number of primary activities, secondary functions are relegated to outside contractors. Finally, firms rely on contractors rather than permanent staff and facilities to meet temporary needs. These generalized statements can be easily illustrated with a simple service provider such as an automobile repair facility. The master mechanic who owns a typical small shop repairs vehicles with the assistance of a few mechanics. Parts supplies are normally obtained on an as-needed basis from a few distributors, relying on the competitive local parts market. Outsourcing is routine as well and might be resorted to when demand overwhelms the facility's capacity. The shop might out activities that require special skills and equipment such as wheel alignments or transmission repairs. (Although such contracts may be informal, an implicit that builds on a long-lasting relationship based on mutual trust may be treated for all practical purposes as a formal contract.) Other relationships, such as a service with a photocopier or computer repair service, stem from secondary functions, in this case running the business side of the operation in an office equipped with machinery that is prone to malfunction. So, too, will the shop have a with a health maintenance organization to cover the medical outlays of the owner and staff. Finally, outside architects and construction crews will manage plant modernization plans and their execution. Similarly, a retained attorney will handle the occasional legal brief and an accountant will file the periodic tax forms. This illustration, however, begs the contract out versus in-house production question. …
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