Outsourcing woes in the public sector

Outsourcing, or subcontracting part of your supply chain to other firms, is still booming in the private sector around the world. A prime example is Apples hugely profitable outsourcing of almost all of its iPhones inputs and assembly to other companies, even competitors, with Apple retaining key hardware and software design elements in-house.

However, government outsourcing came under attack in 2018 with the dramatic failure of Carillion in the UK and the collapse of a privately maintained bridge in Genoa, Italy. These were seen by many as the final proof of the need for change, with some commentators calling for a return to the government running things directly.

Carillion

Despite being the UKs second largest builder, Carillion was best known for being one of the largest and fastest growing providers of outsourced services to the public sector for more than a decade.

Describing itself as an integrated support services business, Carillions phenomenal growth saw it hold at one stage over 450 governmental contracts from the UK education, justice, defence and transport ministries. These services ranged from managing 900 schools and providing school dinners, to maintaining prisons and young offender institutions. It was responsible for the upkeep of 50,000 homes for the Ministry of Defence and provided and maintained 11,500 hospital beds. It also supplied engineering services to Network Rail and had been involved in major infrastructure projects such as rebuilding hospitals and building the Aberdeen city bypass. It was a member of the consortium to build part of the forthcoming HS2 high-speed railway line.

However, by 2017 there clearly was a problem. Carillion had issued three profit warnings and its share price had collapsed. Nevertheless, large contracts continued to be awarded to the firm, including the 1.4bn HS2 contract for the government as late as July 2017, during the period those warnings were being made and the company was known to be in financial difficulty.

In December 2017 the firm convinced creditors to give it more time to repay them, as the situation was only a cash flow problem. Yet, in January 2018 Carillion went into administration (bankruptcy) and when it was liquidated with debts of 1.5bn the firm still had about 420 UK public sector contracts worth about 1.7bn on its books.

What the media and government said about the failure

The UK financial media were quick to pounce on yet another fat cat and rotten company culture story, with the perceived greed of the CEO and CFO and their bonus culture prominently in the headlines. Former chief executive Richard Howson, who headed the company from 2012 until July 2017, earned 1.5m in 2016, which included 245,000 in bonuses and 231,000 in pension contributions. CFO Richard Adam earned over 1m in the same period, including a bonus of 140,000. These men had grown the 5

firm through ill-judged acquisitions while hiding Carillions financial problems from its shareholders.

Adam was blamed for an accounting trick which persistently overvalued the contracts and correspondingly inflated their bonuses. At the time of collapse, Carillion had a 235 million contract to rebuild a huge 1970s hospital in Liverpool, where its engineers had discovered asbestos and cracked support beams hardly surprising for that era of build. Most estimates believed that rectifying the problems would push the deal into the red, but Carillion executives were still projecting a profit on the project and forced it through.

A parliamentary inquiry showed that between 2012 and 2016 the group had paid out dividends of 376m over the five-year period, against a generated net return of just 159m from operations. The report showed that the groups dividend continued to rise even as the cash flow to support it evaporated.

The media suggested that an aggressive race for growth (plus bonuses and dividends) at all costs had created a situation where Carillions strategy for the past couple of years had been to try to outrun its growing cash and debt problems by persistently taking on even low-margin contracts. Aggressive and risky desire for growth made it bid far too low on many of these contracts, many of which would become loss-making, such as the Aberdeen bypass, which all came in well over budget and very late. Others looked at a full order book and just blamed the lack of ability to get paid for contracts in the Middle East. Carillion was a large company taking on large contracts and if its clients did not pay this presented an insurmountable problem.

Two government reports attacked the big four accounting firms for too readily approving Carillions accounts despite its spiralling debt and risk profiles. Deloitte received 10m to act as Carillions internal auditor but was either unable or unwilling to identify failings in financial controls, or too readily ignored them. One report blamed recklessness, hubris and greed for Carillions failure, and also criticised auditors for not spotting its problems. Another report was more critical of the government, stating that there are fundamental flaws in the way the government awards contracts because of an aggressive approach to risk transfer. Sir Bernard Jenkin, the Conservative MP who chaired the committee, said: It is staggering that the government has attempted to push risks that it does not understand on to contractors and has so misunderstood its costs. It has accepted bids below what it costs to provide the service, so that the contract has had to be renegotiated.

Critics of outsourcing argued that firms bid low to win contracts, pay out fat bonuses to the executives and then hope for a government bailout when it all goes wrong. More moderate commentators pointed out the new external environment faced by the whole government outsourcing industry. As governments in the UK have increasingly focused on balancing the budget in the modern rush towards austerity economics, life has become tougher for the outsourcing firms. 6

What Robert Howson said

Having taken severe criticism from parliamentary investigations and the press, especially for deserting a ship he must have known to be sinking (when it became known that collapse was near, he had sold his pension share options as soon as he left and just before the share price crashed), the former CEO replied to Parliament in a series of letters in which he stated his view of things. In brief, he blamed the governments project management process. Governments insisted on fixed-price contracts, but Carillion had been persistently misled during the tender process by contracts which turned out to be much larger and costlier than described. The National Offender Management Service contract to provide facilities management services to prisons in the South of England was a perfect example of where the size of the estate had been completely underestimated in the tender documents. It turned out to be some 60% larger by number of assets than the government had estimated, and yet Carillion was obliged contractually to maintain and administer this bigger estate as part of the fixed price.

It was a cash flow problem primarily, argued Howson; difficulty in obtaining payment from Msheireb Properties (owned by the Qatar Foundation) had been and was still being experienced by Carillion and a number of other contractors and subcontractors in Qatar. In addition, at the time of his departure he said that significant amounts were still owed to Carillion by government departments and the wider public sector.

Required:

Given that the government and Carillion are likely to share the blame for the companys collapse, use the process model to analyse why Carillion failed. You can make any reasonable assumptions as long as you state them.