Posted on September 5, 2016 by Joshua Reddaway
How to apply open book accounting principles without the cost of open-book accounting
Government uses contracts to deliver many public services and has a duty to get value for money. Two recent NAO investigations illustrate, in two very different situations, how contracts can founder when the procuring organisation lacks understanding about the relationship between the contractors’ cost of providing the service and the price of the contract. That’s why central government is now required to apply open-book contract management. But expertise, time and effort is required to apply it in full. For low-risk, more straight-forward contracts, we set out a low-cost, minimal open-book approach.
Two case studies show that government needs to understand the costs of providing a service, as distinct from the price charged by the contractors.
Lessons from past contracts
Our Investigation into the UKTI specialist services contract with PA consulting tells the story of a contract that was cancelled following a commercial dispute over pricing. We found:
It was not clear how the contract was, or was meant to be, priced. As a result, the procurer was unable to understand the commercial deal it had struck, including how changes would affect the economic balance of the contract.
Both sides agreed to negotiate a significant change after bids were submitted but before the contract was awarded. This change was negotiated without competitive tension and led to an increase in the contractor’s revenue and profit from the contract.
The contractor was not sufficiently transparent about how it reported its forecast profit, and did not make clear the amount of corporate overheads built into the price. The lack of transparency led the customer to take false assurance that there was no impact on value for money from the negotiations when that was unlikely to be the case. We concluded that both sides had fallen well below the standards expected by taxpayers.
Our Investigation into the collapse of the UnitingCare Partnership contract in Cambridgeshire and Peterborough is about an NHS contract that was terminated after 8 months when it ran into financial difficulties. We found:
Bidders faced significant difficulties in pricing their bids accurately due to limitations in the available data. A number of issues, such as the detailed scope of services included in the contract, were still outstanding when the contract was signed. Many of these were critical to pricing, but the contractor had not revised its bid price to reflect the uncertainty. Nevertheless, additional contractual and termination clauses added during contract negotiation passed significant financial risk back to the commissioner.
The ‘contractor’ here was a limited liability partnership between two NHS Foundation Trusts. This was formed to meet the commissioner’s requirement for contracting with a single entity. But neither contractor nor commissioner made proper arrangements to fund the ensuing VAT liability.
One month into the contract, the contractor requested some 21% more revenue for the first year, and although both parties negotiated to reduce the funding gap, they were not able to resolve this and the contract was terminated. The two sides differed in their understanding of the extent that the contract clauses allowed the contractor to negotiate additional funding after signing the contract.
Both procuring authorities are taking action to improve their commercial capability and ensure lessons are learned.
So how can government ensure that it does understand the cost drivers?
Since June 2016, all central government buying organisations should be implementing the Cabinet Office guidance on open-book contract management. This requires central government to decide which contracts would benefit from using open-book. The guidance divides contracts into 4 tiers. At the higher tiers, the more complex contracts, government should look at its contractors’ books on a regular basis. But even towards the lower tiers, it recommends understanding cost units and drivers using a ‘customer cost model’, defined as “The model you initially build to invite suppliers to populate in the bid”.
For several years both the Public Accounts Committee (PAC) and the NAO have been calling for the greater use of open-book accounting. But we also recognise that using full open-book accounting is very difficult, requiring expertise, time and effort. The principles behind the Cabinet Office guidance offer a practical way of prioritising its use. It will leave, however, many contracts where government is not using open-book accounting in its full form as normally understand.
Government thus needs ways of applying the principles of open-book even when it is not using audit access rights. These rights can be reserved for a forensic “deep dive” into the contractor’s books if something has gone wrong, but it is vital that the client always maintains a clear understanding of what the costs and price should be.
We have set out what a minimal open-book approach might look like below.
We will be putting out further blog-posts on commercial and contracting matters over the coming months.
Please do share your comments on this post, or contact us to discuss open-book or wider commercial and contracting matters.
Related NAO reports
- Investigation into the collapse of the UnitingCare Partnership contract in Cambridgeshire and Peterborough, July 2016
- Investigation into the UKTI specialist services contract with PA consulting, June 2016
- Open-book accounting and supply-chain assurance, July 2015
- Transforming government’s contract management, September 2014
For an overview of our work on commercial and contracting, see Government Commercial and Contracting: an overview of the NAO’s work.
About the authors:
Joshua Reddaway is the NAO Director responsible for our Commercial and Contracting Community of Practice. This Practice generates cross-government insight on commercial and contracting matters, develops best practice approaches and ensures these are applied across the NAO. Joshua also coordinates our cross-government studies and he is a regular speaker at conferences. He joined the NAO in 2002.
Richard Lewis works in the NAO’s Commercial and Contracting VFM Team. He joined the NAO in 2008 having previously completed a PhD in mathematics. He has worked on a number of VFM reports focussing on commercial and contracting issues and led the team producing the Open Book report.
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