The Carillion business model has always been flawed and the cracks in it have been there for all to see for quite a long time. The share price dropped after the first profit warning almost 6 months ago and nobody showed much inclination to buy enough of the stock for the price to recover.
The company’s debt has been more than 500 million GBP for about 3 years and it was taking 120 days to pay its subcontractors as early as 2013. The signs of a company in considerable crisis has been apparent for a very long time.
It’s times like this when one would hope that there would be an attempt to make the best of what is a really bad mess before allowing the recriminations to begin. Jeremy Corbyn has called for an end to “the rip-off privatization policies that have done serious damage to our public services”. A little bit of misdirection from Mr Corbyn going on there – back to that later. Theresa May has not exactly been very communicative – she may very well feel her inbox folder titled “my problems and other animals” was big enough already.
The problem Carillion has always faced is the government procurement model, which makes it difficult for private companies to flourish. If Carillion was operating it contracts on a time and materials basis then the company would almost certainly be immensely profitable. But it was not.
Government tenders are evaluated using a scale that takes both quality and price into account. From 2015 all public contracts are awarded on “Most Economically Advantageous Tender” (MEAT) criteria and, in some cases, this allows decisions to be made on price alone.
The reason Carillion was winning all these bids was because they were not only amongst the cheapest, they were probably the cheapest. It was effectively delivering business at loss and using the growing debt mountain to fund the shortfall and then sell as hard as possible to scrape in cash from new contracts. This was the reason I ridiculed Jeremy Corbyn’s statement: there has been no large-scale rip-off. The whole reason government uses private tenders is because they are considerably cheaper than if delivered in-house. In-house delivery would be on either a time and materials basis or a fair value model. The real cost with either model would be considerably higher. In fairness to Mr Corbyn, some of the rip-off comments were directed at the C-level executives who awarded themselves significant pay and bonuses but without a significant re-think, there is no way the government can deliver these projects anywhere nearly as cheaply as private enterprise.
Politicians have this remarkable habit of squealing for a 180 degree turn when in reality the basis of the business model needs adjustment rather than complete disposal.
MEAT is murder
The root of the problem lies in the MEAT approach the government adopts in procurement. It encourages companies to bid at the lowest possible price. It forces companies to cut every possible last penny out of the delivery process often at the consequence of increased risk. It allows desperate companies to do desperate things to survive for the short term. It allows a sales function to create bids which appear advantageous on paper for the sake of winning rather than good business sense.
What compounds the problem is the risk factors associated with the whole nature of outsourcing projects. Outsourcing at a government level tends to involve high value projects which have relatively low profit margins. This is an acceptable way to transact business if risk is adequately understood and managed. The reality is this is often not the case. Delays impact cash flow and incur penalty payments. Unforeseen problems arise which creates the need for workarounds. Low margin projects are only effective with low-risk predictable project outcomes. Carillion was operating a low-margin and relatively high-risk strategy. Any forecaster will tell you that at some stage companies who operate like this are going to catch a considerable cold.
What should the government do differently?
Rather than change the whole approach to contracts in the way some have suggested – why not create a “high value/fair price” style process. Part of the tender process has to include independent validation that the bidder has included sufficient risk contingency and will make fair profit.
The upside is a significant reduction in risk of this situation happening again. The downside is the cost to the tax payer will go up and that will have economic consequences.
The other thing the government can do is validate whether they contributed to the low-margin, high-risk business model in the first place and support private enterprise more. That is the subject of another article which you can read here.