Managing the Tools of Government: Contracting and Contract Management in the New Millennium

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1 Managing the Tools of Government: Contracting and Contract Management in the New Millennium Trevor Brown School of Public Policy and Management The Ohio State University Matt Potoski Department of Political Science Iowa State University David Van Slyke Maxwell School Syracuse University Paper for Presentation at the 2005 National Public Management Research Conference, University of Southern California, Los Angeles

2 Once a government decides to deliver a service to its citizens, it must then decide whether to produce the service directly through its own employees or via a contract with a private vendor, nonprofit organization or another government. Contracting proponents, often with roots in public sector economics, champion contracting as a way to reduce service costs through competitive efficiencies and scale economies. Contracting critics, often with roots in traditional public administration fields, counter that contracting tends to sacrifice key public sector values (e.g. equality of treatment) and reduce service delivery capacity. Strident ideological debates have crowded out rigorous, theory-driven analyses of how public managers can effectively manage contracted service delivery. In academic circles, enough research has identified cases of successful contracting that few would doubt whether public services can be delivered effectively through contracts. And yet, research has also uncovered enough cases of failed contracts to make clear that contracting does not always bear its promised fruits. The current challenge for academics is to provide theoretically yet practical grounded guidance to help managers capture the benefits of contracting while avoiding its pitfalls. In this paper, we develop a strategic framework to guide managers through the contract process from assessing the feasibility of contracting, to structuring the contract process, to managing service provision under contract. Our framework brings together the three major contracting and contract management research traditions. From the research on values and strategic management, we assess how stakeholder values shape the contracting context. Managing service delivery requires public managers to balance competing stakeholder values across varying circumstances: different contracting tools are better equipped for maximizing different values. From the research on public law and administration, we consider how institutions shape the service delivery context. The institutional architecture identifies the strengths and limitations of service 2

3 delivery approaches, and defines legal and other resources available for mangers service delivery activities. Finally, we apply transaction cost theory to identify the market and service features that influence the potential for contract failure and what managers can do to mitigate these risks. In short, these research streams provide the theoretical foundation for our strategic approach to managing service delivery via contract. This paper is divided into four sections beyond this introduction. The first section identifies the phases of contracting the make or buy decision, contract specification, and managing service provision under contract and demonstrates how the three phases are not simply discrete decision points, but rather are integrated links in a management chain. Decisions at each phase affect the management imperatives of the other phases. The second section lays out the theoretical foundation of our framework values, institutions, and service markets. We provide a conceptual definition for each factor and describe its influence on the contracting process. The third section illustratively applies the framework in each contracting phase to show how the framework can strategically guide managers through key contracting decisions. Finally, the fourth section concludes the paper by suggesting next steps in research and application. The Contracting Challenge Effectively executing core management functions planning, decision-making, monitoring, managing fiscal resources and external relations improves service outcomes (Hill and Lynn, 2004; Hou, Moynihan, and Ingraham, 2003Knott and Payne, 2004; Meier, O Toole and Nicholson-Crotty, 2004; for a review see Boyne 2003), whether services are provided directly or via contract (Brown and Potoski, 2006; Gansler, 2002; Lawther, 2002; Romzek and Johnston, 2002). As contracting has become more common and politically palatable, public managers have 3

4 come under increasing pressure to be smart buyers and smart managers of contract service provision (Kettl, 1993, Kelman, 2002; and Cooper 2003). Contracting s promised fruits increased efficiency, cost savings, innovation, etc come more readily to governments who invest in strong contract management capacity (e.g. Kelman, 2001, 2002a, 2002b; Brown and Potoski, 2003a, 2006; Van Slyke and Hammonds, 2003). A regrettable but oft-cited presumption is that governments contracting may reduce their management capacity in the same way that they reduce their direct service production capacity (Brown and Brudney, 1998; Van Slyke, 2003). That is, as they eliminate service production personnel and equipment, contracting governments also eliminate the managers responsible for service quality and efficiency. Service contracts in such hollow states are more likely to fail (e.g. Milward, Provan and Else, 1993; Milward, 1994). There are three stages to contract management. The first stage is assessing whether a situation is suitable for contracting (e.g. Donahue, 1989). Managers must assess whether market conditions are likely to support a competitive environment for contract service provision (e.g. Sclar, 2000) and identify which service production and/or management components can be unbundled for contracting (e.g. Brown and Potoski, 2006). In the second stage, after the decision has been made to contract, public managers structure and execute a competitive bidding process (e.g. Lavery, 1999). Contract design is a complex undertaking requiring public managers to make decisions on many fronts, such as the degree of task specificity, the contract s renewal provisions, and the details of incentive systems (e.g. Shetterly, 2000). Finally, after a vendor has been selected and the contract awarded, public managers must manage service delivery under contract (e.g. Kelman, 2002a, 2002b). Here the focus shifts to daily management activities such as monitoring vendors performance and their performance measures, listening to service recipients, and executing incentive programs. 4

5 While these are analytically distinct phases, they are also interrelated. This is because at its core managing service delivery requires managers to constantly balance competing stakeholder values, such as between lowering costs and improving service quality, along with many other decision criteria. Contract management is thus more than specifying tasks and monitoring vendors performance; it is fundamentally about balancing competing values among a myriad of stakeholders with different goals. Better contract management can improve service quality without sacrificing efficiency and can lower the costs of producing quality services. With growing demand for high quality service delivery, declining government budgets, and an increasingly complex contract environment, public managers need guidance for strategically managing the contracting process. A variety of prescriptive step-by-step approaches to contracting and contract management describe the decisions facing public managers, their different service delivery options (e.g. franchises versus contracts, short-term versus long-term contracts, performance versus input based contracts), and the management techniques for delivering them under contract (e.g. Lavery, 1999; O Looney, 1998). The limitation of such step-by-step approaches, however, is that they do not provide a strategic foundation for managing the trade-offs inherent in contracting. The contract environment is ever changing and requires constant rebalancing of competing criteria. Even the most detailed prescriptive text can not fully prepare public managers for all of the contingencies, outcomes and implications of their decisions. As Kettl (2001) states indirect government is not so much a tactical toolbox as a strategic approach to governance (p. 508). Rather than a cookbook, we offer a theoretically informed framework for public managers as they analyze key decisions at each phase of the contracting process. Values, Institutions, and Service Markets 5

6 The strategic framework we propose begins with the assumption that the outcomes of service delivery through contract reflect the intersection of three factors: values, institutions, and service markets. Values are the stakeholder preferences that public managers balance and seek to optimize as they deliver services. Institutions, or the laws and organizational arrangements that frame service delivery, determine the range of tools resources that public managers can employ to optimize values. Finally, the services themselves and the character and composition of the market influence service delivery. Each factor has its roots in different research traditions values in public affairs and strategic management, institutions in public law and public administration, and service markets in economics. In this section we discuss each of these factors, identify how they influence contracting and contract management, and describe the manner in which public managers can assess the extent to which they can shape the contracting environment. We synthesize across these research literatures arguing that, as with the phases of contracting, values, institutions, and service markets are interconnected. In the section that follows this discussion of theory, we present several examples from each of the three phases to illustrate how our framework provides strategic guidance for public managers. Values Public managers operate in a crucible of swirling values effectiveness, efficiency, accountability, responsiveness, equality of treatment, and service quality to name only a few (Frederickson, 1997; Gilmour and Jensen, 1998; Moe, 1996; Posner, 2001; Rainey, 2003; and Seidman, 1998). Managing service delivery is as much about identifying, balancing, and targeting shifting stakeholder values as it is about operations management, vendor relations, and so on. For any service, the list of potential stakeholders is long: interest groups and attentive segments of the 6

7 general public, elected officials, the media, public employees, administrative superiors, collaborators and partners, service recipients, and vendors. Service recipients and their interest groups may be primarily concerned with equality of treatment. Elected politicians may focus on political accountability and responsiveness. Administrative superiors may be most attuned to cost efficiency. Obviously, these values sometimes conflict ensuring equality of treatment may reduce cost efficiency so managers must either frame the trade-offs for key decision makers, or as is often the case, use their discretion to make these trade-offs as they implement services (deleon, 1995; Van Slyke, Horne, and Thomas, 2005). Stakeholder values are the evaluative yardstick for measuring service delivery. Contracting may be more cost efficient and better at stimulating innovation (Bennett and Johnson, 1981; Kettl, 2001; Pack, 1989; Savas, 2000; and Selden, Brewer, and Brudney, 1999). Direct service provision, on the other hand, is thought to better promote political accountability, stability, and equality of treatment (DeHoog, 1984; Donahue, 1989; Kettl, 1993; and Morgan and England, 1992). To some degree these differences are speculative, and the relative strengths of direct versus contract service delivery appears to vary across circumstances (Brown and Potoski 2006; Morgan and England 1988; and Sclar 2000). Nevertheless, an important first step for successful contracting is to identify and prioritize the value preferences of key stakeholders so that public managers can weigh them against one another in their decision making. Because the contextual setting surrounding service delivery is typically dynamic and often contentious, public managers should constantly scan their environment and assess shifts among stakeholders to better assign weights to different values. There is a rich literature on how public managers can gauge stakeholder values (Kraft and Clary, 1991; Serra, 1995; and Thomas, 1995). Surveys can reach large numbers of people, 7

8 although they are quite expensive. To reach groups with more intense and deeply held preferences (e.g. interest groups, service recipients, elected officials), public managers can rely on public meetings and hearings, requests for comment and information, advisory committees, and focus groups. Recently, managers have invited stakeholder participation in developing service delivery goals prior to beginning the contract process (Beinecke and DeFillippi, 1999; Gooden, 1998). Once values have been identified, the strategic management and planning literature suggests a number of approaches for prioritizing competing stakeholder values and preferences, including stakeholder value mapping (e.g. Bryson, 2004), backward mapping (e.g. Elmore, 1979), and balanced scorecards (e.g. Kaplan and Norton, 1996). Synthesizing values is critical to clarifying program goals and identifying the value trade-offs inherent in different service delivery practices. Institutions As managers identify stakeholder values, they also need to identify the tools, resources and constraints that define the potential action they might take in delivering services. Institutions establish the rules of the game (North, 1991) and thereby set the parameters for deciding which alternative service delivery options may be used and the manner in which contractual relationships can be managed and altered. Two institutions are central to the contracting process public law and organizational arrangements. Public law sets the boundaries within which public managers must operate, thereby permitting, authorizing or requiring the range of managers actions. At its root, a contract is a legal instrument, an agreement by particular parties [that] accept a set of rules to govern their relationship, whether it is for the purchase of services or for a cooperative working agreement (Cooper, 1996, 125). For example, at the federal level, the Office of Management and Budget 8

9 circular A-76 establishes the statutory requirements and delineates what federal procurement officials must do when bidding contracts. As the law establishes what is authorized and prohibited, it also defines a managers zone of discretion, either through legal ambiguity or direct delegation. In some cases, these grey areas allow for considerable flexibility, creativity and innovation in the use of contracting tools, or they may restrict discretion to such an extent that they undermine managers ability to manage contracts. Clearly managers need a sound understanding of the laws, ordinances, and administrative statutes governing the contracting process in general and their particular services (Rosenbloom and Piotrowski, 2005; Wise, 1990). Along with legal resources and constraints, organizational arrangements also define the capacity and resources available for managing service delivery. Contract management capacity includes physical and financial capital. Perhaps more importantly, management capacity also includes human capital, such as basic management skills (planning and coordinating service delivery, negotiating with vendors, monitoring task completion, executing incentives [Brown and Potoski, 2003a; Romzek and Johnston, 2002; Van Slyke and Hammonds, 2003]) as well as specific technical skills (e.g. contract drafting). In most circumstances ensuring sufficient capacity requires assigning these managerial responsibilities to public employees such as contract managers. 1 Weak capacity increases the risk of failed contracts (Brown and Potoski, 2005). Service Markets A final set of factors service markets determine whether appropriate conditions exist which favor contracting. When markets work well, competition for contracts helps overcome principal agent problems, monopoly inefficiencies, and other ills that can plague service delivery through government bureaucracies. A competitive market provides information about prices and service quality across vendors and disciplines vendors who fail to meet market standards. Strong 9

10 markets require some fairly strict conditions. Markets need large numbers of buyers and sellers, participants need to be well informed about products and each others preferences, and actors must be able to enter and exit the market and exchange resources at low costs. Markets can fail because of high transaction costs, limited information, uncertainty about the future, and the prospect that people or organizations behave opportunistically in their interactions (Coase, 1937; Williamson, 1981, 1996, 1997). 2 Market failures imply that the win-win outcomes of voluntary exchanges no longer occur. Of particular importance for our purposes are market and service characteristics that give rise to transaction costs, or in Williamson s (1981, p ) terms the comparative costs of planning, adapting, and monitoring task completion under alternative governing structures. In the case of contracting, because parties to a transaction cannot fully predict all possible future scenarios, contracts are underspecified (or incomplete), allowing vendors to opportunistically exploit ambiguities to their own advantage at the expense of the contracting government. To minimize such opportunism, the contracting government must incur transaction costs, such as writing more detailed contracts, implementing performance measurement systems, monitoring vendors performance and executing penalties if necessary. Asset specificity and ease of measurement are two of the central sources of transaction costs in public sector contracting. Delivering an asset specific service requires large specialized investments in things that cannot be translated to other economically valuable activities. Asset specificity can refer to physical infrastructure or to the skills and abilities that can only be acquired through on the job experience. Asset specific services dangerously privilege whoever wins the first contract because in later rounds vendors without the necessary investments are unlikely to remain in the market. Losing bidders who have also made specialized investments are may be unable to market their services elsewhere if the government is the only purchaser. Under such 10

11 monopsonistic conditions the winning vendor can opportunistically exploit the government contracting agency with impunity by raising prices or reducing service quality. Ease of measurement refers to how well public managers can assess the quality of delivered services. Easily measured services have identifiable performance metrics that accurately represent service quantity and quality. If performance outcomes are difficult to measure and observe, a service may still be easy to measure if it is relatively straightforward to monitor the activities of the vendor and the activities are reasonable proxies for final outcomes. A service is difficult to measure when neither the outcomes to be achieved nor the activities to be performed are easily identifiable. Difficult measurement gives rise to information asymmetries between contracting governments and vendors; governments cannot assess the quality of services they are receiving. As with asset specific services, governments contracting for difficult to measure services are vulnerable to unscrupulous vendors that exploit their information advantage by lowering service quality and quantity. Of course, difficult to measure services are also prone to exploitation when delivered internally as well (Jensen and Meckling, 1996; and Milgrom and Roberts, 1992). The advantage of internally producing high transaction costs services is managers actions can more easily counter the information and principal agent problems that come from contracting for high transaction cost services. Mitigating these risks requires deploying management capacity to address market weaknesses, or avoiding the market altogether through internal service delivery. If services are difficult to measure, managers can monitor their own employees more easily than vendors. If services are asset specific, managers can shape employment incentives (through compensation, promotion possibilities, and other non-pecuniary rewards) for strong performers. 11

12 Even strong markets are imperfect, necessitating a minimal investment in management capacity (Brown and Potoski, 2004). Taken together, these three streams of factors frame the contracting process. Stakeholder preferences establish the values to be optimized in the contracting process. The institutions of public law and organizational arrangements establish what types of contracting tools can be employed to achieve those values. Characteristics of service markets influence which available contracting tools and vendors are best suited to achieve stakeholder values. Managing the Phases of Contracting In this section we map the three factors to the phases of contracting and begin to develop a strategic contract management framework. As noted earlier, our approach is not to direct public managers through a series of proscriptive steps, but rather to illustrate how public managers can use the lenses of values, institutions and service markets to manage strategically the contracting process. As our approach is instructive rather than comprehensive, we focus on only a small subset of the many contracting decisions at each phase of the contracting process. We first examine the basic make or buy decision. For the contract specification phase, we examine vendor selection. For the post-contract management phase, we examine vendor monitoring. The Make or Buy Decision The central value tension in public sector service delivery is the efficiency versus effectiveness trade-off. 3 Maximizing efficiency means producing each unit of a good or service at the lowest possible cost, while maximizing effectiveness means producing each unit of a good or service at the highest level of quality, however quality is defined. Holding external factors constant, gains along one dimension often require sacrifices along the other, a tradeoff that holds 12

13 only under conditions of ceteris paribus. More favorable circumstances (such lower transaction costs), better technology, and management innovations, mean that delivery can be more efficient or effective (or both). Thus, while public managers seek to take advantage of management innovations such as gain-sharing and benchmarking which promise to reduce costs while maintaining quality (Osborne and Plastrick, 2000), they must nevertheless balance values against contracting tools when considering the provision of high and low transaction cost services. Because the choice of service delivery favors some values over others, debates about the desirability of contracting are fundamentally grounded in what values public managers should emphasize. Contracting s proponents emphasize market competition s power to lower production costs while its opponents emphasize service effectiveness and other democratic values. Public managers should next map out the range of choices afforded to them by law. Laws tend to clearly delineate whether contracting is required, permitted or prohibited for a particular service. At first glance it might appear that contracting is superior to direct service provision because it offers greater flexibility to manage the efficiency-efficacy trade-off. After all, federal and state administrative procedure acts mandating whistle blower and other employee protections, and open records and meetings create both costs and constraints for government managers (e.g. Cooper, 1996), precisely the kind of legal and bureaucratic inefficiencies contracting is designed to counter, particularly if vendors working under contract can skirt the legal requirements binding governments (Rosenbloom and Piotrowski, 2005). Yet, many laws restrict contracting practices (DeHoog, 1997), such as those that require special protections or more heavily weighted preferences to be considered in the contract decision making process. Such preferences, in an effort to optimize equality, may include awarding extra points in the proposal evaluation stage for minority-owned firms or small businesses. From the perspective of the contracting government, 13

14 onerous legal requirements raise the costs of contracting. Indeed, many private firms and nonprofits may choose not to compete for public sector contracts because of such time-consuming and heavy legal requirements (MacManus, 1991; Praeger, 1994)). These requirements may be less burdensome than those governing internal provision. As such, legal exigencies lower market competitiveness and thereby dilute the advantages of contracting relative to internal provision. Examining the legal arrangements governing service delivery is an important first step in determining whether to make or buy, but other factors notably characteristics of the service market play a more fundamental role in determining the returns from contracting. Low transaction cost services are prime targets for contracting because of the high potential for efficiency and cost savings and the low risk of sacrificing service quality. On the other hand, services with higher transaction costs those that require asset specific investments or are difficult to measure are less attractive contracting candidates because of the higher likelihood of monopolization and vendor underperformance. Managers should assess whether there are sufficient vendors to ensure a competitive market, and in the case of asset specific services, whether there is likely to be a competitive market in subsequent rounds of bidding. Contracting in thin markets with few vendors makes contracting costlier because managers must either counter the lack of information and other problems such markets create or incent and monitor vendors closely to mitigate opportunism and failed contracts. Managers need not be hopeless victims to thin markets: in markets with few vendors, public managers can stimulate competition, for example by recruiting new vendors (Brown and Potoski, 2004). Another option is for managers to split service delivery into multiple contracts, allowing public employees to compete against private vendors (Goldsmith, 1997; Osborne and Plastrick, 2000). Still another is for managers to retain a portion of service delivery in-house to 14

15 provide both information on service quality and cost while also ensuring that there is an alternative provider even in thin markets. However, these activities are costly. When transaction costs are high and markets are thin, governments need sufficient management capacity to ensure the desired balance between efficiency and effectiveness. If the management capacity is expensive, direct service provision may become more attractive. Taken together, public managers facing the make or buy decision should first gauge stakeholders value preferences, particularly along the efficiency versus effectiveness tradeoff. The nature of the value tradeoff varies across types of services, institutional arrangements and market conditions. Contracting is more attractive when legal requirements afford public managers discretion, when service transaction costs are low, and when markets are competitive. Contracting becomes costlier and thus less attractive to the extent these conditions do not hold. Contract Specification Assuming a government elects to buy rather than make, the next stage in the contracting process is the contract specification phase. This includes developing and implementing a bid process, selecting a vendor, and crafting the contract. Frequently this phase is analyzed through the lens of principal-agent relations. The contracting government (i.e. the principal) uses the contract specification phase to constrain the vendor (i.e. the agent) from exploiting information asymmetries at the expense of the contracting government s goals. In this way, the contract is a device to maximally align the vendor s values and actions with those of the contracting government. As discussed earlier, legal requirements for contracting constrain how this process must be implemented, but public managers typically have discretion to shape important decisions, including task specification (e.g. the scope of work), the use of outcome measures (e.g. 15

16 performance based contracts), vendor qualifications (e.g. licensing or accreditation issues), vendor compensation (e.g. time and materials versus cost-plus-fee), contract duration (e.g. short versus long) and renewal provisions, payment schedules, the use of incentives (e.g. punishments versus rewards), and reporting requirements. In this section we focus on a central contract specification decision: the type of vendor selected. Contracting governments can choose among three types of vendors: private firms, nonprofits and other governments. Private firms, whether they are publicly or privately held, are thought to be motivated to maximize profits, and consequently may focus more on innovation and efficiency. However, this efficiency may well come at the expense of the contracting government s goals (Moe, 1996). For example, in a forced choice between taking steps to maintain or upgrade service quality and keeping costs low, the fear is that private firms will cut corners to reduce expenses. In the language of transaction cost theory, private firms are opportunistic and likely to pursue self-interest with guile (Williamson, 1985, 45). Nonprofit organizations are thought to share similar missions with government, and thus maybe more reliable contract partners (Hansmann, 1987; Salamon, 1995; Van Slyke and Roch, 2004; and Young, 1999). Rather than behaving opportunistically, a nonprofit might draw on its own private philanthropic resources (e.g. volunteers, endowments) to augment revenue from its government contract. This distinction, of course, is not without caveats. While nonprofits may be prohibited from distributing profits, they may in fact use channel government revenue to subsidize non-contract programs. Finally, other governments can also be contract vendors. Like nonprofits, other vendor governments are thought to have values aligned with the contracting government because they both share a similar public mission, a workforce committed to public sector values, and the inability to distribute profits. However, intergovernmental contracts may do less to solve the weak productivity, inefficiency, 16

17 lack of innovation and other bureaucratic ills that plague direct government service provision (e.g. Niskanen, 1971). Institutional arrangements play an important role in determining the returns from contracting with each of these three types of vendors. Other governments are subject to the same legal requirements as the contracting government. These requirements may promote service quality, but they likely come at the expense of cost efficiency and innovation. Non-profits are governed as tax-exempt organizations, and as such they are prohibited from distributing profits to their employees or volunteer boards. Consequently, there may be fewer incentives for them to engage in opportunistic behavior, at least in comparison to private firms. Finally, while the profit motive may drive private firms to sacrifice quality for efficiency in a forced choice, private firms may offer more flexibility and discretion under contract because they are not subject to the same rule making and transparency requirements as governments. The type of vendor may be less important for low transaction cost services in competitive markets because the risk of monopolization is low, performance can be easily measured, and contracts effectively enforced. Indeed, governments contract more with private vendors in such circumstances (Brown and Potoski, 2003b), exploiting their competitive zeal and relatively slim legal requirements though rigorous contract specification and enforcement (e.g. claw back provisions or penalty clauses [Brown and Potoski, 2004]). The type of vendor becomes more relevant when contracting for high transaction cost services in thin markets, for example, when a small government needs to deliver a service that requires asset specific investments beyond what it can afford. In these cases, public managers would be wise to solicit bids across the three types of organizations, and perhaps even favor nonprofits or other governments in selecting a winning vendor, since value alignment between the contracting government and these vendors may mitigate 17

18 the risks of failed contracts. Governments more frequently choose nonprofit and other governments when contracting for high transaction cost services and in thin markets (Brown and Potoski, 2003b). Contracting with vendors that purportedly share the same goals is not without risks. Van Slyke (2003) finds that governments often establish long-term contract relations for social services with nonprofits but then neglect oversight and monitoring responsibilities. In monopsonistic situations (in which the government is the only buyer), nonprofits may become increasingly reliant on a public sector contract and begin to behave like a conventional monopolist in order to maintain the resource flow. In the absence of sufficient contract management capacity, nonprofits are able to exploit the contract in the same way a private firm might. However, for those governments that invest in sufficient management capacity, long term contractual relationships can sometimes foster mutual support and sharing, creating a virtuous cycle of trust begetting more trust, and vendors that do not exploit contractual advantages. Economists and organizational theorists refer to these types of relationships under the rubric of relational contracting. In a relational contract public managers work with the vendor toward building a long-term relationship based on trust, reciprocity, and joint involvement in the development and implementation of the contract (Fernandez, 2005). In contracts that are highly asset specific and where the service does not easily lend itself to measurement, relational contracting advocates suggest that less detailed specification, less rigidity, and more flexibility and discretion can lead to greater levels of contractual alignment between government and its vendors, if based on trust, and frequent communication and coordination (Gazley, 2005). The success of a relational contracting approach, which has higher transaction costs in the short term compared to a conventional approach to contract management, can over time lead to lower transaction costs in the form of reduced bidding, monitoring, and legal costs. 18

19 The joint involvement and repeated interactions of government and the vendor are intended to promote goal alignment between the parties. Managing Service Delivery under Contract Once governments select a vendor and turn their attention to contract management, managers face more decisions centering on the efficiency and efficacy trade-off. Perhaps most central among these is monitoring and evaluating vendor performance (Behn and Kant, 1999; Brown and Potoski 2003a; Kettl, 1993; Praeger, 1994). Monitoring and evaluation is the means by which public managers assess whether service delivery reflects the targeted values. Well monitored vendors may be more likely to perform according to contract specifications, although monitoring in turn is costly. Effective monitoring programs must have a solid legal grounding: in some circumstances, monitoring activities not covered in a contract may not be used to evaluate vendors (Kelman, 2002). Contracts can authorize the use of several monitoring tools (Brown and Potoski, 2003c). First, managers can establish formal systems for tracking and monitoring citizens complaints about service delivery. As direct recipients of contracted goods and services, citizens can serve as fire alarms" (McCubbins and Schwartz, 1984), calling attention to occasional transgressions without requiring governments to constantly monitor vendors activities. Second, managers can proactively gauge public sentiment about service quality through citizen surveys (Miller and Miller, 1991; Poister and Henry, 1994; and Swindell and Kelly, 2000). Third, managers can more directly focus on vendors by auditing and analyzing their records and performance data. This method places the burden on the vendor to produce the performance information and can therefore lead to higher costs for the vendor. Finally, managers can also conduct field audits as they often 19

20 do in regulatory contexts in which government employees physically watch as vendors deliver goods and services. In this way, governments can gain direct information about service quality, vendor effort, and citizen satisfaction (DeHoog, Lowery, and Lyons, 1990). These monitoring activities vary in their costs and efficacy depending on the nature of the service and the broader market conditions. For low transaction cost services, performance measures are easy to design and implement. For example, public managers might decide that ontime service is a critical performance criteria for the operation of a bus transit system and then require the vendor to provide periodic reports of how often buses arrive on time at each stop on a route. Public managers might then spot check performance by randomly riding routes, or they may set up a call in system to track citizen s complaints about persistently late routes. Moderately difficult to measure services may require a more extensive monitoring system, with overlapping output and outcome performance measures. Measurement difficulty and the costs associated with designing and implementing a performance measurement system may exceed the benefits. Contracting in such circumstances may require government managers with a deep understanding of the service production process. This can be an onerous undertaking, beginning with uncovering the logic behind the vendors service delivery techniques. Ensuring alignment between government and the vendor may require that the parties discuss the specific program goals, approach to intervention, and jointly agree to the types of measures that would best represent successful service delivery. The goal of any monitoring system is to provide managers with information about service delivery. The need for monitoring is greatest for higher transaction costs services, but so too are the costs and difficulty. Equipped with performance information, managers can realign vendors actions with targeted stakeholder values by executing the contracts penalty and clawback 20

21 provisions. Of course, well functioning markets certainly help impose discipline: managers can replace underperforming vendors with their more promising competitors. Conclusion In this paper, we develop a strategic approach to contract management based on three central factors: values, institutions, and service markets. Stakeholder preferences establish the values to be optimized in service delivery. The institutions of public law and organizational arrangements determine the contracting tools available for balancing among competing values. The characteristics of service markets influence which contracting tools and vendors are best suited to achieve stakeholder values. Governance by contract demands a strategic foundation on which to guide decision making (Cooper, 2003). Our examination of three key decisions whether to make or buy, what type of vendor to select, and what type of monitoring tools to employ under contract illustrates how these heuristic devices can be used to navigate all phases of the contracting process. We have examined only three of the many decisions involved in contracting, although our goal is for this framework to guide research. For example, scholars could examine why governments use different contract incentive and sanction mechanisms and whether their efficacy varies across different types of vendors and types of service markets. Because of the varying legal constraints under which they operate, other government, for profit and nonprofit vendors may respond differently to any particular incentive program. The proof is ultimately whether public managers find value in our framework for promoting their contract management capacity. 21

22 References Behn, R. and P. Kant. (1999). Strategies for avoiding the pitfalls of performance contracting. Public Productivity & Management Review 22: Beinecke, Richard H., and DeFillippi, Robert. (1999). The value of the relationship model of contracting in social services reprocurements and transitions: Lessons from Massachusetts. Public Productivity and Management Review 22(4): Bennett, James T., and Manuel H. Johnson (1981). Better Government at Half the Price. Ottawa, IL: Carolina House. Boyne, G.A. (1998). Bureaucratic Theory Meets Reality: Public Choice and Service Contracting in U.S. Local Government. Public Administration Review 58 (6): Brown, M.M. and J. L. Brudney. (1998). A smarter, better, faster, and cheaper government: Contracting and geographic information systems. Public Administration Review 58 (4), Brown, Trevor and Matthew Potoski. (2003a). Transaction Costs and Institutional Explanations for Government Service Production Decisions. Journal of Public Administration Research & Theory 13(4): Brown, Trevor and Matthew Potoski. (2003b). Managing Contract Performance: A Transaction Cost Approach. Journal of Policy Analysis and Management 22(2): Brown, Trevor and Matthew Potoski. (2003c). Contract Management Capacity in Municipal and County Governments. Public Administration Review 63(2): Brown, Trevor L., and Potoski, Matthew (2004). Managing the Public Service Market. Public Administration Review, 64(6): Brown, Trevor L., and Potoski, Matthew. (2005). Transaction costs and contracting: The practitioner perspective. Public Performance and Management Review 28(3): Brown, Trevor L., and Matthew Potoski. (forthcoming 2006). Contracting for management: Assessing management capacity under alternative service delivery arrangements. Journal of Policy Analysis and Management. Bryson, John M. (2004). Strategic Planning for Public and Nonprofit Organizations, (3 rd ed). Jossey-Bass Publishers, San Francisco: CA. Coase, Ronald The Nature of the Firm. Economica, 4: Cooper, Phillip J. (1996). Understanding what the Law Says about Public Responsibility. In James L. Perry (ed.), Handbook of Public Administration. San Francisco: Jossey Bass, Cooper, Phillip J. (2003). Governing by Contract: Challenges and Opportunities for Public Managers. Washington, D.C.: CQ Press. DeHoog, Ruth Hoogland, (1984). Contracting Out for Human Services: Economic, Political, and Organizational Perspectives. Albany, NY: State University of New York Press. DeHoog, Ruth Hoogland, Lowery, David, and Lyons, William E. (1990). Citizen Satisfaction with Local Governance: A Test of Individual, Jurisdictional, and City- Specific Explanations. The Journal of Politics 52(3): (1997). Legal issues in contracting for public service: When business does government. In Phil Cooper and Chester Newland (eds.), The Handbook of Public Law and Public Administration (San Francisco: Jossey-Bass), deleon, P. (1995). Democratic values and the policy sciences. American Journal of Political Science, 39, Donahue, John D. (1989). The Privatization Decision: Public Ends, Private Means. Basic Books. 22

23 Elmore ( ). Backward Mapping: Implementation Research and Policy Decisions. Political Science Quarterly, 94(4): Fernandez, S. (2005). Accounting for Performance in Contracting for Services: Are Successful Contractual Relationships Controlled or Managed? Paper presented at the 8 th Public Management Research Conference, University of Southern California, September 29- October1. Gansler, Jacques. (2002). A Vision of the Government as a World-Class Buyer: Major Procurement Issues for the Coming Decade. Washington, DC: The PricewaterhouseCoopers Endowment for the Business of Government. Gazley, B.(2005). Beyond the Contract: Informal Partnerships as Dark Matter in Privatization Research. Paper presented at the 8 th Public Management Research Conference, University of Southern California, September 29-October1. Gilmour, Robert S., and Jensen, Laura S. (1998). Reinventing Government Accountability: Public Functions, Privatization, and the Meaning of State Action. Public Administration Review, 58(3): Gooden, Vincent (1998). Contracting and Negotiation: Effective Practices of Successful Human Service Contract Managers. Public Administration Review. 58(6): Hill, C., & Lynn, Jr, L.. (2004). Governance and public management, an introduction. Journal of Policy Analysis and Management, 23(1), Hou, Y., Moynihan, D., & Ingraham, P. (2003). Capacity, management, and performance: Exploring the links. American Review of Public Administration, 33(3), Jensen, Michael C., and Meckling, William H. (1996). Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure. In Buckley, Peter J., and Michie, Jonathan (1996). Firms, Organizations, and Contracts: A Reader in Industrial Organization. Oxford, NY: Oxford University Press. Kaplan, Robert S., and Norton, David P. (1996). Using the Balanced Scorecard as a Strategic Management System. Harvard Business Review, (January/February): Kelman, Steven J. (2002a). Contracting. In Salamon, Lester M., The Tools of Government: A Guide to the New Governance. New York, NY: Oxford University Press. (2002b). Strategic Contracting Management. In Donahue, John D. and Joseph S. Nye, Jr. eds. Market-Based Governance: Supply Side, Demand Side, Upside, and Downside. Washington, D.C.: Brookings Institution Press. Kelman, S. (2001). Contracting. In L. Salamon (Ed.), The tools of government: A guide to the new governance (pp ). New York: Oxford University Press. Kettl, Donald F. (1993). Sharing Power: Public Governance and Private Markets. Washington, DC: The Brookings Institution. (2001). Managing indirect government. In L. Salamon (Ed.), The tools of government: A guide to the new governance (pp ). NewYork: Oxford University Press. Knott, J. & Payne, A. (2003). The impact of state governance structures on management and performance of public organizations: A study of higher education institutions. Journal of Policy Analysis and Management, 23(1), Kraft, M. E., & Clary, B. B. (1991). Citizen participation and the NIMBY syndrome: Public response to radioactive waste disposal. Western Political Quarterly, 44, Lawther, W. (2002). Contracting for the 21 st century: A partnership model. Washington, DC: The PricewaterhouseCoopers Endowment for the Business of Government. 23

24 Lavery, Kevin. (1999). Smart Contracting for Local Government Services: Processes and Experience (Westport, Connecticut: Praeger) MacManus, Susan. (1991). Why businesses are reluctant to sell to governments. Public Administration Review 51(4): McCubbins, Mathew and Thomas Schwartz. (1984). Congressional Oversight Overlooked: Police Patrols versus Fire Alarms. American Journal of Political Science, 28: Meier, K., O Toole, Jr., L., & Nicholson-Crotty, S. (2003). Multilevel governance and organizational performance: Investigating the political bureaucratic labyrinth. Journal of Policy Analysis and Management, 23(1), Milgrom, Paul, and John Roberts (1992). Economics, Organizations, and Management. Englewood Cliffs, NJ: Prentice Hall, Inc. Miller, T. I., & Miller, M. A. (1991). Standards of excellence: U.S. residents evaluations of local government services. Public Administration Review, 51, Milward, H. Brinton (1994). Implications of Contracting Out: New Roles for the Hollow State. In Ingraham, Patricia, and Barbara S. Romzek,et al New Paradigms for Government: Issues for the Changing Public Service. San Francisco, CA: Jossey-Bass, Milward, H.B., Provan, K., & Else, B. (1993). What does the hollow state look like? In B. Bozeman (Ed.), Public management: The state of the field (pp ). San Francisco: Jossey-Bass. Moe, Ronald C Managing Privatization: A New Challenge to Public Administration. In Peters, B. Guy and Bert A. Rockman Agenda for Excellence 2: Administering the State. Chatham, NJ: Chatham House Publishers, Inc. Morgan, David R., and Robert E. England (1992). The Pitfalls of Privatization: Contracting without Competition. American Review of Public Administration. 22(4): Niskanen, W.A. (1971). Bureaucracy and representative government. Chicago: Aldine Atherton. North, Douglass C. (1991). Institutions. Journal of Economic Perspectives 5(1): O Looney, John A Outsourcing State and Local Government Services: Decision-Making Strategies and Management Methods. Westport, Connecticut: Quorom Books. Osborne, D. & Plastrick, P. (2000). The Reinventor s fieldbook: Tools for transforming your government. San Francisco: Jossey-Bass. Pack, Janet Rothenberg (1989). Privatization and cost reduction. Policy Sciences, 22: Poister, T. H., & Henry, G. T. (1994). Citizen ratings of public and private service quality: A comparative perspective. Public Administration Review, 54(2), Posner, P. L. (2001). Accountability challenges of third-party government. In L. M. Salamon (Ed.), The tools of government: A guide to the new governance (pp ). NewYork: Oxford University Press. Praeger, Jonas. (1994). Contracting out government services: Lessons from the private sector. Public Administration Review 54(2): Rainey, H.G. (2003). Understanding and Managing Public Organizations, (3 rd ed). Jossey-Bass Publishers: San Francisco, CA. Romzek, Barbara S., and Johnston, Jocelyn M. (2002). Effective Contract Implementation and Management: A Preliminary Model. Journal of Public Administration, Research, and Theory, 12(3): Rosenbloom, D.H., and Piotrowski, S.J. (2005). Outsourcing the Constitution and Administrative Law Norms. American Review of Public Administration, 35(2):

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