Stage 1: The Make-or-Buy Decision

Contracting is about much more than the decision to purchase or produce a product, but it always begins with this choice. Commonly referred to as the make-or-buy decision, this is a classic issue of organizational economics. If markets are an ideal mechanism through which to structure transactions, why do organizations perform so many activities within their own boundaries?

Economists' answer is that using markets entails costs. Not all market transactions require a contract, but many do, especially transactions for complex products. In these cases, a contract may mitigate risk stemming from the buyer's uncertainty about what it wishes to purchase. Such uncertainty means the buyer cannot specify clearly what it wants or easily verify whether the seller delivered on its commitments. As a legally enforceable instrument, a contract helps the buyer secure its position with a potentially opportunistic seller.

Problems remain, however, if the contract does not specify every relevant contingency the buyer and seller may encounter over the course of their exchange. Thus, in unforeseen circumstances, sellers may still behave opportunistically. For example, if the contract does not state how a particular aspect of the good or service is to be produced, the seller may elect to “gold-plate” the product “with costly features that increase [its] profits, but for the buyer add little value and considerable expense” (Brown et al., 2010, p. 44). The buyer might also behave opportunistically, perhaps by forcing the seller to make product alterations that drive production costs above the negotiated price.

The costs incurred in structuring a contractual arrangement that mitigates opportunism are called transaction costs, and in some cases they are so high as to make market-based exchange infeasible (Coase, 1937). The buyer, the seller, or both may view their investments in a market relationship—including investments in human and physical resources that cannot be deployed in alternative uses (called relationship—or asset-specific investments; see Williamson, 1971)—as not worth the risk opportunism poses. Here, the solution is typically for the buyer to make the product by bringing the seller and its resources within the boundaries of the buyer's organization (Klein, Crawford, & Alchian, 1978). Having established ownership, the buyer need not write a detailed contract to guide the seller's behavior. It can rely on its authority to direct the seller (now the buyer's employee) using a mix of written and verbal orders.

One might argue that this reasoning does not apply to government (or at least applies less to government than to the private sector), but there is evidence that public sector make-or-buy decisions follow a transaction cost logic. Brown and Potoski (2003), for instance, found that US local governments are more likely to internally produce services for which verifying quality is harder and purchase services for which quality verification is easier. At the federal level, the stated policy is that government should rely on contracting for all commercial goods and services (US Office of Management and Budget, 2003)—those for which transaction costs are low and a market-based arrangement more viable.

With due acknowledgment to the existing evidence and policy, casual observation suggests we need more than economists can tell us to understand government make-or-buy decisions. From a purely transaction cost perspective, governments often buy what they should make and make what they should buy. What is going on in these situations?

Sometimes the institutional arrangements may be such that contracting is government's only choice for the development and delivery of a product. Combined with values-driven restrictions on provider selection, managers must think carefully about how they structure and execute contracts in these circumstances. If policymakers mandate that a good or service be provided by contracting with a restricted set of sellers, a common means of advancing socioeconomic objectives like small business promotion, contracting may be riskier. The market will be thinner, the competition less robust, and the incentives for opportunism more pronounced. Here, Brown, Potoski, and Van Slyke, (2006) recommend a number of strategies, including recruiting additional vendors or breaking the transaction into smaller contracts for which seller performance can be more precisely specified.

At other times, government contracting is about more than crafting an arrangement that minimizes transaction costs. As with other administrative functions, politics matter, meaning values beyond efficiency enter the make-or-buy calculus. For example, in an effort to promote accountability, policymakers may impose stringent legal requirements on contracting, such as rules governing sellers' financial reporting. All else equal, these rules raise the costs of contracting by creating more work for government personnel or restricting competition to providers that can negotiate the red tape, or both. Given sufficient discretion, government in these circumstances may elect to internally produce the good or service, even if contracting makes sense from an efficiency perspective.

Beyond politics, government make-or-buy decisions may also be a function of factors like geography and operational exigency. Markets are usually thinner in rural than in urban areas, even for the same product (Hefetz & Warner, 2004). Thus, depending on their location, governments may elect to internally produce a product for which there is a robust market elsewhere. By contrast, they may contract even in isolated circumstances, especially if there is need for expertise they do not have or do not require on a regular basis. This is often true in disaster and postconflict reconstruction settings, where the challenge of building (or rebuilding) state institutions requires skills government cannot afford to develop internally or needs for only a short time. As in more normal circumstances, in these instances it is incumbent on managers to align institutions and markets in a manner that advances missions, goals, and objectives.

Stage 2: Determination, Solicitation, and Design

Following government's decision to purchase rather than produce a good or service, it must determine what it wishes to buy, from whom, and how. The what, who, and how questions correspond to the tasks of determination, solicitation, and design.

Determination speaks to government's specification of what it wants to purchase. Purchase specifications, called requirements, vary in focus and specificity. As with the make-or-buy decision, values, institutions, and market considerations bear importantly on requirements determination. In the interest of accountability, policymakers may require managers to write precise requirements lest the contractor deliver a product with expensive, unnecessary, or poorly performing features. Tighter requirements tend to result in government's getting what it asks for, but they also inhibit the contractor's ability to be innovative, meaning that government may actually end up purchasing a substandard product. Moreover, intricate requirements tend to crowd out providers that cannot afford to tailor their production processes to government's needs. Therefore, tighter requirements may segment product markets into commercial and government halves, risking a problem of thin markets.

There are two ways to mitigate this problem. One way is to purchase commercially manufactured products (referred to as commercial-off-the-shelf). This option works well for simple goods and services but is less feasible as product complexity increases. The solution that government is seeking may not exist in commercial markets or, if it does, may require substantial alterations to meet government's needs. In these cases, managers can work to preserve market thickness in another way: writing requirements that emphasize results instead of design specifications, thereby opening the market to more vendors and giving them flexibility to innovate. Here there is a trade-off between the risk of opportunism and the possibility of better performance (as results requirements tend to be more vague than design requirements), but in our view, the potential performance gains may often outweigh the risks associated with a results-oriented approach. Ultimately, however, institutional constraints could restrict managers to writing design-specific requirements, meaning they should be cognizant of the issues of potential thin markets.

Solicitation speaks to government's cultivation and selection of product providers. All else equal, simple products allow more choices among providers of different types, including private for-profit firms, nonprofits, and occasionally other governments. More choice tends to be better, since government can reap the price benefits of market competition. That said, institutions may constrain choice (e.g., through regulations privileging small businesses), and selecting providers of different types may yield different results. Contracting scholars (Fernandez, 2009; Heinrich & Choi, 2007) argue that private for-profit firms tend to focus more strongly on efficiency and innovation than do nonprofits or other government providers. The latter, however, may be more aligned with public sector goals like service quality and responsiveness. This also means that they may be more costly. In addition, Van Slyke (2007) has shown that nonprofit goals are not always well aligned with those of government, and Kelman (2002) argues that government provision may suffer many of the same issues as contracted provision. Therefore, provider selection entails negotiating values trade-offs similar to those confronted at earlier stages in the contracting process. When selecting providers, managers must balance cost, efficiency, and innovation with accountability, quality, and responsiveness.

Where managers end up in terms of these trade-offs depends on how they evaluate provider proposals, or bids. Through the bidding process, eligible providers outline how they will produce the product government seeks and at what cost. Institutional rules are usually highly prescriptive regarding bid selection. They may compel managers to select the lowest-cost bid that meets the specified requirements (referred to as lowest price technically acceptable). Other times, managers are afforded flexibility to balance cost and quality, perhaps selecting a more expensive proposal that promises greater value in terms of the good or service purchased (referred to as best value). Such selection is inherently more subjective than a low-bid approach, and under the FAR and other similar regulatory regimes may involve a number of criteria that could be interpreted as idiosyncratic, and therefore as unfair. To address allegations of unfairness, many contract systems have protest mechanisms, procedures for resolving disputes, and agency-level processes of officials meeting with losing bidders. These appeal processes seek to encourage adherence to established bidding rules and are an important way of ensuring transparency in government contracting.

Design speaks to the structure of the contracting arrangement and can be thought of in terms of several components, including purchasing vehicle, pricing, rewards and sanctions, duration, and renewal provisions. Institutions can be highly prescriptive with respect to these provisions as well, though they do not entirely eliminate managerial discretion. Managers' decisions are therefore very important: they shape providers' incentives to deliver on budget, on time, and in accordance with requirements (Malatesta & Smith, 2011).

Purchasing vehicles come in many forms, though the basic distinction is between a one-time and a recurring vehicle. One-time means exactly that: a vehicle through which government awards a contract for a single transaction. Recurring means the opposite and entails government awarding a master contract for several transactions, which might be also be called task orders. Government may fill all these orders with a single vendor or award the master contract to several vendors that compete for each order individually. Government may enjoy bulk purchasing discounts under the single-provider approach, but it forgoes the competitive benefits that come with having multiple providers. (Note, however, that having too many providers, or requiring each provider to compete for every order, can also be detrimental.)

Pricing also varies substantially but can be distinguished in terms of two types: fixed price and cost plus. Under fixed price, government pays for outputs; under cost plus, it pays for inputs plus vendor profits. The risk implications of these approaches are very different—and very important. In a fixed-price situation, the vendor bears the risk of delivering the product on budget lest its production costs exceed the fixed price it is paid. In a cost-plus situation, government bears the risk: it may end up paying higher-than-anticipated costs to receive what it wants. This is especially true given contract ambiguity, in which case the vendor has an incentive to gold-plate (since it is being compensated on costs). As such, Kim and Brown (2012) argue for writing detailed requirements in a cost-plus transaction. These requirements need not be design specific. They can, however, speak relatively precisely to desired performance attributes.

Rewards and sanctions, duration, and renewal provisions represent additional design variants managers can use to structure vendor incentives. For example, in cost-plus situations, this may entail paying fees over and above the vendor's fixed fee if it achieves certain performance goals; it may also entail subtracting from fees for performance failure. In both cost-plus and fixed-price situations, duration can be used to signal government's commitment to a successful relationship, as well as encourage consummate behavior by the vendor. Managers should exercise caution, however, as making the initial contract period too long could encourage the vendor to behave opportunistically (e.g., by delivering products late or generating cost overruns). A solution to this dilemma is a renewal provision, which gives government the option—but not the obligation—to continue a relationship beyond the initial contract. This provision may discourage opportunism, since vendors value repeat business. The key to making renewal provisions work is a credible threat to let them expire in the event of poor performance. If renewal options are exercised without regard to base period performance, they lose their value as an incentive mechanism. Moreover, repeated renewal may lead vendors that did not initially win a contract to exit the market, meaning government may get locked into a bad business relationship.

This risk speaks to a larger issue with contract design: it must be done strategically. Simply adhering to a set of rules or procedures because they are “the way business gets done” does not make for effective contracting. Recall that buying is managing. Failing to think and act strategically in this regard contributes to the outcomes policymakers and citizens bemoan: cost overruns, schedule delays, and performance failures. This does not mean rules should be discarded wholesale. Rather, it means managers should think carefully about existing rules and leverage their discretion to fit contracting strategies and circumstances—again, to align institutions and markets in a manner that maximizes mission accomplishment.

Stage 3: Implementation and Execution

Having decided what to buy, from whom, and how, government's next step is to administer the contract in accordance with its strategy. We call this stage implementation and execution. In our view, both scholars and practitioners devote insufficient attention to these issues. Too often they assume contract strategy is self-executing, or they lack sufficient capacity to ensure successful execution. In either case, the point is the same: getting the strategy right is only half the battle. Effective contracting means having a strategy that is both well formulated and well executed. As in virtually every area of public policy and management, implementation matters. It should not be neglected.

In the context of contracting, implementation involves a range of more or less routine activities. More routine activities include monitoring cost and performance to ensure vendor billings do not exceed budget, verifying completion of the scope of work, making payments in accordance with established pricing arrangements, and meeting administrative requirements associated with closing out a contract at the end of its term (e.g., completing a final audit of vendor billings). Less routine activities include negotiating requirements changes and related modifications in pricing and payment; choosing to exercise or not exercise renewal options; addressing breaches—instances in which one party or the other claims its counterpart violated terms of the written agreement; and occasionally bringing the contracted activity back in-house, which could follow either planned or (as in a breach) early termination of the contract in question.

As these examples suggest, implementation and execution is every bit as complex—and as challenging—as the stages that proceed it. Like the prior stages, however, we believe the values, institutions, and markets framework usefully informs decisions pursuant to implementing a contracting strategy. Indeed, if the examples constitute the “trees,” the values, institutions, and markets framework helps us see the “forest”—or the set of core concerns—underlying routine and nonroutine aspects of postaward contract administration. In our view, these concerns are as follows: monitoring, incentive utilization, and relationship management.