Why Tescos gets economies of scale, but the government doesn’t

Those who believe government can reap economies of scale often quote the example of Tesco. For example, Colin Cram wrote in his Guardian piece this week in favour of shared services, “Where do we spend most of our money – at Tesco or in corner shops?”. The first problem is that retail does appear to show benefits to size but it is the exception. If you get legal advice from a small firm, you expect it to be cheaper than a big city lawyer. If you found a local IT consultant, you know they would be charging less than IBM. Generally you can ask why, if economies of scale are so effective, are services from large companies more expensive than those from small ones.

The second problem is that the government’s approach is very different from Tescos. Imagine for a moment if Tescos’ purchasing was run in the way government runs its procurements. Tescos achieves its low prices through thousands of direct relationships with suppliers, with whom it drives hard bargains. The government approach would be to scoff at the large number of suppliers: “Far too complex, we need to rationalise them”.

They would, for instance, put out a tender for a company to run the refrigerated foods section. “Its far too inefficient to deal with all these different companies”, they might say. “Instead let’s get in a large management company to secure economies of scale.” This company would in its turn subcontract the dairy section to an expert in that field and they would in turn purchase the yoghurts from a third supplier. They would do away with this idea of many types of yoghurts (government procurement never involves providing choice) and instead select one ‘best of breed’ yoghurt provider who would be given a ten year contract to be the sole provider of yoghurt in all Tescos stores – government always goes for long-term contracts, to incentivise the supplier to make the necessary investment.

The result would be a less good service to the consumer, and greater cost as the costs of all three layers of suppliers had to be met. I guarantee that Tescos would no longer be cheaper than the corner shop. And if the quality of that sole yoghurt provider fell, it could only be remedied through the complex legal contracts, and indeed only by 3 layers of legal contracts. (Tescos would be more likely to tell a yoghurt suppleir with a problem “Sort it or you’re out.”)

I do not exaggerate. All this is based on my personal experience:

Rationalising suppliers: In the apprenticeship market, the government has rationalised by refusing to sign a contract with any training provider for less than £500,000. All those with smaller contracts have had to merge or cease provision.

Large management companies: This is the standard government approach, which somehow presumes layers of suppliers with one overall management company provides “economies of scale” rather than bureaucracy and cost. I am Chair of Governors of a school that went through BSF (Building Schools for the Future). Schools were not allowed to buy the different elements direct but were forced instead to select a managing company who would in turn sub-contract to cleaners, ICT support, builders etc. The result of these “economies of scale” was that ICT support became both more expensive and less responsive than it was before.

Local schools not involved in BSF either employ their own ICT staff or sign one year contracts for support, so they can get out easily if the supplier isn’t up to scratch. Our ICT support was truly dreadful but we had been forced to sign a five year contract and, though we did get substantial penalties, it was virtually impossible to get out of. Indeed we didn’t have a contract with the ICT supplier. Instead they had a contract with the managing company, who had a contract with the LEP (Local Education Partnership), who had a contract with the local council, who in turn had a contract with the school. We would have had to trigger break clauses in four complex legal contracts to get out of it.

The reality is that, in most areas of government supply, that small businesses are more flexible and better value than large ones. If our school could have found a good local ICT support company, it would have been far better value. And a one year contract would have made them far more responsive. (I know of one government department who signed an ICT outsourcing contract of over 15 years duration. As a senior manager at the department said to me “We are one of their largest customers world-wide and they treat us like s**t.”)

Government procurement relies on a “big is best” approach on the illusion that some group of people at the centre can decide a “best of breed” to meet the needs of everybody and that complex legal contracts are the best way to get value and good service. (And the one thing you can be sure these big government suppliers are good at is the legals.)

There is an alternative. Short-term agreements provide a natural pressure on service that contracts never can. Instead of choosing a single “best of breed” imagine if they set a quality threshold and a maximum price, but allowed more than one supplier (as Tescos ensures many yoghurts are available) – ensuring the pressure of competition. But I don’t expect any government department to try this more sensible approach any time soon.

Postscript: My next two posts follow on from this:

The public sector is well run, but government procurement is not

Getting value from procurement: competition or economies of scale?

7 responses to “Why Tescos gets economies of scale, but the government doesn’t”

  1. Hello Henry
    Picked this up via David Gurteen on LinkedIn. I hope all is blooming for you. What a great post. Sparknow has had a lifetime of frustrating encounters with bizarre beaurocracy and the Alice in Wonderland experience of British government procurement logic. You’ve not added in the often pointless mounting of a detailed bid which is a kind of work of fantasy that drains resources, sucks out good design thinking and then the client absents themselves rather than making resources available to do the work well and gain the long term value from it.

  2. Henry
    My challenge to you relates to the overall costs of managing the process as you suggest – it creates duplication and waste at every level of management – thats one of the reasons why the public sector has got so fat.

    You are absolutely right when you say that you may be able to get a better price locally. However the unit cost of the goods and services tend to be just one element of the overall cost to the company. On top of the unit cost you have to add in the costs of running the tender process, the cost of maintaining thousands of accounts, the cost of establishing and monitoring multiple contracts, the cost of managing multiple smaller invoices (independent research reports the typical p2p costs are in excess of £125 per transaction) etc etc.

    Add all of these ‘hidden’ costs and the case for consolidation becomes clear – that’s not to say however that I think the government is following the right processes. There are undoubtedly massive efficiencies still to be gained!

    A more efficient way is to consolidate and to take the waste out of the end to end procure to pay process.

    1. Tony, thanks for taking the trouble to respond. You clearly hav a lot of relevant experience. However I would question your assumptions. I have never seen a large governmetn procurement that did not have massive inefficiences. Building schools for the future, based on that standard government model, wasted billions. It is interesting that companies like Tescos achieve low cost by using the method of maintaining thousands of accounts.

      Do keep in touch, though. I have at least two more posts coming on this subject.

  3. As someone who has public sector procurement experience the rationale for letting large contracts is exactly as Tony describes. But I don’t think it’s entirely about cash and value for money. When government departments ran multiple smaller contracts the number of staff working on contract letting and management was inevitably high as there was lots of engagement with contractors and joint working. In government departments, the focus over the last 10 years or so was, and is reducing staff numbers and headcount, because no department can be seen to have a high proportion of ‘backroom ‘ jobs With fewer people to operate them, big contracts are the only way for departments to go. No one asks Tesco’s to declare how many people work in their procurement department each year!

  4. Liz, Its true the focus has been on reducing headcount and moving to large suppliers. But my question is whether this is misguided.

    Apprenticeship contracts give an interesting insight. THe Skills Funding Agency is this year introducing minimum contracts of £500k, because the cost of administrating each supplier was £3k. Cut out 1,000 suppliers, was the logic, and you save £3 million.

    The small suppliers must now sub-contract through large providers, with the large provider allowed to take 15% to cover its admin costs. So the government estimate is that a small supplier with a £200k contract cost them £3k to manage, but will cost the external company £30k to manage – ten times as much. (Small supplier would far rather have paid the £3k admin costs themselves and kept the direct relationship.)

    It may not always be a ten-fold difference but I suspect the same is true of much outsourcing. The bundling into large contracts not only reduces competition (and therefore increases cost) but adds admin costs far beyond those faced by government.

    For more on this, see my latest post: http://bit.ly/iIIEYA

  5. Very relevant discussion. I can recoginize it from Denmark where I am from.
    Here the supply from suppliers are restricted to a few big companies with whom the goverment have made contract with.This means that you can only buy a certain product and only from a certain supplier. I can come with a example.
    We had a agreement with Dell computers, but if we wanted to buy the bargains Dell said we could not buy it because it was to cheap. We could only buy the high priced product. I was hired for a county to buy IT products for a county. The recipiants who should have the products and pay for it was complaining that if they bought it them selves it would only cost a fraction.

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