Rob Kerridge of Sector Treasury Services explains how new accounting treatment of leasing and hire arrangements may point the way to more cost effective ways of structuring these contracts.
What's new in local authority fleet hire and finance? Some commentators are predicting a reduction in the size of vehicle fleets, others that assets will be “sweated” for longer while some anticipate an increase in the level of outsourcing as public sector organisations look to reduce overhead costs.
Certainly, the CSR has brought local authority spending into the spotlight, perhaps more than ever before but, in terms of the outsourcing option, does handing over the reigns to the private sector really deliver the savings so urgently needed? As always, it's “horses for courses” ' the private sector can bring a management ethos that can make a difference and the public sector has its own means for reducing the cost of services but these are not necessarily new inventions. What is new relates to changes in the accounting treatment of leasing and hire arrangements of more than 12 months under International Financial Reporting Standards (IFRS). Although on the surface this might sound like an issue just for finance people, an analysis of the funding arrangements carried out to meet the IFRS requirements helps to point the way to potentially more cost-effective ways of structuring these contracts.
Outsourcing of front-line services, fleet outsourcing and contract hire can all make a contribution to the delivery of efficient services. What all these have in common is that they are, or consist of, funding arrangements. Under IFRS the client authority now has a duty to account for these as leases. With contract hire, this is pretty straightforward. The client will require the provider to declare the actual purchase cost of the vehicle (not the “list price”), the finance and maintenance elements of the rental and ideally, the residual value used in the rental calculations. It is essential that the contracthire and outsourcing providers help their customers by adopting a new and more transparent approach to contract costing.
By contracting out services, the authority will transfer the liability for personnel and property overheads to the contractor and largely fix the operating costs going forward. This is clearly attractive for budgeting but will it actually save money? An options appraisal of the contract charges will point to the answer. When Sector Treasury Services (Sector) has been appointed by local authorities to advise on these arrangements we have found some consistent messages:-
Actual vehicle purchase price
A local authority can buy vehicles at special discount arrangements available to the public sector through various purchasing consortia and organisations such as The Procurement Partnership Ltd (TPP) (www.tppl.co.uk), which represents a buying club of over 330 public sector organisations. Contract hire companies can also access these terms where they are providing vehicles for a TPP member. In almost all cases, these discount terms will be better than those that can normally be accessed by private sector companies so it is unlikely that a contractor can purchase the vehicles significantly cheaper than the local authority.
With the ability to absorb the peaks and troughs of vehicle maintenance costs, potentially across a number of contracts, a contractor is well-equipped to provide maintenance and operational support to a local authority. Contract hire companies manage some significant maintenance budgets across their fleets and their focus on cost is critical to their business. Often, they will agree with the client authority which local service agent to allocate to the contract so that local relationships can continue.
Where the authority has an in-house workshop, it may be possible for an incoming contractor to take over responsibility for the workshop and staff and then introduce third party work to defray the overhead costs. Structured in the right way, this can produce savings that the client authority could not otherwise access. A property lease or a “licence to occupy” will enable the authority to regain the use of the workshops in the future, should the need arise.
Cost of finance
This is where local authorities clearly can win. The current financial climate and the lack of appetite for risk in the banking sector mean that contract hire and outsourcing companies are paying considerably more for their funds than the public sector. Even though the Chancellor recently increased the Public Works Loan Board (PWLB) rates by 1%, at the time of writing, local authorities have access to funds for a typical 5 year term, dependent upon the loan structure, at between 2.4% and 3.3% and can borrow internally at around 5 to 6%.
Part of the new accounting requirements relates to leases that are incorporated within full outsourcing arrangements ' referred to under IFRIC4 (International Financial Reporting Interpretations Committee). An example of where IFRIC4 would apply would be a situation where a contractor is funding assets (for example refuse and cleansing vehicles within a waste management contract) and charging the client authority for these through the contract payments. Under IFRIC4 the underlying funding arrangements are considered to be an “embedded lease” and again, the authority requires a statement of the purchase and funding costs from the contractor in order to comply with their accounting duties.
Sector advise and assist public sector organisations with both meeting their IFRS requirements and carrying out options appraisals of contract structures. In doing so we have identified some considerable benefits that may accrue from a restructure of some externalised service contracts, whereby the strengths of the public and private sectors may be combined in a better way. For example, a waste contractor may welcome the opportunity for the client authority to acquire and fund the vehicles thus reducing pressure on the contractor's balance sheet while they concentrate on managing the manpower and delivering the service. The client enjoys cost savings and the contractor is relieved of the capital burden ' in other words, mixing the best that each party can contribute. The result should be the same or better service levels, delivered at lower cost.
So what does this mean to the local authority procurement manager? Within the tender process the costings for the various alternative contract structures need to be obtained from bidders so that an options appraisal can be made of the different costs and benefits, with the option for the local authority to fund the assets also incorporated in the tender document. This is possible with the co-operation of suppliers who understand the need for a more open approach to pricing contract bids. Outsourcing, whether it encompasses an entire service or just the vehicle fleet, will not automatically save money. However, if the right contract and funding structures are used, we believe that local authorities can achieve both the operational benefits and real savings from engaging with the private sector.