The news headlines over the last week were dominated by the collapse of Carillion, the civil engineering and public service outsourcing firm.

Carillion began as a civil engineering and construction firm but diversified into public service provision.  It held major contracts with local authorities and national governments.  It was involved in major PFI projects to build schools and hospitals.  It built roads and was a major contractor in the HS2 high-speed rail project.  It ran prisons and provided school and hospital catering.

The collapse of Carillion also opens a wider debate into the way public services are outsourced and the business practices of outsourcing firms.

So what went wrong with Carillion?

The answer was that the firm’s directors pursued an extremely risky growth strategy and they forgot the principles of contract bidding.  Getting the contract for cash flow was more important than ensuring sufficient profit margin.

A few years ago, Carillion was a star of the stock market.  It’s share price was high and the company was offering attractive dividends.  However, not everyone in the city was convinced of Carillion’s merits and several hedge funds bet against the firm.  Carillion’s collapse has proven those fund managers right as successive profit warnings were issued and the share price collapsed.

The hedge fund managers betting against Carillion saw the firm for what it was, a form of outsourcing Ponzi scheme.

A Ponzi scheme is named after the American fraudster Charles Ponzi and it is a form of ‘long con’.  It is an adaptation of a pyramid scheme.  A Ponzi scheme is a form of investment vehicle which offers incredibly attractive returns.  Investors may be told that their money will be doubled in a relatively short time.  The scheme then relies on the exponential attraction of new investors.  Money gathered from new investors is used to pay the returns to existing investors.  However, as exponential growth in investor numbers is required, soon there simply aren’t enough new investors to keep the fund going and to pay the investors the promised income.  Unlike a traditional pyramid scheme, which tend to collapse very quickly, a Ponzi scheme can stave off collapse by getting existing investors to put in more money.  But the truth is that it is inevitable a Ponzi scheme will collapse.

The last instance of a Ponzi scheme was the investment fund managed by Bernie Madoff.  This scheme lasted for several years and attracted a number of high-profile celebrity investors.  For many years, Madoff was seen as a financial wizard.  His investment products were seen as highly successful.  However, When the fund ran out of money it collapsed leaving a number of its high profile clients significantly out-of-pocket.

Here there is a parallel with Carillion.  For years the stock market saw the firm as a success.  Only when its need for exponential contract growth could not be met, did its collapse became evident.

Carillion’s business model was to gain as many infrastructure projects and public service contracts as possible.  This meant it was often the low bidder.  The business model didn’t properly account for the price element of the marketing mix.

The first error in Carillion’s pricing strategy was not to properly account for project over runs and unforeseen costs.

It is normal practice for such issues to be properly accounted for in project bids.  As long as projects went ahead with no issues, Carillion could meet its cost expectations.  However, as the company grew it offered low bids on projects which were subject to long delays.  The company also did not account for delays in payment.  This resulted in the firm building up large debts as it had to borrow to cover running costs.

The CEO of another outsourcing firm, Serco, has a toilet brush sitting on his desk.  The brush is a reminder that his firm should not bid on any public service contract where the profit margin is less than 6%.  This is the minimum mark up on the services of an office cleaner.  Carillion were regularly bidding on contracts where the profit margin was far lower than 6%.  If anything went wrong with those projects, Carillion was left out-of-pocket.  And things went wrong.

By under-bidding on contracts, Carillion’s reputation was also damaged.  When I worked in a local authority, many colleagues held the view that Carillion were a ‘bit crap’.

Carillion got to the stage that any income it made was going to pay off its bank borrowings.  The company also had a significant pension black hole.  It is estimated that Carillion had £29 million in bank deposits but that the company’s debt and pension fund shortfall was £3.1 billion.

As a Ponzi scheme runs out of potential investors, there simply weren’t enough new infrastructure and public service contracts in the market for Carillion to meet its debt repayments.  The banks pulled the plug.

Some of the blame for Carillion’s collapse must be laid at the door of the company’s non-executive directors.  It is their job to act as a critical friend to the business; warning management that policies and strategies were dangerous and presented unacceptable risks.  It seems that Carillion’s non-executive directors were ignored by management or that they did not take proper cognisance of their functional role.  Clearly, the management of Carillion were allowed to carry on with a high risk business strategy that was doomed to fail.

So what lessons are there for SMEs from the Carillion collapse.  The first is that if you are in a contract bidding process, always build in a cost factor for delays and late payment (overrun costs).

Secondly, know you’re market and what is acceptable in terms of margin: don’t be fooled into the belief that it is always the low bidder who gets the contract.  If necessary, use a ‘more for more’ strategy which bundles in additional service features for relatively low-cost additions.  The secret to a ‘more for more’ strategy is to bundle in features which are greatly valued by your prospective customer but which cost little additional cost to your firm.

For example, a landscaping firm I know recently bid for a grounds maintenance contract.  The contract went to a competitor. There was little difference in price between the two bids but the competitor offered detailed seasonal planting schemes on top of the grounds maintenance work.  These schemes cost next to nothing to prepare but it offered additional services which were valued by the client.

Finally, when bidding for a contract do not use simple cost-plus accounting to set your price.  Instead combine the bid price with the probability of achieving the contract.  An example:

A builder is bidding on a contract to build an extension to a house.  The cost of the extension is £10,000.  The trader knows that if they offer to complete the job at cost, there is a 100% probability of getting the contract.  If a 3% profit margin (£300) is applied, the probability of getting the job is 90%.  If a 6% profit margin (£600) is applied, the probability of achieving the contract falls to 80%.  If a 15% margin is applied (£1500), the probability of success falls to 18%.  A 20% margin (£2000) means that there is zero probability of the contract being awarded to the firm.

So:

£0 multiplied by 1 = a notional margin of £0

£300 multiplied by 0.9 = a notional margin of £270

£600 multiplied by 0.8 = a notional margin of £480

£1500 multiplied by 0.18 = a notional margin of £270

£2000 multiplied by 0 = a notional margin of £0

So in the above simplistic example the best combination of profit and probability of bid success is to offer a contract price which includes a 6% profit margin and an 80% probability of bid success.

The standard graph of notional margin sees a gradual fall in the probability of a contract being awarded as the margin increases.  However, eventually there will be a sharp fall in the probability of a contract being awarded as the cost exceeds the expectations of the market.