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Service Contracting with Nonprofit and For-Profit Providers

On Preserving a Mixed Organizational Ecology
November 1, 2002 |
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Seeking greater programmatic effectiveness and lower costs, government agencies have long contracted with both nonprofit and for-profit providers for the delivery of a broad range of human services. 1 In recent years, however, the stakes involved in many service-contracting decisions have changed. Public managers today are increasingly having to make judgments about the current and future structure of the provider marketplace that will have far-reaching implications for the organizations that deliver services, the clients who rely on these services, and the public that ultimately finances them. In many fields of human service delivery, the delicate population ecology of nonprofit and for-profit service providers is profoundly shaped by government contracting decisions because public funding represents a large and critical source of agency finance. 2 Thus, when public managers make decisions about the kind of organizations with which they will contract -- nonprofit or for-profit -- they simultaneously make choices not just about ways to achieve particular policy objectives but also about the nature and composition of the population of service providers that will emerge at the end of the process.

The ecology of nonprofit and for-profit service providers has proved over time to be far from stable. Business activity has expanded in many fields long dominated by nonprofit organizations.3 Large for-profit corporations are now providing job training, child care, and rehabilitation services at ever greater levels. In health care, for-profit hospitals and health maintenance organizations are buying out nonprofit institutions and moving into new markets. In education, publicly traded firms have actively staked out a significant portion of the expanding charter-school market in states from Arizona to Florida. In welfare-to-work services, several large defense contractors have begun to compete for and win contracts. As these and many other sectoral boundary incursions have occurred and as for-profit providers have gained ground, nonprofit advocates have argued that it is now necessary to counter some of the real advantages that business firms possess to allow both nonprofit and for-profit providers to take part in the delivery of complex human services. All of this raises the difficult question of how to preserve a human service marketplace that includes both nonprofit and for-profit organizations.

Sorting out -- through the allocation of government contracts -- the division of labor between nonprofit and for-profit service providers ultimately requires an appreciation of the advantages and limitations of for-profit and nonprofit organizational forms and the careful balancing of competing values and priorities across a vast range of contexts.4 In principle, at least, some important public services may be better delegated to for-profit than to nonprofit organizations. Equally true is the proposition that other services may well be handled best by nonprofit organizations. The central argument of this chapter is that preserving room for both nonprofit and for-profit service providers across a range of fields, at least for now, must be viewed as a managerial imperative, given the generally poor state of current knowledge about when and under what circumstances one kind of provider is likely to serve the public interest better than the other. Although significant differences in capacity and culture may allow business firms to beat out nonprofits for service contracts, especially in situations in which cost is a central concern, service contracting inevitably involves complex decisions about competing priorities -- decisions that go well beyond the bottom line. The potential short-term gains generated by exclusive for-profit provision may not always be large enough to justify the wholesale -- and potentially irreversible -- shifts in the long-term organizational ecology of human service fields that may be fueled by government service contracting that prioritizes one kind of provider over another.

Nonprofit and For-Profit Provision of Services

As nonprofit managers survey the terrain of service contracting, many believe that the rise of for-profit providers of human services poses major strategic challenges and questions, not the least of which is how to hold on to the nonprofit sector's traditionally large market share and client base. Some nonprofit organizations, viewing the entry of business firms as a major threat, have attempted to respond to the new competition by becoming more businesslike in their own operations. This has sometimes led to the unreflective adoption of management tools such as total quality management, benchmarking, reengineering, and other techniques that promise to improve operations. 5 Other nonprofits have fallen back on the values and commitments that make the character and quality of their services unique. As a consequence, some nonprofits emphasize the commitment of their staff, the underlying values or faith guiding the organization, and the unique community connections that many small organizations possess. 6Although these emphases may help some nonprofits manage their service delivery operations better in the short run, they are unlikely to be sufficient to stop the trend toward greater levels of for-profit service provision and the erosion of many nonprofits' position in the contracting regime.

In key areas, nonprofits appear to face substantial structural obstacles to competing successfully with business in the market for government contracts. Data on the relative growth of nonprofit and for-profit provision of human services suggest that business may be capitalizing on its advantages to capture a greater share of the human service markets that nonprofits have traditionally dominated. The data indicate that the number of for-profit providers of individual and family services, job training and vocational rehabilitation, day care for children, and residential care for the elderly and the infirm increased by 202 percent between 1977 and 1997, far faster than the number of nonprofit providers. During the same period, the workforce of for-profit human service providers increased by 273 percent, more than twice the growth rate within nonprofit establishments. Even the receipts of for-profit providers have increased at a faster pace than those of nonprofits. Although in 1997 nonprofits still managed to capture a substantial portion of the overall growth in the fields, the success of for-profit activity has raised the question whether the division of labor between the sectors is beginning to undergo a reordering.7

When the competition between sectors comes down to the cost, speed, and quantity of otherwise similar services, nonprofit human service providers face at least five serious competitive disadvantages compared with business firms.8 Public managers seeking to understand the ecology of service providers must recognize that some of the disadvantages detailed below lend themselves to government action, whereas others clearly do not. The main task facing public sector service contractors in the years ahead will be to fashion a response that is sensitive to the need to preserve the mixed organizational ecology that now characterizes most human service fields.

Sale and Complexity Limitations

One of the most common concerns of nonprofit service providers is the scale limitations inherent in nonprofit enterprise. The financial and human resources of most nonprofit organizations limit their ability to mount complex, large-scale programs with the speed and ease possible for for-profit firms. Aside from a few highly visible national charities, nonprofit organizations are for the most part poorly financed and understaffed. They often are run on tight budgets, with narrow fund balances carrying them from year to year. In addition, small nonprofits, which make up much of the organizational population, lack experience with complex information technology and management systems, skills that are needed if they are to handle large caseloads and complex administrative requirements.9

The size problem confronting many nonprofits puts business firms in a strong position within the emerging human services contracting arena. In some instances the scale of human service contracts is simply enormous and requires a mastery of complex information technology. A grassroots or informal nonprofit organization that has focused its entire history on delivering quality services to a small community seems almost certain to flounder under some of the substantial management demands placed on organizations seeking large public contracts. Although some nonprofits may seek to create opportunities for themselves by pursuing smaller contracts at lower levels of government -- contracts that include only direct client services and leave information-intensive reporting work to for-profit firms -- coordinating such a division of labor over the long term will have substantial costs. Many nonprofit organizations simply lack the operational capacity to tackle large-scale contracts, including many of those recently put out for bid by states under U.S. welfare reform.

Availability of Capital

Simple under-capitalization can be a serious problem for nonprofit organizations, given that some government contracts often withhold part of the service fees until the client has been served or some documented outcome has been achieved.10 In the rehabilitation services field, for example, a growing number of contracts pay providers small up-front fees for each client served and deliver the balance of the payment only after the client has completed his or her rehabilitation.11 A contractor who receives payment only months after assisting a client must find a way to pay the up-front costs of delivering services while waiting for payment to arrive. Moreover, many contracted services require facilities that the service provider must either be able to acquire or already have in its possession. This can put substantial capital demands on nonprofit organization.12

In terms of raising the funds needed to meet capital expenses, the positions of nonprofits and business firms could not be more different. Business has long been able to raise millions of dollars through a range of financial transactions. By contrast, most nonprofit officials concede that their firms are undercapitalized by charitable supporters, and few have revenue-generating operations large enough to support major capital outlays. Moreover, even if nonprofit managers could raise operating capital through loans or other means, they might well be subject to criticism from watchdog groups who accuse them of assuming too much risk and exposing their organizations to financial stress.13

Business firms have several tools at their disposal with which to raise capital. If they are just starting out, they may seek large amounts of funding and a long-term commitment from venture capital investors in exchange for a stake in the firm. Often this funding comes with the added bonus of an in-depth relationship in which investors lend management assistance to the firms in which they have a stake. Once a business firm reaches a certain level of operation, it has a second opportunity to raise capital in the equity markets. Through initial public offering and routine stock offerings, business firms can command resources on a substantial scale. Through both venture capital and equities, business sells ownership stakes to outside parties. Businesses that do not want to relinquish ownership can raise funds through the bond market. These funds must eventually be repaid, but firms receive the benefit of being able to spread out major capital and research expenses over long periods of time.

Nonprofit organizations, on the other hand, cannot sell ownership stakes and are not in a position to take part in equity markets. 14 They can, however, and to a limited extent already do, use bonds to fund major capital projects. Most bond offerings to date have been confined to major institutions like hospitals, universities, and museums.15 Few midsize nonprofits have been able to take part in the bond market and use these instruments to launch major expansion efforts. One reason bonds have not been a popular instrument of finance is the high transaction costs associated with evaluating, underwriting, and servicing them. In addition, few existing banks are willing to invest the effort to establish lending criteria in areas that lack an observable track record. As a consequence, only the largest nonprofits are able to meet the threshold at which a bond offering represents a viable option. Because many underwriters look not just at real estate in making decisions but also at reliable sources of income, nonprofits face a real challenge in convincing the lending community that their multiple revenue streams are sufficiently reliable and their assets sufficiently valuable to justify major financial commitments.16

Access to Power

Unlike business firms, public-serving nonprofits are somewhat limited in their ability to engage in lobbying, and this presents another stumbling block for nonprofits. Significant differences in style are obvious between the sectors in terms of the political messages they convey. Lobbyist for businesses often try to educate and inform government officials about the advantages of outsourcing and permitting for-profit competition in the human services. In some cases business firms have intervened in the design of the contracting system under which their firms would eventually operate. One reason for this comfortable relationship is that business is able to present a message of efficiency to government. Nonprofits, on the other hand, often convey a message of equity and caring. Armed with political connections reinforced through campaign contributions and the potent claim of a strict bottom line, the capacity of business to shape the political and funding environment is more formidable than that of 501(c)(3) nonprofits, which face real limits on lobbying and political activity. 17

Congress placed limits on the political activities of nonprofit service providers in 1976, though it took the Internal Revenue Service (IRS) fourteen years to issue final regulations. 18 Nonprofits that elect to come under the law agree to certain limits on the expenditure of money to influence legislation. The regulations differentiate between direct lobbying, which aims to shape legislation through communication with legislators, and grassroots lobbying, which is targeted at shaping public opinion. The 1976 law establishes ceilings on total lobbying expenditures, ranging from 20 percent of expenditures for tax-exempt purposes for smaller organizations up to a flat $1 million for organizations with budgets in excess of $17 million. One of the most widely acknowledged flaws in the current rules of government lobbying by public charities is that lobbying simply is not understood by nonprofit managers, who are often confused about how much lobbying activity is allowed before the 501(c)(3) status of a nonprofit becomes threatened. As a result, they tend to avoid lobbying entirely or to conduct it under the umbrella of a 501 (c)(4) social welfare or advocacy organization, which does not offer contributors a tax deduction and faces no limits on political activities.

Compensation and Human Resources

Major corporations have been able to gain a competitive advantage by attracting and hiring -- sometimes with lucrative offers -- prominent and well-respected human service officials from both the public and nonprofit sectors for management positions in their growing for-profit human service divisions. High-profile expertise is more likely to go to for-profit human services providers, for the simple reason that an undercapitalized nonprofit can rarely offer a salary comparable to what large corporations can pay. As long as business can attract the best talent, as it has recently in the job training and welfare-to-work fields, nonprofit organizations are likely to face tough questions about whether they have the knowledge and expertise to compete at the highest levels. 19 Over time, if disparities between the sectors become too great, nonprofit organizations may face a real talent drain that will weaken the sector's competitive position.

For years government largely turned a blind eye to the difficult issues raised by compensation levels within the nonprofit sector. However, the IRS has recently set in place a new regulatory framework to guide compensation in public charities, along with a system of sanctions that government can now impose on organizations that fail to comply. The U.S. government has taken a position on the subject of how much nonprofit managers earn and attempted to regulate compensation levels in the sector for a number of reasons: because existing disclosure mechanisms are thought to be flawed and unreliable, because nonprofit boards have weak incentives to monitor, because several categories of nonprofits are substantially insulated from any market test, and because, even if stakeholders monitor diligently, compensation regulations may be necessary to ensure that charitable dollars are dedicated to public purposes. New regulations were finally enacted as part of the Taxpayer Bill of Rights in July 1996. In August 1998, the IRS released the details of its plan, and after receiving public comments it revised these regulations. 20 Rather than setting meaningful limits on nonprofit compensation, as was intended, the regulations are likely to have the exact opposite effect, allowing nonprofits to pay higher and higher salaries.

The new regulations define excessive compensation as that which "exceeds what is reasonable under all the circumstances." Compensation is reasonable "if it is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances." 21 On the surface, this sounds like a fairly loose and porous standard, given the challenge to interpret "like enterprise" and "like circumstances." Because there is little case law in this area, the reasonable compensation definition by itself leaves organizations with little notice as to what is required of them and offers little protection to their expert judgment. To allow nonprofits to exercise this judgment with greater certainty, Congress placed a "rebuttable presumption" in the legislative history, a clause that the IRS adopted in its regulations." Charities may rely on a rebuttable presumption that their compensation decision was reasonable if the board that approved it was made up entirely of individuals unrelated to, and not subject to the control of, the applicant; obtains and relies on appropriate comparability of compensation data; and adequately documents the basis for its salary decision. Relevant data for demonstrating reasonableness include, among other things, compensation levels paid by similarly situated nonprofit and for-profit organizations for positions that are functionally comparable.

Although these new rules are not well understood by nonprofit organizations, over time, as the idea of constructing a rebuttable presumption using data on compensation at other nonprofit and for-profit firms takes hold, the lid will effectively be removed on nonprofit compensation. The intermediate sanctions regulations were initially designed to give government an alternative to simply closing down nonprofit organizations guilty of financial mismanagement. However, the protections built into the system effectively make it possible for nonprofits to pay their executives salaries equivalent to those of workers in the corporate sector. Of course, whether nonprofits will have the resources to do this and the extent to which their boards and donors will go along with such an approach remain uncertain.

Normative Constraints

Perhaps the most important obstacle that nonprofits face when attempting to compete with for-profit firms is the absence of both a profit motive and a willingness to cut corners when the bottom line so dictates. Some observers worry about the consequences of contracted payment systems that require specified reductions in the size of the welfare caseload or dictate payment of a fee whenever a client is successfully rehabilitated. One danger is that business firms will "cream" or "cherry-pick" clients by electing to work only with the most job-ready or least disabled clients while writing off those who face multiple barriers to employment. For-profit firms may be tempted to reduce caseloads by cutting off eligible recipients or by taking other steps to achieve performance standards without helping clients become better prepared to function in the work world.

The trend toward outcome funding and performance pay raise all kinds of challenges for nonprofits that want to provide services but have strong social missions and commitments.22 Over time, increased competition with business firms for performance-based contracts will quite likely strain the identity of nonprofit agencies or lead to the slow erosion of funding. Faced with a choice between competition and capitulation, many nonprofits may reexamine their service delivery system and look for ways to increase efficiency and effectiveness. Although this work may lead to improved nonprofit operations, it also risks cutting into the "low-return" charity work that nonprofit service organizations have traditionally undertaken. Special-needs clients, particularly in the fields of education, health care, and social services, may find changes in the quality and availability of their often higher-cost services as cross-sector competition and outcome-based funding take root.

It may be unwise to tamper with the cultural and ethical constraints that are part of the nonprofit sector's identity. Although nonprofits -- particularly value- and faith-based organizations -- may face real disadvantages in competing with for-profits in a market in which outcome funding emphasizes quick and frequent case closures, in many arenas the focus of nonprofits on human needs and long-term personal development are integral to program success. In many nonprofits the willingness to bend rules, the ability to make decisions that are related to mission not margin, and the dedication of staff allow these organizations to offer unique services.

Growing competition between nonprofits and businesses is significant because it ultimately risks narrowing the scope and vision of nonprofit organizations. As they become locked into increasingly fierce competitive struggles with businesses, nonprofit organizations risk becoming ever more instrumental in their approach. When nonprofit organizations are simply efficient intermediaries through which services are produced -- efficient enough that differences in methods between the nonprofit sector and business become obscured -- questions naturally arise as to why these organizations should be granted tax exemption. The competitive drive in some parts of the nonprofit sector to produce services at low cost is an important challenge to the sector's traditional charitable orientation.

Conceptual Needs for Service Contracting across Sectors

The differences between the for-profit and nonprofit forms of organization suggest that as government continues to shift a substantial portion of the responsibility for service delivery to providers outside of government, the ecology of for-profit and nonprofit organizations is likely to continue to shift over the coming decades, especially if business is able to capture the most lucrative and large-scale contracts that federal, state, and local governments make available. As a consequence, interpreting and reacting appropriately to the changing dynamics of the service-contracting landscape is likely to be a central challenge for governance. Given the importance of public funds in most human service fields, it is increasingly hard to avoid the conclusion that as public managers make difficult decisions about the criteria to use in making contracting decisions they will simultaneously be making decisions about the landscape of providers that is likely to emerge at the end of the process. What considerations should public managers therefore have in mind as they make these critical service-contracting decisions? The answer given here is that traditional, short-term considerations must be expanded to include an appreciation of the effects these decisions have on the long-term evolution of the ecology of service providers in the many fields of human services for which government funding represents a critical source of agency finance.

At first blush it might be tempting to deny that the issue of contracting needs to be complicated at all. Some might view the trend toward greater levels of for-profit provision as a sign that business firms not only enjoy competitive advantages over nonprofits but also offer better services. One might also conclude by looking at the growth of for-profit activity that clients simply find corporate forms of human service delivery superior to traditional nonprofit forms of assistance. These conclusions would be misplaced, however. Although a fair amount of evidence supports the contention that business firms have a competitive edge over nonprofits, there is almost no evidence that the services they render are of higher quality than those offered by nonprofit organizations. Indeed, evaluation research on the comparative performance of agencies across sectors is slim and contradictory.

Differences between nonprofit and for-profit forms of production have been analyzed in a select number of fields to determine whether substantial differences in service quality and cost can be located. Beyond some basic intuitions, the actual evidence is utterly conflicting and inconclusive.23 Some studies have shown that nonprofit child care is of higher quality than for-profit alternatives; other studies have shown high levels of parental satisfaction with for-profit providers. Some studies have detected differences in the levels of uncompensated care in nonprofit as against for-profit hospitals, whereas others have not. Several studies have differed in their findings as to the comparable efficiency of for-profit and nonprofit hospitals.24 Early evidence on the comparative performance of nonprofit and for-profit charter schools is not yet conclusive, though parent interest in and satisfaction with some for-profit schools appears strong. Government satisfaction with for-profit providers of job training has been sufficiently high to drive substantial growth in this field while at the same time raising concerns in some areas about the long-term effectiveness of these programs.25

In light of this confused trickle of evidence, the current capacity of public managers to speak authoritatively about the desired organizational ecology of different human services fields is minimal. As a consequence, the shifting presence of for-profit and nonprofit providers can hardly be interpreted in many fields as the result of careful planning or strategy. Moreover, the effects of some of the unplanned and unanticipated ecological shifts have not always been positive. Anecdotal evidence suggest that there may be a fair amount of concern about the expansion of for-profit human services. In the area of health insurance, there is a growing chorus of criticism about the effects of for-profit health maintenance organizations on the quality and accessibility of health services, a trend that has fueled calls for a bill of rights to protect patients. In the nursing home field, which has come to be dominated by for-profit firms, grave doubts have emerged about the capacity of the system to care compassionately for the coming tidal wave of elderly that the retirement of the baby-boom generation will create. Similar concerns have emerged in the area of welfare-to-work services, in which large corporations have established a significant presence. As corporations like Lockheed and Electronic Data Systems (EDS) have secured large state contracts, many community activists have questioned the degree to which these companies are able to provide the kind of help that is needed in the diverse communities in which clients reside, especially to those individuals who face multiple barriers to employment and who need long-term psychological and vocational support.

The paucity of good data on the comparative performance of nonprofit and for-profit service providers has led public managers to focus on the one area for which data is available, namely, cost. Many managers are drawn to the idea that cost should be the central factor in contracting decisions because measuring and comparing costs across proposals is far easier than making tough judgments about the quality of underlying service models or the qualifications of the providers. Political pressures and demands for fairness in the allocation of contracts also tend to push public managers to focus on service cost as the critical criterion in contract allocation. To focus entirely on the cost of service provision is, however, to set up a contracting system that will have the inevitable effect of favoring business firms over nonprofit organizations.

Without a more complex and sophisticated set of criteria, the long-term consequences of such an unreflective approach to contracting is likely to be the slow squeezing out of nonprofit providers from certain fields. This sort of ecological shift might seem to be a small price to pay for the ability of the public sector to economize on the cost of service delivery. However, there may well be unforeseen consequences to this kind of reorganization of sectoral responsibilities. Chief among these is the permanent disappearance of the "nonprofit option." In fields such as nursing home care, in which for-profit market penetration has been deep and complete, it is hard to imagine how a mixed ecology can ever be restored. The sectoral shift in the nursing home arena was accomplished to achieve economies, but it ultimately has had the effect of driving out nonprofit providers. Once a field has been purged of nonprofits, even if consumers want to restore a nonprofit option, policymakers may be unable to take meaningful action because the barriers to reentry for nonprofits are high and play into the sector's weaknesses in mobilizing large blocks of capital.

Because of the difficulty in reversing major ecological shifts in the organizational population, public managers need to radically expand the quality and breadth of their conceptual frameworks for thinking about large contracting decisions. This can be accomplished by developing a set of analytic tools for understanding when and why either nonprofit or for-profit provision is likely to work best, based on the characteristics of providers, the needs of consumers, and the nature of the underlying service. Until a compelling conceptual framework for deciding the division of labor across sectors emerges from the slow accretion of reliable data, protecting the mixed ecology of service providers will require a shift i

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