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The outsourcing of government activities is justified primarily on the grounds of cost savings. In the process of determining whether there are potential savings from contracting out, government agencies are required by various Commonwealth and State Government guidelines to measure the relevant costs of in-house activities and to compare these with external bids. The cost comparison methodology advocated in these guidelines is flawed in that it makes no alIowance for the financial value of the option to contract out (and thus not to contract out). It is wrong to give up (exercise) this option unless the expected cost savings accruing from outsourcing at least equal its value. Contrary to the guidelines and traditional capital budgeting decision criteria, it is not sufficient that expected savings are merely greater than zero. Indeed, depending on the value ofthe option to contract out, the cost savings expected from outsourcing may have to be very large before a practically irreversible decision to outsource is warranted financially. Like other options, the option to contract out provides a hedge against uncertainty, and is all the more valuable the more uncertain (less predictable) the agency's future costs of in-house and external service arrangements. In the face of inevitably uncertain cost streams, there is much to be said for conserving all available options. By interpreting the option to contract out as a financial asset with financial value, this intuitive strategic principle is given a basis in "rational economics".

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