Self-sufficiency is a Long Way Away

The Postal Service released its monthly financials for February that showed an operating loss of $230.   For the year to date operating income was $18 million, meaning that February will be the last month that the Postal Service shows an operating profit this year.

While the February numbers look bad, they do not fully explain how difficult the Postal Service's financial situation really is.  For example:

• Financial self-sufficiency would require that the Postal Service earn an operating profit of over $530 million per month.   ( i.e. an operating margin of 12%)    Only with an operating margin of this size would the Postal Service have the capital to invest in its infrastructure, cover the costs of downsizing, and cover its workers compensation expenses, pay its debt.  It is not clear if even an operating margin of that size would allow it to make the contribution for retiree healthcare obligations without cutting spending that would allow it to remain self self sufficent.
• The Postal Service's incentives for early retirement that were announced on March 15th were pushed back into fiscal years 2012 and 2013.  A self-sufficient Postal Service would have offered the $20,000 lump sum incentive for early retirement as payment upon retirement, increasing the value of the incentive to employees and most likely incresing the number of employees taking advantage of early retirement.  The cash squeeze prevented the Postal Service from offering the incentive that would cut the layer of management that it wants to cut quickly.
• Depreciation as an expense is decreasing over last year and plan.   Declining depreciation suggests that the Postal Service is not upgrading or replacing its physical assets.   Right now the Postal Service is falling behind both foreign postal operators and its customers in upgrading the information technology infrastructure, and using the most efficient mail and parcel sortation and material handling equipment.  The lack of capital also makes consolidating the processing network more difficult as the Postal Service is unable to adjust its network by replacing multiple  plants with one in a new location that could more efficiently and effectively provide the service customers demand.
• Vehicle maintenance expenses are up 11.9% over plan and 13.7% over last year.  The Postal Service operates 215,000 delivery vehicles.  Without the cash to replace this fleet, vehicle maintenance expenses will continue to grow at double digit rates.
• Fuel costs are growing much faster than inflation and the rates on products that require significant transportation expenses.  Besides fuel used by its delivery fleet, contract carriers that move mail by air and truck between facilities all have fuel surcharge provisions in contracts that raise Postal Service expenses as fuel prices rise.  Fuel increases of 1 cent raise Postal Service costs by $6.5 million.   Given current prices of gasoline and diesel fuel and expected trends through the summer driving season, the Postal Service will spend between $500 and $600 more on vehicle fuel costs this year than plan nearly wiping out all of the savings from the management restructuring announced this week. 

On April 5th, the House Oversight and Government Reform Committee will be looking at issues relating to the labor relations and employment law that governs the Postal Service.   These issues are important as compensation costs represent 72% of the Postal Service's total costs this year.  Cutting compensation costs will have some effect in lowering this percentage and requires looking at pay schedules, work hours, and the pay schedule that applies to the employee doing needed work, including whether the work is performed by a non-uinion or unionized employee.   To the extent that the APWU contract allows the Postal Service to reduce total compensation costs then it will help improve the Postal Service's bottom line and have some effect on reducing employee compensation's share of total costs.  

However, as the bullet points above show, many of the red flags associated with the long-term prospects of the Postal Service focus on the lack of capital spending.   The lack of cash has the effect of depressing non-compensation expenses artificially inflating the share of total costs related to compensation buth now but more importantly long term as they reduce the ability of the Postal Service to reduce the labor required to handle the mail it will be expected to deliver.

Why Capital and Flexibility Matters

http://www.gwinnettdailypost.com/localnews/headlines/Post_office_gets_80K__in_penalties_112641144.htmlNews stories about service or safety failures seem to pop up nearly weekly.   Two stories today illustrate the need why the financial problem may be even greater than the Postal Service's inability to pay its bills at the end of the year.

• The Lima News reports of the problem the Postal Service is having in getting mail delivered on time in west central Ohio.  The story describes  mail arriving for delivery late from the processing plant in Toledo which caused carriers to be paid waiting for its its arrival and then forcing delivery well into the evening.   The story also describes a number of instances in which advertising mail is delivered well after the in-home date.   Most telling is this quote from a retired Lima letter carrier Michael Wright, “In Toledo, they don’t have room. It’s chaotic.”
  
  How could this be fixed?   One option would be to expand the plant in Toledo and its automation capabilities to handle the increased volume.   This would require capital expense that the Psotal Service does not have.  A second option would be a better early warning system that allows senior management at the Chief Operating Officer level to know when a plant is receiving more volume than it can handle so that appropriate changes in sort plans and distribution schemes are made so that mail is delivered on time.    A third option would be flexibility that would allow shifting mail from a plant that has back-ups to one that has more capacity on an ad-hoc basis or permanent basis.  There are three plants near Lima that could take some or all of the mail that Toledo (i.e. Columbus, Cincinnati or Fort Wayne) appears to have difficulty handling.  Finally, management needs greater flexibility for part-time and temporary employees to allow local managers to bring in extra staff on short notice during peak months, or days of the month.
  
  As the proportion of mail that is advertising increases, the importance of timely delivery increases.   Mail demand shifts from an "as soon as promised" delivery standard of First Class mail to a "specific in-home date" requirement of advertising, periodical, and parcel mail.  Having sufficient operating capacity for peak periods and flexibility to handle variable levels of volume requires both increased capital and flexibility in labor agreements and management thinking.
  
• Occupational Health and Safety News reported that the Postal Service faces $238,000 in fines for safety violations in Central Massachusetts Processing and Distribution Center in Shrewsbury, Mass.  Just five days earlier, The Gwinnett Daily Post reported that the Postal Service recieved $80,000 in fines for similar safety violations in the Dultuth Georgia facility.
  
  These are just the latest of a set of fines the Postal Service has received for electrical safety and training issues in facilities across the country.   Fixing the problems required requires cash to make necessary repairs, provide proper safety equipment, and provide proper training to ensure that all safety procedures are followed and safety equipment is used.   Again, the shortage of cash most likely causes the Postal Service from spending the funds that would be necessary to prevent these fines. 
  
  The OSHA safety fines raise another question, that is particularly important given how much of the mail is sorted on automated equipment all of which requires electrical power.   Could the problems that cause safety violations be the canary in the coal mine in regards to equipment downtime that could affect service quality and the competitiveness of the Postal Service as a means to handle financial transactions and deliver advertising?  

The OSHA Fines: A Canary in the Coal Mine

The financial problems of the Postal Service have so far had minimal impact on the service that mailers receive.   The Postal Service has generally met its service commitments at levels similar or better than what existed at the time of the passage of the Postal Accountability and Enhancement Act.  To the extent that the financial problems have affected operations, the impact has been hidden from view.

However recent actions by OSHA indicate that the financial challenges are beginning to impact the ability of the Postal Service to safely operate its facilities.   OSHA has found sufficient common violations exist that it issued a complaint to the Occupational Safety and Health Review Commission to order USPS to correct electrical violations at 350 facilities.  The complaint gives the Postal Service unwelcome notoriety as this is the first time that the Department of Labor has sought enterprise-wide relief as a remedy.  OSHA's action follows the Postal Service receiving fines for safety violations in multiple facilities from Boston to Kansas City.

Enterprise-wide worker safety is a serious issue that often only comes to light when there are more systemic problems that either suggest significant malfeasance or significant financial problems that prevents the enterprise from dealing with them.  In the case of the Postal Service, there is no evidence of malfeasance.  Malfeasance is a potential issue in the investigation of safety issues at the Big Branch mine in West Virginia.

The increase in safety violations at the Postal Service reflects the impact of the financial challenges that resulted in budget cuts and deferred capital spending.  These financial problems have generated issues of maintenance backlogs since at least 2007 when the GAO began reporting it.  OSHA's findings of safety issues expand the issue of maintenance and safety to include mail processing facilities as well. 

An increase in safety related issues often coincides with service related problems in transportation firms.   The recent problems with Metro trains in Washington, D.C. are good examples where deferred maintenance, upgrades and capital spending on infrastructure, information systems and new equipment have resulted in delays and a tragic accident.   Following the accident, Metro trains ran much slower for an extended period of time until the track where the accident occurred was deemed safe.  Also questions exist as to whether some of the older, less structurally sound cars should be removed from service which would increase crowding on the system and reduce train frequency.

Safety issues were also a serious issue for US railroads when they were facing significant financial problems in 1970's and 1980's.  Safety issues had a major impact on service as Conrail and other railroads slowed train speed in order to operate safely and even that did not prevent breakdowns that resulted in lengthy delays and complete denial of service to certain points on within the United States freight rail network.   Similar stories can be told in regards to a number of the commuter rail systems where budget constraints resulted in safety issues that forced slower and less frequent service.  
 
For the Postal Services, safety issues could affect the service if the safety issues reflect deterioration of basic systems (i.e. plumbing, ventilation, electrical) that require the facility to be closed.   Such problems have closed retail facilities but have yet to close any processing facility.   Even if the problem is less severe, it can have an impact on service.  For example, if the electrical system serving a significant number of pieces of automation equipment must be taken off line for repairs, then mail from that facility could be delayed as mail must be worked on equipment that is not affected.

Safety and maintenance issues raise additional questions in regards to the Postal Service's retail and mail processing strategy.   The expense of keeping a facility open is not just the operating costs involved.  All facilities require regular maintenance and upgrades to basic systems as well as installation of new generations of material handling and automation equipment.

As such, the costs associated with maintaining the existing retail network is not just the cost of the employees who work there and the regular facility operating costs. (i.e. heating costs, electricity, and rent and/or depreciation)  Measuring the true cost of maintaining the existing retail network must include the cost of items that are not incurred every year including regular upgrades in basic systems, painting and remodeling expenses of the retail counters, etc. If the Postal Service has been deferring these building expenses then any review of historical expenses would underestimate the costs of maintaining the existing retail network.

For mail processing facilities the problem is similar.   Cost models that evaluate the Postal Service's network and decisions to consolidate facilities need to look at the capital spending required to maintain existing facilities when then look at the potential costs and benefits of either consolidation into an existing facility or consolidating two or more older facilities into one newer facility.   Not including these costs misstates, and most likely underestimates the benefits of consolidation and may underestimate the benefits of consolidating processing from multiple older facilities into a better located new facility. Also similar to the issue with retail facilities, underfunding of maintenance expenses both understates the costs of keeping processing facilities open and may impact the potential capital spending needs in the future. 

The problems with deferred maintenance and safety issues suggest that the costs of maintaining the existing retail network and a processing network that is too large for the mail volume and mix that the Postal Service handles is probably greater than what the Postal Service currently measures.   Replacing them with retail and processing networks that make sense for the volume and mix of mail and parcels that the Postal Service handles would generate greater savings than now believed even if the remaining facilities required spending to cover deferred maintenance and capital needs.  Not fixing the retail model creates the possibility that the Postal Service could increasing provide more limited hours of service at existing retail locations and use the labor savings to cover the maintenance costs of the facilities.  Not fixing the mail processing model raise the possibility that maintenance problems could result in a significant service failure if a facility has to be taken down to repair the problem.   

The OSHA citations represent the canary in the coal mine in regards to the Postal Service's financial problems.   They illustrate the first instance of how the financial problems that forced deferred maintenance and capital spending affect key stakeholders of the Postal Service; in this case, its employees.  Given what has happened in other transportation companies, customers could expect that financial problems that resulted in deferred maintenance and capital spending to the service they see.  At this point maintenance issues have affected some retail customers and could affect more if increased maintenance costs require costs in operating costs and hours that retail facilities are open.    Commercial mailers should begin to wonder how soon it will be before the costs of maintaining an over-sized and mis-matched physical plant begins to affect the quality of service that they receive.

Missing from the Postal Service's Action Plan

In the upcoming months, Congress, stakeholders, and Obama administration officials will complete a comprehensive evaluation of the package of changes that the Postal Service proposed in its action plan.   While many stakeholders will focus on what the changes mean for them, Congress and the Obama administration need to focus on what the plan means for the United States postal market and the impact of a financially failing Postal Service on the pace of the economic recovery.

In that regard, Congress and the Obama administration will likely go beyond examination of what is in the plan.  They will quickly identify gaps that need to be addressed.   This process will force the Postal Service to transform the documents designed to mold public opinion into a presentation that is at least as detailed as what creditors would require before re-capitalizing a money-losing firm.   In these documents, the money-losing firm has to detail the changes that will be made in detail, the financial consequences of all changes, the financial result when changes are complete, and most importantly why supporting the transformation will increase the creditor's returns over liquidation of the money-losing firm today.

In that light, here are three gaps in the Postal Service proposal that could affect its successful implementation:

• No financial target associated with a self sufficient Postal Service.  The only financial target presented was a return to break-even in 2020.   A break-even target is same target that all government departments have, the only difference for the Postal Service is that revenue comes from ratepayers and not taxpayers.
  
  Without a return based financial target, it is impossible to know what levels of revenues and costs are required to generate sufficient cash to cover needed investments for the next generation of automation and information systems, transition costs of reducing and restructuring the workforce (including retirement incentives, transfer and training costs, and severance costs), modernizing the retail network, replacing the vehicle fleet, ending deferred maintenance and optimizing the sortation network. 
  
  The lack of a realistic financial target allows mailers and employees to underestimate the scale of the changes that are required for the Postal Service to be a self sustaining enterprise in 2020.   Mailers, employees and stakeholders will find it much easier to argue that changes that hurt them should be eliminated.  This makes Congressional passage of required changes more difficult.
  
  Finally, and more importantly for most stakeholders, the lack of a realistic financial target reduces the probability that Congress will take the necessary and prudent decision to adjust the retiree health payments.    As is clear to most stakeholders, retiree health payments are an issue that must be addressed in order for a sustainable Postal Service to emerge.   A break-even target allows members of Congress and others to argue that no change is needed and forces the Postal Service to operate like Washington DC's Metro and defer maintenance and other capital investments, raise rates, and reduce service in order to balance a budget.   (Similar strategies to balance budgets can be found in the commuter rail operations of METRA in Chicago and the MTA in New York.)
  
  
• No Capital Spending Plan - In response to a question at the forum presenting its action plan, Pat Donohue laid out the Postal Service's approach to capital spending going forward.  In this approach the Postal Service will focus on 1) improving processes using existing capital assets first; 2) increasing the utilization of existing capital assets with a focus on labor contract changes that allow that to happen; 3) reducing emphasis on big purchases; and 4) continuing a parsimonious approach to capital spending due to limited cash flows.  
  
  This approach reflects an organization in survival mode and makes sense right now.   However, there are limits to extending the replacement cycle on existing equipment even as lower volume reduces the wear and tear on existing production equipment and vehicles.   Furthermore, lower volume, and more importantly shorter runs may change the type of capital equipment required in a manner similar to how shorter runs have changed the equipment deployed in the printing industry.
  
  Modernizing the retail network will also have capital expenses.  The Postal Service needs to purchase additional current and next generation automated kiosks.   An expanded contract retail network will require spending to develop and train the new management structure for contract locations, improved information systems designed for managing a larger contract operation, and other start-up costs that will exist to create the more contractor-friendly approach necessary to open the number of locations necessary to make this approach work.
  
  The biggest risk to the survival mode approach to capital spending relates to dealing with adjusting the network to handle single piece mail and flats.  By 2020, the Postal Service may handle only 30% of single piece mail that it does today.   At that level of volume the Postal Service could meet today's service standards at a cost lower than current levels in no more than half of the facilities that sort originating mail today.  The declining volume will require a continuing process of moving equipment, retrofitting existing facilities, and in some cases building new faculties in more optimal locations will involve significant capital spending starting now so that implementation can proceed on a timely basis 
  
  The problem with flats is similar with one difference.  Most flats are sent by large volume mailers.    By 2020, it may make sense to have a flat sortation network, including sortation to delivery route sequences in fewer than one-third of the facilities that sort flats today
  
  Finally, while not exactly capital spending, the speed at which the Postal Service manages the changes that it proposes depends upon the availability of cash needed to handle the impact of the transition on postal employees.   The lowest cost and slowest method is to allow attrition to reduce the workforce. By using only attrition, the Postal Service drives the changes to its sortation and retail networks to the rate that employees leave the Postal Service.  A more efficient but more expensive approach uses retirement incentives and lay-offs that generate severance and unemployment costs to match the speed that it can manage the changes in its operations and therefore the size of its workforce.
   
• No specifics relating to changes required to most effectively and efficiently use non-union employees.  Non-union employees represent less than 10% of the Postal Service workforce.   The transformation envisioned will change the nature of the work that managers and sales, general and administrative staff do.   Just as the Postal Service cannot afford excess craft employees, it cannot afford excess non-union employees, and for that matter contractors who in many cases have staff responsibility that in the private sector employees would have.
  
  More important than the number of non-union employees, the new environment will likely require a different mix in the skills and management abilities than the Postal Service now has.   While many of its non-union employees are nearing retirement, it is unlikely that either their rate of retirement will match the rate that the mix of employee skills required changes or that retirements will occur first in positions that can be eliminated as the position is no longer needed in the new environment in positions requiring skills that are easily found internally or externally.  
  
  The current civil-service like employment rules severely restrict the Postal Service from adjusting its workforce at a rate anywhere near the rate that its skills need changes.  Civil-service like employment rules and pay schedules also encourage the use of contractors who have more flexibility to develop career paths for employees that reflect the changing skill mix required by the Postal Service.   For example, contractors can have large number of employees who meet the needs of the Postal Service for a number of years and then when the Postal Service's needs change, replace those employees with a different set with skills attuned to more current needs.  Of the original group, only a few remain with the firm in management roles and the rest are let go.  In information technology, finance, accounting, economics, engineering and other knowledge based fields, consultants can adjust pay levels for existing employees and new hires more rapidly to reflect changing market conditions than the Postal Service can.  (In fact in some technical fields, competitive pay levels may exceed the salary of postal executives.)
  
  Finally, compensation schedules for non-union employees need to be reviewed at all levels.   An increased focus on growing sales and creating new mail products requires an incentive and possibly a commission based compensation scheme to properly find the best sales and marketing people who compete in an employment market where most compensation is primarily incentive or commission based.  Introducing such a pay structure would require a significant change in compensation policy that may require changes in law.

The three items listed in this post are not likely all inclusive.   However, they identify three gaps that need a serious examination by those responsible for deciding the Postal Service's future.