The US Postal Service is back in the news. Estimated to lose billions of dollars this fiscal year, the folks in Washington are trying to find a way to keep the Post Office from going bankrupt. Both the President and Congress have decided to focus their efforts on improving the service’s cost model–allocating x for letters, y for magazines and z for junk mail. The problem with this is that these costs are not real; but rather they are simply allocations that don’t have much to do with the reality of the Postal Service’s huge fixed cost structure.
Bill Waddell over at Evolving Excellence–experts in the field of lean accounting and common sense in general–has an excellent essay regarding this fallacy.
When someone says the cost of a first class letter is X, while the cost of a piece of junk mail is Y, the only way they could have arrived at those numbers is to have made a bunch of allocations. The actual cost of delivering a letter is pretty close to $NADA. The cost of opening up all of those post office doors and firing up all those trucks, however, is astronomical. They get to the cost of each type of item by going through some undoubtedly very clever arithmetic that ends up telling them x.xxx% of funny truck expense is assigned to letters and y.yyy% is assigned to magazines. Just because someone conjured up a slick equation, and has some pretzel logic to justify the math doesn’t make it so, however. The cost of the truck does not in any way shape or form depend on what sort of stuff it is being used to deliver on any given day. It is simply the cost of the truck and trying to make it into the cost of anything else leads nowhere other than to bad decision making.
Both the President and the Congress are advocating solutions that continue to try to solve the problem of allocated costs by “giving USPS the ability to better align the costs of postage with the costs of mail delivery.” Translation – allow the postal service to raise prices on those products (i.e. junk mail) where allocated costs (that have no relation with the actual cost of delivery) are deemed too high relative to the actual postage. This is the wrong approach.
The reason the post office lost $8.4 billion last year is not because their prices were too low on some products. It is because they have a huge installed capacity (and the associated fixed costs) that was grossly under-utilized. The solution is greater volume. No matter what the price charged for the volume, since the direct cost is zip, any revenue they get for the additional volume will help to cover the fixed costs. That being the case, the key to increasing volumes is not to raise prices – it is to lower them.
No fan of artificial cost allocations, the author takes a strong stance (to say the least) against the practice:
Cost allocating is sending the Post Office down the drain – and a whole lot of our money with it. Pricing has nothing to do with cost. It is set by the market as a function of the value created relative to the value proposition of the competition. It is destructive thinking to believe that COST + PROFIT = PRICE. So long as the government institutionalizes the wrong formula, the Post Office is doomed.
Allocating costs leads to silly conclusions like believing delivering magazines is unprofitable, which leads to price increases, which leads to lower volumes, which leads to allocating the same fixed costs over smaller volumes, which leads to cost increases, which leads to further price increases … you get the picture.
The are no easy fixes to the postal service’s financial dilemma, but the first step needs to be a realization by its stakeholders that the problems are far deeper than to be dismissed simply as pricing issues. And to make matters worse, the Postal Service’s reliance on using (artificially) allocated costs as a proxy for pricing criteria is accelerating the organization’s downward spiral.
Here’s the takeaway: Let the market (not cost) determine price.
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Patrick Lefler is the founder of The Spruance Group – a management consultancy that helps growing companies grow faster. He is a former Marine Corps officer; a graduate of both Annapolis and The Wharton School, and has over twenty years of industry expertise.
Sir, I believe that Mr Spruance is another blind believer in the falsely labeled “free market” theory of economics. Partly this theory is based on the foolishly simplistic “leave me alone, let me do what I want and everything will be fine”; which, as we now know, will allow the foxes to run the chicken house into the ground. Without regulating human nature, which are called laws outside of Wall St, the markets will certainly have continously ongoing bouts of bad behavior which will bankrupt the country. Bearing in mind of course that the country is run for the good of the people NOT the good of the banks. I believe that the Bible dealt with the moneychangers appropriately.
Second, if prices are determined by the allegedly “free market”, then why, during this perhaps inaugural world wide recession, have the prices of gas stabilized without falling to last years prices of at least one dollar less poer gallon? For that matter, why have they not fallen further? In a true “free market ” economy, by definition, this would have to happen.
I would submit that much of economic theory is used to brainwash the government and the general public. I would further submit that the huge corporations use this brainwashing, from the classroom to the boardroom, to deliberately keep this illusion alive as a smokescreen to what the economic situation of the world really is.
I am interested in all/every opinion as I write this democratically.
Mark Comerford
mn4470@aol.com
It is always interesting to me how analysts and market experts always seem to have the most inept concepts of the USPS. The lack luster opinion of Mr. Waddell is to suggest that the USPS should just ignore its overhead costs which are directly related to the processing and delivery of the mail. GENIUS!! Let’s pretend it doesn’t really cost X to delivery letters or Y to deliver flats and arrive at the costs arbitrarily so as to ensure that the USPS is firmly in the trenches of its own demise. Clearly Mr. Waddell has not done any research to determine how the costs are associated to the products and services the USPS provides but rather makes an assumption based conclusion without regard for how the USPS operates. No offense Mr. Leffler, but you should try doing a little of your own research prior to reposting someone else’s failed ideologies. There are real associated costs with processing and delivering the mail as there are with any other physical labor demanding products and services. Those costs ultimately will decide how best to charge your customer base in order for a business to make money, or in the case of the USPS pay its own way with a breakeven mandate. The author also suggests very subtly that he and everyone else are paying for these services beyond the purchase of stamps when he states that “cost allocating is sending the USPS down the drain – and a whole lot of our money to.” That certainly does sound like an assertion of tax dollar subsidizing to me to which everyone by now should know is a fallacy. The truth is that the USPS DOES have real operational costs which must be directly associated with the products and services which we provide in order to determine a fair price. With mail volume on a steady decline and no reason to believe it will ever return, lowering the cost of a product or service under those circumstances is just “bad decision making.”
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“The truth is that the USPS DOES have real operational costs which must be directly associated with the products and services which we provide in order to determine a fair price. With mail volume on a steady decline and no reason to believe it will ever return, lowering the cost of a product or service under those circumstances is just ‘bad decision making’.
Postalpatriot – your ignorance of fundamental accounting is breathtaking. Why must the costs be asociated with the products? To satisfy some hopelessly outdated accounting theory you picked up somewhere?
The fact is that most of the costs of the postal service are NOT related to specific products. If by lowering prices they can increase volumes they will relaize more revenues to cover their fixed costs.
My “lack luster” opinion is not to “ignore” the fixed costs. It is to recognize that the incremental cost of additional mail volumes is virtually zero. The “failed ideology” is allocation based accounting, and rather than suggest that Mr Leffler do some research you might want to consider saving yourself quite a bit of embarrassment and doing a little homework of your own. Obviously the evolution in cost accounting in the private sector over the last 25 years has passed you by completely.
Before you rant in such a simple minded manner, and toss insults around so freely making yourself look quite ignorant of basic finance in the process, I suggest you get a basic accounting education … simple terms like direct costing, incremental costs, price/volume relationships, leveraging fixed costs … the kind of stuff kids learn in Accounting 101 would be a great starting point.
Concerning whose money is at stake if and when the Post Office fails, just who do you think will cover the shortfall if not the American taxpayers?
Finally, I am sure you would be quite surpised at exactly how much I do know about how the Postal Service does its cost allocations.
Mr Comerford,
Your rant against free markets notwithstanding complete with biblical references, in fact the free market does set the letter and package delivery prices. The free market chooses the price of a FedEx UPS or electronic delivery instead of the USPS price far too often. Government santioned price increases to USPS products and services do not mean anyone will pay those prices – in fact, they just encourage the free market to choose Postal competitors instead.
As for why oil prices have not fallen, it is a simple question of supply and demand. You might want to look into an organization called OPEC – controllers of the vast majority of the world’s oil supply – who meet regularly to set production volumes and prices. If oil were not subject to cartel/monoploy control and were subject to free markets instead the price would have fallen as you say should have been expected.
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“If by lowering prices they can increase volumes they will realize more revenues to cover their fixed costs.”
This is simply not true and makes light of the entire business practice of price optimization. An uplift in volume after a decrease in price does not necessarily mean more revenue. For example, a 10% decrease in price that creates a 10% uptick in volume actually results in LESS revenue than just keeping prices and volume constant.
While I agree (and hope) that the United States Post Office is simply not pricing its products in a cost-plus fashion, I would like to point out that cost modeling can be a very fruitful activity. A cost-allocation analysis can be very a useful to help one understand the opportunity cost as well as the long-term profitability of current operations. As all fixed costs are really variable in the long-term (that truck you bought will eventually breakdown), selling products that don’t cover their fixed costs means a business is (1) incurring a lost opportunity to better utilize those fixed costs and (2) never going to be profitable in the long-term.
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