Industry's Downsizing Lessons

s the federal government undertakes what some have called its first serious reorganization since the New Deal, public-sector decision makers have much to learn from the successes and failures of corporate America.

Both the private and public sectors operate in a landscape dominated by economic, political and technological change. Many businesses are responding to this more volatile environment by reducing their "operating leverage," the degree to which they are committed to fixed costs such as property, plant, equipment and full-time salaried employees.

There are many parallels between the trends seen in private restructurings and those the government is undertaking. This is particularly true in the case of the Defense Department, which manages many industrial-type production facilities. DoD has taken the lead in the current round of federal downsizing, instituting several initiatives to reduce permanent staff positions, rely more on temporary help and outsource production.

If some cuts in fixed costs are good, aren't more cuts better? Not always. Take the experience of Honda Motor Company. An industry leader for years, Honda made large cuts in its permanent engineering staff in response to the more volatile sales environment for automobiles since the mid-1980s. These cuts left Honda unable to keep pace with its competitors in the design of new automobiles. The results have been the loss of market share and profit for Honda, which now faces the difficult task of trying to catch up.

The consequence of cutting fixed costs too far could be even more dangerous for a government enterprise like DoD. Cuts in permanent staff and infrastructure could reduce efficiency and eventually hurt deterrence and readiness. If the demand for DoD services one day returns to levels similar to those of the Cold War era, low levels of permanent staff and in-house capacity may even impair the ability of America to defend itself. At that time, no quick-fix options would be available; adding fixed costs would not result in immediate improvements in readiness and deterrence. It takes time to build new facilities and train new permanent staff.

For the Defense Department -- and, indeed, all government agencies -- the operating environment has become more uncertain. Smaller commitments to fixed costs such as full-time staff or in-house production capacity are necessary to enhance efficiency. But how deep should cuts in fixed costs be? Answers can be found by studying lessons from business.

Operating Leverage

For private enterprise, the degree of operating leverage is a critical business decision. If a firm's costs are largely variable, they follow the level of sales closely. In contrast, fixed costs magnify results, both good and bad. High sales levels result in large profits because costs don't rise with sales as rapidly. In a poor sales environment, however, firms with high fixed costs are in trouble. Fixed costs must be paid, even if revenues are not generated to pay them. A firm may be forced into bankruptcy if its commitments cannot be made. Higher operating leverage thus increases risks for private firms.

Volatile sales environments make these high risk levels less acceptable. A more stable or predictable sales environment, on the other hand, offers management an opportunity to take advantage of higher operating leverage. Thus, the first lesson in operating leverage: An assessment of the volatility of the environment is critical.

Many CEOs have made such an assessment. Sales volatility is increasing in many markets. In the computer industry, for example, rapidly changing technology is causing companies to reassess large, fixed-cost commitments. As a result, evidence of decreasing operating leverage in this industry abounds.

Many large computer firms have made dramatic cuts in permanent staff. Standard and Poor's reports that IBM had more than 370,000 full-time employees in 1990 and fewer than 270,000 in 1994. At the same time, computer firms have greatly increased outsourcing of products and leasing of equipment. Both of these trends reduce the requirement for large in-house expenditures on personnel, plant and equipment. Outsourcing and leasing make the enterprise more nimble, more able to quickly adapt to a rapidly changing sales environment. So the second lesson for DoD decision makers is: Cuts in fixed costs may be prudent in a volatile operating environment.

But not all industries have dramatically slashed their fixed costs. Some private entities, such as utility companies, have very stable operating environments and a steady demand for their products. For them, radically reducing fixed costs doesn't make sense. There are other companies, such as Honda, that have reduced operating leverage too much. Hence, the third lesson of operating leverage: Cut fixed costs with care, so as to not undermine the agency's performance in the event that requirements for the organization's products or services increase in the future.

Finally, for the private sector as well as for DoD, full-time employees have become a particularly costly and troublesome fixed asset. Burdened by soaring employee-benefit costs, private firms are cutting permanent staff and relying more on temporary help. Termination of full-time employees is expensive. It results in increased severance payments, the threat of lawsuits and large restructuring costs. According to Standard & Poor's, IBM reported restructuring charges of $ 8.3 billion in 1992 and $ 2.9 billion in 1991 due to the elimination of jobs and the reduction of capacity. That brings us to the fourth lesson of operating leverage: Downsizing costs can be staggering, and once cut, fixed assets are very costly to replace.

Application to Government

For more than 40 years, when the Soviet Union was the paramount defense concern, DoD had a relatively constant requirement to defend the country against a well-studied and relatively predictable threat. The "sales" environment for DoD services was thus quite stable. Within this environment, DoD rationally increased its operating leverage, adding permanent staff and building a great deal of its own production and maintenance capability.

In the Cold War era, DoD was thus comparable to the above-mentioned, publicly owned electric utility; the demand for its products and services was stable and predictable.

Today, however, the operating environment at DoD has become more volatile. Few threats are certain. Unlike the bipolar world that existed previously, the new defense environment is highly fractious and rapidly changing. Thus, the "sales" environment for DoD no longer resembles that of an electric utility. The lessons of operating leverage suggest that DoD should reduce fixed costs to respond to this more volatile environment. From this perspective, even some painful cuts are justified.

These reductions are already taking place. The DoD comptroller predicts a 30 percent reduction in permanent staff between 1985 and 1997. DoD has reduced less drastically its temporary staff, the Reserves and National Guard. Given the current threat (sales) environment, DoD arguably improves efficiency when it relies more on temporary help, much as many private businesses are currently doing. When additional staff are needed (as during the Persian Gulf War), DoD relies heavily on its reserve component and augmentees like the Civil Reserve Air Fleet to help carry the load. But permanent staff and capacity are not added because DoD's roles and missions are changing rapidly.

Along with the reductions in fixed costs associated with permanent staff, DoD is also cutting into its in-house expenditures for production and maintenance. From-1985 to 1997, DoD will close approximately 35 percent of its overseas bases and 15 percent of its domestic bases.

DoD is also beginning to allow private firms to perform many functions traditionally performed in-house, such as base maintenance and security. Other tasks, such as aircraft maintenance and refurbishment, are subject to competition between government entities and civilian contractors.

A Warning

Much of the way DoD is handling its downsizing is consistent with the conventional wisdom about operating leverage. While outsourcing and competition are in line with attempts to improve efficiency in government, they are also classic examples of an organization that is reducing operating leverage. Cuts in fixed costs associated with the reduced levels of plant and equipment owned by DoD are in response to the changing environment. The view is that it is no longer efficient to have high fixed costs. Paralleling the restructuring of many private enterprises, DoD now employs lower levels of fixed costs. The department maintains the flexibility to outsource or add temporary staff in response to changes in the operating environment, recognizing that it may have to pay a premium.

But DoD may be in danger of repeating Honda's mistake and cutting operating leverage too far. Testifying in Congress on military readiness, Defense Secretary William Perry suggested that the cuts are already too deep. And in a speech to 1995 graduates at the U.S. Air Force Academy, President Clinton expressed concern that further cuts may bring about the return of the "Hollow Army" of the late 1970s.

To avoid "hollow forces" yet cut operating leverage wisely, government entities should be more conservative than private businesses when considering cuts in operating leverage. The risks associated with errors in restructuring are much different in the private and public sectors. For private companies, cutting fixed costs too deeply hurts profits. For DoD, cutting fixed costs too far undermines the nation's ability to defend itself. Government must learn from business and recognize the greater error. While increasing volatility in the operating environment for many government entities such as DoD indicates that some reduction in operating leverage is prudent, deeper cuts expose the public sector to unacceptable risk.