The good news? The UK is slowly emerging from a severe global recession. The bad news? The public deficit is expected to hit £178bn this year. With a general election imminent, politicians are staying vague about how they're going to claw this back - but one thing's for sure, the public sector is coming in for the chop.
The public sector presents the biggest cost management challenge. Getting it right increases living standards and opportunity, but getting it wrong creates a dead-weight drag on the future. After the credit crisis, government accounts need to be rebalanced. Tax increases will be part of the solution, but the bigger part must be a restructuring of the cost base.
Even before the credit crisis, public spending in most west European countries was running at 40%-60% of GDP. The French and Scandinavians were at the high end. The UK was at the low end in the 1990s, but a Labour spending boom pushed it over 40% again.
These were already large numbers, and they're now much worse. Since the crunch, the private sector has contracted fast and tax receipts have dropped, yet public sector spending has been maintained - for good reasons, as a Keynesian support to the economy, and for bad, because politicians want to avoid confronting the cost problem for as long as possible.
This has produced breathtaking deficits. In the UK, the shortfall is now over 12% of GDP - as bad as Greece. Public spending has surged to over 50% of GDP. Doing the simple maths on that (and making some generous adjustments), the state is currently spending at least 25% more than it is collecting in taxes.
Why is managing public sector cost so much tougher than managing private sector cost? The first reason concerns payroll. Managing people-cost is tough enough in the private sector. People-cost is sticky: once people are on the payroll, it's hard to get them off. Wages increase at 1% to 2% a year faster than inflation. And the real underlying cost is always a lot larger than the headline salary.
These problems are big in the private sector, but even bigger in the public sector. With no profit imperative, unpleasant 'people' decisions tend to be deferred as long as possible. Pressure on pay, performance and productivity is often weaker than in the private sector. And the hidden costs of a public sector job are much worse, as long-term pension and retirement healthcare benefits are not accounted for in government accounts. If properly recognised, in the UK they would add 30% to 40% extra to the real annual cost of a state employee, and massive sums to the national government debt - an extra 50% or more of GDP. No private business is allowed to account in this way.
There are other intrinsic difficulties. Most state services are monopolies with no shareholders, and excess monopoly returns can accrue only to the workforce, as above-market wages or better job protection. Also, government attitudes to public sector pay are complicated by the 'client-voter' problem: when 20% of a country's workers are working for the state, that's a big share of the voting public with a strong interest in defending their own pay and prospects.
Procurement is the second reason the public sector is such a challenge. The state is a huge buyer of products and services: hospital catering, rubbish collection, prescription drugs, military hardware, IT contracts, roads and infrastructure. In theory, the state should be an efficient purchaser. It has the scale to extract maximum buying clout. It is zero credit risk for a supplier. If it needs to finance a purchase, it can raise funding at a lower cost of capital than private businesses. So, any purchasing failure that we do find in the public sector is an issue of execution, not of fundamental contradictions and difficulty.
Case after case shows us that there is great opportunity to improve this aspect of public sector cost performance. Local government, for example, has been encouraged to increase outsourcing of services such as catering, but staff often lack the procurement skills to make the best of competition. Take public sector consulting and IT projects. These have mostly been disastrous and have cost far too much. The UK's attempt to computerise the NHS has been one of the largest IT projects in the world for the past decade, and is a well-known case of over-spend and mismanagement, leading to negligible results.
The third reason is structural costs problems, notably pensions and healthcare. These two big chunks of state spending are hard to control. State-paid pensions were conceived after the second world war, but since then the expected two years of happy retirement have become 10 or 20 years or more. Even if pension cost per year had been held constant, total government spend per person would have gone up many times, and will continue to go up until state pensions are 'reformed' - by raising entitlement age, reducing payment levels or increasing offsetting contributions during the working lifetime. So far, governments have fudged this issue or nibbled at the margins.
Healthcare is the other cost-escalation monster, its share of GDP on a relentless upward spiral. Here, the problem is growing demand for expensive, ever-expanding medical innovation. When the state takes on the role of main healthcare provider, with universal access to good basic care regardless of abil- ity to pay, it faces an unending cost challenge.
The public sector lacks the two market mechanisms that drive efficiency and innovation in the private sector: the profit motive and competition. So it has to devise indirect ways of stimulating performance improvement, such as output and quality targets, or creating internal competition, by means of league tables of hospitals and schools. These pseudomarkets create distorted outcomes as man- agers 'manage to the measures' rather than delivering the best holistic outcomes.
In the private sector, customers can quickly switch from bad suppliers. Managers track sales and profitability daily, and respond quickly to decline. There is not much organisational distance between a retail CEO and one of his or her store managers. In the public sector, the feedback loop is poor: it takes much longer to find out what is happening and to make or demand changes. Customers can't switch from monopolies, and they can vote only every four or five years. Performance data is often non-existent or late, inconsistent and subject to heavy political spin.
Politicians like working to 10-year timeframes, where implementation and outcome will be hard to track through the mists of time. There is tremendous distance between where funding decisions are made and where operations are carried out. It takes a crisis to produce tough decisions and faster change.
So we can agree that managing public sector cost is particularly tough, but that does not mean we should shy away from the problem. We need strong leadership, professional management and tough actions from public sector managers and from politicians. Let's see what can be done by looking at the main elements of a manager's cost-cutting toolkit - one I developed mainly from work in the private sector: leadership, techniques and tactics, people, suppliers and the internet.
This is a good starting point for a reform-minded, cost-focused public sector manager. The public sector needs to...
Set up a challenging base case - don't accept the current situation and the historical momentum of cost levels and cost growth, but question why and how things are done.
Establish clear individual accountability - and maintain it for some period, rather than a muddle of elected ministers, back-office civil servants and line managers, with frequent re-shuffles, re-organisations and multiple reporting lines.
Establish a continuous improvement culture. Being persistent is really the core challenge. Tough cost management tends to occur only in response to emergencies, after which things tend to revert quickly to a non-tough normal.Set out short timeframes. Avoid making announcements such as 'a 10% saving over five years', in the hope that quiet attrition will save the day or targets will vanish in the mists. What can be done and dusted in the next six to 12 months?
Establish strong feedback loops, and don't be reluctant to give real visibility on progress to the general public.
Avoid over-large strategic projects - big-bang solutions announced with great fanfare and then confounded by poor execution.
Be great role models, as individuals and as institutions. The importance of this cannot be exaggerated. There is a systemic cynicism about senior public 'servants' being mainly focused on quietly feathering their own nests.
TECHNIQUES AND TACTICS
The public sector manager can borrow many techniques from his or her private sector colleague - management accounts and metrics, understanding cost dynamics and natural cost trends, best practice and competitive analysis - but we get an extra layer of richness from these if we move from a public sector man- ager's perspective to a taxpayer's perspective.
In particular, the transparency and quality of publicly available information on government performance needs to be significantly improved - which will in turn raise the government's game. For example, we need much better metrics around the performance of public services' cost and quality. Penetrating the numbers that are released is like wading through treacle, much harder than reading a set of company accounts, and most government figures are produced by the departments being measured.
In a similar vein, government must adopt private sector accounting principles. It's absurd that the state can ignore future liabilities, such as pensions and commitments to Private Finance Initiatives (PFIs).
Much more use needs to be made, too, of systematic 'competitive analysis', where 'competition' in this case means other countries. The UK's independent statistics and audit body should be charged with making and maintaining regular meaningful competitive comparisons across all areas of spending.
Bringing these and other strands together, we could instigate annual public reviews of government performance by department, in the manner of a corporate AGM, where the ministers and managers responsible could be challenged and questioned in public.
Such greater openness in dealing with taxpayer-shareholders might be seen as threat- ening by public sector managers, but this reaction would be short-sighted. Better transparency and quality of information will improve the stakeholder relationship, empowering the public sector managers, reducing public frustration and suspicion, and enabling a more adult debate to take place about the cost and purpose of public services. It will also go a long way to reinstate a relationship of trust that has been eroded.
This is the hardest part of public sector cost management. The most critical action is minimising the size of the core organisation. The state will never be an effective manager of people-cost; as much as possible should be pushed out to the private sector. Multiple firms can compete for the state's business, bringing the benefits of competition and profit discipline, and removing the moral hazard of client-employee voters. The state's share of GDP might not change, but that of employment would, with big potential efficiencies.
But minimising the core is a long-term strategy that will take decades to execute in full. In the meantime, governments will have to confront the painful immediate challenge of reducing the cost of the public sector workforce - not only reducing the numbers but cutting the cost per person. The public sector needs to challenge its own productivity relentlessly: how to get the same jobs done and the same services delivered with fewer people, without sacrificing quality and standards - a key goal of public sector managers.
Fortunately, there are massive opportunities to improve public sector productivity. IT is still under-exploited and badly implemented. Organisational structures, layers and pro- cesses are excessive and inefficient. And the current crisis affords us an opportunity to challenge the raison d'etre of many public sector activities. Why are we even doing activity x or y? Is spending money on a or b the most efficient way to achieve our social goal?
The public sector needs to become better at procurement and project management. It's about getting the right commercial skills in place, being clear on the principles, and establishing good controls.
This is critical as a corollary to minimising the core organisation. It's no good getting the public sector payroll down if potential gains are given away in bad outsourcing contracts. And it has to be got right if governments continue to experiment with complex, long-term public-and-private structures such as PFIs.
The internet is being embraced enthusiastically by public services, both central and local, excited about the potential for e-government: online information, tax filing, transactions, services, self-help, surveys, databases.
Execution is lagging and poor, but the interest and intent are there. E-government is already making radical improvements in customer experience but, so far, governments have used e-contact to do just and only that: enhance service levels. They have added a modest layer of e-cost onto their traditional cost base, but they have not yet progressed to addressing the radical cost-reduction opportunities on offer.
Just as in online banking and e-tailing, the internet can drive the cost of an interaction down close to zero. Tameside Council recently calculated the average cost of a taxpayer interaction at £15 face-to-face, £1 to £2 via a telephone call centre, and 25p for online. This is an analysis that banks did a decade ago. At some point, government will no longer need many of the millions of employees now doing face-to-face meetings or processing mounds of paper records; and joining up front-office e-government with back-office IT will be one of the core platforms for driving productivity.
WHAT TO CUT, WHERE TO SAVE
The current mix of public spending is hard to tackle. Health is an ever-growing component, and the NHS has near-sacred status. Education is almost as sacrosanct, although some offsetting is acceptable, such as university fees. On Defence, there is a common view that British troops are now under-equipped and over-exposed. Interest costs will increase in the future as government debt climbs for several more years and interest rates rise. Soaring unemployment will drive up welfare costs, at least in the short term. And confronting the public sector payroll cost, which represents more than a third of total spend, will be extremely painful.
A further difficulty this time around is that more of the cost-cutting need is likely to be in 'the centre', in central rather than local government, and in senior and middle management rather than lower down the ranks. (Local government spending has been made more efficient over the past two decades, partly through outsourcing.) That makes it more painful to address.
Stepping back, can we apply the top-down 'size of prize' approach of corporate cost reduction to the public sector cost challenge, using our private sector rule-of-thumb that any decent cost-cutting programme should have a target of a 15% cut? There are six cost-cutting themes, in order of increasing practical difficulty...
1. Privatisations and disposals
The easiest: there is still more than £300bn of assets sitting on the Government's books.
2. Investment deferral
This is the first resort in a recession for infrastructure and IT projects and the like, but it should not count as meaningful cost control.
3. Revenue-raising offsets
Not extra taxes but the taxpayer-consumer paying more at point of use or purchase for certain services or activities. This might include more cost-recovery in health and education, motorway charging, or environmental pricing.
4. External purchases
Although the Government has huge economies of purchasing scale, these get dissipated or negated by poor procurement practices. We need a concerted effort to improve these commercial skills. And we need to avoid high-cost, long-term commitments for the sake of short-term cash savings.
5. Redistribution and social protection
This covers the actual money-flows on welfare and so on, not the administrative cost of this activity. There are large inefficiencies and distorted outcomes under this spending umbrella, the largest single spend category. Social goals might be maintained, but spending much better targeted and managed.
6. In-house staff
The toughest nut of all, but critical - addressing numbers, base pay and pension cost. Rectifying historically low and bad investment patterns in IT will be key. There will be too many middle and senior managers on salaries that are too high, and too many self-feeding non-jobs. The underlying need for many processes, departments, layers and quangos will need to be challenged.
COUNTING THE CUTS
Privatisations and disposals: £5bn
Investment deferrals: £0 (Let's be intellectually rigorous and put zero)
Revenue-raising offsets: £10bn
External purchases: £15bn (about 6% of relevant spend)
Social transfers: £20bn (10%-15% of relevant spend)
In-house staff (i): £10bn (real service delivery (eg, NHS, education, local services), 6% of spend)
In-house staff (ii): £10bn (management and back-office and non-jobs, 20% of spend)
TOTAL SAVING - £70bn
By pursuing these, we could save £70bn (see above), about 12%-13% of current spending. Not yet the 15% target, and not yet enough to fix the 25% overspend versus tax revenue.
In recent years, Canada, New Zealand and Sweden have made concerted efforts to roll back public sector overspend and inefficiency. Among Europe's deficit and debt-laden PIGS, Ireland seems to be biting the cost bullet, while the others - Portugal, Italy, Greece and Spain - are pretty much in denial (how would you like an air traffic controller's job in Spain at EUR500,000 a year?).
When you drive up efficiency and productivity in state spending, you get a kick-up in long-term growth across the whole economy. If you do it well, you don't need to make unpleasant trade-offs between social support and institutional investment; in fact, you get more resources and better social outcomes. So cost efficiency in the public sector can simultaneously serve the agendas of both the more right-wing small-state advocates and of the more left-wing state-as-benefactor champions - and anyone holding in-between positions who wants to see maximum growth opportunity for all citizens in a fair society.
Extracted from 'Driving Down Cost: How to manage and cut costs - intelligently' by Andrew Wileman, a new, fully updated paperback with expanded material addressing the public sector cost challenge, published by Nicholas Brealey (RRP £14.99). To order your copy for the special price of £12.99 with free UK p&p, call 020 7239 0360, quoting 'Management Today'. Offer ends 30 June 2010.