On Justification Economies of Worth

STUDIES
IN THE MANAGEMENT OF
GOVERNMENT ENTERPRISE
SOCIAL DIMENSIONS OF ECONOMICS
A series of books
sponsored by
the Department of Economics,
The City College of the
City University of New York
Volume 1
STUDIES IN THE
MANAGEMENT OF
GOVERNMENT
ENTERPRISE
RICHARD J. HORN
EDITOR
MARTINUS NIJHOFF PUBLISHING

BOSTON/THE HAGUE/LONDON
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Library of Congress Cataloging in Publication Data

Main entry under title:
Studies in the management of government.
(Social dimensions of economics; v. 1)
Bibliography: p.
1. Government business enterprises-United States-
Management-Addresses, essays, lectures. I. Horn,
Richard J. II. Series.
HD3887.S78 353.09'2 80-21349
ISBN-13: 978-94-009-8140-9 e-ISBN-13: 978-94-009-8138-6

001: 1 0.1 007/978-94-009-8138-6
Copyright © 1981 by Martinus Nijhoff Publishing

Softcover reprint of the hardcover 1st edition 1981
No part of this book may be reproduced in any form by print, photoprint, micro-
film, or any other means without written permission from the publisher.
Contents
Introduction by Richard J. Horn 7
1. The Government as Manager: Weapons Procure-

ment by James M. Suarez 10
Notes 23
Comments on "The Government as Manager:
Weapons Procurement" by Seymour Melman 24
2. A First Approach to the Economic Theory of

College Management by Barry Bressler 28
Notes 57
Comments on "A First Approach to the
Economic Theory of College Management
by Charles E. Lamberton 59
3. A Post-Accord History of Principal Federal Re-

serve Functions by William B. Harrison 63
Notes 90
Comments on "A Post-Accord History of Princi-
pal Federal Reserve Functions" by Bernard
Shull 92
4. Public Ownership and Natural Resource Utiliza-

tion by David L. Shapiro and Robert B.
Shelton 96
Notes 104
Comments on "Public Ownership and Natural
Resource Utilization" by Gerald Sirkin 109
5. The Development and Implementation of an
Operational Planning System by Gary
Gappert and Martine G. Brizius 114
Notes 139
Comments on "The Development and Implemen-
tation of an Operational Planning System"
by Ellen Susanna Cahn 141
6. New York City's New Integrated Financial Mana-

gement System (lFMS) and Its Managerial
Consequences by James D. Hardy 144
Notes 172
Comments on "New York City's New Integrated
Financial Management System (IFMS) and
Its Managerial Consequences" by Harvey T.
Dill and Roger P. Murphy 176
Introduction
The six studies in this volume represent investigations into

aspects of the management of government enterprise. For the
most part the concern is with those governmental units or
agencies that provide products having nongovernmental
counterparts. In each case the enterprise is taken as given, and
there is no attempt to justify the participation of government in
the production of goods. Instead, these studies attempt to
define the positions and the functions of the decision makers,
to evaluate product and pricing decisions and to specify
appropriate mechanisms for providing the adequate and
timely information required for efficient control.
The first two studies examine the managerial role. James
Suarez defines an enviornment in which the typical public or
private sector classification does not apply. Given the
monopsonistic position of the government in the armaments
market, many managerial marketing decisions are not
available to private firms. Thus the objectives of the
participants in this market appear to be confounded. Suarez
investigates this interdependent relationship.
8 STUDIES IN THE MANAGEMENT OF GOVERNMENT ENTERPRISE
In "A First Approach to the Economic Theory of College

Management," Barry Bressler addresses the problem of
resource allocation within the college establishment. Bressler
draws on utility theory to define the manager's objective
function and on the imposed budget reductions suffered by
units of the City University of New York to suggest some of the
implications of this managerial construct.
The third and fourth papers concentrate on the products of
two government enterprises. In the first case William Harrison
discusses the range of nonmonetary functions assumed by the
Federal Reserve Banks. Those services have been overshadowed
by the monetary role played by the system - services largely
ignored in discussions among economists and largely
unnoticed by the general public. Harrison treats each service
intensively in order to give a complete account of Federal
Reserve activity and productivity.
Shapiro and Shelton approach the managerial decision-
making process by defining an objective function that differs
from that examined by Bressler. Bressler's manager maximizes
utility given a budget constraint. Shapiro and Shelton
investigate an agency that can affect its budget through the
pricing of its product. However, unlike profit-motivated firms
that have pricing power, the government agency involved may
set prices below the marginal cost of production.
The final two studies deal with the application of managerial
techniques in governmental bodies. In both cases the
approaches described have been implemented in order to
expedite the flow of information needed to make timely
decisions.
Gappert and Brezius describe and evaluate a planning
system used by the New Jersey State Department of
Education. This system incorporates aspects of the Planning-
Programming-Budgeting system and the Management-by-
Objectives system. It permits the agency to specify its
objectlves and to measure its success in reaching its goals.
Introduction 9
The last paper by James Hardy describes New York City's

need for a financial managment system by analyzing the
Integrated Financial Management System designed to meet
the requirements of the city and of the financial community as
well.
RICHARD J. HORN
The City College of New York
STUDIES IN THE MANAGEMENT OF GOVERNMENT ENTERPRISE
The Government as Manager:

Weapons Procurement
JAMES M. SUAREZ*
A firm engaged in a major program for the Defense De-

partment is a hybrid. Although a weapons manufacturer is os-
tensibly a private enterprise, to a great extent it is managed and
controlled by the government, for the government determines
many of the firm's broad policies and detailed operating proce-
dures. For a large portion of the economy the distinction bet-
ween public and private enterp!ise has become blurred as the
government has taken on a number of the decision-making
functions that in a wholly private enterprise would be the pre-
rogative of management.
Included in this intertwined public-private sector are
entire corporations, such as Lockheed, General Dynamics,
Grumman, McDonnell Douglas, and Northrop and nearly au-
tonomous divisions of large diversified corporations, such as
the North American Aviation and Aerospace divisions of
Rockwell International and the Pratt & Whitney and the Si-
korsky divisions of United Technologies.These companies and
divisions are geared to meeting the needs of the Defense De-
partment instead of the private marketplace. Prime defense
contractors do not make standard, off-the-shelf commercial
products. Rather they manufacture specialized commodities
*Hunter College, CUNY.

The Government as Managers: Weapons Procurement II
according to the government's order. This chapter will discuss

the characteristics of the defense market and of the businesses
that perform military work. It will then examine how the
government manages these firms.
CHARACTERISTICS OF THE DEFENSE

MARKET
The demand side of the defense market has at least three

important features: There is essentially a single customer, the
total outlays for defense procurement have risen over the
years, and the demand for any particular weapon is less sen-
sitive to price than to other factors.!
The government is the sole domestic purchaser of military
equipment. No one else in the country buys supersonic stra-
tegic bombers, intercontinental ballistic missiles, nuclear sub-
marines, tanks, or any other major component of defense
hardware. Export sales of weapons to foreign nations require
government approval to make sure that the transactions con-
form with national-security and foreign-policy goals. The go-
vernment's monopsonistic power creates notably different
market relationships compared to the commercial sector of
the economy.
Since the end of World War Il,military procurement out-
lays have grown at a fairly stable rate. During the Korean and
Vietnamese wars the buying of military equipment tempora-
rily increased. Although the overall budget for defense spen-
ding has climbed steadily, demand for specific weapons has
fluctuated drastically. Indeed, following a brief time of heavy
expenditures, acquisition of some items (for example, air-
breathing missiles and liquid-fueled booster rockets) ended.
The demand for military hardware is less responsive to
price than to other considerations. The defense establishment
views weapons systems as "necessities" required to maintain
a satisfactory level of domestic security. This attitude gives to

most defense projects low price elasticities of demand. Price
alone seldom determines the acquisition of a weapon.
High performance, short delivery times, political and
economic conditions, national strategic planning objectives,
the capability of technology to produce a weapon, and the
estimated capability of a potential enemy to produce a weapon
play important roles in influencing purchases. The special
interests of individual politicians, weapons manufacturers,
and military officers may occasionally be significant.
On the supply side of the market, the production of major
weapons systems tends to be concentrated in a relatively few
firms. The fifty largest defense contractors generally account
for nearly two-thirds of all prime contract awards. Moreover,
the purchasing pattern has been consistent over time. Despite
some turnover in the list, the firms, their ranks, and their dollar
volumes of business with the armed services have been stable. 2
This stability may seem to conflict with sharp swings
encountered in the demand for a given weapons system. If
procurement of a particular weapon can shift so drastically,
how can the same corporations appear regularly on the list of
recipients awarded military prime contracts? The answer to
this question relates to the nature of the product exchanged in
the defense market, or what the defense companies really sell
to the government and what the government really purchases.
Major weapons contractors are not engaged in the business
of making anyone piece of military equipment. In most cases,
the government buys a product that has certain specified
characteristics but has never before been made. The defense
firm sells its management, research, and production personnel;
its facilities; its scientific and engineering talents; its experience
in researching, designing, testing, and producing complex
weapons systems; and its ability to meet the government's
specifications. In effect the government buys the company's
skills to manufacture a conceptual commodity with projected
The Government as Managers: Weapons Procurement 13
qualities.
The unusual nature of the product offered by military firms
leads to a number of other distinguishing characteristics of the
defense market: a lack of impersonality, prices based on
anticipated or actual costs, the importance of nonprice
competition, a long production cycle,a short product life, the
overriding significance of technology, and the presence of
various barriers to competition.
In each year of the last two decades, more than 80 percent of
total military prime contract dollars has been awarded
through negotiation. Normally the government selects a small
group of suppliers that it considers capable of carrying out a
project. After a series of negotiations and tests, the
government chooses one company to receive a contract.
During the selection process the government works closely
with the contractors. The resulting relationship between the
government and the weapons manufacturers is by far more
personal, intimate, permanent, and interdependent than the
usual ties in commercial markets.
The impersonal interaction of competitive supply and
demand market forces does not determine weapons prices.
Most prime contracts are let on a cost-reimbursement basis to
a single producer. The final price depends on costs actually
experienced plus a separately negotiated fee or profit.
Competition among defense contractors concerns variables
other than price. Because the demand for weapons is inelastic
with respect to price and the price forecast for a specific project
is a problematic estimate tenuously based on expected future
costs, weapons manufacturers do not engage in direct price
competition. The government emphasizes that military
weapons must be of the highest quality. Rivalry among defense
contractors centers on technical performance and
development time. Firms frequently use their records of
accomplishment on previous weapons contracts as selling
points.
Defense contractors manufacture weapons systems only

after obtaining government orders. Production is not under-
taken on speculation or for inventory. Many years usually
elapse between the negotiations on the research contract and
the delivery of a final product. During the long design,
development, and production cycle, the government finances
the bulk of a firm's activities on the project. The Defense
Department provides working capital in the form of progress
payments (outlays given to the contractor while the work is
still underway) and supplies industrial plant and equipment to
the producer.
Military products tend to have short lives. Rapid
technological change may make a weapon obsolete before the
scheduled production is finished, in some cases even before
production begins. For instance, improvements in electronic
target selection, and bomb guidance systems made the A-lO
attack plane obsolete before it was built in 1973.3
Technology has an extraordinarily pervasive impact on the
defense market. Technology becomes virtually an end in its
own right, and technical superiority of hardware rises to
paramount importance. In <,lefense planning the potential to
produce a weapon can be as valuable as having a weapon ready
for deployment. The share of military procurement funds
spent on research, development, testing, and evaluation of
projects is much greater than the portion of sales expended on
research and development in the commercial part of the
economy. In a sense these research outlays create the demand
for more defense spending because fruitful research induces
the government to purchase the new weapons now made
technologically feasible.
Not only does technology affect the level and the
composition of the demand for military equipment, but it also
influences the structure of the supply side of the market.
Research expenditures are even more concentrated than
general procurement funds. Large firms with big research
staffs covering diverse fields receive most of the outlays.

Emphasis on the technological superiority of weapons is
chiefly responsible for the unimportance of price competition.
In addition, technology is a principal impediment to
competitive behavior in the defense market.
Various barriers to free entry and exit exist in the defense
industry. The engineering and scientific knowledge,
experience, and equipment required to develop and produce a
modern weapon system present the main bar to entry into the
market. Few companies possess or can acquire the skills
needed to compete for a prime contract award. The necessary
technical knowledge is hard to acquire without previous
experience in carrying out a similar project.
Government procurement policies pose added obstacles to
entry. The monopsonistic power of the government allows it to
determine the firm's entry, growth, exit, and business
practices. A large number of companies that object to close
government supervision of their activities refuse to bid on
military work. The high overhead costs of complying with
government regulations eliminate many firms. Until a
company actually become a defense contractor, its ability to
satisfy the paperwork requirements and to estimate the
compliance costs is uncertain.
National security restrictions strengthen the government's
discretionary control of the market. Although weapons are
extremely differentiated commodities, a rival cannot study
another firm's product in order to compete against it unless the
Defense Department gives permission. The government is
often in a position to decide whether it will make available to a
particular firm information that the company may need to
prepare a winning bid on a project.
Finally, several factors hinder exit from the defense market.
Many efforts of defense contractors to compete in the
commercial sector have failed. The skills of weapons
producers seem not to be readily transferable to civilian
endeavors. 4 Unlike producers of civilian goods who use low-

cost large-volume production techniques, defense contractors
employ very specialized labor and capital to make a limited
run of a high-cost, extensively-refined product requiring small
error tolerances. Much of the military's scientific knowledge
has no commercial application. Defense contractors have little
marketing talent or experience. Perhaps most importantly, the
overall stability of military spending does not stimulate leaders
of defense firms to move their companies out of the industry.
Top management has no strong incentive to convert to civilian
production as long as the likelihood of a sharp, permanent cut
in military spending is remote.
The Government as Manager

of Defense Contractors
The government has essentially become the manager of a
prime defense contractor. The Defense Department makes
many central decisions for the firm: what products to
manufacture, what accounting and information systems to
follow, what sources of finance to use, what marketing
methods to employ, what personnel policies to implement,
what production techniques to use, and what research fields to
investigate. In order to control the activities of the weapons
producers, the government maintains various direct and
indirect supervisory devices. After showing how the
government determines a firm's products and in general
regulates a company, the military's influence on a firm's
accounting, finance, marketing, personnel, and research
policies will be examined. 5
The government makes the ultimate decisions about the
important features of the product that a contractor will make.
Modern weapons systems. are intricate, complex, specialized
items designed and produced according to the government's
specifications. The Defense Department determines the basic
requirements for a weapon and hires a contractor's capabilities

in research and production to develop the design concept into
an actual product. Traditionally the government issues
detailed specifications concerning weight, size, speed,
tolerances, and other qualities. The Air Force spent five years
and $140 million writing the specifications for the B-1 bomber
that was canceled in 1977 before a production run had started. 6
When a company wins a prime defense procurement award
and signs a government purchase contract, it enters into an un-
usual, close, and continuous relationship with the one custo-
mer for its products - the military establishment. The govern-
ment assumes the right to make many decisions about the in-
ternal operations of a defense contractor that are commonly
considered in the private economy to be the exclusive domain
of the firm's management. Government control and regulation
of the enterprise lasts during the life of the contract and in
some areas a few years after the termination date.
The association between the government and a defense con-
tractor differs in basic respects from the normal relationship
between a buyer and a seller in the private sector. Defense con-
tractors must follow the rules of conduct of a government
agency. In fact they are more similar to government agencies
than to ordinary private enterprises. The military extablish-
ment determines, or actively participates in, numerous major
policy issues and specific operating practices of the businesses
involved.
Procurement methods and regulations governing the en-
suing contracts provide the chief means by which the govern-
ment takes over the management role of prime defense con-
tractors. As the sole purchaser of weapons systems, the gov-
ernment negotiates to select a contractor without formal ad-
vertising and without formal price competition. The military
has the power to choose a firm that will produce a commodity
to the government's best advantage, considering price and
other factors. The Defense Department has wide latitude in
picking the initial group of participants in a project as well as

the final procurement source.
In a prime contract the preliminary negotiations set forth the
general statement of work, the estimated price, and further
contract terms. Standard contract clauses give the government
the right to alter the contract unilaterally. The Defense De-
partment can cancel completely or can order a major change in
a contract without the consent of the contractor. The con-
tractor must accept the modification.
The Armed Services Procurement Regulation (ASPR), with
which all military producers must comply, indicates a
multitude of ways in which the Defense Department becomes
deeply involved in the day-to-day activities of the contractor.
ASPR is comprised of nearly 3,500 pages of rules covering the
entire acquisition proccess. Each semiannual ASPR edition
is issued in 54,000 copies about half of which go to defense
contractors and the remainder to the Defense Department and
the general pUblic. The size and detail of ASPR reflect the
extent to which the government controls a firm's business
practices. The defense establishment's supervision of a
contractor includes direct surveillance and elaborate reporting
requirements.
A program manager in Washington personally monitors a
weapons project. The Defense Department's program officer
has general authority over initial specifications, design,
reliability, costs, and schedules. Program managers approve
plans to subcontract and the choice of a subcontractor. A
contractor's proposed changes in design, costs, and schedules
must be ratified by the program manager.
On-site supervision by the Defense Contract Administration
Service (DCAS) supports a program officer's overall manage-
ment and periodic inspections. The DCAS was created in 1963
to consolidate the administration of defense contracts. If a
contractor's plant has numerous or large continuing projects,
the DCAS will establish a resident field office at the plant.
DCAS plant representatives keep the program manager in the
Pentagon informed about the contractor's activities and the
extent to which the firm is fulfilling the terms of the contract.
Supplementing the DCAS plant representative system are
extensive documented reports required by the military.
An internal business function controlled by the government
is a military producer's accounting procedures. A company
must use the accounting and information systems mandated
by the Defense Department. Most prime weapons contracts
are on a cost-reimbursement basis. Because all property
bought by a contractor and billed to the government belongs
to the government, a contractor must submit to detailed audits
before and after the contract. A firm must keep comprehensive
records of property and provide certificates attesting to the
accuracy and completeness of the cost data.
Under a cost-reimbursement contract the government
decides which expenditures are allowable and allocable to a
contract. The usual unallowable costs are advertising and
selling expenses, management bonuses, and research outlays.
(Until fiscal 1977 interest payments were not allowable.) By
not allowing certain kinds of expenditures the Defense
Department can clearly affect a contractor's operations.
A defense project imposes heavy administrative and
information-gathering burdens on a weapons manufacturer. A
contractor's reports must inform the military about the use of
funds and the cost behavior of a project. A firm has to
demonstrate that funds are adequate to perform the tasks
scheduled in the next few months as well as over the life of the
contract. Funds should be spent at the budgeted rate. A
contractor must follow the Project Evaluation and Review
Technique (PERT) that mandates comparing actual program
progress to the originally forecasted objectives. A prime
contractor must employ value engineering staffs, cost and
schedule control systems, and technical performance
measurement criteria.
A second managerial function greatly influenced by the

government is financial policy. The government finances the
bulk of a contractor's working and fixed capital. Before fiscal
1977 if a manufacturer used private sources of finance, its
interest payments could not be charged to the government and
would reduce the firm's profits. Weapons producers therefore
relied on the Defense Department to supply funds.
The government apparently believed that by this financial
arrangement it would benefit from smaller total costs
because i~ could raise capital at a lower interest rate than could
the contractors. The government routinely permits progress
payments for 80 percent (sometimes up to 95 percent) of the
costs incurred on a project without charging interest to a
contractor; and at no cost to a company the military often
gives to a firm for its use government-owned plant and
equipment.
The dollar amount of government financing of weapons
makers is considerable. At the end of 1976 the Defense
Department was providing $5.9 billion in interest-free,
working capital progress payments to the aerospace industry
alone.7 The Defense Department owns 149 manufacturing
plants worth $5.5 billion and over 100,000 pieces of industrial
equipment. 8 Much of this fixed capital is for the exclusive use
of a single contractor. During the late 1960s the government
owned 99 percent of LTV Aerospace's 6.7 million square feet
of office and laboratory space. 9 At one time the military owned
a plant located within a Lockheed complex that was dependent
on Lockheed for access and water. In 1973 the government
sold that plant to the only feasible buyer, Lockheed.1°
Starting in fiscal 1977 the government permits defense
contractors to charge it for the cost of buying or leasing plant
and equipment. Another change is that the Defense
Department now takes into account a firm's capital investment
in setting profits on new contracts. Profits will rise if a firm
increases the use of its own fixed capital. The earlier approach
did not offer weapons manufacturers an incentive to invest in
more efficient machinery. Any cost-reducing investment by a
contractor would tend to cut profits in the short run (interest
pa yments were not allowed) and in the long run (future profits
would be based on lowered costs). The recent measures seek to
encourage weapons manufacturers to invest in more
productive equipment and to use private sources of long-term
finance.
The Defense Department also affects marketing, personnel,
production, and research programs of weapons manufacturers.
Decisions about prices, quantities to be produced, advertising,
and distribution channels are aspects of the marketing function
in a commercial firm. A defense contractor has little need for
these marketing skills. Costs and negotiations with the govern-
ment determine the price of a product. The military decides how
much to produce. Advertising, an unallowed cost on a defense
project, usually does not promote a particular weapons system
as much as it tries to strengthen a company's image. Defense
contractors deliver directly to the location chosen by the
government. The military becomes responsible for subsequent
distribution and servicing.
The government has a strong impact on the personnel
policies of a weapons producer. Over and above the labor-
practice laws applicable to all employment in businesses
engaged in interstate commerce, a weapons maker must
comply with many specific regulations dealing with millitary
work. All prospective employees are subjected to security
clearance checks into their backgrounds. On a large program
the Defense Department approves a contractor's upper level
management appointments. Defense companies must pay the
legislated minimum, average, and overtime wage scales for
military projects. The government supervises labor disputes
and new labor-contract agreements. It sets work and safety
rules.
For a major weapons system the Defense Department
decides the production methods. The government approves

the production process before the contract is let. Once the
award is granted, the military determines the need for overtime
or mUltiple shifts, the decision to make or buy a component or
to subcontract work, the selection of a subcontractor, and
quality-control tests. Cost considerations playa minor role in
production compared to performance characteristics. The
government pays for all allowable expenses incurred in a
project. Cost minimization is not a goal. To a defense
contractor decreased costs result in less profit on the current
project, a diminished base for negotiating profit as a
proportion of costs on succeeding projects, and decreased
government payments for overhead expenses that are most
frequently calculated as a percentage of direct costs.
Finally, by financing research and development programs,
the government greatly determines what new products a
weapons manufacturers will make. Furthermore, the Defense
Department relieves contractors of any risk of failure.
Irrespective of whether deployable new weapons are
developed, the government rewards military research efforts.
CONCLUSION
Although the government has effectively become the
manager of defense contractors, it not an efficient one. On the
whole, the costs of weapons projects far exceed the originally
estimated amounts, technical attributes fall well below
predicted capabilities, and delivery is effected long after the
scheduled time. 11 By regulating weapons manufacturers, the
military has virtually transformed them into arsenals. Strict
government controls assure certain minimal levels of
contractor performance but preclude the important
advantages of the innovative, competitive, and cost-
minimizing incentives of private enterprise.
The Government as Managers: Weapons Procurement \ 23
NOTES
I. More complete descriptions of the defense market can be found in W. L. Baldwin,
The Structure of the Defense Market. 1955-1964. (Durham, N. c.: Duke University
Press, 1967) and M. L. Weidenhaum, The Economics of Peacetime Defense. (New York:
Praeger, 1974), chapter 4.
2. Baldwin, op. dt. p. 16.
3. J. W. Canan, The Superwarriors. (New York: Weybright and Talley, 1975), p. 233.
4. M. L. Weidenhaum, The Modem Public Sector. (New York: Basic Books, 1969),
chapter 3, details the numerous failures of defense contractors in attempting to sell
commercial products at a profit.
J. R Fox, Arming America, (Boston: Harvard University Press, 1974), discusses in
great detail the technical steps of the weapons acquisition process. S. Melman, Pentagon
Capitalism, (New York: McGraw-Hill, 1970), summarizes important aspects of Defense
Department procurement methods.
6. The Wall Street Journal. July 22, 1976, p. 1.
7. Businessweek, January 10, 1977, p. 53.
8.Businessweek, August 18, 1976, p. 49.
9. R.Lapp, The Weapons Culture, (Baltimore: Penguin, 1969), p. 13.
10. Businessweek, August 15, 1975, p. 48.
II. See J. M. Suare~ "Profits and Performance of Aerospace Defense Contractors,~
Journal of Economic Issues, 10:2 (June 1976), pp. 386-402, for the recent behavior of
some major defense fmns in meeting cost, technical performance, and delivery estimates.
REFERENCES
Agapos, A. M. Ovemment-Industry and Defense. Alabama: University of Alabama
Press, 1975.
Baldwin, William L. The Structure of the Defense Market. 1955-1964. Durham, N. c.:
Duke University Press, 1967.
Businessweek. "The New Faoe of the Defense Industry,M January 10, 1977, pp. 52-58.
Fox, J. Ronald. Arming America.Boston: Harvard University Press, 1974.
Gorgol, John Francis, "A Theory of the Military-Industrial Firm, Min Seymoun Melman,
ed., The War Economy of the United States. New York: St. Martin's Press, 1971.
Kennedy, Gavin. The Economics of Defense. Totowa, N. J.: Rowman and Littlefield,
1975.
Lapp, Ralph. The Weapons Culture. Baltimore: Penguin, 1969.
Melman, Seymour. Pentagon Capitalism. New York: McGraw-Hill, 1970.
- - - - - - - , ed. The War Economs of the United States. New York: St. Martin's
Press, 1971.
Suarez, James M. "Profits and Performance of Aerospace Defense Contractors" Journal
of Economic Issues, 10:2 (June 1976), pp. 386-402.
U. S. Department of Defense. Defense Procurement Handbook, Washington: U.S.
Government Printing Office, 1975.
------.Armed Services Procurement Regulation. 1976 edition. Washington:
U. S. Government Printing Office, 1976.
Weidenbaurn, Murray L. The Economics of Peacetime Defense. New York: Praeger,
1974.
-------.The Modem Public Sector. New York: Basic Books 1969.
Comments on
(( The Government as Manager:
Weapons Procurement "
SEYMOUR MELMAN'"
This overview of the managerial role of the federal govern-

ment in about 20,000 industrial firms (all prime contractors to
the Pentagon) is the kind of discussion that should evoke
excitement among economists, political scientists, and
sociologists. For what is reflected is very likely part of the great
transformation of American industrial capitalism from
primarily private capitalism to primarily state capitalism. To
illustrate some of the issues that are involved, I shall call
attention to the following six problems that are evoked by this
discussion.
1. Where are top decisions in the military economy made?
Notice that in the case of the decision on the B-1 bomber many
identifiable groups participated: the contracting and the
subcontracting firms, trade unions, trade associations,
political organizations for and against larger military budgets,
the Congress of the United States, and others. In one view of
private capitalism -notably, its monopoly-capitalism form-
final political-economic decisions about the economy and
society are made by the top managers of private corporations.
"'Department of Industrial and Managerial Engineering, Columbia

University.
Comments on "The Government as Manager ... " 25
In the present case there is little evidence that the Rockwell
Company, which had very much at stake in the B-1 decision,
was able to exercise a controlling influence. Neither was there
evidence that the Boeing Corporation, which stood to gain
from the new emphasis on cruise missiles, was heavily involved
in the decision not to go ahead with the B-1 bomber
production. Although all other parties named here played
parts, on the evidence available in mid-1977 it appears that the
final decision was made by the president, acting on the advice
of the secretary of defense who, in turn, weighed the military-
economic merits of alternative weapons systems and their
meaning for power among the major branches of the U.S.
armed services. On the available evidence, the top decision
maker was the president of the United States. He apparently
played the role of chairman of the board for one of the most
significant decisions in the American economy.
2. How and to what degree has the federal government been
shifting from being a "regulator" to functioning as the
"manager" of the military economy? One of the very important
and burgeoning sectors of the military economy is the foreign
military sales program. On the evidence, the Pentagon has
taken a major administrative lead in setting up a worldwide
sales organization for pushing American arms sales. At many
points the official selling organization operates in conjunction
with military materiel manufacturers. However, even though
the managers of military industrial firms wage intensive
campaigns for the sale of their respective products, both the
formal structure and the knowledge of field experience
indicate that the government plays the dominant role: it casts a
veto with respect to arms sales abroad and determines the size
of the order, approves or disapproves of the customer, and
arranges for the larger part of financing to make the sale
possible. At what point did the federal government become a
manager instead of a regulator? What are the characteristics of
the regulatory functions as differentiated from the managing
functions? How does one define the transition from regulation

to managing?
3. What is the significance of the military economy for class
relations in industry? For more than a century it has been
widely accepted that occupational class differences between
decision makers and producers constitutes a major category
for understanding the behavior of the people in each of these
groups. Class conflict, involving employees ranged against
managers, has been a continuing part of the industrial
capitalist economy. But something happens in the military
economy that may represent a substantial modification of
both occupatio mil-class position (meaning situation) and
behavior. In the military economy unions and managers often
work in concert to secure and hold contracts, and both parties
often relate in a cooperative manner to the Pentagon
controllers who are located in the larger plants and report on
operations to the Pentagon's central office. As this behavior
persists, what happens to the classic condition of class position
and class relations?
4. What consequences for the microeconomy of private
capitalism flow from the sustained operation of a cost-
maximizing microeconomy as part of the network of the
military economy? Private firms under industrial capitalism
have always sought to maximize their profits and minimize
their costs. In a military economy, however, there seems to be
the development of cost maximizing offset by subsidy
maximizing. As this behavior becomes institutionally fixed,
what is its consquence for the rest of the system, that is, the
civilian economy? In what ways do the cost-maximizing
practices of a military economy infect the rest of the system?
How does one recognize the presence of cost maximizing in a
firm or in an industry? To what degree have industries become
cost maximizers? What indicators of the presence and the
intensity of cost maximizing can be operationally useful?
5. What consequences for the political economy of
Comments on "The Government as Manager ... " 27
American society derive from the creation of a large cadre of
occupations with a primary economic stake in a military
economy? The question is posed not simply because several
million people get paychecks for doing work that serves the
military. That in itself would make for major economic
dependency. The question of linkage and dependency,
however, is amplified by the specialized character of many of
the occupations in a military economy. Thus to the extent that
the substance of occupations has been affected by the cost- and
subsidy-maximizing patterns of a military economy, the
people involved do not have occupational skills that are
readily transferable to cost-minimizing enterprises or
institutions.
6. What evidence, if any, is there of the ability of military
industry firms to convert their physical facilities and work
forces to civilian work? There is reason to doubt the feasibility
of this conversion if it is left to military industry management.
That is not to say that occupations cannot be changed and that
people cannot learn new ways. It is to say that the managers of
military industry firms have shown little interest in or
capability for carrying out such a task. The evidence, for
example, of the Rohr Corporation as a contractor for the
transit systems in San Fransisco and Washington suggests a
grim prospect with respect to the feasibility of conversion to
the civilian economy.
A First Approach to the
Economic Theory of
College Management
BARRY BRESSLER*
Economists have spent a great deal of time and energy

attempting to provide a meaningful analysis of the firm. The
firm has invariably meant a profit-maximizing or at least a
profit-conscious concern. There is virtually no economic
theory of how governmental of other nonprofit institutions
reach equilibrium by balancing various objectives and
payoffs. In particular, one would expect that academic
economists would have contributions to make in
constructing a theory of college or university management.
Do college executives attempt to maximize one or a group
of variables? Are their decisions rational or haphazard? Do
*The author is professor of economics and chairperson of historical,

political, and economic studies at the College of Staten Island, a unit of the
City University of New York. He wishes to acknowledge his debt to the
University Faculty Senate, to the Professional Staff Congress, and to all
faculty members who have over the years worked for full disclosurre of the
budget-making process. The author is also grateful to Dr. Eumond Volpe,
president of the College of Staten Island, for having made available to the
faculty a great deal of useful budget information, for reading the manuscript,
and making some interesting comments and suggestions. Needless to say,
this acknowledgement does not in any way imply agreement with the ideas
expressed in the final version of the paper. Finally, the author thanks
Professors Harold Taylor, Robin Carey, Henry Wasser, and Tom Prapas for
discussing his early thoughts on the subject and for encouraging his efforts.
A First Approach to the Economic Theory ... 29
their objectives coincide with the best interest of their
institutions? What tradoffs are made among competing
objectives? How is an equilibrium position attained, if it is
attained at all? What are the implications of such efforts?
This paper reflects a mathematical inquiry into the
conditions for optimum executive decision making within a
college or a university. The City University of New York (17
constituent undergraduate colleges and one Graduate Center)
is used to provide the skeleton of a model that demonstrates
how a college administration allocates its scarce resources
subject to budgetary constraints.
BACKGROUND
For many years methods and details concerning the
allocation of budgets within colleges were largely hidden from
the public view. Indeed, even in the case of public universities,
precious little was known of what factors determined the
portion of the budget that was allocated to overall personnel
expenses or to instructional costs, to administrative costs, and
to nonpersonnel expenses such as equipment, supplies, and so
on.
Only in very recent years have the interested public in gener-
al and college communities in particular been able to glean
some knowledge-although incomplete at best-of how and
through what process the college pie is divided. Ironically, it
took something like the near catastrophic 1976-1977 budget
for the City University to produce some general principles of
budget allocation on the part ofthe University Budget Office.
In the process of formulating those principles, the general
components that go into budget making were clearly stated for
the first time.
Very late in the academic year (June 1976) and virtually at
the dawn of the new fiscal year (July 1, 1976), the City
University was presented by state and municipal authorities
with a budget of some $470 million. That budget represented a
reduction of $69 million (or 13 percent) from the net operating

budget of the previous year. The University Central Office, for
the first time faced with the task of dividing a dwindling pie
and no longer able to add to college budgets, had to reexamine
its own allocation procedures. In previous years college
budgets were apparently drawn up largely on the basis of
adding some increment onto what each college had obtained
the previous year. But this practice would not do in the face of a
sharply reduced total budget. Nor could cuts be applied
proportionately across the board because they were so massive
and were difficult to absorb in an institution that was
committed to keeping all programs, divisions, and units intact.
Instead, areas of secondary or tertiary priority had to be
identified, efficiency criteria stated, and principles developed
that would provide some logical justification for any
allocation that would be made.
After some frantic study and computations, the Central
Office announced its allocations together with their underlying
formulas. One consequence was that some colleges were cut
substantially more than others. The procedure used was
based on the computation of a number (let us call ita) for each
college that represented its instructional cost per full-time
equivalent student (FTE). This number was based on required
student/faculty ratios for each college (based on whether it
was one of the older senior colleges, a newer senior college, or a
community college), the average faculty salary on each campus,
and the distribution of courses among different disciplines
with concomitant variation in acceptable class size.
The instructional component of each college's budget was
then determined by mUltiplying the computed a by the
projected enrollment for the year. To instructional costs was
added an amount for administrative and instructional support
costs that was determined by the Board of Higher Education
(BHE) resolution on permissable proportions of personnel
budgets to be allotted for those purposes. In addition, funds
for summer session, building and grounds, controllable

nonpersonnel costs, rents, fuel and energy, and fringe benefits
were included. Because the Budget Office could not derive
formulas for the latter categories, each college was allotted the
same amount as it had received the previous year. It was, how-
ever expected that the presidents of individual colleges would
shift some part of those funds (that is, summer funds, building
and grounds, and so on) to augment the funds allocated for
instructional and support services.
KEY RELATIONSHIPS
In concise form, the procedure for determining each
college's budget can be summarized by the following equation.
B=a F + A [ Q F] + K
I -A
where B total college budget
a = instructional cost per FTE (full-time equivalent
student)
F = projected FTE
A = proportion of personnel budget allowed by the BHE
for administrative and instructional support
K = amount allotted for other costs (summer session,
building and grounds, controllable nonpersonnel costs, rents,
fuel and energy, and fringe benefits).
The equation shows the derivation of the budget for each

college. Each college's budget is derived by adding together
three components: (a) an amount for instructional expenses
equal to the instructional cost per FTE (that is,a) multiplied by
the projected FTE (that is, F); (b) an amount for
administrative and instructional support services based on the
ratio of A, the permissible percentage of personnel costs for
administrative and support services, to I-A, the percentage of
personnel costs going to instructional services. Because aF is
the total number of dollars allotted for instruction, (O'F) tA

represents the amount apportioned for administrative and
support services; (c) a constant amount K carried over from
the previous year's budget for other costs.
This basic relationship can be simplified further as:

B= 0' F + -A- (0' F) +K
I -A
= -L (O'F) + K
I - A (1)
To illustrate, suppose A = .21, 0"= 1,100, F = 9,00,
K = 9,400 (in thousands). Then
B =..L.(1,IOO) (9,000) + 9,400
.79
= 22,000 (in thousands)

and a college would be assigned 22 million dollars as its total
budget.
Once a budget figure for any college is derived, the president
of the college, within the constraint of that total is free to shift
money among various categories. A president must, among
other things, ultimately decide what proportion of the total
budget will be used for personnel services and what proportion
of the personnel services budget is to be assigned for purely
administrative services.
We can derive the following important relationships.
Bp = f3B (2) B = total college budget
and f3 = proportion of total given budget alloted by
S = aBp the president for personnel services that is
IS == f3(AaB-'
NT
(3)
a) Bp
used for instructional, administrative, and
instructional support services
I NT = - a) f3BI (4) Bp = personnel services budget
a = proportion of personnel services budget
T = (I - A) Bp allotted by the president for purely
IT = (I - A) /3BI (5) administrative services
S = administrative services budget

A = proportion of personnel services budget
allowed by the BHE for combined
administrative and instructional support
services
NT = instructional support (for examples libra-
rians, counsellors, registrars, and others)
T = instructional budget
Equilibrium Conditions
The question then arises as to how a president of a college
ultimately decides the proportions of the total budget that are
to be allocated to each category of expenditures. Needless to
say, he will weigh whatever advice and input he has solicited.
But after taking all of that into considerations, he will allocate
money acording to the priorities he finally perceives. At all
times he will possess a utility function that indicates the degree
of utility (or rank order) that he associates with each of the
infinite number of possible ways of allocating his budget
among various categories. Some allocations will give him
more satisfaction and some less. We can expect that he will
strive to maximize his utility function subject to whatever
budget constraint exists.
A president's utility function can be expressed as
U = U(S, NT, T, M, D, F, Q)
Where S, NT, T, and F have already been defined and
M = management slack l (that is, management prerequisites
that are not absolutely necessary for the effective operation of
the institution - essentially, an economic rent or a return to
those who are in control of management positions.)
D = discretionary or controllable nonpersonnel costs
Q =quality or the reputation of the college as measured by
the number of faculty publications (rounded to the nearest

hundred).
The functional relationship indicates that the satisfaction
that a president derives from his budget allocations depends on
the level and the interaction of many factors. He is certainly
concerned with the amount of money allotted for staff
reporting to management (measured by administrative
services or S). Aside from the necessity of having
administrators carry out his designs, plans, and objectives, the
number of administrators at his command is surely a sign of
status and power. But his satisfaction is also linked to the size
of his teaching faculty (T) and instructional support staff(NT)
because they constitute the backbone of what a college
produces. They are responsible for the reputation of the
institution.
Management slack is a return to the president and the cadre
of managers responsible to him. It is of ever-increasing
importance especially in a situation (such as City University) in
which the president's salary is fixed by formula and is
independent of actions that he takes or of the efficacy of his
performance. The level of discretionary spending is vital to any
president because, aside from its importance in building a
respected college, it gives him command over resources unlike
the amount that he must assign for noncontrollable expenses.
The size of the college is, of course, intertwined with the num-
ber of students enrolled, and F is a measure of this size. The
greater the number of students, all other things being equal,
the greater the power of management and the easier it is
acquire resources from central university authorities.
Finally, it is reasonable to expect that a president will derive
positive utility from an enhanced academic reputation. The
latter, in turn, is frequently linked to the research productivity
of the faculty. Simply quantifying numbers of pUblications is,
of course, woefully inadequate because of the wide diversity in
quality, contribution, and impact. What is really needed is
some measure that would apply suitable weights to different
publications. We have defined Q only for simplicity. The
results reported in this paper would remain essentially
unchanged irrespective of whether a more sophisticated
measure were used.
The desire to maximize utility must, of course, be related to
the budget constraint facing the college. This constraint can be
expressed as
B = T+NT+S+M+D+ND
where T, NT, S, M, and D have already been defined and
where ND = nondiscretionary nonpersonnel costs beyond the
control of the institution, for example, fuel, rents, and so on.
This equation states that the entire budget will be spent on
personnel costs for the instructional, support, and
administrative staffs and on controllable, noncontrollable,
and management-slack expenses.
We are now in a position to derive the equilibrium
conditions for executive budget allocations. Any college
president making the ultimate budget allocation will seek to
maximize his utility function subject to the budget constraint.
The problem will then appear as:
maximize: U = U(S, NT, T, M, D, F, Q)
= U[t1CTB, (A-o")(jB,(l-A),a B, M, D, FO' QoJ
where relationships (3), (4), (5) were utilized and where it is
assumed that the number ofFTE's is, in the short run,beyond
the control of the president so that F = FO. It is also assumed
that Q is relatively constant because in the short run even a
change in T will not affect Q in any appreciable way. Thus
Q = QO·
SUbject to: B = T+NT+S+M+D+ND
=(I-A)(jB+(A-CT)(jB+(3CTB+ M+ D+NDO
where relationships (3), (4), (5) were again utilized and where
NO is a constant because, by definition, it is uncontrollable.
The total budget (B) is also assumed to be given and fixed. The
constraint condition is then equivalent to
,sB+M+D+NDO-B =0
We thus have a constrained optimization problem with the
four variables,s, 0, M, D. We can generally expect that in the
typical case some of the variables will be able to vary only along
a certain range. If this is the case, then such variables will have
distinct boundaries. In our case assume that
{31< {3 < {32
and 0 1< 0 < O2
that is, the proportion allotted by the president for personnel

services can realistically be no less thanj31 nor more thanj32 if
he wants to run a college. Similarly, the proportion of
personnel services to be allotted for purely administrative
services cannot be less than 0 I nor more than O 2 , Of course,
within these boundaries there is a great deal of presidential
flexibility.
Methods for solving a constrained maximization problem
are explained in [1, pp. 314-323, 3, pp. 4039-407]. The
essential procedure consists offorming a Lagrangian function
as:
F = U [l3oB, (A-o )j3B, (I-A) j3B, M, D, F, Q]+
X(f3B+M+D+NDO-B)
Necessary, or first-order, conditions for a maximization of
utility are derived by setting the first partial derivatives with
respect to each variable equal to zero and solving the resulting
equations together with the equation of constraint. This would
give us
-
aM -
aF = au +
aM
A. = 0
A. = - au
aM
-
aF = au + A. = 0
aD aD
I~ I
au au (a)
aD aM
aF ~Iau
au au
~0 I (b)
aF = au + AB =
-
a{3
-a{3
0
au = B au (e)
a{3 aM
If we take equations (a), (b) and (e) and solve together with
the equation of constraint
(lf3)B-M-D-ND = 0 (d)
we have four equations in four unknowns that can generally be
solved. Once we find the values of j3 and u, it is simple to
compute by using equations (3), (4) and (5) values for S, NT,
and T or the amount to be allocated for administration,
instructional support, and instruction.
The first-order conditions thus require that for equilibrium to
be achieved, the marginal utility of discretionary spending
(au/ aD)be equal to the marginal utility of management slack
expenditures ( au laM), that the marginal utility of additional
proportions of the budget spent on administration be zero, and
that the marginal utility of the ratio spent on personnel be
equal to the total budget multiplied by the marginal utility of
management-slack expenditure or discretionary spending.
Second-Order Conditions
Even if first-order conditions are satisfied, a maximization
of utility is not guaranteed unless the second order or sufficient
conditions are met. That requires that in addition to the earlier

equations, the following conditions (expressed in determinant
form) be met:
>0
and
<0
and
F /30 g/3
FaO ga
FMD gM >0
FOD gD
gD 0
where a double subscript under F indicates a second partial

derivative of the Lagrangian function, whereas a single
subscript under g indicates a first partial of the budget
equation.
Assuming continuity of partial derivatives, the three second-
order conditions are equivalent in our case to the following
B
o >0
o
Uf3f3 Uf3a Uf3M B

Uf3a Uaa UaM 0 <0
Uf3M UaM UMM
B 0 I 0
and
U f3f3 Uf3a Uf3M Uf3D B
Uf3a Uaa UaM UaD 0
UaM >0
Uf3M UMM UMD
Uf3D UaD UMD UDD I
B 0 I I 0
The first of these second-order conditions, in turn, can be

reduced to
B( - BU aa ) > 0
or
B2 U aa < 0
U aa < 0
Thus diminishing marginal utility of additional proportions

of the budget spent on administration is a requirement for
attaining equilibrium. Generally, we would indeed expect this
to be the case as there is diminishing marginal utility of so
many other things. In the event, however, that this condition is
not met because there is present increasing marginal utility of
additional proportions of the budget spent on administration,
there would be no equilibrium solution on the interior of the
function. Instead, a boundary solution would occur. This
would mean that the president would increase the proportion
of the budget to be apportioned to administration more and
more or as much as he possibly could. The result would be that
a would be raised to a 2, which, according to the boundary
condition, is its maximum feasible value. Of course, that will
occur only in the unlikely event of increasing marginal utility.
In any case, we have shown that a determinate equilibrium

solution is possible and indeed is to be expected.
Demand Functions
Until this point we have assumed that certain parameters
had already been stated. In particular, we worked with a fixed
budget (B) and a set proportion of pe.rsonnel services allowed
for combined administrative and instructional support
services (A). If, instead, we look at A and B as open to
variation, then we can still use"the procedure employed above
and solve forfj,a, M, D except that the solution will be given in
terms of A and B. Having values for fj and a will, in turn,
enable us to determine S, NT, and T, or the amount of money
allocated for administration, instructional support, and
instruction. Because all of the results will be given in terms of
A and B, we can consider them to be demand functions
expressing the desire or the intention of spending certain sums
of money on, say, S, NT, T, M, D depending on the values of A
and B.
All of this will become clearer in the next two sections in
which an actual illustrative utility function is used, and
demand functions are subsequently derived.
ILLUSTRATION OF THE PROCESS

OF DETERMINING
EQUILIBRIUM OF THE COLLEGE
To show how a determinate solution would actually be
computed, consider the following illustration. Assume that the
budget allocation for the college is set at 22 million dollars, the
allowable proportionate allocation for administrative and
instructional support is 21 percent of total personnel services,
noncontrollable expenses other than personnel services
amount to 6 million dollars, the projected FTE enrollment is
9,000 students, and the number offaculty publications is 2,000

(nearest hundred). Assume further that at least 30 percent of
the total budget is necesary for nonpersonnel needs and that
the bare minimum to be allotted to personnel is 40 percent. In
addition, it is absolutely necessary to have available at the very
least 5 percent of personnel services for administration and
similarly for instructional support services, that is, there would
be no way to run the college below those minimum figures.
The president's utility function is given as
U = 5InS+3InNT+4InT+2InM+3InD+3InF+4InQ
The constants in this function were, of course, chosen
arbitrarily and can be stipulated at different levels without
affecting the thrust of our conclusions. The logarithmic form
for the function (In represents the natural logarithm so
frequently used in the Calculus) was selected because it
exhibits positive marginal utility for all variables and also
diminishing marginal utility for all variables, both of which
we would ordinarily expect to be true. For simplicity, a
functional relationship was chosen so that the marginal
utilities of each variable would be independent of each other.
This need not strickly hold, but our general conclusions
would not be· altered if the marginal utilities were
interdependent. The only change that would occur would be
that computations would be more complex (especially
second-order conditions).
We then have the following situation:
Given: B = 22,000, A= .21, F= 9,000, Q= 2,000, ND = 6,000
and .40<]3<.70
.05<0<.16
Maximize: U = 51nS+3InNT+4InT+2InM+3InD+3InF+4InQ
subject to the budget constraint:
B = T+NT+S+M+D+ND
22,000 = T+NT+S+M+D+6,000
16,000 = T+NT+S+M+D
Now by the relationships (3), (4), (5), we have

T = (I-A) j3B NT =(A-a)j3B
= .79j3(22,OOO) = (.21- a) j3(22,OOO)
= 17,380j3 = 4,620j3-22,000j3a
S = j3aB = j3a(22,000) = 22,000j3a
so that our problem is equivalent to
Maximize:
U = 51n(22,000j3a)+ 31n(4,620j3-22,000j3a)+4In( 17 ,380j3)
+2InM+ 31nD+ 3In(9000)+4In(2000)
subject to the constraint:
16,000 = 17,380j3+4,620j3-22,000j3a+22,000j3a +M+D
or 16,000-22,OO0j3-M-D = 0
Form the Lagrangian function that will appear as
F = 51n(22,000j3a)+ 31n(4,620j3-22,000j3a)+4In( 17 ,380j3)
+2InM+ 31nD+ 3In(9000)+4In(2000)
+ A(16,000-22,000j3-M-D)
Now set the first partial derivatives equal to zero in order to
arrive at necessary conditions for a maximization of utility
subject to the budget constraint. We have
of = 2 - A = 0
aM M
A=.L
M
M=.1..
A
-
of
aD -
= 3 - A = 0
D
A = 3
D
D =
- 3
A
aF = 5 + 3 + 4 -
-a{3 -{3 -{3
-{3 22,000 A = 0
g = 22,000 A
{3
{3 = 12 .0005454
22,000A A
aF = 5 + 3( -22,000f3)
aa a 4,620,8 - 22,000{3a
= 23,IO0{3 - 176,000{3a
=0
(4,620{3 - 22,000{3a)a
or {3 (23,100 - 176,000a) = 0
and {3=0 or 23,100 - 176,000a = 0

rejected because a = .13125
.40 < {3 < .70
From the constraint we have

16,000 - 22,000{3 - M - D = 0
16,000 - 22,000 (0005454)-2.-.1..= 0

A A. A
16,000A - 11.9988 - 2 - 3 = 0
A
16,000 A = 16.9988
A = .0010624
M= 2 = 1882.5301
.0010624
D= 3 = 2823.7951
.0010624
13 .0005454 .5133659
.0010624
and
S = 22,00130 = 22,000 (.5133659) (.13125) = 1482.3439
T = 17,38013 = 17,380 (.5133659) = 8922.2993
NT = (.21 - 0)13 (22,000) = (.21 - .13125) (.5133659) (22,000)
= 889.405
Thus the first-order conditions can only be satisfied by
allocating 51.3 percent (/3) of the total budget for personnel
services, 13.1 percent (0) of the personnel budget for purely
administrative services, which, by corrolary, implies that 48.7
percent of the budget will go for nonpersonnel expenses and
7.9 percent of the personnel budget for instructional support
(13.1+7.9 = 21 percent = A).
In absolute dollars, $1,482,344 will be allotted for purely
administrative services, $889,405 for instructional support,
and $8,922,299 for teaching services. Moreover, $2,823,795
will be apportioned for controllable nonpersonnel costs and
$1,882,530 assigned for "management-slack' expenses.
We have, however, only explored the necessary conditions
for utility maximization. It is now necessary to examine
sufficient or second-order conditions. It has already been
shown that the second-order conditions are equivalent to the
triple requirement, namely, that
a) U oo < 0
b) Uf3f3 B
Uf30 o <0
Uf3M 1
B o
c) U f3f3 Uf3a UaM Uf3D B
U f3a U aa UaM UaD 0
Uf3M UaM UMM UMD I >0
Uf3D UaD UMD UDD I
B 0 I I 0
The computation of all relevant second partial derivatives
and the expansion of the determinants show that all the
second~order conditions are in fact satisfied for our
illustration.
Illustrative Demand Functions
U sing the above illustration, we can show how demand
functions can be derived for the variables under executive
control (M, D, S, T, NT) in terms of the parameters A and B
that will be determined outside the college.
As before, we have given: F= 9,000, Q = 2,000, ND = 6,000.
But now A and B are undetermined parameters. Our problem
is then to
Maximize:
U = 5InS+3InNT+4InT+2InM+3InD+3InF+4InQ
= 5In(f3aB)+ 3In(Af3B- afiB)+4In(f3B-AfiB)
+2InM+3InD +3In(9000)+4In(2000)
Subject to:
B = T+NT+S+M+D+ND
that is equivalent to
B-fiB-M-D-6,000 = 0
where relationships (3), (4), (5) were used.
We next form the Lagrangian
F = 5In(f3aB)+ 31n( Af3B- afiB)+4In(f3B-Af3B)
+2InM+3InD +3In(9000)+4In(2000)
+ A (B:fiB-M-D-ND)
Setting the first patial derivatives equal to zero gives

of = 2 - A = 0
oM M
A =..2-
M
M = 2
A
-of=3-A=0
oD D
A =.l
D
D=..l.
A
of = 5 + 3 + 4 - BA =0
----
of3 f3 f3 f3
Q= BA
f3
f3 = 11.
BA
1.!: = 2. + 3(-f3B)
oa a Af3B - af3B
= 5AB - 8Ba
(AB - aB) a
o
and 5AB - 8Ba = 0
- 8B - 8
a = 5AB = 5A
From the constraint we get
B - f3B - M - D - 6,000 0
-A. -A. -A.

B-12 - 2 - 3 - 6 000 = D
'
12 = B - 6,000
A.
A. = 17
B - 6,000
Substituting back into the earlier equation then gives the
following relationships that can be viewed as the college
executive's demand functions
M = 2(B - 6,000) = 2B - 12,000
17 17
o 3(B - 6,000) 3B - 18,000
17 17
S f3aB = E... ~. B = 15A 15A(B - 6,000)

BA. 8 2A. 2(17)
15AB - 90,000A
34
T = (I-A)f3B = (I-A) 12B = 12-12A = (I2-12A) (B-6,000)
BA. A. 17
NT = (A - a) f3B = (A - 5A) ill = ('12A - 60A).L
8 BA. 8 A.
~ ~2A - 6~AW ;/,000)

Thus M, D, S, T, NT have all been expressed in terms ofthe
parameters A and B that are determined outside the college.
Once A and B are given, the college's decision on how much to
allocate for M, D, S, T, NT are known immediately.
Alternative Illustration
It is instructive to see what would occur if the president's
utility function is modified somewhat.
Asume that B, A, F, Q, and ND are all given, as in our earlier
illustration, but that some change takes place in the utility
function so that it is given by
U = 2InS+3InNT+6InT+lnM+2InD+3InF+4InQ
This new utility function places less weight upon
administrative services, management slack, and controllable
nonpersonnel expenditures and greater weight on teaching
services. The budget constraint will be precisely the same as it
was before.
Workin out this illustration by forming the Lagrangian,
setting its first partials equal to zero, and solving gives us the
following solutions:
a = .084
j3 = .56819
M = 1136.36364
D = 2272.72728
S = 1050.01512
NT = 1574.98488
T = 9875.14220
Thus with the new utility function, 56.8 percent of the total
budget will be allotted for personnel services compared to 51.3
percent in the earlier illustration, and only 8.4 percent of the
personnel budget will be apportioned for purely
administrative services compared to 13.1 percent previously.
In absolute dollars, this means that administrative services will
be slashed by more than $400,000, controllable nonpersonnel
costs by more than $500,000, and management slack by more
than $700,000. On the other hand, teaching services will be
increased by more than $950,000 and instructional support by
almost $700,000. This will occur with an unchanged total
budget, with constant enrollment projections, and with fixed
noncontrollable expenses.
Needless to say, there is an infinite variety of ways to modify
the executive utility function, each one resulting in a different
allocation pattern. We can therefore expect that the way in
which funds are used in any college - even within the same
university - could differ significantly depending on variations
among presidential utility functions. Moreover, any
institution undergoing a change of chief executive can
normally be expected to spend money in different ways.
In part this explains the often observed phenomenon of a
new president entering a college scene and shifting money
around in the name of reform, efficiency, innovation, or
charting a new course. In reality, none of these phrases may be
an appropriate description of what is occurring. It may simply
be that the new chief executive has a different utility function
than his predecessor. These results also make one question the
optimality of any of these allocations. They raise some very
important questions about the "best use of resources" that is
available to any college.
Time Periods
The analysis that has so far been employed has in essence
assumed a "short-run" period because certain factors, such as
a ,j3, M, D were considered variables, whereas some, such as F
and Q, were assumed constant and not susceptible to
manipulation. In fact, several different time periods can be
delineated. We now wish to distinguish among three different
time periods, but note that others can also be identified.
Following conventional microeconomic terminology, our
time periods shall be referred to as: (a) very short run, (b) short
run, (c) long run.
Very Short Run

In the very short run, the only variable factors are
management slack (M) and controllable nonpersonnel

expenses (D). All other factors are fixed. This condition
applies typically in the middle of an academic year. Once the
academic year has begun, commitments to teaching,
administrative, and support staffs have been made for at least
the remainder of that year. 2 Allocations for all of the various
budgetary codes ordinarily have been made at about the time
that the overall budget is received. But it is quite possible (and
indeed has on occasion occurred) for the overall budget to be
decreased after the advent of the academic year, whether
stemming from municipal, state, or university machinations.
Theoretically, of course, it is possible - albeit unheard of in
practice - for the overall budget to be increased. In either
case, given its commitments to its staffs (assuming that
retrenchment is not a realistic option in mid-year), the college
will have to modify its allocation for M and/ or D.
Under these circumstances, the following situation would
obtain. Constants: T =To, F =Fo, Q =Qo, B =Bo, A =Ao,]3 =
fi o• a= ao
Variables: M, D
and relationships (3), (4), (5) become
S =fioa 0 Bo
NT = (Ao- ao)J3oBo
T = (I-Ao) (j3oBo)
The college executive then faces the following problem
Maximize:
U = U(S, NT, T, M, D, F, Q)
= U(f.Joa oBo,(A- ao),BoBo,+ (l-Ao),BoBo, M,D,Fo, QoJ
Subject to:
B = T+NT+S+M+D+ND
= (l-Ao)fioBo+(Ao- ao)fio+fio a oB+M+D+ND
or fioBo+M+D+NDo-Bo = 0
Forming the Lagrangian function, we get
F =U[fJo a oBo,
(Ao- a o)J3oBo' (l-AoV3oBo, M, D, Fo, QoJ
+ A(J3oBo+M+D+NDo.-Bo)
Setting the first partial derivatives equal to zero gives
of
--
= au + A = 0
aM aM
A = - au
aM
and
of = au + A= 0
00 00
and
I au ~ au
00 aM
I
Solving the above equality together with the equation of
constraint
(l-J3o)B-M-D-NDo =0
yields two equations in two unknowns (M, D).
Second-order conditions for a maximum are given by
I
FMM FMD gM
FOM FDO go >0
gM go 0
that is equivalent to
U MM UMO
U OM UOD 1 >0
1 I 0
On expanding the later determinant, the condition
becomes
(UDM-UDD) - (UMM-UMD) = (UMD-UDD) - (UMM-UMD)
= 2uMD - U DD - U MM > 0
(assuming that the partial derivatives are continuous).

We note that if M and D are independent in the utility
function, then U MD = 0, and the diminishing marginal utility
of D and M (which we generally expect to be the case) will
guarantee that the second-order conditions are satisfied.
Short Run
The case of the short run is most crucial in college budget
analyses primarily becallse budgets are given each year. In
this time frame, /3, a, M, and D are all controllable, whereas
F and Q are relatively fixed, as explained in preceeding
sections. The analysis of preceding sections is, as we
mentioned, a short-run analysis and as such it is in reality a
special - albeit central - case of the general problem of
executive optimum budget making in varying time periods.
Because we have already dealt with this case in great detail,
we need say nothing more here.
Long Run
Although budgets are generally given annually, individual
colleges can plan to change certain things for the future in
order to maximize their long-run utility. The essential
characteristic of the long run is that even such factors as F and
Q are variable and can be expressed as functions rather than as
constants.
We can then express the following relationship
F = F(DF +C)
suggesting that F depends on the amount spent from
discretionary funds (DF) in order to make the college more
attractive to students, for example, expenditures for films,
library, released time and other inducements to faculty and
administrative staff to plan and implement diverse and
attractive curricula; also spending for recruitment in order to
identify superior teachers and potential students. All of these
factors are included in DF. But there are also other factors
that, despite affecting the number of FTEs, are largely beyond
the control of the individual college. These factors include such
variables as population growth rates, the age distribution of
the population, and how people perceive the value of a college
education. They are included in the constant C.
The relationship for Q appears as Q = Q(DQ+e), which
indicates that Q depends on the amount spent from discre-
tionary funds (DQ) in order to enhance the quality or the
academic reputation of the college, for example, research and
grant money, sabbatical and research leaves, travel money for
faculty, research assistants, research laboratories, office
facilities, and so on. All of the above are included in DQ,
whereas e represents those factors largely beyond the control
of the college, such as the traditional prestige of the college, its
location, and so on.
An adjustment must then be made in the variable that in
preceding sections was called D (discretionary spending). In
the present case we must define D as
D = D I+DF+ DQ.
DF and DQ have already been defined, making DI the residual
of what is left in discretionary funds for all other purposes after
F and Q have been duly supported.
Our analysis then leads to conclude that in the long run the
college executive must seek to
Maximize:
U = U(S, NT, T, M, DI, F, Q)
= U[f3uB, (A-u}j3B, M, D, F(DF+C), Q(DQ+e)]
Subject to:
B = T+NT+S+M+DI+DF+DQ+ND
= (l-A}j3B+(A-u}j3B+j3uB+M+DI+DF+DQ+ND
or j3B+M+D}+D F +DQ+ND-B =0
To maximize long-run utility subject to the budget cOQstraint,
form the Lagrangian function:
P =U[j.3uB, (A-u)j3B, (l-A)j3B, M, Dl, P(Dp+C), Q(DQ+e)]

+ A'(j.3B+M+D 1+D p +D Q+ND-B)
ap = au + A = 0
--
aM aM
A = -au
aM
-
ap
-au + A
=
aO I aD I
= 0
- -
au = au
aO I aM
ap = au = 0
?o ao
= au + AB =
-ap
a{3
-a{3 0
-au
a{3 -aM
= B au
--
ap = au + A = 0
aop aDp
A = -au
ao p
- -
ap = au +
aOQ aOQ
A= 0
-au
aOQ
= au
aDp
We therefore have
au = au au =-
- au
00 1 aO F aOQ aM
which is equivalent to three independent equations and

au = a
00
au = B au
a{3 aM
when combined with the equation of constraint, give a total of

six independent equations in six unknowns (/3, CT, M, Dl, DF,
DQ). Needless to say, second-order conditions would also
have to be verified.
Some Conclusions and Implications

This paper has shown how a college executive arrives at
decisions concerning budget allocations. It is interesting to
note that there are those who maintain that in making such
decisions, presidents act in a way that is generally best for the
insitution. On the other hand, some think that their decisions
are haphazard and often erratic. We have argued that neither
view is correct. Instead, presidents act in a rational and
thoughtful manner, but they seek to achieve priorities as they
perceive them. In the process they are influenced by their
personal sets of values and gains. Alterna tive policies are in the
final analysis viewed through the lens of one person, and
decisions will mirror that fact.
One result is that different presidents with varying utility
functions may make vastly different decisions as indicated by
the two illustrative functions presented above. Indeed it often
happens that a board of trustees of a university selects two
presidents for two constituent colleges and subsequently finds
tha t the patterns of priorities and alloca tions in the colleges are
strikingly different. The typical explanation given by central

authorities is that each college is distinctive and calls for a
unique set of responses. This paper suggests that a more cred-
ible explanation may lie in the different utility functions
possessed by the two presidents. Chance or random events
may be responsible for A being named president of college X
and B president of college Y, but as a result, the nature and the
subsequent development of the college may be significantly
affected.
We are therefore led to the conclusion that there is some
need to limit the absolute power of the president. What is
required at the core of budget making is a community utility
function rather than an individual utility function. Moreover,
the greater the reduction in the "management-slack" variable,
the better the use of the college's resources.
The rush to what is euphemistically called faculty con-
sultation in recent years may seem on the surface to be a move
in the direction toward which we have pointed. However,
observers of the phenomenon have recognized that, by and
large, consultation is not the same thing as participation in
decision making. Consultation falls far short of altering the
crucial presidential utility function toward a communal
perspective The essential point is that even if a great measure
of consultation takes place, a president who possesses a
different utility function, from those he consults will end up
maximizing his utility function, not theirs, with or without
consultation. Consultation can only affect decisions to the
degree that it unearths facts that the president may not have
been aware of and thus is relevant to the maximization of his
utility function. This situation will result unless authority and
power are shared by the president with some group within the
college. 3 Moreover, from the point of view of society, more
than administration and faculty views is needed if the ultimate
decision-making process is to be truly communal.
Another possible and perhaps more practical direction may
be limiting presidential terms to, say, five years. This would
increase accountability and reduce the absolute power of the
president. Of necessity, he would have to incorporate other
views into his utility function, for by satisfying others and
increasing their utility, he would increase his chance of
reappointment.
Further Study
This paper is intended to be suggestive in developing a
model and a frame of reference for serious analysis of
economic decision making on the part of a college. It does not
purport to be definitive. More work in deriving empirical
utility functions, for example, is necessary. The applicability to
these problems of methods developed by Von
Neumann-Morgenstern holds promise. Moreover, other
specifications of utility functions and the relationship between
individual and communal utility functions need more
exploration than was possible in this paper. Further study
about possible conflicts between short-run and long-run
equilibrium and on retrenchment decision making is also
warranted. Finally, a whole host of other decisions made
continually by colleges should be studied.
NOTES
I. The term "management slack" is borrowed from Williamson. See (2,
pp. 354-357,4,5).
2. It is true that the socalled adjunct staff, that is, the part-time staff,
may be terminated between semesters. However, the salaries involved
generally amount to a small portion of the budget. In the event that the
amount is sizable, the very short run could be defined as the middle of the
second semester when even adjunct commitments are set.
3. College administrators often contend that the power of a college
president is severely limited by the noncontrollable or untouchable segments
within the usual budget. Aside from the fact that essence of the present
analysis is unafected by the size of the discretionary budget, such comments
bring to mind the sagacious words of Alfred Marchall, " ... I was led to
attach great importance to the fact that our observations of nature in the
moral as in the physical world relate not so much to aggregate quantities as
to increments of quantities. (Emphasis supplied)
REFERENCES
I. Bressler, Barry, A Unified Introduction to Mathematical Economics,
New York, Harper and Row, 1975.
2. Cohen, Kalman J., and Richard M. Cyert, Theory of the Firm,
Englewood Cliffs, New Jersey, Prentice-Hall, 1965.
3. Henderson, James M., and Richard Quandt, Microeconomic Theory,
2nd ed. New York, McGraw-Hill, 1971.
4. O. E. Williamson, "A Model of Rational Managerial Behavior" in
Richard Cyert and J. G. March, A Behavioral Theory of the Firm,
Englewood Cliffs, N. J. Prentice-Hall, 1963.
5. - - - - - - - - - - , The Economics of Discretionary Behavior:
Managerial Objectives in a Theory of the Firm, Englewood Cliffs, New
Jersey: Prentice-Hall, 1964.
Comments on "A First Approach
to the Economic Theory
of College Management"
CHARLES E. LAMBERTON*
Professor Bressler has presented an interesting and a useful

application of a managerial discretion model and traditional
optimiza tion techniques to the problem of resource allocation
within a public institution of higher education. In doing so he
has opened a potentially fruitful approach to public allocation
problems. Some suggestions can be offered, however, that
could improve the paper.
1. The discretion model assumes that the university
president allocates his available budget among competing
uses in order to maximize his personal utility function. The
available budget is assumed to be determined exogenously,
although it may in fact be partly endogenous to the president.
For example, in most university systems, boards of higher
education or their counterparts allocate funds to members of
the system after considering budget requests from the
members. A university president has some direct input into the
determination of the total budget allocated to his university
through his preparation, submission, and defense of a budget
proposal.
A president also has an indirect input into the decision about
*Assistant professor of Economics, South Dakota State University.

the size of his budget. In the New York City case, Bressler notes
that the university budget is based on a number, a, that
represents the institution's cost per full-time equivalent
student. This number is said to be function of" ... the required
student/ faculty ratios for each college, the average faculty
salary on each campus, and the distribution of courses among
different disciplines with concomitant variation in acceptable
class size." To the extent that the president can influence some
of these determinants on a on his campus, he has an indirect
influence on his budget size. Such influence may be of a longer
term character and not fit into the short-term model presented
but could be incorporated into the author's suggested
formulation of a long-run model.
2. Bressler draws positive implications from the discretion
model under the given assumptions and then ascribes those
implications to presidential budget allocation in practice.
Before concluding that the model does, in fact, explain the
actual allocation of university budgets, it would be
appropriate to test empirically both the realism of the
assumptions and the accuracy of the model's predictions.
3. Even if the model were tested and not refuted, it appears
that several of the conclusion and policy recommendations
drawn are not warranted.
(a) No evidence is presented to demonstrate that pre-
sidential utility-based allocation is suboptimal in any sense or
by what standard such optimality can be measured.
The Board of Higher Education may make presidential
appointment decisions in the expectation that the appointee
will implement policies consistent with the goals of the board
and the board's constituents-the pUblic. If this is the case,
then the discretion model in corporating only the president's
preferences is incomplete unless it incorporates a relationship
between the preferences of the president and those of the board
and the pUblic. Certainly, a president appointed by and res-
ponsible to the Board does not have the absolute power
Comments on "A First Approach. .. " 61
attributed to him by Bressler but maximizes a utility function

not inconsistent with the interest of the board and the pUblic.
Thus utility-based allocation may be optimal as measured by
the desires of the board and the public.
(b) Even if the presidential allocation is shown to be
suboptimal in some sense, the author offers no evidence that
his policy recommendations would improve the allocation.
The conclusion that the individual utility function should in
practice be replaced by a community utility function is a non
sequitur. This is particularly true with respect to the
conclusion that power and authority should be" ... shared by
the president with some group within the college." The choice
of this particular community utility function reflects a value
judgment not supported by any evidence included in the paper.
(c) The policy suggestion of a limitation on presidential
terms is also offered without support. Although such a policy
may increase accountability and decrease presidential power,
it might have other consequences as well. Presidential
applicants may be elderly and looking for a last,
semiretirement position before full retirement. Younger
presidents may be less aggressive in their leadership knowing
that they will be back in the job market when their term is up.
They may also neglect their presidential duties as they
concentrate on job search effort during the last years of their
tenure.
In summary, the paper displays a disjoint character. It offers
an innovative application of the managerial discretion model
to further the analysis of resource allocation in higher
education. No evidence is offered, however, to demonstrate
the realism of the model's assumptions and the accuracy of its
predictions. Without such evidence, the normative
conclusions and policy recommendations offered in the paper
are unwarranted. If the application of the model were
supported by empirical evidence, the normative
recommendations would still not be warranted without
theoretical or empirical reason to believe that they would in

some sense improve the allocation of resources.
It would also be useful to specify the relationship between
the president and his superiors and to estimate and evaluate
alternative objective functions. Such results could be
compared with those from social welfare or consumers'
surplus maximization models. If the managerial discretion
model is not refuted by empirical evidence, it might be used by
the Board of Higher Education to evaluate the relationship
between a president's policies and the board's goals. Inasmuch
as a president is responsible to the board, the board can make
such an evaluation as an explicit interpersonal comparison of
utility. Such comparisons are made implicitly in employ-
er-employee relationships.. Making the evaluation explicit
would guide the board in its appointment decisions, budget
allocations, and policy choices. Thus although the conclusions
dra wn are generally not supported by the analysis, the Bressler
paper does offer a fresh approach and an opening to better
analysis of higher education resource allocation.
A Post-Accord History of Principal
Federal Reserve Functions
WILLIAM B. HARRISON *
The unique nature of the Federal Reserve System's work has

long been the basis for defending its autonomous position
within the federal structure. Nevertheless the central bank is
perceived in a variety of ways depending on the orientation of
the observer. Professional economists understandably view
the formulation and the implementation of monetary policy as
the more prominent and fascinating aspect of the Fed's work.
Granting the importance of and the intellectual respect
generated by monetary research, academicians' inclinations
toward this area are understandable. Some economists study
regulatory effects on the structure and functioning of the
commercial banking industry. Commercial bankers are
concerned with both regulatory effects and the services
rendered by Federal Reserve institutions as they influence
*The author is assistant professor of economics, Virginia

Commonwealth University, Richmond. Thomas Mayer and Edward J.
Kane read the manuscript and offered many helpful suggestions. I am
grateful for generous support with time and data sources given by John
Kakalec, controller, and William H. Wallace, director of the Division of
Federal Reserve Bank Examinations and Budgets, Board of Governors of
the Federal Reserve System, Herbert F. Wass, assistant vice president and
secretary, Federal Reserve Bank of Boston, and Welford S. Farmer, senior
vice president Federal Bank of Richmond. I also benefited from excellent
research assistance from Robert E. Rigsby. None of these individuals should
be associated with the views expressed here. This research is supported by the
Grant-in-Aid Program for Faculty of Virginia Commonwealth University.
bank balance sheets and profit and loss statements. Although

most people are probably untutored in the Fed's comprehen-
sive role in linking money to national income and welfare, eco-
nomists seem equally unaware of the system's non-monetary
work. The system's managers, appreciating their
independence, may not be unhappy that the public views the
Fed from a mixed position of ignorance and respect.
Regardless of optical coloration, Fed watchers generally
accept an orthodox independence rational.' This rationale is
logical, but its range of applicability becomes problematical
as one realizes the scope of the system's work.
This paper attempts to rectify to some extent the neglect of
the nonmonetary side of the system's activities by presenting a
brief historical treatment of these functions. In focusing on the
post-Accord period, the study is limited to a time in which the
Federal Reserve, in its modern structural form, reached a great
milestone in its maturity and autonomy within the federal
government.
THE FUNCTIONAL ACCOUNTING

SYSTEM
Under the uniform functional (operational) expense

reporting system, reserve bank expenditures are first
allocated among more than twenty objects of expenditure and
then classified by operation. As devised by the system's
Conference of Presidents and approved and prescribed by the
Board of Governors, all expenses are allocated under 25
operational headings, some of which are subdivided further.
This system facilitates internal evaluation of system efficiency
in two ways: It permits banks and the board to compare
reserve bank expenses with each other on a current
competitive basis and on a historical basis. This practice gives
limited benefit in overall efficiency inasmuch as outside
A Post-Accord History ... 65
comparisons have not been made. It is not clear, apart from
housekeeping and supportive functions, what operations
could be found to compare to the Fed's.
By consulting the board's accounting regulations, which
clearly define operations, and the quarterly or annual
functional expense reports, one can infer both the direction
and the relative cost of the central bank's work in many areas.
From 1952 to 1962, only the average number of employees and
the amount of their salaries were distributed functionally by
the reserve banks.
Because salaries constituted fully half of expenses, fairly
good comparisons could be made among banks during these
years. However, as more labor-saving methods were
introduced, expense comparisons based purely on numbers
and salaries of employees became less useful. By 1961 Reserve
banks began testing and using electronic check-processing
equipment. General purpose computers for accounting,
research, and fiscal agency operations were also being installed
and expanded. On the urging of the Board of Governors, a
committee of Reserve bank officers revamped the operational
expense distribution to reflect the changing cost structure. The
resulting system, which emphasizes resources used and is
probably one of the most complete current expense accounting
systems among federal agencies, has afforded a limited means
of control and budgetary planning since its implementation in
1962. To isolate major operational changes, one can compare,
using various system periodical articles, growth and large
variations in salaries and numbers of employees in each of the
functions since 1952 and in total expense since 1962.2 For
many years most of the regional banks published periodic
reviews of regional and national trends in business, finance,
and agriculture. Those reviews, along with the annual reports
of the Reserve banks, have also afforded information about
operational and policy changes in Federal Reserve functions.
In examing all ofthese reports from 1952 to 1973, I selected for
discussion those changes that apparently had the greatest

impact on the costs of the Fed.
The period from 1973 through 1977 may be considered one
of transition for the Federal Reserve's cost control and
evaluation system. In 1972 the Board of Governors for the
first time functionally allocated its expenses according to
service levels. Formulation of monetary policy, supervision
and regulation of financial institutions, the financial services
system, system policy direction, and board support are the
first-order categories into which costs have been distributed.
These categories are subdivided further into second-through
fifth-order levels. Examination of this framework for cost
control provides one with an excellent means of identifying the
exact nature of the board's duties.
A similar service-oriented framework for a new planning
and control system (P ACS) is evolving now for Federal
Reserve Banks' expense allocation. The reserve banks for the
first time in 1977 allocated their expenditures, capital and
manpower requirements, and piece-work volume count
according to a P ACS manual of definition and format issued
by the Board of Governors. Although the older functional
expense system focused on resources used, the PACS method
calls attention to services provided to the system's clients. Even
the internal support functions are defined so that resources
provided internally can be reported.
The output service framework for a more complete cost
alloca tion in 1977 is being augumented by zero-base budgeting
in 1978 along PACS lines. The PACS framework of cost
control is laying the groundwork for a planning,
programming, and budgeting regimen that requires setting
goals, objectives, and priorities for the system before resources
can be used.
Another paper will identify the System's functional expense
allocation and detail figures and trends from 1952 to 1973.
Annual data for 22 years for all of the Federal Reserve
banks' functions were obtained for the following: number of
employees, salaries, total expenses, and piece-work volume in
certain functions. Trend rates of growth in each of these series
in each function then were computed by the ordinary least
squares method. I am defining technological growth and
productivity as the difference between the trend rate of growth
in the volume of work minus the trend growth in expenses.
Productivity calculations were limited, of course, to piece-
work functions. The considerable computer time consumed in
fitting trend rates to annual data was not expended for
pedagogical reasons but to avoid the arbitrariness of growth
rates based on selected yearly end points)
Expense data and hence growth rates in the major functions
of Research, Fiscal Agency, and Accounting have been
increasingly understated since 1962 because planning,
methods analysis, and computer program debugging work has
been chargeable in large part to new internal service functions:
planning, data processing, and data systems support,
functions that have been detailed separately.
The internal support and service functions of the Federal
Reserve contribute about 51 percent of total costs. The
remaining 49 percent of Reserve bank costs are primarily
allocable to the wholesale banking functions divided among
the check payments mechanism (check collection) - 20
percent, currency and coin - 17 percent, and other banking
functions - 3 percent. Bank supervision takes 3 percent of
Reserve banks' resources,research and bank-public relations
consume 4 percent, and nonreimbursable federal activities use
1 percent. Because the System is reimbursed by the Treasury
for most of its fiscal agency activities, such expenses are not
counted as part of the total.
CHECK COLLECTION
The largest and most technologically advanced operation of
the Fed is the check-collection function, now termed payments
mechanism. Its work includes receiving and paying all checks

in the United States other than those cleared among banks in
the same local area. The number of checks processed increased
at an annual trend rate of6.85 percent from 1952-1973 whereas
salary expenses in check collection grew by 4.70 percent. From
1962 to 1973 total expenses increased at a trend rate of 5.33
percent, indicating a productivity growth of about 1Y2 to 2
percent throughout the period. If growth in salaries and
expenses are adjusted by the implicit deflator for GNP,
productivity growth is about 3 percent more in all areas
measured; for example, in the 4Y2 to 5 percent range for check
collection. 4
Over the entire 22-year period, the check collection function
was probably the most improved. At the end of this period,
from 1972 to 1973, total costs for the payments mechanism
rose from $77 million to $105 million, whereas volume
increased roughly from 8Y2 to 10 billion checks. Nearly half of
the cost change was reflected in personnel costs, and the
remainder was concentrated in greater transportation costs
and equipment rental.
In June 1952 a comprehensive study ofthe check payments
system was undertaken jointly by the American Bankers
Association (ABA), the Association of Reserve City Bankers,
and the Fed. In that year the Boston Fed was reporting
installation of mechanical proof machines, and the Kansas
City Fed reported widespread use of the check routing symbol.
Operators of the improved proof machines, keying in the
symbols and the amounts on the checks, simultaneously sorted
checks into one of 36 pockets of a rotating drum contained in
the machine and listed them on one of the 36 corresponding
tapes. This numeric system greatly improved the sorting and
rerouting of checks over a post-office or pigeonhole alphabetic
system. Throughout the fifties rapid productivity growth
followed from the change to numeric sorting; and service
improved, too, from the increased use of air transport and
private motor carriers for checks. There was one early
departure from the rigid collection pattern imposed by the
geographics of original R:eserve office location and intrareserve
city clearings. This was the establishment in 1953 of the Nassau
County Clearing House Association, a Long Island
arrangement in which the New York Fed participated. Un-
fortunately, very few such outside clearings were
accommodated by the Fed in the fifties and early sixties.
In 1955 the Bank Management Commission of the ABA
began technological explorations with equipment
manufacturers, check printers, and the banking system aimed
at achieving an automated system capable of eliminating
operator handling of individual checks. By 1958 the
Commission had approved a check format for common
machine language; that is, a magnetic ink character
recognition (MICR) one; and by 1961 the Fed and the ABA
were encouraging the public to use checks imprinted with
MICR capability. In the same year five Reserve banks were
appointed to test competitively different new high speed
sorting and listing systems.
Because the volume of properly encoded checks available
for processing on the high-speed system was slow to develop
and because of its newness and the testing of equipment,
productivity growth was slowed for two years. By 1963,
however, all twelve head offices and six branches were using
MICR equipment. In 1964 the Fed was processing over 50
percent of all checks electronically and by 1967 all 36 offices
were using "high-speed" equipment. Between 1963 and 1966,
the combined number of employees charged to the check-
collection function declined by 1,793 and expenses decreased
by $6.4 million, whereas the total number of checks processed
increased 20 percent. With 90 percent of all checks processed
on high-speed equipment by 1966, the relentless rise in check
volume c()t1tinued in the absence of further susbstantive
change in technology into the early seventies.
The next opportunity to effect significant improvements in

costs and services came from the relaxation of the traditional
geogra phic clearing patterns. This development can be
illustrated by an example from the Fed's first regional clearing
area. Prior to 1970 a bank in the Maryland suburbs of the
District of Columbia with a deposited check drawn on a
bank in the northern Virginia suburbs of D.C. would have
to collect the check through two Federal Reserve offices
(Baltimore and Richmond). This required considerable
delay, transport cost, and handling. With the establishment
of regional clearing across territorial lines, modest savings
could be achieved. One Federal Reserve clearing facility was
established with the capability to make the appropriate
entries for all the clearing banks in the contiguous
metropolitan areas. In 1970 the Washington-Baltimore
regional check-processing center (RCPC) began with 2.4
percent of total United States check volume processed for
overnight settlement. By the end of 1972, 24 similar RCPC's
were operating across the country. Double that number were
functioning by the end of 1976.
Another boost to efficiency in check collection occurred
with the establishment of two "automated" clearing houses
(ACH) in Los Angeles and San Francisco in 1972 following the
formation of the Special Committee on Paperless Entries by
commercial bankers in California. The ACH permits
electronic exchange of preauthorized debits and credits with
settlement facilities provided by the Fed. Participating
financial institutions create computer tapes of debit and credit
items based on customer instructions - a preauthorized
payroll deposit is an example - and deliver the tapes to a
settlement facility. Payments are then sorted to the respective
institutions as would be a standard clearing procedure, except
that electronic images instead of paper documents are used.
Those financial institutions that can handle them receive from
the ACH magnetic tapes. 5 Electronic fund transfers will be
difficult to extend rapidly to consumers because ofthe public's

distaste for the impersonal nature of computer service,
immediate debits to accounts for the loss of float, and the loss
of visibility in payroll compensation. 6 There were 19 Federal
Reserve offices handling 270,000 automated payments in May
1976.
The Reserve bank clearing structure that was designed
originally to render primary service to local member banks will
increasingly present problems for the Fed as more and more
nonbank financial institutions expand full payments services
to customers and electronic funds transfer facilities, such as
remote service terminals, are established.? Least-cost,
comprehensive clearing arrangements will be required on a
nationally-integrated rather than a regionally-managed basis.
The semiautonomous regional Reserve office structure will
become increasingly vulnerable to inefficiencies in the
payments system without exceptionally good coordination. As
an example of Fed accommodation, the automated clearing
houses, which now clear and settle electronic payments on a
regional basis, may be united in a nationwide system.
Nevertheless, the continuing adaptation of regional clearing
centers to locational need and especially the reduction in time
schedule and transportation float has rendered to the public a
vastly improved payments mechanism. This is adding
tremendously to system costs that are not being returned in
greater volume handled as was the case in 1963-1966. This isa
prime example of the Fed's perceived need to measure its
productivity in terms of services rather than simply inputs
relative to volume.
ACCOUNTING-WIRE TRANSFER
The Fed has been transferring funds by wire since 1918. The
Federal Reserve cost in 1973 of handling one check was
approximately one cent per item, whereas wire transfers cost
the Fed about 36 cents per item. But because each item
transferred by wire consisted of a very large dollar volume, the
cost per million in dollars transacted was only about 21 cents
compared with $23 per million in check transactions. Despite
the obvious advantages of wire transfers over vast and
continuous cross-country shipments of tons of paper checks,
this operation has remained a relatively small part of the
system's work in terms of resources used and one not showing
increased productivity.8 The annual growth in volume is a
phenomenal 9.50 percent since 1952; but total expenses in the
12 years since it has been completely distributed rose by 12.35
percent annually, indicating a negative nominal change in
productivity. Nevertheless, this function promises to become
the nucleus for a paperless payments mechanism, for the
technological means are available. The Fed hopes that as more
and more payments are handled through expanded equipment
capacity, the convenience of wire transfer, and/ or automated
clearing entry, conventional check processing will soon cease
to grow in volume and demand will lead to the fullest use of
electronic funds transfer.
The story of Federal Reserve wire transfers is one of growing
service, even though it does not offer prima facie evidence of
productivity growth. At the beginning of the period of our
study, free transfer service was limited to simple member bank-
balance transfers in mUltiples of $1,000. In July 1953 a new
leased wire system with expanded capability and automatic
message relay linked all reserve offices, the Board of
Governors, and the Treasury. In addition to wire transfers of
bank funds, this sytem provided government security
transfers, Treasury transfers, and interdistrict settlement
among Reserve banks. In the 1950s and 1960s much of the
expansion in transfer volume throughout the United States
was attributed to the expansion of the federal funds market.
Uses of wire transfers have broadened in nature and kind,
reflecting in part the System's need to promote membership
advantages. For instance, the fees charged banks for third-

party transactions were eliminated, and odd amount
transactions accompanied by payment instructions were
accepted without charge.
The Reserve banks have been grad ually implementing a long-
range plan to reduce the sizable transportation and clerical
cost of the present payments mechanism. This plan looks
toward eventual payments and receipts for most cash items
over an expanded-capability, private-wire system. In 1970 a
new communications center was established at Culpeper,
Virginia, replacing the teletypewriter switching system with a
computer communication system linking the entire Federal
Reserve System. Charges to member banks for transfers of
funds exceeding $1,000 were eliminated in 1971 as plans for
extending hours of service and expanding facilities were
carried out. Each of the Reserve banks has installed automated
communications switching facilities. The Fed now has the
capability to use its communications system and on-line
computers to effect not only reserve balance transfers and the
movement of funds on behalf of bank customers directly to
and from member banks, but it can handle automated check-
transactions service, making its communications network an
integral part of the nationwide mechanism for handling small
payments. Although continuing its long-run reduction in
clerical and transportation costs for conventional
transactions, the Fed has increasingly absorbed the costs of
automated check service to the commercial banking industry.
We do not know whether commercial banks have passed
savings on to the public in consequence of System efficiencies
II
achieved in the handling of payments. This important question

remains to be investigated.
CURRENCY AND COIN

The second largest piece-work operation in the reserve
banks in terms of resources allocated is the currency and coin
function. This function includes shipping and receiving and

on-premises sorting, counting, and assembling of money
shipments. Fourteen Reserve offices also wrap coins for
shipment for which they recover costs through charges to
receiving banks at one to two cents per roll wrapped. Nominal
productivity growth has been negative as salaries (+4.64
percent) and total expenses (+6.49 percent) have increased
more rapidly than has the volume of currency (+2.09 percent)
and coin (+3.62 percent) sorted and counted.
Although nothing comparable to check-processing
automation has occurred in this function, some procedural
changes have effected savings. In 1954 Reserve banks were
permitted by law to payout unworn notes of other banks. This
eliminated the cost of sorting notes by the bank of issue and
transporting them across country for repayment at source
banks. Accordingly, the volume of currency sorted and
counted declined temporarily in 1954 and 1955 by 123 million
pieces, and an approximate reduction of 100 employees was
experienced in those two years. In retrospect, one questions
why Congress and the Fed permitted this wasteful practice so
long.
A severe coin shortage in the United States from 1963 to
1965 resulted in a 50 percent reduction in coins sorted and
counted below 1962 levels, and a corresponding reduction of
50-60 employees in those years. Increased public demand for
coins for automatic vending machines, toll roads, and parking
meters indicates the sizable turnover in coins handled by
reserve banks despite endemic coin shortages.
During the last 25 years there has been little improvement in
the mechanics of money counting. Coin-counting machines
have perhaps doubled their counting speeds in the period. But
bill-counting machines have changed little, and counterfeits
are still detected by their look and feel to an experienced
counter. The outlook for improved efficiency in this area is
poor because of the short life span of paper currency and the
wide swings in public demand for coins and currency.
However, the Stanford Research Institute, under an
agreement with the System, is trying to develop currency
machines that will process bills at a rate of about 50,000 per
hour, sorting and detecting counterfeits, and so forth. Some
prototypes are now being tested at reserve offices.
BANK EXAMINATION
Federal Reserve bank examiners conduct periodic audits and
spot verifications of state member banks and of bank holding
company affiliates. Examiners evaluate state bank applicants
for Federal Reserve membership and in recent years have been
asked to review and comment on the burgeoning number of
merger and holding company applications. Besides field
investigations, examiners analyze and review both Federal
Reserve and other supervising agencies' reports, annual bank
holding company reports, bank call reports on conditions, and
income and dividends reports. Regulatory duties include
enforcement of laws such as the Bank Protection Act and the
Truth in Lending Act.
The average number of employees and the salaries paid in
bank examination have risen at annual rates of 2.80 percent
and 7.02 percent respectively since 1952, whereas total
expenses, mostly for personnel, increased by 7.57 percent
annually from 1962 to 1973.
Because the Fed is only one of a number of government
agencies responsible for bank supervision, the growth of its
expenses and perhaps the efficiency of its work in this area can
be compared to those of functionally similar government
agencies, such as the Federal Deposit Insurance Corporation
(FDIC).9 The FDIC, which examines insured nonmember,
state-chartered banks, has recorded substantially higher
growth in comparable categories, with a trend growth rate of
5.07 percent in the number of employees, 9.95 percent in
salaries, and 10.06 percent in total expenses for bank
supervision for the period between 1952 and 1973. A

comparison of the total number of FDIC employees to the
total number of Federal Reserve employees shows the former
with an annual increase of 4.96 percent from 1952 to 1973 and
the latter with a 3.76 percent growth. 10
Total state member bank deposits grew from $46 billion as
of December 31, 1951, to $131.4 billion at the end of 1973,
whereas nonmember insured banks' deposits rose from $21.9
billion to $150.2 billion in the same period. 1I However, the
Bank Holding Company Act Amendments of 1970
necessitated a substantial enlargement in the Reserve banks'
supervisory and examining personnel. Employees increased
only by 249 from 1952 through 1969 and disproportionately by
206 from 1967 through 1973, largely as a result of the
requirement that 1,500 one-bank holding companies register
with the Fed. In addition, the Fed has had to supervise and
decide on the disposition of applications of bank holding
companies to acquire nonbank activities. From 1971 through
1976 the system acted on 5,079 applications compared to 470
from 1956 through 1970.
RESEARCH, BANK RELATIONS, AND

PUBLIC INFORMATION
Current System accounting groups costs incurred for
statistical series, monetary and economic studies, research
library, meetings, visits to banks, and public information
work. With the exception of statistical series, these activities
have experienced greater salary growth since 1952 than the
System has experienced as a whole.
Operations in the categories of public information and bank
relations include seminars, the preparation of public
addresses, tours of regional reserve banks, visits to banks,
motion pictures and pamphlets, and periodical publications.
Expense for printing and supplies is incurred for monthly bank
reviews of economic conditions, which are valued highly by the
academic, business, and professional commumtIes. Some

costs are also incurred in publishing occasional papers and
booklets on monetary and economic subjects. Each of the
twelve banks also publishes an annual report that usually costs
from $5-$10 per thousand. These reports contain special study
features in addition to annual balance sheets and reports on
activities. Agricultural newsletters are also used to acquaint
the public with the Fed's work.
The late Congressman Wright Patman, chairman of the
House Banking Committee, often questioned expenses for
printing and supplies associated with public information,
meetings, and bank visits. Traveling expense associated with
public information, meetings and bank visits were favorite,
perhaps symbolic, targets for Mr. Patman's scrutiny. But
travel expenses associated with these categories accounted for
only one quarter of a million dollars in 1968, for example.
Total traveling expenses for the entire system were about $2.5
million (about one percent of the system's total expense), half
of which was attributable to member bank examinations. The
variety and the extent of public relations activities are
conspicuously greater than the efforts made by other
government agencies. This activity undoubtedly strengthens
the Fed's autonomy; at the same time it encourages public
appreciation of the agency.
As would be expected, personnel is the dominant expense in
research and bank and public relations. The Board of
Governors is now providing Congress with the titles and the
annual salaries of officers and employees in the upper salary
grades. But because the titles are general, for example,
assistant vice president, it is hard to know what functions these
persons perform. Even lawyers and economists are sometimes
given banking titles.One can only get an idea about salary
levels by computing the average number of employees, say, 260
in 1972 in Research and Public Information, and the salaries,
for example, $2.7 million, paid in that category. One million
dollars in officers'salaries was also charged to that category.

A rough approximation based on the total number of officers in
the system and salary amounts paid indicates that an average of
about $26,000 was paid in annual salary to each officer.
Apparently about 40 officers were assigned to Research and
Public Information in 1972.
Meetings attended typically by Reserve bank personnel for
research and public information purposes include those of the
American Bankers Association, state banking associations,
local banking groups, public relations organizations, and farm
credit unions. The banks have often hosted central banking
seminars for bankers and educators. System officials have
justified travel to and participation in various meetings largely
on the basis of reciprocal informational benefits derived by
Reserve banks,commercial banks, and the public. The receipt
of information seems more apparent, however, in the case of
professional organizations outside the research and public
information area, such as the National Purchasing Agents
Association and the National Machine Accountants
Association, that provide professional knowledge. The
benefits are not so apparent in the case of others like the
exclusive and political chambers of commerce. 12
Besides preparing publications and attending and
addressing a wide variety of meetings for purposes of
informing the public about system objectives and functions
and developing grass-roots support and information, the Fed
has an extensive bank visitation and relations program. Senior
Reserve bank personnel visit commercial banks, members and
nonmembers, at least once a year in most areas. Technical
assistance and personal attention in the area of Federal
Reserve relationships are always available to banks. In 1956
the Reserve banks began to subsidize a functional cost analysis
(FCA) program that was designed to improve member bank
efficiency. Participating banks' expenses and earnings (there
were 1,022 by 1966 in eleven Federal Reserve districts) are
allocated to standard bank functions. Unit costs and returns

are derived for each bank and compared with standards
derived from the most efficient banks.
It seems highly questionable that FCA relates to System
responsibilities; that is, whether the Fed should incur costs to
generate operational improvements at constituent banks.
Presumably, more efficient commercial banks will mean
eventually lower costs to the public for its banking services.
But, again, there is no guarantee that cost savings to banks will
not instead be channeled into commercial bank fixed assets,
affiliates, or dividends. This area should claim much research;
for example, the question of how central bank services are
ultimately dispensed in an uncompetitive, private banking
system.
There are probably some negative aspects to the cultivation
of grass-roots support from regional Fed participation in
banking activities. The bank relations activities are much more
vulnerable than other functions to regional pressure from the
commercial banking system for special dispensations. Much of
Patman's criticism of specific expenditures revolved around
the more visible meetings and travel expenses in that category.
I think that the scrutiny of discount and float policies or the
rendering of questionable services, such as FCA, might have
been more productive. In any case, the banking system in
general and the interbank correspondent banking system in
particular probably excel among American institutions in
paying attention to image building. A banker lacking the social
means to participate in elegant and exclusive meetings is
ineffective. The Fed's officers engaged in public information
and bank relations are placed under tremendous pressure to
relate to other bankers in traditional bank ways. By
conducting themselves as bankers rather than government
agency employees, they can establish an easy informality and a
cooperative atmosphere. Although it is understandable that
Reserve bankers wish to project themselves as bankers, it is not
clear that commercial bankers are more cooperative with them

or that Federal Reserve relationships are more cost efficient
than those of, say, the FDIC or the comptroller of the
currency, both of which have quite limited social contacts on a
regional basis.
Monetary and economic studies, gathering statistical data
for economic and financial series, and the support services of
the research library are efforts chiefly designed to support the
System's monetary policy function. At the Reserve bank level,
statistical responsibilities are clearly justifiable. First, the
duplication of statistical effort among regions can hardly be
claimed by System critics because Reserve banks are actually
collecting and sometimes reporting banking and economic
data on a decentralized basis to promote efficiency, for
example, before national summaries can be made. The
gathering of statistics from regional banking and business
sources is probably less conducive to quality control in
sampling but may produce more cooperative relationships
than would a statistical collection operation based solely in
Washington. More important perhaps is the greater speed with
which data can be collected on a decentralized basis. The
System has a noncompulsory relationship with many of its
respondents, including many nonbanking as well as banking
institutions.
A comprehension of the expanding scope of statistical
operations can be obtained by comparing the indexes of
Federal Reserve Bulletins in 1952 to those in 1975.13 Virtually
all of the regular statistical series and special survey data are
reported in the Bulletin. Many valuable new series have been
added since 1952. The public benefit derived from the new
bank lending surveys, deposit-ownership survey, the flow of
fund accounts, time-deposit surveys, industrial-production
index series, and international statistics is considerable yet
inestimable. The information generated by the Fed's statistical
program provides an important supplement to the
government's comprehensive reporting on economic activity.
It serves a wide variety of forecasts and interpretations from
private individuals to business firms. The expenses of this unit
have grown annually by 10.39 percent since 1962. (Numbers of
employees and salary data are not strictly comparable
throughout the entire period.)
The research library operation has increased its salary
expenses at an annual trend growth rate of 7.23 percent since
1956, and its total expenses have grown by 7.04 percent
annually since 1962. Its main function is to support monetary
and economic studies. The library operation also serves bank
examination, discount, statistical series, and public
information work. This service includes the maintenance of
reporting services, for example, Moody's and Standard and
Poor's manuals, business and financial periodicals, and
periodic reports from other agencies such as the FDIC. The
monetary and economic studies unit has grown more rapidly
in terms of salaries and expenses than any other of the major
Fed operations with the exception of planning and the
reimbursable food stamp program. In 1956, 196 employees,
earning salaries of $1.1 million, were charged to this unit. In
1962, when expenses other than employees' salaries were first
distributed, $0.3 million in officers' salaries was charged.
Within 10 years 412 employees, $4.8 million in employees'
salaries, and $1.0 million in officers' salaries were distributed
to monetary and economic studies.
The principal duties of professional economists, their
research assistants, and typists include advisory service to the
bank president in his capacity as a member of the Federal
Open Market Committee (FOMC). This committee is a
centrally organized arm of the Fed established under the
Banking Act of 1935. The Board of Governors, whose
members constitute 7 of the 12 voting members, is supported
by a staff of specialized economists numbering more than 200.
One may question whether there is considerable overlap and
duplication of effort in furnishing regional bank support to the

FOMe. Regional economists and their staffs also provide
original monetary and banking research. They interpret, in
laymen's terms for use by the public information unit, current
conditions, trends, and recent monetary and banking research.
In a related sense, economists play important roles in apprising
regional directors a bout the cond uct of monetary policy and in
compiling grass-roots feedback from banking and business
leaders.14 As mentioned earlier, regional bank economists
prepare most of the monthly review articles. Because these
articles are submitted informally to the Board of Governors
for suggestions (and several of the reviews provide speciality
formats), there is not as much potential for overlap as one
would suspect.
DISCOUNT
Although the discount function has been a major instrument
of Federal Reserve policy, there are small costs associated with
its administration. Considerable effort over the years has been
expended to study the role and the functioning of this
mechanism, and many policy recommendations have been
made. 15 Nevertheless, the actual operation of discounting for
member banks continues to be simple. A member bank
applies for a loan (discount) by making a telephone call to a
senior clerk at the district Fed. On the basis of a standing
note and collateral arrangement, an entry is posted on the
same day to the borrowing bank's discount account. Because
most borrowing is accomplished with government securities
collateral already held in safekeeping for the member bank,
and few banks abuse the privilege, administration is mostly
perfunctory. The number of employees changed little from
1952 to 1964; since 1962 there has been a trend growth rate of
11.90 percent in total expenses. In 1973 the number of
employees assigned was 159, and total expenses were $2.2
million, mostly for salaries. The principal causes of growth
have been a large increase in borrowing on the part of country
banks since the early 1960s and unusually large total
borrowings in 1969-70 and 1973.
Apart from check operations, there is probably no other Fed
function that receives more introspective study than
discounting. The system's fundamental reappraisal of the
discount function in 1966-1973 was directed mainly toward
developing a rationale and a policy for lending to banks. The
check-payments studies, on the other hand, have been
technologically oriented. Very little change in guidelines for
discounting has come from the exhaustive reappraisal. The
most substantive change has been the seasonal borrowing
privilege. Few banks have used the new seasonal privilege,
however.
FISCAL AGENCY
Operations performed by the Reserve banks for other
departments, agencies, and officials of the government define
the system's role as a fiscal agent. Most of the resulting
expenses are reimbursable to the Reserve banks Some,
principally those that relate to the Fed's traditional payments
functions, are not reimbursable. The costs of processing postal
money orders and government coupons, for example, and of
maintaining the Treasurer's general account are not
recoverable, although Reserve banks must conform to
procedures established by the Post Office Department and the
Treasury. Some of the tax work of the Reserve banks is
reimbursable. Inasmuch as about 97 percent of current net
earnings has been transferred to the U.S. Treasurer's general
account annually in recent years, it makes little difference
whether the costs of fiscal agency activities are recoverable.
Federal Reserve banks' budgetary and cost control procedures
apply equally to all activities.
The largest fiscal agency operation, consuming about 70
percent of total fiscal agency resources allocated, is the public
debt unit. Its work includes the issuing, exchange, and

redemption of public debt issues, including Treasury securities
and savings bonds. Activities that have experienced the most
change have been the currency verification and destruction
unit and the postmasters' deposits and food stamp programs.
The latter began in 1961 on a test basis. By 1964 there were 360
thousand participants in the program. In 1970 there were 5.2
million food stamp participants in the United States. System
employees and expenses rose from 7 and $43 thousand in 1962
to 280 and $2.6 million in 1973 for the food stamp program.
After the Reserve banks receive stamps for immediate credit to
banks' reserve accounts, they verify and and destroy them. The
postmasters' deposit program, began in 1954 as a means to pay
post office receipts into the Treasury's account, was
discontinued in 1971.
The currency verification and destruction unit was begun in
1953 for the purpose of cancelling unfit U.S. silver certificates.
In the late 1950s a developing silver shortage led the Treasury
Department to make sales of "free silver." Congress repealed
the Silver Purchase Act of 1934, and the Treasury entered the
silver market in 1963 to forestall hoarding of silver certificates
and coins. In that same year Congress authorized the Fed to
issue its own fiat notes in denominations under $5. The Denver
and Philadelphia mints were unable in 1964 to meet public
demand for silver coins requiring the Treasury to suspend
redemptions of silver certificates in silver dollars. Against this
background, the number of employees rose from 41 in 1953 to
50 in 1956, then fell to 24 in 1965 when expenses were only $595
thousand. By 1969, when Federal Reserve notes had replaced
Treasury note issues and Reserve banks were authorized to
destroy their own notes, there were 88 employees. In 1973, 187
employees and $2.2 million in expenses were charged to the
unit.
Total fiscal agency expenses have increased (+5.83 percent)
less rapidly since 1962 than has the total of all banks'expenses
(+7.80 percent). The average number of employees and salaries
paid in the fiseal agency function declined 3.04 percent and
3.43 percent respectively compared to total reserve banks'
employees' and salaries that increased 0.63 percent and 4.03
percent respectively.
PURCHASE AND SALE OF SECURITIES

The Reserve banks will buy and sell government securities for
member banks. They will also wire those securities to other
banks in the United States. The volume of purchases and sales
has declined by l3.33 and 9.81 percent respectively, whereas
the average number of employees and the total expenses have
increased 1.41 and 6.69 percent.
THE SAFEKEEPING OF SECURITIES

Safekeeping is principally a service rendered to member
banks, although nonmembers maintain collateral for tax and
loan accounts. The function is comprised of assuming custody
of all securities held in safekeeping or pledged as collateral
except those pledged against U.S. Treasury deposits. The
securitie~ held are owned by member banks, government
agencies, and the Federal Reserve System, including the
Reserve banks' system open-market accounts and retirement
fund. Because activities include cutting coupons, receiving,
verifying, recording, and delivering securities, the introduction
of a Treasury securities book-entry procedure in 1968
promised to save on processing labor as well as printing costs
and vault space. There has been no pause in the upward trend
of salaries (+6.22 percent since 1952) and expenses (+7.23
percent since 1962) however. Substantial achievement in
productivity has not occurred because book entry, that is,
electronic storage and the transfer of securities, was limited to
marketable Treasury issues, and more elaborate procedures
were developed for maintaining surveilance to prevent lost or
stolen securities. By the end of 1970, banks, brokers, and

dealers were being threatened by insurance companies with a
sizable cutback in coverage for lost of stolen bearer securities.
This threat of withdra wal of participants from the government
securities market led the Federal Reserve to develop expanded
procedures and services in safekeeping. Finally, there has been
a marked increase in volume of government and corporate
securities owned by banks.
OTHER FEDERAL RESERVE BANK

FUNCTIONS
Personnel administration constituted about 40 percent of
total personnel costs in 1968, the remainder divided between
welfare and subsidies. These subsidies include employee health
service, cafeteria subsidy, education, and social activities, such
as clubs, employee magazine, and athletics. In 1968 the cost of
the function was $108 per capita; and so the cost ofthe various
benefits came to about $60 per person.
The majority, about three-fourths, of general service
expenses consists of supportive activities for check collection
(mail and express) and money and securities (protection and
vault maintenance). Private carriers have gradually assumed
most of the shipments formerly sent by U.S. mail. They have
generally operated at lower cost to the Fed and have tailored
service to the particular needs of check-sending points.
Potential savings can only come about as EFTS gradually
eliminates the need for transporting checks. Telephone and
telegraph expenses constitute most of the remaining costs of
general service.
Emergency operations grew rapidly after the years of the
cold war. The Federal Reserve first expanded its capability to
relocate and operate from such relocation sites in the event of
nuclear warfare. This program required security files
(duplicate records) and the dispatch of daily account flows to
permit periodic reconstruction in some remote areas of Fed
accounts, including System open-market accounts. Operations
were subsequently extended to permit some commercial bank
security files, emergency cash storage, and standby clearing
facilities at decentralized locations as the Fed's capability for
emergency preparedness programs increased.
The aUditing function at each bank is under the supervision
of regional board of directors. The function provides a
continuous verification of the accounts of the banks and an
evaluation of procedures. The function is administered
independently of the bank organization hierarchy; however,
the auditing staff resides in each district. Bank presidents play
important roles in staffing the audit departments, presenting a
conflict of interest.
The planning, data processing, and data systems support
functions were designated specialized activities to increase
efficiency in the execution and management of these service
functions. They have increasingly performed more technical
and capital-intensive work, assuming much of the
responsibility for planning, methods, and processing that had
been the preserve of the older line Fed operations. This
restructuring has required the assignment of a highly
professional cadre to the new functions and retaining in some
cases merely the skeletal organizational structure of the older
functions. Thus, for example, a manager of a bookkeeping
operation, say, reserve accounts, may have few, if any,
bookkeepers left, but he may retain some of the responsibility
for decisions and coordination. Consequently, the reported
expenses of the line operation may be vastly understated.
The stock of supplies is an inventory account. It reflects
supplies and printing work in process and therefore not yet
charged to another function. There is a weakness in control
inherent in this arrangement, namely, that the responsibility
for using ordinary supplies lies with operational supervisors,
whereas the purchase of supplies for replenishing inventory is
controlled by the general service function.
CONCLUSION
Theoretically there is no explicit limit (other than the branch
building limit) on spending by the System. The Reserve
banks have no reserve requirements. They create bank
reserves and simultaneously add to their earning assets
when they buy government securities in the open market. Even
if the Fed were to spend such large amounts that expenses
exceeded earnings, there would still be available nearly one
billion dollars in surplus. Congress and the public, however,
would not tolerate a "bankrupt" Fed, probably not even one
that failed to generate annual net earnings in excess of
expenditures (it has in every year since 1915). Nevertheless,
there is a very large margin afforded by the annual difference
between net earnings and expenditures. Fed expenses could
have been four times larger in its sixty-year history and still
aggregate net earnings would have been almost twice as large
as aggregate expenses.
There is abroad, I think, a widespread misunderstanding of
the efficiency of the Federal Reserve relative to other
government agencies. This misunderstading is implicit in the
rhetorical question raised by a regional director recently: Is
there any other federal agency (with 29,000 employees) that
operates by using its own funds and then adds revenue to the
V.S. Treasury in such an amount?16 Obviously, the answer is
"No" because no other agency is empowered to create high
powered money and in the process hold $85 billion in V nited
States securities. The earnings derived from those holdings are
public returns just as expenditures by the Fed are public costs.
But there the relationship largely ends. Such huge earnings in
no way attest to the efficiency of the Fed or to the strength of
the decentralized nature of the agency. Some other yardstick
much be used to evaluate the cost effectiveness of the system.
In the circumstance of complete budgetary autonomy this may
be difficult to accomplish. To what shall the expense of Reserve
banks be compared? It seems to me that the great conceptual
weakness in granting full autonomy to the Fed was the idea
that the Fed should be accountable only to itself. This
weakness has become more serious as the range of operation
has become greater.
The System has always been constrained by self-imposed
institutional limits on malfeasant spending. Strong audits by
resident staffs and rigorous examinations by the Board of
Governors are consistently applied. It appears that heightened
Congressional interest and Board of Governors oversight are
increasingly restraining the magnitude as well as the kinds of
Reserve bank expenditures.
This paper has chiefly focused on the nature of the major
operations carried on by the System. Additional information,
beyond that which is publicly available, has been presented to
permit inferences about the growth and the efficiency of
Federal Reserve banks. It is not clear that the autonomy of
monetary policy is well served by the multiplicity of functions
that reserve banks perform. The diverse nature of the system is
confusing to the pUblic. So many functions performed by the
Fed reflect little or no valid bases for insulating them from the
federal budgetary process. And those that do - the monetary
functions - are not operationally related to the
nonmonetary functions in a substantial way. The suspicions of
Congress, the inequitability of placing all these nonmonetary
activities outside Congressional or executive cost controls
relative to other agencies, and the fairly low level of public
understanding of the Fed are disadvantages that seem to
outweigh the marginally greater efficiency that the Fed may
provide in these areas. I would argue that the rationale for
system independence is supportable in terms of monetary
functions. The remaining work of the Fed should be
structurally separate but subject to the central federal
establishment. Regional control of nonmonetary payments
functions is not consistent with uniform national standards
mandated by the Constitution.
NOTES
I. I will capsulize here an orthodox rationale for Federal Reserve
autonomy:
i. There is need to pursue monetary policy goals in circumstances of
freedom from federal budget concerns.
ii. There is need to restrict money and credit at times when the necessary
effects of such restriction are politically unpopular.
iii. Secrecy is essential in some areas of System work. First, large-scale
operations in securities markets can be achieved with minimal speculative
impact on private portfolios only if the specific intentions of impementing
policy are concealed. Second, the collection of data from and the supervision
of individual, privately-owned banking firms must involve highly restricted
access to related information passed by the Fed. Thus the Federal Reserve
must be insulated from forces that would use this sensitive information for
private purposes or would otherwise compromise the objectives of monetary
policy.
iv. If the Fed does not have autonomy of expenditure, its power to conduct
monetary policy independently could be influenced or blocked by the
"power of the purse."
2.Publications bearing on operational and policy changes include Reserve
banks' and Board of Governors' annual reports and monthly review
publications of the banks. The interested reader is urged to consult a
publication of the Philadelphia reserve bank, "The Federal Reserve in
Print," which provides an ongoing subject index of topics associated
with these changes.
3. The source of data is the Board of Governors' Functional Expense
Reports, 1952-1973, unpublished. Logarithms in the annual values of the
items, .Y j , were regressed on a time variable, t:
i
Log Y = a + bt, where j = the item for which growth is to
be calculated, t = 1,2, .... 22, and antilog of the estimate, b, minus 1.00, is
the trend growth rate.
4. I have used the compound annual rate of change in the GNP deflator
reported in the monthly Federal Reserve Bank of St. Louis publication,
National Economic Trends. From 1952 to 1971 the rate was 2.5 percent.
From 1955 to 1973 it was 3.0 percent.
5. Federal Reserve Bank of Richmond, Annual Report, 1975, p. 18.
6. Public acceptance of EFTS might have increased since the U.S.
Treasury began the automatic deposit of social security benefits to accounts
of beneficiaries.
7. Pending legislation to permit such expansion is discussed in the
American Banker, vol. CXL, no. 237, December 12, 1975, pp. I and 24.
8. For an interesting view of the transportation problem, see Wall Street

Journal, February 2, 1976, pp. 1 and 13.
9. Consolidation of federal bank supervisory agencies has been proposed.
See President's Commission on Financial Structure and Regulation,
Report.Washington, D.D.: G.P.O., 1971, also U.S. Congress, Committee on
Banking, Currency, and Housing, Financial Institutions and the Nation's
Economy (FINE), Discussion Principles, 94th Cong., 1st Sess., Title VI
(1975).
10. Number of employees and expenses (compensation, travel, and other
direct expenses) of Federal Home Loan Banks increased by 14.90 percent
and 13.19 percent respectively from 1952-1973, annual trend growth rates.
FDIC and FHLB expenses were obtained from internal records through the
cooperation of these agencies.
11, Federal Reserve Bulletin, vol. 61, no. 7, July 1975, pp. 14-15. and vol.
38, no. 8, August 1952, pp. 899-901.
12. Meetings expense generally chargeable to the general overhead
function also include: American Institute of Banking, Robert Morris
Associates (a credit association), National Association of State Bank
Supervisors, Bank Administrative Institute, (an auditors' and controllers'
organization), Administrative Management Association, Chamber of
Commerce, Business and Professional Women, National Machine
Accountants Association, Systems and Procedure Association, and
Personnel Management Association. This is not an inclusive listing, but it
provides most of those organizations which Reserve banks typically
participate on both a national and local level.
13, Federal Reserve Bulletin, August 1952 and July 1975.
14. See "Regionalism: A Survey of Views of Regional Directors of the
Federal Reserve, "Journal of Economics and Business, Fall 1977.
15. See Reappraisal of the Federal Reserve Discount Mechanism, Board
of Governors of the Federal Reserve System, vols. I-III, 1971-1972.
16. "Regionalism: A Survey." op. cit.
Comments on
'A Post-Accord History of Principal
Federal Reserve Functions"
BERNARD SULL*
Professor Harrison's paper appears to have three

objectives: " ... to rectify to some extent the neglect of the
nonmonetary side of the (Federal Reserve) System's activi-
ties," to measure changes in productivity in Reserve Bank
functions; and to evaluate the traditional argument for Federal
Reserve independence in light of the extent to which
"nonmonetary" activities engage System resources.
These objectives are not so closely related tnat their
juxtaposition is necessary or inevitable. One could, for
example, enlighten economists and others about the non-
monetary side of the Federal Reserve without considering
change in productivity. Change in productivity is in itself a
worthwhile topic but need not be of critical importance to the
issue of Federal Reserve independence. (After all, it has not
been Federal Reserve inefficiency in a technical sense that has
persuaded many economists that the system should be more
directly responsive to Congress and/ or the President). Finally,
the scope of the System'snonmonetary activities need not be
significant to independence. If one believes that it is, the
analysis should focus on the closeness of the relationship
between "monetary" and "nonmonetary" activities as well as
the extent of each. The first and last objectives may be related,
*Hunter College, Department of Economics
Comments on "A Post-Accord History ... " 93
but some careful taxonomy is needed.

Unfortunately, Harrison's attempt to deal with all three
issues in a related fashion doesn't work. Not one is given the
attention it merits. One is left with few, if any, persuasive
conclusions.
In discussisng the nonmonetary side of the System's activity,
Harrison relies on classifications provided by an internal
functional cost accounting system used by the 12 Reserve
Banks. Costs are separated for functions such as "bank
examination," "currency and coin," "accounting-wire
development transfer," 'bank examination," and so on. His
description of these functions and their development is useful.
But given the issues that he raises, it would seem obligatory to
attempt a separation of monetary from nonmonetary
functions-perhaps no more than a crude one-to provide the
reader with a universe for description and with a sense of the
relative importance of the nonmonetary side. There is
none. True, the accounting system is not particularly kind to
such attempts. For example, research, bank relations and
public information are grouped as a function; data processing
support for "monetary" and "nonmonetary" functions is not
separated. Moreover, some rather well-defined functions have
monetary as well as nonmonetary elements, for example, the
discount function and bank examinations. In this case,
Harrison's difficulty is reflected in has introductory statement
on the discount function: "Although the discount function has
been a major instrument of Federal Reserve policy, there are
small costs associated with its administration," a statement
that suggests that the administration ofthe discount function
has nothing to do with its use as an instrument of Federal
Reserve policy. Of equal difficulty is the fact that the
accounting system is apparently used only by the Reserve
Banks and not by the board; and so the "nonmonetary"
activities of the board, whatever their extent-which I suspect is
considerable-are ignored. The upshot is that by relying solely
on the accounting system, Harrison is not in a position to

classify the System's nonmonetary activities. The
"rectification of neglect" purpose is only vaguely achieved.
And no legitimate quantitative estimate of the nonmonetary
activities is possible.
Harrison does provide estimates of change in productivity
for several ~unctions from 1952 to 1973. He compares rates of
change in physical piece-work measures of output to rates of
change in functional costs. On this basis "check collection" has
become more efficient; and he concludes that "currency and
coin" have not. Many of the functions do not have as obvious a
physical output as the number of checks processed or the
volume of currency and coin handled. Thus no attempt is made
to provide a quantitative estimate of productivity for such
functions as "bank examinations" or "fiscal agency." In con-
sequence, no overall estimate of change in Federal Reserve
productivity is possible.
Productivity is defined as a relationship between physical
output and physical imput. The physical output-to-expense
measure must be adjusted for changes in prices when used in
time-series analysis. Harrison does make a rough adjustment,
using the GNP deflator. But for some reason that is unclear to
me, his concluding statements are cast in terms of nominal or
unadjusted changes in productivity. Thus he finds that there
has been "a negative nominal change in productivity" in
"accounting-wire transfer" and that "nominal productivity
growth has been negative" for "currency and coin." He leaves
to the reader the job of making the appropriate price
adjustment that indicates that in both cases there have been
small increases in productivity.
In any event, the problem of evaluating Federal Reserve
operations is more complex than indicated by comparing rates
of growth in output and expenses. Federal Reserve expendi-
tures, for example, in the area of electronic fund transfers and
automated clearing houses may result in gains for others,
Comments on "A Post-Accord History ... " 95
including the general public, without being completely

reflected in Federal Reserve productivity. Harrison recognizes
this possibility but has not begun to grapple with the issue of
externalities.
Harrison accepts the argument that the Federal Reserve
needs to be "independent" in its monetary policy function.
However, he sees no reason to apply the same argument to its
nonmonetary work. Thus he is in favor of GAO audit of the
nonmonetary segment and budgetary control by Congress.
There is not much to argue with here. It has never been
completely clear that GAO audits-even for the monetary
segment-would necessarily compromise Federal Reserve in-
dependence. It is clearer that budgetary control by Congress
could. Nevertheless, a number of issues arise. What functions
are to be classified as "monetary" and what as "nonmonetary";
are any of the nonmonetary functions (in Bank Holding
Company Act language) "so closely related" to the monetary
function that they could be granted immunity from budgetary
control; do any of the nonmonetary function, not so closely
related, suggest distinct arguments for "independence", such
as the conglomerate of functions related to bank supervision.
There is currently a bill in Congress to extend GAO audit to
the nonmonetary functions of the Federal Reserve. Given this
approach, a careful analysis of the functions that should be
independent and those that need not be is certainly in order.
This paper provides a background which such work could
proceed.
Public Ownership and Natural
Resource Utilization***
DAVID L. SHAPIRO* AND ROBERT B. SHELTON**
INTRODUCTION
Fashionable at the moment in federal policy-making circles

is the notion of conservation. The President of the United
States has called for the pricing of petroleum and related
products at their cost of replacement. [5] The plan eschews the
use of market forces but relies heavily on a variety of taxing
and regulatory measures. [5] Nonetheless, the general idea is in
accord with economists' conclusion that marginal cost pricing
will ensure that resources flow to their most highly valued uses.
However, when governmental agencies "own" natural
resources of the renewable variety, many departures from
marginal cost pricing can be observed. The existence of these
departures raises two sets of interrelated questions.
1. Is there a systematic tendency for such pricing practices
to exist? If such is the case, what are the reasons for this
tendency?
2. If governmental agencies are not pricing at the
* Federal Energy Administration. (The opinions expressed here are

solely those of the writer and do not necessarily represent the views of the
Federal Energy Administration.)
**National Energy Strategies Project, Resources for the Future, Inc.
***The authors would like to thank William Morgan and Gerald Sirkin
for helpful comments.
Public Ownership and Natural Resource Utilization 97
replacement cost when resources are under their direct
control, can these agencies be relied on to ensure that such
pricing will take place when the resources are in private
hands but subject to government regulation?
Answers to these questions must be sought in models of
bureaucratic behavior. Only when the behavior of public
agency personnel is better understood will it be possible to
make reliable predictions concerning the effects of entrusting
resources to such agencies.
This paper will begin by examining some existing studies of
agency pricing. We will then develop a model that is consistent
with the observed tendencies of water resource agencies to
price their output below the actual marginal costs of supplying
such output. Next, the methods by which underpricing occurs
are discussed. Finally, an empirical example that tends to
support the general model developed in this paper is presented.
SOME RECENT EVIDENCE OF AGENCY

PRICING
Several writers have reported studies indicating that public
agencies price output below costs of production. The study of
Hirshleifer, DeHaven, and Milliman examines the pricing
policies of publicly-owned municipal water systems based on
data compiled by the American Water Works Association.
Their technique involved examining the aggregate rate of
return on capital for these systems, arguing that "a low
aggregate rate of return demonstrates that in such
circumstances new capacity is usually built prematurely to
provide for demand increases that should instead be handled
by price adjustments." [3, p. 109]. On this basis they conclude:
It seems quite conclusively established, therefore, that water rates -
especially those of publicly owned systems - are characteristically far too
low to recover a correctly calculated average cost. If our argument above was
sound that marginal costs for the expanding water-supply probably exceed
average cost, by and large, we may conclude afortiori that current rates are
far too low ... [3, p. Ill]
A second study suggests that public agency prices are too

low when judged on the bases of economic efficiency. In their
book on water resources in Northern California, Bain, Caves,
and Margolis examine the pricing practices of water agencies
that market both argicultural and municipal water to
determine whether such agencies are economically efficient.
They conclude:
Distortions of water allocation among classes of urban customers thus may
have greater relative importance than those among agricultural users. But
for both groups of agencies deficiencies in retail pricing practices and
resulting allocational distortions are varied and important.
The major distortion seems to lie in prices too low to reflect the long-run
marginal costs of the typical system. This conclusion rests on the failure of
urban pricing systems to differentiate between demands expressed at the
system?s peak demand and at other times; and upon the accounting practices
and the use of rationing to restrict peak demands among irrigation agencies.
In addition neither class of retailer makes allowance for any external
marginal opportunity cost of the water it sells ... [1, p. 361]
A third study is concerned with the sale of electric power.

Richard Wallace published a study examining the pricing
practices of the Tennessee Valley Authority (TV A). He found
evidence of agency underpricing in the critical area of electrical
energy. His technique was to ascertain the incremental costs of
new capacity and to determine whether the revenues generated
by TVA were sufficient to cover such costs. (As in the other
studies, the critical consideration is whether prices are
sufficient to cover incremental costs.) Wallace's estimated
costs of new capacity were remarkably close to the estimates
made by the agency itself. He concluded:
... TV A's rates are too low to reflect the cost of overall increases in power
supply. Even the minimum cost assumptions used in this study, 4.5 percent
interest and payment of no federal corporate income tax, indicate a deficit of
10 percent on increased sales. The deficit increases to 17 percent if interest is
computed at 6 percent. The deficit increases to 30 percent if an interest rate of
6 percent and payment of federal corporation income taxes are assumed. [10,
p. 5331
SOME REASONS FOR UNDERPRICING

Agency officials are reluctant to bring prices up to marginal
cost levels because of a variety of adverse effects that stem from
such price increases. Some of these effects are the following:
1. Effect on Project Adoption
High prices for prospective project output tend to worsen
the prognosis for project adoption. The enthusiasm of
prospective purchasers will be inversely related to the price
level of that output. [Needless to say, it is somewhat
embarrassing when water projects face protracted delays in
adoption because of the reluctance of designated project
beneficiaries to contract for the output or because local taxing
jurisdictions refuse to furnish the requisite financial
contributions to the project.] These factors motivate water
agency planning officials to depress output prices as much as
possible.!
Agency officials in general stand to gain a great deal from
project adoption. In the absence of new or expanded projects,
agencies will not grow and may even contract. The failure to
expand endangers the position of management and employees
of an agency. Conversely, expansion creates additional
positions and opportunities for agency personnel. For these
reasons, officials are motivated to depress output prices in
order to further agency activities. 2
2. Tenure of Officials
After a project has been adopted and is in operation,
reluctance to raise prices continues. Significant increases in
price will tend to create strong opposition among users of
project output. These users are also voters who can exert
political pressure on legislators and policymakers. A rebellion
by such "user-voters" can cause considerable discomfort for
agency officials. Officials who are too quick to raise prices may
find themselves replaced by new officials.

3. Effects on Quantity Demanded
Finally, and in support of the preceding points, raIsmg
prices can jeopardize the continuance of agency activities by
severely reducing the amounts of agency output demanded.
For example, raising agricultural water prices to their true
opportunity costs (which is usually the use of that water for
municipal and industrial uses) would go a long way toward
eliminating several projects the main justification of which was
to supply agricultural water. (Even such projects that supply
large quantities of urban water, such as the Feather River
Project in California, would find it difficult to dispose of urban
water if actual marginal costs were covered.)
Once a project is in place, it should be noted that several
legal problems may inhibit or deter increases in price.
Although the statutes authorizing most projects state that
costs must be covered, an attempt to cover esoteric (to the
laymen) types of cost, such as the opportunity cost in the most
valuable alternative use, may dra w successful legal challenges.
Furthermore, when projects are constructed, it is common for
an agency to execute long-term contracts for the sale of output,
and attempts to abrogate these contracts would undoubtedly
draw legal fire.
In sum, the expectation that officials will ever make
substantial efforts to set prices at marginal cost levels is quite
remote.
A MODEL OF AGENCY PRICING

We will now construct a formal model of agency behavior
consistent with our observations. 3 In fact, these arguments
may be summed up by stating the basic assumption that
agencies attempt to maximize their budgets. 4 We shall assume
that the agency's budget is based on two sources of revenue-
revenue from the sale of output and per-unit subsidies, both of
which are determined by the legislative process.
We begin by defining the following variables:

B = The amount of agency budget
R = The revenues derived from the sale of agency output
P = The price charged for agency output
S = The subsidy to agency output provided by the
appropriating legislative body
LS = The lobbying support exerted on behalf of the
agency by its constituent pressure group
Our system of hypothesized relationship can be charac-
terized as follows:
B = R + S (1)
where R = f(P), oR > 0 ( la)

oP
S geLS), ~ > 0 (lb)

oLS
oLS
and LS = h(P), '§"i> < 0 (1c)
The budget maximand with respect to price then becomes

oB oB oR oB oS oLS
op =a'R8P + oS oLSaP =0 (2)
But oB
TR = as
oB
= I so that (2a)
-oR - ---
oS oLS
oP - oLS OP ----" (3)
Equation (1) states that an agency's budget is the sum of the

revenues received by the sale of agency output and the
revenues received from the legislature. (The agency cannot
ordinarily run a deficit but must receive the difference between
its costs and revenues from the legislature.) Equation (1a)
reflects the fact that the revenue received for agency ouput is a
function of the price charged for that output; (1 b) expresses the

notion that the subsidy that the legislature is willing to confer is
a function of the lobbying support that is exerted on behalf of
the agency; and (l c) represents the inverse relationship
between the price charged for agency output and the amount
of lobbying support that the constituent pressure group is
willing to furnish. Equation 2 describes the actual
maximization process. The agency attempts to set a price that
assures it the largest amount of revenues, that is, maximizes
the agency's budget; and (2a) reflects the simple fact that a
dollar increase in either revenue or subsidy results in an
additional dollar of budget.
All of the above leads to equation 3 that encapsulates the
essence of the argument being made here. Agency decision
managers will raise the price of agency output as long as there
is no net decrease in the agency's budget. The price will not be
raised beyond the point at which more is lost in the subsidy by
the erosion of lobbying support than is gained by increased
revenue as a result of the price increase.
Lobbying support and subsidies playa key role in our
model. Lobbying support may appear to be a nebulous
concept. However, large quantities of real resources are
expended in order to assure passage of legislation and to
influence legislators for other purposes.
In addition to such explicit lobbying efforts on behalf of
specific legislation, the major reason for the existence of many
or most trade associations is the conduct of ongoing efforts to
influence legislators. In the water resource field several "users"
associations were formed in California to persuade the federal
government to alleviate real or imagined water shortages. The
organization and maintenance of these groups are very costly.
Naturally, these groups will concentrate their attention on
specific agencies whose output, tangible or intangible, has
economic value to the groups' members. (The groups that
concentrate on particular agencies are often called the
constituent pressure groups of those agencies.) The argument

associated with our model is that resources will be expended by
those groups in order to lower the prices of the output to them
or, as our model explicitly shows, increase the subsidies to
them. Therefore, subsidies are direct functions of lobbying
support. Furthermore, our model argues that lobbying
support is inversely related to the price of the agency output.
Pressure groups will invest in lobbying support as an
alternative to paying an increased price for a product. There
would be no point to financing lobbying support if the "mar-
ket" price or something close to it had to be paid for output.
More specifically, the problem facing an agency manager
who must decide (or recommend) a pricing policy is clear in the
simple case in which an agency produces only one output. An
agency will propose a price that will create the maximum
lobbying support for both passage of the legislation and for a
subsidy of the output. (In this simple case, the two aspects of
lobbying support actually collapse into one.)5
However, a much more interesting and complex situation is
one in which the agency produces mUltiple outputs, each
producing a different net revenue and varying amounts of
lobbying support. The agency manager is then in a position to
"cross-subsidize" agency outputs. That is, the agency manager
can increase the price of an output which generates little
political support and use the positive net revenues to lower the
price of an output which will generate political support for the
agency. This is independent of any questions of external
subsidization by the legislative authority. Of course, the
internal subsidization will simply increase the political
pressures for legislative subsidies by increasing lobbying
support. 6
SOME FURTHER EMPIRICAL EVIDENCE

OF AGENCY PRICING
The Bureau of Reclamation's pricing policies support
directly the cross-subsidization model presented in this paper.

Table 1 shows the distribution of revenues received from
power generation by the Bureau of Reclamation. As indicated,
over $4 billion in present value terms has been received or is
anticipated from existing bureau projects or projects coming
on line and will be used to subsidize irrigation projects. As one
may expect, the irrigation interests have been the most
important political supporters of the bureau's projects.
It is also interesting to note the sources of revenue from
power generation. As Table II indicates, over 88 percent ofthe
revenue from power sales comes from sales to intermediaries,
whereas only a little over 11 percent comes from sales to
ultimate consumers. A cross-subsidy pricing scheme based on
political considerations, whereby an agency may wish to
minimize the lobbying activities of counterpressure groups, is
consistent with such a revenue distribution. 7
SUMMARY AND CONCLUSIONS

This paper argues that there are political reasons for agency
officials to ignore actual marginal cost considerations when
pricing the output of their agencies. Raising prices to marginal
cost levels for all agency outputs is a hazardous enterprise for
agency managers. Fulfilling the imperatives of efficient
resource allocation may impede the expansion of their
agencies and thereby diminish the bureaucratic rewards
available to these officials. For these reasons, officials cannot
be relied on to incorporate the entire array of marginal costs
into pricing decisions for all agency outputs, and there will be a
tendency to cross-subsidize agency outputs. Empirical
experience strongly supports these conclusions.
NOTES
I. This process has been formalized in Shapiro and Shelton in a
forthcoming article [9]. The notion of "as much as possible" is given further
meaning in that article.
~
C)-
;:;.
-
o
TABLE I ~
~
~
~
Repayment of Reimbursable Costs by Commercial Power Revenues, June 30, 1975.
'6'
Ultimate Repayment During Payout Period on Current Schedules I:l
~
I::),..
Reimbursable Sources Other Obligations Repayable by Power Revenue Surplus Power Total
~
lo:::
-
Commercial Other Than Irrigation or Interest Operating Revenues as Reimbursable ~
Power Reclamation Other Aid Charges Expenses Scheduled by -
Power (Credits not Reclamation ~
c.,
(Credit Scheduled) Power
o
lo:::
~
Total, USBR $3,146,662,109 $60,111,662 $4,193,677,822 $2,044,738,629 $6,563,860,312 $645,201,926 $16,709,189,185 S
E:
1-.1'
SOURCE: Federal Reclamation Projects: Water and Land Accomplishments; 1975. Project Data, I:l
Statistical Appendix II. (U. S. Department of the Interior, Bureau of Reclamation), p. 49. -c·
~
-
oVI
...-
o
0-
CIl
-l
c:::
TABLE II o
m
CIl
Electric Energy Sales by Reclamation Power Systems, Fiscal Year 1975. Z

-l
Sales to Electric Utilities X
tTl
Municipal State Rural Other Federal Privately Subtotal SALE: s::
;l>
Utilities Utilities Cooperatives Agencies Owned TO z;l>
[For Resale] Utilities ULTIMATE
Cl
CONSUMERS tTl
s::
tTl
Z
TOTAL ALL PROJECTS -l
Energy Sales (kWh) 7,173,018,086 7,581,185,204 8,573,712,023 18,550,188,977 6,028,403,882 47,906,508,172 6,171,663,404 o."
Percentage 13.26 14.02 15.86 34.30 11.15 88.59 11.41 Cl
Distribution o
-<
tTl
Revenues (dollars) 38,609,754 49,333,586 52,341,043 9,533,198 42,347,745 192,165,326 21,279,179 ;;z::l
Revenue per kWh 5.38 6.51 6.10 .51 7.02 4.01 3.45 Z
(mills)
s::
tTl
Z
-l
SOURCE: Federal Reclamation Projects: Water and Land Accomplishments, 1975. Project Data, tTl
Z
ttistical Appendix II. (U. S. Department of the Interior, Bureau of Reclamation), p. 115. -l
tTl
;;z::l
'"?::
CIl
tTl
2. The motivations of agency officials to increase agency size are explored
in [5, 8].
3. This model is constructed from observations made by several authors
[2, 5, 8, 9]. However, some of the observations on which the model is
constructed are not based on the bureaucratic process being discussed here
but rather on the regulatory bureaucratic process [see 7].
4. Actually, as is generally recognized, it is perhaps more appropriate to
assume a utility function for the bureaucrat and to maximize this utility
function with respect to the appropriate arguments and subject to some
constraint. However, as others have recognized, the budget is the dominant
argument, and there is little to be gained by such a construction (See [2]).
5. This simple case is essentially the one examined by Shapiro [8].
6. Niskanen, examining a different funding situation (namely, a bureau
that receives all of its support from a legislative sponsor and sells none of its
output), arrives at similar conclusions. He argues that an agency will use
some of its funding to subsidize services that are not due the subsidization
because of " . . . the inability of the sponsor to know or control the
expenditures by service." [5, p. 110]
7. The literature abounds with discussions of other methods of
subsidization (such as agencies' ability to avoid property and income taxes)
and discounting procedures. For a discussion of the issues, see [3]. The
interest rate used in discounting has been especially critical.
REFERENCES
1. Bain, J., R. Caves, and J. Margolis. Northern California's Water
Industry. Baltimore: Johns Hopkins Press, 1966.
2. Breton, A. The Economic Theory of Representative Government.
Chicago: Aldene Publishing Company, 1974.
3. Hirshleifer, J., J. DeHaven, and J. Milliman, Water Supply:
Economics, Technology, and Policy. Chicago: The University of Chicago
Press, 1960.
4. Hirshleifer, J., and D. L. Shapiro, "The Treatment of Risk and
Uncertainty," in Public Expenditure and Policy Analysis, ed. R. H.
Haveman and J. Margolis. Chicago: Markham Publishing Company, 1970,
pp. 291-313.
5. Niskanen, W. A. Bureaucracy and Representative Government.
Chicago: Aldene-Atherton, 1971.
6. Russell, M. R. "Energy" in Setting National Priorities - the 1978
Budget, ed. J. Pechman. Washington: The Brookings Institution, 1977.
7. Russell, M. R. and R. B. Shelton. "A Model of Regulatory Agency
Behavior." Public Choice, XX (Winter 1974), pp. 47-62.
8. Shapiro, D. L. "Can Public Investment Have a Positive Rate of
Return?" The Journal of Political Economy, LXXXI (Marchi April 1973),
pp.401-413.
9. Shapiro, D.L. and R. B. Shelton. "The Application of an Agency

Decision-Making Model." Public Choice, forthcoming.
10. Wallace, R. "Cost and Revenue Associated with Increased Sales of
TV A Power." Southern Economic Journal, (April 1967), pp. 526-534.
Comments on "Public Ownership
and Natural Resource Utilization"
GERALD SIRKIN*
The economics profession has been slow and other

disciplines have been slower in recognizing the disconnection
between the scientific analysis of public policy and the policy
that actually emerges from the public choice process. The
reigning perception of man as public policy maker has been
"political man" who "evaluates and maximizes on behalf of the
public interest, rather than his own. "I "Political man
predominates in public policy discussions, where good will or
public interest guides the behavior of politicians, legislators,
and functionaries in the bureaucracy.''2 This naive view of
orthodox social scientists is slowly giving way to the perception
of modern public choice analysis that social optimization is
not the goal of voters, politicians, and bureaucrats.
Shapiro and Shelton provide a neat case study of the gap
between "political man" and real public decision makers in
their analysis of the gap between an optimizer's policy
(marginal cost pricing) and the actual pricing policy of a
government agency selling a product.
I have found it interesting to translate their model into
revenue and cost curves of the conventional textbook variety.
These diagrams refer to pricing decisions after the projects
have been adopted.
*Department of Economics, The City College of the City University of

New York.
llO STUDIES IN THE MANAGEMENT OF GOVERNMENT ENTERPRISE
Price,
Marginal
Revenue,
Average MC
Cost,
Marginal
Cost
D
I Quantity
I
Total I
Revenue, I
Total Cost I
ITC
IlAI
-~I TR +8
I
I
Q1 Q2 Q3 Q4 Quantity
Figure 1
Comments on "Public Ownership ... " III
In Figure I the total revenue and total cost curves of Project

1 are shown. The total revenue curve (TR) rises and then falls
as the price is reduced in accordance with the standard
assumption of a demand curve with declining elasticity.
To the total revenue curve is added the subsidy (s) that
begins when the price is low enough to attract political support
and increases as the price is reduced. The total receipts of the
agency from Project 1, therefore, are shown by the curve
labeled TR + S.
Profit maximization would call for price pI and quantity QI.
Marginal cost pricing would set the price at p2, when the price
equals the marginal cost, and the quantity supplied (Q2) will
equal the quantity demanded at P2. (lfthe scale of the project
were optimally adjusted, the lowest point of the average cost
curve would lie on the demand curve, and the price would
equal the marginal cost and the average cost.)
Agency officials attempting to maximize the agency budget
under the constraint that the budget must balance will set the
price at p3 and sell Q3 if this project is the only agency project.
At that point total receipts will be as high as they can be and
still cover the total cost.
Next, suppose that the agency also manages Project 2 that
can attract no subsidy no matter what price is charged for its
product. To economize on diagrams, assume that the second
project has the same demand and cost functions as the first.
The agency will then set the price on Project 2 to make a profit
and use that profit to cross-subsidize Project 1. The price set on
Project 2 will be between the profit-maximizing price (PI) and
the price that maximizes total revenue on Project 2. Where in
that range the price for Project 2 is set will depend on the
marginal effect on the total budget as the price is reduced
below pI, increasing the total revenue on Project 2 but
reducing the profit on Project 2 and therefore, reducing the
cross-subsidy to Project 1 and thus reducing the potential
additional revenue and legislative subsidy on Project 1. (The
calculation of the budget-maximizing price for Project 2 will

depend on the marginal costs and the marginal revenues of
Projects 1 and 2 and the marginal propensity of the legislature
to subsidize Project 1.)
The cross-subsidy is illustrated in the diagram by assuming
that the budget is maximized by setting a profit-maximizing
price of PIon Project 2. The total profit (labelled A) is used for
a cross-subsidy to Project 1 (labelled A'). The price on Project
2 is then set at p4 and the quantity at Q4.
The theory underlying the Shapiro-Shelton model is stated
in terms of bureaucratic behavior. But it should be noted that
this case is not one of a divergence between the objectives of
bureaucrats and the objectives of politicians, such as occurs in
the ordinary examples of bureaucratic budget-padding,
inefficiency, or dissemination of misinformation about the
bureau. In other words, this analysis is not only concerned
with the implementation of public choice, as distinguished
from the making of public choice. In this model of agency
pricing, the public-choice process and bureaucratic behavior
are not separate phenomena because bureaucrats are merely
implementing politicians' choices. Subsidies to the agency
budgets are the rewards that induce bureaucrats to satisfy
politicians' preferences. The preferences of politicians, as
determined by their dominant motivations - to win elections,
are controlled by the preferences of voters. And the
preferences of voters for inefficient government policies rest, I
believe, on "rational informational bias,''3 that is, voters'
propensity to acquire information about public policies that
directly benefit them and to be ignorant of the more remote
policies that injure them because it would be irrational to incur
much cost to obtain information on public issues.
NOTES
1. Karl Brunner and William H. Meckling, "The Perception of Man and
the Conception of Government," Journal of Money, Credit and Banking,
Comments on "Public Ownership ... " 113
Feb. 1977, Part 7, p. 74.

2. Ibid.
3. See Gerald Sirkin, "The Anatomy of Public Choice Failure", The
Economics of Public Choice, Robert D. Leiter and Gerald Sirkin, Eds.
Cyrco Press, N.Y. 1975.
The Development and Implementation
of an Operational Planning System*
GARY GAPPERT AND MARTINE G. BRIZIUS**
I. INTRODUCTION
The management problems of government enterprises are
often obscured by a concern with budgets, budget planning,
and the allocation of fiscal resources. Those are important
concerns, but they must be linked and related to the planned
allocation of time and talent. The New Jersey State
Department of Education has designed an operational
planning system that incorporates some of the features of both
program budgeting and management by objectives (MBO).
The primary focus of this system is planning and monitoring
through a structure of "program centers. "Through this system
*This paper could not have been possible without the cooperation and
substantial imput of our friends and colleagues, Peter Hahn and Lloyd
Fredericks. They have provided much ofthe design work associated with the
current phase of the operational plan. Their work follows the earlier work of
Bill Cozzens, Bob Hanson, and Ed Jackowski. We also appreciate the
motivation and enthusiasm of the operational plan coordinators of the
different divisions of the State Department of New Jersey. The support of
the deputy commissioner, Ralph H. Lataille, has been critical to the success
of this system. His determination to introduce rationality into the system has
been the principal nuturing factor behind the implementation of the plan.
Commissioner Fred G. Burke has of course been the ultimate contributor to
the success of the planning system. His ability to impart "clarity" to the
"complexity" of planning is truly outstanding.
**Division of Research, Planning and Evaluation, New Jersey
Department of Education
The Development and Implementation ... 115
we have initiated an effort to link fiscal accountability to the

planned activities and objectives of the professional staff. The
process allows for the more precise identification of
governmental "product" and provides for some control over
productivity through attention focused on objectives and
activities at a middle management level.
This paper reviews the rationale for an integrated planning
and monitoring system, describes its elements, and discusses
its implementation in a bureaucratic organization. The
discussion indicates that a "clarification" component is
required in a planning system to offset an augment the
"calculation" and "control" components. The implementation
of planning systems in support of management needs to be
assessed against standards of "modified rationality" as well as
"modified frustration." The "clarification" component
establishes communications and managerial feedback as
critical, often neglected, processes in implementation.
We need to begin by considering the purposes and the
problems associated with the introduction of new planning
systems into public agencies over the last decade and a half.
Different planning technologies have flourished. These
systems include PERT (Program Evaluation Review
Technique), CPM (Critical Path Method), MBO
(Management by Objectives), PPBS (Planning-
Programming-Budgeting System), and others. ZBB (Zero
Based Budgeting) is the latest.
Each planning technique seems to have a certain utility at a
particular time and place. But their diffusion of techniques as
tools for general organizational policy planning has evoked
limited success. It appears that there is no general planning
model or system that can be transferred across different
organizations without major adaptations and without
generating a high degree of frustration and failure. Indeed,
where planning systems have been imposed, their so-called
successful implementation has produced a new paper process
that lasts only as long as the "imposers" remain in power or

remain motivated to exercise that power.
We need a new administrative theory to counteract the
excesses of both the Hitch/ McNamara paradigm ofPPBS and
the AMA mission of Management by Objectives. The cost-
accounting and goal-setting efficiencies of both systems can
exact too high a price, the most obvious being a smothering of
management initiatives with a sea of paper. These systems also
introduce a rigidity of planning tha t converts the process into a
rational ritual.
In this paper no attempt is made to develop a new theory.
But it proposes adding a new dimension to the purposes of
planning systems and then discusses the experience of
implementing a planning system in a state agency in New
Jersey.!
Dahl and Lindblom described planning in the early 1950s as
being based on the twin purposes or processes of "calculation"
and "control." Calculation refers to processes of rational
analysis and control obviously deals with the exercise of
power. The exercise of power is, of course, more likely to be
less systematic and more arbitrary than rational.
What seems to be necessary as the third purpose of a
planning system is a process of "clarification. " Clarification is
the process that can lead to both "modified rationality" and
"modified arbitrariness." The role of clarification processes
will be discussed in several ways.
First, it is clear that the calculation components of plan-
ning procedures are introduced to modify the arbitrariness of
command and control decisions at various levels of a
hierarchial organization. By necessity decisions in crisis
situations are made either on the basis of limited information
or by a rapid, ad hoc "opening of the circle" to include the
relevant managers or project staff who have better information
or data about given situations. On the other hand, routine
decisions based on stable, periodic data "codified" at least
informally into rules or habits over many years and situations

do not require new analysis. Organizations encountering new
environments or situations must find some systematic way to
"calculate" the consequences of these emergent situations; the
calculations are used to communicate new data and new
tradeoffs to the top decision makers of the organization who
then must integrate such calculations into subtle or abrupt
shifts from established procedures for the allocation of money
and people and other areas of decision making. The
calculation must be communicated in such a way that it can
effect real decision options.
Second, it is less clear but no less true that the control
components of planning systems are needed and desired in
order to modify the rationality of the decisions suggested by
the calculation components. The "calculations" flowing from
the interactions of an established organization with an
emergent situation2 point to some reallocation of both
resources and values - suggesting a reordering of priorities.
Such a reordering may cause "loss" and "grief" as well as
"windfall gains" in an organization. Knowing this, the
operators of the control center of the organization may wish to
regulate the pace of change. In other cases, communication
and negotiation are required with those who can either inhibit
and obstruct or promote and facilitate change. The calculated
changes must be negotiated.
Third, the linkage between planning and budgeting is always
weak within any large, complex organization. In large
organizations planning is delegated to the "calculators" and
command over fiscal resources is delegated to the
"controllers." These two groups are usually separated by
tradition and training as well as by structure and style. A
structure and a cycle of communications need to be established
between these two units. Interaction may be facilitated by the
fact that usually the staff controllers are also interested in
"calculations." But they may be interested in different kinds of
calculations and for different sets of reasons. Therefore,

communication between these groups is important. In today's
organization of "no-growth" or "cutbacks" common language
involves reordering priorities. 3 At the very least, there is
usually a common interest in maintainging existing levels of
service to important client groups even in the face of sharply
reduced resources. However, in a well-led organization that
faces demands for new services in changing environment, the
purposeful expansion of service areas or a planned
retrenchment and shrinkage make agreement essential.
Calculations to support and defend "rational" cutbacks
enhance the value of those who can generate and use data-
based arguments. Planners who have established good
relations with operating units can usually identify where the
greatest "slack" is and propose the redistribution of resources
and/ or the reordering of objectives and activities. (The
reordering analysis of the planner requires motivation and
communication skills so that support can be built for the new
organizational sructure and functions.)
Fourth, in an organization that is attempting to respond to
new demands and/ or new constraints, some, if not total,
reorganization is necessary.4 Any reorganization exercise must
ultimately involve the middle managers - those who manage
important program centers. Reorganization can be termed
clarification. New organizational functions, goals, and
objectives are identified, and new organization structures are
"fitted" to those functions. At the same time however, there are
partial reorganizational needs that emerge almost
continuously at some levels of a large, complex organization.
The need to institute processes of managerial feedback is the
fundamental role of clarification and communication in a
planning system. The calculation and control components
must provide clear opportunities (and time) for the middle
managers to manage.
In this paper we layout the core and ancillary components
of a planning system. Although the m-odel may seem simple,

the implementation of the system is viewed as a complex
undertaking that requires a commitment to continuous
communication. The concerns or lessons of implementation
are presented in Part III. The ultimate lesson involves
"modified frustration" - the achievement of modest
increments of rationality is viewed as progress.
II. ELEMENTS OF THE OPERATIONAL

PLANNING SYSTEM
A. The Structure of the Organization
The first step in establishing the new operational planning
system involved designing an organizational structure that
would be more precise and more flexible than the existing
structure. This need was met by changing the designation of
the existing major units in the department. Divisions were
divided into programs, programs into projects, and projects
into subprojects (whenever that level of specificity was
useful). These terms were felt to more accurately reflect the
product outcomes expected of the System than the older
terms 'Branch', 'Bureau' and 'Office'.
Such a change in nomenclature is critical as a f ounda tion for
a system that must be updated every year and revised quarterly
in order to respond to changing client and organizational
needs. Bureaus and offices seem to imply a justification for
their existence merely by being bureaus and offices. Programs
and projects, on the other hand, put the focus properly on the
outcomes desired.
Participants in the Operational Planning System were
assigned the similar names of division heads, program
managers, and project directors. In addition, each division
appointed a representative, usually from its management and
operations program, to serve part time in the capacity of
operational planning coordinator. The operational planning
coordinators are respondible for coordinating the
implementation of the various components of the Operational

Planning System in their divisions, conducting the necessary
staff training, and providing, at monthly meetings with
operational planning staff, critical feedback on questions
concerning the design, implementation, and evaluation of the
system.
B. Components of the Operational Planning System
The Operational Planning System can be viewed as a core
data base around which revolve several ancillary systems:
1. monthly reporting system
2. employee performance planning and appraisal system
3. quarterly evaluation system and
4. annual reporting system.
The core data base, known as the annual operational plan,
consists of separate plans prepared for each division, program,
and project in the organization. Each division has a division
plan that consists of: (1) a narrative section, and (2) the
division's organizational structure. The narrative section
contains: (a) division purpose - the mission statement of the
division; (b) division client needs statement - an
identification of the division's clients and their needs, with
supporting evidence; and (c) division priorities - the specific
goals of the division, derived from needs, and ranked after
considering attainability, cost, and importance. The
organizational structure is a graphic representation of the
division's programs and projects.
Program plans focus on program purpose, program client
needs statement, program priorities, and an organization chart
of the program's projects (subprojects, if appropriate). Project
plans repeat the narrative and organizational-structure
sections, giving a project-level specificity of information.
Project organization charts also include a job summary for
each person. In addition, projects prepare objectives, linked to
priorities at all levels, stated in terms of process or product
outcomes, and tied to timelines indicating completion dates
for interim and final products.
The monthly reporting system, the most fully developed of
the ancillary systems, serves, by linking monthly activities to
objectives in the annual operational plan, as a management
tool for assessing monthly progress and focusing attention on
concerns, problems, recommendations, and opportunities
requiring action. It provides information for making operating
adjustments on a monthly basis and for reviewing the
projections of the annual operational plan as part of the
quarterly evaluation system.
The monthly reporting system also provides a regular
communication channel among the various levels of the
organization. This kind of communication provides
information for regular staff meetings, analyses of special
problems and other action as indicated. It also fulfills certain
reporting requirements by providing all information needed
for the preparation of the commissioner's monthly report to
the governor and some information for the preparation of
various annual reports required of the commissioner under
state statute and federal regulations.
The monthly reporting system, like the operational plan,
consists of a project-level report, a program-level report, and a
division report. The monthly report of project activities
reports by project objectives on activities that were worked on
or were projected to be worked on during the month with
appropriate comments added at the discretion of the project
director or as required in the procedures manual for activities
recorded as supplemental or behind schedule. Activities are
coded as planned or supplemental and completed or ongoing.
The planned completion month and the actual completion
month are recorded for each activity, tying the dates to the
timelines set forth in the operational plan. The project director
also prepares a one-paragraph summary of the progress,
concerns, problems, recommendations, and opportunities
detailed in the project report.
The summary paragraph from each project is then compiled

and edited by the program manager for incorporation into the
montly report of program activities. The program-level report
consists of the paragraph summary for each project. The limit
of one paragraph for each project forces the managers to focus
on the exact information required by the next level of
management.
Each program-level report in a division is forwarded to the
division head who directs the preparation, usually through the
division's operational planning coordinator of the monthly
report of division activities - a similar synthesis of program
summary paragraphs focusing on only the information that is
needed by the commissioner and the deputy commissioner of
the Department of Education. The division-level report is
signed by the division head and forwarded to the
commissioner and the deputy commissioner who signs and
returns it to the division head.
Division heads receive each program rep.ort with the more
detailed project reports attached for immediate reference. The
commissioner and deputy receive each division report with the
more detailed program reports attached. Thus top managers
receive concise summaries of matters requiring their attention
and additional information should it be needed or desired.
Copies of program and division reports are also sent to the
operational planning office, which provides a cross-divisional
analysis of the reports for use by the commissioner at senior
staff meetings. Managers at all levels of the organization are
encouraged to communicate the contents of the monthly
report to their employees.
The second ancillary system to be implemented, the
employee performance planning and appraisal system,
instituted a system for individual job assignement and
accountability for employees that required coordination with
the New Jersey Civil Service. The name of this system indicates
the dual focus of staff development and staff assessment.
As a tool for staff development, the system serves to clarify

the job to be done and the performance expectations and by
doing so enhances communications between supervisor and
subordinate. This clarification in turn helps employees to
improve performance and ultimately facilitates the setting and
the attainment of department goals through improved
individual performance.
As a staff assessment tool the employee appraisal system
uses data developed in the staff development sections of the
system to evaluate employee performance. The data then serve
as bases for judgments about salary and promotion as outlined
by sections for employee participation and, when necessary,
supervisory assistance to improve performance.
The system has two components:
1. the employee performance planning and appraisal guide
2. the employee performance evaluation form.
The employee performance planning and appraisal guide is
completed in three stages throughout the year. Additional
revisions may be made to reflect changing conditions. At the
beginning of the fiscal year, objectives to be accomplished by the
employee are listed in the guide. It is important to note that
the objectives must be chosen from the operational plan. Once
the objectives are recorded, specific activities to be completed
by an employee are developed for each objective and are also
recorded on the form. Planned completion dates for the
activities are similarly recorded.
The guide contains an "actual completion date" column and
a "performance review" column. Actual completion dates and
appropriate comments, indicating whether activities were
completed satisfactorily or the reasons for slippage or
noncompletion, are entered in these columns by the supervisor.
Entries must be completed by the end of the fiscal year. A
second part of the guide, to be completed sixty days before the
employee's anniversary date, provides the employee with
feedback on the supervisor's general appraisal of those aspects
of the position that are being done well and those that require
support or the development of skills in order to be improved.
The guide can be completed in several ways. The first
requires the employee to fill out the form and then discuss it
with the supervisor who may make changes as appropriate.
The second is for both the employee and supervison to fill
out copies of the form independently, discuss individual
perceptions, and arrive at a common version. Alternatively,
the supervisor may fill out the form first, discuss it with the
employee, and incorporate any changes in the final form.
Both sections of the employee appraisal guide are signed by
both the employee and the supervisor to indicate
acknowledgment by the employee and approval by the
supervisor. Both parties retain a copy of the completed
form.
The employee performance evaluation form contains a
section for checking one of five ratings, ranging from
outstanding to unsatisfactory and for recommending a salary
increment. The rating checked must reflect the written
narrative responses contained in the employee performance
guide. This evaluation is completed yearly (twice a year for
new employees), before the employee's anniversary date.
The evaluation form is substantially the same as that used
for civil service evaluation. The significant change involves the
method of appraisal. The annual rating is no longer based on
whatever method or criterion the supervisor chooses to use but
is tied to the objectives contained in the operational plan of
each employee's project.
The quarterly evaluation system, piloted in September 1977
and implemented by the entire department in December 1977,
provides an opportunity for the organization to identify and
analyze fluctuations in progress toward obtaining objectives
over a three-month period and to adjust the operational plans
accordingly. Like the other ancillary systems, this system
serves three primary purposes: (1) as a management tool,
The Development and Implementation. .. 125
(2) as a communication channel, (3) to facilitate required

reporting.
As a management tool, it provides a mechanism for
identifying and analyzing fluctuations in progress toward
objectives with reference to changes in operating conditions. It
then provides a systematic procedure for adjusting the
objectives developed at the beginning of the fiscal year and a
base for detailed quarterly planning of employee activities as
required in the employee performance planning and appraisal
guide.
As a comunication channel, it provides an information and
feedback mechanism for discussing the redirection and
updating of project objectives. It also provides top
management with concise summaries of major changes in
objectives and a related commentary on the implications of
such changes.
The quarterly evaluation system also encourages the
summarizing of progress over three month periods. Such
summaries can provide information necessary for the
preparation of various reports required of the commissioner.
The quarterly evaluation system, like the monthly reporting
system and the operational plan itself, consists of three levels
of reporting: (1) the quarterly project report, (2) the program
report, (3) the division report. The quarterly project report
consists of a completed quarterly update of project activities
form listing revised project objectives and changes made
according to specified criteria. Those criteria are: (1) the
achievement of the process of product outcomes identified in
the objectives; (2) the projection of variances in operating
conditions caused by (a) resources available, (b) allocation
priorities, (c) product requirements, (d) unanticipated
problems; (3) the inclusion of additional objectives to reflect
the evident needs of clients or further mandates.
The program-level report for quarterly evaluation is a
simple statement of changes in operating conditions that
resulted in adjustments to project objectives in high-priority

areas. This statement is added to the monthly report of
program activities for the last month of the quarter. As with
the monthly reporting system, the quarterly report highlights
only significant changes that should be brought to the
attention of management at the next level.
The division-level report is a synthesis of the program
statements and is added to the monthly report of division
activities for the last month of the quarter. This report
highlights changes that should be brought to the attention of
the commissioner and the deputy commissioner.
The annual reporting system provides a master plan for
organizing and combining the preparation and the
presentation of the various annual reports required of the
commissioner by state and federal law and regulations.
Phase I of this system combines for fiscal year 1977 the
major department-wide annual reports. Phase II,
implemented during fiscal year 1978, coordinates the
preparation and the presentation of other division, program,
and project annual reports.
C. Procedures of the Operational Planning System

Procedures of the operational planning system focus on five
major strategies:
1. operational planning coordinator meetings;
2. mUltiple organizational messages;
3. staff training sessions;
4. involvement of other key actors;
5. direct technical assistance.
Most of the procedures for designing, implementing, and
evaluating the operational planning system revolve around
monthly meetings of the operational planning staff with the
operational planning coordinators. At these meetings
coordinators are provided with manuals and forms for the
various components of the system, scheduling and
implementation plans, evaluation forms and results, training

materials, and various summary explanations that assist them
in carrying out their duties.
The implementation of a component tends to follow a
regular pattern over the course of many months. The first step
involves the presentation and discussion of outlines of purpose
and procedures proposed for a particular component or
planning cycle. Based on this discussion, revised or final
versions of the component will be presented at a subsequent
meeting. For an entirely new component, an extra step, that
of a pilot phase, may follow. One or more divisions, by a
process of mutual agreement, are chosen to pilot the draft
component and to provide feedback to be used in other
divisions. The next phase for both continuing and new
components is the actual implementation phase. At this point
scheduling aids, detailed training instructions, and general
problem solving are provided at the meetings.
The next strategy, mUltiple organizational messages,
focuses on providing information to various levels of the
department in order to support and reinforce the detailed work
of the operational planning coordinators. Agendas and
minutes of the operational planning coordinators meetings are
sent regularly to the senior staff. Items that require further
imput form the senior staff are raised at weekly senior staff
meetings. Individual briefings with division heads are scheduled
regularly to solicit suggestions and deal with concerns raised
during the process of implementing the various components.
These discussions and informational messages may be
reinforced by formal implementation directives from the
commissioner or deputy. Congratulatory letters may also be
sent to each division upon completion of a major phase of the
plan.
Instructions provided to the operational planning
coordinators and summary messages provided to division
heads are then followed by staff training sessions. Staff
training uses two general approaches. Department-wide

sessions providing orientation to the operational planning
system have been held for all program managers. These
sessions conducted by the operational planning staff, have
involved other department personnel as appropriate. They
focus on the general concepts behind the various components
and the interrelated cycles rather than on the actual procedures
associated with anyone component.
The most common approach to staff training is training
sessions conducted by the operational planning coordinators
for program and/ or project staff within one division. The
operational planning coordinator may request support for the
following purposes: (1) briefings to explain the summary
purposes and procedures involved in implementing a
component; (2) detailed training to effect implementation;
(3) follow-up training or trouble shooting in the early stages of
implementation.
Another important strategy is the involvement of other key
actors from the department in the operational planning
activities. This involvement tends to fall into two categories.
The key actors may be involved in one or more of the
operational planning coordinators meetings to discuss related
issues or activities that planning coordinators should be
informed about. One example of this involvement is a
presentation by the coordinator of the department's master
calendar that, although not strictly part of the operational
planning system, is nevertheless an important tool for
clarifying department activities and priorities. Another
example is the participation of the chief of budgeting and
accounting in the meeting at which coordinators make yearly
changes in program structure that affect the accounting
structure. The other kind of involvement concerns working
with relevant department staff in the planning of a component
for a cycle. The director of personnel and the president of the
State Employees Association are both key figures in designing
and implementing the employee performance planning and

appraisal system. Similarly the priority planning activities
conducted by divisions as part of the annual operational plan
must be coordinated with a priority planning process
conducted for the State Board of Education.
The fifth major strategy is that of direct technical assistance.
The operational planning staff not only responds to requests
for individual assistance but initiates such help when it seems
necessary. This assistance may be provided to a new
operational planning coordinator who needs to be given
information that other coordinators already know or to the
coordinator of a division undergoing reorganization.
Assistance may take the form of helping a planning
coordinator with a particularly large or difficult training
session or consulting with an individual program manager
whose objectives require extensive clarification before they
can be translated into operational planning terminology.
The major concept behind employing mUltiple strategies is
the recognition of the complexity of demands raised by
implementing such a planning system. Devising multiple
strategies recognizes the need to respond to those complexities
with an appropriate array of information and assistance.
D. Cycles of the Operational Planning System

In addition to the distinct components of the operational
planning system, the planning and management processes in
the department have been structured around three interrelated
but separate cycles:
1. fiscal planning
2. priority planning
3. operational planning.
These cycles in turn are conducted in order to focus
simultaneously on the current year, the coming
implementation year, and the next budget request year.
III. PROBLEMS AND PRINCIPLES OF

IMPLEMENTATION
The design of a rational planning system is easy but futile in
many cases. The problems of initiating and implementing a
new planning system are immense. It must be considered three-
to five-year process of sustained effort. As has often been
reported, the first year is the "complaint" year; the second year
is the "spite" year in which active resistance and studied
indifference prevail, and the third year is the year of
"refinement." One knows that implementation is likely to be
successful when refinement and fine tuning can being.
We shall summarize our experiences as a series of principles
or propositions.
First, it is important to adjust the timing and the design of
components to the needs of the organization. Rationality
might have to be modified to reflect the communication time
required for coordination and clarification. A new planning
system requires new avenues of communication paved not
only with paper. If one purpose of the system is better
management, one must allow for growth on a learning curve to
occur. The initial collection of too much data may establish a
habit, but it may also inhibit genuine management feedback.
One example is the extension of the monthly reporting
implementation from a two-month period to a three-month
pilot and a two-month, phase-in stage of implementation,
modifying implementation for programs not ready to institute
the system. The organization has a history of producing
copious monthly reports to the commissioner of education,
which went unread except by those responsible for reducing
and incorporating them into a monthly report to the governor.
To replace this habit, a monthly reporting system was
designed. The nature of its three-tiered design forced managers
at each level to summarize and highlight only those concerns,
problems, recommendations, and opportunities that required
action by the next higher level of management. The

involvement of the operational planning coordinator from
each division was critical in fine tuning both the timing and the
design aspects of the system.
Second, an attempt must be made to build on the existing
habits, reports, regular events, and so on, of the organization
to reduce newness and highlight the fact that a new component
is replaing an old one, not being added to the old. It is easier to
explain that a new planning component is going to do what a
previous report did, only do it better, than it is to encourage
new habits in an organization. Change is always resisted to
some extent. Current organizational habits most likely fill
some needs, if only the need for a secure routine amid much
uncertainty. To the extent that a new component builds on
those existing habits, it is possible to link the needs met by the
previous system to the new or revised one. On the other hand,
new components are easier to install when there is a recognized
or a perceived gap. The development of a priority planning
process is a good example.
Third, related to the principle of building on existing habits
of the organization, is the principle of establishing and
delineating linkages. This means that all relationships and
logical links should be made and that disparate pieces should
be incorporated into a meaningful whole.One of the strongest
sources of support for a planning system is its potential for
making sense ofthings, for generating a sense ofthe whole, and
for showing how each piece fits, even if awkwardly. Again, the
need for organizational clarification become important.*
Fourth, related to establishing linkages is the principle of
*The vector analogy is old, but it still provides a useful illustration of

the potential of an MBO system to focus the efforts of an organization in
a more productive direction.
getting others to share ownership of the system. Establishing

links makes sense of disparate elements, but encouraging
others to own a part of the MBO system increases its chances
for success and survival. It is important to distinguish between
different kinds of ownership, however. One is the ownership of
participation. In New Jersey this is best exemplified by the
intimate involvement of most of the operational planning
coordinators in every stage of the process from the first draft
design, to the staff training required for implementing the
component, to evaluating the component's effectiveness. The
second kind is the ownership of control. This can be
subdivided into (1) designing a component and assigning
responsibility for its implementation; and (2) defining
linkages with existing systems, and improving the
design/ usefulness of the linkage but allowing ownership of the
component to remain unchanged. (In some cases, however, the
purpose of a planning system is to disrupt the existing pattern
of ownership. In some organizations that may be thought
necessary but may also lead to a great deal of wasted effort. In
that case it is best to avoid "clarification.")
Fifth, an operational planning system should be designed
neither entirely from the top down nor entirely from the
bottom up. Direction in New Jersey is provided by
department-wide priorities prepared one year in advance to
accompany the department's budget proposal. As the year for
implementing these priorities approaches, the department
priorities are revised at a senior staff retreat. Divisions then
prepare division priorities that relate to broad priorities. A set
of program priorities are prepared that may relate to
department and/ or division priorities and to legislative
mandates and/ or funding source goals. Objectives are
prepared to meet the assigned priorities.
Priorities, in turn, are prepared in response to statements of
need generated by the State Board of Education and the senior
staff at their planning retreats. Divisions, programs, and
projects then prepare statements of client needs from which
their priorities flow.This process must result in agreement on
priorities negotiated by related levels of a division.
Completion of the negotiation may actually require several
iterations up and down the line. Communications are essential
in order to clarify the meaning of priorities.
The complexity of the process has been referred to jokingly
as being modeled on an ancient Inca rain dance. The humor
should not, however, obscure the fact that the intricacies of
this iterative process provide a more useful approach than does
the neat kind of goal setting espoused by most varia tions of the
Delphi model. This approach also avoids the other trap of
oversimplification, that of simply aggregating individual
managers' personal objectives to obtain an MBO system for an
entire organization, an approach more suitable to profit-
making institutions than to those who consider themselves
accountable to some diffuse standard of the "public good."
Sixth, the inclusion of statements of client needs in the
annual operational plan places the system in line with the
emerging focus of public sector services. This trend is based on
the fact that the public sector, unlike the private sector that
has clear statistics on productivity, has few if any concrete
measures of productivity. Assumptions about the declining
productivity of public-sector services are based on citizen
perceptions of those services as declining in quality. Although
the sophistication of the analysis of client needs used by the
various programs in the department generally varies a good
deal (with some based on techniques at least as sophisticated as
any marketing survey), this section requires all levels to give at
least cursory consideration to clients before setting objectives.
Another aspect of the client needs section is the potential to
focus on the organization's functional areas (cost centers) and
project management areas (product centers). For example, the
operational planning system's clients are other units of the
department. The Right To Read Project's clients are local
education agencies, but Right To Read is a client of the

statewide testing project, and both are clients of the data pro
cessing project. These internal client relationships are often
crucial to the overall productivity of the organization. Clari-
fying these internal input/ output relations is a critical
component that grows in importance as the planning system
is implemented. Much of the most valued bureaucratic
output may be internally consumed.
Seventh, there is also a need to avoid too much simplicity.
The operational planning system avoids the approach of many
(especially computerized) MBO systems that reduce all
activity to a set of objectives and cost and time figures (cost
effectiveness) to measures of the achievement of those
objectives. The operational planning system addresses the
criticism that such planning systems have not portrayed the
true complexity of situations. The narrative section allows
participants to elaborate and to explain the unique problems
they face. It provides an opportunity to offset the strangeness
of structured objectives and timelines.
Avoiding too much simplicity allows the organization to
strike a course midway between the two extremes of
(I) writing objectives for and reporting on the achievement of
every single activity, and (2) managing only on the basis of the
"top ten per cent" or the most critical objectives. The natural
progression of an MBO system moves toward the approach of
reporting only on the most significant accomplishments
and/ or exceptions to planned achievements. To force this
progression too quickly is to foster unnecessary resistance to
the basic principles of al MBO systems.With this in mind, the
monthly reporting system was not designed to be an exception
report because of the strong history of the "brag sheet."
If the clarification component is to be adequately developed,
the management feedback processes must allow for
exploration as well as routine. The "routines" are best viewed
as simplifications of what is known in order to provide time to
explore the unknown, including changes in emerging
priorities.
Eighth, ultimately a planning system in the public sector
must be used to clarify the nature and the quality of
bureaucratic output. Cost/ benefit attempts to establish dollar
comparability for governmental products have reached a
ludicrous dead end (note the ill-fated water projects suspended
by President Carter). The planning processes introduced can
focus attention on tradeoffs between different projected
expenditures by following cost-effectiveness procedures. The
development of the calculation component becomes
important, especially over time. But the processes must also
focus on clarifying the kinds and the nature of products.
First, there is a need to distinguish among kinds of programs
or cost centers. In the Department of Education there are at
least six types of centers:
• Centers that perform monitoring and technical assistance
functions
• Centers that perform. problem-solving and technical
assistance functions
• Centers that perform development and analysis functions
• Centers that perform regulation and adjudication
functions
• Centers that perform interdivisional service functions
• Centers that perform leadership and management
functions
Obviously, at least some of the cost centers are mixtures of pure
types.
Second, because of their program nature, different centers
may generate particular kinds of bureaucratic products.
Bureaucratic products may include:
memos
papers
reports
decisions (approvals
disapprovals, appeals,
interpretations)
innovations
technical assistance services
• new techniques
• new problem-solving methods
data
communications
meetings
workshops
frustrations
distribution of funds
Third, how do we develop criteria for measuring the quality
of the forms of output listed above? How do we evaluate the
efficiency and the effectiveness of output? Raising these
questions evokes rational and sUbjective reactions to
measurable objectives and projected milestones of
accomplishments.
A different interpretation implicit in the work of Mike Gam
and Kevin Lancaster suggests that otherwise identical outputs
can and should be treated as different outputs depending on
the "who" and "how" of production. A service is produced
jointly by a producer and it user or consumer. The producer
and its beneficiary must interact to produce the output - there
cannot be an independent producer.Furthermore, the role of
the beneficiary or user is at least partly determined by forces
external to the behavior of the producer. Also the "style" of
implementation may be critical of the quality of the product.
However, the problems focusing on definitions and concepts
of output can only be dealt with once a common planning
discipline has been imposed, learned, and made habitual.
The ninth principle suggests that a balance between
prescribing process and focusing on outcomes must be
reached. Our organization has prescribed much of the process
to be used by units of the organization in generating the
products required by the planning system. For example, the

priority planning process designed for the FY 1978 and FY
1979 planning cycles layed out not only how many meetings of
what level of managers were to be held but also provided scripts
for persons leading the meetings as well as charts to checkoff
the completion of the various steps in the process. Also in the
manual of procedures for each component of the planning
system, roles are clearly defined for the completion of certain
parts of the required products: a project director is responsible
for final preparation of the project plan in the annual
operational plan; an operational planning coordinator is
responsible for channeling forms, manuals, due dates, and
other required information to persons in that coordinator's
division.
Other processes are quite flexible; coordinators are
encouraged to innovate, experiment, try several approaches,
and share their experiences with each other at the monthly
meeting and in more informal circumstances. Suggestions are
provided by they operational planning staff, but these
suggestions are optional. Operational planning staff generally
suggested that the best way to train employees in the new
monthly reporting system was to let them rewrite their
monthly reports in the new format at the training sessions. One
coordinator proposed, however, that he would complete such
a rewriting for each of his projects and then meet with project
personnel to discuss his changes. This coordinator believed
that his division would benefit from such a directed approach.
Some coordinators meet with the staff of each project in their
division, preferring to keep close tabs on the training that is
conducted. Others believe that only a more hierarchial
approach will work; these coordinators train the program
managers in their division and let program managers train
project directors.
It is still unclear whether this emphasis on proccesses can be
followed by prescribing output specifications. In a priority-
directed organization faced with resource constraints, both the

means (personnel activities) and the ends (objectives with
targeted outputs) need to be clarified; specifying means and
ends must eventually be considered the way by which
productivity concerns and issues are clarified.
A tenth principle suggests the need to tie ongoing
organizational analysis to the process of structural change and
development. A planning process in an emergent organization
must be able to project organizational issues for further
calculation. In order to do this, the process must clarify,
among other things, the relevant production functions of the
organization. As Peter Drucker, the prolific management
consultant, asked, What business are you in?
An eleventh principle involves emphasizing training in data
collection and utilization at the middle and lower levels of the
organization. Although the process is structured from above,
the success of the objectives section of the MBO system is tied
to creative interaction among project-level staff. When this
interaction is conducted well, project personnel are able to
reduce their uncertainty about what they should be doing.
But interaction takes, training in order to achieve learning.
The final principle suggests that planners must learn to live
with the imperfect and incomplete implementation of their
rational designs. To move an organization from little or no
rationality to some rationality is progress. This is the lesson of
modified frustration. The purpose of pUblicity and the internal
diffusion of successful management and planning experiences
is to help relieve frustration by showing that some rationality
can be introduced to support better decision-making and the
implementation of decisions.
IV. SOME CONCLUDING REMARKS

The Carter administration projected both governmental
reorganiza tion and zero-based budgeting as innovations in the
federal government. If reorganization and zero-based
budgeting are considered the calculation component of a new
planning system, this enormous task shrinks in conceptual
magnitude.
Based on our experience in New Jersey, it is suggested that
reorganization redistributes or reallocates control and that
zero-based analysis is required to justify new as well as
changed functions. The impact of these initiatives is only
weakly reflected in the budget process at the start. But these
initiatives do generate further clarification as well as a
redirection of personnel activities. Ultimately the budget
shifts to reflect these concerns and the decisions associated
with them. One must not let the technology of rationally
designed models for planning and budgeting interfere with
understanding how and when an organization must use the
processes of control, calculation, and clarification.
The ultimate difficulty, of course, involves coordination and
communication. Communication consumes time (which is
another resource of the organization). The model chosen for
imp1emenation must be adapted in such a way that the time of
the third-and fourth-level managers can be used; the ultimate
role of organizational analysis is to collect from those
managers data that reflect their needs in implementing new
organizational functions. As one works at developing the
clarification component of planning and reorganization, the
organization ultimately faces issues relating to staff
development, personality growth, and human commitment.
What begins as an exercise in budget control develops into a
concern with personnel. The process of organization
clarification transforms the rationality of calculation into a
communication system for and by managers.
NOTES
I. The circumstances in New Jersey should be cited. Governor Brendan
Byrne took office in January 1974. Fred G. Burke became commissioner
of education on July I, 1974. A state supreme court decision (Robinson

vs. Cahill) in 1973 led to the passage of Chapter 212 of the Public Laws of
1975 in September 1975. However, it was not until the state supreme
court ordered the schools closed in mid-1976 that the legislature financed
the fiscal provisions of Chapter 212 by passing a state income tax in July
1976. Implementation of the new law began with the submission of initial
school district reports on December I, 1976. These circumstances may be
specific, but the general problem of a state agency attempting to plan in
an atmosphere of legislative uncertainty and fiscal discontinuities is a
condition that has become more common than unusual. A new but
uncertain mandate now prevails.
2. The emergent situation stems from changes in the overall
environment triggered by different causes, such as a court decision,
legislative action, executive mandate, an energy crisis, an assassination,
and so on.
3. Although the term priorities has been a planning term of some
popularity for the last decade-ever since the Vietnam War absorbed
whatever growth dividend was left in our affluent society-there is no
precise definition of priorities and how they are to be incorporated into a
planning system. Priorities have become gross decision rules that reflect
illusions rather than mechanisms. This paper recognized and relates to the
role of priorities, but it does not attempt to identify how a rational
priority planning system would function. That task would take a different
paper.
4. As futurists we project an "era" of governmental reorganization (and
re-reorganization). Economic discontinuities will contribute to an
environmental reality of political uncertainty and social turbulence. See
"Post-Affluence: The Turbulent Transition to a Post Industrial Society" by
G. Gappert in The Futurist, October, 1974. For a more extended
discussion, see "Alternative Agendas for Policy and Research in the Post-
Affluent Future" in The Social Economy of Cities, ed. G. Gappert and
Harold Rose Sage, 1975.
Comments on "The Development and
Implementation of an
Operational Planning System"
ELLEN SUSANNA CAHN*
The aim of the operational planning system described by

Gappert and Brizius is to coordinate budget allocations with
the planned allocation of time and talent. If budgeting is to
operate as a control device, it is essential that the allocation of
fiscal resources be linked to a ra tional planning function that is
flexible enough to respond to changes in an organization's
environment. This linkage is especially important in the
management of public organizations that are subject to abrupt
changes because of their political connections. Gappert and
Brizius point out the importance to this planning-controllink
as well as the fact that it is often neglected in practice.
Gappert and Brizius have concentrated on the information
flow and communication aspects of the planning system,
probably the most critical elements of any planning system.
Information forms the basis of any plan; if it is not reliable, the
plan and any allocations based on it may represent a futile
exercise. At the core oftheir operational planning system is the
annual operational plan that consists of a series of plans at the
division, program, and project levels in the organization. Each
of these plans includes a statement of the purpose of that
*Department of Economics, the City College of the City University of New York.
organizational unit, a statement of the client needs served by

that unit, the priorities of that unit, and its organizational
structure.
The assignment of a priority ranking to specific goals based
on attainability, cost, and importance is closely connected to
the control function. It provides objective means for budgeting
an expansion or a cutback as the financial environment
changes. It also provides a rationale on which to base
allocations between projects and programs. It is unfortunate
that more detailed consideration was not given to the possible
use of these priorities for budgeting, especially in an uncertain
environment. Although Gappert and Brizius mentioned the
importance of the integration of planning and budgeting in
their introduction, they did not elaborate on this connection in
the body of their planning system.
By making explicit the purpose, needs, and priorities of each
level, a rational basis for planning and organizing is
emphasized. It would be difficult to support unwarranted pet
projects under this system. Organizational levels are linked by
the monthly reporting system. A report of each unit's activities
is compiled; the director of the unit then prepares a one-
paragraph summary that is to be used by the director of the
next higher level. The restriction to one paragraph is a
mechanism through which excesses of paperwork are to be
avoided. This reporting system based on a network of
summaries forces both analysis and synthesis to be made at
each organizational level. Because information flow is limited
to important issues, management control of operations will be
facilitated, and maneuvering and "exceptions" in
administering funds will be precluded.
The operational planning system has the additional
advantage of providing uniform guidelines for all divisions,
programs, and projects in the agency. This incorporates
objectivity into the planning process and budgeting that is
based on that process.
Comments on "The Development ... " 143
The only change in structure is the renaming of branches,

bureaus, and offices as divisions, programs, and projects. This
suggests very little short-term change in performance,
although it may serve to emphasize the importance of output,
as hypothesized, for newcomers to the organization who were
not witnesses to the switch. In this way it might produce long-
term positive results.
The merits of implementing such a planning system depend,
of course, on the nature of the planning system that it is
replacing. It would be difficult to evaluate this change without
knowing more about the specific situation. The operational
planning system should contribute objectivity and explicitness
to the planning process. But if it is not an integral part of con-
trol and operations, it could result only in more paperwork.
New York City's New Integrated
Financial Management System
(IFMS) and Its Managerial
Consequences
JAMES D. HARDY·
I. THE CITY'S FINANCIAL

MANAGEMENT PROBLEM
In 1975 nationwide publicity attended New York City's
fiscal crisis. Early in that year the city had successfully
marketed two large issues of short-term notes, albeit at a 9.5
percent interest rate. In late February, however, the Urban
Development Corporation, a quasistate agency, defaulted on
some $104.5 million of its short-term notes and shook investor
confidence. As a result, the city failed to find buyers for a $260
million issue of tax anticipation notes; as its cash reserves
neared crisis level, it found buyers for only 40 percent of a $537
million issue of bond anticipated notes.! By June, when $792
million of obligations were scheduled to mature, the city had
*Assistant Director, Urban Academy for Management, New York City

The views expressed in this paper are solely those of the author. Nothing
contained herein be construed as an official expression or view of Urban
Academy for Management, Inc., its board, officers, or staff.
Assistance in the preparation of this paper was provided by Harvey T. Dill
and Roger P. Murphy, both of Iowa State University, and by George W.
McGurn and Prem Ramchandani, both of Urban Academy.
New York City's New IFMS ... 145
neither the required funds nor the ability to borrow in the open
market. Even federal assistance seemed unlikely. The presi-
dential response that the city's media reported, accurately or
otherwise, was "Drop dead, New York City."
Only timely state intervention and the creation of the
Munitipal Assistance Corporation (MAC) prevented the final
slide into municipal bankruptcy. MAC was followed in three
months by the Emergency Financial Control Board (EFCB)
and at the end of the year by federal assistance. 2 The city's
voters, perhaps propitiously, chose November of the same year
to amend the city's home rule charter, also addressing therein a
number of managerial and financial management reforms. 3
In the almost three years that have followed those events,
considerable effort has been made to identify both the long-
term and the short-term causes of the crisis in order to take
corrective action.4 As a consequence, the city's operations and
management with respect to both service delivery and finances
have received considerable attention.
Analysis of the causes of the fiscal crisis, admittedly from the
advantageous perspective of hindsight, suggests two distinct
dimensions, one long term, the other short term.
Long-Term Causes
The long-term dimension of the city's problems has been an
ever-increasing differential between the level of service
demand and the availability of resources to meet that demand.
As a result, city expenditures have exceeded revenues for a
number of years - and, more recently, cutbacks in
expenditures have been made with apparent detriment to
service delivery (although this much-advertised proposition
has not yet been empirically validated). The reason for an
accumulating disparity between demands and resources are
many.
Service Growth
First, there has been a discernible growth in both the
breadth of governmental services and the pattern of their

usage. That is not to suggest some ex-cathedra stimulus.
Rather, it flowed from a citizenry prompted by political
leaders who sought to enlarge the functions of government and
respond to salient needs in the social fabric.
In New York City the emergence of three powerful, new
political actors - the Democratic reform movement, the
school-integration movement and the unionization of city
employees movement - created new alliances that thrust
John Lindsay into the mayoralty. City programs and ex-
penditures reflected the political clientele and constituency
of his administration. s Moreover, growing numbers of people
stepped forward to assert their "entitlements," further
demands that previously had been unarticulated.
In respect to this growth in service demand, the city was not
unique. Insteads it reflected a pattern that was especially
evident at state and local levels. In the decade ending with
fiscal year 1972, total spending by all state and local
governments increased almost 180 percent; especially high
increases were recorded in such areas as higher education,
public welfare, and health services.
Federal and State Roles

Second, the growth of mandated social programs, most
often stimulated by federal matching funds and state man-
dates, increasingly burdened the city. During the mid 1960s,
in particular, the national mood generated by the "Great
Society" and its "war on poverty" culminated in programs that
were devised and organized at the national level and then
offered or mandated on a cost- sharing basis to localities.
When, in the early 1970s, federal financial support was
reduced or reversed, cities were left with the unattractive
choice of ending services to their citizens or continuing them at
greater municipal cost.
New York City was no exception. Indeed, its innovative and
expensive welfare role was encouraged to exceed the federal

minimum set for the state. It was the state that also set the
formulae for the city's substantial contributions, a burden not
imposed on their cities by 39 other states. As a result, the city
continued to pay a relatively disproportionate share of costs
for social programs. 6 Unlike other cities whose counties pay a
large proportion of public assistance costs, New YQrk is
coterminous with its counties and has no wealthy suburbs to
help share its costs.
Population Shift and Economic Decline

Third, over the last two decades the city experienced a
disadvantageous shift in population. In general those who left
the city and moved to the suburbs beyond its jurisdiction had
acquired higher education skills, earning capacity,
employability, and spending. Newcomers with relatively lower
incomes replaced those who left. 7 The tendency for those in the
most productive age groups to migrate out also resulted in
a popUlation disproportionately skewed toward those under
age 25 and over 55. The younger group places heavy demands
on educational services, heightens unemployment as they
attempt to enter a decliningjob market, and in consequence,
solidifies a social climate of discontent, crime, poverty, and the
"cycle of ghetto culture." The older group consists of heavy
consumers of social and health services, especially in periods of
inflation.
These population shifts complemented, if not caused, the
economic decline of the city. In the decade preceding 1975,
more than 1200 businesses, many of them substantial
employers, left the city. Between 1970 and 1975 alone, the city
lost 468,000 private - sector jobs as a result of business
relocation, increased business tax burdens, and downturns in
national, regional, and local economics. 8
A caveat is appropriate here. This author subscribes to the
school of trend analysts who view these popUlation and
economic shifts as limited in duration. By way of evidence, it is

noteworthy that in the largest of the nation's cities, "ghettos"
are becoming increasingly suburbanized, whereas core - cities
are becoming revitalized. Moreover, immigration and in-
migration patterns evidence more stability. The passage of
time also changes demographic imbalances. Finally, national
and local economic resurgence is ameliorating previous
excesses. Although a little data do not substantiate a trend,the
author sees cause for optimism. There is no doubt that New
York City and its government must shrink further and that this
shrinkage will cause contracting pains. The long - term
consequences, however, may be beneficial.
Future prospects notwithstanding, the combined effects of
population shift and economic decline resulted in a citizenry
that placed increasingly heavy demands on public services as
the tax base and municipal revenues declined. In the absence of
a sufficient infusion of money, a fiscal crisis was inevitable.
Magnitude of the Crisis
Fourth, the sheer size of New York City adds magnitude to
its crisis conditions. The city's municipal government is
charged with servicing some 7.5 million citizens - and in some
cases caring for their every need from maternity ward to burial
plot. This undertaking has created a multibillion dollar
conglomerate, with a budget slightly less than$14 billion and a
work force in excess of 204,000. On the Fortune 500 scale, the
city government ranks seventh in size. In international terms,
it ranks with such nations as Austria in the size of its
population and with Spain in the size of its expense budget.
Although this author does not subscribe to the view that the
size of the city's government prevents it from managing its
resources efficiently, it is accepted that size compounds
problems of disparity between resources and demands. Even
minor adjustments in urban phenomena become magnified
into large numbers and dollars when they involve New York
City.
F or example, the extension of salary and pension benefits

under Mayor Lindsay in 1969 seemingly produced minimal
changes in the following year's budget but by 1975 had
translated into $1.3 billion (or 25 percent of payroll
expenditures) and resulted in the projection of the need for an
additional $300 million every year until 1995. Similarly,
despite an increase in federal and state contributions to the
city's spending (from about 25 percent in 1963 to almost 50
percent by 1970), the exponential costs of conducting govern-
mental business even at that date resulted in projections
of an ongoing deficit of at least $200 million per year. To cover
such a gap would require city action each year to double the
personal income tax, or increase the sales tax by 1.5 percent, or
triple water charges, and so on. In fact, even those projections
were highly conservative. Beginning in fiscal year 1970, the
Lindsay administration disguised its deficit by borrowing $1.3
billion in outstanding short-term loans. The folloiwing year,
the city "rolled over" that amount and expanded its short-term
debt to $2.3 billion. This pattern continued until 1975, by
which time the city held almost $5.8 billion in short-term debt.
This amount almost equaled the long-term debt of $6.1 billion
for the same year.
The effect of the first three-year plan to balance the city's
budget by July 1978, moreover, has been to expand the city's
debt,for the city continued to spend more than it received until
1978. 9 The difference now relates to the proportion of short-
and long-term debt. As of January 1977 the city's outstanding
debt was $14.4 billion (including $3.5 billion MAC bonds), of
which only $3.7 billion was short-term debt. The picture by
mid-I978 showed even more improvement. Having paid offin
cash or exchanged for MAC bonds over 65 percent of its
"moratorium" notes, the city has reduced its short-term debt
holdings to $2.3 billion out of a total indebtedness of $12.8
billion (inclusive of $3.2 billion in MAC holdings). Recently
enacted federal legislation has enhanced still further the city's
slow climb back from the brink. Yet there remains a significant
magnitude to accumulated debt; stretched over a longer time,
certainly, the burden is lessened; but it remains, nevertheless,
almost Damoclean by its very presence at all.
The postition has also been taken by some commentators
that the city's size inherently increases per capita costs of
service delivery in such areas as police, fire, sanitation, and
administrative services. Empirical data certainly support the
higher per capita service costs of New York compared to
Chicago, Los Angeles, and Philadelphia. lo Noticeably,
however, Washington, D.C. costs are even higher than New
York's. Moreover, the data do not exhibit a linear correlation
with city size. Magnitude as an independent explanatory
variable of service cost is a dubious one.
Nevertheless, there is merit to the assertion that, at least
indirectly, the scale of New York City's operations and the
dollars involved are significant and create in themselves
another element of crisis. By way of illustration, the city of
Yonkers faced bankruptcy in the amount of a mere $133
million as a result of a $6 million deficit. When New York City
faced a similar predicament in 1933, the deficit was about $0.25
billion, to which the city's financial community was able to
respond. The close to $6.0 billion short-term debt of 1975 and
the $13 billion dollar total debt of 1978 represent different
orders of crisis.
Short-Term Causes
The short-term dimensions of the city's crisis involve
management practices, both operational and financial.
Although it is undoubtedly accurate to state that the city's
managers at all levels have responded to the longer-term
dimensions of the crisis, the nature of those responses has
drawn much criticism.
Faced with increasing demands and decreasing resources,
political leaders have been reluctant, for obvious reasons, to
say "no." As a result, for almost a decade the city agreed to

maintain and even expand services to its citizens, to extend
employee benefits, contract working hours, and permit
inefficient work rules and practices, all of which in the longer
term have resulted in exacerbating fiscal problems. Moreover,
under the pressure generated by the demands for services
and the limited resources with which to pay for them, the
city ignored the fiscal implications of its public policy
decisions. Most often such public policy decisions were
determined on the basis of political rather than fiscal merits.
In articulating this concern, the author is not intent on
subscribing to some variant of undemocratic government or to
elitist rule by bankers and econometricians. Rather, the view is
taken that the city cannot afford to educate all its citizens, act
as the nations's largest landlord, subsidize its mass
transportation, engage in wholesale income redistributions,
and provide a comprehensive cradle-to-grave range of social
welfare services. At least, it cannot do all those things
concurrently and without some external beneficence.
Consequently, decisions need to be made about the
appropriateness of city services. The selection is one for the
polity; but it must be informed of the relative costs of
alternatives. If not, New York's citizens run the risk of
debilita ting all services. The notion of more of everything that
was pervasive during the last decadee is no longer available.
The haphazard provisions of insufficient services is no answer.
Management practices that identify options and evaluate and
implement them are required.
The city's financial management practices over the last
decade largely served to understate, obscure, and defer the
realities of the crisis. A variety of interrelated techniques was
applied to serve this purpose: first, the myth of the balanced
budget; compounding it, a reliance upon borrowing as a re-
venue source; then, a tendency to underestimate expendi-
tures and overestimate revenues; 11 added to this, an account-
ing system that treated expenses on a cash basis and

revenues on an accrual basis; 12 and finally, the use of capital
budget funds to finance operating expenses. 13 All ultimately
required a spiraling pattern of borrowing that continued
until an erosion of investor confidence in the city's ability to
pay its debts closed off its ability to borrow and precipitated
the 1975 crisis.
Parallel with its debilitating financial management
practices, the city has been severely taken to task for the
equally poor quality of its operational management. A number
of phenomena are worth noting. First, civil service hiring
constraints have had an inhibiting effect on the city's ability to
attract, hire, and retain the highest quality managerial
personnel. This should not be misread as an unmitigated
attack on the civil service ethos or as an unequivocable
condemnation of city personnel. On the contrary, there is
merit still in civil service precepts, if not in all of its practices;
and there are more high quality personnel in the city's ranks
than media mythology would have one believe. Yet the fact
remains that archaic practices, excessive regulation,
collectively bargained protectionism, and the overpervasive
penetration of trade unionism into the highest ranks produce a
milieu that is not conducive to sound management. The result
is an acculturated style of operations that emphasizes
muddling through, fighting bushfires, and responding to ever-
present crisis. It is difficult to attract managerial talent to such
a debilitating and frustrating environment and more difficult
still to retain such talent or to prevent it from becoming lost in
the bureaucratic morass.
The fiscal collapse of the city powerfully inhibited much
needed efforts for change. In some respects, this has simply
meant a lack of money. For example, the city's fleet of
sanitation vehicles, old and overused, is desperately in need of
replacement. Yet limited funds of short-term duration have
been allocated to manpower and then to the maintenance of
equipment. Such a short-range allocation, of course, has

become increasingly less efficient. The problem, however, has
been symptomatic of a more disquieting phenomenon, namely
a pervasive sense among municipal managers and personnel
that the only answer was more people and more money.
The city's inability to supply either continues to suggest the
inappropriateness of the proposed remedies. Nonetheless, the
persistent articulation of such salvationlike dream-wishes has
discouraged more realistic attempts to use resources effectively,
to innovate, and to improve operational and fiscal
management.
In such a climate it is not remarkable that activities are
inconsistently performed, improperly executed, delayed, or
deferred. Indeed, according to some observers, it is remarkable
that the city is managed at all - and that anything is
accomplished.
This author elects not to join the doomsayers who espouse
such views. But it is conceded that the city's day-to-day
operations, management practices, and procedures provide a
substantial litany of case studies in inefficiency, lack of
rationality, misapplication of effort, and simple
mismanagement. Public frustration with bureaucracies is not
new; nor is bureaucratic frustration with itself. In New York
City this latter phenomenon has engendered an intense self-
consuming angst and despair that has permeated public
service. The paradox that results places almost a quarter of a
million well-intentioned, often committed, and talented,
public servants in a daily battle with themselves and their own
crisis mentality. Somewhat akin to battle-scarred veterans,
they continue to wage a war that they are not sure anymore
they believe in; some have lost faith altogether; some have
become bitterly cynical; others battle on valiantly,
succumbing over time to weariness; inevitably the common
time horizon becomes the present and coping with it. Like
Alice in the Garden of Live Flowers, it is necessary to run faster
each day just to stay in the same place. The institutional effect
of all this is much effort to little avail. It is not, as the media
often intimate, the presence of willful mismanagement that is
the problem, but the absence of sufficient superior
management - in practices, systems, experience, and skills.
Having painted such a gloomy picture, a brighter light needs
to be added. It stems from yet another paradox, namely, that
like the Phoenix of fable, the city's failures have so
consumingly burned that their heat has engendered a rebirth
from the ashes of fiscal downfall. The city has taken the
opportunity to review quite radically its managerial, fiscal, and
opera tional insufficiencies and to respond with innovative and
creative dynamism. The city's financial management
information system is one such example, the creation of a
citywide mayor's office of operations and its activities
constitute another; and throughtout agencies, large and small,
new systems, procedures, and a concern for management
practices and longer-range planning are surfacing.
The Interrelationship Between

the Long- and Short-Term Causes
Both descriptive and analytic purposes have been served by
the foregoing distinction between long- and short-term causes
of the fiscal crisis. They are not, however, unrelated. Indeed, as
phenomena, they are integrally linked.
As presented, the long-term causes cluster around the area
of demand-resource resolution, whereas the short-term causes
superficially revolve around the fiscal juggling acts employed
to disguise the crisis but thereby reveal these as mere symptoms
of the problem of distressed management. In a sense, then,
both long- and short-term dilemmas have major managerial
components; the former expands geometrically with the
growth of the latter. The crisis thus reflects short-term
mismanagement compounded over the long term, at which
New York City's New IFMS. .. 155
point it is so complex and extensive that it almost defies

solution.
On the contrary, the solution is to be found in the problem:
What the city needs is short-term management improvements
that will themselves be compounded positively over the longer
term.
This short- and long-term linkage cari be sustained more
convincingly than the foregoing suggests. The whole range of
resource-allocation activities and managerial actions pose
similar questions - what are goals, missions, priorities, cost-
benefit ratios, relative merits of choices, alternative situations,
contingencies, and so on? All of these questions ultimately
reduce to issues of information - knowing before doing.
Certainly, information is a critical element (a necessary but
not sufficient condition, to be more precise) in any action. It
can define an A and a B so that we can connote movement
between them; or it can identify the X, Y, Z that intervene
habitually or inhibit some causal statement; and it can identify
the nature, direction, or magnitude of change (or measure
consequences). It is by manipulating information, often
symbolically, that we are able to discern the relative merits of
different options or choices and thereby justify resource-
allocation actions. If information then, is a prerequisite to
management, management itself defines a form of action that
is rational and calculative in the nature of its execution and
consistent thereby with deliberative goals.
For New York City the fiscal crisis, in a sense, can be
reduced to these two elements - information and
management, that is, the longer-term problem of reconciling
resources and service demands requires expertise in resource
management that in turn requires the precise and up-to-date
information that enables resources and service-delivery
operations to be monitored and controlled. That resource
management exhibits two facets: one operational, the other
financial. City mnanagers, then, need to know what they are
expected to deliver, what they are delivering, and at what cost.

It is important, therefore, to ensure that the city has a means
of calcula ting, assigning, estimating, monitoring, and
controlling costs, that is, a financial information system for
management. Moreover, it is critical that such a system and the
financial and operational management stemming from it be
based on sound financial management (accounting) principles.
II. INFORMATION SYSTEMS AS

INSTRUMENTS FOR FINANCIAL
CONTROL
One analyst familiar with New York City's problems and the
development of its current solutions has suggested that three
maj or factors contributed to the inadequacy of local
government financial information system. 14 First, given
programmatic growth and intergovernmental stimulus, local
government management has become very complex, leading
in turn to more complexity in accounting and reporting
procedures frequently unique to a particular grant. Second,
local government employees often find it in their interest to
retain outmoded obfuscating systems on the premise that
information is power and control and status result from the
expertise of being "the knower". Finally, local governments
often have lacked expertise to undertake reforms of
management systems, just as city managers have rarely been
trained to use sophisticated systems properly. Cities have
exhibited a noticeable lack of commitment to management or
its recruitment.
Overcoming these deterrents to the installation of a new
financial information system is no easy task. Yet the growing
national mood for public-sector cost containment and the
discovery of crisis-ridden management practices are
prompting substantial new efforts. Nowhere has this been
more apparent than in New York City. Yet financial
New York City's New IFMS... 157
information systems can be critical instruments for local
government almost universally because the system serves three
basic needs, two of which are managerial and the third is
concerned with accountability: control (and monitoring),
planning (and analysis), and (external) reporting.
Control (and Monitoring)

Programmatic choices are most usually reflected in a
legislative or electoral resource allocation - the
appropriation. In local government as elsewhere, the
monitoring of expenditures (or, for that matter, revenues)
against such an allocation (or revenue estimation) is the most
effective method of control - that is, the prevention of
una uthorized overexpenditure (or awareness of
undercollection enabling remediative actions). In a complex
multiple-activity local authority, the processing involved in
checking each item against an appropriation balance before
incurring an obligation is time consuming, tedious, and costly.
Moreover, many cities require control against more detailed
allotments and budget schedules to ensure that funds are spent
in ways consistent with legislative intent.
In all such cases, it is the financial information system that
must provide the means of monitoring and controling
expenditures (or revenues), regardless of the levels or
complexities of control. Indeed, it must do more: It must keep
close track of all city resources to prevent their theft or misuse
and thereby justify governmental stewardship and retain
public confidence. Control and monitoring, then, is not a small
matter. Moreover, monitoring and control of current budget
or revenues constitute only part of an effective system. A
comprehensive financial management system must not only
focus on accounting for the use of funds but for the flow of
funds and for the stock of assets and liabilities. Capital
budgeting and accounting, debt service accounting, recording
of fixed assets within specific fund entities (including
enterprise fund accounts), and controls of interfund transfers

must all be present to ensure the comprehensiveness of control
and thereby the availability of accurate and adequate data for
planning and analysis.
Planning (and Analysis)
Every day city managers and elected officials need to make

choices concerning the priority of one program or activity over
another. To be able to make an effective choice, information
must be available on the overall costs and benefits of each
program. This is by no means an easy matter. For there are
complex problems of measurement and concerns for the
public right to set priorities. Thus the real issue IS not so
much planning for effectiveness but rather for efficiency.
That is, within choice parameters set in the political arena,
city managers need to be able to calculate and plan for the
most efficient use of resources given stated goals or
missions. This requires the assignment of specific respon-
sibilities to individual managers for revenue generation
or service delivery. Because there is frequently an overlap of
the location of responsibilities, funding sources, and agency
jurisdictions, information concerning costs, revenues, and
efficiencies of all services needs to be synthesized by the city's
financial information system and used as the basis for
comparative analysis, diagnosis, projection, and planning of
service strategies and options. A financial information system
is thus an indispensable planning tool.
To be an effective tool, the system must be organized so that
it can collect, sort, calculate, and produce information in a way
that is useful to a manager in evaluating efficiency. On the
revenue side, for example, it is most efficient to identify
information on collections measured against monthly or
quarterly projections or to provide sufficient information to
enable the preparation of claims for timely state and federal
reimbursements. Similarly, on the expenditure side, It IS

equally efficient to identify expenditures against both
obligations and projected obligations and to use unit cost
standards and cost accounting to effect resource allocation.
Such techniques, of course, require quite explicit criteria for
evaluating financial information and comparing unit cost
data. Although this may be a complex, difficult, or changing
task, it is critical that financial information be organized in a
way that facilitates analysis, financial and operational, and the
planning for efficiency that stems from sound analysis.
(External) Reporting
All local governments are required by federal, state, or local
statutes or ordinances to make full and adequate disclosures of
financial activities to the public. Indeed, the notion of
accountability to the public is critical for the effective
operation of a civil service. Thus although the reporting
requirements for communicating information to the public are
frequently less technical and demanding than those required of
underwriters who market municipal bonds and notes, the
former are more significant. Any informed citizen should be
able to find out easily from what source government money is
drawn, to what uses it is put, what specific goods are services
are obtained, and how efficiently resources are used as shown
by both comparative and longitudinal analyses. This
information should be made available in language that a
layman can understand, rather than couched in technical
gibberish. The result is not only a more informed citizenery but
one with a greater interest in governmental activities.
Multipurpose Systems
It may be apparent that the three major needs served by
financial information systems are not precisely compatible. In
practice, certainly, a system designed to meet one need is less
responsive to another. Emphasing accountability, for
example, may result in controls so cumbersome and

bureaucratic that they inhibit analytic and managerial actions.
Similarly, the structuring of classifications or financial reports
may meet accounting or legal requirements but result in
reports incomprehensible to the layman.Programmatic-
oriented budgets may faciliate policy analysis but hamper
effective day-to-day operational control or vice versa.
The tension between mUltiple needs and objectives does not
prohibit the creation of a balanced mUltipurpose system.
Rather, it suggests that such systems, carefully developed to
provide sophisticated flexibility and a capacity for adaptation,
to effective government and its search for crisis-prevention or
remediation strategies. Such was the situation in New York
City when its government assessed its needs and undertook to
introduce its own system, IFMS, the integrated financial
management system.
III. THE GOALS OF IFMS

The implementation of New York City's integrated financial
management system is a challenge to financial managers
throughout the city government to make more effective use of
the financial data that the system generates. The data available
from IFMS help managers carry out a number of functions
primary among which are:
• financial control
• planning and analysis
• accountability
Under IFMS, financial control is improved by restructing
the budget so that it clearly separates revenues from
expenditures. It organizes the budgets for both in a way that
closely corresponds to actual organizational units and their
activities and accounts for each in accordance with accepted
accounting practices. In addition, the new IFMS budget
structure indicates relationships between budgeted
expenditures and revenues earmarked to finance them so that

the support for such activities may be realistically determined.
Improved controls on expenditures and revenues are made
possible by monthly reports that compare actual performance
to budgeted targets. In addition, clear responsibility for
monitoring both expenditures and revenues is assigned to
designated financial managers. The actual expenditures and
revenues are required to match predefined plans.
Planning and analysis are improved by the provision of
better financial information for both fiscal and program
managers. IFMS produces financial data that help an agency
manager to make detailed decisions on priorities and resource
allocation. Such financial information is available both in
regularly issued reports and in some cases in special reports
thay may be requested as the need arises. Managers thus have
data readily available to assist them in choosing more efficient
alternative activities and staffing plans by analyzing associated
expenditures. Similarly, program managers are provided with
the information that they need to assess the financial
implications of their programs. In turn, all this assists the city
to deliver services more efficiently.
Accountability also is improved by the availability of
financial reports to meet the information requirements of the
state, the federal government, the investment community, and
the general pUblic. IFMS reports come from a unified financial
information data base that may be easily audited in
conformance to generally accepted municipal accounting
practices. A single data base prevents discrepancies that
previously arose among separate information systems housed
in various central and line agencies. It also provides more
rigorous auditable reports on expenditures that are
reimbursable, thus ensuring the integrity of the claims
procedure.
Although IFMS is a tool to help managers, it is not a
substitute for the creative aspects of managing. Managers are
still required to recognize problems, request information,

develop plans. choose among options, make decisions, and
control situations. The primary goal of the computerized
system is to support and direct managerial decision-making by
providing more accurate, timely, and relevant information.
IV. BACKGROUND OF THE IFMS

PROJECT
The IFMS project was a managerial initiative on the part of
the city, undertaken in 1976 as a response to its financial
difficulties. Specifically, it enabled the city to comply with the
terms of state legislation, enacted in June 1975, that
established the Municipal Assistance Corporation and
required the city to reform its accounting and budgeting
systems to conform to acceptable standards.
In addition, major revisions to the city charter enacted in
November 1975 required changes in the city's budgeting and
accounting systems, a quarterly budget allotment system,
decentralization of many detailed financial management
procedures to city agencies, and a stricter expenditure control
system.
Federal legislation providing for short-term loans to the city
during its recovery from the fiscal crisis also required the city
to provide auditable financial statements and much improved
financial-reporting and budget-control systems.
All of these coincident requirements for changes in its
financial practices were viewed by the city an as opportunity to
undertake a comprehensive review of its financial system and
operations rather than make piecemeal changes. The scope of
IFMS and its impact on the city were thus considerable.
IFMS is a comprehensive, unified financial information and
control system, structured specifically to meet New York
City'S requirements. It is far-reaching in its scope and
advanced in its technical approach; it was ambitious in its
intent and demanding in its implementation. The system's

impact on the city, its personnel, and its financial activities has
been both pervasive and considerable. Administered through
the Financial Information Services Agency, the system also
maintains the division of powers between the offices of mayor
and comptroller, as mandated in the city charter.
IFMS was, however, considerably more than a reflex
action. It was a positive development, innovative in its scale
and approach to the complex problems of governance. It
recognized that the effective control of public resources
depends on accurate, up-to-date information and that the
selective, timely presentation of critical information is a
prerequisite for financial control, crisis prevention, and good
management.
v. KEY FEATURES OF IFMS

The scope of IFMS is extensive. It encompasses most
citywide financial management functions - budgeting,
payroll, purchasing, accounting, and financial reporting in
each of these areas. Expansion of its scope to cover areas of
capital budgeting and accounting, fixed assets, and grants
management is also in progress.
IFMS changed many city procedures and practices. It
required new forms to be completed, new procedures to be
followed, new designations of responsibility to be undertaken,
and new reports to be reviewed. Underlying all these detailed
changes were four key features:
• a unified system
• an integrated system
• a conformance to municipal accounting standards
• a new budget structure
A Unified System
Prior to IFMS, the city's financial management data were
fragmented among multiple systems housed in several separate
data processing facilities. As a result, "bottom-line" totals of

budgeted or expended dollars provided by different systems
were sometimes incompatible or required difficult
reconciliation.
IFMS operates citywide as a unified system. Budgeting,
accounting, purchasing, and payroll functions for all city
agencies have been brought together in a single computer
facility at the recently created Financial Information Service
Agency (FISA).
An Integrated Data Base
IFMS is not only unified in the way it centralizes financial
data for the city as a whole, but it is also an integrated system
by virtue of the nature of its data base. It stores all information
in a single integrated data base, where each element of
information is recorded only once. Nevertheless, IFMS
processes its financial data in a variety of ways and for a variety
of purposes. For each given task, the system selects and uses
only the data required to complete that task. Because each
major subsystem has access to data in the others, there is no
longer any need for a subsystem to maintain its own separate
version of the budget or to generate its own set of accounts.
The system's integration is further ensured by its use of a
single dictionary for characterizing transactions throughout
the IFMS. The chart of accounts acts as the basic dictionary, in
effect governing the structure of the system's data and ensuring
that data are consistently classified throughout the system.
Finally, the system maintains master tables that store
information about relationships among data elements, permit
the cross-referencing of data, and provide the system with the
capacity to retrieve data selectively and generate from them an
extensive variety of reports.
A Conformance to Municipal
Accounting Standards
To conform with legislative requirements that the city
follow standard municipal accounting standards in keeping its

books, IFMS incorporates those standards that apply to the
city. The most significant effect of this requirement is apparent
in the city's new fund structure, its accounting bases for
recording revenues and expenditures, and its procedures for
dealing with transactions among city agencies.
Under IFMS, starting in fiscal year 1978, the city recognized
expenses on a current encumbrance basis. This means that in
most cases funds are obligated upon issuance of a city purchase
order or a contract with a vendor. To give effect to this
procedures, IFMS includes an automated encumbrance
control system to account for and control encumbrances
centrally. The city also has changed its basis for recognizing
revenue. Under IFMS, the city now recognizes its revenues on
a "modified accrual" bases, that is, the city accrues revenues
prior to cash receipts only when they are "known and
measurable." In general, this provision is interpreted to allow
accrual of state and federal aid revenues based on an invoice or
claim submitted to the grantor. All other revenues, such as
taxes, licenses, and fees, are recognized on a cash basis. As a
result, the budget for revenues to be recognized on a cash basis
reflects only the cash expected to be received during the period
from July 1 through June 30.
Finally, IFMS provides for special treatment of interagency
purchases and sales. This procedure simplifies accounting and
helps the city increase outside revenues by detailing the cost of
claimable activities.
A New Budget Structure

IFMS operates with a new citywide budget structure that
has three important new features. First, the revenue and
expense budgets are separate, linked only by cross-referencing
to show where changes in one affect the other. This separation
ensures improved controls, removes any chance of obfuscation
between the two budgets, and enables a citywide balancing of
income and expenditures without implying, as did the previous

structure, that the expenditure of revenues earned is somehow
a prior entitlement of the earning agency. Second, the budget is
structured on an organizational basis so that the hierarchical
c1usterings of budget lines reflect real organizational entities,
such as police precincts, fire borough commands, arid service
delivery components. This structrure is maintained, moreover,
without sacrificing the ability to compute programmatic
expenditure costs that cut across organizational domains.
Finally, the budget structure is integrated into the IFMS
system in order to allow the generation of reports that serve to
monitor actual revenue and expenditure flows against
quarterly targets and allotments and monthly plans.
VI. IFMS' IMPACT ON THE CITY

The IFMS project is a complex mix of new systems, new
procedures, new jargon, new forms, and new tasks, many of
which have replaced pre-IFMS activities, whereas others have
modified or incorporated them. For city personnel, who have
already weathered a fiscal crisis, IFMS is an innovation that
has been greeted with mixed emotions. Some have shown awe
at its technological power, some have been skeptical of its
intent, some have shown weariness at the demands it makes to
learn anew, some have expressed confusion over terminology
that might previously have conveyed other things, some have
been excited at the challenge it presents, and some have
expressed pride at its symbolic signal that New York City is
again at the leading edge of innovation and progressive
change.
There is no doubt that the revision offinancial management
policies, procedures, and systems has had sweeping
implications for city personnel. This is so for the most senior
city managers, in both central and line agencies, through the
functional and technical staff in areas of budget and fiscal
affairs, accounting, purchasing, and payroll to the operations,
programmatic, and service delivery managers and their

technical and clerical staffs. Indeed, as IFMS became fully
operational and enhanced its impact increased ratber than
diminished. The flexibility of the system has given city
managers the chance to use the system's products to enhance
their own task performance. IFMS's usefulness is growing as
its operators become more experienced and skilled in its
operation.
Given the stress on greater responsibility for sound financial
management in line agencies, the professional and managerial
personnel in the functional areas of IFMS - budgeting and
fiscal officers, accounting and auditing staff, purchasing and
payroll managers - have also been most substantially affected
by the system.
There been a direct impact on the structure and input of
routine financial data (and on the forms in which such data are
reported) and on the more indirect uses to which IFMS has
been put. The availability of a variety of programmatic "cost-
accounting" features in IFMS has strengthened the interaction
of agency financial managers with both senior agency
managers and with agency managers having programmatic
responsibilities. These last groups have also been affected by
IFMS. They have had to become familiar with the system's
capabilities and limitations to extract financial data from the
system in forms appropriate to their needs. They have had to
develop skill in interpreting and using such data and in
integrating it with other information currently available to
them in determining day-to-day priorities and efficient
resource allocations.
IFMS has affected not only the responsibilities of
managerial personnel, although that has been its primary
objective and far-reaching consequence, but the system's
operations also have required the processing of many new and
modified forms and new procedures. This has affected clerical
and supervisory staff - the employees who have day-to-day
responsibility for the accurate, timely entry and processing of

IFMS data. For this reason, careful documentation offorms
and procedures for IFMS has been required. Thorough
familiarization with the procedures and in some cases with the
equipment necessary to process data, such as video display
terminals, has also been required.
The process of implementing a system on such a substantial
scale is as ongoing as its impact. With almost incredible
rapidity, the system was designed and put in place in some
eighteen months. IFMS became operational on July 1,1977.
In fact it was operational several days earlier and the
inauguration on the first day of fiscal year 1978 was more
symbolic than substantive. Moreover, the system of the first
day as compared to today was akin to a basic "factory-
equipped" automobile without accessories and options, that is,
the system consisted of a fully operational basic budgeting and
accounting information system with capabilities to process
purchasing documents and interface with a preexistent payroll
system (operated by the comptroller's Office).
In the period since its inception, the system has embellished
its integration of all four systems: a new IFMS payroll system
is now integrally linked. The on-line inquiry network is
extensive, operational, and well used. Work is in process to
expand IFMS to cover capital budgeting and accounting in
addition to the current expense budgeting and accounting.
Plans have been made to add capabilities for fixed asset
accounting; interfund agreements; more sophisticated
timekeeping and cost allocation features; vendor information;
and new formats for the distribution of management reports.
In short, like any system, IFMS continues to be dynamic and
responsive to its multifaceted and multitudino~s clientele.
VII. IFMS AND MANAGEMENT

DEVELOPMENT
Simply stated, the key concern of New York City's
New York City's New IFMS. .. 169
government is management improvement. To meet the quality

of life, or economic development objectives, the city needs to
be able to provide adequate services at reduced levels of
expenditure. This can only be accomplished by a more
effective managerial capacity. In turn, the results of an
effective managerial cadre can only be harvested from the
seeds of managerial development.
Broadly construed, managerial development addresses both
people and their tools. Enhancing the skills, experience, or
sophistication of managers is not enough. They must also have
the tools to match their talents - the systems, information,
and support services that free them for creative analysis,
diagnosis, and decision making. The tools without the skills to
use them and equally insufficient.
The need for efficient and productive governance of the city
is most acute. The result is even more pressure on its
traditionally weak managerial capacity. The fiscal crisis simply
served catalytically to heighten the gap between needs and
capacities. 15
Recognizing this, the city has embarked on a substantial
effort to emphasize management improvement (with key
words such as revenue generation, cost containment, and
productivity) and encourage it by means of management
development.
The creation of a management planning and reporting
system during the past few years has focused attention on
the missions, priorities, performance goals, and records of
the agencies, both citywide and within each agency and its
operating units.
In a related effort, the city created an office of operations
charged with encouraging and monitoring citywide efforts at
improvements - drawing extensively on private-sector
management experiences and bringing them to bear on a
multitude of areas, practices, and programs.
Supporting these efforts, the city's Department of Personnel
has been engaged in the development of a new managerial

service plan and in the broadbanding of many civil-service
titles to facilitate improved work-force planning.
All of these activities complement the installation of IFMS
with which they are linked. Performance data or goals are
more meaningful when related to compatible cost data;
improvements are more discernible when information is
available to highlight needs and measure successful change;
personnel changes constitute only one facet of planning for
more effective resource allocation - dollars and cents are the
other. In short, (perhaps the critical) elements of municipal
management and elements that provide a foundation for
improved management practices.
Noone who has seen IFMS introduced into New York
City's municipal bureaucracy would suggest that it has
miraculously changed everything overnight. Neither would
anyone seriously suggest that it has made no difference.
Indeed, an indication of the difference is that many of the
system's users have forgotten their pre-IFMS standards of
efficiency and assimilated new ones. Nobody asks any longer
"do we know if we're overspending?" Instead, the question is
"why is my terminal taking as long as two minutes and three
seconds to report my budget, obligations, expenses, and
available balance?"
Similarly, freed of some traditional constraints, managers
are more creatively attacking substantive or managerial
problems. Processors of contracts are finding that a review of
the records can point them to other agencies and an available
performance reference; operations directors are finding it
possible to focus on identifying and controlling overtime,
energy costs, and space costs; agency heads and program
directors are finding ways to interpret data and select program
options; revenue-worriers are cutting data to improve
reimbursement justifications and revenue collections; cash-
managers are able to plan and invest more effectively - in
short, the tip of the iceberg of a municipal management

revolution.
VIII. THE IMPLICATIONS OF IFMS

FOR THE MANAGEMENT OF
MUNICIPALITIES AND OTHER
COMPLEX LARGE-SCALE SYSTEMS
This paper has argued that New York City has experienced a
fundamental managerial problem. It had short-and long-term
causes; it produced short- and long-term consequences: fiscal
crisis was merely its exacerbation and a symptom of its
underlying causes.
IFMS does not and cannot solve the fundamental problem.
It can, however, be an effective tool in addressing short-term
needs. Its technology is extremely efficient, if appropriately
applied. The nature and magnitude of the tasks facing New
York City's municipal managers require more than just a
sophisticated computerized system.
Those who would manage the city must develop the skills to
manage and apply their new technology effectively. Only that
consequent application can they bring creative talent to bear
on the long-term problems of reconciling service demand with
available resources.
The IFMS implementation experience has revealed the
following phenomena:
• Large-scale change seems more likely, more endurable
and more welcome as a response to a situation of crisis.
• Change in the style and substance of municipal
management is possible, indeed welcome, especially when
the objective of such change is to reduce managerial
frustration, alienation, and resignation.
• The implementation of an automated management
information system is substantially enhanced ifthe system
is viewed as one of several tools in a management

improvement capacity and development strategy.
• The success of a system's implementation in part rests on
the recognition of the complementary relationship
between technological tools and the development and
training of skills.
• The large-scale effort over a short period of time
facilitates policy-level decision making.
• The initial support of top management, filtering down
into the ranks, enhances and expedites the
implementation of large-scale systems. User involvement
is critical.
• Large-scale systems require almost endless ongoing
efforts directed toward enhancement and maintenance.
• It takes time - one step at a time - for managers to
absorb and respond creatively to new tools and a new
managerial environment, but in time there are discernible
beneficial outcomes.
In summary, then, IFMS has made a significant and
ongoing contribution as a new municipal management tool
and as an element of a broader management development
strategy. It will not cure New York City's ills overnight, but it
will help its managers to seek and pursue long-range goals to
overcome ills. As an instrument of that contribution, IFMS is
to be welcomed, encouraged, and displayed for both its
substantive and symbolic roles. It is, symbolically and In
reality, a mark of progressive change in Gotham.
NOTES
1. New York State's Local Finance Law provides for a number of forms
of indebtedness. Tax anticipation notes (TANs) permit short-term
borrowing (maturing in one year, with annual renewal up to five years)
against taxes levied or to be levied during or prior to the fiscal year of note
issue. Revenue anticipation notes (RANs) permit short-term borrowing
(maturing in one year, with annual renewal up to two years) against revenues
anticipated during the year following the fiscal year of note issue. Similar
New York City's New IFMS... 173
urban renewal notes (URN s), for urban renewal projects specifically, mature
in one year with annual renewal up to seven years. Budget anticipation notes
(budget notes), issued in special emergency conditions, permit short-term
borrowing against the following fiscal year's appropriations (with one-year
maturity and no renewals). Finally, bond anticipation notes (BANs) are for
short-term borrowing permitted in conjunction with the sale of long-term
bonds. BANs in effect involve short-term borrowing against expected long-
term borrowing.
2. MAC was extablished by New York State legislation in June 1975. It
issued tax-free bonds that were backed by the diversion to MAC of sales-tax
revenues previously routinely paid by the state to the city. The EFCB was
established in Septermber 1975 by state legislation when credit available to
MAC became insufficient. Its role was both to administer a state-aid
package of $2.3 billion and to oversee the financial operations of the city.
The city was required to submit quarterly expenditure plans and
performance reports to MAC and the EFCB. Federal aid was forthcoming
under the New York City Seasonal Financing Act of 1975 (Public Law 94-
143), which required a three year plan leading to the elimination of $1.5
billion in deficits, a balanced budget and independent audit by July 1978,
and improved financial management operations and reporting. In return,
the federal government provided up to $2.3 billion in short-term loans,
equivalent to RANs, redeemable by the end of each fiscal year of issue.
3. The November 1975 revision of the New York city charter included the
following major changes: requirement of mayor's management report on
program and performance goals; quarterly spending allotment system;
ombudsman role for city council president; creation of legislative office of
budget review; creation of new community districts and boards cotermimous
service dis~r\c~s for selected agencies; creation of district and borough service
cabinets; new uniform land use procedure; removal of mayoral vote on his
budget before Board of Estimate.
4. Among a variety of material, some lucid, some accusatory, and some
exculpatory, are: Roger Alcalyand Helen Bodian, "New York's Fiscal Crisis
and the Economy" in Alcahy and Mermelstein: The Fiscal Crisis of
American Cities; Terry N. Clark, "Why Did New York Go Broke ... ?"
Conference Board Paper, University of Chicago, October 1976; Terry N.
Clark, I.S. Rubin, etal: How Many New York's; Paul De BrulandJackNew-
field: The Abuse of Power; Fred Ferritti: The Year the Big Apple Went
Bust; Ray Horton: The City in Transition; Terry W. McAdam and Lorrie
Slutsky, "The New York City Fiscal Situation, "Citizens Union Research
Foundation; Martin Shefter, "New York's Fiscal Crisis," The Public
Interest, vol. 48; Lester C. Thurow, "New York, A Declining Activity," New
York Affairs, vol. 4 no. 3; Rona B. Stein, "The New York City Budget:
Anatomy of Fiscal Crisis," FRBNY Quarterly Review; Winter 1976; Donna
Shalala and Carol Bellamy, Duke Law Journal Case Study, 1976; Jonathan
Brown, unpublished Harvard University (JFK School of Government) Case
l74 STUDIES IN THE MANAGEMENT OF GOVERNMENT ENTERPRISE
Study, 1976; and numerous publications of the city, state, and federal
governments; The New York Times and other print media.
5. The three major municipal programs in which expenditures rose
between 1966 and 1971 were higher education (251%), welfare (255%), and
hospitals (123%). In 1969-70, contract negotiations for city employees also
secured substantial employee salary and benefits increases. Between 1966
and 1971, the budgets for police, fire, and sanitation accordingly increased
an average of 66%.
6. 1970 Census Bureau data starkly illustrated this disparity. New York's
per capita expenditures on education, welfare, health and hospitals, and
housing were $253, $254, $128, and $62 respectively. Com para ble figures for
Chicago were $10, $3, $10, and $11; for Los Angeles: $0, $0, $1, and $6; and
for Philadelphia: $3, $11, $31, and $46. Only Washington, D.C.
approximated New York, with $283, $125, $155, and $43 respectively. It is
noteworthy that the district's government currently is responding to
forebodings of a crisis akin to New York's.
7. Between 1970 and 1974, the average family income offamilies leaving
the city was $1,300 higher than that earned by those replacing them.
8. The post-1970 decline is particularly significant. Between 1950 and
1970 private-sector employment rose steadily from 3.1 to 3.2 million before
dropping to 2.7 million in 1975. Because public-sector employment over the
same period rose from 0.4 to 0.5 million, overall employment shows a gain of
3.5 million in 1950 to 3.7 in 1970 and then a decline to 3.3 in 1975.
9. The first three-year recovery plan leading to a truly balanced budget by
July 1978 required reductions in spending over the three years totaling some
$1.3 billion in the operating or "expense" budget and $0.7 billion in the
capital budget. Notwithstanding these reductions, an additional deficit of
some $1.6 billion was planned to ease the transition and maintain levels of
service delivery. This deficit resulted in an increased long-term debt for the
city.
10. For example, per capita expenditures on police, fire, and sanitation for
Chicago, Los Angeles, and Philadelphia average 80%, 70%, and 55% of New
York's expenditures for the same services. City size and per capital
expenditure on any service,however, do not correlate. Moreover, similar
service costs for Washington, D.C., are 166%, 103%, and 147% respectively
of those in New York.
11. The city's record of estimating both expenses and revenues is littered
with substantial errors. Mayor Lindsay's pension cost estimates were based
on actuarial data that were 30 years out of date. Revenue estimation
especially presented great difficulties. Even the application of the most
sophisticated analytic tools and the best of faith often resulted in errors of
$100 million magnitude (a phenomenon of the magnitude of the data).
V olatile federal and state uncertainties compounded the problem, especially
when reimbursement was involved. Moreover, quite probable errors of
revenue estimation could not easily be offset by manipulating and
controlling expenditures: a $50 million error translates into about 5,000

layoffs.
12. Until the advent of its integrated financial management system, the city
inconsistently recorded its revenues and expenditures. Revenues were
"accrued" or recorded as soon as they were identified, even when they would
not be received as cash for some time (indeed, often, if at all). Expenditures
were nor recorded until the actual cash was spent. This practice violated
generally accepted accounting standards - record when incurred or
transacted but not a mix of both - and certainly not this mix.
13. In 1972 the city began another budget-balancing technique - moving
items of the expense budget to the capital budget, where they could be
financed by medium- or long-term bonds. Each year larger amounts were so
treated: $274 million in 1973, $564 million in 1974, $722 million in 1975, and
$737 million in 1976. The last sum represented 38% of the total capital
budget; half of it had only tenuous connections to capital projections; and its
extensiveness began to limit much needed expenditure on genuine capital
improvement.
14. See Jan M. Lodal: "Improving Local Government Financial
Information Systems," Duke Law Journal. vol. 1976, no. 6, pp. 1133-1155.
15. The reduction of the municipal work force (some 60,000 since the fiscal
crisis began) has changed its basic characteristics. It is older (almost half will
be over 45 by 1980; only one-fifth will be under 35); its racial and gender
composition, expanding in the 1960s to the benefit of nonwhites and females,
is again changing (the mayoral agencies in 1976 were 72% white and 74%
male); its total costs (direct and indirect) are continuing to grow; resultant
random attrition results in insufficient staffing patterns and high overtime
costs.
Comments on
"New York Citys New
Integrated Financial Management System
(IFMS) and Its Managerial Consequences"
HARVEY T. DILL AND ROGER P. MURPHY·
The author is to be commended for identifying the fiscal

problem of New York City as being that of an increasing
differential between the demands placed on the city relative to
the resources available to finance those demands. The author
labels the problem as long term and suggests that the city's
plight should be addressed in terms of both long-run and short-
run problems. However, a definition of what constitutes short-
term problem(s) is not made in the article. Instead, the article
seems to suggest that the financial wizardry employed to
disguise the financial crisis is the short-term problem.
Actually, this fiscal subterfuge is a chronic symptom of a
distressed financial management system.
Having specified the long-term problem and alluded to what
constitutes short-term problems, the author states that the two
time dimensions are reconciled through the components of
both operational and financial resource management.
However, as we intend to point out in this review, the IFMS
described by the author focuses only on the operational
aspects of municipal finance to the complete exclusion of those
.Both assistant professors of industrial administration, Iowa State

University.
Comments on "New York City's New IFMS ... " 177
elements of sound financing accounting that may assist in

averting a crisis such as that faced by New York City. The
operationally described thrust of IFMS will do nothing for the
short run if it cannot indeed do anything in terms of the long
run.
Before defining what the IFMS can accomplish, the author
identifies the needs that should be met by an efficient finan-
cial information system: planning, control, and external
reporting.
Under the topic of planning, the need is cited for
information to provide measurement of costs and benefits in
order to define priorities through the election process.
Financial managers are custodians of public funds, and their
task should be to direct those funds toward areas deemed
deserving by society. The data required to provide cost
measurement can be provided readily in a financial
information system. Whereas the financial management
system does not provide a basis for gauging benefits, it may
allow planners to measure the efficiency of spending.
Planning as a need served by IFMS encompasses more than
only the operational aspects treated in this article. Continual
forward planning includes capital budgeting that will
anticipate major acquisitions required in the future coupled
with planning for the means that will be used to finance these
acquisitions.
Another need cited as being served by IFMS is that of
control. The author focuses on control in terms of a system
that monitors appropriations in order to prevent overspending
and the misuse of funds. We certainly concur but also think
that control extends far beyond the operational aspects of the
"current budget" orientiation of this article. In this area the
author failed to include capital budgeting as a necessary
ingredient of a sound financial management system. A capital
budgeting program not only includes planning for major
acquisitions but also requires that fixed assets be properly
accounted for so that they may be controlled. Proper

accounting for fixed assets will also allow for the evaluation of
their use.
Before treating in more detail what we think has been
omitted in the IFMS described in the article, a comment is in
order with respect to external reporting, cited as the third
need served by a financial management system. The author
suggests that proper external reporting should allow the
layman to know more about current spending and long-range
trends, but this is difficult to accomplish because of legal
reporting requirement that may produce reports that cannot
be understood. This need not be the case if, as stated, the city
has a unified data base. Such a data base could readily
assimilate the financial information that we think should be
added to the IFMS program.
It is in order at this point to treat in greater depth some ofthe
things that we think have been overlooked in the IFMS
described in the article. We have no argument with respect to
those changes that the new system will make in terms of such
"current budget" operational features as monitoring actual to
budgeted performance targets for revenues and expenditures.
However, an ~fficient financial management system should not
only focus on accounting for theflow of funds but should also
include accounting for stocks of assets and liabilities.
As stated earlier, proper financial accounting should include
capital budgeting that would provide plans for proposing
capital outlays and for acquiring the funds to finance them.
Controls must be exercised over fixed assets in order to provide
accountability and a means of evaluating their use. Fixed
assets should be recorded within specific fund entities, such as
enterprise, trust, or general fund accounts. these assets should
also be classified in terms of their original sources of funding,
such as, for example, special revenue funds, capital projects
funds, general funds, and special assessment funds.
Fixed-asset accounting should also include the recording of
Comments on "New York City's New IFMS. .. " 179
depreciation on these assets. In this was it would be possible to

measure the full costs of providing services. If IFMS is to put
the city on a sound accrual accounting basis, proper fixed-asset
accounting, including depreciation, is a must for all assets
other than general fixed assets (the assets of the government as
a whole that are not accounted for in a specific fund).
If IFMS is to accomplish anything with respect to the city's
long-run financial problems,this system should also include
sound accounting practices for liabilities as well as assets. The
system should reveal the nature of the sources of funds as well
as their uses. Unfortunately, the author has failed to say
anything specific about how IFMS incorporates debt
management. The posture of a municipality with respect to the
financial community is a direct function of the debt
management/ accounting practices of that municipality.
Competent financial management requires a soundly designed
and operated financial system coupled with proper knowledge
of debt purposes, debt repayment, and debt limitations. Any
debt for any purpose will require debt servicing from future
revenues. Consequently, IFMS should integrate information
about revenue sources, special revenue funds, debt service
funds, special assessment funds, and enterprise funds in
anticipation of the eventual retirement of this debt.
Adequate actuarial reporting of estimated future outlays for
such items as unfunded pension costs is also an important and
necessary aspect of a sound financial management system.
Private enterprises are required to disclose those liabilities
when seeking funds in the capital markets. Municipalities
should also be required to disclose those items.
In summary, we think the author has done an admirable job
in describing improvements in the short-run operational
aspects of IFMS. But he seems to have omitted most of the
long-term financial management aspects that we have
attempted to emphasize.

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STUDIES

MARTINUS NIJHOFF PUBLISHING

DISTRIBUTORS OUTSIDE NORTH AMERICA:

Library of Congress Cataloging in Publication Data

ISBN-13: 978-94-009-8140-9 e-ISBN-13: 978-94-009-8138-6

Copyright © 1981 by Martinus Nijhoff Publishing

Introduction by Richard J. Horn 7

1. The Government as Manager: Weapons Procure-

2. A First Approach to the Economic Theory of

3. A Post-Accord History of Principal Federal Re-

4. Public Ownership and Natural Resource Utiliza-

6. New York City's New Integrated Financial Mana-

The six studies in this volume represent investigations into

In "A First Approach to the Economic Theory of College

The last paper by James Hardy describes New York City's

The Government as Manager:

A firm engaged in a major program for the Defense De-

*Hunter College, CUNY.

according to the government's order. This chapter will discuss

CHARACTERISTICS OF THE DEFENSE

The demand side of the defense market has at least three

a satisfactory level of domestic security. This attitude gives to

Defense contractors manufacture weapons systems only

staffs covering diverse fields receive most of the outlays.

endeavors. 4 Unlike producers of civilian goods who use low-

The Government as Manager

requirements for a weapon and hires a contractor's capabilities

picking the initial group of participants in a project as well as

A second managerial function greatly influenced by the

decides the production methods. The government approves

This overview of the managerial role of the federal govern-

"'Department of Industrial and Managerial Engineering, Columbia

functions? How does one define the transition from regulation

Economists have spent a great deal of time and energy

*The author is professor of economics and chairperson of historical,

reduction of $69 million (or 13 percent) from the net operating

for summer session, building and grounds, controllable

The equation shows the derivation of the budget for each

the total number of dollars allotted for instruction, (O'F) tA

This basic relationship can be simplified further as:

= 22,000 (in thousands)

IT = (I - A) /3BI (5) administrative services

S = administrative services budget

the number of faculty publications (rounded to the nearest

that is, the proportion allotted by the president for personnel

conditions are met. That requires that in addition to the earlier

where a double subscript under F indicates a second partial

Uf3f3 Uf3a Uf3M B

The first of these second-order conditions, in turn, can be

Thus diminishing marginal utility of additional proportions

In any case, we have shown that a determinate equilibrium

ILLUSTRATION OF THE PROCESS

9,000 students, and the number offaculty publications is 2,000

Now by the relationships (3), (4), (5), we have

and {3=0 or 23,100 - 176,000a = 0

From the constraint we have

16,000 - 22,000 (0005454)-2.-.1..= 0

Setting the first patial derivatives equal to zero gives

From the constraint we get

-A. -A. -A.

S f3aB = E... ~. B = 15A 15A(B - 6,000)

~ ~2A - 6~AW ;/,000)

Very Short Run