Home » Economics » Investment Approach to Deregulation

Investment Approach to Deregulation

Sign up to the Barefoot Economist’s Newsletter

© Barefoot Economic Services

All content on this website (unless otherwise specified) is copyright of Barefoot Economic Services. Please acknowledge any content used in your work appropriately. Thank you for your consideration.
Image: Red tape.

Image: Red tape.

Last week, the consulting firm Deloitte’s released a new report titled, Get out of your own way: Unleashing productivity as part of their ‘Building the Lucky Country’ series. One of the main results was that Australian businesses imposed more red tape on themselves than the government does. Deloitte’s quantified the annual cost of self-imposed $155 billion compared to $94 billion from government-imposed regulation. Furthermore, this cost is associated with the growing ‘compliance sector’ that replaced the back-office staff that had been shed as a result of improvements in technology. So Australian firms have effectively spent their productivity dividend on beefing up their compliance capacity rather than concentrating on core activities. Deloitte’s attributes the growth of the ‘compliance sector’ to the growing risk-aversion among large Australian corporates to avoiding ‘stuff ups’. I generally found it an interesting report, although I thought it brushed over an important point: imposing rules is an implicit investment decision. I want to go through this important point in more detail in this post.

To motivate this point, I borrowed this anecdote from the report, which in turn was borrowed from the Harvard Business Review:

“…leaders at one large manufacturing company recently discovered that a regularly scheduled 90-minute meeting of mid-level managers cost more than $15 million annually. When asked “Who is responsible for approving this meeting?” the managers were at a loss. “No-one,” they replied. “Tom’s assistant just schedules it and the team attends.” In effect, a junior VP’s administrative assistant was permitted to invest $15 million without supervisor approval. No such thing would ever happen with the company’s financial capital.”

What this anecdote points out is that making rules is an implicit investment decision. Rules explicitly determine the allocation of an organisation’s resources, in this case, the allocation of the company’s middle managers’ time. Other internal rules have similar effects. Rules aren’t necessarily inefficient, if the rules are consistent with aligning effort with high-value activities. But the Deloitte’s report argues that internal rules are conservatively estimated to cost Australian businesses $155 billion by diverting workers from presumably high-value activities to low-value activities. If we think about rules as an investment decision, does that mean we can use conventional investment frameworks to think about deregulating an organisation?

I think so. Estimating costs is relatively straightforward. If you ever had to work under a pointless rule, you probably have a good idea on how much time you could have used on a more high-value activity. Multiplying the hours used on this activity by your hourly rate gives you the cost of your time under that rule. Estimating benefits for a rule can be a more challenging task because often these rules are about prevention. How do you estimate the benefit of avoiding a specific event? There is some guidance from the benefit-cost literature on how to estimate risk avoidance. Generally, think about how much it would cost the company if that event occurred. For example, the risk of a information technology project failing because you decided to neglect testing before going live. What would happen if it goes wrong? How much would that cost? You may surprise yourself and find that not all rules are completely useless. Using this information, you could use common investment appraisal methodologies such as a Net Present Value (NPV) calculation to estimate the net benefits from removing (or introducing) a rule. Using an investment appraisal methodology reveals the costs and benefits of a rule. The process of estimating costs and benefits may reveal opportunities for improving the process to retain the benefits but at reduced costs. By adopting a transparent and systematic approach to analysing the costs and benefits of a rule, it prevents an organisation from potentially making a bad situation worse by abolishing rules that may have a useful function. In other words, an investment approach to deregulating an organisation is an evidence-based approach.

An example may help make the principles of investment approach to deregulation more tangible. Say you are a food manufacturer that wants to implement a quality assurance (QA) program that goes beyond current regulation. You may want to introduce more rigorous processes to access high-value markets that pays a premium for quality and safety (e.g. the Japanese market). How would you estimate the benefits and costs from introducing the new QA process? First, let us think about the costs. Cost from a rule can be divided into administration and compliance costs. Administration costs are those required to develop, implement and enforce the new rule. These costs could include re-training staff, hiring consultants to write a manual for the new process and staff time to document the implementation process for audit purposes. Compliance costs are essentially the new cost structures of adopting this new process. That includes the cost of new equipment and the increase in staff time to ensure compliance with the new QA program. Now, to estimate the benefits. We have alluded to one of the benefits, which is being able to obtain a higher price for the product. But there could be other benefits such as more efficient use of inputs as a result (e.g. reduced chemical use). Quantifying these costs and benefits on an annual basis would allow you to use an investment appraisal calculation to determine the net benefits from adopting a new rule.

Using investment appraisal methods to identify rules that are holding your organisation back is a transparent and systematic approach to deregulating your organisation. Conversely, it could also be used to examine the introduction of new rules. The transparency forces managers to rigorously justify deregulating or regulating their own organisations. It has the additional benefit of introducing evidence into making or removing rules rather than following the latest management fad. Could using an investment appraisal approach introduce more red tape? Depends on whether or not you think explicitly calculating the benefits and costs of removing or introducing a new rule is a useful process. Analysis can help inform decisions, preconceptions could lead you to repeat the same mistakes again and again. It’s a matter of personal preference but I would feel more comfortable if my managers could produce some analysis to justify important decisions.