Arntraud Hartmann and Syed Ali Nawab
In many developing countries public manufacturing enterprises contribute a large portion of industrial output and are the backbone of the industrialization process. According to the World Development Report 1983, in developing countries for which data are available, the contribution of state-owned enterprises to GDP in the 1970s increased from 7 to 10 percent. Public manufacturing enterprises also contribute substantially to investment. In developing countries, state-owned enterprises account for at least a quarter of capital formation. In some countries the share is much higher; for example, in Algeria, Burma, and Zambia, it is over 60 percent, while in Pakistan it is 45 percent.
Governments justify the creation and operation of state enterprises in many ways. Ideology, lack of a sufficiently strong private sector, and noncommercial objectives, all play a part in the decision to establish or sustain state enterprises. Noncommercial objectives are diverse and may cover employment generation and industrialization of underdeveloped regions, supply of products considered important to attain self-sufficiency of the country, maintenance of social peace through union contracts favorable to workers, support to other public firms through procurement of inputs at noncompetitive prices, and national security (in the case of defense-related enterprises). However, the performance of public enterprises in developing countries has often been disappointing, and public firms are generally judged to be less efficient than their counterparts in the private sector. As a result, governments often have to pay large subsidies to cover operating losses of public enterprises.
The unsatisfactory performance may result from high production costs because of noncommercial objectives pursued by public enterprises, price controls on inputs and outputs, poor financial structures of the firm, and unsuitable location of these enterprises. In many cases, it is also the result of poor management that continues to employ unsuitable production patterns and outdated technology, and results in low labor productivity and poor marketing. Managers of public firms often lack adequate experience in the management of commercially viable units, and appointments are frequently based on political considerations. They are also usually hampered by a tight network of government controls that regulates all types of managerial decisions and does not foster risk taking and innovation. Public managers also frequently lack clear objectives and do not receive incentives for improved performance. They are seldom rewarded for the good performance or penalized for the poor performance of their enterprises.
To monitor performance and provide incentives for improved management of its public sector, Pakistan introduced a “signaling system” for most of its public manufacturing firms in 1983. The system provides for clear quantifiable performance targets for each enterprise, and managers are evaluated and receive bonus payments according to these. To date it has only been implemented for manufacturing firms, but extension of a modified system to other public companies, such as utilities and transportation corporations, is being considered. The fact that the system links substantial bonus payments to quantifiable targets makes it an interesting and innovative attempt. While several developing countries are currently trying to establish similar systems, the experiment in Pakistan probably presents the most advanced and boldest approach. It has so far been well received by public managers within the country, and the interest expressed by other developing countries indicates that it may well serve as a model for evaluating the performance of public enterprises in other countries.
Public manufacturing in Pakistan
The public manufacturing sector in Pakistan remains relatively small but quite important. It accounts for only about 15 percent of industrial output but dominates a number of key industries: fertilizers, cement, engineering, steel, petroleum refining and chemicals, automotive assembly and manufacture of parts, and vegetable ghee (cooking oil). These industries supply a large number of other enterprises in the private sector with inputs, thus affecting the quality, level, and prices of other products in the economy at large. The existing public manufacturing sector reflects the industrialization policy pursued by the Government in control during 1971–77 that assigned the public sector the leading role in industrial development. That Government established a number of large public industries. The succeeding administration reversed that policy. It denationalized smaller agro-industrial units, provided legal guarantees against further nationalization, and announced that it expected the private sector to spearhead industrial development. The public manufacturing sector would be limited to its present size and would receive no government budget allocation for new investments. Further, public firms would be expected to act more like their counterparts in the private sector. Currently, there is a strong emphasis on commercial objectives, and public units are expected to become financially viable and to maximize profits.
The majority of Pakistan’s public manufacturing firms come under the Ministry of Production through nine holding corporations. The Ministry sets guidelines and coordinates policies for most of the public manufacturing sector. Each holding corporation supervises 1 to 13 units from the same subsector, for example, the National Fertilizer Corporation oversees all public fertilizer plants, the State Cement Corporation all cement units, and the State Engineering Corporation all engineering units. Holding corporations plan and monitor financial performance, production targets, and investments, and approve many of the day-to-day decisions of public managers.
To enable the public units to become more efficient and dynamic, the Ministry has initiated a number of structural reforms. These include increased delegation to the holding corporations of decision-making authority on operational matters and the introduction of an improved salary structure that provides appropriate differentiation of salaries by levels of skill and responsibility. These measures have already led to improved performance by public units, particularly in productivity. However, profitability in many units remains low. Poor operations are not only the result of inadequate management but also of pricing regulations that provide for guaranteed rates of return in selected sectors (including cement, fertilizers, petroleum products, vegetable ghee). Pricing arrangements differ from sector to sector but generally provide insufficient incentives for reduction of costs, reinvestment of funds, or maximization of profits.
The conglomeration of targets and incentives that guide managers is called the signaling system. In Pakistan the system consists of three major components: a management information system; a performance evaluation system; and a bonus salary system. The system was designed by Professor Leroy Jones of Boston University for the Government of Pakistan and prepared over a three-year period by a consulting firm in cooperation with the implementing agency, the Experts Advisory Cell (EAC), a small autonomous organization under the Ministry of Production. The World Bank financed the preparation of the signaling system under a technical assistance credit from the International Development Association, and Bank staff have monitored its implementation closely.
Information system. A comprehensive, reliable, and timely information system is a precondition for an effective performance evaluation system. The establishment of such a system and the creation of computerized information on each of the public enterprises was, therefore, the first step to be carried out in the implementation of the signaling project. Each month information on production, manufacturing costs, salaries, profits, taxes and duties, inventories, capacity utilization, and employment is fed into a computerized file on the basis of standardized reports submitted by each unit. The Ministry of Production has direct access to this information.
The task of establishing the system turned out to be more challenging than anticipated. Operational data, financial statements, and the terminology employed differed widely from unit to unit. This made intercompany comparisons very difficult. To standardize information, the EAC designed an accounting manual that introduced uniform cost-accounting systems as well as standard terminology. The EAC publishes monthly, quarterly, and annual reports that include full financial information for every enterprise, complemented by a number of economic variables such as value added, labor productivity, revenues, and price changes. Monthly performance reports for each enterprise are also available to the holding corporations and the Ministry of Production so that they can monitor progress on a continuous basis and detect possible problems early.
Performance evaluation. The performance evaluation system consists of the negotiation of annual targets for each enterprise before the beginning of each fiscal year and the evaluation of results at the end of the year. Setting appropriate performance targets for public enterprises is a difficult and important task. Targets guide managers in their decisions and focus their efforts toward achievement of the stated goals. In the long run, therefore, targets direct a firm on the right or the wrong development path. Performance targets for public and private firms need to be defined differently. In the long run, the objectives of a private firm are to maximize profits and returns only to private equity holders. Since in the case of state-owned enterprises the government owns the equity and represents all groups within a society, public enterprises should attempt to increase the returns to the society as a whole. The final objective of the signaling system in Pakistan is, therefore, to define targets in terms of “public profits” that measure the difference between social costs and social benefits contributed by a firm to the economy—that is, the difference between what a firm takes out and puts into an economy.
The concept of public profits uses private after-tax profit as a point of departure but eliminates all transfer payments, such as taxes and subsidies, since transfer payments as such do not increase or decrease national welfare and the public manager should not try to maximize subsidies or minimize taxes. Then, private profits are adjusted through the so-called “social adjustment account.” This is primarily used to quantify higher production costs incurred by the public enterprises in pursuing noncommercial objectives, such as high transportation costs because of operations in backward areas, high wages because of social considerations, or high labor costs because of overstaffing for employment creation. Assuming that these higher production costs, in fact, lead to comparable social benefits, they are added to the profits. The social adjustment account is also used to make corrections for major distortions of input or output prices.
A further feature of the public profit indicator in Pakistan is that it has been defined as a single-period indicator (limited to one year for now). Unlike calculations of private profit, neither depreciation nor financial charges for other than working capital are entered as a cost. The single-period indicator was chosen since public managers in Pakistan generally cannot influence financial structures or the capital endowment of their units but are expected to maximize profits within these given parameters. Taking this observation one step further, it was also decided to use “public profitability” instead of public profit as the final indicator of performance in later stages of the signaling system. Public profitability, defined as the ratio of public profit to operating assets, relates profits to the amount of capital available in a plant. It, therefore, allows comparisons between different firms in the same sector that often operate with very different capital structures and therefore achieve different profit levels. The Government was reluctant to introduce “public profits” or “public profitability” as an indicator in the initial stages of the program. It was concerned that enterprises that improved performance according to public profitability, but still ran financial losses, would require subsidies from government budgets to cover their bonuses. The Government also was concerned that bonus payments for managers of financially nonviable firms would lead to demands for bonus payments from workers, who, under union contracts, normally would receive such payments only if their firms made commercial profits.
The system adopted to measure performance used private profitability as a criterion in the first year, but added to it other indicators in the second year (see Chart 1). For most units the performance criterion consists of a weighted average of private profitability, physical production, productivity, and energy consumption. Weights attached to each indicator differ from firm to firm, depending on the relative importance of each indicator for each firm. In most cases, private profitability receives the maximum weight. The only exception to this are firms that are guaranteed fixed rates of return under the government’s regulated pricing system. In those cases, private profitability becomes a meaningless concept and is replaced by other indicators. Depending on the nature of the pricing arrangements, private profitability is substituted by partial indicators such as productivity, production of selected higher value-added products, capacity utilization, variable costs, or energy consumption. Finally, specific target values are assigned to each weighted indicator with corresponding grades for full or partial achievement of these values.
The annual targets for a fiscal year are set in the fourth quarter of the preceding fiscal year. This involves complex and lengthy negotiations between the individual firms and the EAC during which agreement is reached on indicators, weights, and targets. Targets are based on the budgetary proposals prepared by the enterprise and additional considerations, such as past performance of the enterprise, achievements of similar firms in the private sector or in other developing countries, specific financial and physical constraints expected for the enterprise during the next fiscal year, and possible effects of macropolicies on inputs and outputs of the enterprise. In defining the target values, the EAC attempts to avoid adversely affecting the cash flow position of a firm because of bonus payments. The target negotiation process culminates in the signing of a contract between the EAC and each participating enterprise (see sample, Chart 2).
Bonus system. With a comprehensive information system and agreed targets in place, evaluation of achievements and payments of bonuses are an automatic process. Bonuses amounting to three months’ salary are paid to managers of firms that receive grade A, two months for grade B, one month for grade C, half a month’s salary for grade D, and none for grade E. Chart 3 illustrates the hypothetical grading of one enterprise and the weighted score corresponding to each grade. Bonuses are paid to all employees in managerial grades in a unit but not to workers who currently are eligible for bonus payments under union contracts. The distribution of bonus payments to the individual employees in the management group is left to the discretion of the managing director of each enterprise.
Chart 3Performance evaluation system
In fiscal year 1983/84, 41 out of the 61 units that were then under the Ministry of Production participated under the system, of which 11 units achieved grade A; 5 units grade B; 9 units grade C; 1 unit grade D; and 15 units grade E. Operating results were generally comparable to previous years. Given the novelty of the system in this first implementation cycle it was not expected that operating results would be greatly influenced by the targets of the signaling system, particularly since targets were negotiated very late in the fiscal year, leaving managers little time to adjust their decisions to the new system.
The implementation of the system has proceeded very smoothly and the innovation has been welcomed by public managers. Implementation has greatly benefited from the fact that it rests in the hands of a small government agency outside the direct chain of command of the ministries. The EAC operates as a monitoring, evaluation, and consulting organization to all public manufacturing enterprises under the Ministry of Production and is fully financed by the public corporations. Staff of the institution are specially recruited and are not part of the civil service with its frequently rotating assignments, and they receive relatively attractive salaries. The organization has also benefited from the authority of the Ministry of Production, under which it operates, in getting assistance from other government bodies and the cooperation of the firms being monitored. This has been a vital factor in the success of the unit in collecting timely data for the monitoring system and in implementing the evaluation program.
The establishment of the information and monitoring system has already brought about a major improvement in the timeliness and availability of information on the operations of public enterprises. This enables the Ministry of Production to meet regularly with the staff of holding corporations and to review the performance of the enterprises. The systematic and timely collection and evaluation of data for this system should, over time, replace many of the routine reporting requirements to ministries and holding corporations that currently occupy much of the public managers’ time.
Much of the system’s success will depend on whether it defines the right targets and whether these targets encourage managers to alter their managerial behavior. This process of target definition remains the most challenging hurdle. The present procedure of having a number of partial indicators, including private profitability, is an acceptable interim solution. In the long run a more standardized and consistent criterion needs to be applied that takes better account of the noncommercial objectives of public units and makes some necessary accounting adjustments between public and private profits. The introduction of a public profitability criterion will, of necessity, need to be a gradual process, since the economic concepts behind such a criterion are complex and need to be carefully explained to, and understood by, the affected managers.
Appropriate targets also need to be defined as part of a longer-term plan prepared for each firm. Targets are currently only defined as single period indicators that do not take into consideration the medium- or long-term development plans of enterprises. The EAC recognizes this and intends to strengthen the currently very weak corporate planning efforts of public firms with a corporate planning and assistance program. This would help each firm to prepare a detailed corporate strategy and plan, which, after evaluation by the EAC, would provide the framework for the definition of targets for each enterprise.
Improvements in public sector efficiency not only depend on a better directed management but also require a better managerial environment with greater decision-making authority delegated to the individual manager, and a rationalized incentive system and pricing policies. While the signaling system, itself, does not provide for any changes in the regulatory environment, it can set the stage for further deregulation and reformulation of policies. By providing for clearly defined targets and judging managers by results, the need for a system to control operating decisions is reduced. By requiring public managers to adopt longer time horizons through detailed corporate plans, contractual arrangements between individual enterprises and the Government could be made, similar to the contrat plan system established for public enterprises in France and in some countries in West Africa. These contracts could provide for a more predictable and rationalized external environment and incentive structure for the individual enterprise.