Report to Local Government Commission on
Hawkes Baytransition costs

6 November2014

File: StimpsonReportOnHawkesBayReorganisationTransitionCostsV8.docx

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Report to Local Government Commission on Hawkes Bay reorganisation transition costs

A.)EXECUTIVE SUMMARY

a)Transition to a Hawkes Bay Council as proposed by the Local Government Commission is viable with a payback period of around four years.Table 6 shows that annual ongoing savings build to around $10 million from year five, requiring transition costs of around $19 million.
b)Undiscounted gains over thirty years total $260 million. The net present value of these gains is estimated at $87 million.
Table 6. Payback period and net present value of transition costs and ongoing savings

c)Savings gains totalling $10 million identified by Brian Smith Advisory Services are in ranked order: corporate personnel (37% of total) corporate other (30%), activities opex (14%), activities capex (9%), governance costs 6%) and audit costs (4%).
d)The six transition costsmodelled to achieve amalgamation gains are listed below:
  • Transition body own costs (includes wide range of change management workstreams).
  • Implementation costs - comprising:
  • Information technology costs to underpin acceptable levels of service on day one, and investment required over a total of three years for all Councils to be served by common systems. These costs would initially be incurred by the transition body on behalf of the new entity and from day one by the new entity.
  • Accommodation, signage and costs of interim management engaged before the entity start date.
  • Human resource transition costs - consisting of:
  • Redundancy costs (largely met by the existing Councils).
  • Harmonisation of remuneration costs, terms and conditions).
e)Even under a pessimistic scenario where the $12.6million IT cost (the largest transition expense) is doubled, the amalgamation remains viable.

B.) BACKGROUND

Purpose and scope of this report.

  1. This report is for the Local Government Commission (LGC). It summarises the financial costs and benefits of the transition of the five Hawkes Bay local authorities to a single Unitary Hawkes Bay Council. Inputs to this report are:
  • Report from Brian Smith Advisory Services Ltd (BSAS) - analysis of cost efficiencies.
  • Report from Master Business Systems Ltd on IT Implementation and associated business process redesign costs that allow the merged organisation to function on day one and the further investment needed to support the gains identified by BSAS.
  1. Detailed cost calculations are set out in appendix one. This spreadsheet attachment also collates key calculation spreadsheets from BSAS and Master Business Systems.

Our approach

  1. The structure of the Hawkes Bay Council is that proposed by the Local Government Commission in its draft proposal in November 2013[1]. Stimpson & Co worked with BSAS Master Business Systems to define the parameters of the cost savings, the IT costs necessary to support these gains and the costs of a transition body and redundancy expenses. Key assumptions have been agreed with the LGC. The team’s previous experience of advice on the Wellington Amalgamation options which in turn was informed by the Auckland Council / Auckland Transition Agency (ATA) experience has provided useful benchmarks.
  1. Based on these inputs and assumptions, Stimpson & Co has prepared estimates of the transition cost and benefits. We have then calculated both a payback period and the net present value of the proposal over thirty years.

Definitions

  1. “Transition costs” is the term used in this report to describe the one off restructuring costs of establishing the new entity or entities. They include the short to medium term capital and operating costs of transition and implementation to allow the new entity to function on day one and the five years immediately thereafter. These temporary costs would not be found in the budgets of the existing entities -nor in the new entity. For the purposes of this report, the term “transition costs” is interchangeable with “integration costs”.[2]

The assumed approach to transition

  1. The assumptions about transition and short-term efficiency gains are set out below.
  1. The transition path will follow a commercial approach of rapid transition.
  2. Transition has been considered in two phases. The first phase is the cost necessary to achieve minimum acceptable levels of amalgamation by day one. The second phase extends to end of year five.
  3. It will be possible to select the best of breed of current systems within the merged councils and expand them to support the new council, or to adopt a new system (i.e. the Selwyn Building Consent Authority system) within a short period of time.
  4. Critical systems requiring integration early in the transition period are: payroll, finance, HR, and resource and building consents.
  5. Other key systems that should be able to be migrated using adoption of best available systems assumption are: asset management, RAMM, and GIS.
  6. There is a transition cost associated with each area of potential saving.
  7. No change to the organisational structure. For example - no more or less outsourcing or establishment of CCOs than at present.
  8. No changes in the level of service or changes in the long-term capital works programme as a result of the amalgamation changes.

Transition cost rule of thumb

  1. The merger or integration examples shown in Table 1 indicate that integration costs usually amount to a least one, and up to two, times the annual efficiency gains once fully realised. Estimated mid-range savings for the proposed Hawkes Bay Council of $10million and costs of around $19million suggest our analysis is at the conservative end of the rule of thumb range.

Table 1 Transition / integration cost bencmarks

Merger / reorganisation examples / Ratio of integration costs to annual efficiency gains
ANZ acquisition of National Bank of New Zealand. / 2.1 times
Westpac acquisition of St George / 2.0 times
Suncorp / Promina merger / 1.6 to 1.8
Bendigo / ADB / 1.0
Office of the Deputy First Minister in Northern Ireland - study of education, health and local council entities / 1.9
Cornwall Council amalgamation 2009 / 1.6
Deloitte 2008, - “full integration”[3] / 2.3
TDB desktop forecast for Royal Commission’s preferred option / 1.0 - 2.0

Auckland experience

  1. Testing this rule of thumb with the actual Auckland experience is problematic due to the difficulties in locating actual costs across existing Councils, the ATA and the new Auckland Council. Work by TDB identified $95mof targeted first year savings of which the vast majority were staff cost savings. The actual savings budget eventually contained in the First Auckland Council Annual Plan prepared for it by the ATA was $81m. Integration costs totalled around $180 million, or around two times the targeted savings. Costs comprised: the operating costs of the ATA ($30 million), in kind contribution to ATA workstreams ($ unknown), upfront IT investment ($122 million) and redundancy costs ($27 million).

Cost methodology - summary of transition costs estimated for the Hawkes Bay Council.

  1. This report analyses five transition costs below, in preference to use of rule of thumb transition cost ratios:
  • Transition Agency own costs (includes wide range of change management workstreams).
  • Implementation costs - comprising:
  • Information technology costs to underpin acceptable levels of service on day one, and investment required over a total of five years for all Councils to be served by common systems. These costs would initially be incurred by the transition body on behalf of the new entity and from day one by the new entity.
  • Accommodation, signage and costs of interim management engaged before the entity start date.
  • Human resource transition costs - consisting of:
  • Redundancy costs (largely met by the existing Councils).
  • Harmonisation of remuneration costs, terms and conditions).

Hawkes Bay Council amalgamation timeline

  1. Table 2summarises the assumed timeline. We have assumed a two-year preparatory period (years -2 and -1) from the date of the final proposal from the LGC. By year -1 it is assumed there is a Transition Body in place and an interim CEO able to enter into contracts that can bind the future Council. This is important for the purpose of contracting the necessary IT investment to allow operation on day one.

Table 2. Assumed timeline for establishment of the Hawkes Bay Council

Savings

  1. Efficiency gains identified by Brian Smith Advisory Services build to $9.6 million. The gains are in ranked order: corporate personnel (37% of total) corporate other (30%), activities opex (14%), activities capex (9%), governance costs 6%) and audit costs (4%).
  1. Efficiency gains detailed in the BSAS report take effect from year +1 to +3. We have made a further conservative assumption that the BSAS year three increase in savings are spread across years +3 to +5. This assumption ensures the timing of cost savings does not precede supporting IT investment that is modelled to extend to year four.

C.) HAWKES BAY COUNCIL TRANSITION BODY COSTS

Cost benchmark for Hawkes Bay Transition Body costs

  1. The Auckland Transition Agency (ATA) experience was used as a starting point for our previous work on Wellington amalgamation options. The vastly larger scale of these projects (eg: $30million operating expenditure for the 18 month period of the ATA.) means they are not closely comparable benchmarks for estimating costs in a rural / provincial New Zealand context. These projects are useful however for identifying issues and cost categories. Our previous work on the Wellington amalgamation options made an estimate of $2million for the transition body for the amalgamation of the three Wairarapa Councils.
  1. Table 3 shows the build up of an assumed $4 million budget over 12 months for a Hawkes Bay transition body.

Table 3. Wellington Transition Agency costs and timing

Budget items / Hawkes Bay
Transition body
$M
Administration costs (accommodation rental & supplies) / 0.10
Audit fees- ATA / 0.10
Audit - planning document assurance / 0.00
Audit - assurance services on workstreams / 0.10
DIA support - financial, IT, telecoms / 0.50
Election costs / 0.00
Finance charges (mainly interest to the Crown) / 0.10
New organisation recruitment & senior staff costs / 0.50
Employee benefit costs (Staff - Executive Chair and non executive board members) / 0.50
Workstreams
1)Business processes and systems
2) Communications & public affairs
3)Community services
4)Council controlled organisations
5)Customer services / 2.00
6)Environmental services
7)Policy & planning
8) Regulatory
9)Finance and Treasury
10)Governance
11)Legal
12)Property & assets
13)Workforce and human resources
Depreciation & amortisation / 0.00
Total Transition Body costs / 3.9
Implementation operating expenditure (Branding, signage, accommodation) / 0.10
Total Transition body managed costs (12 months) / 4.00

D.) IMPLEMENTATION COSTS

  1. The ATA incurred a range of operating and capital costs on behalf of the new Auckland Council before it came into existence. These were called “implementation” costs in the ATA financial reports. This expenditure was mainly IT and on a far smaller scale - accommodation and signage. These costs were incurred in order to allow the new entity to function with minimum acceptable levels of amalgamated service from day one.

Hawkes Bay Council Implementation costs - IT systems design & delivery

  1. Table 4summarises the IT cost estimates from Master Business Systems. A $10.5 million mid-point from the low to high range is utilised in the calculations of net benefits. Provision has been made for core IT infrastructure, amalgamation of main IT systems vital for day one operation, and other systems that can be amalgamated at a slower and less costly pace.
  1. The costs of reengineering the business systems that are supported by IT are also provided for. Allowing a further 20% cost contingency on the mid-range estimate gives a total IT cost estimate of $12.6 million over five years.

Table 4. ICT systems design & delivery cost estimates from Master Business Systems

  1. A sum of $200,000 for “other implementation cost” incurred by the Transition body is also providedin Table 6. In Auckland this cost item provided for an interim management team during the period just prior to day one.

E.) HUMAN RESOURCE TRANSITION COSTS

  1. Savings in years one to threehave been estimated by BSAS for six categories of costs. The following three cost categories are assumed to involve staff cost reductions and therefore redundancy expenses:
  • Activities opex
  • Corporate - personnel
  • Governance (includes elected members and Chief Executive.)
  1. Cost saving categories for which no redundancy costs, or any other investment beyond upfront IT expenditure is assumed, comprise:
  • Corporate - non personnel
  • Activities capex
  • Audit costs
  1. Redundancy costs are assumed to be incurred the year prior to the year of saving. Under the Auckland transition, redundancies were largely completed before the Auckland Council start date.

Redundancy costs as a ratio of staff cost savings

  1. Table 5 shows the extent to which the savings are related to inhouse personnel and therefore likely to trigger redundancy costs.

Table 5. Summary of redundancy costs

  1. The Auckland experience was that staff cost savings came from a combination of: reduction in staff, unfilled vacancies and filling positions at lower rates of remuneration. Around $80million in staff cost savings were associated with $27 million in redundancies. Redundancy costs were therefore around 33% of staff cost savings.
  1. Existing Hawkes Bay Council’s redundancy provisions are typically, six weeks pay after one year’s service, plus two weeks pay for every year of service thereafter. This is similar to our analysis of Wellington region local authorities. Mean and median lengths of service vary from 6.5 to 11.0 years and 4.0 to 8.2 years respectively. Assuming an average staff tenure of around 8 years, redundancy costs would be around 20 weeks pay - or 38% of base salary. Assuming staff cost reductions also come from the other sources such as vacancies held open and reduced remuneration, redundancy costs at 33% of staff cost saving is considered reasonable.
  1. Governance cost savings with redundancy implications relate to CEOs only, where 50% of the annual savings are assumed to be paid out in contract terminations. This is likely to be a conservative assumption as most CEOs are on contracts that terminate sometime in 2016 or at the time of any amalgamation.

Staff cost savings & redundancy expense in the “Activities opex” category

  1. BSAS analysed cost savings in the following functions within the “activities - opex” category:roading, three waters, solid waste, Regional Council Public Transport payments, regulatory, economic Development and other activities.
  1. 36% of activities opex is estimated to be personnel related - based on 75% of savings in regulatory and other activity costs. Savings in the infrastructure activities are assumed not to be personnel related.

Staff cost savings and redundancy expense in the “corporate personnel support” cost category.

  1. BSAS has analysed corporate support activities and identified the personnel related costs for the following functions: finance, IT, communications, human resources, records, customer service, Mayoral/CEO support, other corporate support, council meeting and committee support, and other specialist support functions. Redundancy costs are assumed at 33% of the staff cost savings for all functions in the corporate personnel support cost category. This category does not include CEO costs, which are covered in the governance category below.

Staff cost savings and redundancy expense in the governance cost category

  1. This cost category includes reductions in the numbers of both elected members and Chief Executives. There is no redundancy cost associated with reductions in elected members. The redundancy provisions that apply to most staff including senior management do not apply to CEOs. They are engaged on fixed term contracts of varying lengths. Termination of these CEO contracts in a worst case could involve full payment to the end of the contract. In practice a negotiation is likely to result in some lesser payment for this severance.

Remuneration harmonisation

  1. A degree of variation in pay rates and conditions across the Hawkes Bay region is expected. An allowance of $0.2m is provided for funding a one-off buy out of conditions to achieve consistent engagement of staff.

F.) RESULTS

Summary of total transition costs and cost saving benefits by option

  1. The results summarised in Table 6, assuming mid-range IT costs, show a Hawkes Bay Council is strongly financially viable under an expected case set of assumptions. Total costs of around $19m are recovered in around four years. These early benefits are assumed to become embedded in the organisation. The net present value of these costs and benefits are calculated over a period of thirty years. During this thirty-year period a wide range of other costs and benefits would also come to bear on the new organisations.
  1. Undiscounted gains over thirty years total $260 million. The net present value of these gains is estimated at $87 million.

Table 6. Payback period and 22 year net present value (NPV) of upfront amalgamation costs and ongoing saving benefits

Sensitivity analysis

  1. IT costs are the most significant influencing factor on the economic attractiveness of the proposed Hawkes Bay Council. Even if the IT contingency factor is increased to 100% and IT costs were to double to $21million, the financial viability of the proposal remains strong with a payback period of five years.

Appendix One.

Stimpson & Co spreadsheet work book - file: TransitionCostCalcsV6.xlsxcontaining supporting calculations and detailed assumptions for this report.

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Report to Local Government Commission on Hawkes Bay reorganisation transition costs

[1]Draft Proposal for Reorganisation of Local Government in Hawkes Bay.

[2]In addition to its own costs of operation, the ATA also reported “Implementation” costs. These were operating and capital costs of staff, IT, communications, offices and signage for the new Auckland Council prior to its start data on 1 November 2010. These expenses are included in this report as part of Transition” costs. The term “Integration costs” has been used by others to describe the “one off costs above, and also the “Temporary parallel costs of running essential activities to ensure business continuity” It is assumed any such parallel costs are also new costs not found in existing council budgets and would be largely represented by the “implementation” costs discussed above. An example of these costs would be the ATA’s “implementation” costs of employing a senior management team prior to the start of the new Auckland Council entity. In this circumstance there was a senior management team running in parallel with existing senior management teams for a short period. These costs are included in the “Implementation - other” cost category of this report