The Friction Economy American business just got the bill for the terrorist attacks: $151 billion--a year
By Anna Bernasek

(FORTUNE Magazine) – It's a frigid early morning in January, and Michael DePasquale, or Rusty, as he prefers to be called, has finished loading his van with containers of milk, sugar, cups, and coffee-brewing equipment. Barreling into the front seat, the heavyset 33-year-old, a driver for national coffee distributor Filterfresh, begins his haul to downtown Boston, looking more like a bouncer than a deliveryman. Everything about Rusty, with the possible exception of his wild Fu Manchu mustache, calls out "no nonsense." He wants to cover his route, get the job done, then pick up his two kids from school. That's it. No messing around. But just 45 minutes after he leaves the company warehouse in Woburn, Mass., a mess is exactly what he gets. He used to be able to unload his freight and walk right in the building at 53 State Street, a 40-floor office tower that's home to many financial services firms. Not anymore.

Now there's a guard on duty at the loading dock who carefully inspects Rusty's paperwork and the brand-new ID badge he has to carry. The guard knows him--but still has to call upstairs and double-check. No one answers. The guard waits a few minutes and tries again. This time the receptionist is there to give the okay. "I hate this building," Rusty spits out. "A few weeks ago I came in the front door as I always do to clean the coffee machines--it's much faster than waiting for the freight elevator, which can take 15 minutes--and they wouldn't let me in because I wasn't on the list. Nothing worked, and I couldn't do my job."

Since Sept. 11, Rusty and his fellow Filterfresh drivers have at times felt as if they're fighting a new war, battling their way into office buildings. Vans are often searched inside and out at some buildings--and those are the few that still permit on-site parking. Such nuisances are minor, it would seem, but they add up. Indeed, they add up in a surprisingly large way. For Filterfresh's 250 drivers across the country, delays have tacked on an estimated full hour per day to each route.

Back at Filterfresh's head office in Westwood, Mass., CEO Daniel Cousineau is explaining what that extra hour means to the $300-million-a-year business. A sophisticated, clean-cut French Canadian, Cousineau speaks with soft precision as he leans forward in his chair. Five additional hours a week per delivery person, he says, equals an extra 1,250 hours a week. By that measure, Filterfresh needs 24 more delivery people to do the same work it did prior to Sept. 11. "That's a 10% increase in our labor costs just so we can hold our ground," Cousineau says.

Four months after the savage terrorist attacks, American business is back to normal in many ways. The headlines have shifted from the Afghan front to the homegrown blight of Enron. Fear and uncertainty, once pervasive, now mingle with resignation. Leading economic indicators, as measured by the Conference Board, have risen for the past three months, and even Fed Chairman Alan Greenspan seems to believe the recession has turned toward the exits. Yes, things are back to normal. What's remarkable, however, is how much "normal" has changed.

It wasn't so long ago that corporate chiefs and management gurus were boasting that godlike efficiency was within the reach of their businesses. The unrestrained flow of goods and capital--thrust forward by free trade, the borderless Internet, and deregulation--made the productivity marvel possible. Companies like Dell were fast shrinking the inventory they kept on their shelves, shipping off products as quickly as their virtual supply chains could package them. American companies connected with suppliers and customers halfway around the world, it seemed, almost as easily as with those in neighboring states. The effect was massive. Allen Sinai, chief economist at Decision Economics in New York City, estimates that the free flow of money and merchandise alone contributed at least three-quarters of a percentage point to annual U.S. growth from 1995 to 2000.

One can't help but feel nostalgic. Today, post-Sept. 11, the economy faces a subtle new reality: Call it friction. It's as if fine sand has been sprinkled into the gears of American business--the intricate productivity machine that had been so well oiled during the 1990s. From higher security costs to airport delays, from planning for supply-chain breaks that might arise to dealing with personnel problems that have already occurred, companies are staring at substantial new costs in their operating budgets. The bill this year may top $150 billion, a full 1.5% of U.S. domestic output. (More on that later, we promise.) And worse still, Wall Street's economic models--you know, the ones pointing to a full, if sluggish, recovery by midyear--don't appear to have factored these costs into their scenarios. The surprise could be nasty for CEOs and shareholders alike.

The already weak economy doesn't help. In an environment where price discounting is rampant and excess capacity abounds, even the smallest bump in expenses can do big damage to a company's bottom line. Indeed, if the trends continue, the U.S. could well see the reverse of what happened during the past decade.

Whether the squeeze will be proportional to the dramatic expansion of the '90s has yet to be seen. But consider where just some of that sandy friction is falling, and you realize that it's landing all around us: in the higher premiums companies are forced to shell out for property insurance, in the jacked-up rent on office buildings as new security measures are passed on to tenants, in increased IT spending to beef up Internet security, and in extensive new spending on backup computer operations. Longer waits at the border (to say nothing of office lobbies), higher shipping and air-freight costs, and less predictable mass transit are also grinding the gears. So are heavier inventories, mail delays, rising premiums on workers' compensation, and a raft of new government regulations.

How painful is the final bill? To come up with a fair estimate, we've added and subtracted, rounded off, eliminated double counting, and vetted the findings against a consortium's worth of economists. That left us with the staggering figure of $151 billion, not including the tip. What it does include is $18 billion of new costs related to workplace security, $15 billion for IT security and contingency operations, $65 billion for logistical changes to supply chains, $12 billion for employee travel, $35 billion for insurance and liability, and $6 billion for employee absenteeism. (See table for specifics.) Yes, there's plenty of guesswork here, but we've deliberately erred on the side of conservatism. Nor have we included the squishy costs--things like morale, psychology, fear, distraction from strategic goals--all of which exist but prove even more difficult to quantify.

There's another rub, besides. Many of these friction costs are ongoing and must be figured into future company expenditures. A firm that hires ten new security guards, for instance, has to pay those ten salaries each year. That means the $151 billion tab facing corporate America could well be an annual one. As most of that cash is diverted to protective uses from productive ones (such as spending on research, product development, and more efficient technology), that $151 billion--while still a small part of GDP--can have a wallop on growth. Richard Berner, Morgan Stanley's chief U.S. economist, figures the cost over time to be a half-percentage-point reduction in annual growth in domestic output.

If all these projections seem too high in the ether of theoretical science, consider your monthly insurance bill. Business after Sept. 11 is simply a riskier proposition, and companies have little choice but to swallow the additional risk in the bitter form of surging premiums. It's happening right now. "We're seeing broad-based hikes," says Bill Yankus, a managing director at investment firm Fox-Pitt Kelton, which studies the insurance industry. "And it's of a magnitude we've never really seen before." Not only are property and life insurance premiums jumping by large percentages and even multiples of what they were a year ago, workers' compensation costs are rising between 30% and 50%, Yankus says. Wall Street analysts estimate a $35 billion rise in corporate insurance costs this year--which alone is likely to cause rumbles on the bottom line. Alice Cornish, an analyst at Prudential Securities in Boston, calculates that pretax profits for the companies in the S&P stock index could drop by an average of 2.5% in 2002 because of higher insurance premiums.

Airport delays are an equally obvious if potentially more costly friction point for businesses. If you thought your preflight wait was bad during the high-alert weeks just after the terrorist attacks, well, get ready to visit that airport bar. New baggage security rules imposed by the federal government on Jan. 18--mandating that every bag be screened or matched with a passenger--are likely to compound the wait. Some airlines are recommending that domestic passengers check their luggage not just two hours prior to departure, but three.

To be conservative, however, consider what only a single extra hour at the airport costs the economy., a West Chester, Pa., economic consulting group, has actually done the math. With 17 million business travelers flying each month, the loss in productivity neatly adds up to 17 million hours a month. At last year's output per worker of $40, figures a loss in output of $680 million a month, or $8 billion a year.

The effect, unfortunately, has been magnified at the Long Island headquarters of Audiovox, a major supplier of wireless products like cell phones. For CEO Phillip Christopher and his 50-member sales and engineering team, travel is a way of life. If they're not on the road showing off new products to telecom outfits like Qwest and Sprint, they're not doing their job. But more than four months after the initial shock of Sept. 11, flying remains something of a dirty word at the firm. "Most of our people are fearful and really reluctant to travel," says Christopher. "It has presented quite a challenge to us."

So the boss found a solution. His staff, he discovered, was more willing to fly if each person had a buddy so they could travel in pairs. While that has coaxed his sales and engineering team back into the air, it has meant a loss of productivity to the firm--a meeting that would normally involve one person now takes two.

Aggravating the situation, Audiovox's salespeople and engineers carry loads of electronic equipment, making the routine of airport security that much more arduous and time-consuming. The compounded delays have meant that Christopher now has to send his staff the night before to ensure that they're on time for morning meetings in distant cities. Thus, the one-day visits Christopher and his team used to make to a company like Sprint in Kansas City have turned into two-day affairs, requiring an overnight hotel stay. So far, Christopher calculates that all this has raised the firm's total operating costs by 1%. "Not huge," he says, "but in this economic environment, every dollar counts."

No kidding. And the fact is, higher airport security costs have already raised costs elsewhere in the economy. The annual $29 billion cost of air freight has risen 3% since Jan. 1, according to Jim Valentine, a transportation analyst at Morgan Stanley. UPS and FedEx have likewise increased their general shipping charges by 3% to 4% since the start of the year instead of the more typical 2.5% annual increase. Both firms say the higher costs reflect new inefficiencies caused by heightened security. On top of general charges, both FedEx and UPS have jacked up some other prices by 20%, including those for pickups and, naturally, the transport of hazardous materials.

Remember just-in-time inventory? Well just-in-time has morphed into "just in case." The change is having a significant impact on costs. It's not merely delays at American airports that are causing problems. Certain European hubs now require a 24- to 96-hour hold on cargo. At the same time, all border crossings into the U.S. are taking longer, though nowhere near the chaotic delays seen immediately after the September attacks. Many industrial companies have had to "buffer" their operations by stockpiling more parts, components, and materials at plants, says Joseph Martha, vice president of global supply-chain management at Mercer Management Consulting in Cleveland. But some firms, particularly those in the electronics, automotive, and high-tech industries, will have to go further, he says, by "looking carefully at their suppliers and deciding what should now be sourced domestically."

It's an issue Jim Commiskey doesn't need to be reminded of. Vice president of global services at Vector SCM in Michigan, he helps manage GM's $5.5-billion-a-year global logistics operations. Commiskey used to assume a one-hour lag for U.S. customs in his planning estimates when it came to GM parts arriving from Canadian plants. Now it's more like four. "Are we going to return to the days when going to Canada was like crossing from Michigan to Ohio?" he asks. "No. Those days are gone, and you have to build it into your supply chain."

The new frictions, in some capacity, affect virtually every company that moves its products around the country--but that's especially true if what's being moved could be turned into a weapon. Witness the recent experiences of Du Pont, the country's largest chemical company, where Jerry Donnelly, director of its $1.6-billion-a-year logistics operations, has had a trying couple of months. "I don't anticipate it's going to settle down much in the next year either," he says. "I'd like to get back to the business of shipping safely and saving money, but there are all these other things to deal with."

Like what happened on Oct. 7, 2001. That was the day the U.S. went to war in Afghanistan, but for Donnelly it marked the start of a focused period of contingency planning. That Sunday evening he got a frantic call from a colleague, informing him that Washington had stopped the shipment of hazardous materials by rail. Some 20% of the group's sales are from substances classified as hazardous, and he feared the worst. Du Pont normally keeps two to three days of feedstocks at its plants, and without those supplies they'd be forced to shut down.

On Monday morning Donnelly mobilized his team of 150 people at Du Pont's Wilmington headquarters, and they went to work--first figuring out inventory levels at 15 plants across the country, then coming up with alternative ways to move the chemicals. Donnelly felt they could probably ride out the crisis in all but one case--Du Pont's shipments of chlorine, a chemical used extensively to purify drinking water. The main obstacle: Chlorine, which is toxic if breathed into the lungs, can be transported only by rail. Checking inventories, Donnelly knew that after 72 hours several of its plants needing chlorine would sit idle. The problem "tied up our whole group for three days," says Donnelly. "We were running around with our heads off."

Luckily for Du Pont, the government called off the red alert by Wednesday afternoon. Yet for Donnelly the lesson was so clear that he's been planning for threats to the company's supply chain ever since. "Things that we thought would never happen have, and we need to adjust," he says. And that means considering shipping chemicals by trucks or barges--and in the case of chlorine, deciding whether to relocate the entire supply chain, a far more costly enterprise.

Uncertainty in and of itself is a frictional cost. And Donnelly is facing it from all sides, even from the government. For example, the Chemical Security Act, now being debated in Congress, would require companies to do everything from conducting more thorough inspections of chemical shipments, to providing detailed documentation of their production and delivery systems, to beefing up security at plants. The effect of new regulations for Du Pont will mean one thing, says Donnelly--adding operational cost. "We'll either have to use more equipment and have higher carrying costs, or we'll keep more inventory and that will increase our costs too," he says.

Smart logistics are the cornerstone of an efficient economy--indeed, many economists credit the relentless drive to lessen the costs of moving and storing goods as a key factor in the supercharged 1990s economy. Michigan State University logistics expert David Closs measures the progress this way: By 2001 the average large American business held 1.36 months of inventory, compared with an average of 1.57 months a decade earlier. Closs, unfortunately, thinks that progress is over--at least for a while. He expects the figure to rise to 1.43 this year as higher transportation costs and security measures lead companies to hold more just-in-case inventory. New logistics costs alone could add $50 billion to $80 billion to corporate America's bill in 2002, he estimates.

Security, you wonder? David Hale, chief economist at Zurich Financial Services in Chicago, estimates that the nation's businesses will cough up big money to hire 300,000 new security guards. John Santora, an executive vice president at real estate giant Cushman & Wakefield in New York City, believes that security costs at corporate headquarters will rise by an average $250,000 per year. The majority of firms don't have complete disaster-recovery or backup computer systems yet, according to several experts. They may have to add them--at a cost of $1 million for a typical software system. Throw in a few thousand background checks for new employees--at an average cost of $2,500 to $5,000 per person--and the security bill grows bigger still.

Few of those expenses are likely to be productive in terms of generating sales or improving operating margins. The new security measures divert scarce funds from R&D and technology that might improve a firm's operating efficiency--at a time when industry titans like Intel, General Motors, and Calpine have said they will slash their 2002 capital-spending budgets even further than previously announced. In a December survey of 3,200 CFOs by Financial Executives International and Duke University, a surprising 47% of companies said they will reduce cap-ex spending this year. Duke professor John Graham, who ran the survey, says that it's the largest number of firms making such cuts since the poll began in July 1996. "Before Sept. 11, cap-ex spending was flat," he says. "That really pushed it over the edge."

But the biggest costs may not be the nuts-and-bolts expenses associated with airport delays, insurance premiums, and Internet firewalls. They may instead be what we've called the squishy costs--the kind that are hardest to isolate, to quantify, and perhaps to avoid. Squishiest of all is the stuff of hundreds of management books and how-to seminars: thinking big. Whether you call them strategic initiatives or Big Hairy Aggressive Goals, the seeds of growth come from the mindset and often the sheer will of a management team--a commitment to invest in an uncertain future, to take risks.

That mindset seems to be a short-term casualty of the war on terror. Just ask Joe Forehand, managing director of global consulting group Accenture. Forehand has found that his biggest challenge since the terrorist attacks is boosting the morale of his 75,000 worldwide employees. "The loss of economic and personal security removed the anchor a lot of people had," he says.

The expense--in terms of the boss' time, at least--has been real. Forehand estimates he's budgeted an extra 20% of his hours to focus on employee issues. Rainmaking, to a minor extent, has given way to regular town meetings, which he conducts in Accenture offices around the world. "There's been a shift in my emphasis," he explains, "inwards--to our business and people--and away from business strategy." The candor is telling in itself. What modern-day CEO (a management consultant, no less!) admits to not being consumed with growth 24 hours a day?

The country's work force appears to be adjusting its priorities as well. Some people are focusing on family rather than career; others are suddenly shunning urban commutes and high-rise office towers. Morale, of course, is a messy thing to measure. But at least one recent survey, conducted by the Bureau of National Affairs in Washington, D.C., has tried. Out of 146 employers queried, a stunning 74% reported "fear and anxiety among employees" more than two months after the attacks. Some 27% said they'd seen a greater need among workers for counseling services, a quarter saw a decline in productivity, and a fifth claimed a drop in morale.

Some of that anxiety clearly comes from the nation's response to the terrorist attacks rather than the terror itself--for example, not being able to get into downtown office buildings. Which brings us back to Filterfresh and its 60-person sales team. The harder it is to get inside, the harder it is to generate new sales, a fact that plainly bothers CEO Cousineau. Before Sept. 11, the company's sales force would generate new accounts by walking from floor to floor in every office building, knocking on doors. Until recently the big worry for Cousineau's salespeople was whether they could get a meeting with an office manager to pitch their products.

Now they have a bigger concern--how to get in the door to set up the meeting in the first place. It's simply impossible now for the salespeople to enter most buildings without permission. And if you think Filterfresh is alone in this challenge, take a walk over to the photocopy machine. Companies like Xerox, snack-food groups like Hostess, and linen and bottled-water companies all generate sales by knocking on office doors.

Morgan Stanley's Berner calls these new economic drags a "terrorism tax" and adds pointedly that they're here to stay: "Even if we catch bin Laden, part of the way we'll continue to feel safe is by being prudent and cautious." What's more, the terrorism threat could have lasting global impact, retarding the advances made in the 1990s on macro issues like free trade and deregulation. "I'm worried we'll back away from our commitment to keep markets open and competitive," Berner says. Many executives in the trenches agree. "The ability to trust people has been a great strength of this economy," says Don Schneider, who presides over one of the world's biggest trucking companies. "When all of a sudden you have to check and double-check everything, it becomes embedded in our costs and makes us less efficient."

So the question becomes, Is there any way to shelter the already fragile American economy from all this falling sand? Some would answer with a resounding yes. A lesson that can be taken from the events of Sept. 11 is how economies adapt--and American business has proven in the past to be particularly resilient. The new frictions, say some economists, will offer a fresh incentive to improve efficiencies in other ways.

Paul Strassmann, a former head of IT at Xerox, General Foods, and Kraft, and now a productivity consultant, is one of those who predict a robust efficiency rebound. He contends that the new frictions will ultimately lead to savings as companies become smarter in dealing with them. Unnecessary business travel will be cut out, he says. Costly office space in metro areas will be shunned in favor of highly distributed office locations in less expensive areas. And firms will realize that the best defense is to be strategic about long-term security, not simply to throw money into lobby guards in the rush of panic. "It's an environment of using your head," says Strassmann, "not your muscle."

Optimists also point to the example of Israel. In the two years following the onset of the intifada in December 1987, productivity and business investment dived. But then both began to tick up as firms adjusted to the new environment. Richard Kasmin, head of research for Hotspot FX, a foreign-exchange trading firm in New Jersey, says Israel eventually built an economy that could function under the threat of terrorism. For the U.S., he says, the shock of domestic terror is going to diminish productivity, but firms will readily adjust.

In the meantime, however, anyone counting on a swift and strong recovery should think twice. And don't worry--you'll have plenty of time to think at the airport.