Impact of Inflation and Changing Prices

The Postal Reorganization Act requires that the Postal Service provide universal mail service and operate on a financial breakeven basis. Therefore, the prices we charge in the form of postage rates and fees must, over time, reflect the changes in the cost and quantity of resources needed to effectively operate our business. The primary input resources are labor and the related cost of benefits, energy costs that impact the cost of transportation and utilities, material costs, and the cost of maintaining, replacing and expanding our distribution network.

We have maintained stable prices since the implementation of the last omnibus rate case recommendation in the summer of 2002, and we have committed to maintaining stable prices until 2006. We have achieved rate stability through continuous productivity improvement and from the benefit of reduced CSRS retirement costs of P.L.108-18. We plan to continue mitigating inflationary pressure with $1.4 billion of cost reductions planned for 2005. But these productivity improvements alone will not offset the continuing upward cost pressures resulting from resource cost inflation, the continuous expansion of our delivery network, or the loss of First-Class Mail volume and its high level of contribution to institutional costs. Also, we recognize that P.L.108-18 "savings" will be lost in 2006.

Expense Growth

We estimate that total expenses in 2005 will be $68.5 billion, a 3.9% increase over our 2004 expenses of $65.9 billion. We expect personnel costs, including contractual pay increases, employee benefits, and retiree benefits, to increase by $1.7 billion, or 3.2%. This increase will be driven by increased workload due to our expanding delivery network. This increase will also be driven by higher cost-of-living pay adjustments and health insurance premiums, coupled with an increase in our contributions to the Federal Employees Retirement System (FERS) from 10.7% of each FERS employee's salary to 11.2% as required by law.

We expect non-personnel costs excluding transportation expenses to increase approximately $600 million, or 6.9%, because of investments in programs to promote use of postal products, updates to and improvement of information technology capabilities, and improvements to customer access and service. Transportation costs will grow $150 million, or 3.0%, because of higher fuel costs and the impact of revised Department of Transportation requirements limiting the number of consecutive hours that drivers may spend behind the wheel.

Our 2005 projected expenses reflect cost reductions of $1.4 billion and include our plan to reduce workhours by 23 million. This workhour reduction is the equivalent of more than 10,000 full-time positions, even as we deliver mail to a projected additional 1.6 million new addresses. Without these cost reductions, our 2005 expenses would increase 5.9% instead of 3.9%. From 1971 through 1999 we had annual expense growth of less than 4.0% only three times. We expect that 2005 will be the fifth year out of the last six that expense growth will be less than 4.0%.

Item 7A. Quantitative and qualitative disclosures about market risk

Market Risk Disclosure

In the normal course of business, we are exposed to market risk from changes in commodity prices, certain foreign currency exchange rate fluctuations, and interest rates. With the limited exception explained on the following page, we do not use derivative financial instruments to manage market risks. Additionally, we do not purchase or hold derivative financial instruments for speculative purposes.

General Inflation Risk

Each of our labor contracts with our largest unions includes provisions granting cost-of-living allowances (COLAs). COLAs are generally granted semi-annually and are linked to increases in the consumer price index (CPI). Nonbargaining employees do not receive COLAs. Because employee compensation represents a significant portion of our annual expenses, an increase in the CPI greater than had been incorporated into our financial plans could be a significant risk to our financial results. We estimate that an increase in the CPI of 0.5% would cause an annualized increase in our COLAs of about $100 million.