Cost Recovery Approach - 10 - How should charges be structured?

10 - How should charges be structured?

Step 6

Analyse how operational costs are structured and what are the key cost drivers.
In light of this analysis, assess the options for structuring charges, including the status quo, against the objectives of cost recovery and other relevant considerations.
Identify whether steps need to be taken to minimise unders and overs and, thereby, smooth the recovery of costs from year to year.

Rationale

In order to make informed decisions on how should charges be structured it is important to consider how operational costs are structured and what are the key cost drivers.

For example, if overheads are a significant component of costs, then charges set at short run marginal costs may not fully recover total operational costs. If fiscal cost minimisation is a priority, other charging options may need to be considered.

The options for structuring charges (refer Box 5) need to be considered in light of this information and assessed against the objectives of cost recovery and other relevant considerations. As was emphasised in respect of Step 4, the analysis of options should include the status quo as an option.

Suggested approach

How operational costs are structured and what are the key drivers will differ across the products and services delivered by MAF. Relevant issues to consider include:

fixed and variable costs, as this will determine the difference between the options of charging long and short run marginal costs (refer Box 5);
how large are indirect costs, such as overheads, as this will have a determining influence on whether marginal cost pricing is likely to achieve or fall short of full cost recovery;
the lumpiness of capital expenditures, as lumpy expenditure may imply under recovery in some years and over recovery in others, unless a means of smoothing capital costs is incorporated into charging structures;
location specific factors, if different factors drive and cause an uneven distribution of costs across locations;
time specific factors, for example, whether costs are higher at night due to overtime rates being paid or because special equipment has to be used; and
other relevant factors (for example the risk profile of passengers and craft, whether services provided are intermittent or dedicated, and technological considerations).

Box 5: Options on how to structure charges

We suspect that in the majority of instances where MAF wishes to recover its costs average costs exceed marginal costs. This is particularly likely when overhead and fixed costs are high. In these instances we suggest that two part tariffs are the best means of structuring charges. As the name suggests, charges consist of two parts:

unit fees for variable costs (short run marginal costs or long run marginal costs, refer below); and
an additional fixed fee to cover the shortfall.

The fixed fee may be thought of as for "membership" of the club of beneficiaries. Variations in fixed fees between parties can be contentious. Variations could be determined on the basis of fairness. Alternatively, if some parties are more price sensitive than others, variations could be determined on the basis of Ramsey pricing principles(refer below). A third option would be to adopt an accounting method for allocating costs.

If "membership" fees are not practical then options are to increase unit fees or for government to meet overhead and capacity costs. Again determining differential mark-ups on unit fees can be contentious. Mark-ups could be varied according to the service provided, on the basis of Ramsey pricing principles with respect to use or, as before, on the basis of an accounting method for distributing overhead and capacity costs.

If significant mark-ups deter utilisation, the adverse effects of this can, in some circumstances, be avoided by offering bulk discounts to larger users (this is an example of what economists term non-linear pricing). The advantage of this is that it secures the required revenue over a core level of consumption while allowing users thereafter to use additional quantities at a low incremental price close to just variable costs.

Definition of key terms used in the above discussion:

short run marginal costs: Short run marginal costs can be determined by assessing either: (1) what variable costs could be avoided if services could be reduced by one unit; or (2) what would be the increment in variable costs if services were increased by one unit. As the term implies, variable costs represent the cost of inputs, such as labour, that are easily varied over the short term.
long run marginal costs: The different between short and long run marginal costs is that changes to the costs of inputs that are generally regarded as fixed in the short term, such as capital, are taken into account when assessing avoidable or incremental costs at the margin. In practice, this generally means taking into account depreciation and capital charges.
accounting methods to distribute costs: The basic idea here is that overhead costs are shared in proportion to some benchmark, such as variable costs, hours or numbers of consignments
Ramsey pricing: The principle here is to charge the most price sensitive the least and the least price sensitive the most. This principle may be applied in respect of use or participation. That is, for fixed fees, which participants are most likely to drop out altogether; with variable charges, which users will most likely reduce their level of utilisation. Ideally we would need to know the price elasticity of demand of the different users or participants. In practice, however, price sensitivity may need to be inferred by less precise means.

In light of the analysis of how operational costs are structured and what are the key cost drivers the options for structuring charges (refer Box 5 above) should be assessed against the objectives of cost recovery and other relevant considerations. We suggest a similar framework for assessment as developed in step 4, that is, a matrixed approach. We refer the reader back to this step for a discussion on the different approaches that could be used when fleshing out the matrix.

In Table 7 (over) we identify some generic implications of the various charging options.

Table 7: Analysis of options to structure charges

Objectives / Options	impact on ...					other relevant considerations
	outcomes	efficiency	equity / distributive	fiscal	transaction costs
status quo
short run marginal costs		marginal cost pricing is most likely to advance allocative and operational efficiencies		if fixed costs and overheads are high this option is not likely to fully recover costs
long run marginal costs				takes account of fixed costs if overheads are high this option is not likely to fully recover costs
accounting methods to distribute costs		accounting methods do not advance efficiency and could adversely impact demand		methods could be structured to achieve full cost recovery		may be regarded as a tax rather than a charge
two part tariffs		the marginal cost element of the tariff will advance efficiencies the distributed residual could compromise these gains and adversely impact demand		enables full cost recovery	charges with two parts may be complex to set and administer	the distributed residual may be regarded as a tax rather than a charge
Ramsey pricing		this option is least damaging to demand as price sensitivities are taken into account when structuring charges		could be structured to enable full cost recovery	difficult to determine the price sensitivities of persons and groups	likely to be regarded as unfair
other

Example: Options for structuring charges at the border

The example used here is a summary of the analysis in this Institute's report to MAF on "Cost Recovery of Passengers and Craft Border Clearance Services" (Clarke, 1998). We refer readers to this report, which is available within the Ministry, if they are interested in the more detailed analysis.

The key factors that drive the cost of border clearance services include:

the high proportion of total costs that locational specific fixed costs and centrally imposed overheads represent;
the high volume of passengers through the main international airports compared to the smaller regional airports and seaports;
the greater frequency of craft landings and takeoffs at the main international airports and the increased likelihood that craft will be filled to capacity;
the incremental cost of extending services to a marginal port will help to spread overheads but may imply significant capital, people, accommodation and other costs;
the riskiness of passengers, which is assessed according to country of origin and intelligence systems, is greatest at the main international airports;
the main international airports require a dedicated service, while other airports and seaports are serviced intermittently, often by persons tasked with other duties; and
advances in technology, such as the x-ray machine at Auckland airport, can improve the effectiveness, speed and cost of border clearances. However, its not cheap and can only be justified where there are large numbers of high risk passengers.

The implications of this are that the three main international airports are able to deliver services at least cost per passenger and craft. Economies of scale at these airports allow costs to be spread more thinly and enables cost saving technologies to be justified.

The options for charging assessed in the report were:

marginal cost pricing;
basing charges on the national average cost per passenger; and
basing charges on locational specific costs.

Table 8 translates the analysis in the Institute's report into the framework we suggest above.

Given that one of the major advantages of charging port companies is the scope such enables for gains in operational efficiency, the ranking of options is as follows:

Marginal cost pricing, provided central fixed costs are not overly large and likely to compromise full cost recovery, as this option relates costs directly to usage.
Charges based on the locational specific costs, if such costs are large, as this option reflects usage while enabling full cost recovery.
Charges based on the national average cost per passenger. This ranks last as it is not related to usage and, by definition, is a tax rather than a charge.

Table 8: Analysis of options to structure charges for border clearance services

Objectives / Options	impact on ..					other relevant considerations
	outcomes	efficiency	equity / distributive	fiscal	transaction costs
marginal costs		this option is most likely to advance allocative and operational efficiencies		as locational specific fixed costs and centrally imposed overheads are high this option is not likely to fully recover costs
charges based on national average costs per passenger		over-charges the main airports provides little incentive for ports to urge constraint of direct costs limits the potential for contestable border clearance services may distort decisions about opening international operations at some airports	enables an even-handed distribution of costs does not weight passenger and craft numbers per port by risk	enables full cost recovery	simple and thereby easy to administer	may be regarded as a tax rather than a charge evenly distributes any negative tourism impacts across the ports
charges based on locational specific costs		creates an incentive for ports to urge cost constraint encourages contestability in border service provision	eliminates any cross subsidisation the per passenger share of centrally imposed fixed costs at small regional airports will be large does not weight passenger and craft numbers per port by risk	enables full cost recovery	more complicated than charges based on the national average	may be regarded as a tax rather than a charge may change the incentives of tourists to visit different parts of New Zealand, but not in an inefficient sense

Contact for Enquiries

MAF Information Services
Pastoral House
25 The Terrace
PO Box 2526
Wellington, NEW ZEALAND

Fax: +64 4 894 0721
Contact this person

10 - How should charges be structured?

Contact for Enquiries

Search Publications