How Cost-Based Method Can Fix Skewed Rates

Eric A. Briese

For years, public utilities have analyzed their operating costs, added a fair profit and divided the total equally among its ratepayers when setting its rates. The result: The more services a customer used, the more that customer paid.

Now, customers are demanding fair cost distribution, and the solid waste industry is listening by considering cost-based rates.

Viewpoints vary on the use of cost-based rates. Some private contractors prefer this method because they are ensured of recovering their costs and are virtually guaranteed some level of profit each year.

For this reason, municipalities that regulate the private waste management companies register less enthusiasm. The idea of guaranteeing profits to a business regardless of the service quality means the waste collector has no incentive to minimize its operational costs. Obviously, higher costs equal higher profits to the collector.

Because these conflicting views often force a stand-off between municipalities and waste management companies in establishing rates, it is essential that private contractors understand the cost-based rate method to ensure their waste collection program's success.

Know The Basics The cost-based rate method is easier to understand when it is reduced to the components of the cost analysis package: the allowed profit base costs, the allowed pass-through costs, the disallowed costs, the operating ratio (which determines the profit layer) and the cost allocation to the appropriate services and users (see chart).

Most operating costs of a waste management company are considered reasonable and necessary, and municipalities allow them to be included in the cost base when setting rates. However, due to prior agreements, some of these "reasonable" and "necessary" costs (such as interest expense on debt and income taxes) may not be allowed.

The company should review its agreements with the municipality each year. Allowed costs are recovered from the ratepayers and, except for the pass-through costs explained below, are used to determine the company's profit. Thus, they can be referred to as "allowed profit base costs."

Certain costs, such as regulatory fees, taxes or interest, are passed through to the customer with no profit added.

A difficult task in developing a cost-based rate is determining which costs should be disallowed. Some are obvious: company-owned vacation homes or vehicles purchased by the owners for personal use. Other costs are open for scrutiny and negotiation. Eventually, some are not recovered from the ratepayers and are absorbed by the company.

Profit is determined by the operating ratio, which is applied to the allowed profit base costs. An operating ratio of 90 percent means a 10 percent profit for the company -- 90 percent of the total rate will account for cost recovery.

Next, the costs must be equitably allocated among the services and locations. These costs can be calculated in several ways, including the number of labor and truck hours spent in each area. Whatever methods are used, the underlying statistical data should be objectively prepared and supported by documentation.

Negotiating Rates When the cost analysis is nearly complete, the next step is to present it to the municipality. Invariably, cost and methodology issues will be raised. For example:

* The municipality may think that the company should not necessarily earn a guaranteed profit and will be looking for any areas of unnecessary or unreasonable costs to offset the potential for what they consider a "high profit."

* The municipality may want the operations ratio to be increased, re-ducing the profit. This will be especially true if the company's current contract with the municipality does not specify an operating ratio or vaguely addresses the company's profit. It is important, therefore, that the new contract is clear on these issues.

* The municipality may limit the use of "balancing accounts" to reduce the appearance of a guaranteed profit. Balancing accounts offsets any variances between forecasted costs used in setting the next period's rates and its actual costs. Such variances are either added to or subtracted from the next cost analysis to make up for the prior period's understated or overstated forecast costs.

Using a "full" balancing account means that all variances are considered, whether or not the costs are controllable by the company, and the company is virtually assured of the full profit.

When variances are considered only on those costs that are not controllable by the company, a "modified" balancing account is being used. This method ensures full profit on these uncontrollable costs. Such costs include tipping fees and truck repairs. Remember, this method will limit profits on controllable costs such as salaries, overhead and related party expenses.

Further, if the contract is vague on using balancing accounts, some municipalities may object in order to eliminate the guaranteed profit.

Rate setting methods and allowed costs are both subject to question. Owners' and officers' compensation is the most common - and perhaps the most sensitive - cost area to be scrutinized. All types of compensation may be reviewed, including salaries, pension contributions and life and health insurance premiums. In many cases, officers' compensation is limited to a negotiated a-mount.

The Game Plan Preparing a complete, accurate, easy to understand cost analysis and rate application is vital to successfully negotiating a cost-based rate. The analysis should flow logically to avoid misunderstandings that can sap valuable time in order to interpret the data.

To supplement the cost analysis, related documentation should be organized and preferably cross-referenced to the analysis.

Industry and geographic cost standards also can help when dealing with issues such as officers' compensation. For example, information, such as surveys on comparable costs in the firm's area, can be valuable during negotiations.

Finally, consultants who are specialists in this area are available. They can be helpful during rates negotiations, as well as assist in analyzing costs.

In 1988, five jurisdictions in Marin County, Calif., that were served by the same waste hauler decided to form a rate setting committee to review requests.

Prior to this, rate setting had been mostly a matter of the hauler standing before the city councils, or district boards, with a request for a rate increase that was not highly scrutinized.

Due to heightened public awareness of recycling and increased disposal costs, the jurisdictions felt they needed assistance in determining the proper compensation level for their hauler.

The task was complicated by the fact that the hauler provided some services which were not regulated by the jurisdictions, such as debris box hauling and operating a material recovery facility (MRF). The hauler also partially owned the company that provided curbside recycling.

The jurisdictions hired an independent accounting firm to review the hauler's expenses and to provide a way to determine expense allocation be-tween the regulated and non-regulated parts of the busi- ness.

For its part, the hauler hired a financial consultant to ensure that all expenses related to the regulated part of the company were being properly applied.

Each year, the in-house financial consultant prepares the rate application, giving a detailed description of projected labor, equipment, dumping, depreciation and administrative costs.

They also describe the meth-od of allocating costs shared between the regulated and non-regulated parts of the company, such as administrative expenses and hauling costs.

This application is summarized showing all regulated expenses. The company is not allowed to earn an operating profit on some costs, such as interest expense; these costs are removed, and the requested operating ratio is applied to the remaining costs.

The pass-through costs are then added back to determine the total revenue required. If a revenue deficiency exists when the company projects its future revenue, the application is presented to the rate committee for review.

Next, the application is given to the rate committee's independent consultants who review reasonable operating costs, consistent treatment of certain costs (such as disallowed or pass-through) and overall accuracy.

Finally, the consultants recommend adjustments to the reported costs or modifications to the operating ratio based on their experience in other communities.

If the hauler has strong supporting documentation for its recommendation, the jurisdictions may negotiate a compromise.