TRANSPORTATION, WATER AND URBAN DEVELOPMENT DEPARTMENT THE WORLD BANK
February 1995 Transport No. RW-10
UNDERSTANDING THE COSTS OF COMMERCIAL RAILWAYS Phil Anderson
Commercial railways must understand their costs. Therefore, the World Bank has encouraged railway borrowers to improve their understanding of costs in order to evolve into competitive, commercial railways. In many projects assistance has been provided for development of costing systems for pricing, investment, and operating decisions. But results usually have been disappointing, and the time and effort required to achieve a good understanding of costs leave exceeded expectations. Although it has been difficult for railways including those in the United States -- to develop and use reliable cost information for pricing decisions, there is an urgent need for better costs for railways in China and India especially.
Why has it been so difficult for railways in most developing countries to design and install costing systems for pricing decisions and for analysis of investment and operating options? Partly it was because a credible costing system is complex, but the main reason has been an absence of government mandates for railways to be
commercially-driven rather than merely social services. COMMERCIAL RAILWAYS IN THE U.S.
In the U.S. the commercially-driven railway and the availability of good cost information were a long time in coming. An early milestone was in 1,962 when a task force of ten prominent economists was formed by the
Association of American Railroads to recommend costing principles for pricing of freight traffic in regulatory cases decided by the Interstate Commerce Commission.
The AAR task force agreed that: "rates for particular railroad services should be set at such amounts ... as will make the Greatest total contribution to net income. Clearly, such maximizing rates would never fall below incremental costs. In the determination of cost floors as a guide to the pricking of particular railroad services, or the services of any other transport mode, incremental costs of each particular service are the only relevant costs" (Baumol, et al, p. 9).
To implement this approach, several U.S. railways tried in the 1960s to maximize total contribution to net income through a combination of cost control strategies, value-added customer service packages, and differentiated pricing. To the extent they could estimate their customers' demand elasticities, they tried to set marketbased Ramsey prices to maximize total contribution, with incremental (i.e., variable) cost as the floor. At first the estimates of variable costs were made on the basis of historical accounts. But historical accounting data for track maintenance, for example, understated actual wear and tear if railways had been deferring maintenance.
Another problem involved how to assign the joint costs of railway transport to the many specific services which railways offer. Ernie Poole of Southern Pacific Railway, a pioneer cost analyst, illustrated the problem with the laborer who screens sand from gravel and other materials. How much of the labor cost should be borne by the sand
and how much by the gravel, if both are desired outputs? Because the railway joint cost problem is more complex, cost analysts did not always agree on how to distribute joint costs to various rail services. One problem with their joint cost distributions has been that actual results have not always matched the estimated costs. There was a credibility crisis when management acted on the basis of cost analysts' predictions and later found that actual expenses differed greatly!
With all the difficulties, 20 years passed before the necessary changes in government regulation were made and new Internal management policies led to widespread provision by commercial railways of competitive services at prices designed to maximize total contribution to overhead and profit.
As U.S. railways began using better cost estimates, regulation of maximum railway prices became less necessary as their markets were served or contested by competitive railways and motor carriers who knew their costs and set prices with costs as a floor. Thus, both the railways' and other carriers' potential market power was curbed by market regulation rather than government regulation.
Railway freight traffic costing was not unique to U.S. railways. After British Railways freight traffic was deregulated in the 1970s and BR was given a commercial mandate, it developed costing models arid pricing) policies which paralleled those in the U.S. The French National Railways also developed similar freight traffic costing models. Both railways have provided traffic costing assistance to Bank, borrowers.
CHARACTERISTICS OF RAILWAY COSTS
Railway costs are not mere accounting data in a new guise. Instead, they have some distinguishing characteristics (see Box). First, the costs consist only of those elements which are relevant to the specific pricing, investment, or operating decision under consideration. No single "cost" will meet ail needs because the definition of which cost elements are relevant may change. Railway cost finding thus is an art, which is why the analyst may ask "which cost do you want, the high cost or the low cost?"
Characteristics of Railway Costs
z Includes only relevant cost elements z Separates fixed and variable costs z May measure the congestion effect z Treats inefficiency as a fixed cost z Is usually forward-looking
The relevant costs can be divided into fixed and variable costs . Fixed costs, which are independent of volume changes, are an important part of railway costs since large sunk investments in track and other facilities incur fixed costs for maintenance, operation, and replacement whether or not any traffic is carried. For some uses such as deciding whether to build a new railway line, fixed costs can be relevant and incremental. In contrast, variable costs are those which depend on traffic volume. For a particular group of expenses, the percentage of variable cost to total fixed and variable costs depends on the time frame of the decision for which the variable cost is being estimated. The longer the time frame, the higher the percent variability. Ultimately, as is often said, all costs are variable!
The estimated variable unit cost may itself vary as transport output increases due to the congestion effect. Because the railway is a closed system, the freight and passenger cars in that system will increasingly incur delays as the capacity of the infrastructure is approached. Vehicle ownership and maintenance unit costs, which usually are important components of variable unit cost, would then rise as vehicle utilization deteriorates due to infrastructure congestion. If this situation exists, the variable unit cost should measure this congestion by increasing as volume nears infrastructure capacity.
have been if operations were more efficient. This cost differential is best viewed as an overhead cost which should be controlled whether or act volume chancres. Since it is better treated as a fixed cost rather than as part of variable cost, it is fixed cost of inefficiency.
Railway costs usually are forward-looking, in that they reflect what is anticipated about the future results of a decision to change prices or operations, or undertake investments. The need to be forward-looking has led to use of "engineered costs" rather than historical accounting data. Examples might be the predicted maintenance cost of an untried type of locomotive or a new railway line. An engineered cost may be calculated simply from the
modification of historical accounting data, or it may be the outcome of a complex study of how input-output
relationships of the railway would change because of new methods or investments. In the latter case the cost analyst is challenged to understand the "production function" of railways and to predict how future input-output
relationships may change. ESTIMATION PROBLEMS
When railways first begin to use costs for pricing and other decisions, the costs must be developed with difficulty from historical accounting data used for financial reporting. It may be much lacer, after the value of cost finding has been demonstrated to management, that railways can expect to have good historical data from a "cost accounting" data base.
From accounting data, the cost analyst directly assigns actual expenses to actual operations where possible. If the accounts of railway borrowers offer little or no detail by geographical or functional cost center, few expenses can be directly assigned in this manner.
Next, variable unit costs must be estimated from the out-of-pocket or variable portion of selected accounts. In some cases an account's "percent variable" may be calculated by correlating expense dam either for one railway over several reporting periods (time series analysis), or among several railways for the same period (cross-sectional analysis). For other accounts the percent variable may have to be assumed. An example of variable unit cost elements is shown in the table, below.
Elements of Variable Unit Costs and Basis of Estimation (if relevant) z Ownership costs
Locomotives Replacement cost Freight cars Replacement cost Coaches Replacement cost
Infrastructure Incremental investments
z Maintenance costs
Locomotives Unit cost/loco unit-km
Unit cost/liter of fuel used Freight cars Unit cost/car-km
Unit cost/carload Unit cost/car-year Coaches Unit cost/coach-km Unit cost/coach-year Track Unit cost/gross ton-km Unit cost/track km-year Bridges and other infrastructure Unit cost/track km-year
z Transportation costs
Train fuel Unit cost(gross ton-km Train crew wages Actual by cost center Loco crew wages Actual by cost center
Shunting Unit cost/shunting minute Station operations Unit cost/train-km
Billing Unit cost/carload Other Unit cost/train-km
z Variable overhead Percent additive to above
To estimate variable unit costs for railways which operate both freight and passenger traffic, for some accounts there must be a separation of variable costs assignable to freight service from those assignable to passenger service. Separation of freight and passenger costs is especially difficult for accounts that report maintenance of permanent way expenses.
In recent years the Bank has provided assistance for development of railway costing systems in China, Indonesia, Mongolia, India, Bulgaria, Romania, Mexico, Colombia, Bolivia, Ghana, Kenya, Tanzania, and Uganda. A costing system developed with Bank assistance for use on small and medium-size railways has been OSCAR (Operational Simplified Costing for Railways).
WHY ALL THIS IS IMPORTANT
In moving goods by rail, it can be shown that one ton is costlier than another; thus a ton of machinery or frozen foods costs more than a ton of coal since it uses more transport space and more expensive services. Likewise, one kilometer can be costlier than another since it takes more power and fuel to climb mountains than it does to cross flat country. Costs per mile decline with distance, and they are less in the backhaul direction because empty freight cars are available at little cost. Since costs per ton-kilometer of different goods differ, it follows that railways need good cost data to set prices properly.
Consider China Railways, which in 1994 reported a net loss of RMB yuan 813 million, excluding the Railway Construction Fund surcharge. In 1995 its prices must be adjusted substantially to offset rapid price inflation in labor, fuel, and other inputs, to reduce ballooning external requirements for financing the railways' rapid ,growth with new debt and equity (see table).
(Figures in billions) 1991 1992 1993 Converted ton-km 1,362 1,454 1,540 Internal sources, RMB yuan 19.2 20.9 33.8 Internal applications, RMB yuan 20.0 24.5 44.6 Net internal funds, RMB yuan (0.8) (3.6) (10.8)
The case in China parallels that in the U.S. in the early 1970s, when fuel and labor costs rose at 12 to 15% per year and most railways lacked a detailed understanding of their costs. One difference is that for several years the Bank has been assisting the railways of China in the development of a traffic costing system which should now be sufficiently developed to help determine patterns and amounts of selective price increases.
CONVENTIONAL WISDOM
When railways do understand their costs, the U.S. experience shows that conventional wisdom about railways will change. For example, the previous conventional wisdom was that the most profitable railways were highly-efficient ones with low-rated bulk traffic. This led many railways to decide not to provide special, costly services for high-value commodities, and they consequently lost the traffic to trucks.
Today, the view of railways who understand their costs and markets is that high-value commodities can produce a contribution above variable cost, but only if they are carried in efficient vehicles, if their variable costs are
controlled, and if their markets' competitive conditions and regulatory policy allow adequate prices. These railways also learned that, when high-valued commodities are carried in containers at "freight-all-kinds" (FAK) rates, competitive market conditions can produce low revenue yields and negative contribution unless very efficient freight cars and methods are employed.
The costs of Indian Railways (see table) and, to a lesser extent, their impact on CONCOR, its cancer transport subsidiary. are not too well understood. The Bank and the Netherlands are providing assistance for improvement of CONCOR's costing system. At the same time the Asian Development Bank is providing assistance to Indian Railways to improve its costing system.
Unfortunately, many other Bank railway borrowers do not understand their costs, and this has been a factor in their failure to obtain a commercial mandate from their government. Some railways also have a large profitable traffic base that is subsidizing non-commercial passenger and freight services instead of providing investment funds to improve the general efficiency of the railways.
CONCLUSION
In competitive industries "no cost system can really assure that all costs will be covered and a 'normal' profit
earned, for sales volume will play a significant role" (Baumol, et al, p. 8). Of course, sales volume depends not only on price, but on the services provided and the quality of those services, facts that U.S. railways took a long time to realize. Moreover, a normal profit cannot be assured for railways if prices are 'cost-based" and set equal to variable costs. Instead, if railways are to survive in a competitive transport environment, they must maximize contribution by attempting to set marketbased Ramsey prices with variable cost as the floor. For this they will need to
understand their costs and markets.
INDIAN RAILWAYS
It seems to be the fate of Indian Railways - one of the great railway systems of the world - to be unable to maximize contribution and profitability as commercial railways. A large contribution to profit from bulk traffic has been used to subsidize lowdensity lines, some passenger services with low revenues, and other loss-producing services, instead of investing the funds in efficiency producing improvements. Critically scarce railway assets have been preempted by transport demand that either has been handled at a loss or has contributed less than other transport demand might have. The problem has become more acute in recent years as the government has withdrawn budgetary support and the implied subsidy for these public service obligations has decreased.
The reason for the misapplication of resources has been the widely perceived role of railways as a social service. Also, the government still views the railways as a macro-economic development tool.
Without a clearly defined commercial mandate from the government, it will be impossible for Indian Railways to evolve into commercial railways. Long term, the railways' ability to provide sufficient, low-cost transport is in jeopardy, and the transport problem for the country will become serious.
The lack of a commercial mandate is partly due to the railways' inability to offer credible cost estimates for the social services the railways are required to provide. However, better costs are a necessary but not a sufficient condition, since for many years Indian Railways has estimated costs on the basis of accounting data and provided Parliament with these estimates. Indian Railways now may be where the U. S. railways were in 1962, the railways do not know their costs well, the public does not accept the railways' story about the burden of social services, and nothing is done.
To Learn More
Baumol, William J., Burton N. Behling, James C. Bonbright, Yale Brozen, Joel Dean, Ford K. Edwards. Calvin B. Hoover, Dudley F. Pegrum, Merrill J. Roberts, and Ernest W.
Williams, Jr. October 1962. "The Role of Cost in the Minimum Pricing of Railroad Services." Journal of Business of the University of Chicago, XXXV - Preprint.
Canadian Transport Commission. 1984. Railway Costing: State-of-the-Art-the-Art. Ottawa: Unpublished World Bank document.
Hargrove, M. B., and C. D. Martland. 1989. TRACS.- Total Right-of-Way Analysis and Costing System. Association of American Railroads, Washington, D.C.
Hickling Consultants. 1990. OSCAR (Operational Simplified Costing for Railways). Petersen, E. R. 1989. QRAIL (C) User's Manual. Queen's University, Kingston, Canada.
