Service charges pose policy issues that are quite different from those that local officials encounter with taxes. These issues include
• Keeping charges in line with costs
• Pricing strategies
• Choices in cost recovery
• Provisions for a policy statement on service charges and regulatory fees.
Keeping charges in line with costs
Charges for utilities and other self-supporting services accounted for in a businesslike enterprise fund receive careful scrutiny because governmental accounting standards require that rates be sufficient to recover all costs. Often an outside firm will be retained to undertake a cost-of-services study to identify both the direct costs and indirect costs of providing a service, arrive at a defensible basis for the charges set, and ensure that the rate structure fairly distributes the cost of the service among users. Charges for general fund services, by contrast, rarely receive the same scrutiny—in part because they are not self-supporting and because the revenue is comingled with tax revenues in the general fund. Because of the infrequent scrutiny, rate adjustments—when they come—
are substantial, often to compensate for a substantial revenue shortfall; this has the effect of depressing user demand for the service, at least in the short term.
The following actions are recommended for keeping charges more in line with the cost of service provision.
List services More systematic monitoring of charges for governmental types of services begins by asking each department to compile a list of services for which it cur-rently levies a charge or fee. The budget office (or finance office, if no separate budget office exists) should oversee this task. Departments should cite the legal basis for each charge, along with information on the rate and amount of revenue it yielded during the previous fiscal year.
Codify charges and fees by function Because legal authorization for charges is scattered throughout the local code, local governments should consider codifying charges and fees by category or function. One approach is to list all charges in one ordi-nance and all regulatory fees in another, making reference to the underlying ordiordi-nances authorizing their use. An alternative is to group charges and fees by function and then adopt an ordinance setting the rates for each functional area.
Review charges and fees annually The next step involves each department re-viewing the charges and fees it administers as part of the annual budget preparation pro-cess. Departments should complete an online form that identifies the expected revenues from the service at current rates and the cost recovery ratio (revenues divided by cost).
Periodically (although not annually), a cost-of-services study of governmental types of services should be undertaken to establish a baseline of the potential revenue available from users of each service, the portion of full cost that should be recovered from con-sumers, and the indirect costs that should be assessed for internally provided services.
Recommend adjustments where appropriate As part of the detailed revenue analysis submitted to the city or county manager, the budget office should include a list of all governmental services for which a charge or fee is assessed and the proportion of cost recovered by the charge or fee. In consultation with each affected department, it may recommend adjusting the charge or fee to better match the cost recovery target.
Pricing strategies
As a general rule, public managers have less experience in pricing goods sold to their consumers than their counterparts in the business sector. For private sector managers,
price decisions involve knowing the prices of competitors and positioning their goods so as to garner a greater share of the market. Public administrators, on the other hand, have less of an opportunity to learn the demand structure of their market because they have few or no competitors in their service area with which to compare prices and service quality. For example, a university offered a premium reserved parking option in a newly constructed parking garage; the assumption was that patrons would be willing to pay the $1,575 annual charge to park in a reserved space on the first level rather than half that rate for a nonreserved space on higher levels. Two parking spaces were sold in the first year that the option was available.
For public managers, the key to effective pricing of services is to know your consumers.
As discussed in later chapters, when formulating their operating budgets, especially for general fund services, managers spend considerable effort trying to assess the preferences of their citizens. When the same level of effort is not expended to know the preferences of consumers, a mismatch between price and consumption is inevitable.
Most state laws and court decisions require that prices be reasonable and not arbi-trary. In most states, local governments may earn a reasonable return on their investment (a profit), especially for enterprise services such as water, sewerage, and electric power.
Deciding on the right price for a service requires that public officials resolve how rates should be structured so as to equitably reflect the cost of serving different types of users.
Where the level of service consumption varies among users and where the cost of serving different user groups varies, charges should approximate the average cost of serv-ing each group in order to avoid inequitable and often unintended subsidization of one group of consumers by another. Also, wherever possible, individual service use should be measured through metering or other means to ensure a more equitable allocation of the cost of providing the service. In addition to the equity gains, metering ensures more effi-cient use of the service since it is the user who bears the cost of wasteful consumption.
Local governments use one or a combination of several of the following procedures for pricing their services.
Flat-rate pricing In cases for which measuring use is not feasible, a flat rate is usu-ally assessed, based on the average cost of serving each class of user. However, flat rates provide no incentive to reduce wasteful consumption, so they should be employed only in cases where it is administratively infeasible to measure use. In Denton, Texas, which uses a flat rate for its residential and commercial solid-waste collection (Figure 5–2), even the containerized service is provided at a flat rate; although the fee increases as container capacity increases, it does so at a declining rate because of the lower cost to collect each additional gallon (or cubic yard) of waste. Sometimes, a flat rate is the most cost-effective way of allocating the cost among users even though it has none of the rationing benefits associated with charges scaled to the amount of consumption.
Variable- and block-rate pricing The variable rate, or two-part tariff, charges users a fixed rate (or facility charge) for the fixed costs of access to the service and a variable rate based on the volume of service used. A variation on this is a block-rate structure, in which the volume rate changes for each block as consumption changes.
A block-rate structure reflects the fact that the per unit cost for overhead, capital, and operations changes as consumption changes. In some cases, as in the energy charge for wintertime use of electric power by residential consumers, the block price declines as consumption increases. In the summer, however, just the reverse occurs, and higher levels of consumption move consumers into a higher-priced block. Such a pricing strategy approximates the marginal-cost pricing model discussed below. Water rates
Figure 5–2 Rate schedules for Denton, Texas, municipal utilities
for summertime consumption in Figure 5–2 illustrate block-rate pricing, and the wastewater rates illustrate a two-part tariff.
Peak-period pricing Peak-period pricing determines prices according to when a service is used. In cases where a service cannot be stored, such as electric power or public transit, peak demand means that capacity must be built to satisfy peak usage. Charging the same rate for such service, regardless of time of use, means that off-peak-period users are subsidizing peak-period users. Public transit provides a good example. Fares should be higher during morning and evening rush hours to reflect the additional capacity in bus and rail service and the additional personnel required to meet demand during these peak-demand periods. Local governments are increasingly using congestion pricing, which adjusts tolls upward automatically whenever traffic increases and downward as congestion eases.7 Similar capacity costs are incurred for water, sewer, electric power, and natural gas services. Both electric and water utilities for Denton use peak-period pricing in combination with block pricing (Figure 5–2). Peak-period prices should vary according to the cycles in use of the service, such as by hour, day, or season.
Pricing by classification of users Classification of users may be according to type of user (seniors, children, disabled), location of user (resident, nonresident), or lo-cation of service (transit zones). Where costs vary by classifilo-cation of user, prices should be stratified so that low-cost users do not subsidize higher-cost users. Nonresidential rates are usually higher than residential rates because of the greater distance required to deliver services to nonresidents. However, the cost of serving different classes of users is not always the overriding consideration in classifying users; for example, adults generally pay a higher admission charge for recreational services than children do, but this does not reflect actual higher costs in serving adults. In the case of utility services, consumers in Denton are generally classified as residential and commercial (Figure 5–2).
Choices in cost recovery
Another policy issue that local governments must resolve is whether to price a service so that it recovers all or only a portion of its cost. The common practice, especially for nonutility services, is to recover only part of the cost through service charges, with the remainder subsidized by general revenues. The sidebar on page 112 listing services for which charges are commonly collected also identifies those services that should be priced at full (direct and indirect) cost—or at full cost for at least some users—and those services for which partial cost recovery is justified.
The various pricing strategies available to local governments are as follows:
Full-cost and return-on-investment pricing Under most circumstances, enterprise services (e.g., utilities) should be priced at full cost, including both direct and indirect costs associated with service provision. As noted above, in some cases a reasonable re-turn on investment is legally and administratively justified. Privately owned utilities earn a return on their investment, and it makes sense for government-owned utilities to earn a comparable return. State and local laws vary in the amount of return authorized.
Partial-cost pricing For merit goods and services, a partial subsidy is usually warranted.
This poses two issues that local governments must resolve when setting a price: (1) when should a subsidy be provided and (2) how much of a subsidy should be provided? For merit services, partial-cost pricing is justified when any of the following conditions exists:
• Some of the benefits from the service accrue to the whole community. For example, a rabies vaccination program reduces the risk of this disease for all pet owners, not
just for those obtaining the inoculation. A portion of the program’s costs should be funded from general revenues.
• The local government wants to stimulate demand for the service. For example, a county library provides long-term benefits to a community by enriching its quality of life. Policy makers can encourage library use by fully subsidizing its operations from general taxes or possibly by charging only a token fee for users.
• Enforcement of the charge at full cost would result in widespread evasion. For exam-ple, setting a fee for dog and cat tags at full cost may give pet owners an incentive to evade purchase of these licenses. This increases enforcement costs and creates an adversarial relationship between owners and the animal control unit. Partial-cost pricing may be justified under such circumstances.
• The service is used primarily by low-income households. For example, rental rates for public housing should be set below full cost, with the difference made up by subsidies from federal and state grants.
The second challenge for local governments is deciding how much of a subsidy is jus-tified for services with spillover benefits to the community. Often political considerations enter into this discussion,8 with the relative political influence of the users weighing heav-ily in the decision. Politically active groups, such as senior citizens or sports enthusiasts, may effectively lobby to keep a service charge lower than would otherwise be the case.
Competitive pricing A competitive pricing strategy considers the prices charged for comparable services by private or nonprofit providers or by surrounding local governments. For example, a village may set its admission price for a swimming pool to be competitive with the YMCA’s charge. In the case of utility services, decision makers give particular consideration to the prices charged by surrounding jurisdic-tions and private suppliers. In today’s deregulated environment, especially for electric power and natural gas, public utilities must keep a close eye on the pricing practices of private providers, who have an incentive to “cherry pick” (i.e., lure away the low-cost, high-revenue accounts).
Marginal-cost pricing Marginal-cost pricing sets prices to reflect the cost of produc-ing each additional unit of service. For example, higher prices for summertime electric and water rates, as shown in Figure 5–2, shift the additional cost for this marginal capac-ity to those who create that need. Economists support this approach because it leads to the most efficient allocation of resources. Since the price reflects the marginal cost, only consumers who value that additional unit will purchase it. However, this strategy poses significant administrative difficulties in determining the marginal cost of each service. It also leads to prices that do not always recover the full cost of producing a service. Some pricing structures, such as peak-period and two-part tariff pricing, may approximate marginal-cost pricing, but pure marginal-cost pricing is rarely used in either the public or the private sectors.
Provisions for a policy statement on service charges and fees
Politically and legally, a cost-of-services study or rate analysis provides a defensible basis for the price charged to users. It can buttress a government’s contention that its prices were not set arbitrarily, particularly in cases where different rates are charged to differ-ent classes of users. In the case of merit goods and services, knowing the full cost also provides the manager with an indication of the value of the subsidy going to the service.
Finally, knowing the cost of providing services heightens administrators’ awareness of
the need to control costs. It aids managers in reviewing cost trends and the effect of those trends on budget allocations.
Costs to include The objective of a cost-of-services study is to identify the cost of providing a service, but governments seldom maintain accounting information on the basis of costs (or expenses). Instead, such information is usually maintained on the basis of expenditures (the value of goods and services purchased during the budget peri-od), which must be converted into costs (the value of the inputs used to produce the particular service during the budget period). Accountants identify two types of costs:
direct (those associated with the direct provision of the service, such as wages, benefits, supplies, equipment) and indirect (those associated with supporting operations, such as general management, accounting, purchasing, human resources, payroll, utilities). Direct costs include those expenses that would be eliminated if the service were discontinued.
Indirect costs result from the support (or staff) services provided by one department to other government departments.
For utility services, local governments generally set rates so as to recover both direct and indirect costs. For services other than utilities—for example, park and recreation services, animal control, toll roads, public transit, and public health services—local governments almost never recover indirect costs, and even recovery of full direct costs is problematic because most of these services provide community-wide benefits.
One of the thorniest issues in cost analysis is the equitable allocation of indirect costs to each chargeable service. Support services, such as personnel or accounting, constitute indirect costs not only for line services but also for other support services.
For example, the finance department provides accounting and payroll services to the water department and also to the personnel department, which is itself a support service for the water department. This complexity suggests the need for a series of simultaneous equations to determine the proper allocation ratio for the indirect costs of all government services.9 Cost studies usually use two less sophisticated procedures for allocating indirect costs: the consolidated allocation method and the step-down method.
Consolidated allocation method The consolidated allocation method involves summing the cost of all support services, including services sold for a price, and then allocating these costs to each activity using some allocation criterion, such as each activity’s share of the total budget or share of total salaries and fringe benefits. However, consolidated allocation completely ignores the interdependence of support services and thus allocates more support service costs to line activities (including chargeable services) than is justified.
Step-down method The step-down method gives some consideration to the benefits that support services derive from each other. Support services are first ranked according to the amount of service each provides to all other support services. Line activities are not ranked. The benefits of each support service are then apportioned to all support services ranked below it. At least some compensation is thereby made for the benefits that support services derive from each other before indirect costs are allocated to line activities. Properly allocating indirect costs will yield more accurate estimates of the true cost of providing services and provide a more accurate basis for pricing those services. However, the success of any allocation ratio ultimately depends on whether department heads are convinced that it is fair.