Mitigating Risk in Transportation Costs
Appendix 4A provides a detailed discussion of cost concepts in transportation, including accounting, economic and social costs. Review these costs, and in a three- to four-page paper in APA format, be sure to address the following:
Discuss how accounting, economic, and social costs can be used in transportation to mitigate risks associated with these costs.
Analyze how the company’s focus can impact these costs and impact risks.
Provide at least one recommendation for each cost area that could mitigate the risks of those costs.
Cost ConceptsAccounting CostThe simplest concept or measure of cost is what has sometimes been labeled accounting cost, or even more simply as money cost. These are the so-called bookkeeping costs of a company and include all cash outlays of the firm. This particular concept of cost is not difficult to grasp. The most difficult problem with accounting costs is their allocation among the various products or services of a company. If the owner of a motor carrier, for example, was interested in determining the cost associated with moving a particular truckload of traffic, all the cost of fuel, oil, and the driver’s wages associated with the movement could be quickly determined. It might also be possible to determine how much wear and tear would occur on the vehicle during the trip. However, the portion of the president’s salary, the terminal expenses, and the advertising expense should be included in the price. These costs should be included in part, but how much should be included is frequently a perplexing question. The computation becomes even more complex when a small shipment is combined with other small shipments in one truckload. Some allocation would then be necessary for the fuel expense and the driver’s wages.Economic CostA second concept of cost is economic cost, which is different from accounting cost. The economic definition of cost is associated with the alternative cost doctrine or the opportunity cost doctrine. Costs of production, as defined by economists, are futuristic and are the values of the alternative products that could have been produced with the resources used in production. Therefore, the costs of resources are their values in their best alternative uses. To secure the service or use of resources, such as labor or capital, a company must pay an amount at least equal to what the resource could obtain in its best alternative use. Implicit in this definition of cost is the principle that if a resource has no alternative use, then its cost in economic terms is zero. The futuristic aspect of economic costs has special relevance in transportation because, once investment has been made, one should not be concerned with recovering what are sometimes referred to as sunk costs.1 Resources in some industries are so durable that they can be regarded as virtually everlasting. Therefore, if no replacement is anticipated, and there is no alternative use, then the use of the resource is costless in an economic sense. This is of special importance in the railroad industry. Railroads have long been regarded as having durable and therefore costless resources. That is, some of the resources of railroads, such as concrete ties, some signaling equipment, and even some rolling stock, are so durable and so highly specialized that they have no alternative production or use potential. So the use of such resources, apart from maintenance, is costless in an economic sense. Consequently, in a competitive pricing situation, such resources could be excluded from the calculation of 140141fixed costs. Also, such specialized resources can be eliminated in comparing cost structures.2 Although the economic logic of the above argument on the use of durable, specialized resources is impeccable, it is frequently disregarded by pricing analysts and regulators. In a sense, the elimination of such costs from pricing calculations defies common sense. From the money or accounting cost perspective, these costs usually should be included. The conclusion that must be drawn is that economic costs differ from money or accounting costs. Money costs are by their very nature a measure of past costs.This does not mean that money costs do not have any relevance in the economic sense. Past costs do perform a very important function because they provide a guide to future cost estimates. However, complete reliance should not be put upon historical costs for pricing in the transportation industry.Social CostA third category of costs—social costs—might also be considered. Some businesses might not concern themselves with social costs unless required to do so by law. These costs take into consideration the cost to society of some particular operation and, in fact, might outweigh money cost. For example, what is the cost to society when a company releases its waste materials into a stream? Today many regulations and controls are administered by various regulatory agencies to protect society from such costs. These agencies make the business organizations responsible for social costs. (For example, strip-mine operators are customarily required to backfill and plant.) In spite of such controls, however, there are still instances when chemicals or other hazardous materials are discharged or leak out and society has to bear the cost of the cleanup operations as well as the health hazards. This discussion is not trying to castigate business organizations or suggest that all investment decisions result in negative social costs because, in fact, there can be social benefits from business investments. However, to ensure that the discussion is complete, social costs must be considered.Analysis of Cost StructuresThere are two general approaches to an analysis of a particular cost structure. Under one approach, costs can be classified as those that are directly assignable to particular segments of the business (such as products or services) and those that are incurred for the business as a whole. These two types of cost are generally designated as separable and common costs, respectively. Usually, common costs are further classified as joint common costs or conjoint common costs. Separable costs refer to a situation in which products are necessarily produced in fixed proportions. The classic example is that of hides and beef. Stated simply, the production or generation of one product or service necessarily entails the production or generation of another product. In terms of transportation, joint costs occur when two or more services are necessarily produced together in fixed proportions. One of these services is said to be a by-product of the other. The most obvious illustration is that of the backhaul situation; the return capacity is the by-product of the loaded trip to the destination.3 It is a generally accepted fact that large transportation companies, especially railroads, have a significant element of common costs because they have roadbed, terminals, freight yards, and so on, the cost of which is common to all traffic. However, the only evidence of true jointness appears to be the backhaul.4 Nonjoint common costs are those that do not require the production of fixed proportions of products or services. Nonjoint common costs are more customary in transportation. For example, on a typical train journey on which hundreds of items are carried, the expenses of the crew and fuel are common costs incurred for all the items hauled (see Figure 4A-1). 141142Figure 4A-1 Directly Assignable Cost Approach A technique for allocating costs directly to activity centers has been implemented in both the carrier and shippers communities. Activity-based costing (ABC) identifies costs specifically generated by performing a service or producing a product. ABC does not allocate direct and indirect costs based on volume alone; it determines which activities are responsible for these costs and burdens these activities with their respective portion of overhead costs. One application for ABC today by both carriers and shippers is the calculation of customer profitability.5 Under the other basic approach to analyzing a particular cost structure, costs are divided into those that do not fluctuate with the volume of business in the short term and those that do. The time period here is assumed to be that in which the plant or physical capacity of the business remains unchanged, or the short run. The two types of costs described are usually referred to as fixed and variable costs, respectively. In the first approach, the distinction between common and separable costs is made with the idea that costs can be traced to specific accounts or products of the business. 142143In the second approach, the distinction between fixed and variable is made to study variations in business as a whole over a period of time and the effect of these variations upon expenses. In other words, with fixed and variable costs the focus is on the fact that some costs increase and decrease with expansion and contraction of business volume, whereas other costs do not vary as business levels change. Because of the two different approaches to studying costs, it is possible that a certain cost might be classified as common on one hand and variable on the other, or common under one approach and fixed under the other, and so on, for all the possible combinations. Therefore, the only costs directly traceable or separable are the variable costs, which are also separable. For example, fuel expense is generally regarded as a variable cost, but it would be a common cost with a vehicle loaded with LTL traffic. The second approach of cost analysis—namely, fixed and variable costs—is important and should be discussed further. As indicated previously, total fixed costs are constant regardless of the enterprise’s volume of business. These fixed costs can include maintenance expenses on equipment or right-of-way (track) caused by time and weather (not use), property taxes, certain management salaries, interest on bonds, and payments on long-term leases. Fixed costs per unit of output decline as more volume is allocated to a fixed cost asset. A business has a commitment to its fixed costs even with a zero level of output. Fixed costs might, in certain instances, be delayed, or to use the more common term, deferred. The railroads frequently delay or defer costs. For example, maintenance of railroad rights-of-way should probably be done each spring or summer, particularly in the northern states. Freezing and thawing, along with spring rains, wash away gravel and stone (ballast) and may do other damage. Although this maintenance can be postponed, just as, for example, house painting might be postponed for a year or two, sooner or later it has to be done if the business wants to continue to operate. There is a fixed commitment or necessity that requires the corrective action and associated expense.6 The important point is that total fixed expenses occur independently of the volume of business experienced by the organization. Variable costs, on the other hand, are closely related to the volume of business. In other words, firms do not experience any variable costs unless they are operating. The fuel expense for trains or tractor—trailers is an excellent example of a variable cost. If a locomotive or vehicle does not make a run or trip, there is no fuel cost. Additional examples of variable costs include the wear and tear on tractor—trailers and the cost for tires and engine parts. Thus,variable cost per unit remains constant regardless of the level of output, while total variable costs are directly related to the level of output. Another related point is that railroads and pipelines, like many public utility companies, are frequently labeled as decreasing cost industries. The relevance of this phenomenon to pricing was discussed earlier in this chapter, but it also deserves some additional explanation now. Railroads and pipelines have a high proportion of fixed costs in their cost structures. There is some debate about the percentage, but the estimates range from 20 to 50 percent. Contrast this with motor carriers whose average is 10 percent. As railroads produce more units, the proportion of fixed costs on each item will be lower. More importantly, this decline will occur over a long range of output because of the large-scale capacity of most railroads. 143144 An example of the above situation is useful here. Assume that a particular railroad incurs $5 million of fixed costs on an annual basis. In addition, assume that the railroad is analyzing costs for pricing purposes between Bellefonte, Pennsylvania, and Chicago. In its examination of cost, the railroad determines that the variable cost on a carload is $250 between Bellefonte and Chicago. Although it might be unrealistic, assume that the railroad only moves 10 cars per year. The cost would be as follows: Fixed cost $5,000,000Variable cost $2,500 (10 cars × $250)Total cost $5,002,500Average cost $500,250 per car If it moves 1,000 cars, the cost would be: Fixed cost $5,000,000Variable cost $250,000 (1,000 cars × $250)Total cost $5,250,000Average cost $5,250 per car If it moves 100,000 cars, the cost would be: Fixed cost $5,000,000Variable cost $25,000,000 (100,000 × $250)Total cost $30,000,000Average cost $300 per car The relationship is easy to see. If the number of cars increased in our example, the average cost would continue to decline. Theoretically, average cost would have to level out and eventually increase due todecreasing returns, but the important point is that the high proportion of fixed costs and the large capacity cause the average cost to decline over a great range of output (see Figure 4A-2). There would be a point, however, at which additional cars would require another investment in fixed cost, thus shifting the average cost curve. The significance of the declining cost phenomenon to a railroad is that volume is a very important determinant of cost and efficiency. Furthermore, pricing the service to attract traffic is a critical factor in determining profitability, particularly where there is competition from alternate modes of transportation.Figure 4A-2 Average Cost and Output 144145 Another cost concept that is of major importance in this analysis is marginal cost, because of its key role in understanding pricing decisions. Marginal cost can be defined as the change in total cost resulting from a one-unit change in output, or as additions to aggregate cost for given additions to output.re sense in transportation because of the difficulties of defining the output unit. Marginal cost also can be defined as the change in total variable cost resulting from a one-unit change in output, because a change in output changes total variable cost and total cost by exactly the same amounts. Marginal cost is sometimes referred to as incremental cost, especially in the transportation industry. There is one other type of cost that should be mentioned because of its importance in price decision—out-of-pocket costs. Out-of-pocket costs are usually defined as those costs that are directly assignable to a particular unit of traffic and that would not have been incurred if the service or movement had not been performed. Within the framework of this definition, out-of-pocket costs could also be eith58er separable costs or variable costs. Although the above definition states that out-of-pocket costs are specifically assignable to a certain movement, which implies separable costs, they can definitely be considered as variable costs because they would not have occurred if a particular shipment had not been moved. The definition also encompasses marginal cost because marginal cost can be associated with a unit increase in cost. The vagueness of the out-of-pocket costs definition has left the door open to the types of cost included as a part of the total cost calculation. The difficulty lies in the fact that from a narrow viewpoint, out-of-pocket costs could be classified as only those expenses incurred because a particular unit was moved. For example, the loading and unloading expense attributable to moving a particular shipment, plus the extra fuel and wear and tear on equipment (relatively low for railroads) could be classified as out-of-pocket costs. On the other hand, a broad approach might be used in defining out-of-pocket costs in regard to a particular shipment, thereby including a share of all of the common variable expenses attributable to a particular movement between two points. The confusion surrounding the concept of out-of-pocket costs would seem to justify elimination of its use. However, the continued use of the term would be acceptable if its definition was made synonymous with the definition of one of the particular economic costs that its definition implies—marginal costs—because this term is important in price and output decisions and evaluations of pricing economics. Typically, out-of-pocket costs are most important to the firm’s accounting system because they are payments that must be made almost immediately as an operating expense. The out-of-pocket cost concept is useful in that it is used as a way to estimate the amount of liquid funds that a transportation firm must keep on hand for daily operations.7 Figure 4A-3 gives a good breakdown of the methods of cost analysis. It illustrates the close relationship between the three cost concepts of variable, marginal, and outof- pocket costs. Although attention is devoted to cost structure in the separate chapters dealing with each of the modes of transportation, some consideration will be given in this section to an analysis of modal cost structures. Such discussion is useful and necessary background to the analysis of the approaches to pricing. 145146Figure 4A-3 Short-Run Cost/Volume Output ApproachRail Cost StructureOne of the characteristics of railroads, as previously noted, is the level of fixed costs present in their cost structures. It is a commonly accepted fact that a relatively large proportiontion of railway costs are fixed in the short run. At one time it was believed that more than half of rail costs were fixed, and some individuals estimated that these costs ran as high as 70 percent of total cost. The exact proportion of fixed expenses is subject to some debate; however, it is generally accepted that fixed expenses constitute a significant portion of railroad total costs, ranging from 20 to 50 percent. The high proportion of fixed costs can be explained by railroad investment (in such things as track, terminals, and freight yards), which is much larger than the investment of motor carriers, for example. For this reason, railroads are generally regarded as having increasing returns, or decreasing costs per unit of output.8 As has been indicated, a significant amount of railroad costs also include common expenses because replacement costs of a stretch of track are shared by all traffic moving over it. This is also true with respect to other items of cost, including officers’ salaries. Some of these common costs are also fixed costs, while others are variable costs (refer to Chapter 6, “Railroads”).Motor Carrier Cost StructureThe motor carrier industry is exemplified by a high proportion of variable costs. It has been estimated that variable costs in the motor carrier industry arethat variable costs in the motor carrier industry are 90 percent or more of total costs.9 This high degree of variability is explained to a large extent by the fact that motor carriers do not have to provide their own right-of-way because roads are publicly provided. It is true that motor carriers do pay fuel taxes and other taxes to defray the cost of providing the highways, but these expenses are variable because they depend on the use made of the highway. The economic concept of the “long run” is a shorter period in the motor carrier industry than in the railroad industry. The operating unit, the motor carrier vehicle, has a shorter life span than the rail operating unit. It is smaller and therefore more 146147adaptable to fluctuating business conditions. The capital investment required is smaller too, and fleets can be expanded and contracted more easily. The motor carrier situation varies greatly with respect to common costs. Companies that specialize in LTL traffic will have a significant proportion of common cost, whereas contract carriers with only two or three customers who move only TL traffic will have a high proportion of separable costs. Other companies that carry a mixture of TL and LTL traffic will be in the middle of the two extremes (refer to Chapter 5, “Motor Carriers”).Carriers’ Cost StructuresInformation on water carrier cost structure is less prevalent because many companies are privately owned or exempt from economic regulation. The cost structure is probably very similar to that of motor carriers because their right-of-way is also publicly provided. There are some differences, however, because the investment per unit of output is greater, and a large volume of traffic is necessary to realize mass movement potentialities.10 (See Chapter 8, “Water Carriers and Pipelines”). The pipeline companies have a cost structure similar to that of railroads. The fact that they have to provide their own right-of-way and the fact that their terminal facilities are very specialized mean that they have a large element of fixed and usually sunk costs. They also usually have significant common costs because they move a variety of oil products through the pipeline (see Chapter 8, “Water Carriers and Pipelines”). The airline companies have a cost structure similar to that of water carriers and motor carriers because of the public provision of their right-of-way. Also, terminal facilities are publicly provided to a large extent, and the airlines pay landing fees based upon use. Airlines tend to have a significant element of common cost because of small freight shipments andcommon cost because of small freight shipments and the individual nature of passenger movements; for example, airlines very seldom sell a planeload to one customer (see Chapter 7, “Airlines”). The differences in the cost structures of the modes of transportation and their differing service characteristics make pricing of their services very important. If motorcarrier service is better than rail service, motor-carrier prices can exceed rail prices. The cost structure of the motor carrier might dictate that their prices can exceed rail prices. The cost structure of the motor carrier might dictate that their prices have to be higher than the rail prices. The critical question is what the relationship between demand and cost (supply) is in such cases.NOTES1.William J. Baumol, et al., “The Role of Cost in the Minimum Pricing of Railroad Services,” Journal of Business, Vol. 35, October 1962, pp. 5–6. This article succinctly presents the essence of sunk versus prospective costs.2.A. M. Milne, The Economics of Inland Transport, London: Pitman and Sons, 1955, p. 146.3.Robert C. Lieb, Transportation, the Domestic System, 2nd ed., Reston, VA: Reston Publishing, p. 138.
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