Sunday, August 7, 2011

PRC Conducting Study to Allow More Flexible Costing And Pricing

On August 2, the Postal Regulatory Commission issued a Request for Proposal to produce a “Report on Peak Load Costs.” Peak load costs are traditionally thought of as additional costs that are born to cover higher demand than normal. For electric utilities that have multiple options for producing or purchasing power, the most profitable operating model involves using the lowest cost electricity first and as demand rises going to more and more expense options for producing power. For that reason, many utilities have developed models that show that costs of handling peaks in power demand are higher than the cost of handling base demand and often set tariffs that encourage electricity customers to use power when there is likely to be excess capacity of the lowest cost option for producing Power.

Traditionally, it is thought that Postal volume peaked in the fall and is at a low point in the summer month. Similarly, certain days of the week, and days of the month have more mail volume than other that relate to publishing, billing, and sales cycles. To the extent that labor, capital, and purchased transportation assets are less flexible than the variation in mail volume would result in times when there is excess capacity and other times when all asset are more than fully utilized and overtime costs are born or additional transportation is added. Recent changes in the American Postal Workers Union contract that increases flexibility through the use of both non-traditional full time schedules as well as the introduction Postal Support Employees to the mix of labor resources available increase the flexibility of the Postal Service to deal with variations in volume.

Study Suggests Commission Believes Existing Costing Models May No Longer Be Sufficient

In the first paragraph of the scope listed in its request, the Commission indicates that measuring the differences in costs between peak and slack periods will likely become a more important part of its regulatory role in the future and existing costing approaches can no longer meet these needs. (The underlined sentence reflects the traditional view of Peak Load issues.) More importantly from a rate regulation standpoint, the first paragraph of the scope suggests that the Long Run Marginal Cost Models may have less value in the future and a new costing approach that can deal with costs associated with a large number of specific customers or groups of customers whose cost differ from the long run marginal costs due to when and where mail that they want the Postal Service to deliver enters and exits the network.

“Under prior law (the Postal Reorganization Act, or PRA), the Commission’s analysis of cost behavior focused primarily on how product costs respond to changes in volume over a multi‐year rate cycle. This focus on long‐run volume variable costs reflected the Commission’s primary duty under the PRA, which was to recommend relatively infrequent changes to the Postal Service’s rate schedule. The current law (the Postal Accountability and Enhancement Act, or PAEA) places less emphasis on the Commission’s duty to evaluate periodic changes in the Postal Service’s rate schedule. The PAEA places more emphasis on the Commission’s duty to evaluate the costs and benefits of various proposals to adapt postal services to the fundamental changes that are occurring in the economic environment in which they are provided. These proposed adaptations include changing the frequency of delivery, offering seasonal discounts, using a short‐run marginal cost standard to evaluate periodic changes in rates, and downsizing the Postal Service’s processing and delivery networks. Common to all of these proposals is a need to estimate the costs of coping with short‐run fluctuations in workload (generally, workload that fluctuates more rapidly than labor resources can be adjusted) while adhering to preferential mail service standards and the staffing and scheduling constraints imposed by collective bargaining agreements.”

Scope Appears to Go Beyond Peak Load Cost Analysis

The second paragraph of the scope suggests that the costing issues that the Commission believes that it may have to address questions in the future may go beyond what is required to respond to proposals for experimental and discounted rates by the Postal Service. The paragraph begins by focusing on traditional peak load issues as they relate to mail processing, delivery and transportation costs.
  • Mail Processing:The Commission needs to be able to estimate the effect on mail processing labor costs of workload fluctuations within eight‐hour labor tours, by day of the week, and by season (as well as annually, if it is determined that labor resources take longer than a year to fully adjust to workload).
  • Delivery: “The Commission needs to estimate the effect on city delivery carrier labor costs of workload fluctuations by day of the week and by season, and by year.”
  • Transportation: [A costing model] needs to be able to estimate the effect on purchased transportation costs of workload fluctuations by time of day, by day of the week, by season, and by year.
These costs should be modeled in such a way that the effect on costs volume variation, of relaxing preferential service standards, and of relaxing staffing and scheduling constraints, can be separately identified and estimated.”

Specific Tasks Have Could Have Significant Impact on Postal Policy and the Details of Postal Reform Legislation

The policy focus of the Postal Regulatory Commission’s costing model problem is further indicated by the focus of Task 2:

Contractor shall prepare, a proposed methodology, or methodologies, for analyzing peak load costs under the constraints applicable to the Postal Service such as labor union rules and product specific service standards. The methodologies should be able to answer the following questions:

  1. How might changes in delivery frequency impact peak load and what are the costs associated with those changes? This question is designed to improve the Commission’s approach in providing information to Congress and other policymakers regarding how changes in delivery frequency could affect costs.
  2. What savings will be gained from new labor flexibilities and when will they be achieved? This question recognizes that existing cost models provide little information about Postal Service costs in 2012 and beyond as it implements new work-rule flexibility in the APWU and other contracts yet to be signed.
  3. Can operational inefficiency be quantified? The issue of inefficiency goes to the heart 0f the policy problem and implies a second question “how much can costs be cut before service changes are required?” So answering this question is important for the Commission is important so that Congress has an independent assessment of the limits of efficiency gains in under current operating constraints and if service level (i.e. delivery frequency and time between acceptance and delivery) or labor related restraints are changed. Due to the unpredictability of mail volumes, even an efficient operation may have slack labor, overtime costs, idle sortation equipment, and empty space on trucks under all scenarios and understanding potential efficiency goals will be needed for sound policymaking. The introduction of inefficiency is particularly interesting given the focus on “labor union rules.” It raises the possibility that a study of the impact of variances in volume by hour, day, week, month and season could be used to estimate the “efficiency” impact of relaxing specific union rules that affect management’s ability to match labor resources employed during each hour of work day to the amount of work required to meet customer service commitments.
  4. How do unit costs change with seasonal fluctuations in volume? The seasonal fluctuation focus raises four particularly interesting policy questions.
    1. Do prices need to be uniform over a year or can prices vary with a year?
    2. How can prices under a price cap deal with seasonally adjusted prices especially when prices were uniform over the course of a year before?
    3. Which products can be allowed to fluctuate from season to season, or for that matter month to month or even day to day which ones cannot?
    4. As the mix of customers that use a particular product may change from season to season, are rates based on seasonal differences in costs the first step toward customer specific rates and therefore customer specific costs?Good examples of customers that only use mail in specific seasons are political campaigns. Political campaigns use the mail heavily the month before both primary and general elections. In highly contested election years, political campaigns and independent groups can generate a sufficiently significant increase in mail volumes that the Postal Service in its long range volume forecasts has to account for election years in their forecast models.

Implications of Study for Cost Differences Unrelated to Time or Calendar

The last of these four questions is particularly important given the implication that mail sent by customers that only use the Postal Service during specific times of a year could pay different rates than customers that use the Postal Service year round or during other time periods. If customer costs can be differentiated based on the time of the year that they send their mailings, what other factors could be used to distinguish customers whose mail has different levels of cost than other customers. For example,
  • Do customers that send mail on a regular schedule impact operating costs differently than customers that do not?
  • Do customers that can provide the Postal Service advance information about a mailing including both total volume and the number of pieces to be delivered by 5, 9, and 11 digit bar-codes as well as carrier routes affect costs differently than those customers that do not provide advance information?
  • Could First Class bulk mail customers that can accept an additional day to deliver the mail than those bulk mail customers that do not? (Having such a service could allow the Postal Service to develop a service that competes with pre-sorters using slack machine time in originating sortation operations that are idle today.) 
  • Should customers that use the Postal Service for either last mile delivery of parcels or first mile handling of returns pay different rates depending on the destination or origin respectively if the costs of handling those parcels differ in different parts of the country?
  • Should drop shipment discounts be uniform nationwide if the cost of delivery differs between one region and another?

Implications of the Study for Existing Long-run Marginal Cost Measurement and Activity Based Costing

All of these examples, as well as the time based example identified by the Postal Regulatory Commission illustrate that developing modern cost-based postal rates may require accepting that the existing long-run marginal cost models used in ratemaking may have outlived their usefulness and a new approach and new data systems are required. A recent article by Jessica Lowrance and Gene Del Polito, “Rationalizing Postal Costing in the 21st Century,” suggests that it is time to seriously look at a bottom-up, activities-based-costing approach for Postal Costing.

While the Lowrance and Del Polito paper makes the case to moving to a new costing system, it does not detail the regulatory and legal challenges of making this transition. The Commission, in requesting proposal to study how costs vary by time of day, week, month and season illustrates that it is interested in starting the process of making a transition toward customer based costs and prices. The limited scope of this project illustrates that a transition under current law and regulatory precedent will likely be cautious. If Congress believes that greater customer focused service and price flexibility is required to improve the Postal Service’s ability to serve its customers and speed its return to profitability, then it will need to assist the Postal Service and the Postal Regulatory Commission to replace the current cost model with one more suited for measuring customer based costs and setting customer based prices.

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