Public Monopoly with Management Contract / Legal Aspects / Legal Instruments / Management Contract / Compensation

Compensation
The public monopoly’s primary obligation under the management contract is to compensate the management company for its services.

A management contract involves the transfer of a package of skills and resources that may be unique to the management company. The pricing of that package is somewhat arbitrary since benchmarks to assess it are usually unavailable. The result will be most likely a compromise (i.e., what the public monopoly is ultimately willing to pay and what the management company is ultimately willing to accept).

In the urban bus transport sector, compensation of the management company is usually set on the basis of a fixed-fee (without costs or plus costs) or a fee based on a percentage of the gross fare revenue. Incentive payments may be added to either type of basic compensation formula.

Fixed fee
Fixed fee (without costs)
As the name implies, a fixed fee is a fixed amount determined in advance by the parties to the management contract. The fixed fee may be paid only once a year or on a periodic basis, such as the beginning or end of each month.

From the point of view of the management company the fixed fee provides it with a guaranteed source of income and minimizes some of the risks to which it might be subject, such as an early termination of the management contract. On the other hand, a serious misjudgment on its part as to the costs of its services — especially if under pressure to bid low if the management contract is awarded on the basis of competitive bidding — may entail substantial economic hardship.

From the point of view of the public monopoly there are several advantages to a fixed fee — the full cost involved in hiring the management company is known in advance and can be properly budgeted, the management company’s income remains static in spite of rising costs and higher sales volume, and where a competitive bidding process is involved in the award of the contract, the various bids can be more easily compared.

On the other hand, the fixed fee provides no incentive for the management company to operate the urban bus transport services enterprise efficiently or to reduce the enterprise’s operating costs. Whatever the level of performance, the fixed fee must be paid.

Fixed fee plus costs
A variation of the fixed fee is the fixed fee plus costs. In a fixed fee plus costs compensation formula, the fixed fee is substantially reduced by:

excluding from it an array of reimbursable costs (that need to be clearly enumerated and defined in the management contract); and
limiting the extraneous elements that would otherwise go into it, such as perceived country risks (if the management company is a foreign company), constraints placed upon the management company’s other projects, inflation (if there is no escalation mechanism in the contract to provide against it).

As long as a reasonable profit element is set in the fixed fee component of the fixed fee plus costs compensation formula and proper controls over expenditure, such as clear invoices and conformity with budgeted outlay, are met, compensation of the management company on the basis of reimbursement of actual costs can be advantageous to the public monopoly.

It allows it to monitor the management company more closely since reimbursement of actual costs requires a line-by-line analysis of expenditure, whereas the payment of a fixed fee (without costs) provides no basis for understanding the allocation of internal costs of the management company.

The fixed fee plus costs suffers from the same basic flaw as the fixed fee (without costs) — namely lack of any performance incentive on the part of the management company.

Fee based on a percentage of gross fare revenue
Instead of a fixed fee, without costs or plus costs, the parties to a management contract sometimes prefer to stipulate a fee based upon a percentage of any of several variables, such a revenue, profits, sales or production quotas. In urban bus transport, this kind of fee is usually based on a percentage of the gross fare revenue received by the bus transport enterprise that is being managed.

While a fee calculated on a percentage of gross fare revenue provides the management company with a stake in the urban bus transport services enterprise, this revenue is not profit.

The management company has no incentive to minimize costs or maximize profit unless the fee based on a percentage of the gross fare revenue is coupled with incentive payments based on profits. The management company is thereby encouraged to maximize both gross fare revenue and profit (or minimize deficit).

Incentive payments
Incentive payments can be based upon a percentage of any of several variables, such as revenue, profits, sales, production quotas. They may serve to supplement either type of compensation formula discussed above.

In both cases, incentive payments based on a percentage of profits, which may be calculated on the basis of pre-tax or post-tax profits (those based on post-tax profits would be more favorable to the public monopoly), make sense.

Where the management company is compensated by way of a fixed fee, without costs or plus costs, a percentage of the profits would encourage it to operate the urban bus transport services enterprise efficiently and to reduce the enterprise’s operating costs.

Similarly, where the management company is compensated by way of a fee based on a percentage of the gross fare revenue collected by the urban bus transport services enterprise, a percentage of the profits would encourage it to maximize both the enterprise’s gross fare revenue and profits.

Where bus services are subsidized, and the enterprise is not expected to earn a profit, the incentive may be in inverse proportion to the level of deficit.