Area Contract (Gross Cost) / Financial Aspects

Financial Aspects
Financial objectives
Very often reform is undertaken for financial purposes and it’s likely that there will be considerable interest in ensuring that financial objectives are set and achieved.

At the highest level the objective is to try to achieve the best possible transport service for a given level of funding. The overall level of funding for public transport in a city is usually decided after several rounds of discussions in which various levels of service are compared with various funding levels. Ideally once a figure is set it can be maintained for future years.

After the overall budget has been agreed, it’s the responsibility of the authority to make wise use of its funds and set some internal objectives. These might include:

Controlling its own expenditures within budget.
Controlling the capital expenditures within budget.
Controlling the recurrent costs within budget.
Improving the financial performance of the total bus network.
Ensuring proper execution of contracts by the bus operators.

Specific objectives which can be measured might include:

The cost recovery ratio of all services.
Average cost per km.
Average cost per place km.
Average revenue per km.

The cost recovery ratio might be set with an objective of increasing it from say 60% to 80% over a five-year period.

Many authorities make use of financial models to help them assess the financial position and forecast future costs in an effort to improve their ability to meet their objectives. For more information on objectives see additional benchmarks and indicators.

Key financial characteristics of gross-cost area-contracts

The use of area contracts suggests that the authority does not intend to offer the routes awarded under the area contract for retendering on a regular basis.
Area contracts are normally awarded for periods of eight to 10 years with either formal or informal undertakings to extend, subject to satisfactory performance. The extension can be given in the form of a rolling extension of say two years keeping the contract period at or close to the original amount. Alternatively it could be renewed say one year prior to expiry for another fixed term. The former arrangement gives greater confidence for steady investment while the latter is more aligned with lumpy investment.
There is a need to agree in advance how to amend the unit costs for changes in underlying prices (e.g., fuel, labor and spare parts) on an ongoing long-term basis. While changes to the tendered unit cost items can be related to specific inflation rates or price changes in the short term (i.e., for a few years after the initial bid) over the long term this is impractical. It’s necessary for the authority to be in a position to assess whether or not the cost adjustments proposed by the operator on a year-by-year basis are reasonable.
The operator should include an element for profit in his bid. This would normally be a percentage either of turnover or of asset value or some other quantifiable measure. While this could be a fixed percentage for the initial years of a contract, it may have to be varied subject to mutual agreement over the longer term as the financial environment changed (e.g., from a low interest rate to a high interest rate environment). Thus the authority would be required to get involved in agreeing reasonable profit levels for the operator — a situation he could avoid with the periodic re-tendering of the route-contract system.
After the initial bid the regulator would not normally have any access to the operating cost data of any of the operators.
Since the contract is gross cost the operator is not concerned with fares or fare increases. The regulator would, however, have full knowledge of all revenues.
Since the contract is gross cost, there is no need to apportion revenue to operators which avoids considerable work and debate. The only reason to do so would be for internal financial planning purposes.

The authority’s financial obligations
The authority is responsible for four major cost items

The running costs of the authority itself (e.g., staff, overheads and offices).
The capital investment program for works related to public transport that may be the authority’s responsibility (e.g., terminals, stops and shelters and bus lanes).
The ongoing maintenance and management of authority-owned infrastructure.
The obligations for payment to the operators under the gross cost contracts.

Spending limits
It is very likely that the city will have a limit to the amount that it wishes to spend on public transport and it is the authority’s job to prepare budgets for each of the above four cost headings and reach agreement with the city. Ideally this budget should cover not just the coming financial year but also three to five years into the future to ensure that the city is aware of its ongoing commitment for expenditure on public transport.

Forecasting cost increases
Items 1) and 3) above are likely to be relatively stable increasing gradually in line with general inflation and with the growth and aging of infrastructure under the authority’s control.

Item 2) could vary considerably from year-to-year depending on the need to construct major facilities. Usually these costs are longer-term projects and considerable time is needed for planning. As a result the financial implications are known well in advance.

Item 4) is the most complex of the cost items. In the initial stages of the reformed system, the authority will be involved in the transitional aspects of moving from the old system to the new one and preparing tender documents for existing and new routes.

Depending on how the transitional phase was handled, the authority may or may not have a good knowledge of the operating costs and revenues for each of the initial set of routes in the area tender. Irrespective of this, the authority must prepare a budget setting out their estimate of the costs and revenues that will be submitted by the tenderers. Taken over the whole system — if there is more than one area contract in the city — this will provide the authority with an estimate of their financial obligations for the coming year or so and the extent to which they require funding to cover any shortfall in fare revenue. The actual amount of course cannot be determined until all areas have been tendered and completed bids submitted.

Since the contracts will normally be for a period of at least eight years and since the authority will be committed to maintaining service within the tendered area for this period, the authority’s financial obligations stretch over a period of at least eight years. Within this time however as a result of wage inflation, changes to fuel costs and other variables, it’s likely that in absolute terms the operating costs will increase.

The authority must be able to forecast the increase in its commitments and ensure that the city agrees in a timely manner to either a) increase fares to maintain the financial obligation at some agreed level or b) increase the subsidy.

Often the authority will develop financial models that are designed to examine future scenarios such as increases in fuel prices, increases in inflation rates and exchange rate changes. This allows the authority to keep watch on its financial obligations.

The finance division of the authority must also ensure that they have sufficient manpower and procedures to make prompt payments to the operators. Usually there will be a fixed day within a billing period (e.g., bi-weekly or monthly), by which the operators must submit their claims for payment accompanied by statements of kilometers operated and any variations from the agreed schedules.

They should also note whether these variations were due to reasons beyond the control of the operator (e.g., unusual traffic congestion), or whether these were due to their own faults (e.g., non-availability of staff). The finance division of the authority must have procedures in place to deal with all these situations. For more information see costs.

Revenues
Under the gross-cost structure all revenues collected on and off bus are for the account of the authority. This means the authority must make every effort to ensure that all fares are collected and all income reported to it by the operators.

There are two ways of handling revenues. One is for the operator to collect the on bus revenue, bank it in their account and report the amount to the authority. In this case the authority deducts the amount the operator has retained from the amount he is due under the contract and pays the balance. The other approach is for the operator to count the money but transfer it all to the authority. In this case, the authority pays the operator the full amount of the contract.

Fraud
Under either system, the authority must set up a procedure to ensure that there is no fraud occurring at any point in the revenue trail. This implies ensuring that all fares are collected, all fare revenue is handed in to the company and that the company reports or hands over as appropriate all revenues to the authority.

Forecasting
Since the authority designs the routes and specifies the timetable and hours of service, it suggests they have made forecasts or estimates of ridership and, by extension, of revenue. One of the risks that the authority incurs under the gross cost arrangement — but not under net cost — is that ridership and revenue are lower than forecast. Since the agreement with the operator is likely to give him some protection against the authority reducing the scheduled kilometers (and thus his income) without compensation, it is the authority’s financial position that will suffer.

Conversely if the ridership forecast is much too low and demand is much higher than estimated, then there may be a need for more buses. If the service is loss making then each additional bus allocated to the routes in the area will lose money and again the authority’s financial position will suffer. Only where the additional ridership can be carried with the existing bus allocation does the authority stand to gain. For more information see funding sources.