Area Contract (Net 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 net-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.

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 net 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 five years and since the authority will be committed to maintaining the tendered routes for this period, or providing the contractor with alternative routes, the authority’s financial obligations stretch over a period of at least five 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.

As a result in the net-cost arrangement, some provisions must be included in the contract for increasing fares. If these provisions are somehow related to established indices such as consumer price figures or other indices which do not track increases in bus operating costs then the authority must make provision for the contract payment amount to change.

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.

If the fare increases are related to the increases in bus operating costs — which may cause social problems if these increases are greater than general inflation rates — the authority is less at risk financially since both costs and fares should rise at about the same rate.

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 net cost arrangement the collection of fare revenue is the responsibility of the operator and does not directly concern the authority. However, for more information see funding sources.