Route Contract: Net Cost / Financial Aspects

Financial Aspects
Financial objectives
Very often reform is undertaken for financial reasons 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 used as a base for future years.

After the overall budget has been agreed, it is the responsibility of the authority to make wise use of its funds and set some internal objectives. These would 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 entire 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 route-contracts

Route contracts imply that after the initial tender exercise there will be regular, mandatory re-tendering of routes.
Since the route contracts will last for about five-to-seven years, 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). This implies that the cost figures given in the bid document by the bidder must show itemized groups of costs according to the basis for increase over time. These will be determined by the regulator.
The operator should include an element for profit in his bid. This would normally be a fixed amount or a fixed percentage and would not be subject to adjustment over the life of the contract. Thus the authority does not get involved in having to agree to reasonable profit levels for the operator as would be the case in a longer-term arrangement for an area-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 net cost the operator is paid the amount he submitted in his tender which was his forecast shortfall in revenue required to cover his costs and profit. The operator is therefore very concerned that his revenues should not fall below his forecast amount as this would directly affect his profit.
Since the contract lasts for five to seven years it must make some comment on fare increases (as it has to do for cost increases). Fare increases clauses can either specify when and by how much fares can increase, (e.g., depending on consumer price indices or perhaps on agreed cost increases). Alternately they can simply say that fare increases will be given at the authority’s discretion. Either way the operator has to make proper allowance for fare increases. The authority must also be sure that it takes accurate account of the impact of fare changes and does not adjust the payments to the operator in a manner detrimental to its own interests.
Since the contract is net cost, there will be a need to apportion off bus revenue to operators. The rules for this must be laid down in advance. The impact of concession fares and time-based passes must be considered especially if there is no smart card ticketing system to provide basic data on the use of each ticket type.
Under the net-cost system a minimum service provision is specified in the contract. In the event of increased demand, an operator is free to operate additional km if he believes that the additional revenue will outweigh the additional costs. Under the gross-cost contract there would be no incentive for the operator to run additional km unless an agreement with the authority had been reached in advance for payment to be made for the additional km.

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’s very likely that the city will have a limit to the amount that it wishes to spend on public transport and it’s the authority’s job to prepare budgets for each of the major cost items listed above 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 tendered routes or packages of routes. Despite this, the authority must prepare a budget setting out their estimate of the costs that will be submitted by the tenderers and also their estimates of revenue under the prevailing fares regime. Taken over the whole system this should 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 the routes 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 amounts paid to the operators 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.

Financial models
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 fares 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). Where missed kilometers are deemed the fault of the operator it is customary for the contract to contain penalty clauses with financial penalties for various degrees of non-compliance. 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.