By identifying the variable and fixed portions of the internal service fund costs of a service or product, this model builds in a flexibility that enables it to handle changing cost structures.
Internal service funds (ISFs) traditionally have been set up by state and local governments to provide and account for products and services to other departments and agencies within the same government. ISFs exist because presumably they are more effective and efficient in providing the necessary services than any organization outside the government providing similar services. Activities of an ISF can range from being relatively simple, such as handling supplies, to very complex services, such as motor pools, data processing and risk management. Services can be either infrequent or continuous in nature.
Price setting for products and services for an ISF is an important decision for administrators to make. ISFs are expected to be financially self-sustaining through appropriate pricing practices; however, there are no mandated policies for calculating costs or for establishing prices. The prices can be set by management and need not be based on arms-length transactions. Comparability, reliability and consistency of reporting can be compromised if prices are set arbitrarily.(1)
The purpose of this article is to present a model that can be used to set prices for ISFs. It progresses through a discussion of general ISF price theory to the development of the model and then to a comprehensive example to illustrate the concepts.
ISF Prices: Meeting Objectives
The price-setting policy for ISFs needs to consider numerous, often conflicting, objectives: fund sustainability, performance measurement, impact on user behavior, cost recovery and equitable sharing of costs.
Fund Sustainability. A major aspect of ISFs is that they are self-sustaining in nature. Break-even pricing is not enough: the ISF must charge appropriately to cover for replenishment of its assets. ISFs are sometimes referred to as revolving funds because fund resources are used to provide goods and services and are subsequently replenished by charges paid to those funds. Then those resources are used to provide goods and services, and so on. The fund must be solvent enough to hedge itself against uncertainties and to prepare for necessary growth as demand for its services grows.
A question arises with ISFs as to markups in the price of offered services. Cost recovery is a key long-run concern. But as required by Governmental Accounting Standards Board (GASB) standards, the ISF takes the form of a proprietary entity. The American Institute of Certified Public Accountants AICPA audit guide, Audits of State and Local Government Units, states, "rates should not be established at confiscatory levels that siphon off assets earmarked for other purposes. Likewise rates should not be set so low that significant losses are incurred that result in retained earnings deficits... [A]ccumulation of resources or deficits over a long-term is considered inappropriate."(2)
Caution is warranted. Any price that includes markups or artificial costs can have negative effects, such as merely transferring resources from the buying unit to the ISF and, thus, providing neither a true measure of surplus or deficit nor of the value of the services consumed. Artificial markups to generate profits to the fund can cause user departments to view the whole process with skepticism and question the value of the services being offered.(3)
On the other hand, the ISF needs to charge for services in a way that enables it to support itself. It therefore needs to have earnings available to cover such costs as replacement of inventories and fixed assets. The ISF must recover and pay for replacement of its invested capital.
To reconcile these conflicting viewpoints, markups on services need to be consistent, reasonable and communicated. Any prices charged above cost and recovery of capital charges should be disallowed and returned to the user departments. Large fluctuations in charges from period to period can lead users to lose faith in the motives of the ISF and should be avoided. Price fluctuations also would make it difficult for user departments to budget future expenditures and might cause them to play timing games hoping for a lower rate in the future on discretionary expenditures for services.
Performance Measurement. Generally, user departments do not have access to outside sources of the service being provided by the ISF. This does not mean that a comparable service does not exist outside the government, but rather that the users are not allowed to use it. If the ISF cannot provide the service at a cost that is less than or equal to any outside price, there is a serious question of whether the ISF should even exist.(4)
Impacts on User Behavior. During the life of an ISF and its particular service situations arise wherein it may be desirable to set prices that will encourage or discourage usage. For example, new services that can enhance management performance of government functions might be offered at a lower-than-normal price to encourage use. Free services might even be offered if it is felt there are real long-run benefits. On the other hand, users often view the price of a service as representative of its value. Free or low price service might be overused or perhaps believed to be not valuable enough to use. A flexible pricing structure is necessary to help ensure the use of the services in the most beneficial manner.
Cost Recovery. Given the lack of an available outside market, ISFs will price their services on a cost basis. This is a far more complicated matter than it first appears, raising many questions that need to be addressed: Should the ISF price be based on actual costs or on a budgeted basis? What level of cost should be used? For example, should total costs or variable costs be used? How are fixed costs priced? What about the price for a new service? Should a markup be included to help sustain the fund? If so, how much? Should the fund use different prices at different times to encourage or discourage usage?
Equitable Sharing of Costs. Equitable rate setting will allow user departments to be charged only for their "fair share" of the costs of running the ISF and will not charge a user department for services based on the activity in other user departments.
A pricing model that meets these objectives will be described and examined in the next section.
Pricing Model in Brief
Economic theory generally holds that the best ISF price to set among departments is one that reflects the price in the open marketplace; in practice, however, there is often no comparable outside market for the products or services of the ISF. In effect, user departments are the captive clientele of ISFs. The economy, efficiency and effectiveness of the ISF need to be monitored closely under such circumstances since the lack of outside competition tends to lead to inefficiencies and unnecessarily high costs.
The pricing model described here has been adapted from one defined by David Solomons.(5) The model, which helps determine price in a manner similar to that of a business, is concerned with transfer pricing, or the setting of prices between independent divisions within the same firm--a relationship very similar to that between an ISF and the user departments. It refers to the situation where the following conditions exist:
* there is no outside market for the transferred products or services,
* the transfers constitute a large part of the supplying division's business and
* the seller can meet all probable requirements of the buyer.
The model can be stated as follows: price equals standard variable cost plus an allocation of ISF fixed costs based on a long-run allocation base not subject to short-run fluctuations.
By identifying the variable and fixed portion of the ISF cost for pricing, the model builds in flexibility that enables it to handle changing cost structures. A measure of variable costs makes it possible to:
* easily price new services;
* set a minimum price that encourages users to make wise use of the services and to recognize the costs of the services;
* set a price when excess capacity is available in the ISF;
* measure efficiency of the ISF by knowing what costs change with changes in the level of provided services.
The use of standard cost is intended to restrict the costs that the ISF is allowed to recover to those related to the variations in the demands made on it. It also encourages the ISF to be efficient, since it must bear the cost of variances from standard costs that are the result of its own inefficiencies.
In this model, fixed costs are charged as period costs, not as product costs to the government areas using its products. The essential requirement is that the decisions of the consuming department concerning the volume of service to use should not be distorted by the conversion of the ISF fixed costs into the consuming department's variable costs in the price of every unit of intermediate product that they consume. The user departments can be charged for the ISF's fixed costs while avoiding the distortion just referred to by assuring that they receive a monthly charge for a proportion of the fixed costs. This charge, rather than relating directly to the volume of services during any particular month, is based on a long-run allocation base not subject to short-run fluctuations.
The allocation base used in this model derives from the budgetary calculation of the proportion of the ISF's capacity earmarked to serve a specific government department. Although other allocation bases can be used, this expected average long-run utilization base is conceptually preferred. Fixed fees based on this measure force the user departments to recognize the full cost of the ISF service and motivate them to cooperate in choosing the proper level of productive capacity to acquire. They also will encourage users to be more honest in the capacity acquisition stage: if they overstate their requirements to ensure adequate capacity for their own use, they will pay a higher fixed fee; if they understate their expected requirements to avoid or reduce a fixed charge, they may not have sufficient capacity for their needs. Understated capacity can be monitored by watching actual usage over time.
A charge, or markup, for capital maintenance is necessary to sustain the fund. The markup on services consists of a charge to cover replacement cost of equipment and supplies. The charge, which should be consistent, reasonable and made known ahead of time to the users, can be included as part of the fixed-cost sum and be applied on the same long-run basis as the fixed costs.
The use of budgeted fixed costs and the departments' budgeted demands on capacity as the bases for price determination has advantages over the use of actual data. First, the ISF is left to carry any spending variances over budget and is not able to pass them on to users. Second, the system eliminates any danger that fixed costs will enter into the departments' decisions about how much service to use during the year. Third, accounting is made simpler, as charges can be made at the time of service rather than at the end of the period, when actual costs have been accumulated. Another advantage of this model is that it does not hold managers responsible for changes in ISF usage in other departments.
The Pricing Model in Use
The following example focuses on a motor pool ISF that provides relatively continuous, complex services--the most common type of ISF.(6) The model will start with the simplest version of the pricing method, based on actual usage and actual costs, and then will be refined. It assumes that there are four departments using the motor pool on an ongoing basis, and the allocation base for pricing is hours of maintenance and repairs performed for each user department.
Version One: Actual Costs and Actual Usage. The advantage of this method is its simplicity. For example, if a month's actual costs for the motor pool were $400,000 and each user department incurred 200 TABULAR DATA OMITTED hours of usage, each user would be billed for 25 percent of the total cost or $100,000.
Using this pricing structure, if actual costs were $420,000 due to inefficiencies on the part of the ISF, each user would be charged an additional $5,000--hardly an equitable arrangement. Under this pricing structure, there is no incentive to control costs or perform efficiently. The ISF should not pass on these additional costs to user departments; they should remain within the ISF and be shown as unfavorable variances, and the cause of the inefficiencies should be identified.
Another problem that would arise with this billing system is illustrated in the following case. If in a particular month Department Two, for example, decreases its usage by 50 percent while the ISF costs remain at $400,000, the billing to each department would be as shown below.
Dept. 1 200 hours/700 x $400,000 = $114,286 Dept. 2 100 hours/700 x $400,000 = $ 57,142 Dept. 3 200 hours/700 x $400,000 = $114,286 Dept. 4 200 hours/700 x $400,000 = $114.286
Total 700 $400,000
Department Two would receive a smaller charge for usage as compared to the first example, while the other departments would be billed a larger amount. Managers of the other three departments would be justifiably confused to see their charges increasing even though their usage and the total ISF costs remained constant. In effect, these departments would be held responsible for what occurs in other departments. This approach would be defensible only in the extreme example where all costs were variable.
Version Two: Actual Fixed and Variable Costs. A refinement to the actual-cost model is to determine the fixed and variable costs of the ISF. This example assumes fixed costs of $300,000 per month; variable costs are about $125 per hour, which include an estimate of parts used in repair, supplies used and appropriate labor cost.
In this version, price equals $300,000 + $125(hour). If each department uses 200 hours in the month, total billing would be: $300,000 + $125(800) = $400,000. If each department used 200 hours, each department would be charged equal amounts, or $100,000, just as in version one of the model. Any inefficiencies would be passed along to the user departments, since actual costs are the basis for pricing.
If Department Two drops usage to 100 hours, under this pricing structure the total cost would be $300,000 + $125(700) = $387,500. Charges would be as follows:
Dept. 1 200 hours/700 x $387,500 = $110,714 Dept. 2 100 hours/700 x $387,500 = $ 55,358 Dept. 3 200 hours/700 x $387,500 = $110,714 Dept. 4 200 hours/700 x $387,500 = $110,714
Total 700 $387,500
The managers of Departments One, Three and Four would be even more confused than in version one, seeing the total ISF cost go down, their department's hours remain the same and their charge increase (from $100,000). Fixed costs, in effect, would have turned into a variable cost. In reality, there is little, if any, relationship between the ISF fixed costs and short-run usage. Clearly, this is not an equitable pricing procedure.
Version Three: Budgeted Fixed and Variable Costs. To fully implement the objectives of the ISF through the pricing model, modifications need to be made. The basic formula is as follows: price equals standard variable cost of the service applied to actual usage plus a measure of fixed costs based on long-run average utilization.
Here, the illustration assumes that budgeted average fixed cost per month is $300,000, including a reasonable markup estimate. The standard average variable cost is $125 per hour as in the previous version, and it is charged based on the budget rate applied to actual usage by the user departments. Although this example uses labor hours to price both fixed and variable costs, different bases can be used for each cost category and different hourly rates for variable costs can be used for different services. Budgeted rates are used so as not to transfer price variances to the user departments.
The average long-run expected usage per month for each department is assumed as follows:
Dept. 1 200 hours Dept. 2 150 hours Dept. 3 175 hours Dept. 4 225 hours
Total 750 hours
Each month the departments would be charged for fixed costs based on their respective percent of total average long-run expected usage, resulting in the charges shown below:
Dept. 1 200 hours/750 x $300,000 = $80,000 Dept. 2 150 hours/750 x $300,000 = $60,000 Dept. 3 175 hours/750 x $300,000 = $70,000 Dept. 4 225 hours/750 x $300,000 = $90,000
Total 750 $300,000
These amounts would be billed to each respective department on a monthly basis regardless of usage during the period.
This type of allocation serves two purposes. First, each department is not charged for changes in activity that occur in other departments. Second, it will not influence department usage. Managers, seeing these costs unitized, may be less willing to use the services because of additional charges that bear no direct relationship to the activity.
If all departments use 200 hours of service for the month, the amount charged would be as follows:
Dept. 1 $ 80,000 + $125 (200) = $105,000 Dept. 2 $ 60,000 + $125 (200) = $ 85,000 Dept. 3 $ 70,000 + $125 (200) = $ 95,000 Dept. 4 $ 90,000 + $125 (200) = $115,000
Total $ 300,000 $400,000
Additional costs arising from inefficient operations would not be charged to the users, and an incentive would be provided for the ISF to be efficient in its operations.
If during a succeeding month Department Two used only 100 hours while the other departments remain at the same usage level, it would be charged $60,000 + $125(100) = $72,500. The other departments are not affected by changes in one department's usage levels. Thus, an equitable pricing model is achieved.
A pricing model incorporating standard variable costs and a fixed monthly charge based on long-run utilization seems well-suited for meeting the objectives of the ISF. The distinction between variable and fixed costs allows for flexibility for pricing new or heterogeneous services and allows for measures for cost control and efficiency. The use of standards keeps costs of inefficient operations in the ISF from being passed on to users. Applying a reasonable markup sustains the fund. Charging fixed costs on a budgeted long-run base provides for an equitable charging of these costs and allows the user to make decisions on levels of usage that will not be dependent on being charged for costs that have no relationship to usage.
It is important to periodically compare ISF prices against available outside prices even though an outside market may not be available to the users. This helps ensure that the services are being priced at no more than market value and the ISF is performing efficiently. Any prices set above a relevant market price needs to be evaluated.
The model uses data and information that are readily available to the ISF as part of its regular accounting system. The cost of implementation of this system would not seem to be significant. Given the objectives it is able to achieve for the ISF, developing and implementing the model might be a step worth taking.
1 Falk, D., and Granof, M., "Internal Service Funds Are Beyond Salvation," Accounting Horizons, June 1990, pp. 58-66.
2 American Institute of Certified Public Accountants, Audits of State and Government Units, AICPA, 1986.
3 Ziebell, M., and DeCoster, D., Management Control Systems in Nonprofit Organizations, Harcourt, Brace and Jovanovich, New York, 1991, pp. 385-419.
4 Ibid, p. 399.
5 Solomons, David, Divisional Performance: Measurement and Control, Financial Executives Research Foundation, 1965, New York.
6 Coe, C. and O'Sullivan, E., and "Accounting for the Hidden Costs: A National Study of Internal Service Funds and Other Indirect Costing Methods in Municipal Governments," Public Administration Review, January/February 1993, pp. 59-64.
PRICING MODEL: BUDGETED FIXED AND VARIABLE COSTS
P = vc + fc
where: P = ISF price vc = standard variable cost fc = an allocation of ISF fixed costs based on a long-run allocation base not subject to short-run fluctuations
LAWRENCE M. METZGER, Ph.D., CPA, associate professor of accounting at the Loyola University of Chicago, is a GFOA member. He currently teaches accounting for governmental and nonprofit entities and has published several articles in the nonprofit area. Readers who would like additional information about ISFs should contact the author at 312/915-7107.…