A Pricing Model for Internal Service Funds

Beginning of article

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 …