A Pricing Model for Internal Service Funds
Metzger, Lawrence M., Government Finance Review
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. …