Saving the Railroad Industry TO Death - The Evil of Economic Freight Rate Regulation

[MichaelSol]

Greyhounds once strongly argued that wheat rates had gone down over the past 25 years, and offered every misreading of every study he could lay his hands on, refusing even to read the explicit texts of the studies he cited to which stated that prices had gone up.

He was vociferous, adamant, expending a great deal of time and energy, even though he has no experience at all with the wheat industry or its rate history-- at one point selecting out of seven or so commonly used inflation indexes the only one that had nothing whatsoever to do with either railroads or agriculture to try and "prove" his point. It was all heat and no light. So much for appropriate methodology.

It was interesting then to see the October 6, 2006 GAO study which showed ... wheat rates had gone up, and in fact GAO singled them out as one of the few categories of rail traffic that had in fact gone up over that time.

So, it is interesting now to see that he has a methodology for "stepping back to check the methodology used."

The wheat rates in question (Montana to the PNW) did decline dramatically in constant dollar terms.  See page 14. 

http://rscc.mt.gov/docs/White_Paper_Meeting_10_05.pdf   (The red line is what the rate would be if it had kept up with the consumer price index.)

The GAO report did not say they went up.

Mr. Sol misrepresents (for whatever purpose) the meaning of the 180% R/VC ratio to the point of falsely claiming that any rail customer above that level is "captive". 

And Mr. Sol has presented absolutely no evidence that any rail customer is being cross subsidized.  He's loudly procliamed that such a thing exists, but saying it don't make it so.

I've got better things to do than argue with someone who I feel misrepresents (out of ignorance, misunderstanding, mallice - I don't know why he does it.) things like this. 

Well, somebody is definitely misrepresenting something.

BLET Newsletter, STB to hold public hearing on grain rates, October 11, 2006:

The financial health of the industry has improved substantially as railroads have cut costs and boosted productivity. Moreover, most rates declined as productivity improvements were passed on to shippers. However, one category of rates examined by GAO--grain rates--diverged from the industry trends. According to the GAO preliminary report, the amount of grain traffic with comparatively high markups over variable cost increased notably between 1985 and 2004.

The Board intends to hold a public hearing after GAO releases its final report, ... as a forum for information about ...  grain transportation markets in general.

Letter, 11/8/06,  JayEtta Z. Hecker, Director, Physical Infrastructure Issues, GAO, to Charles D. Nottingham, Chairman, Surface Transportation Board:

"... At the same time, the 1980 act anticipated that some shippers might not have competitive alternatives-commonly referred to as "captive shippers"-and gave the Interstate Commerce Commission (ICC), and later the Surface Transportation Board (STB), the authority to establish a process so that shippers could obtain relief from unreasonably high rates. This process establishes a threshold for rate relief, allowing a rate to be challenged if it produces revenue equal to or greater than 180 percent of the variable cost of transporting a shipment.

"... Among other things, this report describes the significant changes that have taken place in the railroad industry and reports that from 1985 through 2004, rates generally decreased, but nominal grain rates increased 9 percent. We also found that, on some routes, the amount of grain traveling at rates significantly above the threshold for rate relief had increased since 1985."

White Paper & Briefing Paper For Governor's Schweitzer's Meeting With Vice Chairman Doug Buttrey, STB, Whiteside & Associates, October, 2005:

p. 13. The rail rates in the Northern plains have increased 40% faster than the Rail Cost Adjustment Factor including productivity Unadjusted.

p. 14 The Surface Transportation Board developed specifically for U. S. Railroads a Rail Cost Adjustment Factor which is utilized in measuring Rail Rates and has an adjustment for Productivity Gains. The Montana 52 Car PNW Wheat Rates would be 39 cents/bushel lower today than they are if the BNSF had shared the productivity gains adjustments with Montana farm producers. Comparing rail rates to RCAF has far more relevance than to CPI.

General Accountability Office Report, October 2006, FREIGHT RAILROADS: Industry Health Has Improved, but Concerns about Competition and Capacity Should Be Addressed GAO-07-94:

p. 9: Rail rates generally declined between 1985 and 2000 but increased slightly from 2001 through 2004. Likewise, rail rates have declined since 1985 for certain commodity groups and routes despite some increases since 2001, but rates have not declined uniformly, and some commodities are paying significantly higher rates than others. For example, from 1985 through 2004, coal rates declined 35 percent while grain rates increased 9 percent.

p. 13: Grain rates initially declined from 1985 through 1987, but then diverged from the other commodity trends and increased, resulting in a net 9 percent increase by 2004.

 

[Datafever]

The wheat rates in question (Montana to the PNW) did decline dramatically in constant dollar terms.  See page 14. 

http://rscc.mt.gov/docs/White_Paper_Meeting_10_05.pdf   (The red line is what the rate would be if it had kept up with the consumer price index.)

The GAO report did not say they went up.

...

You are correct in saying that the GAO report did not say that wheat rates had gone up.  In fact, the GAO report never separates out wheat from other grains.

Here is what the GAO report does say:

Rail rates generally declined between 1985 and 2000 but increased slightly from 2001 through 2004. Likewise, rail rates have declined since 1985 for certain commodity groups and routes despite some increases since 2001, but rates have not declined uniformly, and some commodities are paying significantly higher rates than others. For example, from 1985 through 2004, coal rates declined 35 percent while grain rates increased 9 percent.

[greyhounds]

Greyhounds once strongly argued that wheat rates had gone down over the past 25 years, and offered every misreading of every study he could lay his hands on, refusing even to read the explicit texts of the studies he cited to which stated that prices had gone up.

He was vociferous, adamant, expending a great deal of time and energy, even though he has no experience at all with the wheat industry or its rate history-- at one point selecting out of seven or so commonly used inflation indexes the only one that had nothing whatsoever to do with either railroads or agriculture to try and "prove" his point. It was all heat and no light. So much for appropriate methodology.

It was interesting then to see the October 6, 2006 GAO study which showed ... wheat rates had gone up, and in fact GAO singled them out as one of the few categories of rail traffic that had in fact gone up over that time.

So, it is interesting now to see that he has a methodology for "stepping back to check the methodology used."

The wheat rates in question (Montana to the PNW) did decline dramatically in constant dollar terms.  See page 14. 

http://rscc.mt.gov/docs/White_Paper_Meeting_10_05.pdf   (The red line is what the rate would be if it had kept up with the consumer price index.)

The GAO report did not say they went up.

Mr. Sol misrepresents (for whatever purpose) the meaning of the 180% R/VC ratio to the point of falsely claiming that any rail customer above that level is "captive". 

And Mr. Sol has presented absolutely no evidence that any rail customer is being cross subsidized.  He's loudly procliamed that such a thing exists, but saying it don't make it so.

I've got better things to do than argue with someone who I feel misrepresents (out of ignorance, misunderstanding, mallice - I don't know why he does it.) things like this. 

[Datafever]

My understanding is that additional volume approaching capacity limits is a good thing.  ...   Underutilized capacity is not normally a good thing.

This is where, in my view, railroading separates from the manufacturing model.  In a broad view, I disagree with both of these statements, but oh my gosh ... that's a thread to itself ...

Well, it isn't like this thread is anywhere near its original discussion, nor have I seen anyone else trying to veer it back to the issue of regulation, so please continue.  Expound on the reasons behind your enigmatic statement.  I'll keep in mind that you are taking the broad view, and not specific micro-examples. 

EDIT: Since you edited your post, I'm editing mine.

I would define capacity as that point at which inefficiencies enter the system.  But bear in mind that my statement was "approaching capacity", not "at capacity".  

[MichaelSol]

My understanding is that additional volume approaching capacity limits is a good thing.  ...   Underutilized capacity is not normally a good thing.

This is where, in my view, railroading separates from the manufacturing model.  Railroading has a range of capacity that is economically efficient. Above or below it, and it is inefficient. These guys that argue that railroads should operate "at capacity" have never run the numbers of just how expensive it is to run a railroad "at capacity." In a broad view, I disagree with both of these statements, but oh my gosh ... that's a thread to itself ...

[Datafever]

Mr. Sol, I guess that I am just going to have to pass on this one until there are some things that I understand a little better.

I think that I basically agree with you, but it would appear that the terminology that I have used is inconsistent with "proper" terminology.

My understanding is that additional volume approaching capacity limits is a good thing.  Reaching or exceeding capacity limits is a bad thing.  Underutilized capacity is not normally a good thing.

For any distributed network that is not perfectly balanced (which would include practically all real-world networks), there will always be routes on that network that will become bottlenecks as network traffic increases.  Increasing capacity on those routes will cause other routes to become bottlenecks as traffic continues to increase.  If a network is well distributed, traffic will be more balanced.

[MichaelSol]

  But how does one determine if cross-subsidization is taking place then? 

A CVP analysis -- cost, volume, price -- is how a manufacturing firm analyzes a combination of rates at given volumes for its product lines or services.

I posted the following a couple of pages ago, and I wouldn't know what to add to it.

"Pretty good summary. At that point, both volume and capacity become key factors. With excess capacity, anytime the company can sell the product at any percentage over the VC, the company earns revenue to cover fixed costs.

"Enough volume, and the product or commodity can in fact generate a profit in excess of the total fully distributed costs (FC + VC(x)) of the service for that product or commodity. Indeed, as cross-subsidized traffic adds volume, the fixed cost allocation per unit for all traffic declines, most of the time, and other traffic becomes more profitable relative to their fully allocated costs as a result. Cross subsidization does not exist in a vacuum and has both positive and negative potential impacts on the profitability of other services as well as the company as a whole.

"However, until the service in question covers its own variable and fixed costs, it is cross-subsidized. After that point it is a genuine profit center.

"At close to capacity, cross-subsidized products or services suddenly develop sharp edges. The company can't just keep adding volume. The capacity constraint may prevent development or acquisition of more profitable traffic. And, this is more true for railroads than just about any other industry -- as capacity limits are approached, costs of operation -- variable costs -- begin to climb. Cross-subsidized traffic that may have been contributing to  fixed costs suddenly gets swallowed up by rising variable costs.

"The rate of climb in operating costs for Class I's over the past 4 years is unprecedented in a low inflation environment. Slower trains, dead on hours, all of the indicators of capacity limits all increase operating costs. This is why the average R/VC has slid over the past six years so that more traffic now travels at rates under 180% R/VC than six years ago -- and why more traffic is now forced to travel at rates over 300% R/VC to make up for it."

The idea of allocating fixed costs is a management tool. It is commonly called absorption cost accounting. But, it is stand-alone -- used to measure the quality of a given product or service in terms of profitability -- but which becomes critical where capacity is a constraint. Can't use it in CVP analysis.

 

[Datafever]

Okay, we seem to have come full circle on this discussion.  As I recall, the expression of fixed costs as a percentage of variable costs was first brought up by you as a means to show that a particular revenue level was profitable.

For a company as a whole, there is a historic relationship of FC to VC. FC run about 35% of VC. Taking it further than that, and attempting to say that 37% FC/VC, or 28% FC/VC, or some other ratio is taking the historical relationship to a place that it cannot go. My point was, what's the point?

We don't know what a high FC/VC rato means, or a low one for that matter. So, while there is a historical record that stays fairly constant of fixed costs to variable costs, I did not and do not see the analytical purpose of attempting an analysis based on a FC/VC ratio since for analytical purposes the analysis doesn't report anything useful.

An historical observation did not translate into an analytical tool. 

Okay, point taken.  But how does one determine if cross-subsidization is taking place then? 

[MichaelSol]

Okay, we seem to have come full circle on this discussion.  As I recall, the expression of fixed costs as a percentage of variable costs was first brought up by you as a means to show that a particular revenue level was profitable.

For a company as a whole, there is a historic relationship of FC to VC. FC run about 35% of VC. Taking it further than that, and attempting to say that 37% FC/VC, or 28% FC/VC, or some other ratio is taking the historical relationship to a place that it cannot go. My point was, what's the point?

We don't know what a high FC/VC rato means, or a low one for that matter. So, while there is a historical record that stays fairly constant of fixed costs to variable costs, I did not and do not see the analytical purpose of attempting an analysis based on a FC/VC ratio since for analytical purposes the analysis doesn't report anything useful.

An historical observation did not translate into an analytical tool.

 

 

[Datafever]

"But in trying to determine if cross-subsidization is occurring or if the railroad is making unreasonable profits, the ability to determine the FC/VC ratio becomes necessary.  Depending upon how fixed costs are "allocated" (poor choice of words on my part - I apologize), it may very well be possible that a shipper receiving a rate of 120% R/VC is not being cross-subsidized, or that a shipper paying 160% R/VC is being cross-subsidized. "

An "FC/VC ratio" is outside my experience or education in marginal cost pricing theory. Never heard of it. I think that has to do with the fact that marginal cost pricing theory as used by the Staggers Act creates a mathematical threshold that includes an absolute, which is the variable cost. The railroad receives 100% of the variable cost.  Always. No matter what it is.

On a percentage scale, there are only two mathematically exclusive circumstances, 0% and 100% -- they are exclusionary of alternatives existing. Just like dividing by zero creates a mathematical impossibility, trying to create a "percentage" analysis out of a 100% cost formula yields complete gibberish.  

I was so puzzled  by the notion of an FC/VC ratio, I created a model to see what in the heck people are talking about by a "FC/VC ratio."

...

If a commodity moves at $2800 a carload, and the company has $300  in fixed costs on a fully distributed basis, and variable costs are $2000 -- the commodity will have a 140% R/VC ratio, and earn 22% net on a fully distributed basis. The FC/VC ratio in that instance is 15%.

Suppose the commodity moves on a shorter haul -- lower VC, lower revenue, right? Say $1,000 VC, and $1600 revenue. Fixed cost allocation has to stay the same at $300, but varies in relation to the variable cost (unless the company allocates on the basis of ton-miles). The FC/VC ratio has doubled to 30%! Gasp. What does that mean? It means in that case that the R/VC increases to 160%, and profitability increases to 23%.

Well, what does that mean? A high FC/VC ratio is bad? Good?  

To me at least, an FC/VC ratio is meaningless.

Okay, we seem to have come full circle on this discussion.  As I recall, the expression of fixed costs as a percentage of variable costs was first brought up by you as a means to show that a particular revenue level was profitable.

Let's go back to widget building.  If a company designs and builds multiple types of widgets, it will no doubt be able to define the "per unit" manufacturing cost of each widget type.  But unless it has some way to identify the "fixed costs" associated with a particular widget type, how can it ever determine if that widget is "profitable" for the company or not?  Or is it sufficient to decide that if all the fixed costs are being covered by the revenue generated by the sales of all the widgets, then profitability for a particular LOB is irrelevant? 

[MichaelSol]

Fixed cost expressed as a percentage of total cost vary (don't get confused) with volume.  So the 35% figure will, in fact, "vary all over the place" with volume on a particular line segment.  This figure is a percentage of total cost.  If the percentage of cost that are variable goes up, the percentage of cost that are fixed must go down.

Fixed costs are "operating" costs. They arise from centralized shop and mechanical facilities, administrative overhead, annualized expenses such as financing and taxes associated with physical plant.  Most of these are not directly associated with the "line" at all. Most states even charge ad valorem property taxes on rail plant -- not on the valuation of a given "line" in the state. Can't even get out from under a general mortgage that may be paying off a "line" --  sure enough, the general mortgage survives whether the line is there or it is abandoned -- whether it has all the traffic or none of it. That's why certain costs are considered overhead.

What you are saying is that if a company were to be completely arbitrary and say that overhead costs can be allocated to a geographical entity such as a line, and then divert traffic to that line -- say double it -- the company can indeed show that overhead costs per unit volume would decline, by 50% in that case. In that instance, and here is the conundrum of your proposition, the fixed cost per unit volume varies "all over the place" only when you allocate it to the actual traffic on the line -- but you say you are not doing that and yet that is exactly what you are doing!

But, if the traffic on the system had legitimately doubled -- overhead will increase. Historically, overhead pretty much tracks overall variable costs as a given percentage. The only way fixed charges could vary all over the place is by cooking the overhead books, isolate an example, artificially redefine overhead, and voila' ... 

"But in trying to determine if cross-subsidization is occurring or if the railroad is making unreasonable profits, the ability to determine the FC/VC ratio becomes necessary.  Depending upon how fixed costs are "allocated" (poor choice of words on my part - I apologize), it may very well be possible that a shipper receiving a rate of 120% R/VC is not being cross-subsidized, or that a shipper paying 160% R/VC is being cross-subsidized. "

An "FC/VC ratio" is outside my experience or education in marginal cost pricing theory. Never heard of it. I think that has to do with the fact that marginal cost pricing theory as used by the Staggers Act creates a mathematical threshold that includes an absolute, which is the variable cost. The railroad receives 100% of the variable cost.  Always. No matter what it is.

On a percentage scale, there are only two mathematically exclusive circumstances, 0% and 100% -- they are exclusionary of alternatives existing. Just like dividing by zero creates a mathematical impossibility, trying to create a "percentage" analysis out of a 100% cost formula yields complete gibberish.  

I was so puzzled  by the notion of an FC/VC ratio, I created a model to see what in the heck people are talking about by a "FC/VC ratio."

Looking at two extreme examples on the model.  A commodity travels at $2800 per carload. If the fixed cost is $300 per carload, and the variable costs vary between $100 and $3500, the "FC/VC ratio" varies between 300% -- at which the commodity is earning a 2800% R/VC ratio and a 600% net profit and an FC/VC ratio of 10%, at which the R/VC is 93% and net profit is -15%.

Another model variant, the variable cost is $1,000. What happens if fixed cost "varies" from $100 per carload to  $3,000 per carload? The results when the FC/VC ratio is 10% is a 280% R/VC and a net profit of 155%.

In other words, the FC/VC ratio tells the company absolutely nothing, nothing at all.  

The reason is that the VC is an undefined number. It is 100% of some reality which does, in fact, vary. Fixed costs are not directly related to the variable costs of the move. A "percentage" analysis by means of an FC/VC ratio is just gibberish -- if it means anything at all in a particular instance, it is an accident.

If a commodity moves at $2800 a carload, and the company has $300  in fixed costs on a fully distributed basis, and variable costs are $2000 -- the commodity will have a 140% R/VC ratio, and earn 22% net on a fully distributed basis. The FC/VC ratio in that instance is 15%.

Suppose the commodity moves on a shorter haul -- lower VC, lower revenue, right? Say $1,000 VC, and $1600 revenue. Fixed cost allocation has to stay the same at $300, but varies in relation to the variable cost (unless the company allocates on the basis of ton-miles). The FC/VC ratio has doubled to 30%! Gasp. What does that mean? It means in that case that the R/VC increases to 160%, and profitability increases to 23%.

Well, what does that mean? A high FC/VC ratio is bad? Good?  

To me at least, an FC/VC ratio is meaningless.

 

 

[Datafever]

  I would think that if a shipper doubles the amount of material shipped from one location to another, then the only cost that has changed is the VC.  In fact, the VC would have almost doubled, no? 

This is only a technical point; I think it is clear what you mean.

"Variable Cost" is conventionally defined as the cost per unit. That variable cost exists on a curve that is variable with reference to production run and economic unit size. You could, perhaps, have a "Total Variable Cost" but it would instantly change with the addition or loss of one unit of production.

The Cost Equation uses VC as the single unit cost; TC=FC+VC(x). 

Mr. Sol, I have been pondering what you said all day, trying to come to grips with it.

Part of me understands what you are saying, but part of me is having problems with trying to adjust it to the specifics of railroading.

So, let me fall back to what I know better than nothing.  In reading the STB reports, it appears fairly clear to me that a shipper's total volume is used when trying to determine R/VC.  As volume is irrelevant to that equation (increased volume = increased revenue = increased variable costs), that is not an issue.

But in trying to determine if cross-subsidization is occurring or if the railroad is making unreasonable profits, the ability to determine the FC/VC ratio becomes necessary.  Depending upon how fixed costs are "allocated" (poor choice of words on my part - I apologize), it may very well be possible that a shipper receiving a rate of 120% R/VC is not being cross-subsidized, or that a shipper paying 160% R/VC is being cross-subsidized. 

[Datafever]

Thank you, arbfbe.  You are correct in pointing out that doubling the "volume" will not always cause an increase in variable costs, and I expect that a doubling of VC would probably be the upper limit.

Your post caused me to reflect on other situations too.  For instance, if a doubling of volume caused capacity problems such as congestion that required double-tracking buildout or additional yards, then the fixed costs could also increase.  In such a case, FC could potentially increase to a greater extent than VC, causing the FC/VC ratio to increase instead of decrease.

In a nutshell, increased volume can decrease the FC/VC ratio if the capacity is available to handle the additional volume, but could increase the FC/VC ratio in certain other cases.

As someone else said, it is always possible to build scenarios where the "general" case falls apart.  IMO, it doesn't mean that such scenarios should not be investigated.  In some cases, the special cases may help identify a broader range of dynamics for establishing the general case.

When all is said and done, I can understand why the FC/VC ratio tends to stay fairly steady for a large (Class 1) railroad. 

[arbfbe]

Mr. Fever,

Say the shipper is moving ten cars per day of product.  Now he increases that to twenty cars per day.  He has indeed doubled the quantity shipped but since neither amout is enough to require a dedicated move the variable costs have not doubled.  Crew costs will remain the same so long as all twenty cars move in the same train, fuel costs will rise incrementally and there may be some additional wear and tear on the infrastructure.  Most additional variable costs will be barely measurable.

Now if the increase is from 100 cars per day to 200 cars per day then variable costs will be very nearly doubled.  Twice as many crews, twice as many locomotives (probably anyway, unless the power from the first train is doubled back with the mtys to make the second trip), twice as much fuel, twice as much dispatching time and so on and so on.  

   

[MichaelSol]

  I would think that if a shipper doubles the amount of material shipped from one location to another, then the only cost that has changed is the VC.  In fact, the VC would have almost doubled, no? 

This is only a technical point; I think it is clear what you mean.

"Variable Cost" is conventionally defined as the cost per unit. That variable cost exists on a curve that is variable with reference to production run and economic unit size. You could, perhaps, have a "Total Variable Cost" but it would instantly change with the addition or loss of one unit of production.

The Cost Equation uses VC as the single unit cost; TC=FC+VC(x). 

[MichaelSol]

No, you can properly and accurately "assign" fixed cost to a line segment such as a branch line.  ...

It's fairly simple to identify such line specific fixed cost.  

greyhounds:

10-15-2006, "STB to Hold Hearings on Grain Shipments":

"What Mr. Sol continualy fails to understand is that you can not allocate fixed cost."

What I said a few post back was that while you can not allocate fixed cost to business moving over a line, you can identify fixed cost that will cease to exist if the line is abandoned.  The cost must be covered by the traffic on the line, but can not be allocated amongst the business on the line.

There is no contradiction between my two statements.

Well, there is. One explicitly contradicts the other. Line allocation is, in fact, "an allocation" of the type you rejected when the argument was convenient to do so on another occasion.

Operating costs are generated by traffic. Not by "a line."  Fixed costs are a version of operating cost. Administrative overhead in Chicago is paid for by all traffic, and will not likely increase or decrease one iota as the result of a line abandonment.

Fixed costs are borne by the company -- that is, the total of traffic or service.

Now, abandonment costs. Is that an operating consideration? No. In explicitly the same fashion that investment decision analysis through internal rate of return methodology requires "allocation,"  neither abandonment nor investment are operating cost considerations.

You can't allocate anything that is not an operating cost to operating costs, and we in fact are talking about operations, not investment or abandonment. Those are capital or extraordinary charges and not even remotely classified as operating costs, notwithstanding an investment, regulatory or SEC reporting requirement to identify the charge or the write-down as the case may be.

For general operating considerations, fully distributed cost allocation goes to the traffic or market share, not the building (line) housing the operation or a portion of it. 

See: 

"Profitability Analysis by Market Segments", Leland L. Beik; Stephen L. Buzby, Journal of Marketing,  37:3, Jul., 1973.

"The Problem of Fixed Charges", Donald L. Raun, The Accounting Review, 26:3, July, 1951, January, 1961.

"Overhead Costs and Income Measurement", William Ferrara, The Accounting Review, 36:1.

"Separation of Fixed and Variable Costs", Julius Wiener, The Accounting Review, 35:4, October, 1960.

"Bases for Allocating Distribution Costs", Robert H.  Watson, Journal of Marketing, 16:1, July, 1951.

"Profit Maximizing Cost Allocation Using Cost-based Pricing", Teresa Pavia, Management Science, 41:6, June, 1995.

"Cost Allocation in Transportation Systems", Robert C.  Anderson, Armin Claus, Southern Economic Journal, 43:1, July, 1976;

 

 

[Datafever]

I have one of those stuck-on-stupid types of questions.

Could someone explain to me how studies (including the GAO report) determine R/VC for a particular shipper?  I would think that it can't be completely straightforward, or the rate relief process through the STB would not take 3+ years.

[greyhounds]

No, you can properly and accurately "assign" fixed cost to a line segment such as a branch line.  ...

It's fairly simple to identify such line specific fixed cost.  

greyhounds:

10-15-2006, "STB to Hold Hearings on Grain Shipments":

"What Mr. Sol continualy fails to understand is that you can not allocate fixed cost."

 

What I said a few post back was that while you can not allocate fixed cost to business moving over a line, you can identify fixed cost that will cease to exist if the line is abandoned.  The cost must be covered by the traffic on the line, but can not be allocated amongst the business on the line.

There is no contradiction between my two statements.

[MichaelSol]

No, you can properly and accurately "assign" fixed cost to a line segment such as a branch line.  ...

It's fairly simple to identify such line specific fixed cost.  

greyhounds:

10-15-2006, "STB to Hold Hearings on Grain Shipments":

"What Mr. Sol continualy fails to understand is that you can not allocate fixed cost."

 

[Datafever]

Well, the fixed costs don't vary all over the place, per se, but the variable costs certainly can.  I would think that if a shipper doubles the amount of material shipped from one location to another, then the only cost that has changed is the VC.  In fact, the VC would have almost doubled, no? 

Well, you're right.  The variable cost would go up - I don't know about doubling.

But what we were talking about with the 35% figure was the percentage of cost that were fixed. 

If the variable cost go up (double?) and the fixed cost remain constant (which they must do or they are not "fixed" cost) then the percentage of fixed cost as a component of total cost must go down.  Which will cause the 35% figure to change.

Fixed cost expressed as a percentage of total cost vary (don't get confused) with volume.  So the 35% figure will, in fact, "vary all over the place" with volume on a particular line segment.  This figure is a percentage of total cost.  If the percentage of cost that are variable goes up, the percentage of cost that are fixed must go down.

Exactly - that's the point that I was trying to make.  In your original post, you didn't claim that the fixed costs would vary, only that the 35% FC to VC would vary.  If VC doubles, then the FC/VC ratio would halve. 

[greyhounds]

Well, the fixed costs don't vary all over the place, per se, but the variable costs certainly can.  I would think that if a shipper doubles the amount of material shipped from one location to another, then the only cost that has changed is the VC.  In fact, the VC would have almost doubled, no? 

Well, you're right.  The variable cost would go up - I don't know about doubling.

But what we were talking about with the 35% figure was the percentage of cost that were fixed. 

If the variable cost go up (double?) and the fixed cost remain constant (which they must do or they are not "fixed" cost) then the percentage of fixed cost as a component of total cost must go down.  Which will cause the 35% figure to change.

Fixed cost expressed as a percentage of total cost vary (don't get confused) with volume.  So the 35% figure will, in fact, "vary all over the place" with volume on a particular line segment.  This figure is a percentage of total cost.  If the percentage of cost that are variable goes up, the percentage of cost that are fixed must go down.

Or, as I once learned in an accounting class; "Variable cost are fixed and fixed cost are variable."  That means that variable cost remain constant per unit of production while fixed cost expressed per unit of productiion fluctuate (vary all over the place) with volume. 

[Datafever]

The 35% figure will vary all over the place.

How much?

 

  In general. A high volume line will have a lower fixed to variable ratio than a low volume line.

 

"Overhead [fixed] costs  ... are typically incurred in the production of all of the services provided by a firm." Ronald Braeutigam, "An Analysis of Fully Distributed Cost Pricing in Regulated Industries,"  The Bell Journal of Economics, 11:1, Spring, 1980, pp. 182-196, 184. 

Fixed costs are company costs, not line costs. 

By definition, they can't "vary all over the place."

 

Well, the fixed costs don't vary all over the place, per se, but the variable costs certainly can.  I would think that if a shipper doubles the amount of material shipped from one location to another, then the only cost that has changed is the VC.  In fact, the VC would have almost doubled, no? 

[greyhounds]

The real problem is allocating the revenue to a specific line segment.  How much revenue from a through move that starts on a branch and ends on a main line do you allocate to the branch?  There's no good answer to that one. 

In the 1970s at the C&NW we just went with the ICC regs.  They told us to allocate 50% of our division of the revenue to the branchline under study. If an off branch movement cost $1,000 and we got 25% of the revenue we would take 50% of our $250 and apply that $125 to the revenue account on the branch.

We went with the ICC formula to avoid hours of pointless testimony about how to allocate the revenue and the costs.  If someone objected to the formula we just said we were only following the ICC's rules.

We did the same at the ICG.  There was no choice.  It was obvious that the 50% figure was pulled out of the air, but that was the ICC regulation and the ICC had to approve the abandonment.

The regulators had all kinds of detailed rules for an abandonment.  Then they pulled this 50% figure out of the air.   I thought it was unreal.  It was very real.  That's the best they could come up with.

 I remember one of the rules was that we had to notify the top 10 customers on a line that we were going to abandon the line.   But many of the lines didn't have 10 customers.   So I went and ask a lawyer what to do in that situatiion.  I never did get an answer. 

[bobwilcox]

The real problem is allocating the revenue to a specific line segment.  How much revenue from a through move that starts on a branch and ends on a main line do you allocate to the branch?  There's no good answer to that one. 

In the 1970s at the C&NW we just went with the ICC regs.  They told us to allocate 50% of our division of the revenue to the branchline under study. If an off branch movement cost $1,000 and we got 25% of the revenue we would take 50% of our $250 and apply that $125 to the revenue account on the branch.

We went with the ICC formula to avoid hours of pointless testimony about how to allocate the revenue and the costs.  If someone objected to the formula we just said we were only following the ICC's rules.

[greyhounds]

The 35% figure will vary all over the place.

How much?

 

  In general. A high volume line will have a lower fixed to variable ratio than a low volume line.

 

"Overhead [fixed] costs  ... are typically incurred in the production of all of the services provided by a firm." Ronald Braeutigam, "An Analysis of Fully Distributed Cost Pricing in Regulated Industries,"  The Bell Journal of Economics, 11:1, Spring, 1980, pp. 182-196, 184. 

Fixed costs are company costs, not line costs. 

By definition, they can't "vary all over the place."

No, you can properly and accurately "assign" fixed cost to a line segment such as a branch line.  You can't allocate those cost to various traffic segments moving over the line, but they can be line specific.

There certainly are cost elements for any line that are 'fixed' in that they do not vary with the amount of traffic moved on the line.  Examples are taxes and ownership cost on the property.  Since these don't change with traffic volume they are 'fixed' and can not be allocated to any particular business on the line.  If the business goes away, they don't change.

However, if the rail line goes away, so do those expenses.  It's fairly simple to identify such line specific fixed cost.   A goal of accounting is to match revenues with expenses.  Sometimes you can do it well, sometimes there is no match to be found.  But the line specific fixed charges can be matched to the line and they're a big consideration in branch line abandonments.

The real problem is allocating the revenue to a specific line segment.  How much revenue from a through move that starts on a branch and ends on a main line do you allocate to the branch?  There's no good answer to that one. 

There are common corporate expenses, such as heating the HQ building, that can not be assigned to any particular piece of the business.  But big elements of fixed expense on a particular line can be properly assigned to the line - but not allocated amongst the traffic on the line.

 

 

[MichaelSol]

Almost all coal moves under contract.  Coal accounts for nearly 50 percent of tonnage but only 23 percent of revenue for Class I railroads.  Of the remaining traffic by tonnage, this means 40% moves under contract and 60% moves by tariff. Of the 40% that moves under contract, any bets as to who gets the genuine competitive advantage -- competitive or non-competitive shippers? Who has the bargaining power?

If what you are saying is correct (regarding coal tonnages and revenue), then the other 20% of contract tonnage accounts for 48% of Class 1 revenues.  That doesn't sound like much of a price break to me.

Well, Hunt, UPS -- there are some contracts out there that are not of the coal variety. 

The difference is between when the contracts were made, and now. Bob's post goes to this situation.

Railroads were trying to lock shippers into contracts to avoid the free fall in rates that was occuring. Mainly, it locked railroads into ultimately non-compensatory prices. Those contracts have been expiring and are expiring. 

The rationale behind the contracts was railroad driven -- a miscalculation ultimately on their part, but not really useful in this discussion as it obscures, and does not illuminate, the captive shipper/competitive shipper problem.

Depends also on the "when" of the contract. Current coal contracts renegotiated this year are at two to three times the former price. My coal revenue/tonnage numbers were from 2002 or 2001.  Captive  shippers who need contracts -- coal is one -- are currently renegotiating in a substantially different environment than 15-20 years ago.

Railroads contract to avoid price drops. Shippers contract to avoid price increases. Depending on which way the price actually goes defines who gets the benefit. Contracts are a "hedge", and do not necessarily reflect markets.

 

 

 

[Datafever]

Michael - I thought grain shippers had to use tariffs but this article talks about a contract.  Will the terms of this contract be made public?

I would expect the ratio of contract to tariff movements is shifting to tariffs.  Twenty years ago a lot of small movements were put in contracts for a variety of reasons. One year at the SP we had a contest where the salesmen who negotiated the most contracts got a very nice one week vacation in Maui for they and their significant other.  Many times a 100 car package got split into four 25 car contracts. Oh well, it was a great week at the Hyatt.

There has been a push on the get these small moves out of contracts and into tariffs to reduce the back office burden.

Speaking of which, shippers are lamenting the move from contracts to published rates, based on the argument that published rates reduce competitiveness. 

[bobwilcox]

Michael - I thought grain shippers had to use tariffs but this article talks about a contract.  Will the terms of this contract be made public?

I would expect the ratio of contract to tariff movements is shifting to tariffs.  Twenty years ago a lot of small movements were put in contracts for a variety of reasons. One year at the SP we had a contest where the salesmen who negotiated the most contracts got a very nice one week vacation in Maui for they and their significant other.  Many times a 100 car package got split into four 25 car contracts. Oh well, it was a great week at the Hyatt.

There has been a push on the get these small moves out of contracts and into tariffs to reduce the back office burden.

[Datafever]

Almost all coal moves under contract.  Coal accounts for nearly 50 percent of tonnage but only 23 percent of revenue for Class I railroads.  Of the remaining traffic by tonnage, this means 40% moves under contract and 60% moves by tariff. Of the 40% that moves under contract, any bets as to who gets the genuine competitive advantage -- competitive or non-competitive shippers? Who has the bargaining power?

If what you are saying is correct (regarding coal tonnages and revenue), then the other 20% of contract tonnage accounts for 48% of Class 1 revenues.  That doesn't sound like much of a price break to me.

[MichaelSol]

Almost all coal moves under contract.  Coal accounts for nearly 50 percent of tonnage but only 23 percent of revenue for Class I railroads.  Of the remaining traffic by tonnage, this means 40% moves under contract and 60% moves by tariff. Of the 40% that moves under contract, any bets as to who gets the genuine competitive advantage -- competitive or non-competitive shippers? Who has the bargaining power?

Here's a good example --  an announcement Monday. This involves a contract. It also involves a particular kind of shipper in otherwise captive territory.

Columbia Grain, BNSF Agree on Montana Shuttle Train Facility

GREAT FALLS, Montana, and FORT WORTH, Texas, December 4, 2006:

Columbia Grain, Inc. (CGI) and BNSF Railway Company (BNSF) announced today that they have agreed to terms and conditions under which Columbia will expand its facility at Carter, Mont., to accommodate 110-car shuttle grain trains. The upgrade to the facility, which currently loads 52-car trains, is expected to be completed during the third quarter of 2007.

The agreement follows BNSF’s announcement in 2004 that it would maintain its Great Falls-Fort Benton line, on which the Carter facility is located, to allow for the operation of 110-car shuttle trains.

“We are pleased to have reached this agreement with Columbia Grain,” says Kevin Kaufman, BNSF’s group vice president, Agricultural Products. “This facility will provide the benefits of shuttle train service to even more Montana farmers, and it reinforces our commitment to the Fort Benton line.”

“Columbia Grain looks forward to the opportunity to better serve Chouteau County producers with efficient and competitive shuttle service,” said Tom Hammond, chief executive officer of Columbia Grain.

Columbia has other shuttle loading facilities in Montana at Harlem, Kasa Point and Rudyard. Addition of the Carter facility will bring the number of BNSF-served shuttle loading facilities in the state to 13.

Columbia Grain is a leading world grain exporter located in Portland, Ore. It supplies superior quality western grain to service both U.S. domestic markets and export markets worldwide. Columbia’s supply lines include the western region of the United States, well known for its high quality wheat, feed grains and pulses. With extensive origination facilities, Columbia is able to supply reliable and quality products to meet its customers’ needs.

 

[Datafever]

I may be confused myself. Not sure I understand the 140% reference.

I apologize.  The 140% value was not directed to you.  It was just a thought I had while I was typing my response to your post.  If you look back through the thread, you will notice where the 140% - 180% range comes from, which is why you needed to post your first response to unconfuse me. 

[Datafever]

Mr. Sol, for the data that you have posted (including the study that you participated in), does the data include confidential contracts?

I think the question answers itself. 

Sounds like a BobWilcox question. However, we did ask elevator operators the question and got some answers. There was little incentive for railroads to offer captive shippers significant concessions, whereas the railroads appeared to have plenty of incentive to offer concessions to competitve shippers.

You might ask what the bargaining leverage of a captive shipper is?

Contracts did appear to exist for companies like Cargill -- favoring large corporate agriculture over the co-ops and independent -- and using the locations where they had compettive alternatives as the source of their bargaining power for their captive facilities. Not "really" captive shippers in those cases because they did have a source of market power.

The largest captive coop shuttle elevator we spoke to said the railroad wasn't interested. There was a logic in our conclusion that confidential contracts  were consistent with our findings and represented nothing that would skew the findings.

I'm sorry - I don't think that I meant the question the way you took it.  No, the question really doesn't answer itself as there is some information known about confidential contracts.  What I don't know is how much information is available. 

For instance, the GAO report says that 70% of all traffic (tonnage) moved under contract.  If it is known how much tonnage (and revenue - 71%) moves under contract, then it seems reasonable to me that other information might be known also, even if only in a summarized form.

On the other hand, if (as you seem to imply) the rates being charged under confidential contracts are not being taken into account when these studies are done, then a HUGE piece of the picture is missing as far as I'm concerned.

Also, I get the impression from what you have said that confidential contracts are mostly used with "competitive" shippers.  Yes?

[MichaelSol]

Mr. Sol, for the data that you have posted (including the study that you participated in), does the data include confidential contracts?

I think the question answers itself by the use of the word "confidential". 

Sounds like a BobWilcox question. However, we did ask elevator operators the question and got some answers. There was little incentive for railroads to offer captive shippers significant concessions, whereas the railroads appeared to have plenty of incentive to offer concessions to competitve shippers.

You might ask what the bargaining leverage of a captive shipper is?

Contracts did appear to exist for companies like Cargill -- favoring large corporate agriculture over the co-ops and independents -- and using the locations where they had competitive alternatives as the source of their bargaining power for their captive facilities. Not "really" captive shippers in those cases because they did have a source of market power.

The largest captive coop shuttle elevator we spoke to said the railroad wasn't interested. There was a logic in our conclusion that confidential contracts  were consistent with our findings and represented nothing that would skew the findings except perhaps further in favor of competitive shippers -- since they alone had bargaining power.

 

[MichaelSol]

Okay, I'm confused already.

But another flaw that I've just noticed is the use of the 140% number.  To claim that a shipper that pays 145% or even 150% R/VC is captive just doesn't wash at all.  Or at least, such shipper is not being charged "captive rates".  After all, the railroad does have to earn a profit. 

I may be confused myself. Not sure I understand the 140% reference. Congress intended to deregulate rates charged below 180%. The message was to the railroads, for so long as you charge below that R/VC threshold, charge away. The threshold is based on the studies at the time which showed that, industry typical fixed and variable costs, the following net profits would be produced. 

 R/VC %    Profit

135    0.00%
140    3.70%
145    7.41%
155    14.81%
160    18.52%
165    22.22%
170    25.93%
175    29.63%
180    33.33%

Above the 180% R/VC threshold, cross-subsidization beyond anything the market was likely to tolerate became unacceptable -- or at least regulated -- because Congress was aware it was permitting a class of shippers to exist who would not be able to access competitive markets for this service. In order to permit railroads to continue to be exempt from direct anti-trust regulation, protection of these shippers was a necessary part of the law.  

 

[Datafever]

Mr. Sol, for the data that you have posted (including the study that you participated in), does the data include confidential contracts?

[Datafever]

Careful. It is easy to confuse numbers with dollars here. Thirty one % of Class I revenue is obtained from captive shippers [economist's version] or potentially captive shippers [Staggers Act version], that is, rates moving at over 180% R/VC.

The average rate charged to the average competitive shipper might well be 106%, and that might represent rates charged to 50% of the shippers.  But, 5% of the shippers might represent 50% of the railroad revenue and their overall rate average might well be within the 140%-180% range. 

And that's probably not far off.

 

Okay, I'm confused already.

Futuremodal's original comment (and my reply) was in respect to the GAO report which was actually basing its percentages on revenue.  So even though futuremodal (and myself) used the word "Shipper" my thought was total revenues generated by those shippers.  But then I seem to have switched gears and applied that same concept to the study that you posted numbers for, which seems to have been an incorrect thing for me to do.

But if I understand you correctly, while the number of shippers charged rates in the 140% to 180% category are small, the revenues that they generate could be quite large.

But another flaw that I've just noticed is the use of the 140% number.  To claim that a shipper that pays 145% or even 150% R/VC is captive just doesn't wash at all.  Or at least, such shipper is not being charged "captive rates".  After all, the railroad does have to earn a profit. 

[MichaelSol]

To clarify, the number of captive shippers based on the >180% standard is around 30%.

The number of captive shippers based on the >300% standard is 6%.

Then the number of captive shippers based on a 140% standard can be guesstimated at about 45%(?), while the number of captive shippers based on having one physical connection to a Class I is about 55%(?).

I don't know that it would be accurate to guesstimate "captive" shippers using a 140% standard at 45%.  If the figures that Mr. Sol posted have any validity at all, then the number of shippers who pay from 140% to 180% R/VC would have to be very small.  Small enough that there are probably less than 5% of shippers that fit into the 140 - 180% category. 

Then using a 140% standard should get you no more than 35%.

Careful. It is easy to confuse numbers with dollars here. Thirty one % of Class I revenue is obtained from captive shippers [economist's version] or potentially captive shippers [Staggers Act version], that is, rates moving at over 180% R/VC.

The average rate charged to the average competitive shipper might well be 106%, and that might represent rates charged to 50% of the shippers.  But, 5% of the shippers might represent 50% of the railroad revenue and their overall rate average might well be within the 140%-180% range. 

And that's probably not far off.

 

  

[Datafever]

To clarify, the number of captive shippers based on the >180% standard is around 30%.

The number of captive shippers based on the >300% standard is 6%.

Then the number of captive shippers based on a 140% standard can be guesstimated at about 45%(?), while the number of captive shippers based on having one physical connection to a Class I is about 55%(?).

I don't know that it would be accurate to guesstimate "captive" shippers using a 140% standard at 45%.  If the figures that Mr. Sol posted have any validity at all, then the number of shippers who pay from 140% to 180% R/VC would have to be very small.  Small enough that there are probably less than 5% of shippers that fit into the 140 - 180% category. 

Then using a 140% standard should get you no more than 35%.

[MichaelSol]

The 35% figure will vary all over the place.

How much?

 

  In general. A high volume line will have a lower fixed to variable ratio than a low volume line.

 

"Overhead [fixed] costs  ... are typically incurred in the production of all of the services provided by a firm." Ronald Braeutigam, "An Analysis of Fully Distributed Cost Pricing in Regulated Industries,"  The Bell Journal of Economics, 11:1, Spring, 1980, pp. 182-196, 184. 

Fixed costs are company costs, not line costs. 

By definition, they can't "vary all over the place."

 

 

[Datafever]

 

And margins aren't profitablity.  A railroad can make more money on freight priced at 110% of variable than it does on freight priced at 200% of variable.  It depends on volume.

Wrong.  Dead wrong.  No railroad can make money at 110% R/VC if the VC + FC ratios are around 140% of R.  Therefore, if a railroad is charging one customer 110% R/VC, they have to make it up on the 200% customer or they will go under.  Volume means nothing if you aren't covering TC.

As I read greyhounds post, I noticed that he used the words "can make money".  In my mind, he did not imply that this was a common thing, or even that it was actually the case in the way that today's railroads are run.  He seemed to only be pointing out the possibility of profitability below some magical number.

An example that I could think of would be a hypothetical industry that ships more than a dozen unit trains a day along a relatively short piece of track.  The fixed costs would be quite small compared to the variable costs and such railroad could very well be covering TC with 110% R/VC. 

[oltmannd]

 

And margins aren't profitablity.  A railroad can make more money on freight priced at 110% of variable than it does on freight priced at 200% of variable.  It depends on volume.

Wrong.  Dead wrong.  No railroad can make money at 110% R/VC if the VC + FC ratios are around 140% of R.  Therefore, if a railroad is charging one customer 110% R/VC, they have to make it up on the 200% customer or they will go under.  Volume means nothing if you aren't covering TC.

Sure it could - run it like Nike.   Transform all your fixed costs into variable costs.  Sell every possible asset and lease back on day by day operating lease.  Outsource all G&A functions on a week by week or job by job basis.  Hire train operators as contractors.  The only assets they'd have would be the land under the track and the only fixed costs would be a skeleton staff.  Trim the network to maximize traffic density.

The whole notion that dividing up costs into fixed and variable categories has some sort of deep and cosmic source and meaning is ridiculous.  Costs are costs.  Dividing them into these various categories is for the convenience and enterainment of accountants and lawyers....and sometimes the marketing department.  And then of course, these forums!

[TomDiehl]

And most importantly of all, all captive shippers are domestic.

So you're saying that every other country in the world has at least two rail lines serving each shipper?

I guess those potash mines in SK served only by the CP are not captive. Then again there is the entire country of China.   

 

I didn't realize that China had more than one railroad serving each industry.

[MichaelSol]

And most importantly of all, all captive shippers are domestic.

So you're saying that every other country in the world has at least two rail lines serving each shipper?

I guess those potash mines in SK served only by the CP are not captive. Then again there is the entire country of China.   

When someone in the United States [or any nation of origin] refers to "domestic" vs. "foreign" it is a convention that he or she is referring to the nation from or about which he speaks as "domestic" for freight or services originating in that country, and "foreign" otherwise. The comment was clear on that, as was the context.

 

[Anonymous]

Santa Fe started offering express air shipping in the 50s using, I think, leftover C47 aircraft from the war.  The federal govt shut that down almost overnight because it made it more difficult for the budding airlines to survive.  Of course, most never survived anyway.

[bobwilcox]

And most importantly of all, all captive shippers are domestic.

So you're saying that every other country in the world has at least two rail lines serving each shipper?

I guess those potash mines in SK served only by the CP are not captive. Then again there is the entire country of China.   

[TomDiehl]

And most importantly of all, all captive shippers are domestic.

So you're saying that every other country in the world has at least two rail lines serving each shipper?

[Anonymous]

 

And margins aren't profitablity.  A railroad can make more money on freight priced at 110% of variable than it does on freight priced at 200% of variable.  It depends on volume.

Wrong.  Dead wrong.  No railroad can make money at 110% R/VC if the VC + FC ratios are around 140% of R.  Therefore, if a railroad is charging one customer 110% R/VC, they have to make it up on the 200% customer or they will go under.  Volume means nothing if you aren't covering TC.

[Anonymous]

That's probably the most reasonable approach, far more reasonable than the GAO's extreme example of defining only rates above 300% R/VC as being captive.  It should be disappointing to any American that the normally credible GAO would use such an extreme and irrational methodology for determining captive rail customers.

Here's some articles in Railway Age that touch on the subject of the looming spector of harsher regulations to come:

http://www.railwayage.com/B/xfromtheeditor.html

http://www.railwayage.com/B/feature1.html

No wonder the GAO's (and Ken's) ascersion that "only 6% of rail customers are captive" seemed more fishy than usual.......

Whoa, whoa, whoa!!!  The GAO does not define captivity as > 300% R/VC.  It uses the 180% value for its basis of potentially captive shippers.   The GAO also recognizes the 180% value as the threshold for statutory relief.

Here's the values from the October 2006 report:

Since 1985, and as a percentage of all traffic, the amount of potentially captive traffic traveling at rates over 180 percent R/VC and the revenue generated from that traffic have both declined. Revenue generated from traffic traveling at rates over 180 percent R/VC decreased from 41 percent of all industry revenue in 1985 to 29 percent in 2004.

However, since 1985, tonnage from traffic traveling at rates substantially over the threshold for rate relief has increased. Total industry tonnage has increased significantly (from 1.37 billion tons in 1985 to 2.14 billion tons in 2004), with the tonnage traveling at rates above 300 percent R/VC more than doubling—from about 53 million tons in 1985 to over 130 million tons in 2004.

As a percentage of all industry traffic, traffic traveling at rates between 180 and 300 percent R/VC decreased from 36 percent in 1985 to 25 percent in 2004. In contrast, the percentage of all industry traffic traveling at rates above 300 percent R/VC increased from 4 percent in 1985 to 6 percent in 2004.

 I hope that clarifies the GAO position.

What I'm getting at is Ken's claim a while back that the GAO has measured the percentage of captive customers at only 6%.  Obviously, he left out a few details!

To clarify, the number of captive shippers based on the >180% standard is around 30%.

The number of captive shippers based on the >300% standard is 6%.

Then the number of captive shippers based on a 140% standard can be guesstimated at about 45%(?), while the number of captive shippers based on having one physical connection to a Class I is about 55%(?).

And most importantly of all, all captive shippers are domestic.

[Datafever]

Based on that, I would then have to agree that any shipper that pays less than approximately 135% R/VC is potentially being cross-subsidized.  (The 135% number based on Mr. Sol's value that fixed costs are approximately 35% of variable costs). 

The 35% figure will vary all over the place.  In general. A high volume line will have a lower fixed to variable ratio than a low volume line.

And margins aren't profitablity.  A railroad can make more money on freight priced at 110% of variable than it does on freight priced at 200% of variable.  It depends on volume.

Agreed.  Thanks for pointing that out. 

[greyhounds]

Based on that, I would then have to agree that any shipper that pays less than approximately 135% R/VC is potentially being cross-subsidized.  (The 135% number based on Mr. Sol's value that fixed costs are approximately 35% of variable costs). 

The 35% figure will vary all over the place.  In general. A high volume line will have a lower fixed to variable ratio than a low volume line.

And margins aren't profitablity.  A railroad can make more money on freight priced at 110% of variable than it does on freight priced at 200% of variable.  It depends on volume.

 

[Datafever]

That's probably the most reasonable approach, far more reasonable than the GAO's extreme example of defining only rates above 300% R/VC as being captive.  It should be disappointing to any American that the normally credible GAO would use such an extreme and irrational methodology for determining captive rail customers.

Here's some articles in Railway Age that touch on the subject of the looming spector of harsher regulations to come:

http://www.railwayage.com/B/xfromtheeditor.html

http://www.railwayage.com/B/feature1.html

No wonder the GAO's (and Ken's) ascersion that "only 6% of rail customers are captive" seemed more fishy than usual.......

Whoa, whoa, whoa!!!  The GAO does not define captivity as > 300% R/VC.  It uses the 180% value for its basis of potentially captive shippers.   The GAO also recognizes the 180% value as the threshold for statutory relief.

Here's the values from the October 2006 report:

Since 1985, and as a percentage of all traffic, the amount of potentially captive traffic traveling at rates over 180 percent R/VC and the revenue generated from that traffic have both declined. Revenue generated from traffic traveling at rates over 180 percent R/VC decreased from 41 percent of all industry revenue in 1985 to 29 percent in 2004.

However, since 1985, tonnage from traffic traveling at rates substantially over the threshold for rate relief has increased. Total industry tonnage has increased significantly (from 1.37 billion tons in 1985 to 2.14 billion tons in 2004), with the tonnage traveling at rates above 300 percent R/VC more than doubling—from about 53 million tons in 1985 to over 130 million tons in 2004.

As a percentage of all industry traffic, traffic traveling at rates between 180 and 300 percent R/VC decreased from 36 percent in 1985 to 25 percent in 2004. In contrast, the percentage of all industry traffic traveling at rates above 300 percent R/VC increased from 4 percent in 1985 to 6 percent in 2004.

 I hope that clarifies the GAO position.

[Anonymous]

Okay, I've gone off and done my homework.  After much reading (particularly in the areas of electric utilities and telecommunications), I have come to the conclusion that my orginal concept of cross-subsidization is only a part of the picture.

It seems to be commonly accepted that urban utility customers cross-subsidize rural utility customers.  For instance, the maintenance cost per mile of rural lines is higher than the cost per mile of urban lines.  In addition, there are significantly fewer customers per mile of rural line than there are in urban areas.  So even though rural customers *may* pay a higher rate than urban customers, it is commonly accepted that their rates would be significantly higher if they had to pay full cost.  What this means is that (a large number of) urban customers pay a slightly higher rate so that (a small number of) rural customers can end up with a significantly reduced rate. 

Similarly in manufacturing - if a product is not being sold at a price high enough to not only cover the cost of manufacturing the product, but also the full cost of research, development and marketing of the product, then that product is considered to be cross-subsidized.

 What is not considered to be cross-subsidization is differing profit rates.  If one product produces a profit margin of 20% while another product only produces a profit margin of 2%, no cross-subsidization is considered to have taken place.

Based on that, I would then have to agree that any shipper that pays less than approximately 135% R/VC is potentially being cross-subsidized.  (The 135% number based on Mr. Sol's value that fixed costs are approximately 35% of variable costs). 

That's probably the most reasonable approach, far more reasonable than the GAO's extreme example of defining only rates above 300% R/VC as being captive.  It should be disappointing to any American that the normally credible GAO would use such an extreme and irrational methodology for determining captive rail customers.

Here's some articles in Railway Age that touch on the subject of the looming spector of harsher regulations to come:

http://www.railwayage.com/B/xfromtheeditor.html

http://www.railwayage.com/B/feature1.html

No wonder the GAO's (and Ken's) ascersion that "only 6% of rail customers are captive" seemed more fishy than usual.......

[Datafever]

Hey, I am not disagreeing with you.

Thanks for your support, selector.  And I invite you (and anyone else) to participate.  I would think that you have an interest, or you probably wouldn't even read threads like this. 

[selector]

They grow thick and fast in these "fertile" discussions.  Get used to them.

Personally, I don't see any reason to get used to them.  There really is no place for character assassination on this forum (or anyplace else, for that matter).  Among other things, there are minors that read this forum.  Wouldn't it be great if we could teach them that it is possible to have disagreements that foster reasonable discussions?

I am participating in these discussions in order to learn.  I am finding that what I thought I *knew* isn't always what really IS.

Hey, I am not disagreeing with you.  I have attempted to point these fallacies out myself, but find that I am peeing into a windstorm.  Do what you can, and what you feel you must; just don't look for any meaningful results.

My opinion based on my experience here. 

I sincerely hope you do better.

[jclass]

Lots of times in accounting, you have to make a gut decision about applying a cost.  The decision is arbitrary or at best based on estimates.  The decision isn't made for instance out of an axe to grind.  It's arbitrary. 

[TimChgo9]

They grow thick and fast in these "fertile" discussions.  Get used to them.

I am participating in these discussions in order to learn.  I am finding that what I thought I *knew* isn't always what really IS.

I'm with DF on this one.  I get tired of the shots certain people take at others. I for one am trying to learn also, and the insults and bad blood take away from the arguments both sides are trying to make.  I think we can do without the insults.....

[Datafever]

They grow thick and fast in these "fertile" discussions.  Get used to them.

Personally, I don't see any reason to get used to them.  There really is no place for character assassination on this forum (or anyplace else, for that matter).  Among other things, there are minors that read this forum.  Wouldn't it be great if we could teach them that it is possible to have disagreements that foster reasonable discussions?

I am participating in these discussions in order to learn.  I am finding that what I thought I *knew* isn't always what really IS.

[selector]

And he don't say.  Ask yourselves, are Sol's actions those of an honest man? 

There really is no call to use personal attacks here.  In fact, he stated quite clearly what he *presumed* the study to use as a criteria for captive/non-captive.  It wasn't his study so he went with what the study most likely used as a criteria.

 Now ask yourself this question -  What sort of person resorts to ad hominem attacks?

They grow thick and fast in these "fertile" discussions.  Get used to them.

[MichaelSol]

Similarly in manufacturing - if a product is not being sold at a price high enough to not only cover the cost of manufacturing the product, but also the full cost of research, development and marketing of the product, then that product is considered to be cross-subsidized.

 What is not considered to be cross-subsidization is differing profit rates.  If one product produces a profit margin of 20% while another product only produces a profit margin of 2%, no cross-subsidization is considered to have taken place.

Based on that, I would then have to agree that any shipper that pays less than approximately 135% R/VC is potentially being cross-subsidized.  (The 135% number based on Mr. Sol's value that fixed costs are approximately 35% of variable costs). 

Pretty good summary. At that point, both volume and capacity become key factors. With excess capacity, anytime the company can sell the product at any percentage over the VC, the company earns revenue to cover fixed costs.

Enough volume, and the product or commodity can in fact generate a profit in excess of the total fully distributed costs (FC + VC(x)) of the service for that product or commodity. Indeed, as cross-subsidized traffic adds volume, the fixed cost allocation per unit for all traffic declines, most of the time, and other traffic becomes more profitable relative to their fully allocated costs as a result. Cross subsidization does not exist in a vacuum and has both positive and negative potential impacts on the profitability of other services as well as the company as a whole.

However, until the service in question covers its own variable and fixed costs, it is cross-subsidized. After that point it is a genuine profit center.

At close to capacity, cross-subsidized products or services suddenly develop sharp edges. The company can't just keep adding volume. The capacity constraint may prevent development or acquisition of more profitable traffic. And, this is more true for railroads than just about any other industry -- as capacity limits are approached, costs of operation -- variable costs -- begin to climb. Cross-subsidized traffic that may have been contributing to  fixed costs suddenly gets swallowed up by rising variable costs.

The rate of climb in operating costs for Class I's over the past 4 years is unprecedented in a low inflation environment. Slower trains, dead on hours, all of the indicators of capacity limits all increase operating costs. This is why the average R/VC has slid over the past six years so that more traffic now travels at rates under 180% R/VC than six years ago -- and why more traffic is now forced to travel at rates over 300% R/VC to make up for it.

Congestion increases operating costs, and that needs to be fixed.

That requires investment, and an increase in fixed costs. Hmmm, and where does that investment go?  Well, that's where cross-subsidized services always, always, represent the sharp edge. Because it is typically priced below its fully compensated cost, a cross-subsidized service represents an inherent economic subsidy from other products or services. Like any subsidized service, it attracts more business or users than a non-subsidized, or fully compensated, service. And, in an elastic market, the more it is cross-subsidized, the more business it gets. Cross-subsidization became a much more significant driver of pricing post-Staggers than it was during the regulated era -- it was the why and how of the "race to the bottom" in post-Staggers rates.

And the average manager or investor looks and sees ALL THAT BUSINESS! Let's spend some money on it and get some more.

Well, that is usually about when the pin is pulled on the hand grenade.

 

[MichaelSol]

Well, maybe it's just me, but my reading of his post is that there was only one study that he participated in, and that was one that identified levels of R/VC in "captive areas", something which could more easily be defined than "captive shippers".

That's exactly right. THAT study, which I did participate in, broke export wheat shipments down by origin and by carload category (1-25, 26-51, etc), and performed a multivariate analysis of both distance to ports and distance to the nearest  competitor railroad or barge facility from the point of origin -- the point of origin being every grain elevator on the BNSF system.

We didn't have a R/VC definition for captivity or non-captivity, so I can't tell you that we used one since the study wasn't designed that way -- it was designed to show us where captivity occured as a geographical statistic. So, I guess my answer is that Greyhounds asked the wrong question -- we didn't define it, we let the results define it.

The bound volume of the study is at the office, and I am at home, so this is just from memory, but the distances described above were requested in blocks -- less than 300 miles, 300-500 miles, 500-800 miles, 800-1200, and 1200 and up, something like that. These were distances of both transit and nearest competitor, so while it would be difficult to find an origin 800 or 1200 miles from a competitor, for example, there were plenty of transit distances in that range. The less than 300 mile distance might have been broken down further -- I don't recall as we discussed a variety of alternatives and fiddled with any number of them. I think we ran one alternative at standard 200 mile increments as well, but I don't recall the data outcomes from that.

As I recall, the R/VC rate that we established for the under 300 mile competitor distance ranged from about 86% to about 106% for traffic traveling 800 miles or more. For grain traffic located between 500 and 800 miles, traveling 800 miles or more, the rate ranged between 240% and 380% R/VC. These represented the extremes of the R/VC data generated, clearly showed where the competitive and non-competitive locations were, with a 97% correlation in the 500-800 mile range between transit distance and the R/VC factor using regression analysis. The signficance of that to us was that it indicated virtually no outside influences of any kind on the rate -- i.e. competition -- at that level. Both the high degree of correlation and the very high R/VC ratios indicated to us that the rates were truly captive rates and that the shippers were truly captive shippers.

The lowest correlation was somewhere in the 57% range, for traffic in the 300-500 mile category -- again, if I am recalling correctly. We looked at a number of explanations for why rates varied so much in that specific range and ultimately decided that highway location appeared to be a significant factor in some areas and that trucks played a significant role in rate determination in some places and not others depending on the available highway system.

 

[Datafever]

Well, maybe it's just me, but my reading of his post is that there was only one study that he participated in, and that was one that identified levels of R/VC in "captive areas", something which could more easily be defined than "captive shippers".

[greyhounds]

And he don't say.  Ask yourselves, are Sol's actions those of an honest man? 

There really is no call to use personal attacks here.  In fact, he stated quite clearly what he *presumed* the study to use as a criteria for captive/non-captive.  It wasn't his study so he went with what the study most likely used as a criteria.

 Now ask yourself this question -  What sort of person resorts to ad hominem attacks?

Nope,  Mr. Sol said he "Participated" in the study.  I ask a question and he don't answer.

 

[Datafever]

And he don't say.  Ask yourselves, are Sol's actions those of an honest man? 

There really is no call to use personal attacks here.  In fact, he stated quite clearly what he *presumed* the study to use as a criteria for captive/non-captive.  It wasn't his study so he went with what the study most likely used as a criteria.

 Now ask yourself this question -  What sort of person resorts to ad hominem attacks?

[greyhounds]

Greyhounds once strongly argued that wheat rates had gone down over the past 25 years, and offered every misreading of every study he could lay his hands on, refusing even to read the explicit texts of the studies he cited to which stated that prices had gone up.

He was vociferous, adamant, expending a great deal of time and energy, even though he has no experience at all with the wheat industry or its rate history-- at one point selecting out of seven or so commonly used inflation indexes the only one that had nothing whatsoever to do with either railroads or agriculture to try and "prove" his point. It was all heat and no light. So much for appropriate methodology.

It was interesting then to see the October 6, 2006 GAO study which showed ... wheat rates had gone up, and in fact GAO singled them out as one of the few categories of rail traffic that had in fact gone up over that time.

So, it is interesting now to see that he has a methodology for "stepping back to check the methodology used."

Judging by the wheat rate example, I gather he has always considered himself exempt from the analytical process he describes as important.

In nearly every study I have ever seen, the 180% R/VC threshold is used as the measure of captivity for study purposes. The underlying econometric studies found captivity to exist in typical market settings of around 160% R/VC, but in any case, the 180% R/VC used was a "probable" in statistical terms, even though railroads got the benefit of the doubt when the statute, a political compromise, defined it as more of a "maybe."

I have no doubt the captivity study I cited above followed the industry standard terminology.

The study was published in Rail Price Advisor, an industry periodical published by Escalation Consultants, Inc. of Gaithersburg, Maryland. It has since been widely referenced elsewhere. CURE, naturally, references it on their website and maintains it there for permanent reference.

They have a more detailed chart from an earlier study there as well.

http://www.railcure.org/pdfs/captivitychart.pdf

With thousands of pages of testimony and commentary available which in many cases references the 2003 study, I have found no industry refutation of the either the methodology or the results.

And so Mr. Sol continues to refuse to answer the question.  What criteria did he use to define a "captive" rail customer vs. a "compeitive" rail customer in his "study".

There's no reason for an honest man to duck, bob and weave- an honest man will simply answer the question.  He can quantify and qualify all he wants.  There has been no call on my part for a "Yes/No" answer.  But I did ask him directly how he classified rail customers as "captive" or "competitive".

And he don't say.  Ask yourselves, are Sol's actions those of an honest man? 

[Datafever]

Okay, I've gone off and done my homework.  After much reading (particularly in the areas of electric utilities and telecommunications), I have come to the conclusion that my orginal concept of cross-subsidization is only a part of the picture.

It seems to be commonly accepted that urban utility customers cross-subsidize rural utility customers.  For instance, the maintenance cost per mile of rural lines is higher than the cost per mile of urban lines.  In addition, there are significantly fewer customers per mile of rural line than there are in urban areas.  So even though rural customers *may* pay a higher rate than urban customers, it is commonly accepted that their rates would be significantly higher if they had to pay full cost.  What this means is that (a large number of) urban customers pay a slightly higher rate so that (a small number of) rural customers can end up with a significantly reduced rate. 

Similarly in manufacturing - if a product is not being sold at a price high enough to not only cover the cost of manufacturing the product, but also the full cost of research, development and marketing of the product, then that product is considered to be cross-subsidized.

 What is not considered to be cross-subsidization is differing profit rates.  If one product produces a profit margin of 20% while another product only produces a profit margin of 2%, no cross-subsidization is considered to have taken place.

Based on that, I would then have to agree that any shipper that pays less than approximately 135% R/VC is potentially being cross-subsidized.  (The 135% number based on Mr. Sol's value that fixed costs are approximately 35% of variable costs). 

[MichaelSol]

  As Bob pointed out, in the past the government forced cross-subsidization through their economic regulation.  But that's pretty well gone now so Mr. Sol's claim of voluntary cross-subsidization flies in the face of all reason.

To me, it is baffling when someone like Bob takes a position that is so contrary to actual business practice  -- there is a genuine reality out there on matters such as this, and it had nothing to do with regulation per se. I just simply don't understand how someone can be so unaware and yet speak to the issue claiming a credibility on it.

And, it's not like you need to be running an actual business at the moment to be aware of it. Cross subsidization is described in nearly every strategic management book I have ever seen as an important business tool -- but one with sharp edges that can profoundly hurt the user... or innocent bystanders such as captive wheat shippers.

The sharp edges are the problem. Greyhounds inadvertently offers the explicit rationale for the 180% R/VC threshold. It's the "safety equipment" on this particular management tool.  

Greyhounds is correct on one point. I am sure it was an accident. But, his idea of cross subsidization, when taken too far, does in fact "fly in the face of all reason."

Congress stated that the inquiry as to when cross subsidization does, in fact, "fly in the face of all reason" begins when the rate exceeds 180% R/VC.

Greyhounds' reasoning on the topic, that cross subsidization can be toxic is entirely true. And Congress has acted to limit such cross-subsidization. I accept the fact that Greyhounds believes the 180% R/VC threshold is entirely appropriate to limit extremes of cross-subsidization because, as he specifically states, at some point such cross subsidization is beyond all reason, and I fully agree.

Congress obviously agreed as well.

 

[MichaelSol]

By defining captivity as R/VC > 180%, then it is rather obvious that by definition the captive shippers will be paying a higher R/VC than the non-captive shippers.  In fact, the average R/VC of those shippers who pay over 180% MUST be over 180%, while the average R/VC of those shippers who pay under 180% MUST be under 180%.

In fact, you would find similar results no matter where the line was placed - 140%, 200%, whatever. 

No doubt, it would mean one thing if the average was 181% for captive shippers and the average 120% for competitive -- as opposed to 80% for competitive and 500% for captive.

It is true that in any study, the subject populations have to be defined somehow. It is also true that statistical measure of each population then describes only that population. But, that's how populations are compared.

 

[Anonymous]

By defining captivity as R/VC > 180%, then it is rather obvious that by definition the captive shippers will be paying a higher R/VC than the non-captive shippers.  In fact, the average R/VC of those shippers who pay over 180% MUST be over 180%, while the average R/VC of those shippers who pay under 180% MUST be under 180%.

In fact, you would find similar results no matter where the line was placed - 140%, 200%, whatever. 

Here's the solution:  JUST INTRODUCE INTRAMODAL COMPETITION SYSTEMWIDE!  Then we can all dispense with these subjective, manipulatable definitions of what *real* rail captivity is.

[Datafever]

By defining captivity as R/VC > 180%, then it is rather obvious that by definition the captive shippers will be paying a higher R/VC than the non-captive shippers.  In fact, the average R/VC of those shippers who pay over 180% MUST be over 180%, while the average R/VC of those shippers who pay under 180% MUST be under 180%.

In fact, you would find similar results no matter where the line was placed - 140%, 200%, whatever. 

[MichaelSol]

Well, it won't surprise many of you to read that I strongly disagree with Mr. Sol, his numbers, his "study" and his conclusion.

When someone does a "study", or analysis, like this, a final step is to ask yourself "do my results make sense?"  If they don't, there is a need to go back and check the methodology used. 

Greyhounds once strongly argued that wheat rates had gone down over the past 25 years, and offered every misreading of every study he could lay his hands on, refusing even to read the explicit texts of the studies he cited to which stated that prices had gone up.

He was vociferous, adamant, expending a great deal of time and energy, even though he has no experience at all with the wheat industry or its rate history-- at one point selecting out of seven or so commonly used inflation indexes the only one that had nothing whatsoever to do with either railroads or agriculture to try and "prove" his point. It was all heat and no light. So much for appropriate methodology.

It was interesting then to see the October 6, 2006 GAO study which showed ... wheat rates had gone up, and in fact GAO singled them out as one of the few categories of rail traffic that had in fact gone up over that time.

So, it is interesting now to see that he has a methodology for "stepping back to check the methodology used."

Judging by the wheat rate example, I gather he has always considered himself exempt from the analytical process he describes as important.

In nearly every study I have ever seen, the 180% R/VC threshold is used as the measure of captivity for study purposes. The underlying econometric studies found captivity to exist in typical market settings of around 160% R/VC, but in any case, the 180% R/VC used was a "probable" in statistical terms, even though railroads got the benefit of the doubt when the statute, a political compromise, defined it as more of a "maybe."

I have no doubt the captivity study I cited above followed the industry standard terminology.

The study was published in Rail Price Advisor, an industry periodical published by Escalation Consultants, Inc. of Gaithersburg, Maryland. It has since been widely referenced elsewhere. CURE, naturally, references it on their website and maintains it there for permanent reference.

They have a more detailed chart from an earlier study there as well.

http://www.railcure.org/pdfs/captivitychart.pdf

With thousands of pages of testimony and commentary available which in many cases references the 2003 study, I have found no industry refutation of the either the methodology or the results.

 

 

[greyhounds]

Mr. Sol's conclusion of a sure thing "cross-subsidization" just doesn't make sense.  No for profit corporation would willingly subsidize a customer...As Bob pointed out, in the past the government forced cross-subsidization through their economic regulation.  But that's pretty well gone now so Mr. Sol's claim of voluntary cross-subsidization flies in the face of all reason.

Ford, GM, and Chrysler do it all the time. They admit it. They are clearing inventories, they are attempting to retain market share, sometimes they are simply driving up the risks of entry for prospective market entrants. Obviously, this is something you simply know nothing about, as you admit.

Cross subsidization is all over the place. I am not going to try and justify here what you should have learned in school, or especially at International Harvester which did it all the time. I will suggest this.

Go to the bookstore that handles business books.

Go to the section of books that are written by Michael Porter. I am simply using his name as an example because people genuinely familiar with management will instantly recognize his name as one of the foremost authorities on business strategy.

Go to the book entitled Competitive Advantage: Creating and Sustaining Superior Performance.

It is currently one of the best selling management books on the market.

Turn to Chapter 12.

The subtitles in that chapter are as follows:

CROSS SUBSIDIZATION

Conditions Favoring Cross Subsidization
Risks of Cross Subsidization
Cross Subsidization and Industry Evolution
Strategic Implications of Cross Subsidization

Please read it. "It flies in the face of all reason," but it will educate you on the subject.

Then you can apologize.

 

But you didn't answer the question.  What criteria did you use to classify rail customers as "captive" or "competitive"?

[MichaelSol]

Datafever wrote:

What is the definition of cross-subsidy?

BobWilcox: It is a regulatory concept from decades ago.

Mr. Sol's conclusion of a sure thing "cross-subsidization" just doesn't make sense.  No for profit corporation would willingly subsidize a customer...As Bob pointed out, in the past the government forced cross-subsidization through their economic regulation.  But that's pretty well gone now so Mr. Sol's claim of voluntary cross-subsidization flies in the face of all reason.

Ford, GM, and Chrysler do it all the time. They admit it. They are clearing inventories, they are attempting to retain market share, sometimes they are simply driving up the risks of entry for prospective market entrants. Obviously, this is something you simply know nothing about, as you admit.

Cross subsidization is all over the place. I am not going to try and justify here what you should have learned in school, or especially at International Harvester which did it all the time. I will suggest this.

Go to the bookstore that handles business books.

Go to the section of books that are written by Michael Porter. I am simply using his name as an example because people genuinely familiar with management will instantly recognize his name as one of the foremost authorities on business strategy.

Go to the book entitled Competitive Advantage: Creating and Sustaining Superior Performance.

It is currently one of the best selling management books on the market.

Turn to Chapter 12.

The subtitles in that chapter are as follows:

CROSS SUBSIDIZATION

Conditions Favoring Cross Subsidization
Risks of Cross Subsidization
Cross Subsidization and Industry Evolution
Strategic Implications of Cross Subsidization

Please read it. "It flies in the face of all reason," but it will educate you on the subject.

Then you can apologize.

 

[greyhounds]

[For each major railroad in 2003, the average R/VC of captive and competitive traffic was as follows:

RR ...Captive....Competitive

BNSF... 215.6% 109.1%

CSX... 186.8% 93.1%

NS ...209.2% 102.3%

UP ...210.4% 106.8%

These are averages. A study I participated in two years ago showed that on BNSF for a given commodity there was a variation of 20% either way system wide in competitive areas and ranged from between 240% and 380% in captive areas. In other studies, BNSF's average has been as low as 101% R/VC for competitive traffic.

It is inarguable that there is cross-subsidization occuring by even the narrowest definition of cross-subsidy. 

 

Well, it won't surprise many of you to read that I strongly disagree with Mr. Sol, his numbers, his "study" and his conclusion.

When someone does a "study", or analysis, like this, a final step is to ask yourself "do my results make sense?"  If they don't, there is a need to go back and check the methodology used. 

Mr. Sol's conclusion of a sure thing "cross-subsidization" just doesn't make sense.  No for profit corporation would willingly subsidize a customer.  As Bob pointed out, in the past the government forced cross-subsidization through their economic regulation.  But that's pretty well gone now so Mr. Sol's claim of voluntary cross-subsidization flies in the face of all reason.

Time to check things out.  The first question is obvious.  How did Mr. Sol classify customers as "Captive" or "Competitive".  This is a very subjective thing, but he seems to have readily been able to put rail customers in two very distinct classifications.   So my first question to Mr. Sol is:  "What criteria did you use to classifiy rail shippers as captive vs. competitive?"

 

 

[MichaelSol]

The STB does not care about cross subsidies.  The only thing they care about in a rate case is if a rate is "reasonable".  If the rev/lrvc is over 180 and their is a lack of competition the railroad has a very heavy burden to prove their rate is reasonable.

That is accurate. Cross subsidies are part of the economic theory that underlies the Staggers Act and the 180% R/VC.  Railroads were given free reign for so long as the rate was under 180%, including the right to cross-subsidize to their heart's content for so long as they did not exceed the rate threshold. Administrative agencies are not good places to undertake broad discussions of policy and economics. 

The 180% threshold is the tangible economic (and legal) expression of a large body of economic theory and discussion to achieve underlying economic goals for society. Railroads bear a burden of proof of "reasonableness" above that threshold because on a case by case basis there can, in fact, be legitimate reasons under the marginal cost theory as to why 180% R/VC does not offer a reasonable rate of return -- a high fixed cost installation, for instance, to serve a given shipper.

As with any legislation, the trick is in the proper administration of the intent of the law, as applied on that case by case basis referred to above. And, as with any agency charged with that administration, the execution of Congressional intent is often less than stellar. Nothing new about that.    

Part of the  momentum leading to the Staggers Act was the increasing bureaucracy of the ICC (and FRA) in dealing with Congressional intent, coupled with (often conflicting) court decisions.  Congress acted, nearly every 20 years, to try and fix the Interstate Commerce Act that the railroads themselves had originally clamored for.  As the original post on this thread shows (I take a different lesson from the PRR drama), the railroads were often their own worst enemy, and most typically it was the opposition of other railroads that prevented given railroads -- and ultimately the industry as a whole -- from adapting to changing times.

Just as the rail industry clamored for ICC regulation as relief from plummeting rates, the rail industry clamored for deregulation --  and was stunned when rates plummeted thereafter. Sometimes an economic historian might wonder just how well this industry understands its own business model.

The key point, however, is that rates were not entirely deregulated -- the 180% R/VC threshold is, in fact, a regulatory threshold, for the reasons discussed in the thread above. Just as under the ICC, the railroad then has to justify the rate if it is challenged by the shipper.

Is the STB doing any better of a job than the ICC did?  Well, federal courts have already ordered a different standard of measure for rate reasonableness than that identified as appropriate by the economists who designed the system and as ordered by Congress. The system for making the determination has evolved into a cumbersome, very expensive, and time-consuming process.

 It is beginning to sound like the ICC.

<> 

[bobwilcox]

The STB does not care about cross subsidies.  The only thing they care about in a rate case is if a rate is "reasonable".  If the rev/lrvc is over 180 and their is a lack of competition the railroad has a very heavy burden to prove their rate is reasonable.

[Datafever]

Okay, having read more than anyone would ever want to know about how STB adjudicates shipping rate complaints, I have come to the conclusion that the STB includes absolutely everything that could possibly be attributed to the cost of supporting one particular shipper to the variable costs side of ledger.  I've even seen line items such as the number of steel welding guys that are needed to repair cars.

I'm left with wondering exactly what is on the fixed costs side as those costs are not mentioned.  No real need to mention those costs as the pricing ratio is against only the variable costs.

One statement that I ran across a couple of times that has me rather baffled.  I don't have the exact quote, but the STB makes the claim that even if R/VC is less than 100%, that is not necessarily an indication that cross-subsidization has taken place.  The only thing that I can suggest is that the phrase "not necessarily" in this case means that there is a distinct probability (however small) that under the most awesome of circumstances it just might be possible for R/VC to be less than 100% and yet cross-subsidization has not taken place.

[Victrola1]

Why is it that whoever, by whatever method, attempts to dictate a paradise of "equality" and plenty ends up producing misery and want? There is a certain irony in the collapse of the I. C. C. and the Soviet Union coming within such a short time of each other.

[MichaelSol]

Could you provide me with some examples of what is considered FC vs VC?  I mean, some things are obvious, like fuel costs are VC while company management is FC.  What is track repair?  The engineer's (prorated) salary? 

Ouch. I am not a railroad accountant and never played one on TV. My first lessons on the topic were from Ernest Poole, Costs -- A Tool for Railroad Management, 1962. I still have the book. To the extent that there are always some discretionary decisions -- arguments -- battles royale -- between what is fixed and what is variable in any industry, the STB prescribes these currently under the UCRS and to the extent that they are statutorily defined for reporting purposes, there is a complete list of such costs which STB uses in its Railroad Cost Program for the specific R/VC function.

[MichaelSol]

As the designer of deregulation in America, Alfred Kahn was no dummy. That's how all the world works -- businesses routinely pass on more than 100% of their productivity increases -- and still become more profitable. Passing on less than 100% creates a level of profit which absolutely at some point invites competitors -- and then the rate drops back down, with the new competitors in hot pursuit. That invites the "race to the bottom." A sophisticated manager does not want to be there. Producers always end up yielding more than 100% to the customer, even if they "think" they can do otherwise.

Yet still earn more profit.

That is the genius of the market system, it is genuine win-win, and a careful producer passing through more than 100% will carefully price to minimize competition at that price.  

You will note that the R/VC does in fact rise -- but if the equation is completed through to the penultimate factor -- profit  --  the higher R/VC % very coincidentally begins to show net profits which are unattainable in a genuine market. The R/VC formula is, in fact, a good predictor of that if you finish the calculation.  In that instance, you will see that the seller that is driven by authentic market forces would be compelled to lower the price charged  -- pass through more of the productivity -- and the R/VC ratio declines as a result, and both complies with the law and its purpose to simulate market forces in non-market circumstances which is ... to drive productivity increases and price efficiency.

Alfred Kahn was no dummy. 

[Datafever]

Or improve its productivity which is, in general, the long term approach to profitability.  That, of course, is why  the economists who designed the deregulation structure felt it necessary to impose a marginal cost pricing guideline to restrict cross-subsidization -- the easy alternative to productivity increases is simply to raise prices -- and that tends to be for captive shippers. That design, then, is important. Productivity improvements are the driving engine of capitalism, not raising prices because it easier. The whole idea of "the market" is to drive price efficiency -- actively compel it. It is not efficient in a captive market. That's why the protections are given to the captive shippers in the Staggers Act and should be enforced.

Improvement of productivity is another area that seems a little counter-intuitive to me.  No, I don't mean that RRs shouldn't improve their productivity, but let me use another example---

VC = 100, R = 180, R/VC = 180% -- shipper is happy

Now if improvements are made resulting in a VC reduction of 20 -- 

VC = 80, R = 160, R/VC =  200% -- shipper is unhappy even though the rate lowered?

In other words, if the improvement in productivity occurs on the VC side of operations, R/VC will rise even if the full savings of the improvement in productivity are passed on to the shipper. 

[Datafever]

The  historical  FC on BNSF is about  35%-37% of the VC. FC and VC are llinked more closely than people might imagine, at least statistically, and at least on railroads.  There is certainly an interesting hypothetical out there to imagine "what if", but the 180% R/VC threshold is a very liberal standard, for which we now have 25 years of actual experience and data to draw from.

Could you provide me with some examples of what is considered FC vs VC?  I mean, some things are obvious, like fuel costs are VC while company management is FC.  What is track repair?  The engineer's (prorated) salary?  Or an agent that deals with three shippers in a terminal area? If a track services only one shipper (such as branch line to a coal company), is that track maintenance considered VC or FC?  How about a manager (and staff) that provides service to a single intermodal firm?  RR ownership of boxcars?  Are there guidelines for this somewhere?  Or is it up to each individual RR to decide if a particular cost can be allocated to a particular shipper?

[MichaelSol]

If BNSF decides that it wants to return to the same level of profitability (15.63%) that it had before losing all that business, it will need to boost its rates to 171% R/VC across the board.  Of course, doing so will drive away even more business... 

Or improve its productivity which is, in general, the long term approach to maintaining profitability.  That, of course, is why the economists who designed the deregulation process felt it necessary to impose a marginal cost pricing guideline to restrict cross-subsidization -- the easy alternative to productivity increases is simply to raise prices -- and that tends to be for captive shippers.

That design, then, is important. Productivity improvements are the driving engine of capitalism, not raising prices because it easier. The whole idea of "the market" is to drive price efficiency -- actively compel it. There is no incentive to efficiency in a captive market, for the obvious reason that there is no actual "market." That's why the protections are given to the captive shippers in the Staggers Act and should be enforced.

They do not protect the captive shippers, they protect the economy as a whole.

 

[MichaelSol]

Ordinarily, textbook production reflects that the variable costs of production fluctuate with changes in product numbers. No less so than with trains. A 20 car train has much the same overall variable costs of operation as a 110 car train, and some differences as well (less fuel, lower capital charges). However, for the smaller train, the cost per revenue unit will be higher than with the big train. But, as a rule, less business higher VC, more business lower VC per unit. Marginal cost pricing theory grants to the railroads the entire variable cost, no matter what it is.  That is, 100% of VC are recovered.

The  historical  FC on BNSF is about  35%-37% of the VC. FC and VC are linked more closely than people might imagine, at least statistically, and at least on railroads.  There is certainly an interesting hypothetical out there to imagine "what if", but the 180% R/VC threshold is a very liberal standard, for which we now have 25 years of actual experience and data to draw from.

Too, that liberal threshold permits a wide range of rate making and the average is only that -- a statistical artifact of thousands of independent prices  tailored to each competitive market or service need, or "not", as the case may be, and varying as noted above, from a net loss on variable costs to a very healthy profit margin from captive shippers who are plainly subsidizing competitive shippers.  Averages, in that sense, are difficult however to budge. Very difficult.

Elasticity plays a large role, and that contributes to the stability of the statistical average. Coal and agriculture are about 60% of the whole RR ball of wax, and the demand for railroad services for those industries are relatively inelastic. For the 31% of RR revenue that is extracted from captive shippers, the elasticity approaches zero.

 

[Datafever]

A hypthetical railroad named BNSF has $10 billion in operating expenses. Historically, that breaks out to roughly $7.4 billion in variable costs and $2.6 billion in fixed costs.

If the BNSF is charging an average of 160% R/VC, its revenue will be $11.85 billion, showing a net profit of $1.85 billion. That is a 15.63% rate of return on revenue which is substantially above the WACC of the BNSF over the past ten years. At 180%, it would be a 25% rate of return.

You bring up an interesting example here.  Let me posit a counter-example:

This hypothetical railroad named BNSF decides to set rates to 160% R/VC across the board.  In doing so, it loses 25% of its business to competitors (and I don't care whether those competitors are other railroads and any other means of transportation or if it just means that the shipper goes out of business).  Straight up, there is a 25% reduction in variable costs, so VC is now $5.55 billion.  But fixed costs only decrease 5% (just for sake of the example) so FC is now $2.47 billion.  Total costs are now $8.02 billion.  At 160% R/VC, revenue now comes in at $8.88 billion for a profit of $0.86 billion or a 10.7% rate of return on revenue.

If BNSF decides that it wants to return to the same level of profitability (15.63%) that it had before losing all that business, it will need to boost its rates to 171% R/VC across the board.  Of course, doing so will drive away even more business... 

[jclass]

In the world I'm familiar with, there's some pricing theory, and what works.  Not all this mincing about cross-subsidy and such.  I think lean manufacturing and lean accounting are starting to clean out some of this stuff. 

[MichaelSol]

The generic definition of cross-subsidy that I have seen repeatedly is this:

"Cross subsidization occurs when one purchaser pays a relatively high price and thus enables another purchaser to pay a relatively low price.'

True enough.  If the game is to earn, achieve or exceed WACC [weight adjusted cost of capital], the market no doubt determines the feasible price mix to achieve the goal. The problem is when a customer is captive. There is no market based price. And this presents the dilemma when a company -- and many do -- utilizes market share pricing rather than marginal cost pricing.

The company can buy more market share -- at lower prices than it would or could ordinarily charge -- if other customers can be forced by their captivity and inelastic demand needs to contribute the additional profit margin necessary to meet the earnings goals of the company. If all the players in a given market have captive shippers, that enables those companies to compete on price for market share at rates lower than any of those companies would or even could otherwise charge those customers. Sometimes they don't have captive customers and still go for market share pricing for a variety of reasons. Auto companies do it all the time, and pay the economic consequences from time to time.

In essence, the customers paying the lower share are subsidized by the very existence of the captive shipper -- receiving services at prices that could not be rationally offered to them based solely on market principles, without the compensating income gained by the company at the other end of the price spectrum.

It is both an artificial subsidy, for some, and an artificial price penalty, for others. It could not exist in either case if genuine market conditions prevailed.

It is not differential pricing, rather it is inverse pricing -- the captive customer often pays more for less service, rather than for a differentiated service. 

It subsidizes some customers at the expense of others and disrupts genuine market mechanisms of customers because competing customers receive irrational prices compared to each other, and it affects the competitive outcomes of other producers in other industries as a result. That is a recognized economic negative, introduces inefficiencies into the economy, and is the reason for the regulation.

It is command economy power, given over to a private corporation which dictates price to a customer  with no practical alternatives. Our system has been adverse to that principle, as the principle is as deadly to rational investment decision making in private hands as it is in government hands. The active principle is not improved from an economic standpoint simply because the identical power is exercised on behalf of a board of directors rather than a politburo.

The 180% R/VC is a statutory price threshold designed to minimize cross subsidization -- which was one of the key objectives of the Staggers Act in the first place.

The former regulatory requirement of high profit shippers subsidizing low profit services has been replaced by a competitive drive to lower prices below a sustainable return, because and only because of the existence of shippers who can be compelled to pay higher prices to produce the necessary profits. 

But, that is still called cross-subsidization because it is not the source of the compulsion that generates the definition, but the result.

 

 

 

[bobwilcox]

What is the definition of cross-subsidy?

It is a regulatory concept from decades ago.  When railroad's prices and services were regulated, government agencies would tell they had to run a money losing service and could make up the difference on the profits from another service.  As an example coach passenger rates were held low but the railroads were told they could make it up on their share of Pullman travel.  It was almost like a income transfer from wealthy passengers to poorer passengers.  The STB no longer has the authority to make such a ruling. 

 

[Datafever]

It is inarguable that there is cross-subsidization occuring by even the narrowest definition of cross-subsidy. 

So let me ask you the question that I don't seem to be getting a plethora of responses to:

What is the definition of cross-subsidy?

I thought that the term referred to the subsidy of a money-losing LOB, e.g. the sale of a product at a price less than the cost to manufacture it - something that a manufacturer might do in order to gain name recognition/boost market share.

Certainly the term can't just refer to one LOB being more profitable than another LOB within a company.  So what determines when cross-subsidization is taking place?  I'm not trying to define the term, I'm trying to understand it. 

[MichaelSol]

I wouldn't say that what I stated was a definition, per se.  It just kind of "makes sense" to me.  After all, if an LOB is actually losing money (not covering the variable costs) then I think that it is inarguable that such LOB is being cross subsidized by the rest of the business.

For each major railroad in 2003, the average R/VC of captive and competitive traffic was as follows:

RR ...Captive....Competitive

BNSF... 215.6% 109.1%

CSX... 186.8% 93.1%

NS ...209.2% 102.3%

UP ...210.4% 106.8%

These are averages. A study I participated in two years ago showed that on BNSF for a given commodity there was a variation of 20% either way system wide in competitive areas and ranged from between 240% and 380% in captive areas. In other studies, BNSF's average has been as low as 101% R/VC for competitive traffic.

It is inarguable that there is cross-subsidization occuring by even the narrowest definition of cross-subsidy. 

 

[MichaelSol]

The 180 rev/lrvc thing is only a legal thng.  The Law Deparment thinks about it but it has virtually nothing to do with how the railroad and it's customers do business with one another.  In negotiating dozens of contracts with margins over 180% in never came up.  Not once in 23 years!

This is misleading all the way around. 

It is an important economic concept, written into law. The concept was designed by the economists who forcefully and successfully advocated deregulation but who also felt it was of utmost significance to have a marginal price formula to restrict monopolistic behaviors.

This was a regulatory alternative to placing railroads under the general jurisdiction of the Justice Department where general anti-trust law is enforced. The alternative to a straightforward marginal price constraint is constant re-examination on a case by case basis using the Herfindahl-Hirschman Index, or other more generalized measures of market control or market share, and imposing standard anti-trust remedies that other businesses in the United States are subject to.

In the case of railroads, the economists who devised the concept recognized the dangers of captive shippers and potential monopoly under deregulated conditions and advocated -- in all cases of deregulation, not just railroads -- a marginal price formula to ensure that, within a broad range of economic conditions, businesses could engage in differential pricing subject to an approximation of market restraints under those circumstances where genuine markets did not exist.

The 160% R/VC ratio was recommended based on economic studies. The rail industry successfully lobbied for the higher threshold of 180% R/VC.

The number of litigated cases involving shippers and railroads where the subject of the 180% R/VC threshold "came up" in the course of discussions -- resulting in outright litigation -- is lengthy.

Outside of litigation, the number of pages of shipper testimony regarding their difficulties in negotiating with railroads over the significance of that threshold fills many, many volumes.

 

[bobwilcox]

The 180 rev/lrvc thing is only a legal thng.  The Law Deparment thinks about it but it has virtually nothing to do with how the railroad and it's customers do business with one another.  In negotiating dozens of contracts with margins over 180% in never came up.  Not once in 23 years!

[greyhounds]

Could someone provide me with a definition of cross subsidization as it applies to railroad pricing?

In my mind, a LOB is only being cross subsidized if revenue is less than variable costs.  From the posts on this thread, it appears that there are other definitions being used.  Anyone?

The STB standard is 180% of revenue to variable cost.  Thus, in the railroad context any rate structure which results in an R/VC of less than 180% is probably being cross subsidized by the rate structure in which revenues exceed variable costs by more than 180%.  Compare that to your statement above, where you believe cross subsidization only happens when revenues are less than 100% of variable costs.  For the record, the lowest R/VC ratio that I know of is 108%, so by your definition there is currently no cross subsidization taking place.

Whether the 180% measure itself is too arbitrary is another discussion altogether.

You're right, there is no cross subsidization taking place.

The 180% figure is just a political compromise benchmark.  A study found 61% of rail business to be priced below that figure.  If a rail freight rate is below 180% of variable cost the traffic is deemed to be in a competitive situation and the rail customers have no legal standing to make a complaint about their rates.

If the rate exceeds 180% the customers may file with the Surface Transportation Board, which then could conduct an investigation.  The shipper is "potentially" captive.  But the rate may be well over 180% of variable cost and still be the result of competive factors. 

It has nothing to do with cross subsidies. 

[greyhounds]

Here we go again, a personal attack about personal attacks.... the topic is an interesting discussion, keep your announced personal vendettas that you keep dragging into these threads, and what you "are never going to forget," to yourself. Back to the regularly scheduled economic discussion ....

You aren't in charge and you're not going to tell me what I can or can not say.

[Datafever]

[This was subsequently modified to 180% and then not implemented as a cap.  If it had been implemented as a cap, then by what you said, no railroad could ever be revenue adequate.

?

Well, fix my math if I am misunderstanding you.

A hypthetical railroad named BNSF has $10 billion in operating expenses. Historically, that breaks out to roughly $7.4 billion in variable costs and $2.6 billion in fixed costs.

If the BNSF is charging an average of 160% R/VC, its revenue will be $11.85 billion, showing a net profit of $1.85 billion. That is a 15.63% rate of return on revenue which is substantially above the WACC of the BNSF over the past ten years. At 180%, it would be a 25% rate of return.

If that is not revenue adequate, there is not a Fortune 500 corporation that is going to make it. They're all doomed.

I fear that you have taken my quote out of context.  I was responding to a post that declared that 180% R/VC was the standard by which the STB determines if a railroad is revenue adequate. 

[MichaelSol]

[This was subsequently modified to 180% and then not implemented as a cap.  If it had been implemented as a cap, then by what you said, no railroad could ever be revenue adequate.

?

Well, fix my math if I am misunderstanding you.

A hypthetical railroad named BNSF has $10 billion in operating expenses. Historically, that breaks out to roughly $7.4 billion in variable costs and $2.6 billion in fixed costs.

If the BNSF is charging an average of 160% R/VC, its revenue will be $11.85 billion, showing a net profit of $1.85 billion. That is a 15.63% rate of return on revenue which is substantially above the WACC of the BNSF over the past ten years. At 180%, it would be a 25% rate of return.

If that is not revenue adequate, there is not a Fortune 500 corporation that is going to make it. They're all doomed.

 

[MichaelSol]

Here we go again, a personal attack about personal attacks.... the topic is an interesting discussion, keep your announced personal vendettas that you keep dragging into these threads, and what you "are never going to forget," to yourself. Back to the regularly scheduled economic discussion ....

[greyhounds]

Groan,  Well here we go again.  Greyhounds started with his model assinging $1000 per car load of coal to fixed costs.  Now he comes along and says, "(You can not allocate fixed cost to any specific movement - you have to cover them with your entire traffic base, but you can not allocate them.  The only way the ethanol shows a loss is through the impossible allocation of fixed costs to the movement.)"  So which is it, can you assign fixed costs to reveue cars or not?  You cannot have it both ways.

So here is my plan.  I will not read any more of your posts and thus will not be tempted to reply to any more of them.  Perhaps that way you can keep a straight line of thought instead or bouncing around the spectrum in order to be contravailing.

Also, please note.  Though containers have the potential to be loaded bidirectional the reality is the loaded movements eastward with imports far exceeds the loaded westbound boxes loaded with export or domestic product.

You know, these personal attacks out of Montana got old a long time ago. 

I intentionally set up a simple situation where a rail line had only one movement.  In that scenario, that one movement obviously had to carry the entire cost of the line, both fixed and variable cost. 

I then introduced a second movement of freight that had to be sold below average cost to demonstrate that such a movement could be sold at a profit to the railroad company as long as it exceeded variable costs.

You now falsely accuse me of "assigning" the fixed cost in the initial situation.  No, I didn't "assign" them - but since there was just that coal business on the line, nothing else was there to carry those cost.  

You evidently can't/won't understand this so you resort to personal insults.  And I'm not ever going to forget your attack on me for my involvement in Greyhound racing.  That's something I'm very proud of.  And it's something else you know nothing about.  But your lack of knowledge didn't stop you then either.   

[Datafever]

The 180% standard is used to determine revenue adequecy.  Thus, any rate structure below 180% R/VC supposedly does not cover all costs (variable, fixed, etc.) of the move, so we presume such would have to be made up for by someone else's rate structure which exceeds the standard.

You seem to be throwing things my direction that I have never run across before.  That doesn't mean that you are wrong, it just means that my research hasn't encountered what you are saying.  Could you provide a reference or two to back this up?

From what I have read, revenue adequacy is determined by return on investment.  Further, it is my understanding that when Staggers was originally proposed, 160% R/VC was going to be the cap.  This was subsequently modified to 180% and then not implemented as a cap.  If it had been implemented as a cap, then by what you said, no railroad could ever be revenue adequate.

The fact that the GAO uses this standard for the totally unrelated purpose of *determining* captive shipper status just means that some ivory tower beauracrats are too lazy to use the more logical method of determining captivity, aka the physical limitation to one Class I service provider.

The GAO does not use the 180% R/VC as a method for determining captive shipper status as an arbitrary measure.  Staggers defines a "potential captive shipper" as one whose rate exceeds 180% R/VC.  In other words, the term is a legal definition.  For the GAO to willy-nilly use a different definition would be silly.

In so far as your definition being a more logical method, I am not convinced.  Perhaps we could run through some scenarios and you could elaborate.

[Anonymous]

Could someone provide me with a definition of cross subsidization as it applies to railroad pricing?

In my mind, a LOB is only being cross subsidized if revenue is less than variable costs.  From the posts on this thread, it appears that there are other definitions being used.  Anyone?

The STB standard is 180% of revenue to variable cost.  Thus, in the railroad context any rate structure which results in an R/VC of less than 180% is probably being cross subsidized by the rate structure in which revenues exceed variable costs by more than 180%.  Compare that to your statement above, where you believe cross subsidization only happens when revenues are less than 100% of variable costs.  For the record, the lowest R/VC ratio that I know of is 108%, so by your definition there is currently no cross subsidization taking place.

Whether the 180% measure itself is too arbitrary is another discussion altogether.

I am aware that the STB uses the 180% value to determine potential captive shippers (per Staggers), but I have not read anything that would indicate that the 180% value is used to define cross subsidization.  Would you happen to have any links to information that would validate that?

If one shipper pays 181% R/VC and another shipper pays 179% R/VC, would you say that cross subsidization has taken place?  If that were a valid criteria, then any shipper that paid a higher R/VC percentage would be cross subsidizing any other shipper that paid a lower R/VC regardless of the actual percentage.

I wouldn't say that what I stated was a definition, per se.  It just kind of "makes sense" to me.  After all, if an LOB is actually losing money (not covering the variable costs) then I think that it is inarguable that such LOB is being cross subsidized by the rest of the business.

The reason that I brought it up is because the various posts that have been made seem to indicate that not everyone is on the same wavelength as to what cross subsidization really means in this context.

The 180% standard is used to determine revenue adequecy.  Thus, any rate structure below 180% R/VC supposedly does not cover all costs (variable, fixed, etc.) of the move, so we presume such would have to be made up for by someone else's rate structure which exceeds the standard.

The fact that the GAO uses this standard for the totally unrelated purpose of *determining* captive shipper status just means that some ivory tower beauracrats are too lazy to use the more logical method of determining captivity, aka the physical limitation to one Class I service provider.

[oltmannd]

Groan,  Well here we go again.  Greyhounds started with his model assinging $1000 per car load of coal to fixed costs.  Now he comes along and says, "(You can not allocate fixed cost to any specific movement - you have to cover them with your entire traffic base, but you can not allocate them.  The only way the ethanol shows a loss is through the impossible allocation of fixed costs to the movement.)"  So which is it, can you assign fixed costs to reveue cars or not?  You cannot have it both ways.

So here is my plan.  I will not read any more of your posts and thus will not be tempted to reply to any more of them.  Perhaps that way you can keep a straight line of thought instead or bouncing around the spectrum in order to be contravailing.

Also, please note.  Though containers have the potential to be loaded bidirectional the reality is the loaded movements eastward with imports far exceeds the loaded westbound boxes loaded with export or domestic product.

Any box moving in either direction, loaded or empty, is a revenue move except for RR controlled equipment, which is a shrinking piece of the pie.

[Datafever]

Could someone provide me with a definition of cross subsidization as it applies to railroad pricing?

In my mind, a LOB is only being cross subsidized if revenue is less than variable costs.  From the posts on this thread, it appears that there are other definitions being used.  Anyone?

The STB standard is 180% of revenue to variable cost.  Thus, in the railroad context any rate structure which results in an R/VC of less than 180% is probably being cross subsidized by the rate structure in which revenues exceed variable costs by more than 180%.  Compare that to your statement above, where you believe cross subsidization only happens when revenues are less than 100% of variable costs.  For the record, the lowest R/VC ratio that I know of is 108%, so by your definition there is currently no cross subsidization taking place.

Whether the 180% measure itself is too arbitrary is another discussion altogether.

I am aware that the STB uses the 180% value to determine potential captive shippers (per Staggers), but I have not read anything that would indicate that the 180% value is used to define cross subsidization.  Would you happen to have any links to information that would validate that?

If one shipper pays 181% R/VC and another shipper pays 179% R/VC, would you say that cross subsidization has taken place?  If that were a valid criteria, then any shipper that paid a higher R/VC percentage would be cross subsidizing any other shipper that paid a lower R/VC regardless of the actual percentage.

I wouldn't say that what I stated was a definition, per se.  It just kind of "makes sense" to me.  After all, if an LOB is actually losing money (not covering the variable costs) then I think that it is inarguable that such LOB is being cross subsidized by the rest of the business.

The reason that I brought it up is because the various posts that have been made seem to indicate that not everyone is on the same wavelength as to what cross subsidization really means in this context.

[Murphy Siding]

    What does LOB stand for?  Thanks

Line Of Business

     Thanks Datafever.

[Anonymous]

Could someone provide me with a definition of cross subsidization as it applies to railroad pricing?

In my mind, a LOB is only being cross subsidized if revenue is less than variable costs.  From the posts on this thread, it appears that there are other definitions being used.  Anyone?

The STB standard is 180% of revenue to variable cost.  Thus, in the railroad context any rate structure which results in an R/VC of less than 180% is probably being cross subsidized by the rate structure in which revenues exceed variable costs by more than 180%.  Compare that to your statement above, where you believe cross subsidization only happens when revenues are less than 100% of variable costs.  For the record, the lowest R/VC ratio that I know of is 108%, so by your definition there is currently no cross subsidization taking place.

Whether the 180% measure itself is too arbitrary is another discussion altogether.

[Datafever]

Could someone provide me with a definition of cross subsidization as it applies to railroad pricing?

In my mind, a LOB is only being cross subsidized if revenue is less than variable costs.  From the posts on this thread, it appears that there are other definitions being used.  Anyone?

[MichaelSol]

 

oltmannd wrote:

Or, perhaps rates are a function of capacity.  In the real world, when something gets too crowded, you raise the price.

If a line goes from A to B to C and is at or near capacity, any shipper wanting a ride from A to B or B to C better expect to pay the A to C rate - or better!

My problem with this statement is that there seems to be a facile generalization for every scenario by which the posters propose how the "real world" works, then when faced with contrary evidence, an opposing facile generalization is substituted. The real world must be more elusive than alleged.

In this instance, congestion and capacity problems are undeniably on the intermodal corridors. Is that a reasonable test of the statement? Well, it ought to be -- it represents a big chunk of business, the evidence is strong, and it ought to fit the proposition, in a rational world that is authentically market driven.

Yet, since the year 2000 the rail price index has increased approximately 25.7%, while intermodal rates have increased only 11.5%, among the lowest of all categories. Real growth in intermodal rates has represented a decline in the rates over the time period, even as costs have increased, and particularly both variable and fixed costs associated with the traffic.

With a declining rate even at capacity, will an increase in fixed costs to create additional capacity generate greater profit? Can an econometrician make a reasonable claim that the company will increase its profits? Well, according to your proposition, if capacity is increased -- if a line has excess capacity -- rates will be lower .... yet rates are declining, even though at capacity, contrary to the proposition that rates should have increased because of the specific constraint of capacity as you specifically proposed.

Whew, you may have a logic in there somewhere, but perhaps the theory proposed doesn't actually match reality very well -- and intermodal is "Exhibit A." The good question, then, is, why doesn't intermodal follow your theory?

This is my problem with your statement; it seems to be a statement of convenience that is, in fact, contrary to what is happening. Transparently false in a large, compelling context, it is unlikely to suddenly become a profound truth in a narrower context of captive shippers.

Where the proof of your proposition fails, is that evidence then that the circumstance is not market driven? Not a lot of options there, it either is or it isn't. And I agree with you, if truly market driven, intermodal prices would have gone up relative to costs, not down.

But they didn't. If they are not following genuine market pricing as I think you accurately propose the theory, is that evidence of cross-subsidization, since cross-subsidization is the plausible alternative explanation when the market pricing explanation fails?

I think it is.

 

[Datafever]

    What does LOB stand for?  Thanks

Line Of Business

[arbfbe]

Groan,  Well here we go again.  Greyhounds started with his model assinging $1000 per car load of coal to fixed costs.  Now he comes along and says, "(You can not allocate fixed cost to any specific movement - you have to cover them with your entire traffic base, but you can not allocate them.  The only way the ethanol shows a loss is through the impossible allocation of fixed costs to the movement.)"  So which is it, can you assign fixed costs to reveue cars or not?  You cannot have it both ways.

So here is my plan.  I will not read any more of your posts and thus will not be tempted to reply to any more of them.  Perhaps that way you can keep a straight line of thought instead or bouncing around the spectrum in order to be contravailing.

Also, please note.  Though containers have the potential to be loaded bidirectional the reality is the loaded movements eastward with imports far exceeds the loaded westbound boxes loaded with export or domestic product.

[Murphy Siding]

    What does LOB stand for?  Thanks

[oltmannd]

"Rail transportation companies [have] carload rail prices standing 31.0% higher than they were five years ago. ... In contrast, intermodal service prices were [only] 13.1% higher than they were in 2001."

Elizabeth Batz, "Pricing Across the Transportation Modes," Logistics Management, 5/1/2006.

"Seems" like rates ought to be a function of capacity -- problem is in offering a rational explanation why they obviously aren't -- and why other freight is paying the cost -- cross-subsidizing -- of the enormous investment required for intermodal.

There is no cross subsidy.

Investment decisions by companies are made using projections of the discounted (for risk and time value of money) cash flow into the future.  Cash flow is a function of margin (revenue less cost) and volume.  Intermodal produces less margin but much more volume.  A 240 container stack train will produce gross revenue of around $120 for every mile it moves.  And if it's loaded with international containers, the railroad will have no equipment ownership expense outside the locomotives.  (they will pay per diem and mileage on the well cars.)

And those containers will produce that revenue in both directions, unlike a grain car.  A grain car goes back empty at no revenue.  The containers can be revenue loads both ways.

No rational firm will cross subsidize any line of business (exception: start up lines of business that are projected to produce positive cash flows in the future.)  To maintain otherwise is to maintain that railroad management is acting irrationally.  They're not.

To maintain they are is what is irrational.  There is no cross subsidy.

...and, them may purposely wring a dying LOB dry in order to support a more lucrative LOB.  That is not cross subsidization, either.  It's just good business.

You MIGHT be able to make the case the the the RR holding companies used other businesses they owned to prop up the RR in the 50s, 60s and 70s.  That may have been bad business - or altruism.

[oltmannd]

Capacity, in this case, is constrained by equipment.

And, obviously, it doesn't pay to invest in more.

Or it does, if the capacity constraint is something different. My point is, your generalization was one of those generalizations that is true or isn't true, depending on [fill in the blank].

Don't know how it is in your part of the country, but the BNSF grain fleet is utilized almost continuously. You may not think that 20 year old (average), paid-for equipment, operating at between 15 and 20 cycles annually is good business -- and ag generates the highest carload revenue of any marketing group.

Asset productivity is very good in this instance on this railroad. Compared to the labor intensive handling required for intermodal, a shuttle grain train is almost an entirely automated process.

Well, sure, all generalizations fail somewhere.  If they didn't we'd call them laws. 

Conversion of grain from loose car to unit shuttles and/or large blocks is certainly a good thing as is BNSF's capacity management scheme for grain. 

I'm not so sure why you think intermodal is labor intense.  The terminals are capital intense but the gate, inspection, positioning and loading are not labor intensive -15 to 20 man minutes per box total.

[MichaelSol]

Capacity, in this case, is constrained by equipment.

And, obviously, it doesn't pay to invest in more.

Or it does, if the capacity constraint is something different. My point is, your generalization was one of those generalizations that is true or isn't true, depending on [fill in the blank].

Don't know how it is in your part of the country, but the BNSF grain fleet is utilized almost continuously. You may not think that 20 year old (average), paid-for equipment, operating at between 15 and 20 cycles annually is good business -- and ag generates the highest carload revenue of any marketing group.

Asset productivity is very good in this instance on this railroad. Compared to the labor intensive handling required for intermodal, a shuttle grain train is almost an entirely automated process.

[oltmannd]

Or, perhaps rates are a function of capacity.  In the real world, when something gets too crowded, you raise the price.

If a line goes from A to B to C and is at or near capacity, any shipper wanting a ride from A to B or B to C better expect to pay the A to C rate - or better!

Except, that's the theory, not the real world. Look at intermodal.

It has been demanding the most capacity and growth resources. Nearly all new construction goes to meeting intermodal demand. Enormous resources are being required, compared to, say, wheat. Yet, wheat pays the highest prices, and is one of the few categories of freight rates that GAO found had increased, rather than decreased, since Staggers.

"Rail transportation companies [have] carload rail prices standing 31.0% higher than they were five years ago. ... In contrast, intermodal service prices were [only] 13.1% higher than they were in 2001."

Elizabeth Batz, "Pricing Across the Transportation Modes," Logistics Management, 5/1/2006.

"Seems" like rates ought to be a function of capacity -- problem is in offering a rational explanation why they obviously aren't -- and why other freight is paying the cost -- cross-subsidizing -- of the enormous investment required for intermodal.

You seem to be insinuating that RR mgt has no idea what their the ROI is for their capital projects.  That they'd "steal" huge sums of money from profitable LOBs to sink into marginal intermodal business.  As if they have no idea of their margins.  Really!

To state the obvious:

Wheat is lousy business.  It only moves when the price is right and then EVERYBODY wants their wheat moved.  Asset productivity is lousy.  BNSF has the right idea with their capacity auctions.

Intermodal is steady, growing, very profitable business, on the whole.  Asset productivity is terriffic.  BNSF is investing quite a bit trying to make their carload business perform like intermodal - lots of transload terminals and the like, integrated into new and expanded intermodal terminals.

Well, if you propose that "at capacity" means raise rates, and an example is shown -- the biggest example possible -- where that clearly does not happen, then obviously there is a different reason why rates are not raised, isn't there?

That's my point, exactly.

The fact that there is or might be does not mean that both your contentions, proposing opposite rationales, can be true .... or, as you say, it is "obvious."

Capacity, in this case, is constrained by equipment.

And, obviously, it doesn't pay to invest in more.

[MichaelSol]

Or, perhaps rates are a function of capacity.  In the real world, when something gets too crowded, you raise the price.

If a line goes from A to B to C and is at or near capacity, any shipper wanting a ride from A to B or B to C better expect to pay the A to C rate - or better!

Except, that's the theory, not the real world. Look at intermodal.

It has been demanding the most capacity and growth resources. Nearly all new construction goes to meeting intermodal demand. Enormous resources are being required, compared to, say, wheat. Yet, wheat pays the highest prices, and is one of the few categories of freight rates that GAO found had increased, rather than decreased, since Staggers.

"Rail transportation companies [have] carload rail prices standing 31.0% higher than they were five years ago. ... In contrast, intermodal service prices were [only] 13.1% higher than they were in 2001."

Elizabeth Batz, "Pricing Across the Transportation Modes," Logistics Management, 5/1/2006.

"Seems" like rates ought to be a function of capacity -- problem is in offering a rational explanation why they obviously aren't -- and why other freight is paying the cost -- cross-subsidizing -- of the enormous investment required for intermodal.

You seem to be insinuating that RR mgt has no idea what their the ROI is for their capital projects.  That they'd "steal" huge sums of money from profitable LOBs to sink into marginal intermodal business.  As if they have no idea of their margins.  Really!

To state the obvious:

Wheat is lousy business.  It only moves when the price is right and then EVERYBODY wants their wheat moved.  Asset productivity is lousy.  BNSF has the right idea with their capacity auctions.

Intermodal is steady, growing, very profitable business, on the whole.  Asset productivity is terriffic.  BNSF is investing quite a bit trying to make their carload business perform like intermodal - lots of transload terminals and the like, integrated into new and expanded intermodal terminals.

Well, if you propose that "at capacity" means raise rates, and an example is shown -- the biggest example possible -- where that clearly does not happen, then obviously there is a different reason why rates are not raised, isn't there?

That's my point, exactly.

The fact that there is or might be does not mean that both your contentions, proposing opposite rationales, can be true .... or, as you say, it is "obvious."

 

 

[oltmannd]

Or, perhaps rates are a function of capacity.  In the real world, when something gets too crowded, you raise the price.

If a line goes from A to B to C and is at or near capacity, any shipper wanting a ride from A to B or B to C better expect to pay the A to C rate - or better!

Except, that's the theory, not the real world. Look at intermodal.

It has been demanding the most capacity and growth resources. Nearly all new construction goes to meeting intermodal demand. Enormous resources are being required, compared to, say, wheat. Yet, wheat pays the highest prices, and is one of the few categories of freight rates that GAO found had increased, rather than decreased, since Staggers.

"Rail transportation companies [have] carload rail prices standing 31.0% higher than they were five years ago. ... In contrast, intermodal service prices were [only] 13.1% higher than they were in 2001."

Elizabeth Batz, "Pricing Across the Transportation Modes," Logistics Management, 5/1/2006.

"Seems" like rates ought to be a function of capacity -- problem is in offering a rational explanation why they obviously aren't -- and why other freight is paying the cost -- cross-subsidizing -- of the enormous investment required for intermodal.

You seem to be insinuating that RR mgt has no idea what their the ROI is for their capital projects.  That they'd "steal" huge sums of money from profitable LOBs to sink into marginal intermodal business.  As if they have no idea of their margins.  Really!

To state the obvious:

Wheat is lousy business.  It only moves when the price is right and then EVERYBODY wants their wheat moved.  Asset productivity is lousy.  BNSF has the right idea with their capacity auctions.

Intermodal is steady, growing, very profitable business, on the whole.  Asset productivity is terriffic.  BNSF is investing quite a bit trying to make their carload business perform like intermodal - lots of transload terminals and the like, integrated into new and expanded intermodal terminals.

 

[greyhounds]

"Rail transportation companies [have] carload rail prices standing 31.0% higher than they were five years ago. ... In contrast, intermodal service prices were [only] 13.1% higher than they were in 2001."

Elizabeth Batz, "Pricing Across the Transportation Modes," Logistics Management, 5/1/2006.

"Seems" like rates ought to be a function of capacity -- problem is in offering a rational explanation why they obviously aren't -- and why other freight is paying the cost -- cross-subsidizing -- of the enormous investment required for intermodal.

There is no cross subsidy.

Investment decisions by companies are made using projections of the discounted (for risk and time value of money) cash flow into the future.  Cash flow is a function of margin (revenue less cost) and volume.  Intermodal produces less margin but much more volume.  A 240 container stack train will produce gross revenue of around $120 for every mile it moves.  And if it's loaded with international containers, the railroad will have no equipment ownership expense outside the locomotives.  (they will pay per diem and mileage on the well cars.)

And those containers will produce that revenue in both directions, unlike a grain car.  A grain car goes back empty at no revenue.  The containers can be revenue loads both ways.

No rational firm will cross subsidize any line of business (exception: start up lines of business that are projected to produce positive cash flows in the future.)  To maintain otherwise is to maintain that railroad management is acting irrationally.  They're not.

To maintain they are is what is irrational.  There is no cross subsidy.

 

[MichaelSol]

Or, perhaps rates are a function of capacity.  In the real world, when something gets too crowded, you raise the price.

If a line goes from A to B to C and is at or near capacity, any shipper wanting a ride from A to B or B to C better expect to pay the A to C rate - or better!

Except, that's the theory, not the real world. Look at intermodal.

It has been demanding the most capacity and growth resources. Nearly all new construction goes to meeting intermodal demand. Enormous resources are being required, compared to, say, wheat. Yet, wheat pays the highest prices, and is one of the few categories of freight rates that GAO found had increased, rather than decreased, since Staggers.

"Rail transportation companies [have] carload rail prices standing 31.0% higher than they were five years ago. ... In contrast, intermodal service prices were [only] 13.1% higher than they were in 2001."

Elizabeth Batz, "Pricing Across the Transportation Modes," Logistics Management, 5/1/2006.

"Seems" like rates ought to be a function of capacity -- problem is in offering a rational explanation why they obviously aren't -- and why other freight is paying the cost -- cross-subsidizing -- of the enormous investment required for intermodal.

 

 

[oltmannd]

And now back to reality......

 

 

It is absolutely fair to the original shipper.  He is harmed not one iota by the "new" traffic.

But....

In this example, once the coal mine plays out and all that's left is that ethanol traffic, what would be "fair"?  The RR can no longer afford to move the ethanol at $2400/car load.  So the RR raises rates to cover fixed costs which causes the consingee to switch to an alternate source of supply - at greater cost to him.  The RR abandons the line, since it has a negative economic value.  The ethanol consumer has higher costs and winds up at a disadvantage in the market he serves since his competitor haslower costs (lets assume exactly similar circumstances except his RR line didn't lose it's base load traffic) and he goes belly up.  It this because of some "unfairness" on the part of the RR with regard to the shippers?  Or, is it just "life in big city"?

And, this is EXACTLY where the RRs found themselves in the regulated environment.  Other modes came and stole big chunks of the base load traffic (often with the gov't assistance) and the RRs were not free to adjust to the new conditions.  Rates were set entirely by calculated costs with no respect to the value of the service provided.   The notion that there is "fairness" in prices being set in relation to calculated costs is nuts.  Nobody runs their household that way.  Nobody sells things on Ebay that way (wanna buy a PS3?).  And nobody would ever run a small business that way.  So why should a RR be any different? 

The thread was about cross subsidization of traffic, in effect the railroad "taxing" one shipper with higher rates to cover more of the fixed costs to allow another shipper a lower rate to attract the business to the line.  I am sure the higher rate shipper would find the situation unfair, the subsidized shipper would be happy with the situation and would look for some way to justify the tarrif on the other shipper.  The railroad would be happy since they could make more money with the non-equal tarrifs.

Regulation was perhaps not good for the railroads and marginal lines.  The same happens today without regulation.  One customer closes shop or is bought out by another entity which moves production elsewhere and the line is forced to close since there is not enough business left to cover fixed and variable costs.  Regulation has nothing to do with that, business cycles and decisions do.  The railroads can keep the line open if they choose by raising rates to shippers on other lines to cover the fixed costs on the line they want to remain open. 

It's all about how you define your terms.  Cross subsidization is basic fact of life in the US. People without kids cross subsidize the schooling of those who have'em.  States with few interstate highways and lots of vehicle miles travelled (like NJ) cross subsidize those that many Interstate miles and few vehicle miles travelled (like Montana).  Once upon a time, residents on a steam loop got their heat subsidized by electic consumers (it ain't "waste heat" if it's keeping your toes warm) 

Fair and Unfair are highly subjective terms.  New neighbors move in and set up a virtual junk car lot on their front lawn, killing the value of your house.  Is that fair to you?  Don't they have property rights, too?  Is it fair to keep them from using their land the way they want to?  Is it fair for you to lose value just because you have new neighbors?

The whole economic system functions as a whole and always has some level of regulation.  How much, in what manner and to what end are what's variable and they all effect the rules of the game that producers and consumers operate under.  The rules will always have winners and losers but the goal is to maximize the efficiency of the whole system.  Once you start to draw boundaries around this chunk or that and set up special rules to try to optimize that part, you lose the whole.

Back to that example.  A RR is moving coal at $3000 a car load and is covering all their costs.  Then, they find through inovation that they can reduce their operating cost 50%.  Are they under any obligation to pass along some of the savings or is the value of the service still $3000 a car load?  Is it fair that the shipper should get to share in the value of the RRs inovation?  Wouldn't that be the RRs inovation going to cross subsidize the shipper, who did nothing to earn the savings? 

What if that $3000 a carload coal was going to plant A.  The mine wanted to ship to plant B that was further down the main line, but the RR cost for that was $3500 and they were being undercut by another mine that was short haul trucking the coal there for $3100 (car load equivalent).  But, now with reduced costs, the RR can do $2900 to Plant B and win the business.  $3000 for the shorter haul and $2900 for the longer haul on the same line by the same RR.  Worse yet, let's say that because the RR did the hard work to reduce their costs that the $3000 load is now over the STBs magic 180% mark.  Where is the cross subsidization?  Who did the cost savings work?  Who is gets to reap the benefit?

 

[greyhounds]

Well, sort of close but your model fails to mention a couple of points concerning fixed costs.  Fixed costs are more related to costs per mile

No they're not.  They're not specifically related to anything.  Cost per mile of what?

  Going with your example of assigning $1000 per car in fixed costs for the original traffic that will pay the fixed costs for the line at the given traffic level.  Now when you add the new ethanol traffic and increase the number of cars on the line you should reduce the fixed cost charges per car.  If the fixed charges divided by the original number of cars came out to $1000 then the same fixed charges divided by the higher number of cars will give a number lower than $1000.  Now if this new lower figure of fixed costs per car comes in at $400 then your ethanol business pays it's own way.  If the new number is say $600 per car and the variable costs remain at $2000 per car then you are losing $200 per car with the new traffic.  But wait, since you are still charging your original customer $3000 per car they are paying ALL the fixed costs for the line.  The new customer is contributing $400 per car towards those fixed costs but these costs have already been met by the original shipper.  So this contribution goes right to the bottom line, pure profit!  Nice for the railroad but the original shipper is cross subsidizing the new customer account the new shipper cannot meet the charges fully for his share of fixed costs.  Now say the new fixed costs per car do work out to $400 per car.  The ethanol guys are now paying $2000 per car to cover variable costs and $400 per car to fully cover their share of fixed costs.  All is  well, right?  No, since no railroad in their right mind will call the original shippers who are willing to pay $3000 per car for a move which is $2000 in variable costs and $400 in fixed costs.  That leaves $600 per car which the railroad takes to the bottom line.  So if the original shipper does not find out about the new $2400 per car price structure he still ends up subsidizing the new traffic.

This is the kind of false reasoning one has to use if one is trying to show there is a cross subsidy that doesn't exist.  In our example, the railroad is running along without the ethanol traffic.  Then it gets the ethanol at a price of $2,400/car.  It's additional cost is only $2,000/car.  It's $400 ahead for every car of ethanol it handles.  But this somehow becomes a $200 loss.  And that "loss" has to be made up by other shippers.  This is the so-called cross subsidy.  But there is no such "loss".  Again, the railroad is $400 ahead on each car.  There's nothing to be made up.  There can't be any subsidy.  There's nothing to subsidize.  (You can not allocate fixed cost to any specific movement - you have to cover them with your entire traffic base, but you can not allocate them.  The only way the ethanol shows a loss is through the impossible allocation of fixed costs to the movement.)

Now is that fair to the original shipper?  What does the Railroad care about fair? 

The original shipper hasn't been affected at all.  And he's had nothing to do with the ethanol traffic.  I don't see how it's "unfair". 

Is your proposed solution:

1) everytime a railroad develops new business it has to give an across the board rate reduction to all existing shippers?  There will be precisous little new business.

2) prohibit the railroad from moving the ethanol at $2,400/car and deny the receiver the opportunity to use his low cost supplier

Differential pricing, which does not involve cross subsidization, seems to be the best answer to the situation.  I haven't heard a better one from you.

 

[arbfbe]

And now back to reality......

 

 

It is absolutely fair to the original shipper.  He is harmed not one iota by the "new" traffic.

But....

In this example, once the coal mine plays out and all that's left is that ethanol traffic, what would be "fair"?  The RR can no longer afford to move the ethanol at $2400/car load.  So the RR raises rates to cover fixed costs which causes the consingee to switch to an alternate source of supply - at greater cost to him.  The RR abandons the line, since it has a negative economic value.  The ethanol consumer has higher costs and winds up at a disadvantage in the market he serves since his competitor haslower costs (lets assume exactly similar circumstances except his RR line didn't lose it's base load traffic) and he goes belly up.  It this because of some "unfairness" on the part of the RR with regard to the shippers?  Or, is it just "life in big city"?

And, this is EXACTLY where the RRs found themselves in the regulated environment.  Other modes came and stole big chunks of the base load traffic (often with the gov't assistance) and the RRs were not free to adjust to the new conditions.  Rates were set entirely by calculated costs with no respect to the value of the service provided.   The notion that there is "fairness" in prices being set in relation to calculated costs is nuts.  Nobody runs their household that way.  Nobody sells things on Ebay that way (wanna buy a PS3?).  And nobody would ever run a small business that way.  So why should a RR be any different? 

 

The thread was about cross subsidization of traffic, in effect the railroad "taxing" one shipper with higher rates to cover more of the fixed costs to allow another shipper a lower rate to attract the business to the line.  I am sure the higher rate shipper would find the situation unfair, the subsidized shipper would be happy with the situation and would look for some way to justify the tarrif on the other shipper.  The railroad would be happy since they could make more money with the non-equal tarrifs.

Regulation was perhaps not good for the railroads and marginal lines.  The same happens today without regulation.  One customer closes shop or is bought out by another entity which moves production elsewhere and the line is forced to close since there is not enough business left to cover fixed and variable costs.  Regulation has nothing to do with that, business cycles and decisions do.  The railroads can keep the line open if they choose by raising rates to shippers on other lines to cover the fixed costs on the line they want to remain open. 

[MichaelSol]

  Rates were set entirely by calculated costs with no respect to the value of the service provided.  

?.

[oltmannd]

Well, now we know that Ken thinks the earth is flat.

His *example* to prove me wrong is itself a faulty premise.  He forgets that most captive customers are either located on the mainlines, or are former branch customers who now must truck their product to the mainline (and as such are still captive to that railroad, albeit with higher initial shipping costs added on).  There are little if any additional fixed cost allocations, merely variable costs, yet the customers are paying a rate that far exceeds those variable costs.  Meanwhile, the railroads are bringing in imported goods are rates that are near or under the STB's 180% R/VC standard as they compete irrationally for double stack business, which means that such moves are not covering both variable costs and an allocation of fixed costs.  Somewhere along the line, someone somewhere has to make up the deficit to keep the tracks in decent running condition, and that someone is those who pay the rates that exceed 180% of R/VC.

Only a purposefully blinded individual would look at that disparity and not call that cross subsidization.

The distinction you are trying to make between "base load" and "incremental" traffic is completely arbitrary and fallacious.  The only thing that matters is the net for the total traffic.  The only factor price should be based on is value of the service.  The service provider's cost to provide is irrelevant to the shipper. Anything that distorts the relationship between the value of the service and the price charged is a cross subsidization.  And, the value is based in large measure by the alternatives the shipper has available.  There are always alternatives (another RR, another mode, move, reengineer, liquidate, etc.)

The whole notion of fixed vs variable costs is only so the RR has some idea of long term profitability of the traffic.  Its not some be-all end-all holy grail method for pricing.

[Anonymous]

Well, now we know that Ken thinks the earth is flat.

His *example* to prove me wrong is itself a faulty premise.  He forgets that most captive customers are either located on the mainlines, or are former branch customers who now must truck their product to the mainline (and as such are still captive to that railroad, albeit with higher initial shipping costs added on).  There are little if any additional fixed cost allocations, merely variable costs, yet the customers are paying a rate that far exceeds those variable costs.  Meanwhile, the railroads are bringing in imported goods are rates that are near or under the STB's 180% R/VC standard as they compete irrationally for double stack business, which means that such moves are not covering both variable costs and an allocation of fixed costs.  Somewhere along the line, someone somewhere has to make up the deficit to keep the tracks in decent running condition, and that someone is those who pay the rates that exceed 180% of R/VC.

Only a purposefully blinded individual would look at that disparity and not call that cross subsidization.

[oltmannd]

And now back to reality......

 

Well, I could acknowledge that differential pricing is cross subsidization.  I could also acknowledge that the Earth is flat.  Such acknowledgements on my part would not make either one of these false premises true.

OK, I'll explain why Dave is wrong.  And he is wrong.  I'll try to write to a broad audiance.

 First, the costs of any enterprise may be broken down into two broad groups:  1) Fixed, and 2) Variable.

Fixed costs do not change with the amount of service provided by the railroad.  An example would be the taxes paid on the right of way.  They are the same whether the railroad operates 1 train per day over a line or 30 trains per day over the same line.

 Variable costs do change with the amount of service provided by the railroad.  An example would be the fuel used to move the freight.  The more freight moved the more fuel consumed, so fuel expense “varies” with the amount of business.

 Both fixed and variable costs must be covered if the enterprise (railroad) is to remain viable.  The ratio between fixed and variable will change according the amount of business.  A low volume line will have a higher percentage of its costs in the fixed category than a high volume line. 

 As an example, let’s take a 1,000 mile line used primarily to move coal to power generating stations and use a fixed cost to variable cost ratio of 1:2.  That is 1/3 of the total costs are fixed and 2/3 are variable.  If the railroad’s variable costs work out to $2,000/car, then the railroad must charge at least $3,000/car to break even.   The “average” cost is that $3,000/car.

 This line has additional capacity available.

 Now let’s say a demand for ethanol develops at the city served by the generating plants.  This ethanol can be provided from several sources, one of which is near the coal mines.  Other sources are closer to the receiver and can economically use trucks to move the ethanol.   Because of this, if the railroad attempts to charge $3,000/car for the ethanol, it will not get the business.

 But if it only charges $2,400/car for the ethanol, its source will become the low cost supplier and get the business.  But $2,400 is below the average cost on the line.  What to do?  (We’re assuming that the cost per car of moving the ethanol is the same as the cost per car for moving coal.)

 Well, the railroad prices the ethanol move at $2,400/car and takes the business.  That’s the most it can get.  Since the $2,400 covers the $2,000 variable cost of the movement, $400/car goes toward covering the railroad’s fixed costs.  It would be foolish for the railroad not to take the traffic at $2,400/car, and it would be even more foolish for government regulation to prohibit them from doing so.

 Now Dave falsely claims this is a cross subsidy.  It’s not.  The ethanol shipper is paying for his movement and contributing to the fixed costs.  No money is going from the coal producers to the ethanol producer.  They’re not paying any more because he’s using the line.  There is no cross subsidy.

 What are Dave’s alternatives?   Well, he don’t say.  Dave hasn’t shown that open access will lower costs.  (I’m sure it will increase costs).   Would he preclude the railroad from pricing the ethanol at $2,400?  Who would benefit from that?  Certainly not the coal producers.  Would he require the railroad to reduce the coal charges to $2,400?  Can’t do that.  Then they’d be selling everything below average costs and be going broke.

 The solution is differential pricing which produces a win-win for all involved.   Including the coal producers who now have some other shipper to at least contribute to the fixed cost of owning the rail line.

 

 

 

    

 

Well, sort of close but your model fails to mention a couple of points concerning fixed costs.  Fixed costs are more related to costs per mile but have to be reimbursed by cars hauled.  Going with your example of assigning $1000 per car in fixed costs for the original traffic that will pay the fixed costs for the line at the given traffic level.  Now when you add the new ethanol traffic and increase the number of cars on the line you should reduce the fixed cost charges per car.  If the fixed charges divided by the original number of cars came out to $1000 then the same fixed charges divided by the higher number of cars will give a number lower than $1000.  Now if this new lower figure of fixed costs per car comes in at $400 then your ethanol business pays it's own way.  If the new number is say $600 per car and the variable costs remain at $2000 per car then you are losing $200 per car with the new traffic.  But wait, since you are still charging your original customer $3000 per car they are paying ALL the fixed costs for the line.  The new customer is contributing $400 per car towards those fixed costs but these costs have already been met by the original shipper.  So this contribution goes right to the bottom line, pure profit!  Nice for the railroad but the original shipper is cross subsidizing the new customer account the new shipper cannot meet the charges fully for his share of fixed costs.  Now say the new fixed costs per car do work out to $400 per car.  The ethanol guys are now paying $2000 per car to cover variable costs and $400 per car to fully cover their share of fixed costs.  All is  well, right?  No, since no railroad in their right mind will call the original shippers who are willing to pay $3000 per car for a move which is $2000 in variable costs and $400 in fixed costs.  That leaves $600 per car which the railroad takes to the bottom line.  So if the original shipper does not find out about the new $2400 per car price structure he still end

-Don (Random stuff, mostly about trains - what else? http://blerfblog.blogspot.com/) 

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