Cost plus regulation

Cost Plus Regulation

Cost plus regulation is a pricing strategy used by regulatory bodies, primarily governments, to control the prices charged by businesses, especially those operating as natural monopolies or in essential public services. Under this approach, the regulator sets prices based on the firm's actual operating costs and capital expenditures, plus an allowed profit margin. This method falls under the broader financial category of regulatory economics, aiming to balance fair returns for providers with affordable services for consumers while promoting economic efficiency.

History and Origin

The concept of cost plus pricing, and by extension, cost plus regulation, gained prominence in various sectors, particularly during periods of significant government procurement or when regulating essential services. Cost-plus contracts were first utilized by the U.S. government during World War I as a mechanism to incentivize and accelerate wartime production by American businesses. This contracting method allowed nascent technology firms to recover research and development costs that they might not have been able to bear on their own, fostering innovation and the creation of new economic sectors. In the context of utility regulation, a similar principle emerged with the Public Utilities Act of 1935, which introduced "parity pricing" to ensure that utility companies could charge rates that covered their costs and allowed for a reasonable profit.⁶

Key Takeaways

• Cost plus regulation sets prices by reimbursing a firm's actual costs and adding a predetermined profit margin.
• It is primarily applied to natural monopoly industries, such as public utilities, to prevent excessive pricing.
• A key benefit is ensuring that regulated firms can cover their expenses and earn a reasonable return, promoting financial stability for essential services.
• A significant criticism is the potential for regulated firms to lack incentive for cost control, as increased costs can be passed on to consumers.
• Variations exist, with some forms (like cost-plus percentage of cost contracts) often prohibited due to perverse incentives.

Formula and Calculation

The fundamental principle of cost plus regulation can be expressed by a straightforward pricing formula:

Where:

• Price represents the total amount charged to consumers for the good or service.
• Allowable Costs include all verified and approved expenses incurred by the regulated entity in providing the service, such as operating costs, maintenance, depreciation, and a return on its capital expenditures.
• Allowed Profit is the determined financial return the regulated entity is permitted to earn, often calculated as a percentage of the allowable costs or a fixed fee. This ensures the company's financial viability and provides an incentive for investment.

Interpreting the Cost Plus Regulation

In practice, interpreting cost plus regulation involves assessing whether the regulated prices achieve a balance between consumer protection and industry viability. Regulators meticulously audit a company's reported costs to ensure they are "allowable," "allocable," and "reasonable" before permitting them to be passed on to consumers. The "allowed profit" component is crucial; if it is too low, the firm may struggle to attract investment or maintain quality service. Conversely, if too high, it could lead to excessive charges for consumer surplus. The goal is to determine a fair cost of service that supports the long-term operation and necessary upgrades of the service provider, particularly in sectors dominated by utility companies.

Hypothetical Example

Consider a newly established water utility operating under cost plus regulation. The local regulatory commission determines that for the upcoming year, the utility's projected allowable costs—including infrastructure maintenance, salaries, water treatment chemicals, and administrative expenses—total $10 million. The commission also approves an allowed profit margin of 10% on these allowable costs.

1. Calculate Allowed Profit: $10,000,000 (Allowable Costs) * 0.10 (Allowed Profit Margin) = $1,000,000
2. Determine Total Revenue Required: $10,000,000 (Allowable Costs) + $1,000,000 (Allowed Profit) = $11,000,000
3. Set Price: If the utility expects to deliver 100 million gallons of water over the year, the average price per gallon would be $11,000,000 / 100,000,000 gallons = $0.11 per gallon.

This approach ensures the utility recovers its expenses and earns a set profit margin, providing stability and an incentive for the utility to operate, while theoretically limiting its ability to charge exorbitant prices due to its natural market power.

Practical Applications

Cost plus regulation is predominantly found in industries where competition is impractical or undesirable, leading to natural monopolies. Its most common applications include:

• Public Utilities: Electricity, natural gas, water, and sometimes telecommunications and transportation are frequently regulated using a cost-plus framework. This ensures essential services are accessible and affordable, as these industries often involve massive fixed costs and economies of scale. The history of cost of service regulation in the investor-owned electric utility industry shows its adaptation over time to new issues.
• ⁵ Government Contracts: Many government contracts, particularly for research and development, defense, and complex infrastructure projects, are structured on a cost-plus basis. This is because the scope of work and associated costs can be highly uncertain at the outset, and cost-plus contracts shift some of the financial risk from the contractor to the government. The⁴se contracts reimburse contractors for allowable expenses plus an agreed-upon fee.
• Healthcare: In some healthcare systems, particularly those with strong government involvement or single-payer models, the pricing of medical procedures, drugs, or hospital services may incorporate elements of cost plus reimbursement.

Limitations and Criticisms

Despite its role in stabilizing essential services and fostering innovation in high-risk ventures, cost plus regulation faces significant limitations and criticisms:

• Lack of Cost Control Incentive: One of the primary drawbacks is the diminished incentive for the regulated firm to minimize costs. Since all allowable costs are reimbursed, there is less motivation to pursue efficiency improvements or cost-saving innovations. This phenomenon is sometimes referred to as the "Averch-Johnson effect" in the context of rate of return regulation.
• ³ Information Asymmetry: Regulators often struggle with information asymmetry, where the regulated firm possesses more accurate and detailed knowledge of its own costs than the regulator. This can make it challenging for regulators to determine "allowable" costs and "reasonable" profit margins, potentially leading to inflated cost submissions or what is known as regulatory capture.
• Inflationary Pressures: In environments of high inflation, regularly adjusting prices to cover rising costs can contribute to an inflationary spiral, continually pushing up consumer prices.
• Disincentive for Innovation: If the allowed profit margin is fixed or determined based on existing assets, firms may have less incentive to invest in new, more efficient technologies that could reduce future costs but require significant upfront capital expenditures.
• Prohibition of "Cost Plus a Percentage of Cost": Some variations, specifically "cost plus a percentage of cost" (CPPC) contracts, are explicitly prohibited by government agencies like FEMA for federal disaster assistance. This is because CPPC contracts provide a perverse incentive for contractors to inflate costs, as their profit increases directly with the total cost incurred, thereby lacking provisions to control costs and maximize efficiency.

##²# Cost Plus Regulation vs. Rate of Return Regulation

While often used interchangeably or as closely related concepts, cost plus regulation and rate of return regulation have distinct focuses.

Cost plus regulation, in its broadest sense, is a pricing strategy that simply ensures costs are covered plus a profit. Rate of return regulation is a specific form of cost plus regulation common in utilities, where the allowed profit is tied directly to the firm's capital investment, aiming for a "fair rate of return." Confusion arises because both involve covering costs and adding a profit component, but rate of return regulation introduces the explicit concept of a return on the capital base.

FAQs

What is the main goal of cost plus regulation?
The main goal of cost plus regulation is to allow a regulated company, especially a natural monopoly, to cover its legitimate costs and earn a reasonable profit margin. This ensures the continued provision of essential services while preventing the company from exploiting its market power to charge excessive prices.

Why is cost plus regulation used in government contracts?
It is often used in government contracts, particularly for complex projects like defense or research and development, because the exact costs are difficult to predict at the outset. This type of contract reduces financial risk for the contractor, encouraging them to undertake projects with high uncertainty, as their operating costs will be reimbursed.

What are the biggest criticisms of cost plus regulation?
The biggest criticisms revolve around the lack of incentive for cost efficiency. Since all "allowable" costs are reimbursed, the regulated entity may not have a strong motivation to reduce expenses or innovate to lower costs, potentially leading to higher prices for consumers over time. It can also lead to issues like regulatory capture.

Does cost plus regulation promote efficiency?
Generally, cost plus regulation offers limited direct incentives for efficiency. While regulators aim to approve only "allowable" costs, the system can inadvertently reward higher spending. More modern regulatory approaches, such as incentive regulation, attempt to address this by incorporating mechanisms that encourage cost savings and performance improvements.

Is "cost plus a percentage of cost" contract allowed by the U.S. government?
No, "cost plus a percentage of cost" (CPPC) contracts are generally prohibited for U.S. federal government use, including by agencies like FEMA. Thi¹s specific type of contract is banned because it gives contractors an incentive to inflate costs, as their profit directly increases with the total expenditure, leading to potential waste and inefficiency.