Thursday, September 19, 2013

More on Transfer Pricing, Budgeting, and Incentives

The class session wasn't completely satisfactory today, especially if one your classmates, whose alias is Oliver Williamson, is right about not being able to tie the theory well to realistic scenarios.  So I'd like to take the reverse tack in this post - start with a couple of quite realistic scenarios and from there go to how those are being managed and bring in the pricing issue at the end.  The two scenarios I'd like to discuss are:

(1) energy pricing (mainly electricity) on campus, and

(2) the decline in campus revenue from the State of Illinois in it's budget and what the campus is doing to adjust to that reality.

* * * * *

The campus is an energy producer via Abbott Power Plant.  It is also an energy consumer.  Indeed consumption outstrips production so the campus is a net importer of energy.  It purchases the remainder of its consumption from commercial providers, such as Ameren.  This situation, then, is remarkably similar to the M&R textbook model of transfer pricing in the presence of an outside market.

Historically, the energy bill has been paid off the top at the campus level with unit (college and departmental) budget officers aware of the aggregate number only, but not knowing how much their unit contributed to the aggregate demand.  One obvious reason for why this funding happened off the top was because in older buildings there were no meters to measure usage on a per building basis.  The newer buildings do have the meters.

Now, while staying on the general topic of energy production and consumption, let us turn to how the campus might promote "green efforts" (meaning energy conservation) and what role pricing can play in doing so.  You likely have some understanding of this based on your own experience, if you lived in campus housing in your first year, where the energy bill is bundled in with your overall housing payment, and then moved into an apartment, where the energy bill is separate from the rent.  I have had many students tell me over the last few years that they practiced conservation more once they moved into an apartment.  (They kept their apartments cooler in the winter and warmer in the summer than was the practice in the dorms. )  The conservation was a consequence of trying to economize on the energy bill.

In the same way, to get greater conservation on campus, it would make sense that each unit pay for its own energy consumption.  This would provide better incentives for the unit to promote a green approach (think about how thermostats are set in offices and on whether the staff member's computer gets turned off when the person goes home at the end of the day) and for the units to monitor on this and otherwise encourage a green effort.  The plan is to gradually move away from off the top funding toward unit pay as metering of buildings becomes more common.

It is my understanding, however, that the units wouldn't directly contract with outside providers.  The campus would still be billed.  Then it would pass those charges along to the units based on usage and an internal transfer price.  According to M&R, the internal transfer price should be the same price what the commercial providers charge the university.

Real life is more complicated than textbook models, so here let me bring up some additional real world issues that are not in what M&R present.  Actual energy pricing varies seasonally.  Electricity is more expensive in the summer.  Heating oil is more expensive in the winter.  Both of these are explained by what is referred to as a peak load pricing issue.  Demand varies seasonally, primarily because of weather variation.  But there is also within season variation in the weather.  Weather can be reasonably mild, if you are lucky, and energy consumption will be less as a consequence.  Or weather can be more severe, which exacerbates energy consumption. The economic question is who should bear the risk from this variation, the units or the campus.  There is a further issue that large consumers, like the  U of I, can negotiate bulk discounts with the energy providers if the large consumers are willing to, in exchange, do extra conservation during the extreme weather incidents.  In the summer, in particular, this is a way for the energy providers to prevent brownouts and blackouts.

In the old way of doing things, the campus self-insured on the issue of extreme weather causing high energy bills.  It would hold back funding (meaning it wouldn't budget those funds for other purposes).  These expenses fell into a budget category called "unavoidables."  If that category got overspent, it meant the campus would have to take the money from elsewhere - fewer new hires, less discretionary money passed down to the units, and other ways to economize on operations to make up the shortfall.  I am not sure how this will work when the energy charges are passed down to the units.  We have already discussed in class how it is not good for an organization to have such self-insurance happen at the lower rungs of the hierarchy.  It leads to an accumulation of balances that is not desirable.  So what is wanted is some self-insurance done centrally but in general paying for energy costs in a distributed manner.  It will be interesting to see how this gets worked out.

There is one other matter that complicates things.  Some units, either because of a research need or a production need, must operate in a temperature controlled environment.  (Think of animal research in Vet Med and Animal Science as examples of the research need and campus computer servers offering heavily used online services as an example of the production need.)  These units will need to be exempt from green efforts undergone elsewhere on campus.  The question then is how to manage the exemption, given the new transfer pricing regime.  One possible way to do this is to enhance the off the top funding these units receive so they can better bear the energy costs they will incur.

* * * * *

This next example is more about managing the amount of personnel at the campus level than it is about transfer pricing.  Here is some background first.

The campus has four main revenue sources:
(a) Money provided by the State of Illinois that it was originally collected as tax revenue.  Among Deans and their budgeting officers, this is referred to as General Revenue Funds (GRF).
(b) Tuition dollars that students pay.
(c) Grants and contracts.  Much of this is money from the National Science Foundation and the National Institute of Health to support the research activity on campus.  There are funds from other government agencies such as The Department of Education, The National Endowment for the Humanities, etc.  And there are funds from Foundations.  The SCALE grant that I mentioned in class today came mainly from the Alfred P. Sloan Foundation.
(d)  Gifts from donors.

Of these, two were impacted adversely by the financial crisis - (a) and (d).  I believe gifts have made a comeback since, a consequence of the rebound in the stock market.  And (c) is being adversely affected now by the sequester.  Let's keep our fingers crossed that this is temporary.  But the state remains in fiscal crisis and further, only state funds are used  to pay employee benefits - mainly health care but also life insurance and other benefits.  As health care costs have risen, there are fewer state provided funds left over for other purposes.  The question is what to do to make up for the shortfall of this funding source.

How GRF funds have been allocated to various colleges can be explained one way in theory and perhaps a different way in practice.  Some colleges, notably ACES via its extension service and Engineering too, have as part of their mission to provide services state wide.  Some of the state funding can be explained to support this external part of the Campus mission (after all, we are the Land Grant College in Illinois).  Another part of the GRF might have been used to reward those colleges that did particularly well in getting grants and contracts.  The idea, in a nutshell, is to reward winners.  This sort of research funding conveys prestige on the university.  So the allocation of the GRF is aimed to create a positive feedback loop for those who do well in this arena.  A third usage of GRF is as subsidy for units or activities that are absolutely necessary but that themselves wouldn't otherwise be money makers.  This is how, for example, English can afford to teach the introductory rhetoric courses in comparatively small sections, where other departments can't do likewise for their Gen Ed offerings.

That is the theory.  The reality on the ground is that units become accustomed to receiving their GRF monies and over time these funds became locked into the unit's budget, at least in the mind of the unit's executive officer.  While this lock-in of funding was happening, the reason for the allocation initially becomes more remote as it fades into the past.  To other units that are less dependent on GRF, the allocation begins to look less rational and appears more about the Provost playing favorites.

The campus has approached the GRF shortfall in two different ways - one was a quick downsizing via what was called the Voluntary Separation Incentive Program. In this program individual employees who opted in received a severance payment based on how much they were earning.  The program succeeded in reducing the number of campus personnel.  However, it didn't manage at all who would separate.  That was left entirely to the employees to decide.  The result is that some areas were more severely impacted by turnover than others.

There has also been a more deliberate attempt at reducing overhead via a program called Stewarding Excellence (VSIP was actually a component of Stewarding Excellence) which is still ongoing regarding implementing recommendations.  You can think of Stewarding Excellence as making recommendations about consolidating smaller units on campus that seem to have a like purpose, in an attempt to reduce overhead, or to eliminate some units entirely, if they seem redundant or if their mission is no longer central to the mission of the campus.  In case it is not obvious, members of such units don't want to merge with another unit, nor do they want to be downsized into oblivion.  So none of this is easy to accomplish.  But given the revenue situation, the organizational structure issues must adjust to the new realities.

* * * * *

In this last section, let me return to when off the top funding is good and when cost recovery is the preferred mode of funding.  There are some issues that we didn't get to in class today on this point that might help to better understand these concepts.

Many people refer to the "Library Model" when talking about off the top funding.  Library services are free to the end user and particularly the electronic services (eJournals, electronic databases, and eBooks) are really public goods.  One person's consumption of these services in no way blocks the consumption of the service by others on campus.  For public goods, it is better that they are free to the user than that here is a usage charge.

This itself is only a partial explanation of why the Library receives off the top funding.  An alternative is the each unit would pay the Library to produce collections in its area.  So, for example, the Economics Department might pay the Library to subscribe to economics eJournals and other electronic economics content.  The issue here is that there are economists elsewhere on campus, in Business, ACES, Education, Engineering and elsewhere.  Those people have interest in these journals.  How does that interest get aggregated into the Library's purchasing decision?  Similarly, some of the database content is multi-disciplinary in its offering.  For both reasons, this is an argument for aggregating at the campus level (off the top funding) rather than having individual units pay.

So that is the good with off the top funding.  The bad about it is that it doesn't adjust well at all to dynamic changes in usage patterns, either growth or shrinkage.  Cost recovery is much better for that.  If usage is growing and downstream units with users want to support that, the upstream provider will get more revenue devoted to the activity.  Likewise, if usage is waning, the upstream provider will receive less revenue.  So cost recovery is better at making the revenue spent on the service match the usage.  But it is less good at providing access of public goods.

Those are the tradeoffs.

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