Costs for Better Management Decisions: CRA Versus Fully Distributed Costs
September 17, 2012 (RARC-WP-12-016)
This paper investigates the suggestion that the Postal Service could make better management and pricing decisions if it were to use a fully distributed costing (FDC) methodology to allocate all of its costs to products. In order to shed light on this subject, the Office of Inspector General asked Professor John C. Panzar, an economist with expertise in postal costing, for his opinion on whether FDC would be a good tool to use to evaluate the profitability of new initiatives. The following paper, Costs for Better Management Decisions: CRA Costs versus Fully Distributed Costs, is the result of this effort.
Professor Panzar’s analysis reveals that institutional costs, and therefore FDC, should not be used to judge the profitability of new initiatives. Instead, profitability should be evaluated based on the comparison of the revenue the new initiative will produce to the incremental costs it adds. If the revenue exceeds the incremental costs, the initiative should be offered on the market. Otherwise, the Postal Service is missing an opportunity to earn more revenue. Professor Panzar also concludes that FDC should not be used when, due to resource constraints, management needs to choose between two profitable initiatives. He demonstrates that using FDC can lead to poor decisions, such as choosing to offer a product with little contribution (profit) over a more profitable product.
This paper should not be interpreted to mean that the Postal Service should not be concerned with earning sufficient revenues to cover its institutional costs. This is a laudable and necessary goal. Rather, this paper points out the potential problems the Postal Service would incur if it were to use FDC to estimate the profitability of new initiatives and make decisions about which products to bring to market. Using FDC would create a conservative policy that would help the Postal Service to avoid bad initiatives. However, it could rob the Postal Service of revenue opportunities at a time when they are greatly needed.