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TRANSPORTATION, WATER AND URBAN DEVELOPMENT DEPARTMENT

THE WORLD BANK
February 1995
Transport No. RW-10

UNDERSTANDING THE COSTS OF COMMERCIAL RAILWAYS

Phil Anderson
Commercial railways must understand their costs. Therefore, the World Bank has encouraged railway borrowers
to improve their understanding of costs in order to evolve into competitive, commercial railways. In many projects
assistance has been provided for development of costing systems for pricing, investment, and operating decisions.
But results usually have been disappointing, and the time and effort required to achieve a good understanding of
costs leave exceeded expectations. Although it has been difficult for railways - including those in the United States - to develop and use reliable cost information for pricing decisions, there is an urgent need for better costs for
railways in China and India especially.
Why has it been so difficult for railways in most developing countries to design and install costing systems for
pricing decisions and for analysis of investment and operating options? Partly it was because a credible costing
system is complex, but the main reason has been an absence of government mandates for railways to be
commercially-driven rather than merely social services.
COMMERCIAL RAILWAYS IN THE U.S.
In the U.S. the commercially-driven railway and the availability of good cost information were a long time in
coming. An early milestone was in 1,962 when a task force of ten prominent economists was formed by the
Association of American Railroads to recommend costing principles for pricing of freight traffic in regulatory cases
decided by the Interstate Commerce Commission.
The AAR task force agreed that: "rates for particular railroad services should be set at such amounts ... as will make
the Greatest total contribution to net income. Clearly, such maximizing rates would never fall below incremental
costs. In the determination of cost floors as a guide to the pricking of particular railroad services, or the services of
any other transport mode, incremental costs of each particular service are the only relevant costs" (Baumol, et al, p.
9).
To implement this approach, several U.S. railways tried in the 1960s to maximize total contribution to net income
through a combination of cost control strategies, value-added customer service packages, and differentiated pricing.
To the extent they could estimate their customers' demand elasticities, they tried to set marketbased Ramsey prices
to maximize total contribution, with incremental (i.e., variable) cost as the floor. At first the estimates of variable
costs were made on the basis of historical accounts. But historical accounting data for track maintenance, for
example, understated actual wear and tear if railways had been deferring maintenance.
Another problem involved how to assign the joint costs of railway transport to the many specific services which
railways offer. Ernie Poole of Southern Pacific Railway, a pioneer cost analyst, illustrated the problem with the
laborer who screens sand from gravel and other materials. How much of the labor cost should be borne by the sand
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and how much by the gravel, if both are desired outputs? Because the railway joint cost problem is more complex,
cost analysts did not always agree on how to distribute joint costs to various rail services. One problem with their
joint cost distributions has been that actual results have not always matched the estimated costs. There was a
credibility crisis when management acted on the basis of cost analysts' predictions and later found that actual
expenses differed greatly!
With all the difficulties, 20 years passed before the necessary changes in government regulation were made and
new Internal management policies led to widespread provision by commercial railways of competitive services at
prices designed to maximize total contribution to overhead and profit.
As U.S. railways began using better cost estimates, regulation of maximum railway prices became less necessary as
their markets were served or contested by competitive railways and motor carriers who knew their costs and set
prices with costs as a floor. Thus, both the railways' and other carriers' potential market power was curbed by
market regulation rather than government regulation.
Railway freight traffic costing was not unique to U.S. railways. After British Railways freight traffic was
deregulated in the 1970s and BR was given a commercial mandate, it developed costing models arid pricing)
policies which paralleled those in the U.S. The French National Railways also developed similar freight traffic
costing models. Both railways have provided traffic costing assistance to Bank, borrowers.
CHARACTERISTICS OF RAILWAY COSTS
Railway costs are not mere accounting data in a new guise. Instead, they have some distinguishing characteristics
(see Box). First, the costs consist only of those elements which are relevant to the specific pricing, investment, or
operating decision under consideration. No single "cost" will meet ail needs because the definition of which cost
elements are relevant may change. Railway cost finding thus is an art, which is why the analyst may ask "which
cost do you want, the high cost or the low cost?"
Characteristics of Railway Costs
z
z
z
z
z

Includes only relevant cost elements

Separates fixed and variable costs
May measure the congestion effect
Treats inefficiency as a fixed cost
Is usually forward-looking

The relevant costs can be divided into fixed and variable costs . Fixed costs, which are independent of volume
changes, are an important part of railway costs since large sunk investments in track and other facilities incur fixed
costs for maintenance, operation, and replacement whether or not any traffic is carried. For some uses such as
deciding whether to build a new railway line, fixed costs can be relevant and incremental. In contrast, variable costs
are those which depend on traffic volume. For a particular group of expenses, the percentage of variable cost to
total fixed and variable costs depends on the time frame of the decision for which the variable cost is being
estimated. The longer the time frame, the higher the percent variability. Ultimately, as is often said, all costs are
variable!
The estimated variable unit cost may itself vary as transport output increases due to the congestion effect. Because
the railway is a closed system, the freight and passenger cars in that system will increasingly incur delays as the
capacity of the infrastructure is approached. Vehicle ownership and maintenance unit costs, which usually are
important components of variable unit cost, would then rise as vehicle utilization deteriorates due to infrastructure
congestion. If this situation exists, the variable unit cost should measure this congestion by increasing as volume
nears infrastructure capacity.
Frequently it is important to distinguish between the actual cost of rail services provided and what the cost might
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have been if operations were more efficient. This cost differential is best viewed as an overhead cost which should
be controlled whether or act volume chancres. Since it is better treated as a fixed cost rather than as part of variable
cost, it is fixed cost of inefficiency.
Railway costs usually are forward-looking, in that they reflect what is anticipated about the future results of a
decision to change prices or operations, or undertake investments. The need to be forward-looking has led to use of
"engineered costs" rather than historical accounting data. Examples might be the predicted maintenance cost of an
untried type of locomotive or a new railway line. An engineered cost may be calculated simply from the
modification of historical accounting data, or it may be the outcome of a complex study of how input-output
relationships of the railway would change because of new methods or investments. In the latter case the cost analyst
is challenged to understand the "production function" of railways and to predict how future input-output
relationships may change.
ESTIMATION PROBLEMS
When railways first begin to use costs for pricing and other decisions, the costs must be developed with difficulty
from historical accounting data used for financial reporting. It may be much lacer, after the value of cost finding has
been demonstrated to management, that railways can expect to have good historical data from a "cost accounting"
data base.
From accounting data, the cost analyst directly assigns actual expenses to actual operations where possible. If the
accounts of railway borrowers offer little or no detail by geographical or functional cost center, few expenses can
be directly assigned in this manner.
Next, variable unit costs must be estimated from the out-of-pocket or variable portion of selected accounts. In some
cases an account's "percent variable" may be calculated by correlating expense dam either for one railway over
several reporting periods (time series analysis), or among several railways for the same period (cross-sectional
analysis). For other accounts the percent variable may have to be assumed. An example of variable unit cost
elements is shown in the table, below.
Elements of Variable Unit Costs and Basis of Estimation (if relevant)
z

Ownership costs
Locomotives
Freight cars
Coaches
Infrastructure

cost
cost
cost
investments

Maintenance costs
Locomotives
Freight cars

Coaches
Track
Bridges and other infrastructure
z

Replacement
Replacement
Replacement
Incremental

Unit
Unit
Unit
Unit
Unit
Unit
Unit
Unit
Unit
Unit

cost/loco unit-km
cost/liter of fuel used
cost/car-km
cost/carload
cost/car-year
cost/coach-km
cost/coach-year
cost/gross ton-km
cost/track km-year
cost/track km-year

Transportation costs
Train fuel
Train crew wages
Loco crew wages

Unit cost(gross ton-km

Actual by cost center
Actual by cost center

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Shunting
Station operations
Billing
Other
z

Unit
Unit
Unit
Unit

cost/shunting minute
cost/train-km
cost/carload
cost/train-km

Variable overhead Percent additive to above

To estimate variable unit costs for railways which operate both freight and passenger traffic, for some accounts
there must be a separation of variable costs assignable to freight service from those assignable to passenger service.
Separation of freight and passenger costs is especially difficult for accounts that report maintenance of permanent
way expenses.
In recent years the Bank has provided assistance for development of railway costing systems in China, Indonesia,
Mongolia, India, Bulgaria, Romania, Mexico, Colombia, Bolivia, Ghana, Kenya, Tanzania, and Uganda. A costing
system developed with Bank assistance for use on small and medium-size railways has been OSCAR (Operational
Simplified Costing for Railways).
WHY ALL THIS IS IMPORTANT
In moving goods by rail, it can be shown that one ton is costlier than another; thus a ton of machinery or frozen
foods costs more than a ton of coal since it uses more transport space and more expensive services. Likewise, one
kilometer can be costlier than another since it takes more power and fuel to climb mountains than it does to cross
flat country. Costs per mile decline with distance, and they are less in the backhaul direction because empty freight
cars are available at little cost. Since costs per ton-kilometer of different goods differ, it follows that railways need
good cost data to set prices properly.
Consider China Railways, which in 1994 reported a net loss of RMB yuan 813 million, excluding the Railway
Construction Fund surcharge. In 1995 its prices must be adjusted substantially to offset rapid price inflation in
labor, fuel, and other inputs, to reduce ballooning external requirements for financing the railways' rapid ,growth
with new debt and equity (see table).

(Figures in billions)
Converted ton-km
Internal sources, RMB yuan
Internal applications, RMB yuan
Net internal funds, RMB yuan

1991
1,362
19.2
20.0
(0.8)

1992
1,454
20.9
24.5
(3.6)

1993
1,540
33.8
44.6
(10.8)

The case in China parallels that in the U.S. in the early 1970s, when fuel and labor costs rose at 12 to 15% per year
and most railways lacked a detailed understanding of their costs. One difference is that for several years the Bank
has been assisting the railways of China in the development of a traffic costing system which should now be
sufficiently developed to help determine patterns and amounts of selective price increases.
CONVENTIONAL WISDOM
When railways do understand their costs, the U.S. experience shows that conventional wisdom about railways will
change. For example, the previous conventional wisdom was that the most profitable railways were highly-efficient
ones with low-rated bulk traffic. This led many railways to decide not to provide special, costly services for highvalue commodities, and they consequently lost the traffic to trucks.
Today, the view of railways who understand their costs and markets is that high-value commodities can produce a
contribution above variable cost, but only if they are carried in efficient vehicles, if their variable costs are
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controlled, and if their markets' competitive conditions and regulatory policy allow adequate prices. These railways
also learned that, when high-valued commodities are carried in containers at "freight-all-kinds" (FAK) rates,
competitive market conditions can produce low revenue yields and negative contribution unless very efficient
freight cars and methods are employed.
The costs of Indian Railways (see table) and, to a lesser extent, their impact on CONCOR, its cancer transport
subsidiary. are not too well understood. The Bank and the Netherlands are providing assistance for improvement of
CONCOR's costing system. At the same time the Asian Development Bank is providing assistance to Indian
Railways to improve its costing system.
Unfortunately, many other Bank railway borrowers do not understand their costs, and this has been a factor in their
failure to obtain a commercial mandate from their government. Some railways also have a large profitable traffic
base that is subsidizing non-commercial passenger and freight services instead of providing investment funds to
improve the general efficiency of the railways.
CONCLUSION
In competitive industries "no cost system can really assure that all costs will be covered and a 'normal' profit
earned, for sales volume will play a significant role" (Baumol, et al, p. 8). Of course, sales volume depends not only
on price, but on the services provided and the quality of those services, facts that U.S. railways took a long time to
realize. Moreover, a normal profit cannot be assured for railways if prices are 'cost-based" and set equal to variable
costs. Instead, if railways are to survive in a competitive transport environment, they must maximize contribution
by attempting to set marketbased Ramsey prices with variable cost as the floor. For this they will need to
understand their costs and markets.
INDIAN RAILWAYS
It seems to be the fate of Indian Railways - one of the great railway systems of the world - to be unable to
maximize contribution and profitability as commercial railways. A large contribution to profit from bulk traffic
has been used to subsidize lowdensity lines, some passenger services with low revenues, and other loss-producing
services, instead of investing the funds in efficiency producing improvements. Critically scarce railway assets
have been preempted by transport demand that either has been handled at a loss or has contributed less than
other transport demand might have. The problem has become more acute in recent years as the government has
withdrawn budgetary support and the implied subsidy for these public service obligations has decreased.
The reason for the misapplication of resources has been the widely perceived role of railways as a social service.
Also, the government still views the railways as a macro-economic development tool.
Without a clearly defined commercial mandate from the government, it will be impossible for Indian Railways to
evolve into commercial railways. Long term, the railways' ability to provide sufficient, low-cost transport is in
jeopardy, and the transport problem for the country will become serious.
The lack of a commercial mandate is partly due to the railways' inability to offer credible cost estimates for the
social services the railways are required to provide. However, better costs are a necessary but not a sufficient
condition, since for many years Indian Railways has estimated costs on the basis of accounting data and
provided Parliament with these estimates. Indian Railways now may be where the U. S. railways were in 1962,
the railways do not know their costs well, the public does not accept the railways' story about the burden of
social services, and nothing is done.
To Learn More
Baumol, William J., Burton N. Behling, James C. Bonbright, Yale Brozen, Joel Dean, Ford K. Edwards. Calvin B.
Hoover, Dudley F. Pegrum, Merrill J. Roberts, and Ernest W.
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Williams, Jr. October 1962. "The Role of Cost in the Minimum Pricing of Railroad Services." Journal of Business
of the University of Chicago, XXXV - Preprint.
Canadian Transport Commission. 1984. Railway Costing: State-of-the-Art-the-Art. Ottawa: Unpublished World
Bank document.
Hargrove, M. B., and C. D. Martland. 1989. TRACS.- Total Right-of-Way Analysis and Costing System. Association
of American Railroads, Washington, D.C.
Hickling Consultants. 1990. OSCAR (Operational Simplified Costing for Railways).
Petersen, E. R. 1989. QRAIL (C) User's Manual. Queen's University, Kingston, Canada.

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