Ratio of Attributable to Institutional Costs and Inframarginal Costs 2007 to 2013 Bob Cohen and John Waller 1

Postal Service Variability Ratio and Some Implications Ratio of attributable to institutional costs from 1980 to 2013 Inframarginal costs from 2007 to

Significance of the Ratio Increasing attributable costs generally associated with improving finances and benefits of scale economies Decreasing attributable costs generally associated with a lower cost volume mix or declining volume Because of recent growth of revenue from parcels, finances can improve even with increasing institutional costs 3

Operational Factors Affecting the Ratio Volume Volume Mix (average unit attributable cost of the volume) Weighted Volume (weighted by average unit attributable cost of the products) Productivity 4

Nonoperational Factors Affecting the Ratio Exogenous Factors Methodological Changes Both affect year to year values of the ratio, but not the overall directional trend 5

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Worksharing’s Impact Began in 1976 for FC and in 1978 for third class Large growth started in 1980 Reduced SP First Class, increased presort and greatly expanded third class Reduced the average attributable cost of the mail mix Offset the growth in attributable cost from the doubling of volume from 1989 to

Volume (Red) and Weighted Volume (Blue) 9

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1980 to 2000 Decreasing Slope 2000 to 2013 Increasing Slope 11

Current and Future Factors contributing to institutional % increase First-Class Single Piece decline reducing attributable costs Volume drop is reducing attributable costs Fixed Costs (and thus institutional) will continue to have a greater share of total costs Percent Institutional likely to increase Factor contributing to institutional % decrease Competitive Products growth (higher attributable costs 25% in 2013 vs. 10% in 2007) 12

Reasons for Bumps Exogenous costs (primarily institutional costs) Retiree Health Benefit Fund payments Worker’s compensation payment adjustments OBRA Methodology Changes Single subclass attribution method 1985 to 2005 USPS adjustment of carrier costs 1987 to 1992 Removing smooths ratio but does not alter trends 13

Exogenous Changes 14

Methodology Effects Changes in cost component methodologies persist once adopted Examples of significant methodology changes City carrier street time: Commission single subclass attribution from R87-1 to R About 2 % point change Postal Service adjustments to elemental Load 87 to 92. About 1 % point change Vehicle service drivers about 0.5 % point change Mail processing Postal Service proposal in R97-1 and subsequent cases not adopted by Commission. Would have been about a 5 % point change. 15

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Role of Inframarginal and Fixed Costs Volume and all costs types have dropped during 2007 to 2014 Volume: 25.4% Cost Percentage Decreases in 2007 Dollars: 18 Attributable24.1% Inframarginal15.4 Fixed 9.4 Total19.7

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Fixed and Inframarginal Costs Behavior Relatively stable 2007 to 2013 in nominal dollars Decreases when measured in real 2007 dollars Total inframarginal costs are not proportional to attributable costs, Even if it is true for many cost components, Due to aggregation process and annual shifts in component shares of accrued costs. Bumps still occur Fixed costs in 2011 and 2013 increased due to special personnel awards Attributable and inframarginal costs increased in 2011 due to surge in city carrier costs despite drops in volume. 21

Impact of Inframarginal & Fixed Costs on Average Unit Cost ‘A’ as Volume ‘Q’ Decreases Depends on two independent factors Fixed cost magnitude Economies of scale Illustrative example Two different volume with same cost function form C = F i + zQ i e for i = 1 or 2 for different volume levels, z a constant and e = elasticity of variable part of function. V 2 = xV 1 with V USPS volume, x < 1 Unit cost increase is: (F 1 /Q 1 )/(1 - 1/x) + zQ 1 e-1 (1 – x e-1 ) Fixed effect + Variable effect 22

Illustrative Example of Effect of Fixed Costs as Volume Decreases from 2013 Levels Average Unit Increases if Fixed Costs = Institutional Costs x = % Vol Decrease Volume Decrease 3.0%5.0%20.0% Fixed Effect Variable Effect Total Increase Average Unit Increases if Fixed Costs = Half of Institutional Costs x = % Vol Decrease Volume Decrease 3.0%5.0%20.0% Fixed Effect Variable Effect Total Increase

Conclusions Variability ratio may increase only slightly due to growth in competitive products with high attributable costs. Fixed costs are less than half of institutional costs per Report 2 (and maybe 5 percentage points lower) Unit cost calculations may not be affected significantly for volume changes less than 5 percent but are for values greater than 10 percent, especially for volume changes like the 25 percent drop between 2007 and 2013 Fixed and inframarginal vary with volume with the sizeable drops in current mail demand. 24