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Cost Reflective Pricing

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Practice Advice on Public Financial Management

Cost Reflective Pricing (OECD)

Summary Advice: The OECD suggests that when a case cannot be made for either corporatising or ring-fencing business activities, a range of frameworks can be used to calculate cost reflective prices. 

Main Points: This methodology determines full costs and includes competitive neutrality adjustments. It involves calculating the cost base for each activity; the competitively neutral cost benchmark; and the competitively neutral market price.

The cost base for each activity: includes all of the direct (labour, materials, service), indirect (HR and IT services, administration, finance costs) and depreciation costs of the activity and accounts for all of the real resources used to produce the service. In order to assess these costs, agencies need to have in place adequate financial management structures that allow costs, including indirect costs to be allocated to particular activities. Accrual accounting, output based costing and asset valuation systems, for example, would generate the information needed to calculate the cost base of a government business activity.

The competitively neutral cost benchmark: includes the cost base plus an adjustment for any advantages or disadvantages the activity receives because of government ownership (adjustments for private sector rate of return, taxes, regulation and legislation). It needs to be demonstrated that the constraints are externally imposed, exceed those facing the private sector and subsequently impose a cost on the government agency. In many cases it would be preferable to remove the cost disadvantage rather than trying to adjust prices.

The competitively neutral market price: is different than the cost calculation as it factors in what the market will bear (which may change over time); the level of competition between service providers; any technological advantage available to other suppliers of goods and other service providers; and market strategic price behaviours, such as the introduction of loss leaders or cross product subsidisation. Pricing needs to cover the cost benchmark in the medium to long run.

Source: OECD (2012) "Competitive Neutrality: A Compendium of OECD Recommendations, Guidelines and Best Practices" at http://www.oecd.org/daf/ca/50250955.pdf (accessed 28 February 2013).

Page Created By: Matthew Seddon on 28 February 2013. The content presented on this page is drawn directly from the source(s) cited above, and consists of direct quotations or close paraphrases. This material does not necessarily reflect the official view of the publishing organization.

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