1 In fiscal year 1972 and subsequent years, the liability for repatriation of employees was computed on a contractual obligation basis, instead of an immediate liquidation basis. The new method of stating the liability was adopted to more properly recognize and disclose the contractual obligations of the Canal Zone Government.

NOTE.-Panama Canal Company services prorated at 130 pct of object 25 on object classification schedules.

Pt. II.—A (10) In the Appendix to the Fiscal Year 1977 U.S. Government Budget, page 319, it is indicated that the estimates of tolls revenues for the future are based on "the Company's projection of toll rate increases yielding an estimated $7.1 million in the transition quarter and $29.0 million in 1977." What exactly are the assumptions of these projections? Are the toll rate increases which are indicated here assuming the implementation of the proposed measurement rules alone, or do they assume the proposed rule will be approved and then followed by another tolls increase?

Answer: The assumption underlying the toll projections contained in the 1977 Budget were (a) that the proposed measurement rule change would go into effect February 1, 1976 and (b) that a general toll increase would become effective July 1, 1976. The measurement rules changes will go into effect on approval by the President.1 An increase in the rates of tolls, if approved, will go into effect about November 1, 1976.

Pt. II-A (11) To what extent are the accounting policy changes of recent years responsible for the net losses incurred in FY 1975 and expected for periods subsequent thereto?

Answer: Since the accounting policy changes were provided for in the July 8, 1974 toll increase, their impact on the net operating results of the Company in FY 1975 was nil. The only factors contributing to the loss in FY 1975 are economic events that occurred subsequent to the last toll increase causing revenues to be down and costs up.

Pt. II-B (1) Delineate those costs of the Canal organization which are fixed and those which are variable?

Answer: A study by Arthur Andersen & Co. on this specific question was made in 1970. An abstract from their report is attached hereto. The detailed report, entitled Report on Development and Evaluation of Tolls Policies and Alternative Systems, dated November 1970 was provided for the Committee files. The report delineates in a very comprehensive manner the types of cost as between fixed (minimum capability) and variable. The conclusion in this report of the relationship of fixed costs of minimum capability and marginal costs as being 65% to 35%, respectively, is still valid.

1 On March 23, 1976 the President approved the measurement rules changes with the exception of the proposed new rule which would provide for inclusion in net tonnage of the space occupied by deck cargo.

(From Report on Development and Extension of Tolls Systems, Nov. '70, Arthur Andersen & Co.)

PART V-MARGINAL COST OF OPERATING CANAL

1. INTRODUCTION

A usual source for providing substantial direction in the design of a pricing system is the cost incurred to provide the service for which a price is charged. Therefore, it was considered essential to this tolls study to make a limited review of Panama Canal costs for purposes of identifying factors which may influence these costs and which may be significant in determining how to differentiate the tolls assessed to individual ships. To accomplish this, a limited study was made in order to: a. Define and estimate fixed costs, b. Define and estimate marginal costs, and c. Determine how such marginal costs are affected by the various elements of service being rendered. The scope of the study was to identify the relationships among costs rather than to determine precise amounts.

Marginal costs are defined as those incremental or direct costs that increase or decrease with fluctuations in the number of size of ships. Hence, they exclude any element of costs which are fixed. These latter costs, which include sunk and constant costs, exist regardless of the number or size of ships and, therefore, in themselves provide no guidance for assignment of the tolls charged individual users. For this purpose, the classification of a cost as fixed does not imply that it will remain unchanged in the future. Such factors as inflation and the introduction of different technology will cause the costs to change but the change occurs independently of the number or size of ships using the Canal.

Marginal costs provide a standard for structuring tolls rates, as follows: a. They establish a measure of the minimum toll since marginal costs are controllable costs that can be avoided if the service is not performed. A ship paying tolls less than such an amount would be paying less than the direct cost of providing the service.

b. They establish a means of measuring the amount of contribution to the fixed costs being made by the various users. This contribution provides a measure of the fairness of the tolls system.

A further discussion of the significance of costs in structuring a tolls system is contained in Part IV.

2. CONCLUSIONS

From the limited cost study, it was concluded that:

a. The costs associated with the operation of the Panama Canal are predominantly fixed. The study indicated that marginal costs comprise approximately 35% of the total costs at current levels of traffic. However, even at increased levels of traffic, fixed costs would predominate. This relationship permits substantial flexibility in the design and selection of tolls systems.

b. Of the marginal costs, 80% were caused by the number of ships using the Canal and the remaining 20% were caused by the size of the ships. These later costs, identified as size marginal, were related to vessels with a beam of 80 feet or more.

c. The fixed costs are not affected by either the number or size of ships. Thus, these costs cannot serve as a basis for differentiation in the structuring of a tolls system.

d. The long-range capital program to bring Canal capacity to 26,800 transits annually would cause no significant change in the overall level of operating marginal costs. Certain additional marginal costs that would be incurred because of the added capacity would be offset by economies in other costs.

3. CHARACTERISTICS OF THE PANAMA CANAL

a. Operating characteristics

A general understanding of the operating characteristics of the Panama Canal is helpful in relating the various elements of cost to the service performed.

The Panama Canal is fifty miles long from deep water in the Atlantic to deep water in the Pacific. The sea level sections of the Canal comprise about 15 miles of this total length. The remainder of the Canal, including the Gatun Lake area, is about 85 feet above sea level (varying in the range of 83 to 87 feet depending on the season of year and the amount of runoff for the year). The water in the elevated portion of the Canal is fresh water and is retained by dams and by lock structures at either end. Ships are raised or lowered through the locks. There are three sets of locks, each containing two lanes with chambers 1,000 feet long and 110 feet wide. On the Atlantic side, Gatun Locks raise or lower a ship in a continuous flight of three steps. On the Pacific side, a ship is raised or lowered through two sets of locks-Pedro Miguel Locks consisting of one step and Miraflores Locks consisting of two steps. These two locks are separated by the one-mile-long Miraflores Lake. The transit of a ship is controlled through the Canal's navigational service which provides for the scheduling of the ship for transit, the assigning of pilots, the monitoring of the progress of the transit, the furnishing of tug assistance, and the providing of lock towing locomotives and necessary deckhands.

A ship under the control of a Canal pilot normally enters the approach to the lock chamber under its own power, although in certain instances, tug assistance is required. At this point, towing locomotive cables are attached to the ship. Under the direction of the pilot, the towing locomotives control the ship within and assist in pulling it through the lock chambers. The averagesize ship requires four locomotives, but the larger ships may require up to eight locomotives.

In transiting the Canal, a ship proceeds through a clearly defined channel marked by naviagtional aids. Parts of this channel require periodic dredging to maintain a proper depth.

Fresh water is the basic raw material required for the operation of the Canal with each regular transit expending 52 million gallons. The required water is collected in reservoirs created by dams. Based on the current facilities of the Canal, it is necessary during the dry season to restrict the allowable draft of ships because of the seasonal fluctuation in the level of Gatun Lake.

Transits are made 24 hours a day. On the average, a ship spends approximately 15 hours in Canal Zone waters, although only 8 hours are normally required for making the actual transit.

b. Cost characteristics

The costs of the Panama Canal can be classified into three broad groups: (1) Those directly related to the transit of ships, 2) Those related to supporting services, and (3) Those related to general corporate operations.

The costs directly related to the transit of ships include pilots; traffic control; tugs; locks operation; and maintenance of equipment, locks, and the channel itself through dredging, stabilization of banks, and replacement of navigational aids. These are primarily the marginal costs.

The supporting services costs include those logistical in character such as employee services and supply activities. These services, in the aggregate, recover their costs through either: (1) The internal transfer of the cost to benefiting activities, or (2) The realization of revenues from the sale of services or products.

General corporate costs include the following major types of expenditures: (1) General and administrative expenses. These costs are associated principally with the overall administration of the Canal, such as legal, financial, personnel, and executive direction.

(2) Interest. This is the annual payment made to the U.S. Treasury at rates assigned annually by the Secretary of the Treasury for the investment of the U.S. Government in the Canal.

(3) The net cost of Canal Zone Government. This represents costs of the usual governmental services such as police, fire, education, and health services. These costs are incurred in providing the required governmental functions in the Canal Zone within which the Canal is located. To the extent that the costs of these services are recovered through user charges, such revenues are netted against the applicable costs. The Canal Zone Government costs are largely fixed in character.

Each of these costs is described in detail in Table V-2.

4. DEVELOPMENT OF MARGINAL COSTS

a. Methodology

Three sources of information were utilized in developing marginal costs: (1) The accounting records, (2) The long-range capital program, and (3) The informed judgment of operating officials.

To furnish a basis for identifying marginal operating costs, total costs for FY 1969, the most recent completed year, were analyzed. Marginal costs were those costs remaining after segregating costs that were related to minimum capability. Minimum capability was defined as that level of operations at which 1,000 transits a year would use the Canal. The cost level for that volume of operation was considered to be fixed. Costs above that level were considered to be those over which management could exercise control as the level of traffic changed. The marginal costs thus determined were further analyzed to differentiate between costs closely related to the number of ships ("number marginal") versus costs closely related to ship size ("size marginal"). This separation between number marginal and size marginal was based both on an extensive cost analysis and on discussions with operating officials; as such, the results reflect the informed consolidated judgment of many.

The method chosen to measure marginal operating costs assumed that such costs increase and decrease proportionately as traffic change, although it is recognized that, in actuality, the relationship is not entirely linear. For purposes of this study, a more precise measurement of marginal costs was not deemed necessary since the establishment of a general range and magnitude of marginal costs was considered adequate.

Relevant costs for establishing price differentiations among the users of the Canal include not only current operating costs but also capital costs which benefit users over a long period of time. To determine the latter, it was necessary to give consideration to the capital costs the Canal will incur in the future. Such capital costs are of two types: (1) Those required for the replacement of existing facilities, and (2) Those required for the expansion of Canal capacity.

To the extent that the Canal needs to replace relatively short-lived equipment, the cost thereof should be assigned to the users that benefit from this equipment. For the study, the specific equipment that was identified for replacement was that equipment which will be replaced over the next twenty years, and the amount which this short-lived equipment would contribute to marginal costs was assumed to be equal to the depreciation. This assumption, which implies that the equipment will be replaced at the same cost as the existing equipment, tends to understate the marginal costs because of inflation. However, the extent of understatement is not considered significant.

The Canal's recent study, Improvement Program for the Panama Canal, estimated that a step-by-step expenditure totaling $92.5 million in capital costs based on price levels estimated for 1971 would increase the capacity of the Canal from about 15,700 to 26,800 transits per year. Since these costs are controllable and will be incurred only as required to meet future demands for service, it is appropriate to include them in the marginal costs.

b. Determination of marginal and fixed costs

For purposes of this study, fixed costs were defined as those costs of operating and maintaining the Canal to service a minimum number of transits which was set at 1,000 transits per year (i.e., minimum capability). In determining the allocation between marginal and fixed costs, the objective was to develop only a relative relationship between marginal and fixed costs, not an absolute relationship.

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To arrive at the relative allocation, the costs for FY 1969 summarized in Table V-1 were analyzed and discussed in detail with operating officials. This review provided the rationale for determining the relationship between marginal and fixed costs as shown in the following tabulation:

The results demonstrate a relationship of 35% marginal costs to 65% fixed costs. This ratio is considered reasonable and indicative of the relationship between these two types of costs. Therefore, the conclusion is drawn that the larger part of the Canal's costs is fixed and that the smaller part fluctuates with number or size of ships. It is recognized that as the number of ships increases, the ratio of fixed to marginal costs decreases, although tests have indicated that the ultimate effect on this relationship is minimal.

c. Determination of number marginal and size marginal costs

There are certain basic services which the Canal must provide regardless of ship size; and the costs related to those services are considered number marginal, e.g., crewing of the locks. Some services are added or increased for large ships; and the costs related to such ships are considered size marginal, e.g., requirements for towing locomotives and tugs. The marginal costs were analyzed to separate number marginal from size marginal. Costs which could not be identified as size marginal were assumed to be number marginal.

The marginal costs of providing services for ships of 300 PC net tons and less, classified as nonocean-going, were considered so small that for this study they were ignored. It was also found that size marginal costs were not applicable to all sizes of ships. Rather, for identifying size marginal costs, the size was considered a factor only for those ships having a beam of 80 feet or more. These were divided into three classes, as follows: (1) Ships having a beam of 80-89 feet, (2) Ships having a beam of 90-99 feet, and (3) Ships having a beam of 100 feet or more.

Ship beam was used as the size denominator because services to large ships are more often assigned on beam than on other dimensions. In addition, capacity studies commonly use beam as the significant dimension. Generally, a ship's external measurement of length and draft will correlate with its beam. Operating costs were identified as marginal with respect to ship size where the cost could be assigned specifically to the large ship or where the large ship caused a disproportionate amount of wear and tear on facilities. Where there was no measurable basis for assigning marginal costs otherwise judged to be size related, they were assigned to the foregoing three classes based on weights of 1, 2, and 4 to give recognition to the pyramiding effect of size on potential for causing wear and damage. The total costs of transiting large ships were their size marginal costs plus their number marginal costs.

The method used to assign Canal improvement program costs for the replacement of existing facilities to the marginal costs of transiting vessels was to: (1) Compute the annual costs of each project by amortizing the acquisition cost over the assumed 20-year replacement period and by adding interest to the amount of the amortization. Since interest would be paid only on the unamortized balance of acquisition costs which assumed repayment of investment at the rate of amortization, an average interest was computed on one half of the acquisition costs. The rate of interest used in this computation was 5 percent. The net additional operating costs related to the Canal improvements were estimated to be insignificant and were therefore ignored.