By Constance Hornig

This is the fourth in a series of articles that identify issues frequently raised in procuring, negotiating, and drafting MSW service contracts. Collectively, these articles will constitute a practical contracts manual that describes approaches that MSW service providers and local governments can take to share risk and reward—and reach a mutually satisfactory agreement. The first article can be accessed at Sharing and Minimizing Labor Risks; the second at Money Talks: Financial (Dis)incentives for Performance and the third at Variable Can Pricing: Generator Diversion.Hauler Disposal Incentive.

Much blood and sweat, and maybe many tears are expended on competitively procuring or intensely negotiating MSW service fees for collection, recyclable materials, or greenwaste processing, transfer, and disposal. But whether those fees remain fair compensation over the term of the agreement depends largely on how they are adjusted (if at all) annually, for pass-through costs (such as disposal tipping fees) or for specified extraordinary circumstances (like changes in regulation).

This article identifies options for compensation adjustment:

1. No adjustment
2. Cost-based adjustment
3. Index-based adjustment
4. Pass-through costs adjustment
5. Hybrid cost-based/index-based adjustment
6. Industry-standards adjustment

This article asks you questions about your operations, policies, and goals to help you determine which methodology is best for you, and discusses the ramifications of each option.

I. No Adjustment
Your first option is to disallow adjustments. Disallowance could range from merely precluding automatic annual adjustments to comprehensively precluding even occasional adjustments for cost increases beyond your contractors’ control, such as disposal tipping fees that otherwise might be passed through to the ratepayer. (Although cost increases beyond contractors’ control are often referred to colloquially as “extraordinary,” this term is a misnomer and not necessarily apt. Those cost increases—such as increases in tipping or regulatory fees—can be anticipated. You and your contractors can expect them to change with some degree of certainty. But the amount of those cost increases cannot be easily quantified. The only difficulty is projecting them with any certainty.)

(1) How long is the term of your agreement? A 20-year bond will bear a higher interest rate than a money market fund because over the long term there is greater risk that you will lose your investment due to unforeseen adverse events. You are rewarded with greater return for assuming larger risk.

Similarly, the longer your contract term, the more likely that costs will change or new costs will be imposed. Costs outside the control of your contractors may increase: Tipping fees at disposal facilities may rise, the price of fuel may go up, insurance premiums may skyrocket, and regulatory changes may require additional capital investment (such as retrofitting vehicles for cleaner emissions). For example, if you disallow annual adjustment, then acting as reasonable businesspersons contractors will look at the average inflation over a period equal to the proposed term and build projected inflation into their initial proposed rate. As another example, if you disallow tipping fees as pass-through costs, contractors will review the history of tipping fee increases, consider pending regulatory reform (such as new liner requirements), survey local disposal capacity (such as whether the local landfill can secure an expansion or renewal permit), and project tipping fee increases over the proposed contract term. Contractors will include their projected cost increases in their proposed initial rates, since without a rate adjustment clause, they cannot add them at a later date if projected increases actually occur.

The longer the term of your contract, the greater the risk of cost increases, and the higher the initial rates to hedge against the unknown liabilities. The shorter your term, the smaller the risk of cost increases, and the lower the initial rate.

(2) Do you expect keen competition? If you anticipate that numerous contractors will submit bids or proposals on your contract, be eager for your business, and sharpen their pencils, then your rates may not be thickly padded to comfortably cushion the contractors against unknown cost increases. If competition is keen, contractors may either conservatively project inflation, tipping fee, fuel, etc., cost increases over the term or assume greater risk of increases by building in smaller margins for their under-estimates.

Alternatively, if you anticipate that few contractors are interested in bidding or proposing on your contract, then your rates may be higher to better protect contractors against uncertainty.

Lastly, absent rate adjustments, contractors may feel the risk of cost increases is not worth the potential contract revenue, and refuse to propose or bid. You may hold a party and no one will come.

(3) Which do you value most: no rate adjustment but stable rates, or rate adjustment and initially lower rates? If you must place every rate increase before your elected officials for a vote, receive much public comment, or stir up divisive public controversy, then you may prefer slightly higher rates as a tradeoff for more stable ones and disallow or limit rate adjustments. If you do not need official approval (which is often the case with index-based rate adjustments) and your rates are sufficiently low to avoid customer complaint at annual, incremental changes, then you may choose to secure theoretically lower rates that inch upward over the term of the agreement as they are adjusted annually or to incorporate pass-through costs.

(4) Do you expect program or regulatory changes? Consider that without a rate adjustment methodology that requires maintenance of prescribed cost data and describes how cost increases translate into rate increases, it may be more difficult to negotiate program and rate changes mid-term. When your contractor has already inked the agreement, you have very little negotiating leverage. In a competitive procurement, you may be able to secure a favorable dispute resolution protocol, such as contractor’s appeal of a public works director’s rate increase determination to the mayor or city manager or county CAO, and/or a second appeal to the elected body that is empowered to make a binding and conclusive determination.

II. Cost-Based Adjustment
If you determine against holding contractors to their proposed price, without subsequent adjustment, you must next decide what sort of rate adjustment methodology you will choose: cost, indexed, or hybrid rate. You might ask yourself these questions:

(1) Is the length of your agreement mid- to long-term? Cost-based adjustment is preferable for mid- to long-term agreements. Index-based adjustment methodology is more suitable for short- to mid-term agreements. The longer the agreement, the more likely that indices will result in rates that do not relate to service costs and correspondingly exceed competitive market rates. Although in theory this could work to the disadvantage of the contractor, in practice it probably works to the disadvantage of the ratepayer, since we routinely experience inflation and rate increases, not deflation and rate decreases.

In addition, the longer the agreement, the more likely that you will want to make service program changes or that new regulations will increase the cost of performance. If you use index-based rate adjustment methodology, you do not have a cost basis for renegotiating rate changes consequent on additional capital investment or operating costs. Again, renegotiation of an executed agreement with no termination for convenience clause or a buyout amount that is economically infeasible to pay may be difficult. The local government has little or no negotiating leverage, and a contractual protocol for resolving rate adjustment disputes can determine whether the program implementation is successful or stymied. By contrast, if you use a cost-based rate adjustment methodology, you have access to data supporting the cost of the program changes and a pre-agreed protocol for translating those costs into rates. (Like index-based rate adjustment methodologies, cost-based rate adjustment methodologies also should incorporate dispute resolution protocol. In fact, it may be more likely that you and your contractor will disagree over (dis)allowable or reasonable and necessary costs and cost allocations that are somewhat subjective and judgmental than that you will argue over application of indexed escalators, which is more formulaic.)

(2) What is the rate impact of contractors’ cost of complying with a cost-based rate review? Contractors argue that cost-based rate reviews raise rates, since contractors incur greater record-keeping, auditing, and administrative costs than they would with index-based adjustments. A cost-based rate adjustment methodology usually requires that contractors maintain itemized data in prescribed categories and allocations. For example, contractors may need to characterize and segregate allowable and disallowable costs or costs that are passed through but not subject to markup for profit or rate of return. They may need to create financial records exclusively for your contract service, even though as a corporate entity they service other communities and contracts. They incur the cost of securing audited financial statements that otherwise might be merely compiled or reviewed. (This is true not only of small haulers, but also of larger haulers whose component divisions or operations might not prepare standalone, audited financial statements.) And lastly, they have to budget significant amounts of staff time to compile data in rate review applications and meet and confer with the local government and local government’s rate consultants to clarify rate adjustment applications and reach an agreement on the ultimate rate adjustment.

By contrast, an index-based rate adjustment methodology should have little rate impact, since financial record-keeping requirements are likely to be less detailed or prescriptive. (Often audited financials are only required if a program change that will increase rates is being negotiated.) Although some index-based rate adjustment methodologies may solicit categories of actual costs (labor, vehicle maintenance, vehicle replacement, fuel, etc.) for application of different indices, often those categories may be a pre-agreed percentage and generally contractors do not need to budget any significant amount of staff time to prepare annual indexed rate adjustment requests. Contractors argue that index-based rate reviews have much lower administrative costs—and, consequently, rates—than do cost-based rate reviews.

(3) Do you have sufficient staff and budget to perform rate reviews/hire consultants? Just as contractors must budget time and money to prepare for and conduct rate reviews, so do you. Consider whether you have the necessary staff and/or budget allocation. Especially if you are not enterprise funded, your hauler may collect rates from generator/customers and you may not have a revenue stream to fund rate reviews. Nevertheless, where funding is not insurmountable, some solid waste agencies feel that administering a cost-based rate adjustment methodology is worth the time and effort because it gives a local government valuable insight into the operations of its contractors. Those local governments may budget for full-time MSW contract managers.

(4) How large is your contract service base and volume of gross receipts? Economies of scale dictate that the larger the number of contract service customers or volume of gross receipts, the cheaper a rate review on a per-customer basis. While cost-based rate reviews may not be economically viable for a 5,000-home residential collection agreement, they may be eminently desirable for 200,000 homes.

(5) Can you secure competitive rates of return/guarantied profit? Cost-based rate adjustment methodologies generally establish allowable costs and then add profit expressed as operating ratios, profit margins, or rates of return. (An operating ratio, or OR, is used in utility regulation and is expressed as total costs/total revenues; inversely, profit margins are total revenues/total costs. Rates of return measure profitability of investments, expressed as profit/net assets. (See www.mlb.ilstu.edu/ressubj/subject/business/ratio.htm#guides for a discussion of financial ratios.) Cost-based rate adjustments are therefore usually synonymous with “cost plus.” If you competitively secure your agreement, each contractor’s OR can be proposed or bid and factored into a life-cycle cost comparison. However, if you are negotiating your agreement on a sole source basis, you may or may not have accurate cost data to determine whether a rate of return is competitive. As an alternative, you might default to comparative industry standard financial ratios for MSW service companies of comparable sizes, prepared by MSW analysts, such as the Risk Management Association at www.rmahq.org/.

(6) Does your cost-plus methodology encourage efficient operations?

i. Disallowable costs. A common criticism of cost-plus rate adjustment methodologies is that they discourage efficient operations. Allowable costs are included in required revenues on which the rate is based, so running an extra route or incurring overtime is fully compensated. If you use a cost-based rate adjustment methodology, pay close attention to the list and definition of dis-allowable costs, such as business development, lobbying, fines and penalties, judicial or contractual damages, charitable or political donations, litigation costs, merger and acquisition costs, etc.

ii. Allowable costs without markup. Another common criticism of cost-plus rate adjustment methodologies is that they may not only discourage efficiencies, but actually also encourage inefficiencies. Since the OR is applied on top of the pass-through costs, the greater the costs, the greater the markup. In order to minimize this efficiency disincentive, your methodology might distinguish between totally dis-allowable costs and those costs that are passed through without markup.

iii. Necessary and reasonable costs. In addition, some cost-plus methodologies strive to curb inefficiencies by allowing only “necessary and reasonable” expenses. However, what is necessary and reasonable involves somewhat subjective judgment and opinions and can open the door to argument and deadlock in the rate review process. Arguably, to ensure that costs are necessary and reasonable, an agreement with a cost-plus rate adjustment methodology must contain a far greater level of detail on operations specifications than an agreement that uses indexed adjustments. In cost-plus agreements, detailed operational obligations not only set performance standards that protect health and safety or ensure quality customer service, but also help contain costs. Yet with a greater level of prescribed operational detail, you may become embroiled in micromanaging and second-guessing your contractor’s operations.

iv. Shared cost-savings incentives. Lastly, cost-plus agreements may provide incentives for efficient operations in the form of shared savings. For example, if the contractor implements savings over a specified amount in any year, half of those savings will nevertheless be included in costs. The contractor keeps half of the savings, and the ratepayer gets the second half through lower costs.

(7) Are you confident that you can analyze true costs? Even though you may require contractors to provide audited financials of segregated contract services, you never will understand their numbers as well as they do.

i. Can you secure audited financials for your contract service? Contractors are understandably loath to provide financials that competitors may use to contractors’ disadvantage. Under the terms of many public information laws across the country, local governments may not be able to assure contractors that financial information will be kept proprietary. This is true not only for privately held companies who do not file public financial statements, but also for divisions or subsidiaries of larger companies whose financials are not public information either, although the financials of their ultimate parent company are filed with the SEC in their quarterly 10Q and annual 10K reports. In the context of a competitively secured agreement, you might have greater success in securing audited financials in sole source procurements because proposing contractors do not want to lose evaluative points for taking exceptions to the terms of your proposed contract and business deal.

ii. Is cost allocation among your contract service and other operations fair? Your contractor may service other communities, and it is difficult to corroborate that cost allocations are made fairly. For example, a route supervisor may double-count his time among multiple contracts, resulting in perhaps each of five contracts paying for 50% of his time for a total cost compensation of 250%. Your agreement can contain representations and warranties as to fair allocation that become defaults if breached.

iii. Is compensation of principals and attribution of parent corporation overhead and service support costs fair? Your methodology must protect against potential abuses in salary payments to company principals and intercompany transfers. One example is compensating a parent corporation for risk management, legal, and other central office administration services. Another is leasing or purchasing goods or services from affiliates at higher-than-market rates. In both examples, the transfers may not reflect market costs, thereby inflating profit.

iv. Are allowable and disallowable costs clear? As in litigation, it can be surprising how contractors and local governments can construe definitions differently. Detail and examples based on hard experience can help forestall disputes.

v. Are projected depreciation expenses adjusted for actual expenditures? In many rate methodologies, depreciation expenses are projected for the next rate year. At the end of that year, when rate adjustment for the next succeeding rate year is made, the projected depreciation may not have occurred. Acquisition unit prices for new vehicles, carts, or other equipment may have been lower than was anticipated, for example, or a contractor may have acquired fewer than anticipated number of units of vehicles, carts, or other equipment. That inaccuracy may be compounded where the operating ratio is calculated on that excessive depreciation cost. Whereas high or low projections of other operating costs are more likely to even out over time, errors of high or low projections of depreciation costs will not only be perpetuated but also be exaggerated over time, if not reconciled with actual costs.

III. Index-Based Adjustment
If neither the no-adjustment model nor the cost-based adjustment methodology meets your needs, then you might turn to an index-based adjustment methodology. Ask yourself these questions:

(1) Is the length of your agreement short- to mid-term? The opposite of the considerations for cost-based adjustment applies here. Over a short term (e.g., five years or less), there is less likelihood that your rates will escalate significantly out of relation to actual costs than over the long term.

(2) Was the initial base rate competitively procured? If the base rate being adjusted by index was not initially set through competitive procurement, you may not have assurance that you began with the best market rate possible. Many—perhaps most—sole source negotiations are conducted without contractors’ cost data, and local governments look to similar services in similar communities for comparative rate verification. Sole source negotiations may leave an uncorroborated amount of money lying on the table. If the base rate is not competitive, subsequent escalation will only exacerbate the overstatement.

(3) What index or bundle of indices best represent your contractor’s costs? This section uses the example of collection services, but the analysis applies equally well to other integrated waste management services and facility operations.

i. Are you familiar with the goods and services included in the Consumer Price Index/new chained CPI? Have you compared the history of possible applicable indices? See the Bureau of Labor Statistics’ Web site at www.bls.gov/ for in-depth information about the consumer price index (CPI) and producer price indices (PPIs). According to the US Department of Labor, “The CPI is the best measure for adjusting payments to consumers when the intent is to allow them to purchase at today’s prices, a market basket of goods and services equivalent to one that they could purchase in an earlier period.” The bundle of over 200 consumers’ goods and services in the CPI comprises housing, 42%; transportation, 17%; food/beverages, 15%; medical care, 6%; recreation, 6%; and education and communication, 6%. This bundle may not well reflect contractors’ operating costs.

The new chained CPI index (C-CPI-U) better reflects consumers’ substitution of goods and services as prices rise, thereby lowering the inflation rate (e.g., 2001 CPI-U 2.8 / C-CPI-U 2.3; 2002 1.6 / 1.2, 2003 3.2 / 2.0). For example, as blueberries pass out of season you may switch to buying less-expensive grapes. If you are entering into a new agreement, you should probably try to use the C-CPI-U as your CPI index of choice. You might compare the historical inflation of assorted possible indices (e.g., national, regional) that could apply to your geographical area to determine which would be most favorable to you.

ii. Consider other indices for a portion of your contractor’s rate and the weighting factor for cost categories (e.g., labor, fuel, vehicle replacement, vehicle maintenance, other). Although the bundle of goods and services in the CPI can be tailored, some contracts use different indices for different cost categories to more closely track actual costs with indexed adjustment. Examples include the following BLS data from the PPI and CPI, which can be copied and pasted directly into BLS hyperlink http://data.bls.gov/cgi-bin/srgate to create annual adjustments on spreadsheets:

1. Labor: Series ID ECS 12102i Service Producing Sanitary Services (or compare Index for Urban Wage Earners)
2. Motor Fuel: Series ID WPU057303 #2 diesel fuel (or compare regional CPIs for motor fuel or diesel fuel to Consumer Customers Index)
3. Vehicle Replacement: Series ID PCU33621113362113 Vehicles on Purchased Chassis (or compare PPI Industrial Commodities)
4. Vehicle Maintenance: Series ID: PCU3339243339243 Parts & Attachments (or compare PPI Industrial Commodities)
5. Other: Monthly Labor Review Series ID: CUURX400 SA0 CPI=All Urban Consumers, All Items West Size Class B/C

Be certain that your contractual language allows for substitution in the event indices are no longer published. For example, this year the Producer Price Index changed from using Standard Industrial Classification (SIC) to a North American Industry Classification System (NAICS), and although many SIC industries were perpetuated as NAICS industries, some SIC industries were recombined to create new NAICS industries.

Example weighting—after removing any pass-through costs—in a collection agreement might be

1. labor, 55%;
2. motor fuel, 5%;
3. vehicle replacement, 5%;
4. vehicle maintenance, 15%; or
5. other, 20%.

These percentages could be prenegotiated and fixed, or you could require your contractor to annually give you new weighting percentages based on historical cost allocations for the past rate year. (In the latter event, however, you might want them to provide audited financials on a contract service basis, for corroboration. Contractors would argue that the costs of preparing those financials would push up the rates and might reduce one of the advantages of index-based over cost-based adjustment methodologies.)

Remember, only those portions of cost that are subject to escalation should be included in escalation. Rarely will you escalate 100% of your fees. Even if you do not pass through costs such as tipping fees or interest expense, the portion of the fees they represent should not be inflated.

(4) Can you take a portion of the CPI on a year-to-year basis in order to offset overstated inflation? CPI indices are overstated. In 1996 the US General Accounting Office’s Boskin Commission Report estimated that the CPI index overestimated inflation by 1.1% annually, and even after adjusting the methodology, the GAO believes a 0.73% to 0.9% overestimate persists.

Over the short term, this can be countered by allowing for only a portion of indexed inflation (e.g., 80% to 85% of the CPI). Because of the effect of compounding, if escalation is less than 100% of the index, you are better off calculating escalation on a year-to-year basis than on a year-to–base year basis. For example: Cost2005 = Cost2004 x {1 + 85%[(CPI2005 / CPI2004) -1]}.

(5) Can you cap inflation? Additionally, especially in competitive procurements, you may be able to set a ceiling maximum on inflation (e.g., no greater than 5%).

(6) Can you compare annual average index changes rather than point-to-point index changes? Use 12-month averages/annual percentage changes for your CPI rather than comparing your CPI for two specific months, point-to-point, since the months could be aberrant and an average would be more representative for the entire year.

(7) Can you coordinate publication dates with your annual budget process? The CPI for particular regions may be published monthly, bimonthly, or semiannually, so you need to coordinate your adjustment timing with the publication date of the index used in your area. Most commonly used is the CPI for urban areas (CPI-U) covering 87% of the US population, which can be seasonally adjusted. (MSW agreements generally do not use seasonally adjusted indices.)

Note, too, that there may be a time delay in publication, although with online access, the publication period is decreased. The chained CPI is first published and then subsequently refined, so build time into your annual rate adjustment calendar. For example, to implement new rates on a July 1 fiscal year, you might use the calendar average for the prior year, giving you sufficient time to gather the indices, calculate changes, and adopt and implement the rate adjustment.

(8) Can you escalate bundled costs, and then allow for profit on their total amount? You might consider establishing bundles of costs like those previously listed (labor, fuel, vehicle replacement, vehicle maintenance, other) but then further allowing for profit on those costs (e.g., dividing the total costs by an operating ratio minus the total costs), and lastly adding the pass-through costs. In a competitive procurement, proposers can propose their base bundled costs and operating ratios, which theoretically exerts market pressure to contain profit and avoids escalating a profit component of the costs. In every succeeding year, the proposed base costs are escalated by the appropriate index and the proposed operating ratio is applied to the sum of those total costs.

Note that there may be additional costs (e.g. lease costs, depreciation) that are not subject to an escalation factor but are arguably included in costs subject to markup for profit.

IV. Pass-Through Costs Adjustment
(1) Does your contractor have costs that should be passed through without escalation or markup? Whether you use index- or cost-based rate adjustment you are likely to compensate your contractor for certain costs that are subject to changes beyond his or her control. Those costs will be reflected in the rate and “passed through” to the ratepayers. Even in the case where you generally do not adjust rates at all for operation and maintenance costs, you might pass through costs such as disposal, regulatory fees, and interest expense.

(2) Can you pre-agree on conversion ratios? Make certain that your agreement contains specified conversion ratios that translate your contractor’s cost increases (expressed in gross dollar amounts) into your rate increases (expressed on a unit basis). For example, if a pass-through disposal tipping fee increases by $0.25 per ton, include a pre-agreed conversion factor in pounds/residential gallon capacity (or if not variable can rates, per household), or pounds/commercial or C&D cubic yard.

Alternatively, for administrative simplicity you may agree that a specified percentage of your fees/customer rates are attributable to a given pass-through cost, and the increases are proportionately passed through. For example, you and your haul contractor may agree that 20% of a $10-per-household collection service fee is attributable to disposal. If the tipping fee increases by $0.25 per ton equal to 5% thereof, then 20% of $10 ($2) will be increased by 5% (or $0.10 per household).

(3) If you contract for refuse disposal separately from collection, can you allocate refuse volume disposal risk to your collection contractor by passing through disposal tipping fees on fixed waste volume? Many collection contracts include not only collecting recyclables, greenwaste, and refuse, but also processing the recyclables, composting the greenwaste, and disposing of refuse. Frequently, unless the contractor also owns the processing, composting, and/or disposal facilities or has secured subcontracts co-terminus with your collection contract, your collection contract will provide that the collection contractor can pass through facility tipping fees.

However, increasingly, local governments are separately procuring collection and disposal agreements, since the related investments have different capital investments and depreciation demands and consequently potentially different-length terms. They also can retain greater system control and accountability. When you contract directly with a disposal facility, you can opt to pay disposal fees to your disposal contractor and then allow your collection contractor to deliver waste for a zero tip fee to your contracted disposal facility. But if you worry that your collection contractor will be tempted to commingle other jurisdictions’ materials with your own, you may prefer to compensate your collection contractor for disposal fees and let the collection contractor pay tipping fees at your contracted disposal facility. (Your disposal contractor may request a performance bond to secure your collection contractor’s payment obligation and provide against the collection contractor’s bankruptcy risk.)

However, by separately procuring collection and disposal agreements, the risk of waste volume generation—due to population growth or changing disposal/diversion patterns of generators—is often shifted to the local government. In moving from a single full-service collection-processing-composting-disposal agreement to separate collection and disposal agreements, the risk of waste volume generation and setout rates often shifts from the full-service contractor to you. In a competitive procurement, you may be able to keep the waste volume generation risk on the hauler by requiring it to propose a fixed tonnage on which a pass-through disposal tipping fee will be paid and adjusted when and if the disposal tipping fee changes. (Your collection contractor will continue to receive compensation for the disposal component in the rate paid by new customers.) This has the added benefit of giving your collection contractor incentive to divert refuse from disposal, since for every ton it diverts, it realizes a ton of avoided disposal cost.

V. Hybrid Cost-Based/Index-Based Adjustment
(1) Can you escalate rates for several years, punctuated by cost-based adjustment? In order to minimize local governments’ contract administration costs of annual cost-based rate review and contractors’ cost of cooperating with that rate review, some local governments use an index-based methodology for a period of years (e.g., three, five, etc.) and then conduct a cost-based rate adjustment at the end of every period. Another variation might be conducting the cost-based adjustment at the local government’s request not more than a specified number of times during the term. (You might particularly want to conduct a rate review prior to determining whether or not to exercise any extension option that lies in your sole discretion.) Still another variation is to allow either the local government or contractor to request rate review a specified number of times during the term. (Numbered instances of possible review help the contractor estimate in advance the worst-case scenario of costs that it should include in its proposed or negotiated rates.)

VI. Industry-Standards Adjustment
Some communities have developed adjustment protocols that use industry-standard operational costs to adjust their contractor’s compensation based on actual operating conditions (number of routes, terrain, type of services) but not on the contractor’s actual audited costs. This method is disfavored by contractors whose capital and operating costs are significantly different from the standards selected.

Conclusion
If you don’t adjust rates, expect to pay higher rates, reflecting contractors’ assumption of cost-increase risk and/or reduced competition. Consider this option only if you prize rate stability and do not anticipate program or regulatory changes that would increase contractors’ costs.

Keep the length of your contract term commensurate with the time that your contractor needs to recover its capital investment.

If your contract term is long (e.g., to recover the contractor’s investment in a facility) and your rate base sufficiently large, favor cost-based rate adjustment over index-based rate adjustment. Ensure that your cost-based rate adjustment methodology clearly defines (non)allowable costs, and include sufficient detail of operational obligations to define that they are “reasonable and necessary” costs. Secure audited financials for your contract services only. Be alert to corroborate fair cost allocations among your contract services and others’, and to ascertain that compensation paid to principals, affiliates, and parent companies are arm’s length. Consider reconciling projected depreciation expenses with actual expenses incurred. Provide a conclusive administrative dispute resolution protocol in the event your contractor objects to your rate adjustment determination.

If your contract term is short and your base rates procured competitively, favor index-based adjustment over cost-based adjustment methodologies. Develop a bundle of weighted indices such as labor, fuel, and equipment replacement/maintenance. For costs that use the CPI, use a percentage of the new chained CPI, comparing average annual changes in the index values from year to prior year and not point-to-point from year to base year. Coordinate index publishing dates with your budget process. Consider capping increases and allowing competitively bid profit/operating ratios on escalated bundled costs.

Whether you use cost- or index-based rate adjustment methodologies, define your pass-through costs carefully. Include specified conversion ratios to translate costs to rates. If possible, keep risk of waste volume on your collection contractor even if you pass through changes in disposal tipping fees.

In longer-term agreements, to reduce cost consider establishing a cycle of several years using index-based rate adjustment punctuated by cost-based adjustment. Even in shorter-term agreements, consider the right to require a specified number of cost-based adjustments at your option.

Acknowledgements
Thanks to Shelley Sussman of Ventura County, CA, Ric Hutchinson of R3 Consulting Group, and Rick Simonson of Hilton, Farnkopf & Hobson for their presentations on CPI and rate adjustment protocols made at SWANA’s Western Regional Symposium on May 4, 2004, in San Luis Obispo, CA.

Constance Hornig is an attorney who represents municipal governments in MSW contract procurement, drafting, and negotiating.

MSW - Elements 2006