President Trump’s accounting lesson

Last weekend President Trump tweeted that taxpayers effectively subsidize Amazon because the United States Postal Service loses $1.50 on each package that it delivers for Amazon.

Given that there are stringent rules for Post Office pricing that are reviewed by the Postal Regulatory Commission, the accuracy of this tweet requires further analysis.

The Postal Regulatory Commission has determined annually that the USPS contractual arrangement with Amazon is profitable.

To conclude who is right, one has to have an understanding of the economic principles associated with marginal cost analysis and how accounting conventions are applied to the situation.

Generally a transaction is profitable when the marginal revenue exceeds the marginal cost. Marginal revenue is the revenue that is generated by the transaction. Marginal costs are the costs that were incurred solely because of that transaction.

In other words, if not for the transaction, the marginal costs would not have been incurred.

From a managerial perspective, it generally makes sense to pursue a transaction when the marginal revenue exceeds the marginal costs because the business will generate additional cash from the resulting profit.

However, a business enterprise incurs a variety of costs, including facilities costs and other overhead costs, which are not marginal costs.

Those costs are generally fixed in nature and do not vary based on transactional volume. However, for financial accounting and income tax purposes, those costs are considered in determining the overall profitability of the enterprise.

In order to account for the profitability of the enterprise, businesses allocate a portion of these costs in some manner to all transactions.

Frequently these costs are allocated based on revenue.

That is precisely how USPS analyzed the Amazon situation.

In 2006, approximately 5.5 percent of its revenue was generated from package deliveries. Therefore, USPS allocates 5.5 percent of its facilities costs to package delivery in an attempt to determine the relative profitability of package deliveries.

Consequently, USPS believes that parcel delivery customers, like Amazon, should bear 5.5 percent of the facilities costs.

Since 2006, package deliveries have become increasingly important to USPS, and they now represent approximately 25 percent of USPS revenue. Clearly the contract with Amazon has been an important component of this increase.

Last year, a Wall Street analyst stated that the 2006 cost allocation methodology allocating only 5.5 percent of its facilities costs to parcel deliveries is obsolete, and if facilities costs were allocated based on the current revenue composition, parcel deliveries should be allocated 25 percent of the facilities costs.

The analyst further stated that, if costs were reallocated in this manner, the USPS would lose $1.46 for each delivery of an Amazon parcel. That methodology evidently is the basis for President Trump’s tweet.

USPS generated $69.6 billion of revenue, but lost $2.7 billion. Therefore, the analyst’s intimation that the Amazon contract is a significant component of this loss sounds plausible to those, like President Trump, who are not familiar with marginal cost analysis.

The reality of the situation is that the analyst’s arbitrary allocation of facility costs is inconsistent with the level of facilities that are actually devoted to Amazon deliveries. In fact most of USPS’s facilities are dedicated to rural service and letter delivery.

Furthermore, according to a statement by Amazon, it “invested hundreds of millions of dollars in a network of more than 20 package sortation facilities that inject directly into the USPS last mile network bypassing most of USPS network.”

In other words, any incremental facilities costs have been borne by Amazon, not USPS.

It’s probably also a safe bet that Amazon’s use of proprietary logistics technology enables it to sort its packages at its facilities much more efficiently than USPS could ever hope to do.

Marginal cost analysis suggests a strong likelihood that the Postal Regulatory Commission’s conclusions are correct and that the arrangement between Amazon and USPS is genuinely profitable and generates substantial cash flow for USPS.

USPS is burdened with a number of problems. It has a mandate to deliver mail to everyone in the United States— even if they live in remote or rural areas where delivery is expensive.

Technology has disrupted its historic business model. Much of the historically profitable mail is now sent electronically. For example, the concept of going green by receiving and paying bills electronically has cut into USPS’s profit margins.

USPS, like many governmental agencies, has billions of dollars of underfunded pension liabilities which further impair its future profitability.

In the wake of this disruption, if USPS hopes to be viable on a long term basis, it will have to innovate to survive the disruption in its historical business model. Its arrangement with Amazon is an example of thinking outside the box to mitigate the disruption it faces.

Students of micro-economics and managerial accounting understand this. Apparently, President Trump does not.