Analysis: Leland Recommends Using the 75% Variable Cost Assumption for Development Impact Models

By David M. Greenwald
Executive Editor

Davis, CA – It is a highly contentious issue, however, when EPS (Economic & Planning Systems, Inc.) issued its projection that DiSC 2022 would generate just under $4 million per year in annual fiscal revenue, some complained that EPS did not at least present an alternative of 100 percent of the variable costs.

The city of Davis’ development impact model was designed by the Goodwin Consulting Group, which includes a component to determine the average coast.

The Finance and Budget Commission had asked to determine whether the variable cost, created by multiplying average expenses by 75 percent was “appropriate.”

In a memo that will be discussed at the December 13, 2021, Finance and Budget Commission meeting, however, Bob Leland, the Special Fiscal Consultant for the city, argues, “Our analysis shows that the 75% variable cost figure is reasonable as a percent of overall costs, although it varies by department.”

As Leland explains, “Any given expense account, however large or small, may be fixed or variable in nature, but the key is identifying major categories of expense that are fixed that can be easily deducted from the total expense by department, leaving the net amount as variable expense.”

The Goodwin model never specifies the basis for the 75 percent factor it uses to identify variable costs.

Leland writes about “costs. It was discussed as being a reasonable number and an ‘industry standard.’”

Leland looks at the following categories of costs that are fixed in nature: Personnel Costs, Pension, Retiree Medical, Debt Service, Grant Match, Contingency, Capital Outlay and Payments to County.

“The costs for these items were then deducted from the FY 2022 budget amounts for the General Fund, using the City’s long-range forecast model,” Leland explains. “This resulted in variable costs equaling 75.1% of total costs, with the amounts by department as used in the Goodwin model ranging from a low of 51.3% to a high of 89.2%.”

However, he also notes there are problems with assigning expenses to proposed development (a problem that we have also identified).

He said, “The problem with computing expenses by an average cost approach is that, in reality, local agencies do not budget this way. On a marginal basis incremental cost increases are small, and it is not practical to scale up precisely with individual growth additions.”

Further, “When a budget is increased, it is done incrementally. The question is whether the workload in a given area justifies the need for an added position, or a larger contract with an outside provider of services and supplies.”

He writes that “for smaller developments, there will not be any incremental costs identified, hence the reliance on average costs.”

He continues, “Ultimately, expenditures are both driven and limited by revenue growth. If there is revenue, an agency will spend it, and conversely, an agency cannot spend what it does not have. Even in times of population growth, if the economic cycle is producing lower revenues, then the agency will spend less, and service levels will suffer.”

Leland argues later, “Despite these underlying pressures on expense, an agency can only spend what it has available.”  Thus, he adds, “Since revenue generation is ultimately the key criterion in determining what a city can spend, it makes sense to compare the baseline revenue generation of the revenue sources most affected by development (current adopted budget), to the proposed development itself.”

This was the model used by BAE (BAE Urban Economics) for evaluating the Fiscal Impact Analysis for the Davis Downtown Plan.

“The fiscal model incorporates cost saving based on assumed efficiencies in downtown service provision,” BAE reports on Page 6 of its analysis.  “Nevertheless, the fiscal model does project substantial increases in costs for the Community Development, Community Services, Police, and Fire Departments, and General Government functions.”

These costs are based on “the increase in downtown DUEs (Dwelling Unit Equivalent) which assume 75% of the existing average cost for DUE are variable and will increase as the Downtown Plan adds DUEs…”

About The Author

David Greenwald is the founder, editor, and executive director of the Davis Vanguard. He founded the Vanguard in 2006. David Greenwald moved to Davis in 1996 to attend Graduate School at UC Davis in Political Science. He lives in South Davis with his wife Cecilia Escamilla Greenwald and three children.

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18 Comments

  1. Matt Williams

    In a written public comment that I submitted to the FBC this morning, items 19 and 20 shared the following thoughts on the 75% assumption.  The bolded sentences at the end beginning with the word “Regardless,” are particularly important.

    ————

    As noted in my submitted e-mail comment of December 1st , in June 2021 the FBC forwarded a unanimous recommendation to Council “that the Finance & Budget Commission recommend(s) to the City Council, based on the analysis completed by the Finance & Budget Commission sub-committee, which provides sufficient evidence that the current 75% marginal cost assumption is unlikely to be correct, that [the Council] commission an independent, expert consultant to develop a default marginal cost valuation methodology to use except in cases where a project-specific analysis has been completed by the developer. The Finance & Budget Commission makes this motion in the interest of ensuring that major project economic analysis is as accurate as reasonably possible.” 

    The final paragraph of the May/June 2021 report on Marginal Costs reads as follows (bold for emphasis added).

    “Based on the above analysis, the Marginal Cost Task Force (the Task Force) has concluded that the data does not support an assumption that additional residents will contribute only 75% the cost of current residents. Data appears to show that costs per capita rise on average with additional population for California cities between 50,000 and 150,000 residents13. The data is mixed for cities in the Yolo County and nearby regions over the 14 year period from 2003 to 2017, with Davis’s own trend rising, implying an increasing cost to serve additional residents over time. 
     
    The task force reached out to the consultant that had completed the economic analysis for the MIRC to understand the basis for the 75% assumption used. They informed us that the approach was an industry rule of thumb, and that they could not point to any analysis supporting this assumption.”

    .
    The bolded passage above indicates that a variability assumption of over 100% should be included in any scenario analysis.  The FBC subcommittee members are in the best position to make any recommendations regarding any specific percentage over 100%.  I defer to their superior knowledge on that subject.  Regardless, the cost per person served does not appear to directly correlate to a variable versus fixed assessment of departmental line items.  Other factors appear to be contributing to the escalating per person served costs in Davis.  Discretionary incremental expenditure decisions like the recent addition of the Fire Department ladder truck and the doubled-up expenditures on Mace Blvd are more than likely important contributors to the pattern the Marginal Cost Task Force illuminated in its May/June report.

    1. David Greenwald

      Having read Leland’s analysis, I don’t think 100 percent variable costs make a lot of sense.

      Two things in his memo really stand out to me. First, as I have argued in the past, you don’t incrementally bump up fixed costs – so you end up modeling in a lot of fixed costs that don’t result in actual expenditure and second and perhaps more fundamentally, costs increase based on the availability of funding rather than need.

      Neither EPS nor Bob Leland are recommending 100 percent cost model – and I tend to agree that that is far too conservative.

      1. Matt Williams

        David, I understand the fixed cost vs. variable cost logic you (and Bob Leland and EPS) are a using, but that logic only works if the quantity and/or categories of costs stays constant.

        However, the quantity doesn’t stay constant. Take the example of the Fire Department ladder truck.  What are the fixed and variable proportions of that ladder truck in either EPS’s or Bob Leland’s or your analyses?

        NOTE: This is my fourth comment today. I will restrict myself to only one more comment in this thread today.

        1. David Greenwald

          I’m no expert on this and really would not want to speak for Leland or EPS. My point has been that under most conditions adding more DUE’s are not going to expand the need for police and fire for example in real terms. So to treat those as variable costs overestimates the cost impact of a development. If the city determines that a ladder truck is needed, that’s a policy decision that takes place outside of specific costs for a development. It does get to the point made by Leland that such expenditures are triggered not by need, but by the availability of funding – in this case, they will either have to generate new revenue or cut existing revenue to pay for the ladder truck.

        2. Matt Williams

          David I understand your point, and I strongly believe you are looking at the situation with blinders on.  The result is that the limited view you are seeing is neither balanced nor equitable.

          In your scenario the developer is paying:
          — None of the City’s fixed costs
          — A proportional per-person-served share of the City’s variable costs
          — None of the ladder truck costs

          And in your scenario the current Davis taxpayers are paying:
          — All of the City’s fixed costs
          — A proportional per-person-served share of the City’s variable costs
          — All of the ladder truck costs

          Where is the equity in that?

        3. Matt Williams

          Yes.  In their case the blinders are probably as a result of the scope of work assignment they have gotten from their client, the City of Davis. Consultants typically do what their clients ask them to do.

    1. Keith Y Echols

      This is subject is not entirely in my “wheel house” but I’m familiar with it in general.

      First a little background on Matt’s view on the subject and mine (I’m going a bit out on a limb and speaking for Matt).  We both understand/believe that as it stands now (with the meager share of property tax with the county) that residential development is a net cost to the city.  The cost of providing services such as road expansion/repair, fire, police, water, sewer … general community services like increased parks and rec services and staff, etc … end up costing a community more than what it takes in from property taxes (as well as the meager in town sales tax revenue created by the new residents).

      Here’s an interesting article that talks about this issue:

       Jaylen French, Modesto’s economic development director, said developing new land is always risky for a city. Because entitled land needs to be fitted with utilities and maintained in perpetuity, embarking on a large-scale development typically results in a “net negative” for a city’s budget.  https://www.modbee.com/news/economic-mobility-lab/article253712863.html

      So the variable cost thing is about how the city assesses how expensive development and expansion in servicing new things (businesses) and people is. Things like the city staff that services these new people aren’t likely to grow unless it’s a really big development growth.  So at what point does a city add another police officer, another fire fighter a new firehouse?  It’s not a straight line of growth; for every person we add $.25 (or whatever the number may be) to the police or fire budget.  That might work for road maintenance but not road expansion … in other words 10 new people aren’t going to warrant a new road and probably not $.25 (or whatever the number is) added to the road expansion fund (if one exists).  The same goes for water and sewer capacity; maintenance could probably be a variable cost but expansion isn’t.

      All this has to do with whether or not the proposed DISC development is, or to what degree is, a positive source of net revenue for the city in the long run.  

      My belief is that costs always are more than they are budgeted for.  So I would rather overestimate them than run the (likely) risk that the costs become a financial detriment to the community.  It’s basically prioritizing fiscal responsibility over growth (housing, commercial, industrial, etc.).  It doesn’t mean you’re against growth, but you want it to either be a net positive for community or at the very least not negative for the community.

      Unrelated to my response to Ron G. I initially read the title of the article as Legoland recommends… It was before I had my coffee but I had to do a double take.

      1. Bill Marshall

        All this has to do with weather (sic) or not the proposed DISC development is or to what degree is a positive source of revenue for the city in the long run.  

        My belief is that costs always are more than they are budgeted for.  So I would rather overestimate them than run the (likely) risk that the costs become a financial detriment to the community.

        As to the first sentence… as best as we can estimate, do you accept that “neutral” (zero-sum) is OK, or is there a “premium” (positive source of revenue) required, in your view?

        As to the second paragraph, I agree, conditionally… depends on how much you ‘over-estimate’…

        I agree that we should avoid known losses…

        As to DISC, I remain neutral, at this point… would like to see a positive cash flow, but some would like to see the new development “pay for the sins of” the current population… resolve the unfunded liabilities… frankly (although I’m not), I “can’t get there”, nor can I espouse an “it has to be financially proven positive, under all scenarios” approach…

        I do espouse the concept and practice of reasonable and honest appraisals of likely costs/revenues… just like I play ‘blackjack’ in the casinos (and yes, I’m a net winner)… but to demand “proof” of fiscal gain, given our past and current situation… just can’t “get there”.  I believe in ‘mitigation’ to address negative impacts… I hope for positive impacts… but I cannot support a “surtax” on development to get us out of a hole we’ve already dug… if it is ‘zero-sum’, in real, reasonably projected time, I’m open to it.

        Even our City impact fees, originally based on projections of current/future ‘growth’, assigned 2/3 of repair/replacement to the 1987 EXISTING (anticipating a 50% of new growth)… new facilities uniquely needed to serve new growth, was 100% assigned to new growth.  I was intimately involved in that original concept, and found it logically, ethically, morally sound.

        1. Matt Williams

          I believe Bill’s 11:00am comment is very sound, and would like to reinforce several of his points. For me “neutral” (zero-sum) is OK.

          The original fiscal model that City Finance Director Paul Navazio put together back in 2005 did an excellent job of “summing up” (both figuratively and numerically) a reasonable 15-year life of a project.  The Forecast contained in the City’s Budget (prepared by the same Bob Leland referred to in today’s article) uses a 20-year time horizon and does the same thing … shows revenues and expenses in each year of the projected project life and literally sums the numbers up.

          In both Paul’s model and Bob’s Forecast the City’s revenues grow by between 2% and 3%, while the City’s expenses grow by between 3% and 4%.   Those “inflation” percentages were chosen based on the City’s historical financial reports.  The fact that expenses/costs grow more quickly than revenues grow poses a challenge for determining/calculating  a “zero-sum”  point.

          The following numbers illustrate that problem.  If revenues in year one are $1,000,000 and expenses/costs are $1,000,000, then year one is truly zero-sum.  However the revenues in year two inflate to $1,025,000 and the expenses/costs inflate to $1,035,000.  As a result the two-year sum is no longer zero, but rather a net loss of  $10,000.  In year two the net loss is $20,600 and the cumulative loss over three years is $30,600.  In year 15 the net loss is $205,721 and the cumulative loss over three years is $1,363,754.  In year 20 the net loss is $323,851 and the cumulative loss over three years is $2,735,024.

          To get the 15 year cumulative sum to equal zero, year one needs to have revenues of just under $1,075,000 if year one costs are $1,000,000.  To get the 20 year cumulative sum to equal zero, year one needs to have revenues of just under $1,110,000 if year one costs are $1,000,000. Either of those two scenarios would be zero-sum for me … and be OK given the historical picture of City revenues and costs/expenses.  Both those scenarios would address your “we should avoid known losses” criteria.

          I also agree 100% with Bill’s statement “some would like to see the new development “pay for the sins of” the current population … resolve the unfunded liabilities … frankly (although I’m not), I “can’t get there.”  I see no reason “the new” should shoulder the burden of the mismanagement of “the old.”  However, “the new” should shoulder their fair share of the true costs of running the City.  In the EPS analysis they use the “current General Fund adopted expenditures”to calculate a cost per person served.  They use the $72.9 million amount from the 2021 Budget in the Expenditure-Estimating Procedures Table B-16. However, General Fund costs as reported in any city’s Fiscal Year Budget are statutorily limited.  They can not exceed the amount of the General Fund revenues.  The City of Davis Budget reports the amount that needed expenses/costs exceed actual revenues as a Shortfall in the Forecast chapter. 

          To illuminate the existence of this shortfall, on January 3, 2017 Mayor Robb Davis included the following statement in his State of the City presentation to the Chamber of Commerce, and then to multiple different subsequent audiences:

          “We are not paying for the things that we’ve already purchased, and we are not paying for those things in adequate amounts to make sure they remain for the future.”

          .
          The true cost of running the City is the adopted expenditures of $72.9 million plus the reported Shortfall amount, which was most recently reported by the City as $14.5 million per year  ($291 million total over the 20-year period).  If you divide the $14.5 million by the number of persons in the City, then each new person gets allocated a “fair share” of the true costs of operating the City.  That doesn’t “resolve the unfunded liabilities.”  The existing population of the City is still responsible for the “lion’s share” of paying for “the sins” that created the unfunded liability, and all residents, both “old” and “new” have the same “fair share” of what it actually costs to operate the City.

           

  2. Matt Williams

    Good question Ron.

    Imagine you are going shopping for holiday presents for someone in your family.  They have told you what they want, and they also have told you what it is going to cost you.  You have recently seen an advertisement for that item that lists its price (its cost to you as $100), but your family member has told you that the item will only cost you $75.  When you actually get to the store and you find that the price isn’t $75, but rather $100, what are your thoughts going to be.

    The City and David and EPS and now Bob Leland are all telling the voters of Davis that it is only going to cost $75 to provide services to DiSC , even though it costs $100 to provide those same services to the rest of the City.

    Their explanation is that some existing costs don’t go up with more people.  In schools budgeting terms (because I know you are very knowledgeable about schools) they are arguing that the costs for the Superintendent do not go up when the District adds more students.

    The problem is that the FBC completed a study using data for the 14 year period from 2003 to 2017 from the Secretary of State of California for cities in California that shows that the actual costs that the City of Davis has expended for added people in Davis has not been $75, and has not even been $100, but has been closer to $105.

    The picture should reflect reality, not wishful thinking.

    1. Ron Oertel

      When you actually get to the store and you find that the price isn’t $75, but rather $100, what are your thoughts going to be.

      If the dollar amounts were increased in your example, I would think that I had arrived at a car dealership.

  3. Bill Marshall

    From Matt W…

    The original fiscal model that City Finance Director Paul Navazio put together back in 2005 did an excellent job of “summing up” (both figuratively and numerically) a reasonable 15-year life of a project.  The Forecast contained in the City’s Budget (prepared by the same Bob Leland referred to in today’s article) uses a 20-year time horizon and does the same thing … shows revenues and expenses in each year of the projected project life and literally sums the numbers up.
    In both Paul’s model and Bob’s Forecast the City’s revenues grow by between 2% and 3%, while the City’s expenses grow by between 3% and 4%.   Those “inflation” percentages were chosen based on the City’s historical financial reports.  The fact that expenses/costs grow more quickly than revenues grow poses a challenge for determining/calculating  a “zero-sum”  point.

    Do not substantially disagree, but feel need to point out:

    Inflation is now running ~ 7% for the first time in a long time… as near 0-2% for years… that is a definite factor for both costs (including erosion of personnel costs [or personnel “taking one for the team”], and other operating costs.  Given the sources of revenue, it is very unlikely that revenues will keep a 7% pace… that might be a transitory issue, it might be “the new normal”… beyond my pay-grade to opine… have lived thru double digit inflation, where my ‘revenue’ went up low-mid single digits… we lived…

    Predictions of weather are highly accurate over a week, if the atmospheric conditions are stable… when they are fluctuating, at best the predictions are only good for 12-24 hours…

    A fiscal / economic model is similar… connect the dots.

    Matt W speaks rationally here… but everyone should understand that not just the goal-posts, but the very field itself are moving… an assumption that revenues will increase 2-3% may be valid, given Prop 13, other current restraints… an assumption that costs (or liabilities) will increase only 3-4% in this next year, or future years is highly speculative… unless one wants to have personnel “take the hit for the team” (expect a higher turnover and/or less staff), or add to the ‘unfunded liabilities’ (maintenance/replacement) overall…

  4. Bill Marshall

    Matt and David… not clear if your current /recent posts are at cross purposes…

    New development and current residents should ALL share fixed operational costs… should be same-same, only trouble being that on the revenue side (basic property taxes) long-term property owners pay proportionally less, per DU, than new residents buying an existing DU or newly developed DU.  [Thank you Howard Jarvis and Paul Gann… may you rest in pieces]

    Existing/long term properties/residents should have a much greater burden for “the sins of the past” (deferred maintenance and its logical consequences)… should not be a ‘burden’ on new development.  By the same logic, existing development should not be burdened by the costs of ‘expansion’… but, once development occurs, by definition, it is “existing”…

    But the fee and tax structures in place makes it real difficult to get to “equity”.

    1. Matt Williams

      I agree that both new development and current residents should ALL share fixed operational costs, which is why I don’t understand the City’s position that they don’t believe that a per-person-served proportion of fixed costs should be allocated to new developments.  Its a puzzlement.

      Actually it isn’t a puzzlement.  It is political spin.

      Regarding “existing/long term properties/residents should have a much greater burden for “the sins of the past” (deferred maintenance and its logical consequences)” … they do.  In the EPS analysis there are 78,420 “persons  served” in the existing/long term population cohort and 2,169 “persons  served” in the DiSC project’s population cohort.  That means that 97.3% of the burden for the “sins of the past” is being borne by the exiting/long term population and 2.7% is being borne by the DiSC project’s population.

      NOTE: This is my fourth comment in this thread today. I will restrict myself to only one more comment in this thread today.

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