The price of the Indian basket of crude oil has gone up to $55 a barrel, almost 96 per cent higher than $28 a barrel in January 2016. The retail prices of petrol and diesel, which have been linked to the markets, have also been rising, though by smaller margins of 18 per cent and 33 per cent, respectively, in the same period.
What is the concern?
Consumers are fretting about is that the price of the Indian basket of crude oil ruled at $107 a barrel in May 2014 and is today almost half of that level. So why have retail prices already breached levels that prevailed in May 2014?
Reasons for price rise –
- Between May 2014 and January 2016, the central excise duty went up by 127 per cent on petrol and by 387 per cent on diesel.
- Most state governments saw this fiscal opportunity later and raised sales tax and value-added tax rates on these products.
Was it justified?
The fiscal move was unexceptionable, justified as it was by the need to tax a scarce imported resource, raise revenues to bridge fiscal deficits and reduce the Centre’s oil subsidy bill.
What should be done today?
- The need for shoring up the finances of the Centre as well as the states is even greater today with rising shortfalls in revenues, increasing expenditure on account of higher government wages and higher demand for capital outlays in order to revive growth.
- Cutting tax rates on petrol and diesel, therefore, might help reduce their prices for the present, but the damage and risks to public finances will be significant and, therefore, should be avoided.
- The inclusion of petrol and diesel in the goods and services tax should be sequenced in a manner that the effects of a consequent reduction in tax rates on revenues can be absorbed gradually.
- It is important to introduce greater cost efficiency and increased competition among the oil companies.
- We can gradually move towards cost-plus pricing system from the current trade parity pricing formula.
What is cost-plus pricing system?
- Cost plus pricing is a cost-based method for setting the prices of goods and services. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup percentage (to create a profit margin) in order to derive the price of the product.
- Cost plus pricing can also be used within a customer contract, where the customer reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred.
Advantages of cost-plus pricing system –
- It is now necessary to move away from the pricing formula based on trade parity and embrace a cost-plus pricing system. The formula based on trade parity fixes the landed cost of petrol and diesel at a level that is slightly higher because of the inclusion of customs duty in it.
- Simple – It is quite easy to derive a product price using this method, though you should define the overhead allocation method in order to be consistent in calculating the prices of multiple products.
- Assured contract profits – Any contractor is willing to accept this method for a contractual agreement with a customer, since it is assured of having its costs reimbursed and of making a profit. There is no risk of loss on such a contract.
- Justifiable – In cases where the supplier must persuade its customers of the need for a price increase, the supplier can point to an increase in its costs as the reason for the increase.
- A cost-plus pricing formula will also introduce transparency and help reflect a more reasonable and correct picture of the oil companies’ under-recoveries, which, in turn, could help reduce the government’s subsidy bill and even reduce retail fuel prices.