[28] A more detailed account of the rise of the Harriman system is in vol. II.

CHAPTER II
THE THEORY OF RAILROAD RATES

Analysis of railroad expenditures, [44].—Constant v. variable outlays, [45].—Fixed charges, [46].—Official grouping of expenses, [46].—Variable expenses in each group, [51].—Peculiarities of different roads and circumstances, [56].—Periodicity of expenditures, [61].—Joint cost, [67].— Separation of passenger and freight business, [68].

Analysis of the theory of railroad rates begins naturally with a study of railroad expenditures. The examination of earnings is not feasible until a later time. For neither a railroad nor a factory can earn money until it has first liberally expended it. A physical plant must be provided, in the first place, which means the guarantee of interest on a large capital; and, secondly, it must often be operated unprofitably at the outset. This is especially true in a new and undeveloped country like the United States; where demand for transportation must be frequently created by the invasion of virgin territory, making it inviting for settlement. Twenty years ago such an analysis of railroad expenditures with any approach to precision, owing to the absence of scientific data, would have been impossible. A few companies, such as the Pennsylvania, the Union Pacific and the Louisville & Nashville, had indeed attempted to systematize their accounts; but there was no agreement as to details, despite a certain harmony in questions of principle. But since the passage of the Act to Regulate Commerce in 1887, and largely owing to the work of Prof. Henry C. Adams as statistician to the Interstate Commerce Commission, the matter may now be examined profitably in detail. The data is published annually in a volume entitled "Statistics of Railways in the United States." The amplified powers of the Interstate Commerce Commission since 1906 have considerably changed the system in force since the original law of 1887; but the general principles remain unchanged.[29] One feature of the new law, however, is important. Not only must detailed reports be periodically and promptly made; but no company is now permitted to keep its books in any other form than the one officially prescribed. This standard was adopted after extended conference with the Association of American Railway Accounting Officers, which body has, in fact, officially approved of the form adopted in most regards. These accounts, therefore, may be said to represent the combined intelligence of the practical and theoretical analysts, of the operating and financial staffs, and of the governmental supervisory board. A great impetus to scientific railroad economics has undoubtedly resulted from this coöperation between government officials and private managements.

The primary distinction in railroad expenses is between those which are constant and independent of the volume of traffic, and those which vary more or less directly in proportion to it. Thus, of the total outlay, it may at once be premised that for a time, at least, certain capital expenditures are entirely unrelated to the volume of business transported. Interest on bonded indebtedness is neither increased nor diminished, up to a certain point, by the number of tons of freight moved; whereas, on the other hand, other items of expenditure, such as wages of train hands and fuel cost, are more or less directly affected. The distinction above mentioned finds its clearest expression in the primary division of railroad accounts into so-called "operating expenses," which are variable; and "fixed charges," which, as the name implies, are constant. Much of the direct wear and tear of equipment belongs to the first class, while, as we have said, interest on its own funded or floating debt, together with capital obligations on leased lines, naturally fall into the second group. This second class of constant expenses, which along with taxes is often denominated in railway reports "Deductions from Income," is a relatively large one. Thus, in 1910, out of a total expenditure by all the operating railroads of the United States of $1,822,000,000, no less than $490,000,000, or about 27 per cent., consisted of interest on debt and taxes. This proportion of absolutely fixed expenditures, moreover, shows a remarkable constancy throughout a series of years. It reached high-water mark during the hard times in 1895, at 33.07 per cent. of all outlay. Indebtedness had accumulated unduly, while at the same time the volume of traffic was so small that mere operating expenses dwindled in proportion. But since that time, largely as a result of the financial reorganizations of 1893-1897, the percentage of fixed charges has reached its present low point. This improvement is also in part due to the growth of traffic, and thereby of operating expenses. The latter have indeed grown faster than the accumulation of debt, owing to the practice prevalent among American roads of paying for many improvements and additions out of surplus income, rather than by charging them to capital account,—that is to say, by borrowing money to pay for them.

Having at the outset deducted approximately one-quarter of our total expenditures to meet fixed charges, we may now proceed to analyze those outlays which remain. And this is to be done, always keeping in mind the fundamental distinction between constant and variable items. From 1887 until 1906 the operating expenses of American railroads were allocated in the four following groups:

This grouping under the new law of 1906 has been somewhat redistributed. But inasmuch as most of the statistical data as yet available is presented under the above-named heads, we shall adhere to that classification. This we may the more properly do, as our object is to show the general bearing of railroad expenditures upon rate making, rather than specifically to analyze cost accounts. For this simple purpose the above arrangement is entirely adequate.