### Chapter 6 Cost Allocation

```Chapter 6 Cost Allocation
6.1 Introduction
• This chapter refers to the next three steps of the “fivestep procedure” , deciding how the revenue requirement
is eventually allocated into different customer bins.
• To create a Cost-of-Service (COS) model, the firm’s
costs are accounted for in three steps:
(1) all known and measurable costs distributed into
functional categories— cost functionalization.
(2) further classified into specific categories-- Classification
customer costs; variable costs; fixed costs.
(3) classified costs allocated among customer groups
(most controversial step: there is no uniformly correct
ways of allocating joint and common costs)
6.2 Cost Functionalization
• Step 2 of the tariff-making procedure.
• FERC established Uniform System of Accounts for this
purpose.
• Importance of cost functionalization:
(1) avoid inefficient and inequitable cost-subsides bw
regulated and non-regulated services—eliminating
“spillovers”
(2) critical to efficient rates even in the absence of
unregulated activities.
• For easily allocable costs (the majority), functionalization
is usually straightforward.
Ex: the cost of building and maintaining a 500-kV electric
transmission line—transmission category.
• For non-allocable costs, or “administrative and general”
(A&G) costs, functionalizing is challenging.
Ex: accounting costs, office costs (rent, etc.)
--requires additional analysis to identify the
corresponding activities.
• Methods (for non-allocable costs):
--allocate each cost account to either labor or plant.
Features:
 standardizes functionalization;
 provides both consistency and predictability.
 Typically, when this method is used, the majority of
accounts are categorized as labor.
(2) Massachusetts method:
--expands Kansas-Nebraska method by taking into
account derived revenues as a third factor.
Three factors are given equal weights.
Table: simplified version of functional & classified
costs.
Each row: one cost function
Each column: one cost classification
Function
Classification
Production
Capital costs
Fuel costs
O&M costs
Transmission
Rights of
way
Capital costs
Payments to
grid operators
Distribution
Three
trimming
Electric poles
Meters
General (A&G)
Office
leasing
Health care
Employee
salaries
Accounting
Billing
system
Postage
Collection
agency fees
6.3 Cost Classification
(1) Variable costs:
--dependent on the amount of a regulated firm’s output
or sales.
(2) Fixed costs:
--incurred regardless of output
(3) Customer costs:
--directly incurred by customers and can be categorized
by customer types.
The optimum method of classifying costs also includes an
allocation mechanism to deal with accounts comprising
a mix of both fixed and variable costs.
6.4 Cost Allocation
• The process of matching the different types of classified
costs to different groups of customers.
• Arguably most difficult step:
(1) how to determine appropriate factors
(2) appropriate factors now may not be appropriate in later
cases
• Controversies:
(1) must confront not only economic efficiency, but also
questions of fairness.
--allocation of joint costs
(2) when costs are allocated based on another
fundamental economic principle: avoiding cross
subsidies
--hard to estimate; conflict with “just and reasonable”
(3) when avoiding cross-subsidies clashes with another
principle: allocating costs to those customers who benefit
from the expenditures
--definition of “benefit”
Cost Allocation Methodologies
• Allocating variable costs: straightforward.
--based on volumetric measures. (w.r.t. output)
• Allocating fixed costs: more difficult.
--many joint or common costs, no unique method
controversies.
-- Principle hard to follow: costs should be allocated to
those who cause them.
Uniform System of Accounts; Pemex method
Allocating Fixed Costs
• --can be problematic: determining the responsibility for
those costs on an annualized basis is difficult.
Ex: operating the peaking units
Moreover:

responsibility may change each time the peaking unit is
used
 How to allocate the variable operating costs associated
with the peaking unit
Examples of Cost Allocation
Methodologies
• Some costs are straightforward to allocate.
Ex: the costs to produce a customer bill are the same
regardless of the level of consumption;
the total cost of coal purchased for a coal-fired power
plant
Table: Natural Gas Distribution Company—Estimation
of Customer and Energy Allocators(2006 Test Year)
Customer
Class
Avg.No. of
Customers
Customer
Allocation
Factor
Total
Consumption(106
cubic feet)
Consumption
Allocation
Factor
Consumption per
Customer
(103 cubic
feet)
(1)
(2)
(3)
(4)
(5)
Residential
40,000
94.11%
3,600,000
39.56%
90
Commercial
2,000
4.71%
1,000,000
10.99%
500
500
1.18%
4,500,000
49.45%
9,000
42,500
100.00%
9,100,000
100.00%
Industrial
Total
• Energy and customer allocators are generally
straightforward.
--coz they are easily measured and they preserve the
goal of aligning costs and benefits.
• Demand allocators, are more problematic.
--natural gas and electric distribution systems are geared
towards meeting peak demand. So pipes must be sized
so that enough natural gas can meet customer’s
demand.
• Allocating joint (or common) costs--fundamental
difficulty, and no unique correct way.
--examine mostly the relationship bw individual group
peak demand at the time of, or coincident with, system
peak demand.
Table: Electric Distribution Company—Estimation of
Demand Allocators (2006 Test Year)
Customer
Class
Annual
Maximum
Class Peak
(MW)
Summer
Coincident
Peak(MW)
Winter
Coincident
Peak(MW)
Spring
Coincident
Peak(MW)
Fall
Coincident
Peak(MW)
Average
Annual
Demand(M
W)
(1)
(2)
(3)
(4)
(5)
(6)
Average
Annual
Factor(%)
(7)
Residential
7,700
7,700
6,400
5,400
5,505
3,752
48.73
Commercial
5,380
5,100
5,380
4,350
4,100
3,360
62.45
Industrial
8,810
8,700
8,810
8,350
8,295
6,831
77.54
21,890
21,500
20,600
18,100
17,900
13,943
-
Total
System
Alternative Allocation Factors
Customer
Class
Annual
Noncoincident
Summer
Winter
Spring
Fall
4-CP
Reciprocal
Factor
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Residential
35.2%
35.8%
31.1%
29.8%
30.8%
31.9%
41.5%
Commercial
24.6%
23.7%
26.1%
24.1%
22.9%
24.2%
32.4%
Industrial
40.2%
40.5%
42.8%
46.1%
46.3%
43.9%
26.1%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
Total System
• Many method developed joint and common electric and
natural gas utility costs, each with its logical appeal.
• But cost allocation ultimately is a zero-sum game
• regulators face difficult choices
• …and strong opposition from customer groups who
believe they have been allocated more than their “fair
share” of costs.
```