Chapter 6 Cost Allocation
• This chapter refers to the next three steps of the “five-
step 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
• Importance of cost functionalization:
(1) avoid inefficient and inequitable cost-subsides bw
regulated and non-regulated services—eliminating
(2) critical to efficient rates even in the absence of
• 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
• Methods (for non-allocable costs):
(1) Kansas-Nebraska method:
--allocate each cost account to either labor or plant.
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
Each row: one cost function
Each column: one cost classification
Production Capital costs Fuel costs O&M costs
Transmission Rights of Capital costs Payments to
way grid operators
Distribution Three Electric poles Meters
Administrative& Office Health care Employee
General (A&G) leasing salaries
Accounting Billing Postage Collection
system agency fees
6.3 Cost Classification
(1) Variable costs:
--dependent on the amount of a regulated firm’s output
(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
(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
--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
-- 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
responsibility may change each time the peaking unit is
How to allocate the variable operating costs associated
with the peaking unit
Examples of Cost Allocation
• 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
Table: Natural Gas Distribution Company—Estimation
of Customer and Energy Allocators(2006 Test Year)
Avg.No. of Customer Total Consump- Consump-
Customers Allocation Consump- tion tion per
Factor tion(106 Allocation Customer
cubic feet) Factor (103 cubic
Customer (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
Industrial 500 1.18% 4,500,000 49.45% 9,000
Total 42,500 100.00% 9,100,000 100.00%
• Energy and customer allocators are generally
--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
• 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
Table: Electric Distribution Company—Estimation of
Demand Allocators (2006 Test Year)
Customer Annual Summer Winter Spring Fall Average Average
Class Maximum Coincident Coincident Coincident Coincident Annual Annual
Class Peak Peak(MW) Peak(MW) Peak(MW) Peak(MW) Demand(M Load
(MW) W) Factor(%)
(1) (2) (3) (4) (5) (6) (7)
Residential 7,700 7,700 6,400 5,400 5,505 3,752 48.73
Commer- 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
Total 21,890 21,500 20,600 18,100 17,900 13,943 -
Alternative Allocation Factors
Customer Annual Summer Winter Spring Fall 4-CP Reciprocal
Class Non- Load
(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%
Total System 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
• 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.