Chapter 6 Cost Allocation by hcj


									Chapter 6 Cost Allocation
               6.1 Introduction
• 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
   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):

 (1) Kansas-Nebraska method:
  --allocate each cost account to either labor or plant.

 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
             Each row: one cost function
            Each column: one cost classification
   Function                         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
      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
• 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
  --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
  peak demand.
   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
               coincident                                                                                 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%

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.

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