Why are plant costs so important to utilities?

Your utility’s list of expenses for this month has just been approved for payment. If one of these expenses was for buying electricity or chemicals, you’d pay the bill and that would pretty much be the end of it. But if you purchased materials for use in the construction of an electric line or water main extension, buying supplies is only the first step when following proper accounting procedures. Initially, the purchase would be charged to an inventory account, and later transferred to an account for construction work in progress. A work order would be created to recapture all the construction costs and continuing property records and mapping systems would summarize cost and track asset location.

Why is plant accounting so complicated in the utility industry? There are a number of answers, but most of them relate to how customer billing rates are determined and how your utility financial results are measured.

Utility rates

All utility rates are designed to recover some level of capital or plant-related costs. For those entities whose rate revenue requirements follow the “utility method” the rates will recover operation and maintenance expenses, depreciation expenses for the utility plant, and a return on the net investment rate base. For those entities whose rate revenue requirement follows the “cash method,” the rates will recover operation and maintenance expenses, cash outflow for routine utility plant, and debt service.

Plant costs directly impact depreciation, return, cash outflow, and debt service. In an electric utility, these plant-related components can be the second largest element of utility costs after generated/purchased power. In a typical utility, power costs average seventy cents of each revenue dollar collected, with plant-related costs weighing in as the largest proportion of the remaining thirty cents. In a typical water utility, plant-related costs account for forty to fifty cents of every revenue dollar. In other words, accurately identifying the plant and capital costs of providing service is essential in order to appropriately configure the rates at which you will charge your customers.

Financial results

The accounting definition of a capital asset in regard to utility plants is an investment in facilities, equipment, land, etc., that has a useful life of more than one year and a cost of more than a set amount, say for example, $1,000. Accounting standards spread the cost of this asset over its useful life through an operating expense called depreciation, while the original $1,000 cost is not classified as an operating expense. As explained above, utility rates generate revenue to cover this depreciation expense. The extent that revenues exceed all operating costs, including depreciation, is your utility net income for the year. Spreading the costs of all plant assets over their useful life matches the benefits of using the investment with the revenues generated to cover the cost, even though the cash payments were made years earlier. In the absence of depreciation accounting, during the year in which that line or main extension is constructed, expenses would be very high, while during the remaining years the facilities are used, expenses would be low. Without depreciation, rates would fluctuate up and down to cover these major expenses, even though the facilities are used pretty much uniformly over their life. This is one example of why plant accounting follows the time-honored accounting theory of matching revenues and expenses with the appropriate usage periods.

For more information on this topic, or to learn how Baker Tilly energy and utility specialists can help, contact our team.