This subject outlines the basic elements involved in the determination and allocation of the costs of service to the various classes of customers, as well as the development of rates to equitably recover the costs of service from each class of customers (Figure 1). It is intended for self-sustaining water systems to assist them in developing adequate, fair, and equitable water rates.

1. DETERMINATION OF REVENUE REQUIREMENTS

In providing adequate water service to its customers, every water utility must receive sufficient total revenue to ensure proper operation and maintenance (O & M), development and perpetuation of the system, and maintenance of the utility's financial integrity. The first step in utility rate making is to determine the total annual operating revenue requirements for the period in which the rates are to be effective. The revenue requirements are the costs of service to be derived from rates.

One generally accepted and practiced approach to projecting total revenue requirements of a water utility is the cash-needs approach. The essence of the cash-needs approach is that the revenues of the utility must be sufficient to cover all cash needs, including debt obligations as they come due, for the period over which the rates are intended to be adequate.

Basic revenue-requirement components generally include O & M expense, debt-service requirements, and capital expenditures not debt-financed.

The O & M expense component of revenue requirements is based on actual expenditures derived from accounting records with adjustments to reflect the level of expenditure anticipated to be incurred during the period that rates are to be effective. Those revenue requirements of the utility that are generally classified as O & M expenses include salaries and wages, employee fringe benefits, purchased power, other purchased services, rent, chemicals, other materials and supplies, smaller items or equipment that do not extend the useful life of major facilities, and general overheads.

The debt service components of the revenue requirements consist of principal and interest requirements on loans outstanding during the period that rates are effective. The amount of cash required to pay principal and interest on outstanding debt is obtained from established debt-service schedules.

The establishment of the cash requirement for future plant improvements or additions is a decision generally affected by the nature of investment and utility financing policies. Capital expenditures (capex) are generally classified into three broad categories, viz., replacement of existing facilities, normal extensions and improvements, and major capital improvements and replacements.

Other cash revenue requirements that may be required to be financed from water system revenues might include equity and reserve. Such additional requirements depend on each local situation and should be considered where applicable.

Revenue-required projections. Among the more significant problems confronting water utilities in recent years has been the impact of inflation. Rapidly escalating costs have affected every component of revenue requirements.

One of the most effective methods used to cope with the problem of rapidly increasing costs is the use of a "forward looking," or prospective, rate period, whereby rates are established to meet projected revenue requirements for a specified period. Table 4-1 shows the prospective projection of the cash revenue requirements of a hypothetical utility for a future five-year period and include O & M expense, debt-service requirements, reserve requirements, and capital improvements not debt-financed.

The example in Table 4-1 illustrates that revenues under existing rates are adequate to meet cash requirements in Year 1 but that revenues under existing rates are insufficient in subsequent years. Such an illustration reflects prudent planning in that Year 1 could very well be the current year, for which projections show that revenues will be adequate to meet revenue requirements but that projections for next year, Year 2, show a need for additional revenues.

In allocation of costs customer classes and design of rates, a period for which the initial rate change is to be adequate is usually considered to be the test year. For this example, it is assumed that rates are to be designed for a one-year period. Year 2 with subsequent rate changes possible necessary to meet the requirements in Year 3 and on.

Projection of expenses in the detail shown in Table-4-1is important for two reasons. First, it provides for small elements of expenses to be more accurately analyzed and projected. Second, the total requirement for O & M expense is separated into cost elements that are readily assignable to appropriate functional cost components in the cost-of-service allocation phase of the rate stud analysis.

The total test-year requirement, Year 2, in the example amounts to P3,727,000.00. This represents the total annual cost of service to be derived from rates anticipated to be incurred by the utility in the test year for providing service during the period of which rates are being designed.

The projected revenue requirements shown in Table 4-1 reflect the cash-needs determination of revenue requirements referred to at the beginning of the chapter.

The prospective procedure develops the revenue requirement for costs, both capital and operating, that are anticipated for the period that rates will be in effect. It is essential to first develop adequate historical data to serve as a basis for projecting future requirements. Historical data also provide the basis for the bridge between the actual costs of the past and the projected costs of the future. It has been the general practice to establish rates based on an actual historical test year, with certain adjustments to historical costs being allowed for known and measurable changes. Typically, such adjustments might include increases in salary and wage expenses resulting from a negotiated labor agreement, known increases in costs for electric power, fringe benefit adjustments, and the like.

While most revenue requirements usually need to be met from rates applicable to water service, some other revenue is derived from miscellaneous income items such as rentals and interest on invested capital.

2. ALLOCATION OF COSTS TO THE FUNCTIONAL COMPONENTS OF THE COST OF SERVICE

Consistent with the exercise of appropriate conservation considerations in providing service, a water utility is required to supply water in total amounts and at such rates of use as desired by the customer. A utility incurs costs in relation to the various expenditure requirements caused by meeting those customer needs. The costs to the utility of providing service vary among customers or classes of customers.

In seeking equitability in charges to the different customers, the basic premise in the establishment of adequate rate schedules is that they should reflect the cost of providing water service. A sound analysis of the adequacy of charges requires allocation of costs among the customers commensurate with their service requirements in order to recognize differences in costs of furnishing service to different types of customers.

The purpose of cost allocation is to express the total utility cost of service, including O & M expense, debt service, and capital expenditures, in terms of:

Costs associated with supplying both the customer's average and peak rates of use or demands.
Costs related to customer meters, services, and accounts.
Direct costs incurred to provide for fire protection.
Those costs by functions, in turn, are further distributed to customer classes on the basis of their particular requirements for service.

Utility costs are allocated, or assigned, in two steps: first to appropriate cost components, then to customers. The cost components vary, depending on the basis of allocation used. One generally used method of cost allocation is the commodity-demand method. The cost allocation includes:

Allocation of costs applicable to the functional cost components of commodity, demand, customer, and direct fire-protection.

Distribution of costs by the various cost components to respective classes of customers in accordance with the respective responsibility of the customer classes for each of the component costs.

Commodity costs are costs that tend to vary with the quantity of water produced. They usually include costs of chemicals, a large part of power costs, and other elements that increase or decrease almost directly with the amount of water supplied. Costs related to impounded reservoir source of water supply or other costs that vary with average daily demands, such as raw-water transfer pumping costs, may also be considered as commodity costs. Purchased-water costs, if water is bought on a unit volume basis, would also be considered as commodity costs.

Demand costs are associated with providing facilities to meet the peak rates of use, or demands, placed on the system by the customers. They include capital-related costs on plant to meet peak requirements plus the associated O & expenses.

Customer costs comprise those costs associated with serving customers, irrespective of the amount or rate of water use. They include meter reading, billing, and customer accounting and collecting expenses, as well as maintenance and capital costs related to meters and services. In detailed studies, the costs for meter reading and billing and for customer accounting and collecting may be considered as one subcomponent and maintenance and capital costs on customer meters and services may be considered as another subcomponent.

Direct fire-protection costs are those costs that are applicable solely to the fire-protection function. Usually, such costs are simply those directly related to public fire hydrants and related branch mains and valves. It should be noted that the costs allocated to the direct fire-protection cost component are usually only a small part of the total cost of fire protection.

Table 4-2 presents an example of allocation of rate base. Each element of utility plant is assigned to commodity, demand, customer, or direct fire-service functions. The results of the allocation of rate base to the various cost components provide a basis for subsequent distribution of rate base, and capital costs related thereto, to customer classes.

For purposes of this illustration, the various elements of rate base in the table are the net book value (original cost less accrued depreciation) of the water system, based on the accounting records of the utility as projected for the test period.

Investment in source of supply, land, land rights and impounded reservoir structures in this example is allocated 100 percent to the commodity cost component in recognition of the fact that such facilities are sized principally to meet annual supply requirements in total, whether or not variations in daily needs are experienced.

Pumping plant and treatment plant, which meet maximum-day demands, are allocated 100 percent to the maximum-day demand cost component. Treated-water mains, which serve maximum-hour demands, are allocated 70 percent to the maximum-day demand cost component and 30 percent to the maximum-hour demand cost component. Rate base for distribution storage is allocated 100 percent to the maximum-hour demand cost component.

Meters and services are allocated to the customer cost component. Fire hydrants are allocated to the direct fire-service cost component.

The value of office buildings, furnitures and equipment, vehicles, and other general plant is allocated to cost components on the basis of the resulting allocation of other plant facilities.

Construction work in progress is allocated to cost components on the same basis as elements of plant in service. In this example, it is assumed that all construction work in progress is transmission and distribution mains.

In some water utility systems, the accounting records will show contributions in aid of construction that ordinarily are deducted from the rate base before applying rate-of-return percentages. Contributions should be deducted from plant value in accordance with the purposes for which the contributions were made. The example illustrated in Table 4-2 assumes that all contributions in this instance are related to customer meters and services.

Table 4-3 presents an example of the allocation of depreciation expense. The categories of items of depreciation expense are allocated to cost components in the same manner as described in the allocation of rate base.

Table 4-4 presents an example of allocation of O & M expense. In general, O & M expense for each facility is allocated to cost components in a manner similar to that for rate base. However, chemical costs, which tend to vary with the amount of water produced, are assigned 100 percent to the commodity cost function. Pumping power costs are allocated 71 percent to commodity cost and 29 percent to maximum-day demand cost in recognition of the fact that power costs vary with demand.

Employee benefits are allocated on the basis of the allocation of salaries and wages. Insurance is allocated on the basis of test-year rate base in Table 4-2. Other administration and general expense is allocated on the basis of all other expenses, exclusive of power and chemicals.

3. DISTRIBUTION OF THE FUNCTIONAL COSTS OF SERVICE TO CUSTOMER CLASSES

The cost of providing service can reasonably be determined for groups or classes of customers that have similar water-use characteristics and for special customers having unusual water-use or service requirements. It is an objective of rate making to assign costs to classes of customers in such a manner that rates can be designed that are nondiscriminatory and meet as nearly as possible the cost of providing service to such customer classes.

The three principal customer classes typical of most water utilities are residential, commercial, and industrial. Definition of these general customer classes differs among utilities, but in very broad terms, the following definitions are common:

Residential - One-and two-family dwellings, usually physically separate.
Commercial - Multifamily apartment buildings and nonresidential, non-industrial business enterprises.
Industrial - Manufacturing and processing establishments.
For specific utilities, there may be a breakdown of these general classes into more specific groups. For example, the commercial customer group may be subdivided into Commercial-A, Commercial-B, and Commercial-C.

In addition to the principal classes of service previously described, water utilities often provide service to certain special classes of customers. Two of those considered here are wholesale service, and fire-protection service.

Wholesale service is usually defined as a situation in which water is sold to a customer at one or more major points of delivery for resale to individual retail customers within the wholesale customers service area.

Fire-protection service has characteristics that are markedly different from other types of water service. The service provided is principally of a standby nature - that is, readiness to deliver relatively large quantities of water for short periods of time at any of a large number of points in the water distribution system while the total annual quantity of water delivered is relatively small.

As a step toward rate design, component costs may be distributed among customer classes in the proportion that the respective class responsibility for those costs bears to the total cost responsibility of all customer classes served by the system. This applies for each of the component costs of service. Responsibility for each component may be expressed in terms of the number of units of service required by each class of customer. The sum of all component costs attributable to a customer class is the total cost of service to be recovered from it.

The total cost of each component, such as commodity cost, may be divided by appropriate total customer requirements or unit of service to express a unit cost for each component. The unit costs of each component serve as a basis for designing rates. Unit of service is defined as an element of service for which a cost can be ascertained, such as thousand cu.m., hundred cu. ft., million gallons per day, monthly bill, etc.. As a basis for distributing component costs to customer classes, it is essential that the units of service attributable to the respective classes be established for the test year. This involves determining or estimating the total quantity of water to be used by each class in the test year and the peak rates of use by the class, usually for both maximum-day and maximum-hour rates of use. In addition, a determination needs to be made of the number of equivalent meters and services by class, as well as the number of bills by class.

Maximum rates of use may be expressed in terms of capacity factor - that is, a percentage relationship of the class maximum rate of use to average annual rate of use. Thus, if a customer class maximum-day rate of use is 2.5 times its average rate, it is said to have a maximum-day capacity factor of 250 percent.

The total annual quantity of water attributable to fire service is usually considered to be negligible, at least in relation to that of other classes.

Customer-related costs for meters and services may be properly distributed among customer classes by recognizing factors that are generally responsible for those costs being incurred. As an example, a method for distributing meter-and-service costs to customer classes is in proportion to the investment in meters and services installed for each customer class, based on the number of equivalent meters. Typical customer meter-and-service equivalent ratios based on investment are as follows:

Meter Size Equivalent Meter-
in. and-Service Ratio

1/2 1.0
3/4 1.6
1 3.2
1-1/2 8.0
2 20.0
3 36.0
4 72.0

Cost related to billing and collecting may be distributed among customer classes based on the total number of bills rendered to the respective classes in a test year. In some instances, it is appropriate to recognize, through billing ratios, that billing and collecting for larger services may incur more cost than for smaller services.

Table 4-5 shows the development of units of service.

Test-year units of service reflect the prospective average annual customer water-use requirements during the test-year study period considered in this example.

For each customer class, under the heading of Commodity in Table 4-5, the total annual water use in cubic meters is shown, as well as the average rate in cubic meters per day. Maximum-day capacity factors are applied to average-day rates of flow to develop total capacity by class. Extra capacity is the difference between maximum-hour capacity and maximum-day capacity. Fire protection service is considered to require negligible flow on an average basis but 97 cu.m. per day on a maximum daily basis. Maximum-hour extra capacity is developed similarly. Maximum-hour fire-protection service reflects the assumption that flow for fires is concentrated in a four-hour period.

All pertinent sources of information need to be investigated and studies in estimating customer-class capacity factors. Such data should include daily and hourly pumping records, recorded rates of flow in specific areas of the system, studies and interviews of large users regarding individual and group characteristics of use, specific-demand metering programs, and experience in studies of other utilities exhibiting like characteristics. Sound and logical inferences can be drawn from customer metering information, provided billing periods are sufficiently short to reflect seasonal differences, usually not to exceed three-month periods.

Equivalent meters and services are derived by applying equivalent ratios to the number of meters of each size by class. The number of bills is simply the total number of bills rendered annually for each class.

It should be recognized that the maximum total capacity on both a maximum-day and maximum-hour basis for the total system is the estimate of the sum of noncoincidental peaking requirements on the system; that is, it is the sum of the peaks for each class, regardless of the day or hour in which such peaks may occur.

Component costs can be directly distributed to respective customer classes in proportion to the respective units of service applicable to each class. For instance, costs of service are distributed among customer classes by application of unit costs of service to respective service requirements. Unit cost of service are based on total costs previously allocated to functional components and the total number of applicable units of service for the test year. Unit cost is defined as the cost of producing a unit of a product or service. An example would be the cost of treating a thousand cu.m. of potable water for use by the water utility's customers.

Unit costs are determined simply by dividing the test-year functionally allocated O & M and capital costs by the respective total system units-of-service requirements in the test year. Similar computation are made to determine unit costs for all other O & M expense and depreciation expense.

The determination of unit return on rate base is made by first calculating unit rate base. The functionally allocated total rate base is divided by respective total system units of service to yield unit rate base. Subsequently, unit return on rate base is derived by applying appropriate rates of return to the unit rate base.

Table 4-6 shows the development of unit costs of service.

For example, the commodity unit cost for O & M expense of P1.7682 per cu.m. may be derived by dividing the allocated commodity O & M expense of P495,100 by the total commodity-component units of service of 280,000 cu.m. Similar computations are made to determine unit costs for all other O & M expense and depreciation expense.

The determination of unit return on rate base is made by first calculating unit rate base. The functionally allocated total rate base is divided by respective total system units of service to yield unit rate base. Subsequently, unit return on rate base is derived by applying appropriate retail and wholesale rates of return to the unit rate base.

Distribution of costs to customer classes. The distribution of the costs of service to the utility's classes is accomplished by applying unit costs of service to individual customer-class units of water service. Commodity costs are distributed to customer classes on the basis of total annual use. Demand-related costs are distributed to the various classes in proportion to the class total responsibility, and customer costs are distributed based on equivalent meter and billing requirements.

Table 4-7 shows the cost distribution to customer classes.

As shown in Table 4-7, residential customers are projected to use 98,000 cu.m. of water in the test year; commercial customers, 48,000 cu.m.; industrial customers, 111,000 cu.m. Applying the retail commodity cost of P1.9698 per cu.m. to the respective units of service yield the distributed customer-class commodity cost of service. By definition, the unit commodity cost is the minimum rate at which water could be sold after customer costs are recovered. Wholesale distributed commodity costs are derived from the application of the unit commodity cost of P2.1132 per cu.m. to the wholesale commodity unit-of-service requirements. The higher unit commodity cost reflects the rate-of-return differential.

Demand-related costs for maximum-day and maximum-hour service requirements are distributed to the classes based on the application of total estimated class service demands and the unit costs of demand.

Customer costs, which include the category of meters and services and the category of billing and collecting, are generally treated separately in rate studies. Customer costs associated with meters and services may be distributed to customer classes on the basis of equivalent meter-and-service cost factors. Meter-and-service costs are based on the total number of equivalent 1/2 in. meters and are applied to customer-class equivalent meter units of service in order to determine allocated cost of service. Units based on equivalent 1/3 in. meters are used to allow for the fact that customer costs will vary and tend to increase with the size of the customer meter and service.

Billing and collecting costs may be related to the number of bills issued and, in turn, distributed to customer classes on the basis of the number of bills rendered to customers within each class. For example, customer-class responsibility is determined by applying the billing and collecting unit cost to the total estimated number of bills in each customer class rendered for the average rate year.

A word of caution should be added that may prevent misinterpretation of the commodity cost of P1.9698 per cu.m. Under no circumstances is this the cost of water. Even with perfectly uniform use, demand and capacity costs must be added.

4. DEVELOPMENT AND DESIGN OF A SCHEDULE OF RATES AND CHARGES TO RECOVER THE REVENUE REQUIREMENTS

The final step in a cost-of-service rate study is the development of a schedule of rates to recover, as nearly as possible, the allocated costs of service from customers. A primary consideration in the derivation of water-rate schedules is the establishment of equitable charges to customers commensurable with the costs of providing that service. Rates are normally design to fit average conditions for groups of customers having similar service requirements. Adherence to the results of the cost-of-service determinations presents a practical basis for determining equitable water rates. Therefore, the basic objective of a rate study should be the development of a rate structure that will attain the maximum degree of requitability among customers, will be consistent with local practice and conditions, and will be in the best interest of both the community and the utility.

The design of a water-rate schedule that requires each customer class to pay its full cost of service takes into consideration unit costs applicable to the level of service rendered. Recognition of the degree to which each component is involved in providing the level of service rendered provides a basis for design of a schedule of rates.

Recovering customer costs. The method of recovering customer costs, such as meter reading and billing-and-collecting, should reflect factors such as meter reading and billing among customers, and it may consider the greater cost of billing for large meters and other factors.

Customer costs related to meter and billing-and-collecting are incurred regardless of the amount of water, if any, that is used. These costs are generally recovered through either a minimum charge or a service charge.

The minimum charge is usually designed to recover all customer-cost elements and both the volume and demand-related costs associated with an allowance for a specified quantity of water usage. The service charge is designed to recover customer-related costs and possibly some demand-related costs associated with readiness to serve, and, consequently, all water use would be billed under subsequent rate blocks. As with the minimum charge, the service may be graduated by meter size, based on an analysis of metering, billing, and other associated costs for customer services of varying sizes.

Recovering costs related to volume and demand. An important issue to be determined in rate design is whether the water rate schedule will consist of (1) a single rate per unit of volume, irrespective of the volume of use, or (2) two or more rate blocks. Because of load-factor effects, the rate for subsequent blocks generally decline for larger rates of use. Such a schedule is often referred to as a declining-block schedule. In some instances, there may be an inverted rate structure, whereby the charge for use beyond the first block would be priced at higher rate rather than at declining rates.

Consideration of the costs of service related to fire protection should normally be included in a cost-of-service study. Public fire-protection service would consist of the costs for fire hydrants and the backup facilities required to provide an adequate water supply in the event of fire. Charges for fire-protection service are based on costs not only of direct facilities, such as public hydrants and fire-service connections, but also the allocated share of costs for backup facilities in the water system. Rates for public fire protection are generally expressed as a total annual charge and may be expressed as an annual charge per hydrant.

Where wholesale or sale-for-resale service is provided, a careful analysis should be made of the cost-of-service elements entering into such service. It is important to carefully define and evaluate the cost of providing water on a wholesale basis and to design the rates accordingly.

Service-charge design. Customer costs, which are comprised of meter-and-service and billing-and-collecting related costs, maybe recovered from customers through a service charge. In addition, a portion of distribution-main costs as well as a portion of demand-related costs are sometimes included in the determination of service charges. No allowance for water use is included in the development of the service charge, and, therefore, the commodity and demand costs are recovered in the volume portion of the rate.

Block-rate design. Block rates provide a means of recovering costs for general service classes of residential, commercial, and industrial users under a single rate schedule by recognizing the differing water-use and associated cost characteristics for each class of service. The blocks that ultimately control the charges for any particular system should be designed on the basis of customer-class water-use information derived from historical billing records for that system. Billing information is tabulated by customer class to establish quantity of usage and number of bills rendered at various usage levels.

Fire-protection service rate design. In the cost-of-service allocations, fire-protection service has been included as a class of service separate from regular retail service customers. Fire protection, like any other class of service, imposes on the utility certain demands and facility requirements with associated costs, and charges can be designed to recover costs for this service. The costs distributed to fire-protection service may include extra capacity costs associated with potential demands on the system by public fire-protection requirements and direct costs related to investment in, and maintenance of, public fire hydrants.

Minimum-bill design. Rather than utilizing a service charge that allows no water use, an alternative minimum charge that provides a customer with some volume of water for the charge may be designed as a part of the rate schedule. The initial block may be designed to recover customer costs and costs associated with use and capacity requirements of the smallest users. The remaining blocks are designed in the same manner discussed previously to recover costs beyond those of the smaller users.

The inverted or increasing block rates. The counter part to declining-block rates. Under such rates, the unit price rises with each successive block, resulting in both the incremental and average cost of water increasing with increased customer usage. The concept of an increasing price per unit of use frequently arises from the desire for conservation in total use.

Unmetered or flat rates. Refer to charges utilized where customer use is not metered. Such rates are applied to certain measures of customer service, such as the number of rooms, the number of plumbing fixtures, and other such elements. Such rates have been common in the past and continue to be used in some water utilities. In specific instances where water conservation is not a significant consideration and the installation of meters is unpractical, such rates can be designed to generally recover estimated costs of service, but they may contribute to excessive use of water with attendant higher total costs.

Lifeline rates. Consumers - advocate groups sometimes propose programs to reduce utility charges for residential customers who are poor. Such assistance is often described by the single category of lifeline rates. The lifeline concept of rate design is frequently proposed as an aid to economically disadvantaged and elderly residential customers who might not be able to pay their bills.