We lost money last year [Exhibit 1], and we obviously have to reverse that this year if we're going to be self sustaining. But that means we've got to know the cost of each of our products. We provide several different products, including some unregulated ones, but we don't know which ones make money and which don't. Liz Conaway, the chief executive office of Harbor City Electric (HCE), was meeting with Robert Simi, her recently hired chief financial officer. She continued: The key lies in our cost accounting system, which is supposed to abide by certain guidelines, but I don't think it does. Yet, without good cost information, I can't know if we're operating efficiently. And, if I don't know that, I can't even think about asking the DPU [Department of Public Utilities] for a rate increase. BACKGROUND HCE was established in 1998, shortly after the state's electric utility industry had undergone some moderate deregulation. According to it's mission statement "... our most important job is to keep the lights on, and if there is a service interruption, to get energy restored quickly and safely." The organization's primary business was energy delivery moving electricity from suppliers to homes and businesses. HCE procured electricity from generators, and, working much like a large warehouse, used bulk purchasing to keep the cost of power low to its customers. In this regard, it offered four categories of services (The revenue for each is shown in Exhibit 1). 1. Distribution. This was for the provision of the capacity to deliver electricity. In accordance with DPU regulations, the revenue from distribution was for the recovery of capital investments plus the operation and maintenance costs related to the organization's electrical distribution infrastructure. 2. Transmission. This was the movement of electricity over high voltage lines from a generator in a power plant to substations. According to DPU regulations, this revenue was for the recovery of the costs incurred for the transmission activity. 3. Acquisition and Transfer. "Acquisition" was the purchase of the electricity itself, usually under longterm contracts with nuclear and nonnuclear power plants. "Transfer" was the movement of that electricity from a substation to the customer. DPU regulations stipulated that the charges to customers were for recovery of the costs incurred to acquire and transfer the energy. 4. Customer Support. This was designed to help HCE's customers use energy more efficiently. With energy costs rising, HCE's customer support programs were seeing rapidly increasing demand. There were four such programs: Commercial Energy Advisor. This program provided detailed information on energy consumption in seven market sectors (Offices, Hotels and Motels, Hospitals, Restaurants, Retail Businesses, Supermarkets, and Schools). Using a benchmarking tool, HCE offered customers advice on low and nocost steps they could take to operate their facilities more efficiently and reliably. HCE claimed that its analysis could reduce energy consumption by as much as 20 percent. Business Solutions. In this program, HCE recommended efficiency upgrades to lighting fixtures. electronic controls, HVAC (heating, ventilating, air conditioning) systems, and mechanical systems. 3 Construction Solutions. HCE provided technical assistance and guidance concerning energy efficiency to organizations constructing new buildings, undertaking major renovations, or adding new or replacement equipment. Building Operator Training. This program assisted building owners and facility managers to optimize the operations of their facilities, so as to minimize the consumption of electricity, natural gas, oil, and water. Charges for distribution, transmission, acquisition, and transfer were billed to customers on the basis of kilowatt hours (KWH) of use. A sample from a customer bill is shown in Exhibit 2. Charges for customer support programs were billed on the basis of consulting hours. Although the programs employed people with different skills and at different salaries, the billable rate (which applied only to professional consultation hours, and not to secretarial or administrative support) had been set at $100 per hour for all four programs. COSTS AND COST ACCOUNTING REGULATIONS HCE's costs were affected by a variety of factors, many of which were outside its control. For instance, weather conditions were not under its control, and yet they influenced the demand for electricity, and hence HCE's costs (and revenues). On the other hand, some costs were well within its control. For example, its decision three years ago to construct a 20 mile underground transmission line had required a significant capital investment, which was financed with a bond offering. The project had thus given rise to increased depreciation and interest expenses. In addition, although some deregulation had taken place about 10 years ago, the company still needed to deal with a variety of complex regulatory matters. These matters include hazardous waste site conditions and cleanup technology. One of the more significant remaining regulations related to the full cost accounting process. As a public utility, HCE needed to be certain that this process adhered to certain guidelines. A member of the DPU's Oversight Board commented on the rationale: Deregulation is fine if it's done properly, but we've seen too many instances where its created all sorts of problems, from sky high prices to blackouts. Also, in many areas of our state, customers don 't have a choice of electric providers. That makes electricity a monopoly, and the legislature has decided that a company can increase its rates only if it gains approval from our board. To be certain that a rate increase is fair, we need to know the cost for each of a company's services. We then can compare that cost to the same cost in other energy companies to judge its appropriateness. Without a standard cost accounting methodology, the comparison would be misleading at best, perhaps useless. Some of the more important cost accounting definitions and requirements were the following: Full cost accounting referred to the total historical costs recorded in the utility's accounting books and records. These costs were either assigned or allocated to individual products (which could be either goods or services) using wellestablished cost accounting standards. If a product caused a cost to be incurred, or benefited from a cost, it was to be assigned or allocated a portion of that cost. If only one product caused the cost to be incurred or benefited from it, the cost was to be assigned to it. Cost assignment was preferred to allocation. 4 If more than one product caused a cost to be incurred, or benefited from a cost, the cost was to be "fairly and equitably" allocated, to the greatest extent practicable, among the products that caused it to be incurred or benefited from it. In this regard, the portion of a joint or common cost that was charged to a particular product depended on a "reasonable allocation basis." A reasonable allocation basis was a measure that had a logical or observable correlation to the product that caused it to be incurred. For example, labor intensive customer operations and servicerelated investments could be allocated based on customerservice labor, using appropriate timereporting methods. Or, if a direct correlation existed between changes in a cost and changes in the quantities sold of the product that caused the cost to be incurred, that cost was to be allocated based on those relationships. An "Unregulated service" meant any product other than distribution, transmission, acquisition or transfer of electricity. These products were not directly regulated by the Public Utility Commission or any other state commission. However, the cost accounting system needed to assure that they received their "fair share" of the utility's joint or common costs. HCE's customer support programs fell into this category. HCE'S COST ACCOUNTING SYSTEM Harbor City's previous CFO had established a system to determine the cost per KWH. According to his method, the cost was a yearly average for all KWHs. The accounting staff would first determine the assigned costs for each regulated product, and would then add the overhead costs of administration, building depreciation, maintenance and repairs, cleaning and upkeep, and information technology (IT) to the assigned costs of all the regulated products to determine total costs. Finally, he would divide the total by the year's number of KWH. In reviewing this method with Mr. Simi, Ms. Conaway explained the problems she perceived. Her main concern was that the method did not determine the full cost for each of the three electricity products. She anticipated complications in making this determination: You have to consider that our overhead costs, like administration and maintenance, need to be included in the cost per kilowatt hour. That would be easy to do if we had a single product, but I'm not certain how we should go about it when we need to calculate costs for multiple products. Also, it's important to point out that our unregulated products also use some overhead, so they need to be included in the analysis. Mr. Simi added some further dimensions to the problem: I've had my staff spend most of their time so far trying to get a handle on how to go about allocating overhead costs to both regulated and unregulated products. General and administrative expenses, for example, seems to help everyone about equally, yet I suppose we might say that more G&A costs are spent on products where we pay more salaries. Depreciation on the machinery and equipment was easy to assign to individual cost centers. This was true for administrative, maintenance, and cleaning equipment, as well, even though they were relatively minor costs in each of the centers. Depreciation on the building, on the other hand, needs to be allocated, and we've decided to do so on a squarefoot basis. The same applies to general cleaning and upkeep, even though not all square feet are equally easy to clean. I've had my staff make the square foot calculations, so the rest should be easy. 5 Maintenance and repair costs are a little tricky, especially the nonsalary portion, because some of these costs are applicable to the unregulated products. I've heard that some other utilities use work orders, which include both labor and materials. That would make the job much easier, but we don't have a formal system like that. So we've got a bit of a dilemma. My staff thinks that the best approach would be to allocate the cost center on the basis of kilowatt hours, but that means the unregulated products won't get an allocation. I'm thinking that perhaps salary dollars would be better, but I hate to go against my staffs recommendation, so we may just have to use kilowatt hours. Information technology is the most confusing. I've had the staff add up the hours of use by the people who are responsible for each product, but I'm concerned that we're treating all hours as the same. Yet, an hour of software programming has a much different cost than an hour of machine run time to produce monthly customer bills. For the moment, though, I'm going to treat all hours equally. The staff has taken a first cut at it all. They've assigned costs to cost centers, and computed the various allocation statistics [Exhibit 3]. Now comes the tricky part. We need to allocate the support center costs to the revenuegenerating centers. Given the rough nature of everything at the moment, I've decided not to use anything very fancy to do this, such as a reciprocal allocation. A stepdown analysis should do the trick. Of course, that raises the question of which support centers should be allocated first. We're having a meeting this afternoon to discuss that. Then we can move ahead with the stepdown, and I can meet with Liz to determine if it makes sense to apply to the DPU for a rate increase.

Required: Prepare a report for Ms. Conway, address ALL the questions/concerns raised. What overall recommendations do you have? Support your inferences and recommendations with relevant cost calculations.

HARBOR CITY ELECTRIC Exhibit 1. Income Statement for Last Year (In Millions of Dollars) Revenues Base charges 304,4 Distribution 528.0 Transmission 257.2 Acquisition and Transfer 1,3039 Unregulated Services 38.2 $ 2.431.7 Expenses Purchased power S 1,361.1 Operations 697.6 Depreciation 350.0 Interest expense 119.2 2.527,9 Net income (loss) S (96.2) Exhibit 2. Charge Computation as Shown on a Customer Bill Rate/KWH KWH S X 1416 Delivery Services Base Charge Distribution Transmission Acquisition and Transfer Delivery services total 0.03891 0.01895 0.09786 Cost 6.43 55.10 26.83 138.57 226.93 1416 1416 X KWH (millions) () Allocation Statistics Consulting Square Hours Feet IT Hours 13.570 13,570 13,570 50.000 49.500 20,000 17,700 30.000 38,600 Exhibit 3. Assignment of Costs and Allocation Statistics (In Millions of Dollars Except for Allocation Statistics) Assigned Costs Purchased Deprec- Non-Salary Salaries Power iation Interest Expenses Total Revenue Generating Cost Centers Electriciry Distribution $ 80.2 $ 284.1 $ 108.1 $ 472.4 Transmission 120.5 34.6 11.1 166.2 Acquisition and Transfer 118.1 1,361.1 1.479.2 Total $ 318.8 $ 1.361.1 $ 318.7$ 119.2 S S 2,117.8 Customer Support Commercial Energy Advisor $ 3.2 S 0.4s 3.6 Business Solutions 5,8 0.5 6.3 Construction Solutions 5.3 0.2 5.5 Building Operator Training 5.6 0.2 5,8 Total $ 19.9 $ - $ S 1.3 S 21.2 Support Cost Centers General and administrative $ 60.4 S 5.1 S 65.5 Depreciation of building 31.3 31.3 Maintenance and repairs 23.8 218.2 242.0 General cleaning and upkeep 10.8 1.3 12.1 Information technology 35,4 2.6 380 S 130.4 $ $ 31.3$ S 227.2 S 388.9 64.000 105.455 88,333 124.444 6.000 5.000 6.200 11.000 8.500 3.300 4.200 9.200 - 20,000 23,600 5.500 6,300 24.200 3.900 1.500 Note: there was some energy loss as the electricity moved from a power plant to a substation, and then to a customer, but it was negligible. Thus, for purposes of cost computations, it is reasonable to assume that 13,570 million kilowatt hours were acquired, transmitted and transferred to customers. - Overall total $ 469.1 $ 1.361.1 $ $ 350.0 $ 119.25 228.5 S 2.527.9 382.232 184.200 160.000 HARBOR CITY ELECTRIC Exhibit 1. Income Statement for Last Year (In Millions of Dollars) Revenues Base charges 304,4 Distribution 528.0 Transmission 257.2 Acquisition and Transfer 1,3039 Unregulated Services 38.2 $ 2.431.7 Expenses Purchased power S 1,361.1 Operations 697.6 Depreciation 350.0 Interest expense 119.2 2.527,9 Net income (loss) S (96.2) Exhibit 2. Charge Computation as Shown on a Customer Bill Rate/KWH KWH S X 1416 Delivery Services Base Charge Distribution Transmission Acquisition and Transfer Delivery services total 0.03891 0.01895 0.09786 Cost 6.43 55.10 26.83 138.57 226.93 1416 1416 X KWH (millions) () Allocation Statistics Consulting Square Hours Feet IT Hours 13.570 13,570 13,570 50.000 49.500 20,000 17,700 30.000 38,600 Exhibit 3. Assignment of Costs and Allocation Statistics (In Millions of Dollars Except for Allocation Statistics) Assigned Costs Purchased Deprec- Non-Salary Salaries Power iation Interest Expenses Total Revenue Generating Cost Centers Electriciry Distribution $ 80.2 $ 284.1 $ 108.1 $ 472.4 Transmission 120.5 34.6 11.1 166.2 Acquisition and Transfer 118.1 1,361.1 1.479.2 Total $ 318.8 $ 1.361.1 $ 318.7$ 119.2 S S 2,117.8 Customer Support Commercial Energy Advisor $ 3.2 S 0.4s 3.6 Business Solutions 5,8 0.5 6.3 Construction Solutions 5.3 0.2 5.5 Building Operator Training 5.6 0.2 5,8 Total $ 19.9 $ - $ S 1.3 S 21.2 Support Cost Centers General and administrative $ 60.4 S 5.1 S 65.5 Depreciation of building 31.3 31.3 Maintenance and repairs 23.8 218.2 242.0 General cleaning and upkeep 10.8 1.3 12.1 Information technology 35,4 2.6 380 S 130.4 $ $ 31.3$ S 227.2 S 388.9 64.000 105.455 88,333 124.444 6.000 5.000 6.200 11.000 8.500 3.300 4.200 9.200 - 20,000 23,600 5.500 6,300 24.200 3.900 1.500 Note: there was some energy loss as the electricity moved from a power plant to a substation, and then to a customer, but it was negligible. Thus, for purposes of cost computations, it is reasonable to assume that 13,570 million kilowatt hours were acquired, transmitted and transferred to customers. - Overall total $ 469.1 $ 1.361.1 $ $ 350.0 $ 119.25 228.5 S 2.527.9 382.232 184.200 160.000