M01

1881

American Water Works Association

Water Rates

AWWA MANUAL M1

Fourth Edition

FOUNDED

Copyright (C) 1999 American Water Works Association All Rights Reserved

Copyright © 1954, 1972, 1983, 1991American Water Works Association

6666 West Quincy Ave.Denver, CO 80235

Printed in USA

ISBN 0-89867-574-X Printed on recycled paper.

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Contents

Foreword, iv

Acknowledgments, vi

Introduction, vii

Chapter 1 Revenue Requirements . . . . . . . . . . . . . . . . . 1

Cash-Needs Approach, 1Utility Approach, 3Revenue-Requirement Projections, 4

Chapter 2 Allocation of Costs of Service to Cost Components . . . . . 9

Base–Extra Capacity Method, 11Commodity–Demand Method, 16Special Considerations, 19

Chapter 3 Distribution of Costs to Customer Classes . . . . . . . . . 20

Customer Classes, 20Units of Service, 23Unit Costs, 26Distribution of Costs to Customer Classes, 28

Chapter 4 Development and Design of Rate Schedules . . . . . . . . 32

Basic Cost-of-Service Rate Philosophy, 32Rate-Design Example, 38Other Rate-Design Considerations, 46

Chapter 5 Rate Design for Small Water Utilities . . . . . . . . . . . 53

Information and Data Requirements, 54Revenue Requirements, 54Rate Design, 59

Appendix A Bill Tabulation Methodology . . . . . . . . . . . . . . 63

Introduction, 63Bill Tabulation, 64

Glossary, 73

Index, 79

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Foreword

In 1954, the American Water Works Association (AWWA) prepared and published areport titled “Determination of Water Rate Schedules,” which later was issued asthe first AWWA manual on water rates. The most recent edition of the manual(third ed.) was published in 1983 to update the 1972 edition (second) and to betterreflect the current water rate-making philosophy.

Dramatic changes in economic conditions that have taken place in the yearssince the 1972 edition was published have had a continuing and far-reaching influ-ence on water utility operational and financial management during that period.Inflation and resulting cost impacts on water utility customers, as well as increasedpublic awareness of the need for conservation and more effective use of naturalresources, together with the need to provide proper price signals, have challengedutility managers to continue providing high-quality service to water utility custom-ers on an equitable and fair cost basis. While the rate of inflation has somewhatdeclined in magnitude in recent years from the previous decade, pressures to main-tain low rates and provide better use of water resources have continued to presentchallenges to utility management. It is also important to note that none of theseforces and pressures have presented any reasons to modify the traditional cost-of-service principles outlined in this manual as a policy of AWWA. In view of thesefactors, it is essential that water utility management have a basic understanding ofthe fundamental cost-of-service principles involved in the evaluation and allocationof water system revenue requirements, the importance of short- and long-term reve-nue adequacy and stability, and the measuring of revenue requirements and designof water rates to achieve the utility’s objectives while reflecting cost-of-serviceprinciples.

Current economic conditions and continuing pressures on infrastructures ofmunicipalities and private companies emphasize the obvious fact that a waterutility, whether government-owned or investor-owned, must consistently provideadequate income to successfully meet its obligations to the public it serves. Thebasis for the rates, including rate of return, must reflect anticipated future condi-tions as well as historical costs. It follows that the financial health of the utility aswell as equitability among customers should be primary objectives of the cost alloca-tion and design of rates to meet revenue requirements. Cost-of-service-based ratesachieve both of these goals in the most efficient way possible.

Development of an adequate revenue requirement to meet both current andexpected future cost is essential. Establishment of revenue requirements basedsolely on current costs without considering elements of expected future expendituresmay result in inadequate revenue to meet the utility’s needs.

This fourth edition of AWWA Manual M1, Water Rates, contains the traditionaland proven rate-making concepts and methodologies endorsed by AWWA in previouseditions; discussion of topics relevant to the evaluation and design of equitable rates;and editorial changes, clarifications, and updates to reflect current thinking and toconform to the recent publication of new rate-related manuals, including AWWAManual M35, Revenue Requirements, and AWWA Manual M26, Water Rates and

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Related Charges. Chapter 1 presents a condensed description of the development ofrevenue requirements based on M35, Revenue Requirements. Chapters 2 and 3,which present methodologies for allocation of total costs of service to various classesof customers served, present the primary considerations in determining the cost ofserving customers. Chapter 4 discusses and illustrates the design of a schedule ofwater rates to derive the allocated costs of service. In addition, this chapter includessome discussion of alternative rate forms that have been proposed during pastdecades as a result of inflationary, conservation, and social concerns. Chapter 5addresses the simplified development of water rates for small utilities. An appendixis attached that briefly sets forth a bill tabulation methodology. A glossary of termsis included in this edition of the manual.

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Acknowledgments

The AWWA Management Division Board of Trustees gratefully acknowledges thecontribution made by members of the Rates and Charges Subcommittee in prepar-ing this edition of the water rates manual. Appreciation is extended to those mem-bers of the subcommittee who updated and drafted the manuscript.

All members of the committee reviewed the manuscript and made constructiverecommendations for revision. Issues involving final changes in organization andcontent were mutually resolved by an editorial committee.

Rates and Charges Subcommittee

A.J. Potochney* (Chair), South Central Connecticut Regional Water Authority,New Haven, Conn.

T.R. Stack* (Vice Chair), Public Utilities Division, Illinois CommerceCommission, Springfield, Ill.

R.F. Banker* (Chair, Editorial Subcommittee), Black & Veatch,Kansas City, Mo.

D.M. Clark, Gannett Fleming Valuation & Rate Consultants, Inc.,Pittsburgh, Pa.

M.D. Day, Dallas Water Utilities, Dallas, TexasF.P. Griffith Jr., Fairfax County Water Authority, Merrifield, Va.C.R. Harrison,* Clackamas Water District, Clackamas, Ore.O.K. Loen, City of Kalamazoo, Kalamazoo, Mich.J.R. McKinley, Black & Veatch, Kansas City, Mo.T.G. McKitrick, American Water Works Service Company, Inc., Voorhees, N.J.F. Moriarty, Jackson, Samson & Associates, Dallas, TexasJ.R. Palko, Associated Utility Services, Inc., Moorestown, N.J.V.F. Pennacchio, Guastella Associates, Weymouth, Mass.G.A. Raftelis, Ernst & Young, Charlotte, N.C.J.E. Robinson, University of Waterloo, Waterloo, Ont.G.S. Saleba, Economic & Engineering Services, Bellevue, Wash.R.S. Schierry, Northern Illinois Water Corporation, Champaign, Ill.D.E. Simpson, St. Louis County Water Company, St. Louis, Mo.R.A. Smith,* General Motors Corp., Detroit, Mich.J. Tolan, City of Pasadena, Pasadena, Calif.M.O. Vann, Water Works and Sewer Board, Birmingham, Ala.C.P.N. Woodcock, Camp Dresser & McKee, Inc., Boston, Mass.

AWWA Management Division Liaison Representative

G.W. Johnstone, American Water Works Service Company, Inc., Voorhees, N.J.

*Member, Editorial Subcommittee

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Introduction

The American Water Works Association (AWWA) statement of policy regarding“Financing and Rates,” adopted by the AWWA Board of Directors on Jan. 25, 1965,revised on Jan. 31, 1982, and reaffirmed on Jan. 25, 1987, states in part: “TheAWWA believes the public can be served best by self-sustained enterprises ade-quately financed with rates based on sound engineering and economic principles.”This manual outlines the basic elements involved in the determination and alloca-tion of the costs of service to the various classes of customers, as well as the develop-ment of rates to equitably recover the costs of service from each class of customer.The identification of the value of the rate base, whether it be the net book value oran established fair market value, must reflect the utility’s need to maintain andmeet future customer needs. The concepts and procedures described in this manualare based on principles that are generally accepted and widely followed throughoutthe industry.

This manual describes in detail two methods for preparing cost-allocationstudies and presents a variety of generally accepted forms for rate structures. Theacceptability of variations in allocation methods or rate designs that are cost-basedand nondiscriminatory is recognized. A methodology that properly allocates costs tovarious classes of customers and then recovers these costs through a rate structureto maintain a self-sustaining enterprise and that is not unduly discriminatory to anyclass of customer is the objective of AWWA.

Generally, the development of water rates involves the following procedures: 1. Determination of the total annual revenue requirements for the period for

which the rates are to be effective. 2. Allocation of the total annual revenue requirements to the basic functional

cost components. 3. Distribution of the component costs to the various customer classes in ac-

cordance with their requirements for service. 4. Design of water rates that will recover from each class of customer, within

practical limits, the cost to serve that class of customer.A simplified diagram of these procedures is presented in Figure I-1 to which

reference can be made as the manual is read and used.Scope. The subject matter is presented in five chapters, which are briefly

summarized in the following paragraphs.Chapter 1, Revenue Requirements. The amount of revenue required may be

determined by either the cash-needs approach or the utility approach. The applica-bility of each approach is discussed, and illustrative applications are presented. Thereference to rate-base “value” is intended to recognize that either net book value oran established fair market value may be used in determining the revenue require-ments. The value must reflect the financial needs of the utility. The reader of thismanual is referred to AWWA Manual M35, Revenue Requirements, for a more com-prehensive discussion of revenue requirements.

Chapter 2, Allocation of Costs of Service to Cost Components. The allocation ofannual revenue requirements, or costs of service, to functional cost components is

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presented using both the base–extra capacity and commodity—demand methods.The application of the general theory involved in making each type of allocation ispresented with illustrative examples.

Chapter 3, Distribution of Costs to Customer Classes. The distribution to cus-tomer classes of component costs is shown for both the base–extra capacity andcommodity–demand methods, and a discussion of the theory and means of distribut-ing costs is presented. Illustrative examples are offered for both cost-distributionmethods.

Chapter 4, Development and Design of Rate Schedules. This chapter discussesthe design of water rates that will recover the allocated costs of serving each cus-tomer class. It should be recognized that rates may be adjusted to recognize pastpractices, local policy, and other special circumstances.

Chapter 5, Rate Design for Small Water Utilities. Simplified procedures fordeveloping rates for small water utilities are presented to assist the smaller waterutilities in preparing rate schedules without the need for relatively complex engi-neering and economic analysis.

Purpose. Rate design for a water utility is a process of matching the costs ofservice to be recovered to the unique economic, political, and social environments inwhich the utility provides service. The AWWA Rates and Charges Subcommitteedoes not endorse any substantial departure from cost-of-service-based rates toachieve social objectives. When special situations require that factors other than thecost of providing service be considered in the final determination of water rates,steps should be taken to minimize any discriminatory effect.

It should be recognized that the results of a cost-of-service study are highlydependent on the accuracy and reliability of the record-keeping systems that furnishthe basic information for the study. Record-keeping practices are, therefore, criticalto the credibility of the rate study. Those persons responsible for conducting ratestudies must continually communicate their information requirements to engineer-ing, operating, and accounting staffs to ensure that the necessary information isavailable on a timely basis.

This manual is not intended, nor should it be considered, as a complete text ofspecific rate making. The complexities of any system require consideration of manyfactors not included in this simplified presentation. Specific rate making for anyparticular water utility, based on sound engineering and economic principles, mayrequire the services of consultants experienced in rate matters. This manual pro-vides a basic outline of the rate-making process and serves as a resource that thepolicymaker or manager may draw on to guide the analysis of the validity of ratesand the basis on which they are founded.

For small water systems, this manual may suffice with minimum supplementalexpertise. Larger utilities with complex system configurations will require moredetailed analysis than illustrated in this manual. If the utility does not have neces-sary in-house expertise to cope with the added complexities, outside independentexperts should be called in to ensure that the rates developed are truly cost-based.Even where in-house expertise is available, an independent review may provideinsights not perceived by personnel with limited exposure related to a single system.An outside independent study also provides the advantage of different judgmentsand additional credibility where public support of the resulting level and structure ofrates is important. For investor-owned utilities, local regulatory agencies frequentlyrequire such independent review, whereas for government-owned systems, manybond agreements require such outside examination and certification.

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Revenue Requirements

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

AWWA Manual M35, Revenue Requirements, presents an extensive discussion ofconsiderations and illustrative tables regarding revenue requirements and theirprojections as they relate to water utilities. The reader is referred to that manual,which was published in 1990, for a more complete discussion of revenue require-ments; the discussion of revenue requirements in this chapter parallels, in condensedform, elements of M35. Numerical examples in this manual are derived from theexamples developed in M35 to provide continuity from one manual to the other.

The two generally accepted and practiced approaches to projecting total revenuerequirements of a water utility are the “cash-needs” approach and the “utility”approach. Each has a proper place in utility practice and each, when properly used,can provide for sound utility financing.

CASH-NEEDS APPROACH __________________________________The essence of the cash-needs approach is that the revenues of the utility must besufficient to cover all cash needs, including debt obligations as they come due, for theperiod over which the rates are intended to be adequate. The cash-needs approach ofdetermining revenue requirements has been generally used by government-ownedutilities and is basically an extension of the cash-oriented budgeting and accountingsystem traditionally used by government entities. Revenue-requirement studiesprepared using the cash-needs approach are, therefore, generally more easilyunderstood by the governing bodies than studies using the utility approach. Anotherfactor encouraging the use of the cash-needs approach by government-owned utilitiesis the use of bond financing, which requires periodic payment toward liquidation ofthe debt.

AWWA MANUAL M1

Chapter 1

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Basic revenue-requirement components considered under the cash-needsapproach generally include O&M expense, debt-service requirements, and capitalexpenditures not debt-financed.

The O&M expense component of revenue requirements is based on actualexpenditures derived from accounting records with adjustments to reflect the level ofexpenditure anticipated to be incurred during the period that rates are to be effective.Pro forma adjustments to historical O&M expenses are determined by incorporatingall known and measurable changes into expense levels or by using well-consideredestimates of future expenses.

Those revenue requirements of the utility that are generally classified as O&Mexpenses include salaries and wages, employee fringe benefits, purchased power,other purchased services, rent, chemicals, other materials and supplies, smaller itemsof equipment that do not extend the useful life of major facilities, and generaloverheads. In a government-owned utility, an additional element of O&M expensemight also include payment to a city’s general fund for support services rendered,e.g., use of the city’s computer facilities, assistance in collecting water bills, rent onoffice space provided for water utility operations, and the like. Since inclusion ofexpenses for such services in the total revenue requirements would be proper if theutility were operating independently, it is also appropriate when the services arefurnished by an associated government entity.

The debt-service components of the revenue requirements in the cash-needsapproach consist of principal and interest requirements on bonds outstanding duringthe period that rates are effective. In addition, there may be obligations todebt-service reserves. The amount of cash required to pay principal and interest onoutstanding debt is obtained from established debt-service schedules. In addition todebt principal and interest expense and payments to reserve accounts established bybond covenants, some utilities may also be required to generate sufficient revenues toprovide coverage on bonded debt. Coverage requirements typically specify that utilityrevenues in excess of O&M expense be sufficient, as a minimum, to equal or exceedby a stated percentage annual debt principal and interest payments, in order toprovide a measure of security to bond holders. As such, coverage requirements mustalso be evaluated in determining total annual revenue requirements to prevent theutility from failing to meet its bond covenant agreements.

The establishment of the cash requirement for future plant improvements oradditions is a decision generally affected by the nature of investment and utilityfinancing policies. Capital expenditures are generally classified into three broadcategories: replacement of existing facilities, normal extensions and improvements,and major capital improvements and replacements. It is a generally accepted practiceto finance normal replacements and extensions and minor improvements fromcurrent revenue, but some utilities also use current revenue to finance a portion ofmajor capital improvements and replacements. To the extent that capital expendi-tures are financed from current revenues, they constitute another component ofrevenue requirements under the cash-needs approach. However, most major capitalprojects are financed from serially funded debt because the repayment of the debtover a number of years distributes the capital costs, to some extent, over the usefullife of the facility. This debt-financing approach results in a better matching of thecustomers’ charges from year to year with the use of the facilities (i.e., existingcustomers will not be paying 100 percent of the initial cost of facilities to be used byfuture customers).

Other cash revenue requirements that may be required to be financed fromwater system revenues might include payment to the general fund for items such as

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payment in lieu of taxes, gross-receipts taxes, or a dividend payment. Such additionalrequirements depend on each local situation and should be considered whereapplicable.

UTILITY APPROACH________________________________________The utility approach to determining revenue requirements is mandated for allinvestor-owned water utilities and for most government-owned (municipal) systemsunder the jurisdiction of state commissions or other regulatory bodies. It is also anappropriate method for determining the costs of service applicable to customersserved outside of the corporate limits by a government-owned water utility. It is oftenused in the allocation of costs among customer classes within the corporate limits.When a government-owned utility provides service to customers outside the corporatelimits, whether at retail or wholesale, the situation is similar to the relationship of aninvestor-owned utility to its customers since the owner (municipality) provides serviceto non-owner customers (customers outside corporate limits). In this situation, thegovernment-owned utility, like an investor-owned utility, is entitled to a reasonablereturn from non-owner customers based on the value of its plant required to servethose customers. The use of the utility approach can reduce controversy since itgenerally results in more stable rates, which are not so immediately affected by thelevel of system capital expenditures as are rates developed under the cash-needsapproach.

For a government-owned utility, the total level of annual revenue required is thesame under either the cash-needs or the utility approach. The O&M expensecomponent of total revenue requirements is usually identical under both approaches.The annual cash requirement for capital-related costs under the utility approach ofrevenue-requirement determination consists of two components: depreciation expenseand return on rate base.

Depreciation is a real part of the cost of operating a utility, whether government-or investor-owned. Depreciation is the loss in value of facilities, not restored bycurrent maintenance, that occurs due to wear and tear, decay, inadequacy, andobsolescence. The annual depreciation expense component of revenue requirementsprovides for the recovery of the utility’s capital investment over the anticipated usefullife of the depreciable assets. It is, therefore, proper that this expense be borne by thecustomers benefiting from the use of these assets. The proper level of depreciationexpense to be included in the total revenue requirement should be based on the costof the depreciable plant in service during the period for which rates are beingestablished. The funds resulting from the inclusion of depreciation expense in theannual revenue requirements are the property of the utility and are available for useas a source of capital for replacement, improvement, or expansion of its system or forrepayment of debt.

The return component is intended to pay the annual interest cost of debt capitaland provide a fair rate of return for the total equity capital employed to financephysical facilities used to provide water service. The annual cost of outstanding debtcan be determined from the accounting records of the utility. The cost of equity capitalis more difficult to determine. The return to the equity owner should be commensu-rate with the return from other enterprises having corresponding risks. The return,moreover, should be sufficient to assure confidence in the financial integrity of theenterprise so as to maintain its credit and to attract and hold capital.

The utility approach of determining revenue requirements requires the estab-lishment of a rate base, defined to be the value of the assets on which the utility isentitled to earn a return, and the fixing of a fair rate of return on the rate base. The

REVENUE REQUIREMENTS 3


rate base is primarily composed of the value of the utility’s plant and property usefulin serving the public. In addition, it is proper to include an allowance in the rate basefor materials and supplies, working capital, and construction work in progress. Onthe other hand, contributions in aid of construction and customer advances forconstruction are generally deducted from utility plant in service for rate-basedetermination.

The total annual revenue requirements of an investor-owned utility includeO&M expenses, depreciation expense, income taxes, other taxes, and a return on ratebase. Operation-and-maintenance expense, depreciation expense, and return on ratebase for an investor-owned utility involve the same considerations discussed above fora government-owned utility using the utility approach.

Federal and state income taxes must be paid by an investor-owned water utilityand are, therefore, properly included in the determination of total revenuerequirements. Other taxes, such as general property taxes and gross receipts taxes,must also be included.

Each state commission and regulatory body has its own rules, regulations, andpolicies for determining total revenue requirements. In preparing for any rate matterwithin a specific jurisdiction, it is essential that the procedures and policies of theregulatory body be determined and that the utility be guided by them in thedetermination of its revenue requirements.

REVENUE-REQUIREMENT PROJECTIONS_______________________Among the more significant financial problems confronting government-owned andinvestor-owned utilities in recent years has been the impact of inflation. Rapidlyescalating costs have affected every component of revenue requirements, whetherdetermined using the cash-needs approach or the utility approach.

One of the most effective methods used to cope with the problem of rapidlyincreasing costs is the use of a “forward-looking,” or prospective, rate period, wherebyrates are established to meet projected revenue requirements for a specified futureperiod. This procedure has been used frequently by government-owned utilities, andit is gaining increasing acceptance by state commissions regulating investor-ownedutilities. The prospective procedure develops the revenue requirement for costs, bothcapital and operating, that are anticipated for the period the rates will be in effect. Itis essential to first develop adequate historical data to serve as a basis for projectingfuture requirements. Historical data also provide the basis for the bridge between theactual costs of the past and the projected costs of the future.

Although the use of a prospective basis for determining revenue requirementsfor rate making may be desirable from the utility’s viewpoint, it has not always beenaccepted in certain jurisdictions subject to regulatory review. In the past, it has beenthe general practice of regulatory commissions to establish rates based on an actualhistorical test year, with certain adjustments to historical costs being allowed forknown and measurable changes. Typically, such adjustments might include increasesin salary and wage expenses resulting from a negotiated labor agreement, knownincreases in costs for purchased water and electric power, fringe benefit adjustments,and the like. Frequent rate adjustments are likely to be needed when a historical yearis used as the basis for establishing revenue requirements, particularly in periods ofrapid inflation, because future cost levels will most certainly exceed those incurred inthe past.

For purposes of illustrating the various principles and techniques of rate makingdiscussed in this and the following chapters, an elementary example for a

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hypothetical utility has been developed. The example is oriented toward government-owned utilities; however, the concepts and tables presented throughout the manualare equally applicable to investor-owned utilities, with the exception of thedevelopment of revenue requirements shown in Table 1-1.

The revenue requirements for the utility in the example, as shown in Table 1-1,are derived from AWWA Manual M35.* They reflect prospective projection of the cashrevenue requirements of the utility for a future five-year period and include O&Mexpense, debt-service requirements, debt-service reserve requirements, and capitalimprovements not debt-financed.

Table 1-1 Projected Revenue Requirements—Government-Owned Utility

Projected YearsLineNo. Expenditure Component 1 2 3 4 5

O&M Expense: 1 Source of supply $86,000 $90,000 $93,000 $97,000 $101,000

Pumping: 2 Purchased power 243,000 259,000 375,000 399,000 425,000 3 Other 185,000 193,000 200,000 208,000 217,000

Water Treatment: 4 Chemicals 116,000 121,000 202,000 211,000 221,000 5 Other 151,000 157,000 283,000 294,000 306,000

Transmission and Distribution: 6 Mains 125,000 130,000 135,000 140,000 146,000 7 Storage 25,000 26,000 27,000 28,000 29,000 8 Meters and services 149,000 155,000 161,000 167,000 174,000 9 Hydrants 12,000 13,000 13,000 14,000 15,00010 Other 70,000 72,000 75,000 78,000 82,000

Customer Accounting:11 Meter reading and collection 235,000 247,000 259,000 272,000 286,00012 Uncollectible accounts 43,000 44,000 45,000 46,000 47,000

Administrative and General:13 Salaries 186,000 194,000 201,000 209,000 218,00014 Employee benefits 171,000 177,000 224,000 233,000 242,00015 Insurance 130,000 135,000 141,000 146,000 152,00016 Other 256,000 266,000 276,000 288,000 299,000__________ __________ __________ __________ __________17 Total O&M expense 2,183,000 2,279,000 2,710,000 2,830,000 2,960,000

Capital Requirements:18 Debt service 710,000 860,000 860,000 860,000 860,00019 Debt-service reserve 30,000 60,000 60,000 60,000 60,00020 Capital improvements 375,000 380,000 385,000 390,000 395,000__________ __________ __________ __________ __________21 Total capital requirements 1,115,000 1,300,000 1,305,000 1,310,000 1,315,00022 Less: other revenue (75,000) (79,000) (83,000) (87,000) (91,000)__________ __________ __________ __________ __________23 Net capital requirements 1,040,000 1,221,000 1,222,000 1,223,000 1,224,000

24 Total revenue requirements from rates $3,223,000 $3,500,000 $3,932,000 $4,053,000 $4,184,000


*Table 6-1, “Flow of Funds,” pg. 42.


The example in M35 illustrates that revenues under existing rates are adequateto meet cash requirements in Year 1 but that revenues under existing rates areinsufficient in subsequent years. Such an illustration reflects prudent planning inthat Year 1 could well be the current year, for which projections show that revenueswill be adequate to meet revenue requirements but that projections for next year,Year 2, show a need for additional revenues.

In allocation of costs to customer classes and design of rates, a period for whichthe initial rate change is to be adequate is usually considered to be the test year. Forthis example, it is assumed that rates are to be designed for a one-year period, Year2, with subsequent rate changes possibly necessary to meet the requirements inYears 3, 4, and 5.

The projections of O&M expense shown on lines 1–17 in Table 1-1 are separatedinto various expenditure components. The accounting system format maintained byutilities varies considerably; however, the categories of O&M expense shown inTable 1-1 are considered to be representative of the type of accounting detail availablein most utilities. Projection of expense in the detail shown in Table 1-1 is importantfor two reasons. First, it provides for small elements of expense to be more accuratelyanalyzed and projected. Second, the total requirement for O&M expense is separatedinto cost elements that are readily assignable to appropriate functional costcomponents in the cost-of-service allocation phase of the rate study analysis.

The debt-service requirements on outstanding debt during the rate period,shown in Table 1-1, total $860,000 in the test year. This total consists of $560,000 onexisting revenue bond debt and $300,000 on proposed new debt, the latter being a$3,000,000 issue with approximately equal annual principal and interest paymentsover 20 years at an average annual interest rate of nearly 8 percent. In the example,necessary contributions to debt-service reserve are estimated to be $60,000 per yearas shown on line 19.

Another item of revenue requirements included in the example is theexpenditure for capital improvements consisting of replacements, extensions, andimprovements not debt-financed. Because such expenditures are generally of arecurring nature, it is proper that they be financed directly from annual revenuesrather than through debt-financing. The appropriate level of normal annualimprovements certainly varies with the size and average age of a particular utility.Prior to years of relatively high inflation, a general rule of thumb for projecting anadequate allowance for such costs is that they should amount to between 1 and2 percent of total depreciable gross plant investment. However, if marked costincreases are experienced, an allowance in excess of 2 percent may be justified, andthe level of expenditures established based on careful examination of historical trendsand anticipated future conditions. An estimate of $380,000 for normal annual capitalimprovements is used for the utility in the example and is shown on line 20 ofTable 1-1.

While most revenue requirements usually need to be met from rates applicableto water service, some other revenue is derived from miscellaneous income items suchas rentals and interest on invested capital. In the example, the estimates of suchother revenue is shown on line 22, and for the test year, Year 2, is $79,000. It isreflected as a deduction from total capital requirements in deriving the total revenuerequirements of the utility.

The total test-year cash requirement for the government-owned utility in theexample amounts to $3,500,000, as shown on line 24 in the second column inTable 1-1. This represents the total annual cost of service to be derived from rates

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anticipated to be incurred by the utility in the test year for providing service duringthe period for which rates are being designed.

If provisions for coverage on bonded debt are applicable to determining revenuerequirements, a comparison needs to be made between these provisions and plannedcapital expenditures to be financed from current revenues. Only the greater of the twoamounts should be included in the determination of total revenue requirements.Generally, revenue-bond covenants prescribe a minimum coverage level with thefrequent provision that revenue amounts in excess of that required for operatingexpenses and debt service can be spent only for capital improvements or early debtretirement.

The projected revenue requirements shown in Table 1-1 reflect the cash-needsdetermination of revenue requirements referred to at the beginning of this chapter. InTable 1-2, this same level of total annual revenue requirements is shown for agovernment-owned utility on both the cash-needs and the utility approach, indicatingthe relationship of the two methodologies. Table 1-2 also shows the revenuerequirements for a similar investor-owned utility.

As shown in Table 1-2, the O&M expense component of the total test-yearrevenue requirement is the same for the investor-owned utility as for thegovernment-owned utility using either the cash-needs or the utility approach. Usingthe utility approach, the annual depreciation expense component of total revenuerequirements, shown on line 5 in Table 1-2, is $414,000. This is determined byapplying a proper schedule of depreciation rates to the total depreciable plantinvestment in service. In the example, the composite depreciation rate is about1.89 percent of the total depreciable plant investment of $21,904,000. Under theutility approach, the annual depreciation expense allowance is the same for either aninvestor-owned or a government-owned utility.

For a government-owned utility to meet the total cash-revenue requirementsunder the utility approach, the level of return to be derived from rates in the exampleis required to be $807,000 ($886,000 – $79,000), as shown on lines 8 and 9 ofTable 1-2. Assuming a rate base of $16,186,000, the overall rate of return for thehypothetical government-owned utility is about 4.99 percent. In any particular

Table 1-2 Summary of Test-Year Revenue Requirements

Investor-Owned Government-Owned Utility Utility

Line Cash-Needs Utility UtilityNo. Approach Approach Approach

1 O&M expense $2,279,000 $2,279,000 $2,279,000 2 Debt service 860,000 3 Debt-service reserve 60,000 4 Capital improvements 380,000 * * 5 Depreciation expense 414,000 414,000 6 Taxes other than income tax 360,000 7 Income taxes 469,000 8 Return (operating income) 886,000† 1,451,000† 9 Other revenue (79,000) (79,000) (31,000)___________ ___________ ___________10 Total revenue requirements from rates $3,500,000 $3,500,000 $4,942,000

*Annual cash requirements for this item are met from depreciation expense and return. †Includes interest on debt.



government-owned utility, the magnitude of existing debt service and policy regardingthe amount of revenue financing of capital improvements will influence the requiredlevel of return and may result in an indicated need for an overall rate of returnmarkedly different from the example.

For the same example utility on an investor-owned basis, income taxes andother taxes must be recognized in the determination of annual revenue requirements.The element of other taxes, shown on line 6 of Table 1-2, amounts to $360,000 andcould include business, occupational, gross receipts, and other types of taxes.

The income tax element of the investor-owned utility’s cost of service is based onthe application of a composite tax-rate allowance for both federal and state incometaxes to total taxable income. In this example, taxable income is equivalent to totalrevenue less O&M expense, depreciation expense, other taxes, and interest expense.Income tax is shown on line 7 to be $469,000.

For the investor-owned utility, the rate base is less than that for thegovernment-owned utility by the amount of accumulated deferred income taxes.

An overall rate of return of 10.5 percent on the rate base of $13,820,000 wasassumed, resulting in a requirement for return (operating income) of $1,451,000. Thehigher return for the investor-owned utility assumed in the example shown inTable 1-2 results from the weighted cost of debt and equity capital. This return wouldbe expected to be greater than the resulting overall 4.99 percent rate of return shownfor the government-owned utility in the example, the latter of which in this exampleis adequate only to provide for cash needs beyond O&M expense and capitalrequirements covered by depreciation expense.

Where a government-owned utility is serving customers who are outside itsjurisdictional boundaries and who are considered to be non-owners, the applicablerates of return may properly reflect a differential between owners and non-owners.For a government-owned utility providing service to non-owners, development of anappropriate rate of return may reflect imbedded interest cost and return on systemequity. Once established, the rate of return assigned to system owners would bedeveloped to recognize remaining cash needs. Consideration of differential rates ofreturn is addressed in a subsequent chapter of this manual.

From the example shown in Table 1-2, it is apparent that the overall revenuerequirement to be obtained from water rates varies with the type of ownership andother requirements of the system. In the example, the overall level of revenuerequirements varies from $3,500,000 for the government-owned utility paying noincome taxes, financed with tax-free bonds, and in which the customers have madethe equity investment for which no return is required, to $4,942,000 for aninvestor-owned utility paying all taxes, having no tax-free financing available, andhaving to pay a fair and reasonable return to equity investors who provided a portionof the investment requirements.

8 WATER RATES


Allocation of Costsof Service to CostComponents

The total annual cost of providing water service is the annual revenue requirementsapplicable to the particular utility, as discussed in chapter 1 of this manual and moreextensively in AWWA Manual M35, Revenue Requirements. Consistent with theexercise of appropriate conservation considerations in providing service, a waterutility is required to supply water in total amounts and at such rates of use as desiredby the customer. A utility incurs costs in relationship to the various expenditurerequirements caused by meeting those customer needs. Since the needs for totalvolume of supply and peak rates of use vary among customers, the costs to the utilityof providing service also vary among customers or classes of customers.

In seeking equitability in charges to the different customers, the basic premisein the establishment of adequate rate schedules is that they should reflect the cost ofproviding water service. A sound analysis of the adequacy of charges requiresallocation of costs among the customers commensurate with their service require-ments in order to recognize differences in costs of furnishing service to different typesof customers. For example, a customer with a high peak rate of use as compared withan average rate of use requires larger capacity pumps, pipes, and certain othersystem facilities than a customer who has an equal total volume of use but takeswater at a uniform rate. Accordingly, cost-allocation procedures should recognize theparticular service requirements of the customers for total volume of water, peak ratesof use, and other factors.

The total annual revenue requirements discussed in chapter 1 are the total costsof service to be derived from water rates and may be considered in the two broadcategories of operation-and-maintenance (O&M) expenses and capital costs. For

AWWA MANUAL M1

Chapter 2

9


government-owned utilities, payments in lieu of taxes may also be a part of revenuerequirements.

Operation-and-maintenance expenses include both the costs of operating thesystem and the costs of maintaining system facilities and equipment. Utility recordsgenerally show these expenses broken down into costs related to supply, pumping,treatment, transmission and distribution, customer meter reading, billing andcollection, and administrative and general. Such cost breakdowns also usually showseparation of salaries and wages, materials and supplies (including power andchemicals), and other categories of expense. Such expenses are of a similar nature,whether the utility is government-owned or investor-owned.

Capital costs may be expressed as annual costs associated with plantinvestment. Under the cash-needs approach, these costs would include suchinvestment-related cash requirements as debt service, contributions to debt-servicereserve, capital requirements not debt-financed, and, in some cases, payments in lieuof taxes. Under the utility approach, capital costs would include depreciation expenseand return on rate base, and income taxes and other taxes if applicable.

In allocating costs of service to customer classes, whether for a government-owned utility or an investor-owned utility, revenue requirements may be apportionedamong customer classes on a utility basis—that is, in terms of O&M expense,depreciation expense, return on rate base, and, where appropriate, taxes. For agovernment-owned utility such as the one illustrated in Table 1-2, the totaldepreciation expense and return are equal to the total cash requirements, beyondO&M expense and other revenues, to be recovered from rate-related revenues to meetcapital-related costs.

The purpose of cost allocation is to express the total utility cost of service,including O&M expense, depreciation expense, and return, in terms of costsassociated with supplying: (1) both the customer’s average and peak rates of use ordemands; (2) costs related to customer meters, services, and accounts; and (3) directcosts incurred to provide for fire protection. Those costs by functions, in turn, arefurther distributable to customer classes on the basis of their particular requirementsfor service.

The allocation of water utility costs have, over the years, gone through anevolution in the application of a variety of bases or methods. In most cases, the costsare allocated, or assigned, in two steps: first to appropriate cost components, then tocustomers. The cost components vary, depending on the basis of allocation used. Thetwo most widely used methods of cost allocation are the base–extra capacity methodand the commodity–demand method. In their respective ways, both of these methodsof cost allocation recognize the fact that costs of serving customers are dependent notonly on the total volume of water used but also on the rate of use, or peakingrequirements. In addition, the methods each recognize customer-related costs as avalid cost function.

Another method of cost allocation, the functional-cost method, has been used inthe past but is little used today because of its limitations relative to the twopreviously mentioned factors, volume and rate of use. Other methods of costallocation, involving incremental, marginal, or special-use service, are of limitedapplication—that is, they apply only in special situations.

Cost allocation under the base–extra capacity and commodity–demand methodsincludes:

• Allocation of costs applicable to the functional cost components of base, extracapacity, and customer costs in the base–extra capacity method, and tocommodity, demand, and customer costs in the commodity–demand method.

10 WATER RATES


• Distribution of costs by the various cost components to respective classes ofcustomers in accordance with the respective responsibility of the customerclasses for each of the component costs.

The allocations of costs to cost components by the base–extra capacity methodand the commodity–demand method are discussed and illustrated in the remainder ofthis chapter. Distribution of component costs to customer classes is discussed inchapter 3.

It is useful to consider the distinctions between variable and fixed cost categoriesin performing base–extra capacity or commodity–demand cost allocations. Variablecosts are those costs that tend to vary directly with the volume of water produced.Examples of variable costs include chemicals used in treatment and the energyportion of the costs of power used in pumping. Water purchased on a charge per unitof volume basis is also considered to be a variable cost. Fixed costs are those capitaland operating costs that remain relatively unchanged over a given operating period,such as a year. Examples of fixed costs would include virtually all capital costs suchas debt service or depreciation expense and return, as well as costs of O&M forsystem facilities.

Such a categorization provides a useful understanding and insight into the waycosts are incurred by the utility. The impact on revenues of significantly changingvolumes of production and the potential resultant revenue instability can be moreeasily recognized with this data available. Moreover, minimum required revenuelevels, based on fixed-cost needs, can be evaluated with respect to each customerclass. Contractual charges to large customers, which include a fixed-cost component,can be appropriately evaluated. Finally, the evaluation process itself provides a usefulconsideration of a utility’s revenue requirements, potentially leading to improvedrecord keeping, budgeting, and recognition of the nature of the utility’s costs.

BASE–EXTRA CAPACITY METHOD ___________________________In the base–extra capacity method, costs of service are usually separated into fourprimary cost components: (1) base costs, (2) extra capacity costs, (3) customer costs,and (4) direct fire-protection costs. In detailed rate studies, some of these elementsmay be broken down further into two or more subcomponents.

Base costs are costs that tend to vary with the total quantity of water used plusthose O&M expenses and capital costs associated with service to customers underaverage load conditions, without the elements of cost incurred to meet water usevariations and resulting peaks in demand. Base costs include O&M expenses ofsupply, treatment, pumping, and distribution facilities, as well as capital costs relatedto water plant investment associated with serving customers to the extent requiredfor a constant, or average, annual rate of use.

Extra capacity costs are costs associated with meeting rate-of-use requirementsin excess of average and include O&M expenses and capital costs for system capacitybeyond that required for average rate of use. These costs may be subdivided into costsnecessary to meet maximum-day extra demand, maximum-hour demand in excess ofmaximum-day demand, or other extra-demand criteria appropriate for a particularutility.

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 expense, as well as maintenance and capitalcosts related to meters and services. In detailed studies, the costs for meter readingand billing and for customer accounting and collecting may be considered as one

ALLOCATION OF COSTS OF SERVICE 11


subcomponent, and maintenance and capital costs on customer meters and servicesmay be considered as another subcomponent.

Direct fire-protection costs are those costs that are applicable solely to thefire-protection function. Usually, such costs are simply those directly related to publicfire hydrants and related branch mains and valves. It should be noted that the costsallocated to the direct fire-protection cost component are usually only a small part ofthe total cost of fire protection. As more fully described and illustrated in chapter 3, asignificant portion of extra capacity costs is also allocable to fire protection in thedistribution of costs to customer classes.

In the base–extra capacity method, care must be taken in separating costsbetween base costs and extra capacity costs. The appropriate allocation factorsbetween base and extra capacity usually vary among systems and should bedetermined on the basis of the actual operating history or design criteria for eachsystem. For example, if a system has an annual average-day use of 7.5 mgd and amaximum-day use of 11.55 mgd, the maximum-day to average ratio would be 1:1.54.Facilities designed to meet maximum-day requirements, such as a treatment plant,may be allocated 65 percent (1/1.54) to the base cost component and 35 percent(0.54/1.54) to the maximum-day extra capacity cost component. If the system also hasa maximum-hour use of 16.65 mgd, the maximum-hour to average ratio would be1:2.22. Facilities designed to meet maximum-hour requirements, such as distributionmains, inherently meet both maximum-day and maximum-hour requirements andmay appropriately be allocated to the base maximum-day extra capacity andmaximum-hour (in excess of maximum-day) extra capacity cost components. The basecost component would be allocated 45 percent (1/2.22); the maximum-day extracapacity cost component would be allocated approximately 25 percent (0.54/2.22); andthe maximum-hour extra capacity component would be allocated approximately30 percent (0.68/2.22). It is cautioned that ratios must be developed with care, andsound judgment must be exercised in their development.

As previously discussed, total costs of service are represented by three principalelements: (1) O&M expense, (2) depreciation expense, and (3) return. In someinstances, payment in lieu of taxes must be included as an element in cost of service.Operation-and-maintenance expense and depreciation expense are annual amountsdirectly allocable to cost components as subsequently illustrated. Return is thebalance of annual capital costs not derived through depreciation expense and isexpressed as a percentage of rate base. Thus, return is allocated on the basis of thedistribution of rate base to appropriate cost components as a basis for subsequentdistribution of responsibility for return to the various customer classes. Payment inlieu of taxes may be allocated similarly.

Table 2-1 presents an example of the allocation of rate base to cost componentsunder the base–extra capacity cost-allocation method. For purposes of this illustra-tion, the various elements of rate base shown in the table are the net book value(original cost less accrued depreciation) of the water system, based on the accountingrecords 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 allocated100 percent to the base cost component in recognition of the fact that such facilitiesare sized principally to meet annual supply requirements in total, whether or notvariations in daily needs are experienced. In some cases, reservoirs may function toprovide not only total annual supply requirements but also to provide for fluctuationsin use on a seasonal or daily basis. Evaluation of each particular local situation willindicate if some portion of the impounded reservoir-related costs should be allocatedto the extra capacity cost function. The source of supply for many utilities may also

12 WATER RATES


include well supply. In these instances, a portion of the rate base for source of supplymay be allocated to maximum-day and/or maximum-hour extra capacity, dependingon the basis of design or usage characteristics associated with the well supply.

Raw- and treated-water pumping and treatment facilities are allocated 65 per-cent to base and 35 percent to the maximum-day extra capacity cost components sincethese facilities are designed to meet maximum-day demands. It is noted that if theexample were to separately identify reservoir intake facilities and/or raw-watertransmission mains, these facilities also would be allocated 65 percent to base and35 percent to the maximum-day extra capacity cost components. Treated-watertransmission and distribution mains are allocated 45 percent to base, 25 percent tomaximum-day extra capacity, and 30 percent to the maximum-hour extra capacitycost components in recognition of the fact that mains provide maximum-day andmaximum-hour service to all customers. Distribution-storage-related facilities, suchas elevated storage tanks, serve principally to assist in meeting maximum-hour extracapacity requirements of the system, and are, therefore, in this example, allocated

Table 2-1 Allocation of Rate Base—Base–Extra Capacity Method (Test Year)

Extra Capacity DirectCustomer Fire-

Line Maximum Maximum Meters and ProtectionNo. Item Total Base Day Hour* Services Service

Intangible Plant: 1 Organization $6,000 $3,000 $1,000 $1,000 $1,000

Source of Supply Plant: 2 Land 423,000 423,000 3 Reservoir 407,000 407,000

Pumping Plant: 4 Land 23,000 15,000 8,000 5 Structures 369,000 240,000 129,000 6 Electric pumping equipment 376,000 244,000 132,000 7 Other pumping equipment 157,000 102,000 55,000

Water Treatment Plant: 8 Structures 426,000 277,000 149,000 9 Water treatment equipment 3,832,000 2,491,000 1,341,000

Transmission and Distribution Plant:10 Land 35,000 4,000 31,00011 Structures 48,000 5,000 43,00012 Distribution storage 1,020,000 102,000 918,00013 Mains 5,842,000 2,628,000 1,461,000 1,753,00014 Services 2,264,000 2,264,00015 Meters 996,000 996,00016 Hydrants 404,000 $404,000

General Plant:17 Land 4,000 1,000 1,000 1,000 1,00018 Structures 190,000 80,000 37,000 31,000 37,000 5,00019 Other 129,000 55,000 25,000 21,000 25,000 3,000___________ __________ __________ __________ __________ ________20 Net plant in service 16,951,000 7,077,000 3,339,000 2,799,000 3,324,000 412,000

Plus:21 Materials and supplies 291,000 122,000 57,000 48,000 57,000 7,00022 Cash working capital 285,000 119,000 56,000 47,000 56,000 7,00023 Construction work in progress 104,000 47,000 26,000 31,000

Less:24 Contributions and advances (1,445,000) (1,445,000)___________ __________ __________ __________ __________ ________

25 Test-year rate base $16,186,000 $7,365,000 $3,478,000 $2,925,000 $1,992,000 $426,000

*Maximum-hour demand in excess of maximum-day demand.



90 percent to the maximum-hour extra capacity cost component. In recognition thatdistribution storage provides some element of system reliability, the base costcomponent is assigned 10 percent of such facilities. The percentage factor used in theallocation of distribution storage is largely dependent on engineering judgment aswell as the operating and design characteristics of the reservoirs in each particularsystem. Meters and services are allocated to the customer cost component. Firehydrants are allocated to the direct fire-service cost component.

The value of office buildings, furniture and equipment, vehicles, and othergeneral plant is allocated to cost components on the basis of the resulting allocationof other plant facilities.

The allocation to base and extra capacity components depends on conditionscontrolling the design of any given system and facilities within the system. It must berecognized that each system requires separate analysis for proper allocation to costcomponents.

Construction work in progress is allocated to cost components on the same basisas similar elements of plant in service. In the example, it is assumed that allconstruction work in progress is transmission and distribution mains.

In many water utility systems, the accounting records will show contributions inaid of construction that ordinarily are deducted from the rate base before applyingrate-of-return percentages. Contributions should be deducted from plant value inaccordance with the purposes for which the contributions were made. The exampleillustrated in Table 2-1 assumes that all contributions in this instance are related tocustomer meters and services.

The results of the allocation of rate base to the various cost components, asillustrated in Table 2-1, provide a basis for subsequent distribution of capital costs tothese components and then to the customer classes, as further explained in chapter 3.

Table 2-2 illustrates the allocation of annual depreciation expense to costcomponents. The categories of items of depreciation expense are allocated to costcomponents in the same manner described in the allocation of rate base.

Table 2-3 presents an example of the allocation of O&M expense to costcomponents under the base–extra capacity method. In general, O&M expense for eachfacility is allocated to cost components in a manner similar to that for rate base.

Expenses that tend to vary directly with water usage are assigned directly to thebase cost component. Chemical costs are an example of such an expense. Power costsare allocated principally to the base cost component. The demand portion of powercosts should be allocated to extra capacity to the degree that it varies with demandpumping requirements. In the illustration, pumping power is allocated 10 percent tothe maximum-day extra capacity cost component in recognition of this factor, with thebalance of power costs, or 90 percent, being allocated to base cost. The extent to whichpower costs are allocated to the extra capacity cost component depends on thevariations in electric demands incurred in pumping and the energy/demand electricrate structure applicable to pumping.

Expenses other than power, chemical, and customer-related costs are allocable tocost components on the basis of the design capacity requirements of each facility.Such expenses, if designed to meet maximum-day requirements, are allocated65 percent to base cost and 35 percent to maximum-day extra capacity cost. Expensesrelated to facilities designed to meet maximum-hour requirements are allocable45 percent to base cost, 25 percent to maximum-day extra capacity cost, and30 percent to maximum-hour extra capacity cost. Expenses related to distributionstorage are allocated in the same manner as for rate base—that is, 10 percent to basecost and 90 percent to maximum-hour extra capacity costs.

14 WATER RATES


Table 2-2 Allocation of Depreciation Expense—Base–Extra Capacity Method (Test Year)

Extra Capacity DirectCustomer Fire-

Line Maximum Maximum Meters and ProtectionNo. Item Total Base Day Hour* Services Service

1 Source of Supply Plant: Reservoir $11,800 $11,800Pumping Plant:

2 Structures 9,600 6,200 $3,400 3 Electric pumping equipment 10,600 6,900 3,700 4 Other pumping equipment 4,200 2,700 1,500

Water Treatment Plant: 5 Structures 11,000 7,100 3,900 6 Water treatment equipment 83,800 54,500 29,300

Transmission and Distribution Plant: 7 Structures 1,200 100 $1,100 8 Distribution storage 28,500 2,900 25,600 9 Mains 161,100 72,500 40,300 48,30010 Services 48,900 $48,90011 Meters 21,500 21,50012 Hydrants 12,300 $12,300

General Plant:13 Structures 4,900 2,000 1,000 800 1,000 10014 Other 4,600 1,900 900 800 900 100_________ _________ ________ ________ ________ ________15 Total depreciation expense $414,000 $168,600 $84,000 $76,600 $72,300 $12,500


Table 2-3 Allocation of O&M Expense—Base–Extra Capacity Method (Test Year)

Customer Costs Extra Capacity Direct

Meters Billing Fire-Line Maximum Maximum and and ProtectionNo. Item Total Base Day Hour* Services Collecting Service

1 Source of Supply $90,000 $90,000Pumping:

2 Purchased power 259,000 233,100 $25,900 3 Other 193,000 125,400 67,600

Water Treatment: 4 Chemicals 121,000 121,000 5 Other 157,000 102,000 55,000

Transmission and Distribution: 6 Mains 130,000 58,500 32,500 $39,000 7 Storage 26,000 2,600 23,400 8 Meters and services 155,000 $155,000 9 Hydrants 13,000 $13,00010 Other 72,000 13,600 7,200 13,900 34,400 2,900

Customer Accounting:11 Meter reading and collection 247,000 $247,00012 Uncollectible accounts 44,000 20,800 6,300 2,800 5,900 7,700 500

Administrative and General:13 Salaries 194,000 70,300 29,100 13,700 33,900 44,200 2,80014 Employee benefits 177,000 64,000 26,500 12,500 31,000 40,400 2,60015 Insurance 135,000 77,600 36,300 19,700 1,200 20016 Other 266,000 96,300 39,900 18,700 46,500 60,700 3,900___________ __________ _________ _________ _________ _________ ________17 Total O&M expense $2,279,000 $1,075,200 $326,300 $143,700 $307,900 $400,200 $25,700




Expenses for meters and services and for customer billing and collecting areallocated directly to the customer cost components. Administration and generalexpense, in the example, is allocated to cost components in three parts. Salaries andemployee 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 2-1. Otheradministration and general expense is allocated on the basis of the allocation of allother expenses, exclusive of power and chemical costs.

COMMODITY–DEMAND METHOD__________________________In the commodity–demand method, costs of service are separated into four primarycost components: (1) commodity costs, (2) demand costs, (3) customer costs, and (4)direct fire-protection costs. In detailed rate studies, some of these elements may alsobe broken down further into two or more subcomponents.

Commodity costs are costs that tend to vary with the quantity of waterproduced. They usually include costs of chemicals, a large part of power costs, andother elements that increase or decrease almost directly with the amount of watersupplied. Costs related to impounded reservoir source of supply or other costs thatvary with average daily demands, such as raw-water transfer pumping costs, mayalso be considered as commodity costs. Purchased-water costs, if water is bought on aunit volume basis, would also be considered as commodity costs. However, recognitionof recent practices to include a demand charge in addition to commodity charge inpurchased-water agreements may dictate that demand portions of purchased-watercosts be allocated to demand components.

Demand costs are associated with providing facilities to meet the peak rates ofuse, or demands, placed on the system by the customers. They include capital-relatedcosts on plant designed to meet peak requirements plus the associated O&Mexpenses. This cost component may be broken down into costs associated withmeeting specific demands, such as maximum-day, excess maximum-hour, or otherperiods of time that may be appropriate to the utility that has to meet these demands.

The definition of customer costs for this method is the same as for thebase–extra capacity method. Direct fire-protection costs are also the same as underthe base–extra capacity cost method.

Table 2-4 presents an example of allocation of rate base under the commodity–demand method. In this example, rate base for each facility is the same as in thebase–extra capacity method presented in Table 2-1. Each element of utility plant isassigned to commodity, demand, customer, or direct fire-service functions. Pumpingplant and treatment plant, which meet maximum-day demands, are allocated100 percent to the maximum-day demand component. Treated-water mains, whichserve maximum-hour demands, are allocated 70 percent to the maximum-daydemand component and 30 percent to the maximum-hour demand cost component.Rate base for distribution storage is allocated 100 percent to the maximum-hourdemand component.

The results of the allocation of rate base to the various cost components, asillustrated in Table 2-4, provide a basis for subsequent distribution of rate base, andcapital costs related thereto, to customer classes, as further explained in chapter 3.

Table 2-5 presents an example of the allocation of depreciation expense to costcomponents under the commodity–demand method. The categories of items ofdepreciation expense are allocated to cost components in the same manner asdescribed in the allocation of rate base.

Table 2-6 presents an example of allocation of O&M expense under thecommodity–demand method. In general, O&M expense for each facility is allocated to

16 WATER RATES


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 tothe commodity cost function. Pumping power costs are allocated 71 percent tocommodity cost and 29 percent to maximum-day demand cost in recognition of thefact that power costs vary with demand.

Administration and general expense is allocated to cost components in a mannersimilar to that described for the base–extra capacity method—that is, in three partsin the example. Employee benefits are allocated on the basis of the allocation ofsalaries and wages. Insurance is allocated on the basis of test-year rate base in Table2-4. Other administration and general expense is allocated on the basis of all otherexpenses, exclusive of power and chemicals.

In comparing allocations under the base–extra capacity and commodity–demandmethods, base costs in the base–extra capacity method include commodity costs plusthat portion of demand costs in the commodity–demand method related to providingservices at average annual rates of water use. In the example, base cost includes all

Table 2-4 Allocation of Rate Base—Commodity–Demand Method (Test Year)

Demand DirectCustomer Fire-

Line Maximum Maximum Meters and ProtectionNo. Item Total Commodity Day Hour* Services Service

Intangible Plant: 1 Organization $6,000 $4,000 $1,000 $1,000

Source of Supply Plant: 2 Land 423,000 $423,000 3 Reservoir 407,000 407,000

Pumping Plant: 4 Land 23,000 23,000 5 Structures 369,000 369,000 6 Electric pumping equipment 376,000 376,000 7 Other pumping equipment 157,000 157,000

Water Treatment Plant: 8 Structures 426,000 426,000 9 Water treatment equipment 3,832,000 3,832,000

Transmission and Distribution Plant:10 Land 35,000 35,00011 Structures 48,000 48,00012 Distribution storage 1,020,000 1,020,00013 Mains 5,842,000 4,089,000 1,753,00014 Services 2,264,000 2,264,00015 Meters 996,000 996,00016 Hydrants 404,000 $404,000

General Plant:17 Land 4,000 2,000 1,000 1,00018 Structures 190,000 9,000 106,000 33,000 37,000 5,00019 Other 129,000 6,000 73,000 22,000 25,000 3,000___________ _________ __________ __________ __________ ________20 Net plant in service 16,951,000 845,000 9,457,000 2,913,000 3,324,000 412,000

Plus:21 Materials and supplies 291,000 15,000 162,000 50,000 57,000 7,00022 Cash working capital 285,000 14,000 159,000 49,000 56,000 7,00023 Construction work in progress 104,000 73,000 31,000

Less:24 Contributions and advances (1,445,000) (1,445,000)____________ _________ __________ __________ __________ _________25 Test-year rate base $16,186,000 $874,000 $9,851,000 $3,043,000 $1,992,000 $426,000




Table 2-5 Allocation of Depreciation Expense—Commodity–Demand Method (Test Year)

Demand DirectCustomer Fire-

Line Maximum Maximum Meters and ProtectionNo. Item Total Commodity Day Hour* Services Service

1 Source of Supply Plant: Reservoir $11,800 $11,800Pumping Plant:

2 Structures 9,600 $9,600 3 Electric pumping equipment 10,600 10,600 4 Other pumping equipment 4,200 4,200

Water Treatment Plant: 5 Structures 11,000 11,000 6 Water treatment equipment 83,800 83,800

Transmission and Distribution Plant: 7 Structures 1,200 $1,200 8 Distribution storage 28,500 28,500 9 Mains 161,100 112,800 48,30010 Services 48,900 $48,90011 Meters 21,500 21,50012 Hydrants 12,300 $12,300

General Plant:13 Structures 4,900 200 2,800 800 1,000 10014 Other 4,600 200 2,600 800 900 100_________ ________ _________ ________ ________ ________15 Total depreciation expense $414,000 $12,200 $237,400 $79,600 $72,300 $12,500

* Maximum-hour demand in excess of maximum-day demand.

Table 2-6 Allocation of O&M Expense—Commodity–Demand Method (Test Year)

Customer Costs Demand Direct

Meters Billing Fire-Line Maximum Maximum and and ProtectionNo. Item Total Commodity Day Hour* Services Collecting Service

1 Source of Supply $90,000 $90,000Pumping:

2 Purchased power 259,000 183,900 $75,100 3 Other 193,000 193,000

Water Treatment: 4 Chemicals 121,000 121,000 5 Other 157,000 157,000

Transmission and Distribution: 6 Mains 130,000 91,000 $39,000 7 Storage 26,000 26,000 8 Meters and services 155,000 $155,000 9 Hydrants 13,000 $13,00010 Other 72,000 20,300 14,400 34,400 2,900

Customer Accounting:11 Meter reading and collection 247,000 $247,00012 Uncollectible accounts 44,000 9,000 18,000 2,900 5,900 7,700 500

Administrative and General:13 Salaries 194,000 16,100 82,800 14,200 33,900 44,200 2,80014 Employee benefits 177,000 14,700 75,300 13,000 31,000 40,400 2,60015 Insurance 135,000 8,200 103,600 21,800 1,200 20016 Other 266,000 22,100 113,300 19,500 46,500 60,700 3,900___________ _________ _________ _________ _________ _________ ________17 Total O&M expense $2,279,000 $465,000 $929,400 $150,800 $307,900 $400,200 $25,700


18 WATER RATES


commodity costs plus 65 percent of the maximum-day demand costs. The maximum-day extra capacity costs include the balance of the costs allocated to the maximum-day demand component, or in the example, the maximum-day extra capacity costs are35 percent of the maximum-day demand costs for such facilities. Consideration of themerits of the base–extra capacity method relative to the commodity–demand methodof allocation is presented in chapter 4 of this manual.

SPECIAL CONSIDERATIONS _________________________________In some water utility systems, there are customers with certain water-usecharacteristics that require special consideration in allocating costs.

Customers provided with firm water service, that is, unlimited service in theamounts and at such times as desired, should be charged rates adequate to recoverthe full cost to the utility of providing such service.

In establishing charges for nonfirm service, such as off-peak or interruptibleservice, consideration should be given to charging special rates that are less than therates for firm service. Such rates might consist of those direct additional costs, suchas for power and chemicals, associated with providing water from existing facilities;however, charges should reflect a recognition of capacity-related and other costs, inaddition to purely incremental costs.

In some areas where irrigation or other seasonal uses impose significantdemands on the system, consideration may be given to separate charges for such use.Costs associated with seasonal use might be recovered through rates applied toseparate metering for such services or through surcharges applied to consumptionover and above an established normal use.

The allocation of the costs of service between inside-city and outside-citycustomers of a government-owned utility system should include special considerationof factors such as facilities required, extent and nature of service, ownership, risk,and other special items. A general approach to this situation is the use of the utilitybasis for assigning cost responsibility to outside customers. This method is presentedin more detail in chapter 3 of this manual. Except in specific instances, such as for ametropolitan service approach, discussed in chapter 3, it is reasonable to establishseparate inside-city and outside-city cost factors in order to properly allocate costsrelated to serving a particular group of customers.

In certain utility systems, the service area may be subdivided into pressurezones or districts due to the geophysical characteristics of the area. Under theseconditions, it may be desirable to assign the costs related to specific facilities to eachpressure district in order to determine the cost responsibility of each section of thesystem. The results of such detailed studies will indicate whether there aresignificant differences in the costs of providing service to each pressure district.

In some instances, consideration should be given to the responsibility for reservecapacity in the system. A typical example would be where a significant portion of thesystem is being held for the future growth needs of a specific customer or class ofcustomers. Means of recognizing this factor vary from one situation to another but,where warranted, are vital to an equitable allocation of costs.



Distribution of Coststo Customer Classes

Preceding chapters of this manual have dealt with the determination of revenuerequirements and the allocation of both operating- and capital-related costs to thefunctional components of cost of service. This chapter presents the third element inthe rate-making process—distribution of component costs to customer classes.

The theoretically ideal solution to developing rates for water utility customerswould be to assign cost responsibility to each individual customer served and developrates to derive that cost. It is not economically practical nor often possible todetermine the cost responsibility and applicable rates for each individual customerserved. However, the cost of providing service can reasonably be determined forgroups or classes of customers that have similar water-use characteristics and forspecial customers having unusual water-use or service requirements. It is anobjective of rate making to assign costs to classes of customers in such a manner thatrates can be designed that are nondiscriminatory and meet as nearly as possible thecost of providing service to such customer classes.

CUSTOMER CLASSES _____________________________________In establishing customer classes for a water utility, consideration is given to servicecharacteristics, demand patterns, and whether service is provided both inside andoutside the city (jurisdiction) limits. Service-characteristic differences may beillustrated by recognizing that customers using treated water require facilities notneeded by raw-water customers. Similarly, large-volume industrial customers,wholesale customers, and other large users tend to be served directly from majortreated-water transmission mains, whereas smaller users are served by both largeand small mains. This factor will, in some cases, warrant recognition in establishingcustomer classes and their costs of service.

Demand patterns of various customers differ, depending on their peak-day andpeak-hour rates of demand relative to average demands. For example, the residential

AWWA MANUAL M1

Chapter 3

20


customer class that places summertime lawn irrigation loads on the system typicallyhas a much higher peak-demand requirement, relative to the average demand, thandoes a petroleum refinery, which may require water on a relatively uniform basisthroughout the year.

The classification of water customers as to whether they are inside or outsidethe city limits is related to each major group’s responsibility for overall costs. Asexplained later in this manual, this factor is of major importance to government-owned utilities and may, in some instances, have a bearing on investor-ownedutilities.

Legal requirements or customs may require recognition of certain customerclassifications from an accounting standpoint, and such requirements can beaccommodated in rate studies. However, general service characteristics, demandpatterns, and location with regard to city limits are generally the principalconsiderations in customer classification.

General ClassesThe three principal customer classes typical of most water utilities are (1) residential,(2) commercial, and (3) industrial. Definition of these general customer classes differsamong 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,

nonindustrial 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 industrial customer group may be subdividedinto small industry, large industry, and special, the latter typified by a petroleumrefinery.

In many systems, particularly larger ones, frequently there are customershaving individual water-use characteristics, service requirements, or other reasonsthat set them apart from other customers with regard to cost responsibility. Thesecustomers should, therefore, have a separate class designation. Such classes mayinclude large hospitals, universities, military establishments, and other suchcategories.

Special ClassesIn addition to the general classes of service previously described, water utilities oftenprovide service to certain special classes of customers. Four of those considered hereare (1) wholesale service, (2) fire-protection service, (3) lawn irrigation, and (4) airconditioning and refrigeration.

Wholesale service. Wholesale service is usually defined as a situation inwhich water is sold to a customer at one or more major points of delivery for resale toindividual retail customers within the wholesale customer’s service area. Treated-water service is provided in most cases, but on occasion raw water is provided towholesale customers. Usually, the wholesale customer is a separate municipality orwater district adjacent to the supplying utility, but it may be in an area within thejurisdiction of the supplying utility.

Fire-protection service. Fire-protection service has characteristics that aremarkedly different from other types of water service. The service provided isprincipally of a standby nature—that is, readiness to deliver relatively largequantities of water for short periods of time at any of a large number of points in the

DISTRIBUTION OF COSTS 21


water distribution system while the total annual quantity of water delivered isrelatively small.

There are two principal approaches to the determination of fire-protectionservice costs that differ widely in both theory and application. One approach proposesthat the costs of fire-protection service, other than those of the direct cost related tothe hydrants themselves, be determined on the basis of the potential demand forwater for fire-fighting purposes in relationship to the total of all potential demandsfor water. A second approach proposes that fire-protection-service costs be allocated asan incremental cost to the costs of general water service. This second approach isbased on the premise that the prime function of the water utility is to supply generalwater service and that fire-protection service is a supplementary service. Eachapproach has advocates among water utility professionals. For the purposes ofillustration in this manual, the first approach discussed above is used.

Costs allocated to fire-protection service as a class can be subdivided into thoserelated to public fire-protection service and private fire-protection service. Thespecific methodology for such subdivision is presented in chapter 4.

The reader of this manual is referred to chapter 2 of AWWA Manual M26, WaterRates and Related Charges, for further discussion of fire-protection rates and charges.

Lawn irrigation. Residential lawn irrigation is characterized by the relativelyhigh demands it places on the water system, usually during the late afternoon andearly evening hours. In most of the United States, lawn irrigation is very seasonal innature, being most pronounced during the summer months and virtually nonexistentduring the winter months.

In most instances, lawn irrigation service is not separate from other service;therefore, the high-peaking characteristics of lawn irrigation need to be recognized asa part of residential-class water-use characteristics. However, where separatemetering for lawn irrigation is provided, as is sometimes the case for automatic lawnsprinkling systems, parks, and golf courses, and where such loads are significant inthe system, a separate class designation is warranted.

Air conditioning and refrigeration. In the 1950s and 1960s, there was atrend away from water-cooled air conditioning and refrigeration. Subsequent to therapid increase in electric-power and natural-gas costs in the 1970s, commercial andindustrial customers have reconsidered the economics of alternative cooling methods.In some cases, it has been found that higher initial outlays for water-cooled units canbe more than offset by the operating economies of water costs versus powerrequirements. In many communities, however, city codes prohibit the use of“water-wasting” units. The use of recirculating units needing only make-up water is aproposed alternative. Make-up water requirements will vary, but a common rule ofthumb for make-up water due to evaporation, quality control, and other causes isestimated as 20 gpd/ton of air conditioning.

A survey of the magnitude of water-cooled air conditioning and refrigerationservice provided or expected could determine the need or advisability of recognition ofsuch service as a separate class.

Service Outside City LimitsMany government-owned utilities recognize in their rate structures the differences incosts of serving water users located outside the corporate limits of the supplying cityor jurisdiction compared with those located within the corporate limits. Agovernment-owned utility may be considered to be the property of the citizens withinthe city. Customers within the city are owner customers, who must bear the risks and

22 WATER RATES


responsibilities of utility ownership. Outside-city customers are non-owner customersand, as such, bear a different responsibility for costs than do owner customers.

The costs to be borne by outside-city (non-owner) customers are similar to thoseattributable to the customers (non-owners) of an investor-owned utility. Such costsinclude operation-and-maintenance (O&M) expense, depreciation expense, and anappropriate return on the value of property devoted to serving the outside-citycustomers.

Those who are responsible for designing or reviewing water rates do not alwayshave a clear understanding of the relationship of the cash-needs approach tomeasuring total revenue requirements to the utility basis of cost allocation withregard to government-owned water systems, and why both elements are used in manyrate studies.

A government-owned utility, in most cases, where not regulated by a state publicutility commission, determines its total revenue requirements, or costs of service, ona cash-needs basis; that is, it must develop sufficient revenue to meet cash needs forO&M expense, debt-service requirements, capital expenditures not debt-financed, andpossibly other cash requirements as described in chapter 1. Such cash needs must bemet by the utility as a whole. However, when that utility serves outside-city,non-owner customers, it is most appropriate to measure the costs of such service on autility basis; that is, assign costs to outside-city customers for O&M expense,depreciation expense, and an appropriate return on the value of property devoted toserving them. It is then the responsibility of the inside-city customers to meet allremaining cash requirements not derived from outside-city customers. Thus, if totalutility revenue requirements are relatively low, perhaps due to a major part of thebonded indebtedness having been retired which resulted in a large amount of paid-upequity, the inside-city customers have relatively low rates, benefiting from havinginvested in and owning paid-up equity in the system. The reverse situation could alsooccur. If the rate of return is properly set, the utility basis of allocating cost of serviceis fair to both the supplier and the outside-city customer.

In some instances, as a matter of policy, a government-owned utility mightchoose to waive the distinction between owner and non-owner customers, consideringthe utility to be metropolitan in nature, where differences in costs between ownersand non-owners are not recognized in cost allocation and rate making. This generallywould require the owner customers to subsidize the non-owner customers to somedegree. Such a policy is a choice to be made by the governing body of the utility.

UNITS OF SERVICE_________________________________________As a step toward rate design, component costs may be distributed among customerclasses in the proportion that the respective class responsibility for those costs bearsto the total cost responsibility of all customer classes served by the system. Thisapplies for each of the component costs of service. Responsibility for each componentmay be expressed in terms of the number of units of service required by each class ofcustomer. The sum of all component costs attributable to a customer class is the totalcost of service to be recovered from it.

The total cost of each component, such as base cost, may be divided byappropriate total customer requirements or units of service to express a unit cost foreach component. The unit costs of each component serve as a basis for designingrates. As a basis for distributing component costs to customer classes, it is essentialthat the units of service attributable to the respective classes be established for thetest year. This involves determining or estimating the total quantity of water to beused 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 some systems, maximum-week or other periods may be appropriate.) In addition, a determination needs to bemade of the number of equivalent meters and services by class, as well as the numberof bills by class.

Maximum rates of use may be expressed in terms of capacity factor—that is, apercentage relationship of the class maximum rate of use to average annual rate ofuse. 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.

All pertinent sources of information need to be investigated and studied inestimating customer-class capacity factors. Such data should include daily and hourlypumpage records, recorded rates of flow in specific areas of the system, studies andinterviews of large users regarding individual and group characteristics of use,special-demand metering programs, and experience in studies of other utilitiesexhibiting like characteristics. Sound and logical inferences can be drawn fromcustomer metering information, provided billing periods are sufficiently short toreflect seasonal differences, usually not to exceed three-month periods.

The total annual quantity of water attributable to fire service is usuallyconsidered to be negligible, at least in relation to that of other classes. However, peakrequirements for fire service can be quite significant. The periodic reports of theInsurance Services Office, New York, N.Y., in which desired rates of flow for fireservice are defined, are a very good source of maximum-capacity requirements for fireservice. Such data must be applied with judgment and care to achieve practical costallocations.

Customer-related costs for meters and services may be properly distributedamong customer classes by recognizing factors that are generally responsible forthose costs being incurred. As an example, a method for distributing meter-and-serv-ice costs to customer classes is in proportion to the investment in meters and servicesinstalled for each customer class, based on the number of equivalent meters.Distribution of customer costs by equivalent meter-and-service ratios recognizes thatmeter-and-service costs vary, depending on considerations such as size of service pipe,materials used, locations of meters, and other local characteristics for various-sizedmeters as compared to 5⁄8-in. meters and services. For purposes of this example,typical customer meter-and-service equivalent ratios based on investment are asfollows:

Meter Size Equivalent Meter-in. and-Service Ratio

5⁄8 1.0 3⁄4 1.11 1.41 1⁄2 1.82 2.93 11.04 14.06 21.08 29.0

Customer meter-and-service costs are sometimes distributed among customerclasses based on factors other than investment. Equivalent ratios based on metercapacity or other measures may be appropriate in some circumstances. Selection ofappropriate measures for distributing such costs should be considered on anindividual utility basis.

24 WATER RATES


Costs related to billing and collecting may be distributed among customerclasses based on the total number of bills rendered to the respective classes in a testyear. In some instances, it is appropriate to recognize, through billing ratios, thatbilling and collecting for larger services may incur more cost than for smallerservices.

An illustration of the development of the test-year units of service for thehypothetical utility, using the base–extra capacity method of cost allocation anddistribution, is presented in Table 3-1. Test-year units of service reflect theprospective average annual customer water-use requirements during the test-yearstudy period considered in this example.

For the example, it is assumed that retail service and fire-protection service areprovided inside the city to residential, commercial, and industrial classes. Outside-city service is provided on a wholesale basis.

For each customer class, under the heading of Base in Table 3-1, the totalannual water use in thousand gallons is shown, as well as the average rate inthousand gallons per day. Maximum-day capacity factors are applied to average-dayrates of flow to develop total capacity by class. Extra capacity is the differencebetween total capacity and average rate of use. Fire-protection service is consideredto require negligible flow on an average basis but 960 thou. gpd on a maximum dailybasis. Maximum-hour extra capacity is developed similarly. Maximum-hour firepro-tection service reflects the assumption that flow for fires is concentrated in afour-hour period.

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

Table 3-2 shows the development of the units of service applicable to thecommodity–demand method of cost allocation. It differs from Table 3-1 only by thefact that the maximum-day extra capacity column is excluded.

It should be recognized that the maximum total capacity on both a maximum-day and maximum-hour basis for the total system (shown in Tables 3-1 and 3-2) is theestimate 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

Table 3-1 Units of Service—Base–Extra Capacity Method (Test Year)

Base Maximum Day Maximum Hour

Annual Average Total Extra Total Extra EquivalentUse Rate Capacity Capacity Capacity Capacity Capacity Capacity* Metersthou. thou. Factor thou. thou. Factor thou. thou. and

Customer Class gal gpd % gpd gpd % gpd gpd Services Bills

Inside-City: Retail service Residential 968,000 2,652 250 6,630 3,978 400 10,608 3,978 15,652 185,760 Commercial 473,000 1,296 200 2,592 1,296 325 4,212 1,620 1,758 14,640 Industrial 1,095,000 3,000 150 4,500 1,500 200 6,000 1,500 251 420 Fire-protection service 960 960 5,760 4,800__________ ______ ______ ______ _______ ______ _______ ________ Total inside-city 2,536,000 6,948 14,682 7,734 26,580 11,898 17,661 200,820

Outside-City: Wholesale service 230,000 630 225 1,418 788 375 2,363 945 34 48__________ ______ _______ ______ _______ _______ _______ ________Total system 2,766,000 7,578 16,100 8,522 28,943 12,843 17,695 200,868




peaks may occur. Thus, the total system capacity shown, as related to the averagerate, is not to be confused with the coincidental maximum-to-average ratio used insystem design.

UNIT COSTS______________________________________________Component costs can be directly distributed to respective customer classes inproportion 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 ofservice to respective service requirements. Unit costs of service are based on totalcosts previously allocated to functional components and the total number ofapplicable units of service for the test year. The development of unit costs of servicefor the base–extra capacity method is presented in Table 3-3.

Unit costs are determined simply by dividing the test-year functionally allocatedO&M and capital costs by the respective total system units-of-service requirements inthe test year. For example, under the base–extra capacity method, the base unit costfor O&M expense of $0.3887/thou. gal may be derived by dividing the allocated baseO&M expense of $1,075,200 by the total base-component units of service of 2,766,000thou. gal. Similar computations are made to determine unit costs for all other O&Mexpense and depreciation expense. Under the utility-basis method of cost allocation,the resulting average unit costs for O&M expense and depreciation expense areapplicable to all customers, both inside and outside the city. Allocation of O&Mexpense and depreciation expense to functional cost components is presented inchapter 2.

The determination of unit return on rate base is made by first calculating unitrate base. The functionally allocated total rate base is divided by respective totalsystem units of service to yield unit rate base. Subsequently, unit return on rate baseis derived by applying appropriate inside- and outside-city rates of return to the unitrate base.

As discussed in chapter 1, for the government-owned utility to meet total cashrevenue requirements under the utility approach, the level of return in the examplewould be $807,000. Based on a total rate base of $16,186,000, the overall rate of

Table 3-2 Units of Service—Commodity–Demand Method (Test Year)

Commodity Maximum Day Maximum Hour

Annual Average Total Total Extra EquivalentUse Rate Capacity Capacity Capacity Capacity Capacity* Meters

thou. thou. Factor thou. Factor thou. thou. andCustomer Class gal gpd % gpd % gpd gpd Services Bills

Inside-City: Retail service Residential 968,000 2,652 250 6,630 400 10,608 3,978 15,652 185,760 Commercial 473,000 1,296 200 2,592 325 4,212 1,620 1,758 14,640 Industrial 1,095,000 3,000 150 4,500 200 6,000 1,500 251 420 Fire-protection service 960 5,760 4,800__________ ______ ______ _______ _______ _______ ________ Total inside-city 2,536,000 6,948 14,682 26,580 11,898 17,661 200,820

Outside-City: Wholesale service 230,000 630 225 1,418 375 2,363 945 34 48__________ ______ ______ _______ _______ _______ ________Total system 2,766,000 7,578 16,100 28,943 12,843 17,695 200,868


26 WATER RATES


return is equivalent to about 4.99 percent. In this example, it is assumed that theutility provides service to both inside- and outside-city customers. Generally, whereinside-city owners provide service to outside-city non-owners, a differential rate ofreturn is appropriate. In this example, a rate of return of 9.0 percent is assumed andapplied to component unit rate base in order to determine the outside-city unit returnon rate base.

Although it is not presented in Table 3-3, total outside-city return may becalculated by determining total outside-city rate base and applying the 9.0 percentrate of return to it. For the base–extra capacity method, total outside-city rate base isderived by applying the unit rate base from Table 3-3 to the respective outside-cityunits of service presented in Table 3-1. Application of the 9.0 percent rate of return tooutside-city rate base of about $1,153,000 results in an outside-city return ofapproximately $103,800. Once outside-city return is determined, the inside-city rateof return is established at a level sufficient to derive the balance of total return—thatis, $807,000 less the outside-city return of $103,800, or $703,200, which is not derivedfrom the outside-city customers.

Determination of the inside-city rate of return is made by dividing the balance oftotal return of $703,200 by the inside-city rate base. The inside-city rate base iscalculated in a manner similar to that described for developing the outside-city ratebase and totals $15,033,000. Total inside-city rate of return is determined to be4.68 percent.

Returning to the unit-cost approach presented in Table 3-3, inside-city unitreturn on rate base is developed by applying the 4.68 percent rate of return to theunit rate base. The differential in inside- versus outside-city rates of return reflects,in part, the municipality’s risk in the ownership of facilities constructed to serve

Table 3-3 Unit Costs of Service—Base–Extra Capacity Method (Test Year)


Meters Billing Fire-Line Total Maximum Maximum and and ProtectionNo. Item Cost Base Day Hour* Services Collecting Service

Total System Units of Service: 1 Number 2,766,000 8,522 12,843 17,695 200,868 2 Units thou. gal thou. gpd thou. gpd equiv. bills

metersO&M Expense:

3 Total $2,279,000 $1,075,200 $326,300 $143,700 $307,900 $400,200 $25,700 4 Unit cost ($/unit) 0.3887 38.2907 11.1888 17.4004 1.9924

Depreciation Expense: 5 Total $414,000 $168,600 $84,000 $76,600 $72,300 $12,500 6 Unit cost ($/unit) 0.0610 9.8573 5.9643 4.0859

Rate Base: 7 Total rate base $16,186,000 $7,365,000 $3,478,000 $2,925,000 $1,992,000 $426,000 8 Unit rate base ($/unit) 2.6627 408.1372 227.7479 112.5742

Unit Return on Rate Base: 9 Inside-city ($/unit)† 0.1246 19.0915 10.6534 5.2659 19,90010 Outside-city ($/unit)‡ 0.2396 36.7323 20.4973 10.1317

Total Unit Costs of Service:11 Inside-city ($/unit) 0.5742 67.2394 27.8065 26.7522 1.992412 Outside-city ($/unit) 0.6893 84.8803 37.6504 31.6180 1.9924

*Maximum-hour demand in excess of maximum-day demand. †At 4.68 percent return on $15,033,000 rate base. ‡At 9.0 percent return on $1,153,000 rate base.



outside-city customers, as well as a return on paid-up equity in system facilities toinside-city customers.

Total unit costs of service are comprised of the O&M, depreciation, and return onrate base unit costs of service and are shown at the bottom of Table 3-3 for inside- andoutside-city customers. Also included in the table are the costs of service that aredirectly allocated to fire-protection service, as discussed previously.

The development of unit costs of service for the commodity–demand method ismade similarly to that used for the base–extra capacity method. Total unit costs ofservice for inside- and outside-city customers under the commodity–demand methodare summarized at the bottom of Table 3-4.

DISTRIBUTION OF COSTS TO CUSTOMER CLASSES__________

Base–Extra Capacity MethodThe distribution of the costs of service to the utility’s customer classes is accomplishedby applying unit costs of service to individual customer-class units of water service.The total units of service and the unit costs of service for the test year, from Tables 3-1and 3-3, respectively, are summarized in Table 3-5.

As discussed previously, base costs are costs that would be incurred in supplyingwater at perfect load factor (that is, at a continuous, uniform rate), without costsincurred in providing extra plant capacity for variation in the rate of use beyond auniform rate. The resulting distribution of cost responsibility for base costs is simplya function of the volume of water used by each class.

Table 3-4 Unit Costs of Service—Commodity–Demand Method (Test Year)


Meters Billing Fire-Line Total Maximum Maximum and and ProtectionNo. Item Cost Commodity Day Hour* Services Collecting Service

Total System Units of Service: 1 Number 2,766,000 16,100 12,843 17,695 200,868 2 Units thou. gal thou. gpd thou. gpd equiv. bills

metersO&M Expense:

3 Total $2,279,000 $465,000 $929,400 $150,800 $307,900 $400,200 $25,700 4 Unit cost ($/unit) 0.1681 57.7277 11.7418 17.4004 1.9924

Depreciation Expense: 5 Total $414,000 $12,200 $237,400 $79,600 $72,300 $12,500 6 Unit cost ($/unit) 0.0044 14.7456 6.1979 4.0859

Rate Base: 7 Total rate base $16,186,000 $874,000 $9,851,000 $3,043,000 $1,992,000 $426,000 8 Unit rate base ($/unit) 0.3160 611.8738 236.9384 112.5742

Unit Return on Rate Base: 9 Inside-city ($/unit)† 0.0148 28.6357 11.0887 5.2685 19,90010 Outside-city ($/unit)‡ 0.0284 55.0686 21.3245 10.1317

Total Unit Costs of Service:11 Inside-city ($/unit) 0.1873 101.1090 29.0285 26.7548 1.992412 Outside-city ($/unit) 0.2010 127.5419 39.2642 31.6180 1.9924

*Maximum-hour demand in excess of maximum-day demand. †At 4.68 percent return on $15,018,000 rate base. ‡At 9.0 percent return on $1,168,000 rate base.

28 WATER RATES


As shown in Table 3-5, residential customers are projected to use 968,000 thou.gal of water in the test year; commercial customers, 473,000 thou. gal; and industrialcustomers 1,095,000 thou. gal. Applying the inside-city unit base cost of $0.5742/thou.gal to the respective units of service yields the distributed customer-class base cost ofservice. By definition, the unit base cost is the minimum rate at which water could besold (if perfect load-factor use could be achieved) after customer costs are recovered.Outside-city distributed base costs are derived from the application of the unit basecost of $0.6893/thou. gal to the outside-city base unit-of-service requirements. Thehigher unit base cost reflects the rate-of-return differential discussed previously.

Extra capacity costs for maximum-day and maximum-hour service are incurredin providing facilities to furnish water at varying rates above the average.Customer-class responsibility for extra capacity costs is determined by applying theunit costs of service to the individual customer-class units of service in a mannersimilar to that used for determining customer-class base costs.

Customer costs, which include the category of meters and services and thecategory of billing and collecting, are generally treated separately in rate studies.Customer costs associated with meters and services (both capital and O&M costs)may be distributed to customer classes on the basis of equivalent meter-and-servicecost factors. Meter-and-service costs are based on the total number of equivalent5⁄8-in. meters and are applied to customer-class equivalent meter units of service inorder to determine allocated cost of service. Units based on equivalent 5⁄8-in. meters

Table 3-5 Cost Distribution to Customer Classes—Base–Extra Capacity Method (Test Year)


Meters Billing Fire- TotalLine Maximum Maximum and and Protection Cost ofNo. Item Base Day Hour Services Collecting Service Service

Inside-City: 1 Unit costs of service ($/unit) 0.5742 67.2394 27.8065 26.7522 1.9924

per thou. per thou. per thou. per equiv. per billgal gpd gpd meter

Retail Service: Residential:

2 Units of service 968,000 3,978 3,978 15,652 185,760 3 Allocated cost of service $555,900 $267,500 $110,600 $418,700 $370,100 $1,722,800

Commercial: 4 Units of service 473,000 1,296 1,620 1,758 14,640 5 Allocated cost of service $271,600 $87,100 $45,000 $47,000 $29,200 $479,900

Industrial: 6 Units of service 1,095,000 1,500 1,500 251 420 7 Allocated cost of service $628,900 $100,900 $41,700 $6,700 $800 $779,000

Fire-Protection Service: 8 Units of service 960 4,800 9 Allocated cost of service $64,500 $133,500 $58,100 $256,100___________10 Total inside-city allocated

cost of service $3,237,800Outside-City:

11 Unit costs of service ($/unit) 0.6893 84.8803 37.6504 31.6180 1.9924 Wholesale:

12 Units of service 230,000 788 945 34 4813 Allocated cost of service $158,500 $66,900 $35,600 $1,100 $100 $262,200__________ _________ _________ _________ _________ ________ ___________14 Total system allocated

cost of service $1,614,900 $586,900 $366,400 $473,500 $400,200 $58,100 $3,500,000



are used to allow for the fact that customer costs will vary and tend to increase withthe size of the customer meter and service.

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

The base, extra capacity, and customer costs, summarized by customer classes,constitute the costs of service to be recovered from the respective classes of customersinvolved. This summation also provides identification of the responsibility of eachclass for the functional costs.

Commodity–Demand MethodThe distribution of costs to customer classes under the commodity–demand method isaccomplished in the same manner used for distributing base–extra capacity costs.Table 3-6 summarizes the application of units of service to unit costs of service, asdeveloped in Tables 3-2 and 3-4 for the commodity–demand method.

In the commodity–demand method, commodity costs are distributed to customerclasses on the basis of total annual use. Demand-related costs are distributed to thevarious classes in proportion to the class total demand responsibility, and customercosts are distributed based on equivalent meter and billing requirements.

Table 3-6 Cost Distribution to Customer Classes—Commodity–Demand Method (Test Year)


Meters Billing Fire- TotalLine Maximum Maximum and and Protection Cost ofNo. Item Commodity Day Hour Services Collecting Service Service

Inside-City:1 Unit costs of service ($/unit) 0.1873 101.1090 29.0285 26.7548 1.9924

per thou. per thou. per thou. per equiv. per billgal gpd gpd meter

Retail Service: Residential:

2 Units of service 968,000 6,630 3,978 15,652 185,7603 Allocated cost of service $181,300 $670,300 $115,400 $418,700 $370,100 $1,755,800

Commercial:4 Units of service 473,000 2,592 1,620 1,758 14,6405 Allocated cost of service $88,500 $262,000 $47,000 $47,000 $29,100 $473,600

Industrial:6 Units of service 1,095,000 4,500 1,500 251 4207 Allocated cost of service $205,100 $454,900 $43,500 $6,700 $800 $711,000

Fire-Protection Service:8 Units of service 960 4,8009 Allocated cost of service $97,000 $139,300 $58,100 $294,400

10 Total inside-city allocated cost of service $3,234,800Outside-City:

11 Unit costs of service ($/unit) 0.2010 127.5419 39.2642 31.6180 1.9924 Wholesale:

12 Units of service 230,000 1,418 945 34 4813 Allocated cost of service $46,200 $180,800 $37,100 $1,000 $100 $265,200

14 Total system allocated cost of service $521,100 $1,665,000 $382,300 $473,400 $400,100 $58,100 $3,500,000

30 WATER RATES


Commodity costs, which tend to vary with the annual quantity of waterproduced, are distributed to inside-city customer classes by applying the inside-citycommodity unit cost of $0.1873/thou. gal to the respective inside-city class units ofservice. Likewise, demand-related costs for maximum-day and maximum-hour servicerequirements are distributed to the classes based on the application of total estimatedclass service demands and the unit costs of demand. Customer costs to be distributedfor meters and services and for billing and collecting are the same under both thebase–extra capacity and commodity–demand methods and are distributed similarly inboth methods. Meter-and-service costs are distributed to classes in proportion to thenumber of equivalent 5⁄8-in. meters, whereas billing and collecting costs aredistributed on the basis of the number of bills rendered.

Cost of service for outside-city wholesale service may also be derived by applyingthe outside-city unit costs of service to outside units of service.

A summation of the distributed costs for each component of cost for inside- andoutside-city customers yields the total distributed customer class cost-of-serviceresponsibility and appears in the right-hand column of Table 3-6.

A word of caution should be added that may prevent misinterpretation of thecommodity cost of $0.1873/thou. gal. Under no circumstances is this the cost of water.Even with perfectly uniform use, demand or capacity costs must be added. Thebase–extra capacity method avoids the possibility of such a misconception.



Development andDesign of RateSchedules

The preceding chapters have discussed general procedures for determining total costsof service and assigning these costs to classes of utility customers in accordance withtheir respective service requirements. This chapter presents the final step in acost-of-service rate study—namely, the development of a schedule of rates to recover,as nearly as possible, the allocated costs of service from customers. The initial portionof this chapter discusses several considerations to be addressed during therate-design process and is followed by an illustration of the development of acost-of-service schedule of rates based on costs identified and allocated in chapters 1through 3. The final portion of this chapter is devoted to a review and generaldiscussion of alternative rate considerations, some of which may deviate fromcost-of-service principles. The circumstances under which such alternatives may findacceptance for meeting social, special service, or other requirements are alsodiscussed. When a deviation from cost-related rates is made, the reason for suchmodification should be explicitly understood so that the responsibility for suchdeviation is placed on legal and policy-making factors, and the public is not misledinto believing that the resulting rates are fully cost-related when they are not.

BASIC COST-OF-SERVICE RATE PHILOSOPHY ________________

General ConsiderationsA primary consideration in the derivation of water-rate schedules is the estab-lishment of equitable charges to customers commensurate with the costs of providingthat service. As previously discussed, the only method of assessing entirely equitable

AWWA MANUAL M1

Chapter 4

32


rates would be the determination of each customer’s water bill, based on his or herparticular service requirements. Since this obviously is impractical, if not impossible,when dealing with thousands of customers, rates are normally designed to fit averageconditions for groups of customers having similar service requirements. Chapter 3developed a basis for categorizing customers into classes having similar servicerequirements and presented a methodology for identifying the costs of serving eachcustomer group. Adherence to the results of the cost-of-service determinationspresents a practical basis for determining equitable water rates. However, beforecost-of-service rates can be designed, several policy considerations, which mayultimately affect the actual development of rates, should be addressed. These arediscussed below.

Once costs of service by class are established, based on the overall level ofneeded revenue requirements, characteristics of the rate-schedule format may beanalyzed for their adequacy in recovering costs of service. While rates designed on thebasis of cost of service should be the principal consideration in rate making, judgmentmust be exercised in the final decision as to revisions to be made in the existing ratestructure. Various factors may affect the decision as to recommended rate modifica-tions. Factors such as general public reaction to changes in rates; consideration of theimpact of shifts in the cost burden from a group of customers that has beenovercharged to a group that has been subsidized under existing rates; reluctance todepart from rate forms that have existed for so long that they have almost becometraditional despite inequities; pressure of special interest groups; and similar factorsmay require consideration as revisions in existing rate structures are made.Therefore, the basic objective of a rate study should be the development of a ratestructure that will attain the maximum degree of equitability among customers, willbe consistent with local practice and conditions, and will be in the best interest ofboth the community and the utility.

Departure from rates based on cost of service is generally a decision made forpolitical, legal, or other reasons. Consideration of rates deviating from cost of service,therefore, is made by politicians, not the rate designer.

A factor that may have some bearing on the rate-design process is considerationof metering requirements associated with various rate formats. There are certainlimitations in designing water rates that relate to existing and economically availablewater meters. For instance, water rates having both demand and volume elementsare practicable only for very large users because demand-metering equipment isgenerally too expensive for most customers. Routine reading of water meters, many ofwhich are located indoors, often presents administrative and logistical problems.Often water meters are only read quarterly or semiannually. Such factors canseriously affect the practicality of seasonal types of rates. Thus, water rates should bedesigned with metering practicalities in mind and with the thought that they may berevised if and when future technology and costs permit.

General Service RatesFor reasons of practicality of application, administration, and customer acceptance, itis common practice in the water industry to provide water service to all generalservice customers within a given jurisdiction through a single rate schedulecomprised of a two-part rate. This two-part rate includes an initial charge togenerally recover customer-related and possibly some volume-related costs, togetherwith a volumetric charge to recover remaining volume costs. This is quite differentfrom the practice of other utility services (such as electricity, gas, and telephone), for

DEVELOPMENT/DESIGN OF RATE SCHEDULES 33


which separate rate schedules are used for residential, commercial, industrial, andother classes of customers.

The design of a water-rate schedule that requires each customer class to pay itsfull cost of service takes into consideration unit costs applicable to the level of servicerendered. Unit costs for each major component of service have been described andillustrated in chapter 3. Recognition of the degree to which each component isinvolved in providing the level of service rendered provides a basis for design of aschedule of rates.

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

Customer costs related to meter reading and billing-and-collecting are incurredregardless of the amount of water, if any, that is used. These costs are generallyrecovered through either a minimum charge or a service charge. The minimum-charge format is usually designed to recover all customer-cost elements and both thevolume and extra-capacity-related costs associated with an allowance for a specifiedquantity of water usage. The water use included in the minimum charge can beestablished at a level such that some nominal percentage of all the residential billswill be rendered under this charge, perhaps on the order of 5 to 15 percent. Thepercentage selected for this purpose should not be so high, and the water allowanceso great, that it effectively approaches a flat rate for a large number of customers.This would encourage waste of water by those customers who normally would use asmaller quantity of water than that included under the minimum charge. Anothercriterion that might be considered is to base the water allowance included in theminimum charge on the winter time (nonirrigation) use of very small households. Thewater allowance under the schedule of minimum charges may be uniform for allcustomers, or it may be graduated, based on meter size.

Another form of minimum charge is a “disappearing” charge, which fixes theminimum amount of dollars to be collected from the customer and incidentally allowsthe customer a given amount of water under the minimum charge. The amount ofwater allowed is simply determined by the quantity that the customer could buyunder the applicable volume rates. Under this type of rate, the minimum charge is“disappearing” in that when use exceeds the amount allowed under the minimumcharge, the regular rate schedule prevails.

Rather than preparing a minimum bill that includes an allowance for somewater use, the rate schedule can be designed to provide for a service charge, orreadiness-to-serve charge, which would be an initial charge that provides nowater-use allowance. The service charge is designed to recover customer-related costsand possibly some capacity-related costs associated with readiness to serve, and,consequently, all water use would be billed under subsequent rate blocks. From thestandpoint of cost recovery, either a minimum bill or a service charge can be used, ifproperly designed. As with the minimum charge, the service charge may be graduatedby meter size, based on an analysis of metering, billing, and other associated costs forcustomer services of varying sizes.

Recovering costs related to volume and extra capacity. An importantissue to be determined in rate design is whether the water rate schedule will consistof (1) a single rate per unit of volume, irrespective of the volume of use, or (2) two ormore rate blocks. Because of load-factor effects, the rates for subsequent blocksgenerally decline for larger rates of use. Such a schedule is often referred to as adeclining-block schedule. In some instances, there may be an inverted rate structure,

34 WATER RATES


whereby the charge for use beyond the first block would be priced at higher ratesrather than at declining rates.

Contrary to usual lay opinion, a declining-block water-rate schedule may bedesigned to recover the costs of serving different classes of customers whilemaintaining reasonable equitability between the customer classes. In the design ofrates, declining blocks do not reflect quantity discounts or lower rates simply becausewater is sold in large amounts. Such rates do provide a mechanism for recoveringcosts from residential, commercial, and industrial users based on the differingwater-use and demand characteristics associated with providing their service. It hasbeen found that the larger users, as a class, characteristically have a much lowerpeak-to-average demand factor with correspondingly lower extra capacity require-ments and related costs than do the smaller users, as a class. Accordingly, a properlydesigned block-rate schedule having a decreasing level of unit charges will ordinarilyrecover revenue for each class in accordance with the cost of providing service to therespective classes.

Where all customer classes are served under a single water-rate schedule, it isnecessary that several rate blocks be used. As an approach to the design of a scheduleof rates, recognition of costs associated with various levels of customer usage, ingeneral, provides a basis for the selection of usage blocks and the development ofrates for respective blocks. An initial block may be designed to recover customer andother costs associated with use of the smallest users. This block is normallyassociated with the allowance included in the minimum charge. Subsequent rateblocks may be designed to recover costs, beyond those of the smallest users,associated with use and capacity requirements of residential and small commercialcustomers. In special cases, an additional block may be warranted for an extremelylarge industry having nearly uniform demand requirements. Each subsequent blockshould be designed to recover that part of the total cost of service that has not beenrecovered through rates for water use in prior blocks.

In order to design rate blocks and to estimate revenues to be obtained throughthe designed rates, an analysis of the number of bills rendered to various customerclasses at various use levels is necessary. The blocks that ultimately control thecharges for any particular system should be designed on the basis of customer-classwater usage information derived from billing records of that system. Such informa-tion can be provided in the form of a bill tabulation showing, by meter size andcustomer classification at each level of use, the number of bills rendered and the use,as well as the cumulative use and bills rendered at each of the various levels of use.This information can then be depicted graphically by means of curves showing therelative percentage of total use by meter size or customer class at various levels ofusage per month. Appendix A presents procedures for tabulating bills and usagebased on hypothetical water billing records.

Figure 4-1 shows examples of curves prepared to express the various levels ofmonthly water use per customer in a class as a percentage of the total water use bythat class. The cumulative percentage of total water use by class is shown on thevertical scale, and monthly water use per customer is shown on the horizontal scale.For residential customers, a usage of 10,000 gal/month intersects the curve at 88percent. The 88 percent figure for residential customers represents total water usedby those customers using a total of less than 10,000 gal/month, together with the first10,000 gal used by customers with greater than 10,000 gal total monthly use.Similarly, the curves indicate that only 12 percent of commercial use and only a verysmall percentage of industrial use occurs in the 0–10,000 gal or less monthly usagerange.



Fig

ure

4-1

Met

ered

wat

er-u

se c

ondi

tion

(exa

mp

le).

36 WATER RATES


Such curves provide a basis for selection of usage blocks in rate design and ameans of estimating total annual revenues by customer class that would be derivedfrom rate schedule designs. For various water systems, the curves are usually similarin configuration, often of an ogee type, but the slope and relative locations of thecurves for any particular utility will depend on the type and mixture of customersserved by the utility. For instance, the amount of lawn sprinkling that occurssignificantly affects the location and shape of the residential curve. The commercialclass curve for a large city would represent a composite usage pattern of numerousstores, office buildings, hotels, and other commercial establishments, whereas for asmaller town, the pattern may be more subject to the possible influence of oneparticular business or customer.

Fire-Protection ServiceConsideration of the costs of service related to fire protection should normally beincluded in a cost-of-service study. The development of rates to recover the costs ofservice are often separated into public and private fire-protection categories. Publicfire-protection service would consist of the costs for fire hydrants and the backupfacilities required to provide an adequate water supply in the event of fire. Privatefire-protection service would consist generally of the costs for backup facilities andseparate connections to the water system for the purpose of providing water to firesprinkler systems, fire standpipes, and private fire hydrants located on customerpremises. Customers with private fire-protection-service connections are generallylarge industrial, commercial, and governmental buildings and facilities.

The division of fire-protection-service costs that are common to both public andprivate fire-protection service may be accomplished in several ways. A relativelysimple method is to base the division of costs related to common facilities betweenpublic and private fire protection on the number of equivalent 6-in. public firehydrant branches and the number of equivalent 6-in. private fire connections.Equivalent 6-in. connections can be determined on the basis of cross-sectional area, orit may be appropriate to consider relative potential fire flows.

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 ofcosts for backup facilities in the water system, including transmission anddistribution mains, storage facilities, pumps, and other facilities. The backup facilitiesnormally constitute a much larger share of the cost of providing fire-protection servicethan the costs directly related to fire-service connections.

Rates for public fire protection are generally expressed as a total annual chargeand may be expressed as an annual charge per hydrant. In some cases, a separatecharge is made for the water mains and backup facilities on an inch–foot (in.–ft)basis—that is, the footage of main multiplied by the inches in diameter. By thismethod, an annual charge is made in cents per inch–foot of main, and an additionalcharge is made per hydrant. Both unit charge methods are founded on soundprinciples and have the merit that the total annual charge for fire-protection serviceincreases with the amount of fire-protection facilities installed.

In some instances, the cost of public fire-protection service is collected as part ofthe basic water rates applicable to retail customers, rather than through a separatecharge to the municipality or fire-protection district served. In this case, publicfire-protection allocated cost of service must be distributed to customer classesbenefited by public fire protection. While there are often legal or other reasons forsuch a practice, the preferred method is to charge the municipality directly forfire-protection service.



As previously noted, the reader is referred to chapter 2 of AWWA Manual M26,Water Rates and Related Charges, for further discussion of fire-protection rates andcharges.

Wholesale Service RatesWhere wholesale or sale-for-resale service is provided, a careful analysis should bemade of the cost-of-service elements entering into such service. For example, wherewholesale customers are served directly from major transmission facilities, anallocation of small distribution mains may not be appropriate since they provide littleservice to such customers.

For service to large-use customers, it may be desirable to design a two-partvolume–demand rate with one part applicable to the volume of water used and theother to measured demands imposed on the system by the customer. This type of raterequires demand-metering equipment, a more costly installation than straightvolume metering; however, it may benefit both the utility and the customer to havesuch a demand rate since it is directly responsive to the service requirements of thewholesale customer. It is important to carefully define and evaluate the cost ofproviding water on a wholesale basis and to design the rates accordingly. Ademand-type rate will encourage the wholesale customer to either install storage onthe system or to adjust operations so as to minimize peak demands to the fullestextent practicable. Such incentives benefit the customer and the water utility interms of reducing peak water demands and costs.

Customer Resistance and LagTwo additional considerations that can be incorporated into the rate-design processare recognition of customer water-use resistance and lag. When a substantial increasein rates is indicated or when the differential increase among classes of service issomewhat drastic, it is wise to consider in the design of the rates possible customerconservation of water use as a resistance to increased charges. In general, reductionin customer water usage following a rate increase is usually temporary in nature,particularly with modest increases. However, when rates reach such a level thatonce-through use is not economical, business and industry will initiate more stringentreuse practices with resulting permanent reductions in water requirements.Similarly, when water is no longer considered an inexpensive service, residentialcustomers will take action to conserve on their usage. The extent of potentialcustomer water conservation with increased charges warrants careful considerationin rate design if the utility is to actually realize the required additional revenues.

Another factor sometimes overlooked in considering a rate adjustment is apossible lag between the date of rate increase and actual receipt of additional funds.The degree of lag can depend on billing frequency, accounting procedures, or otherfactors. Failure to recognize lag in receipt of additional funds can create a revenuecash-flow problem, particularly in the initial year of an increase, with the result beinga shortfall in revenues due to the timing of water revenue receipts.

RATE-DESIGN EXAMPLE ____________________________________The development of a schedule of rates to recover costs of service allocated tocustomer classes in chapters 2 and 3 is presented to illustrate rate-design proceduresdiscussed previously. Development of rates in the example is prepared from costinformation determined under the base–extra capacity method. It is noted that if all

38 WATER RATES


elements of cost are properly allocated, use of either the base–extra capacity or thecommodity–demand method will result in comparable charges.

One particular advantage in using the base–extra capacity method is that itidentifies in the base cost element the minimum unit volume cost of service. Such aunit cost would be applicable as a rate only if perfect load factor or constant rate ofuse could be achieved. Therefore, the unit base cost provides a measure of the lowestpotential charge in a schedule of rates for delivery of uniform service. As such, theunit base cost establishes an important guide in preventing the potential forestablishing a charge that could result in the sale of water below cost. For purposesof this example, the design of a rate form having a service charge with block rates isillustrated. In addition, a minimum charge is also designed to illustrate analternative type of initial charge.

Service-Charge DesignCustomer costs, which are comprised of meter-and-service and billing-and-collectingrelated costs, may be recovered from customers through a service charge. In addition,a portion of distribution-main costs as well as a portion of demand-related costs aresometimes included in the determination of service charges. In this example, however,only customer-related costs of meter-and-service and billing-and-collecting relatedcosts are included in the determination of service charges. As discussed, no allowancefor water usage is included in the development of the service charge, and, therefore,the base and extra capacity costs are recovered in the volume portion of the rateillustrated subsequently.

Table 4-1 presents the development of a monthly service charge for inside-cityretail service customers. Unit customer costs for meter-and-service and billing-and-collecting related costs are presented in column 1. Examples of unit costs are asdeveloped in Table 3-3. Since the meter-and-service unit cost of $26.7522/equivalentmeter is an annual cost, it is divided by 12 to derive the monthly unit cost of$2.2294/equivalent meter/month. The unit billing-and-collecting cost of $1.9924/bill isbased on the total number of bills projected to be issued annually during the rate

Table 4-1 Design of Inside-City Monthly Service Charges (Test Year)

(1) (2) (3)Equivalent

Line Meter-and-No. Unit Cost Service Ratio* Cost

5⁄8-in. Service Charge:1 Meter-and-service-related costs $2.2294/meter† 1.0 $2.232 Billing-and-collecting-related costs $1.9924/bill* 1.99______3 Total 4.224 Total (rounded) 4.20

2-in. Service Charge:5 Meter-and-service-related costs $2.2294/meter† 2.9 6.476 Billing-and-collecting-related costs $1.9924/bill 1.99______7 Total 8.468 Total (rounded) $8.45

*Ratio of investment in this size meter and related service relative to investment in a 5/8-in. meter and related service perchapter 3. †$26.7522 annually/equivalent meter / 12 bills/year = $2.2294/month/equivalent meter per chapter 3.



year. Column 2 presents the equivalent meter-and-service ratio, which reflects therelative ratio of meter-and-service investment as compared to a 5⁄8-in. meter. Asshown in column 2, a 2-in. meter is assigned a factor of 2.9, indicating the relativedifference in cost incurred by the utility to buy, install, and service this meter ascompared to a 5⁄8-in. meter. For purposes of this example, it is assumed thatbilling-and-collecting costs do not vary substantially from smaller to larger customeraccounts, and all accounts are billed at a uniform rate of $1.9924/bill/month.

Application of the equivalent meter-and-service ratio to the unit meter-and-serv-ice cost results in the total meter-and-service cost portion of the service charge. In thecase of the 2-in. meter, a ratio of 2.9 is applied to the unit cost of $2.2294, and a totalcost of $6.47 is determined, as shown in column 3. A billing-and-collecting cost of$1.99 is added to the meter-and-service cost of $6.47 to derive the total 2-in. servicecharge of $8.46, which is rounded to $8.45.

Similar determinations would be made for each meter size to determine the totalservice charge. Service charges for outside-city retail service would be developed in amanner similar to that used for inside-city retail service, except that outside-city unitcosts would be substituted for inside-city unit costs.

Once the service charge is established for each meter size, the charge can beapplied to the total number of customer-class bills to determine total service-chargerevenue for each customer class. Total service-charge revenue by class is consideredsubsequently in conjunction with customer-class revenues from volume-relatedcharges to verify that total water charges generally recover allocated costs of servicefrom each customer class.

Block-Rate DesignBlock rates provide a means of recovering costs for general service classes ofresidential, commercial, and industrial users under a single rate schedule byrecognizing the differing water-use and associated cost characteristics for each classof service. The blocks that ultimately control the charges for any particular systemshould be designed on the basis of customer-class water-use information derived fromhistorical billing records for that system. As previously discussed, billing informationis tabulated by customer class to establish quantity of usage and number of billsrendered at various usage levels. The results of the bill tabulation are thengraphically depicted for each customer class in the form of curves to allow selection ofappropriate usage blocks. The curves depicted in Figure 4-1 are used in this exampleof rate design and express levels of monthly water use by retail customer classes.Comparison of individual customer-class curves reveals the distinct differences in theuse patterns of the classes of customers. These patterns afford a basis for design of arate structure, through proper selection of usage blocks, under which revenues can bederived in accordance with the cost responsibility of each class.

An example of rate-block selection is indicated at the top of Figure 4-1.Examination of the figure indicates that an initial block of 15 thou. gal would includea large portion of the total residential use but relatively little commercial orindustrial water use. Accordingly, most residential costs of service would need to berecovered in this first block, and water-use and cost characteristics of this type ofservice would serve as the predominant basis for the design of rates for the initialblock.

The next 1485 thou. gal, beyond 15 and up to and including 1500 thou. gal,would include a major part of the total commercial water use and only a small portionof industrial water use. The rate for this block would need to be adequate to recovera large part of the costs of providing commercial service. Water-use and related

40 WATER RATES


demand cost characteristics of commercial customer service would be included in thebasis of design of the rate. Figure 4-1 indicates that a final block, including water useover 1500 thou. gal/month, would encompass essentially all the industrial service andthe use by commercial customers not covered in earlier blocks. Accordingly, rates forthis block would be designed to recover primarily the industrial-class costs of service,based principally on the cost characteristics associated with industrial service.

In addition to providing a basis for the initial selection of appropriate limits forblock rates, information in Figure 4-1 also affords a means of estimating revenuesthat would be derived from each class of service for any particular schedule of blocksand rates. Such curves provide a basic tool for use in testing whether or not proposedrates derive revenues from the various customer classes in accordance with therespective class costs of providing service.

After selection of the usage blocks, the next step becomes one of designing anappropriate schedule of block rates. The design of a water-rate schedule that requireseach customer class to pay its full cost of service takes into consideration unit costsapplicable to the level of service rendered. Unit costs for each major component ofservice associated with water usage of base cost and maximum-day and maximum-hour extra capacity costs are developed in Table 3-3. Recognition of the degree towhich each component is involved in providing the level of service rendered providesa basis for design of a schedule of rates.

Table 4-2 shows the derivation of the typical costs per thousand gallons forinside-city service, including the elements of base cost and maximum-day andmaximum-hour extra capacity costs. The total cost for each block reflects the costcharacteristics of the predominant class of water use that occurs within the respectiveblocks.

The base cost per thousand gallons by water-usage block is shown in column 2.Base cost, by definition, is the cost for constant, uniform, or perfect load-factor use,and the unit cost is the same for all levels of use or classes of inside-city service.Accordingly, the variation in the total cost per thousand gallons between levels ofusage reflects solely the difference in extra capacity requirements for classes ofservice representative of the various levels of use.

The first 15-thou.-gal-per-month block includes 94 percent of the residential use,15 percent of the total commercial use, and practically no industrial use. Accordingly,the maximum-day and maximum-hour capacity factors in excess of average-day use

Table 4-2 Derivation of Typical Inside-City Cost per Thousand Gallons by Water-Use Blocks(Test Year)

(1) (2) (3) (4) (5) (6) (7)Extra Extra

Water-Use Capacity Factor Extra Capacity Factor ExtraBlock in Excess of Capacity in Excess of Capacity

Line thou. Base Cost Average Day Cost* Maximum Day Cost† Total Cost‡No. gal/month $/thou. gal % $/thou. gal % $/thou. gal $/thou. gal

1 First 15 0.5742 150 0.2763 150 0.1143 0.96482 Next 1485 0.5742 100 0.1842 125 0.0952 0.85363 Over 1500 0.5742 50 0.0921 50 0.0381 0.7044

*Based on maximum-day extra capacity unit cost of $67.2394 /year/thou. gpd divided by 365 days/year (or $0.1842/thou.gal) applied to the extra capacity factor shown in column 3. †Based on a maximum-hour extra capacity unit cost of $27.8065/year/thou. gpd divided by 365 days/year (or $0.0762/thou.gal) applied to the extra capacity factor shown in column 5. ‡Total cost per thou. gal is equal to sum of values shown in columns 2, 4, and 6.



for the block are shown on line 1 in columns 3 and 5 and are representative ofresidential service.

The next 1485-thou.-gal-per-month block is predominantly a commercial-classblock. Therefore, the extra capacity factors on line 2 of Table 4-2 used in developmentof the average cost for water use in this block principally reflect commercial-servicecharacteristics.

The last block of over 1500 thou. gal/month includes primarily industrial wateruse. Accordingly, the extra capacity factors listed on line 3 in the derivation of theaverage costs for the last block of the rate schedule are considered representative oflarge-volume customer water-use characteristics.

The resulting total costs per thousand gallons are derived in column 7 by addingcosts developed in columns 2, 4, and 6 and provide an initial basis for selection ofpotential rates. The costs indicate that for monthly water use a schedule of rates forinside-city service of $0.96, $0.85, and $0.70 per thousand gallons, respectively, foreach of the three blocks might be proposed. However, the designed rates are subjectto further testing to determine if revenues of each class meet costs of service. Costsfor outside-city service would be developed in a similar manner, using customer-classcharacteristics and unit costs appropriate for those customer classes.

For the purpose of simplicity in illustration, the development of total costs perthousand gallons developed in Table 4-2 is based on a single set of water-usecharacteristics selected as a representative composite of all customer use within eachblock. Actually, the amount and characteristics of use will vary among customerswithin each block. Detailed design studies would involve examination of the costs fora range in both amount and characteristics of water use for various potential userswithin each block and might indicate the selection of extra capacity factors thatreflect a combination of factors from more than one class.

Actual rate-design practice would also recognize that because of the relativelyhigh capacity factors associated with water use in the initial rate blocks, charges inthese blocks may recover costs in excess of the requirements representative of usuallybetter load-factor users in subsequent rate blocks. The calculated charges forsubsequent rate blocks may need to be adjusted downward to recognize costsrecovered in prior blocks.

In this example, the rate applicable to wholesale service is derived simply bydividing the total allocated cost of service of $262,200 from Table 3-5 by the totalannual use of 230,000 thou. gal, resulting in a uniform volume rate of $1.14/thou. gal.Declining-block rates are usually not appropriate for wholesale service becauselarge-use wholesale customers do not necessarily have more favorable peaking factorsthan do small wholesale users. In other words, quantity of use is no indication of loadcharacteristics for this type of customer.

The calculated rates should be tested by application to customer-class waterusage to determine if revenues will be derived from each class in accordance with thecost of service. At this point in the development of the rate schedule, comparison ofrevenue using designed rates with costs of service by customer class may indicatethat designed rates may not adequately recover costs of service from one or morecustomer classes while recovering more than cost from other classes. Selection ofslightly different rate blocks or redesign of rates for selected blocks using modifiedexcess capacity factors may be warranted in order to more closely recover totalallocated costs of service. Normally, if designed rates recover total system costs ofservice and individual customer-class costs of service to within 2 to 3 percent, therates may be considered adequate.

42 WATER RATES


Table 4-3 shows a test for the rate schedule developed for all classes of service.It is noted that final block rates designed for inside-city service are slightly differentthan reflected in the initial schedule of rates developed in Table 4-2 in order to moreclosely recover total customer-class costs of service.

Columns 1 through 3 present the development of the total annual water use byrate blocks for each class of service. The percent of use by rate blocks shown incolumn 2 is derived from the customer-class curves presented in Figure 4-1.Application of these percentages to the total average annual class for the rate yearresults in the projected water use by block shown in column 3. The resulting revenuesunder proposed rates after application of the proposed schedule of charges to waterusage in each block is shown in column 5. The costs of service by customer classdeveloped in Table 3-5 appear in column 6. The revenues, expressed as a percentageof costs and shown in column 7, indicate that the proposed schedule of rates derivesrevenues from all customer classes in accordance with the costs of providing service.Indicated deviations from allocated costs for all classes are less than 2 percent andare well within practical design allowances. Service charge revenues, also shown inthe table, are derived by applying designed service charges by meter size to the totalprojected average test-year number of bills rendered by meter size to each customerclass.

Table 4-3 Summary of Customer Water Use by Rate Block and Application of Proposed Rates(Test Year)

(1) (2) (3) (4) (5) (6) (7)Revenue as

Revenue Under Allocated a PercentMonthly Percent Annual Proposed Proposed Cost of of Cost

Line Usage Block of Use Water Use Rates Rates Service of Service No. Customer Class thou. gal % thou. gal $/thou. gal $ $ %

Inside-City: 1 Residential Service charge 785,300 2 First 15 94.0 909,900 0.97 882,600 3 Next 1485 6.0 58,100 0.86 50,000 4 Over 1500 0.68 0______ _________ _________ 5 Total 100.0 968,000 1,717,900 1,722,800 99.7

6 Commercial Service charge 76,100 7 First 15 15.0 71,000 0.97 68,900 8 Next 1485 79.0 373,700 0.86 321,400 9 Over 1500 6.0 28,400 0.68 19,300______ _________ _________10 Total 100.0 473,100 485,700 479,900 101.2

11 Industrial Service charge 7,50012 First 15 0.2 2,200 0.97 2,10013 Next 1485 13.8 151,100 0.86 129,90014 Over 1500 86.0 941,700 0.68 640,400_________ _________15 Total 1,095,000 779,900 778,900 100.116 Public fire-protection-service annual charge

—1155 hydrants @ $222 per hydrant 256,400 256,200 100.1

Outside-City:17 Wholesale Service charge 1,20018 All usage 100.0 230,000 1.14 262,200_________

263,400 262,200 100.5_________ __________ ______19 Total 3,503,300 3,500,000 100.1



In practice, the development of rates that result in revenue meeting costs withinlimits indicated in the illustration may involve adjustments to the number of rateblocks, usage allowances in each of the various blocks, and the individual block rateswithin the schedule. It should be recognized that satisfactory results on a first-trybasis would be a marked oversimplification of the problems usually involved in thedevelopment of an appropriate schedule of rates.

Rate Design for Fire-Protection ServiceIn the cost-of-service allocations, fire-protection service has been included as a classof service separate from regular retail service customers. Fire protection, like anyother class of service, imposes on the utility certain demands and facilityrequirements with associated costs, and charges can be designed to recover costs forthis service. The costs distributed to fire-protection service in Table 3-5 include extracapacity costs associated with potential demands on the system by publicfire-protection requirements and direct costs related to investment in, and mainte-nance of, public fire hydrants.

In this example, public fire-protection-service charges are stated simply as a costper hydrant. Based on an allocated cost of service of $256,200 and 1155 fire hydrants,an annual hydrant charge of $222 would be assessed to the proper authority. Revenueunder proposed rates for public fire protection is summarized in Table 4-3.

Minimum-Bill DesignRather than utilizing a service charge that allows no water use, an alternativeminimum charge that provides a customer with some volume of water for the chargemay be designed as a part of the rate schedule. The initial block may be designed torecover customer costs and costs associated with use and capacity requirements of thesmallest users. The remaining blocks are designed in the same manner shownpreviously to recover costs beyond those of the smallest users.

Table 4-4 presents the design of the minimum monthly charge for an inside-cityretail customer with a 2-in. meter. The total customer-cost component of theminimum charge is derived in the same manner presented for the development ofservice charges shown in Table 4-1 and is shown in lines 1 and 2 of Table 4-4. Costsfor quantity of water use and capacity requirements are also recognized, and it isassumed the minimum bill would allow 1 thou. gal of water usage per month.Examination of the customer-class usage curves presented in Figure 4-1 indicatesthat this block encompasses approximately 10 percent of the total residential use, lessthan 3 percent of the total commercial use, and only a very small percentage ofindustrial use. For the example, the maximum-day and maximum-hour extracapacity factors in excess of average day of 150 and 150, respectively, are assumed tobe representative of residential customers and are used to design the minimumcharge.

Application of the base and extra capacity unit costs of service to the assumedminimum-user conditions is shown in lines 4 through 6 of Table 4-4. The resultingtotal base costs of $0.57, maximum-day extra capacity costs of $0.28, andmaximum-hour extra capacity costs of $0.11, together with customer costs, representa total cost of $9.42 for the minimum allowed usage of 1 thou. gal. This mayreasonably be rounded to $9.40.

The design of rates for water use in blocks beyond the minimum would includerecovery of costs associated with the requirements of the larger residential,commercial, and industrial customers. The design of a rate for each block would bemade in the same general manner discussed previously.

44 WATER RATES


Base–Extra Capacity Versus Commodity–DemandRate DesignThe design of rates in the foregoing example is based on cost allocations made inaccordance with the base–extra capacity method. Similar computations would also bemade in designing rates using allocations based on the commodity–demand method.

The use of costs derived by either the commodity–demand or the base–extracapacity method as a basis for rate design will result in comparable charges if allelements of cost are properly treated. As previously discussed, the base–extracapacity method directly identifies through the base-cost element the minimum unitcost of service after recovery of customer cost, and this would ordinarily be applicableonly if perfect load-factor use could be achieved. The unit base cost provides ameasure of the lowest potential rate in a schedule of rates for firm service, animportant guide in preventing possible establishment of rates that could result in thesale of water by the utility at below cost.

The principal difference between the commodity–demand method and thebase–extra capacity method of cost allocation is in the effect of system diversity oncost. This difference may be illustrated by considering the allocation of costs to aperfect, or uniform, load-factor customer. Such a customer, exercising a constantdemand 100 percent of the time, does not contribute to diversity in peak-demandrequirements and should not receive benefits in cost that result from such diversity.In the commodity–demand cost method, the demand costs are allocated among userson the basis of their total diversified peak demands. Accordingly, the perfectload-factor customer is assigned a portion of the diverse peak-demand costs, thusreceiving the benefits of system diversity of peak-demand requirements.

In the base–extra capacity cost method, the perfect load-factor customer isassigned only base cost, which is allocated among customers on an average,

Table 4-4 Design of Inside-City Minimum Monthly Bill for 2-in. Meter (Test Year)

Line Monthly CostNo. 2-in. Meter

Customer Costs:1 Meter-and-service-related costs ($2.2294/meter) × 2.9 equivalent

meter-and-service ratio $6.472 Billing-and-collecting-related costs 1.99

3 Assume 1.0 thou. gal monthly allowance, 150% maximum-day extra capacity factor, and 150% maximum-hour extra capacity in excess of maximum day

Base Costs: @ $0.5742/thou. gal4 $0.5742/thou. gal × 1.0 thou. gal 0.57

Extra Capacity Costs:5 Maximum day @ 67.2394/year/thou. gpd = $0.1842 per thou. gal

$0.1842/thou. gal × 1.5 extra capacity factor × 1.0 thou. gal 0.286 Maximum hour @ 27.8065/year/thou. gpd = $0.0762 per thou. gal

$0.0762/thou. gal × 1.5 extra capacity factor × 1.0 thou. gal 0.11_____7 Total minimum charge for 1.0 thou. gal allowance 9.428 Rounded $9.40



nondiversified-use basis. Such a customer is then assigned the full cost incurred inproviding his or her share of the nondiversified system load.

The effect of the difference in the handling of system diversity in the twomethods of cost allocation may be further illustrated by examining the allocation ofcosts to the opposite type of use by the totally standby customer. In thecommodity–demand method, the potential demand of such a customer would be apart of the total diversified-system peak demand, the same as the demand of theperfect load-factor customer. The totally standby customer would share in the benefitsin cost that result from diverse use only to the same extent as the perfect load-factorcustomer, who does not contribute to diversity of peaking water use. In the base–extracapacity method, the totally standby customers would only be assigned extra capacitycost, which is allocated among customers on the basis of the diversified extrademands created by only those customers contributing to the system diversity of peakwater use. The base–extra capacity method provides a better means of cost allocationby recognizing the customer contribution to diversity in system peak water use.

The conditions of a perfect load-factor customer and a totally standby customerillustrate the maximum differences in the two cost-allocation methods. The degree ofdifference in the cost allocations reduces progressively as requirements of thecustomer approach the total-system average requirements. Consequently, for manyutilities the degree of difference will not be large by using either the commodity–de-mand or the base–extra capacity cost method.

OTHER RATE-DESIGN CONSIDERATIONS _____________________Preceding portions of this chapter presented general considerations regarding thedesign of rates, recognizing traditional factors and rate forms, and included anexample illustrating the derivation of cost-of-service rates in the form of a servicecharge and block-rate schedule. The remainder of this chapter describes otherwater-pricing practices through discussions of alternative water-rate forms. It isemphasized that these discussions are meant to be quite general. Considerations inspecific situations may dictate procedures and influences quite different from thosedescribed herein. In every case, rate making must be based on reasonableness underspecific conditions prevailing in the affected utility.

American Water Works Association policy provides that water rates be developedin accordance with sound economic and engineering judgment and cost-of-serviceprinciples. In instances where the disparity between the existing level of charges andcost-based rates is great, a gradual movement toward cost-based rates is acceptable tomoderate the impact of the change in rates on affected customers. In addition,departure from full cost-of-service approaches may be required in order to addressspecial social, environmental, or other considerations as dictated by legal orpolicy-making bodies.

Discussion of both cost-based and non-cost-based rate forms is included in thissection. Departure from rates based on cost of service is not recommended by theAWWA Water Rates and Charges Subcommittee. It is, therefore, suggested that ifdeviation from cost-of-service concepts is to be considered, the consequences of suchapproaches should be brought out so that there is full knowledge and understandingof the effects of such a decision.

General InformationIt is characteristic of the development of utility rates, including water rates, thatwhen the average costs of serving customers are relatively low, systems of charges are

46 WATER RATES


justifiably simple. Rapidly increasing costs have generally prompted additionalattention to equitability in the development of utility charges. At the same time thatutilities are facing higher costs, there has been recent emphasis by certain groups forrecognition of socioeconomic, environmental, and other considerations in thedevelopment of rates, considerations that may not be directly related to the utility’scost of providing service.

The philosophy of water utility rate determination has undergone dramaticchanges over the past century. At the turn of the century, flat-rate (unmetered)charges that gave little recognition to the amount of service provided a givencustomer were utilized for most water customers. With the development of the watermeter in the early 1900s, many water utilities adopted volume-related block-ratestructures to better recognize customer-service requirements and the associatedresponsibility for costs. More recently, water utilities have been considering other ratestructures, including those that try to recognize peak responsibilities in a moresophisticated manner. Rates designed to charge customers for the peak or seasonaldemand that they place on a system may be viewed as simply a normal evolution inthe increased sophistication in structuring rates to more equitably recover costs fromthose individual customers creating them.

To recover water utility costs of service from customer classes, severalalternative rate forms can be utilized, such as commodity–demand rates, seasonalexcess-use charges, other forms of seasonal rates, and uniform volume charges bycustomer class. Some rate forms, such as commodity–demand rates, are theoreticallybetter than others in recognizing individual customer requirements that deviate fromthe customer-class average requirements, but these rate forms have their practicaldrawbacks. Other rate forms, such as uniform rates for all customers, inverted blockrates, lifeline rates, and other special rate forms, although not necessarily consistentwith the cost-of-service concept, still may need to be considered for particular legal orpolicy reasons. The remainder of this section discusses, to a limited extent, these rateforms and other considerations that generally affect the selection and development ofrates designed to recover total costs. It is noted that the AWWA Rates and ChargesSubcommittee is developing a separate manual to provide a more complete discussionof alternative rate methodologies and forms than is provided in this manual.

Uniform Rate by Customer ClassThe majority of investor-owned and government-owned water systems in the UnitedStates today provide water service to all general-service customers under a singledeclining-block rate schedule. This practice is quite distinct from electric and gasutilities, which often provide service to different customer classes under separate rateschedules. One advantage of providing for separate rate schedules by customer classis that each schedule can be designed based on the demand, use, and othercharacteristics of the customer class using a single rate for all customers in the class.Such schedules require up-to-date identification and classification of individualcustomers into rate classes having common characteristics. A list of such rate classesmight include single-family residential, multifamily residential, commercial, indus-trial, public authority, and resale or wholesale. Separate rates for each class maycomplicate rate administration and cost and perhaps enhance the chances ofcontroversy.

Many public water systems have separate rates for retail customers residingoutside the jurisdictional limits. In some instances, the same customer classificationsmight be used for retail service both inside and outside of the city. An initial step in



considering separate rate schedules for outside-city customers is the practicability,identification, and classification of customers by customer classes.

Where uniform rates by customer class are to be designed, they may basically bedeveloped by dividing allocated class costs of service, less customer costs, by projectedclass water use.

Seasonal RatesIn most water systems, the peak demand for water service occurs in the summertime,when lawn irrigation and other outdoor water uses are more prevalent. This fact hasgiven rise to consideration of seasonal rates, whereby higher rates are charged forwater used in the summer, or peak season, than for the non-peaking portion of theyear. Seasonal rates have received greater attention the last several years due, inpart, to localized water shortages. In addition, the recognition of peaking require-ments as a significant element of cost has opened the way to seasonal rates.

There are several types of seasonal water rates. The simplest type is merely tocharge a higher unit price for water used in the summer than for water used the restof the year. A more sophisticated method is to develop a system of excess-use charges.Excess-use charges are characterized by having one schedule of charges forwinter-season level of use, with an additional charge for use in excess of the baseamount during a peak water-using period. Excess use is usually determined from theusage patterns of individual customers. The added charge is developed from ananalysis of costs during peak and off-peak periods. For example, if a customer’saverage monthly usage during the winter period is 10,000 gal and usage during agiven month during the summer period is 25,000 gal, then the excess above-averagewinter-period monthly use of 15,000 gal would be charged at a higher rate than therate for the first 10,000 gal, which would be at the lower winter rate.

One consideration in developing excess-use charges is the determination of asuitable definition for excess use. In the broadest sense, excess use is that volume ofuse over a given period of time that exceeds some base figure. As a practical matter,excess use must be related to the period of time in which the volume of use can bemeasured in order to establish a sound basis for establishing excess usage. Thedefinition of excess use selected will affect the magnitude of both the rate of chargefor excess use and the base rate of charge (that is, the charge for off-peak usage).Before adopting any one definition of excess use, the potential quantitative andsubjective impacts should be carefully considered. Particular emphasis should beplaced on practicality of application, customer understanding, and potential adminis-trative constraints and added costs related to metering, billing, and data processing.

One beneficial aspect of an excess-use charge, even though it is a moresophisticated form of charge, is that it does tend to result in a more equitable bearingof costs by individual customers of the system. The costs incurred in meeting peakingrequirements can be derived from among those customers using the extra capacity,while customers exerting relatively uniform requirements on the system bear only thecosts related to such service. Each water system should consider seasonal rates ontheir individual merits after first determining the objectives to be accomplishedthrough such rates.

There are a number of unknowns regarding the effect of seasonal rates on peaksystem demands. Further experience and study are needed to determine whether ornot and to what extent such rates do, in fact, moderate peak demands.

48 WATER RATES


Commodity–Demand Type RatesCommodity–demand rates. A commodity–demand rate can be developed for

water service whereby the total charge consists of a customer charge to generallyrecover metering, billing, and collection costs; a commodity charge based on the totalvolume of water used; and a demand charge based on the maximum rate of water use.

The commodity-charge portion of the rate usually takes the form of a uniformrate. The demand charge is based on a customer’s peak load imposed on the watersystem. If it were possible to meter and measure each customer’s volume-use andmaximum-demand units of water service, it would be a relatively simple matter toapply the cost-of-service unit costs to customer-service requirements to determineeach customer’s cost responsibility.

Commodity–demand rates offer a sound means of recovering the costs ofproviding service to those customers with water-use characteristics that varysignificantly from the class average. However, where demand rates are used, arecording metering device must be installed to record both volume of use and themaximum rate of flow.

Although the commodity–demand form of rate is, in many respects, moreequitable for all concerned, its application is not practical because demand meters, tothe limited extent to which they are available, are relatively expensive to install andmaintain, and benefits generally do not justify the added costs. As a result,commodity–demand rates are not commonly used in the water industry today.Generally, they are applicable only for large wholesale and industrial users where itis cost-effective to meter both total use and rate of demand.

Peak-load pricing rates. Peak-load pricing and commodity–demand pricingare similar in that each method consists of a multiple-part rate structure in whichcharges are based on both the quantity of water used and the maximum rate at whichit is used. However, peak-load pricing may recognize two types of demand: (1)customer’s demand that is coincidental with the system peak demand, and (2)customer’s noncoincidental demands (each of these demands are priced separately).Although this method of pricing for variations in the load factor overcomes some ofthe objection to demand pricing based on maximum noncoincidental demand only, itstill requires the installation of expensive demand meters, and its administration isapt to be complex and costly.

Off-peak rates. Off-peak rates for delivery of utility service are common in theelectric utility industry and are occasionally considered in the water utility industry.Where used, separate rates or rates lower than average are applied to water deliveredduring off-peak periods. Such deliveries may be advantageous to a water utilitywhereby the overall system load factor is improved. As a practical matter, outside ofpossible industrial application, it has been found that few customers considerworthwhile the potential savings that may result from limiting their use to theoff-peak service and the potentially lower rates related thereto.

Marginal Cost RatesMarginal cost is usually defined as the cost of water from the most recent or nextincrement of plant capacity and supply. Some economists assert that the price ofwater should reflect the marginal cost. Thus, if a water utility needed to develop anew source of supply at considerable expense, the charge for all water sold shouldreflect that cost even though the average could be less. The contention is that onlythrough such pricing is the customer given the proper signal as to the true price of



water and the opportunity to make an economic decision concerning his or her desirefor additional service.

Although the economic theory behind marginal cost pricing is sound, theapplication of the theory to water rates lacks considerable practicality. Pricing allwater at the marginal cost could result in the collection of revenue from customersconsiderably in excess of current needs. It has been suggested by some that suchexcess revenues should be utilized to lower rates to customers whose use is relativelyinelastic, such as low-use customers. Marginal cost rates have some value in theory,but their practical applicability needs to be thoroughly studied before adoption.

Inverted-Block RatesThe inverted- or increasing-block rate structure is the counterpart to declining-blockrates. Under such rates, the unit price rises with each successive block, resulting inboth the incremental and average cost of water increasing with increased customerusage.

The use of inverted rates is a relatively recent development in water pricing.The concept of an increasing price per unit of use frequently arises from the desire forconservation in total water use. Increased concern for conservation of resources hasled to limited acceptance of inverted rates in several areas, particularly those facingimmediate and recognizable water supply problems.

It is not possible to design each rate step in an inverted rate schedule based onthe results of a traditional cost-of-service study. In the traditional cost-of-servicestudy, customers are allocated cost responsibility based, in part, on their demand forextra capacity. Declining-block rates are used to recognize that the average cost ofwater decreases with the volume used, due to improved peaking factors. Inverted-block rates, which charge a higher price for water as usage increases, do not recognizethe generally better load factors of the large-use customers.

It is possible to use some elements of a cost-of-service study as a guide in thedesign of inverted rates. For example, for the residential class, high irrigation useduring the summer season is generally a cause indicative of a poor load factor. Apeak-use-period inverted-block rate schedule could function to charge for such peakuse.

Inverted rate schedules would not likely be appropriate for all customer classes.Some large-volume commercial and industrial customers have very uniform water-use patterns with a resultant lower unit cost of service than residential customers.

A very practical objection to inverted rates is that higher use per customer doesnot necessarily indicate a higher cost per unit of use. Thus, only in specialcircumstances could inverted rates be considered as cost-of-service related. Suchcircumstances should be documented and carefully evaluated before inverted ratesare proposed.

Uniform RateThe uniform rate is a constant unit price for water, regardless of the amount used,and is applicable to all customers served. A uniform rate for all customers impliesthat each unit of water costs the same. The same rate is paid by all users, irrespectiveof user class, amount of water use, patterns of water use, or size of meter and service.Since the rate is generally established by dividing total anticipated costs by totalanticipated water sales, it is easy to understand and administer.

This type of rate may be appropriate where the predominance of watercustomers have similar water-use characteristics and, consequently, there is little

50 WATER RATES


need for more than a single charge. For example, a uniform rate might be appropriatein a suburban community with generally similar residential use only.

Unmetered or Flat RatesFlat rates refer to charges utilized where customer use is not metered. Such rates areapplied to certain measures of customer service, such as the number of rooms, thenumber of plumbing fixtures, the size of irrigated areas, and other such elements.Such rates have been common in the past and continue to be used in some waterutilities. In specific instances where water conservation is not a significantconsideration and the installation of meters is impractical, such rates can be designedto generally recover estimated costs of service, but they may contribute to excessiveuse of water with attendant higher total costs.

Lifeline RatesConsumer-advocate groups sometimes propose programs to reduce utility charges forresidential customers who are senior citizens, poor, or on fixed incomes. Suchassistance is often described by the single category of lifeline rates.

Lifeline rates seek to assure that each qualifying customer may obtain his or hertheoretically minimum requirements for service at a lower-than-cost rate. Revenuesnot recovered from this minimum-usage allowance would need to be recovered byincreasing the rates charged for use above the minimum, increasing the rates chargedto other customers, or relying on revenue from other sources, such as general taxrevenues. The lifeline concept of rate design is frequently proposed as an aid toeconomically disadvantaged and elderly residential customers who might not be ableto pay their bills.

Proponents of lifeline rates argue that (1) such rates are easy to understand andto implement and require no additional tax revenues; (2) the inverted form of rate willencourage conservation, since lifeline rates provide favorable rates for minimal“conservative” use and increasing rates for greater use; and (3) the poor and elderly,who are thought to be the low-use customers, will be the chief beneficiaries.

Opponents of lifeline rates argue that the concept is essentially similar to asingle schedule of inverted rates and has serious drawbacks. The first problem is thatproviding reduced rates to low-volume residential users can discriminate unfairlywithin a class of customers being provided essentially similar service. The subsidizingof one part of a class of customers by other classes of customers may be ruledunlawful discrimination except in those states that have enacted laws supporting thelifeline concept. In addition, a correlation between water use and income levelgenerally has not been proven to exist. Consequently, lifeline rates may, in fact,unduly benefit customers who have low water-use requirements but who have theability to pay for their full cost of service.

Extensive discussion of the theory and practice of lifeline rates is beyond thescope of this manual. The institution of lifeline rates, which are not based oncost-of-service principles, should not be advocated by those responsible for ratedesign, except where legislative authority mandates such a policy. In the absence ofsuch direction, rates should be based on nondiscriminatory cost-of-service principles.

Water Connection ChargesMany water systems require a connection charge for a new customer joining thesystem. The water connection charge is frequently based on a capital contribution bythe customer for the purpose of financing initial capital investment attributable to the



new service. Such charges can be valid, but are not considered as water rates in theordinary sense of the term. Therefore, the concept is beyond the scope of this manual,which addresses general water-service rates. To the extent that such charges areused, development of appropriate charges should proportionately recover the costsincurred by the utility in providing the water service connection.

Other ConsiderationsThe reader is referred to AWWA Manual M26, Water Rates and Related Charges, forfurther discussion of the rate and charge matters set forth in this manual.

Each water utility should maintain adequate records to provide for periodic ratedesign. These include individual customer billing records for which a history of atleast one fiscal year should be maintained. The billing records should be maintainedso that they can be used to develop a bill-frequency tabulation (an example of whichis shown in the appendix). Such records provide information as to the quantity ofwater sold at various levels of use and are used for rate-block design.

In addition, accurate records of total daily raw- and treated-water produced aswell as maximum-day and maximum-hour production at water treatment and majorbooster pumping facilities should be maintained so that they can be used to develop abill-frequency tabulation (an example of which is shown in the appendix). Suchrecords provide information as to the quantity of water sold at various levels of useand are used for rate-block design.

Each utility should also maintain a careful record of all expenditures, includingclassified cost data regarding investment in the physical plant and equipment.Suggested accounting practices are set forth in the AWWA publication Water UtilityAccounting (2nd ed., 1980). The information in this publication is not only vital for arate-design study but is useful as a management tool.

52 WATER RATES


AWWA MANUAL

Chapter 5

Rate Design for SmallWater Utilities

The allocation of the total cost of service to cost functions and the design of waterrates to recover these costs using the somewhat complex techniques described inearlier chapters of this manual requires information not always available to smallwater utilities. Also, the cost of preparing relatively detailed studies may not bejustified for a small utility. As the term is used in this chapter, a small utility maygenerally be defined as one having fewer than about 5000 customers. The purpose ofthis chapter is to provide a simplified cost-based method for the preparation of ratesfor a small utility.

Use of the small-utility method, or simplified method, of rate design described inthis chapter may be considered when the estimated cost of preparing a fullrate-design study exceeds approximately 5 percent of the utility’s annual revenue.However, if a utility has substantial industrial or other special sales, it may beprudent to conduct a full study, even if the cost exceeds 5 percent of the revenue or ifthe utility is facing significant changes in costs. Such a study can demonstrate thechanges in costs and how those costs can be reflected in rates. Generally, thesimplified method is most appropriate for small water utilities with customers whoare either mostly or entirely residential with a few commercial users, and who haveno significant industrial or other special-use customers.

It should be noted that many of the elements of a rate study presented inchapters 1 through 4 provide the background for suggested rate-making procedurespresented in this chapter and should be reviewed and used as appropriate.

53


54 WATER RATES

INFORMATION AND DATA REQUIREMENTSSmall water utility data requirements for determining cost-of-service rates are quitesimilar to those required for larger water utilities. The following information, as aminimum, is required to develop the simplified rate design described in this chapter:

1. The revenue requirements of the water utility for the projected rate period insufficient detail to permit allocation to cost categories.

2. A bill-frequency analysis of metered water use by customer class and metersize.

3. The number and size of meters by customer class.

REVENUE REQUIREMENTSDevelopment of revenue requirements to reflect annual cash needs of the utility is thefirst step in the development of rates and maybe incorporated as an extension of cashbudgeting and accounting techniques practiced by most utilities. The objective ofdeveloping revenue requirements is to determine the cash needs and general timingof utility expenditures in order that adequate funds may be made available asrequirements come due. Basic revenue requirements of a small government-ownedutility would normally include operation-and-maintenance (O&M) expense, debtservice on borrowed funds, allowances for normal annual repairs and replacement ofexisting facilities, possibly some small capital additions to the system, and other cashrequirements for items such as payment in lieu of taxes and payments for servicesprovided to the utility by other municipal departments.

Revenue requirements for investor-owned utilities would include provisions forO&M expense, depreciation expense, income and property taxes, and return on ratebase.

In order to minimize potential cash-flow shortages during the period rates are tobe effective, a “forward-looking,” or prospective, rate year should be used indeveloping revenue requirements. Projections of anticipated expenditures based onhistorical expense trends of anticipated growth in sales of water and of potentialincreases in costs of materials, supplies, and labor would be made for one or moreyears in the future. Recognition of factors such as the effect of inflation and growth onexpenses will reduce the need for frequent rate adjustments likely to be needed if ahistorical test year is used as the sole basis for establishing revenue requirements.This is particularly true in periods of rapid inflation since the current and projectedcosts being incurred by the utility will generally exceed those incurred in the past.This procedure has been used frequently by government-owned utilities, and it isgaining increasing acceptance by state commissions regulating investor-ownedutilities. Chapter 1 presents a more comprehensive presentation of the developmentof revenue requirements on the cash-needs basis, including provisions for recognizingcost escalation.

As mentioned previously, revenue requirements must be identified in sufficientdetail to permit development of cost-of-service rates. Generally, utility costs for O&Mwould be identified in accordance with specific operational areas or cost centers of theutility. Costs might be separated to include costs of O&M for source of supply,treatment, pumping, transmission and distribution; costs of customer metering,billing, and collecting; and costs of general administration. In addition, separateidentification of power-related expense for treatment and distribution pumping aswell as treatment-related chemical expense is recommended. Investment in utilityplant and equipment should also be separated, based on operational areas, to theextent available.


RATE DESIGN FOR SMALL UTILITIES 55

Functional Cost-Allocation ComponentsIn any utility, service provided to customers must include provision for meetingaverage water-use or volume needs as well as peak-demand requirements. In order toproperly distribute revenue requirements, or costs of service, to customers inaccordance with water-service requirements, utility costs must be identified as beingrelated to particular levels of service. Costs related to levels of service provided maybe categorized as either commodity–demand, customer, or public fire-protection costs.Costs allocated to the commodity cost component include those costs that tend to varywith the quantity of water produced. Commodity costs usually include costs ofchemicals and power and other costs that increase directly with the, amount of watersupplied. In the example presented in this chapter, chemical and power costs areallocated to the commodity cost component. Other costs that may be allocated to thecommodity cost component include costs related to impounded reservoir source ofsupply and purchased water since these costs tend to vary with average daily usagerequirements.

Demand costs are associated with providing facilities to meet peak rates of useby system customers. Generally, all transmission and distribution system pumpingand all treatment, transmission, and distribution mains and storage facilities aresized to meet peak demands. Consequently, costs associated with these facilities areallocated to the demand cost component. Source of supply costs related togroundwater sources are generally sized to meet maximum-day demand. Therefore,associated costs would be allocated to the demand component. For purposes of thisexample, supply is assumed to be from groundwater sources. Consequently, relatedcosts are allocated to the demand component.

Customer costs include costs incurred to serve customers, irrespective of theamount or rate of water use. Customer costs include meter and service maintenance,meter reading, billing, and customer accounting and collection costs.

Allocation of Public Fire-Protection CostsPublic fire-protection costs are related to provision of public fire-protection servicesand are directly allocated to the public fire-protection component. It may be difficultfor small utilities to determine the full cost of public fire-protection service withoutperforming comprehensive studies.

Even though a utility may not charge its customers for public fire-protectionservice separately, a fire-protection-service cost allocation is desirable. Publicfire-service costs are primarily demand-related. An estimate of the cost to provide fireservice can be based on the results of cost-allocation studies made for other largerutilities where such information is available. In the absence of other data, anestimate can be developed using Figure 5-1. Based on the number of customersserved, the curve indicates the amount of the fire-service cost as a percentage of thetotal revenue. This curve is an adaptation of a curve developed by the Maine WaterUtilities Association, Gorham, Maine, and has been used by the Maine Public UtilitiesCommission, Augusta, Maine, as a basis for estimating the required fire-service costwhen a detailed fire-service allocation study is not feasible. The results obtained fromFigure 5-1 can be modified to reflect the results of other studies for other pertinentconsiderations as may be known. Fire-service costs derived from the figure may beconsidered to be the cost of service for public fire protection.

— — —


56 WATER RATES

Figure 5-1 Percentage of total revenue allocated as fire-protection-service cost.

—



Allocation of Revenue RequirementsTable 5-1 shows the allocation of plant value to cost functions using a simplifiedversion of the commodity–demand method described in chapter 2. In the case of agovernment-owned utility, capital expense is assumed to include debt service as wellas normal annual repairs and replacement expenditures. For an investor-ownedutility, capital-related costs would include depreciation expense, income and propertytaxes, and return on rate base.

Table 5-2 presents the allocation of O&M expense to functional cost components.Cost allocations to the commodity component include pumping power and treatment-related chemical expenses. Costs allocated to the demand component include labor,materials and supplies, and other expense for O&M of source of supply, pumping,treatment, and transmission and distribution expense for mains and storagefacilities. Customer costs include expense related to services, meters, and customeraccounting and collecting. Hydrant maintenance expense is allocated to the publicfire-protection cost component. Administrative and general expenses are generallyallocated to all cost components, based on the subtotal allocation of all other O&Mexpense, excluding power and chemicals, since relatively little general administrationis required to monitor consumption of power and chemicals.

Total costs of service for the test year to be recovered from general service ratesare presented in Table 5-3. Total allocated O&M expense developed in Table 5-2 isrestated in line 2 of Table 5-3. Capital-related expenses are allocated to costcomponents, based on total allocated plant value and are shown in line 3. Total utilitycosts of service are summarized in line 4 and are offset by revenue from publicfire-protection service shown in line 5.

The revenue to be obtained from public fire-protection service is estimated fromthe curve shown in Figure 5-1. In the example, 22.5 percent of the total revenuerequirement, or $67,500, is allocated to fire-protection service based on the systemhaving 2500 customers. In line 5, fire-protection service revenues are deducted toentirely offset costs allocated to the direct fire-protection cost component, withremaining revenues deducted from costs allocated to the demand cost component inrecognition of the fact that fire service, other than hydrant expense, is predominantly

Table 5-1 Small Utilities—Allocation of Plant Value Using the Commodity–Demand Method

*Assumes groundwater source of supply.†Allocated based on overall weighted allocation of all other plant.

— . — .


58 WATER RATES

Table 5-2 Small Utilities—Allocation of O&M Expense Using the Commodity-Demand Method

*Power for pumping only.†Chemicals only.‡Allocated based on overall weighted allocation of all other expenses, excluding purchased power and chemicals.

Table 5-3 Small Utilities—Allocation of Costs of Service Using the Commodity-Demand Method(Test Year)

*Allocation on basis of allocated plant value, line 1.†Line 2 plus line 3.‡Line 4 less line 5.



related to peak rates of use. The small amount of commodity cost that might beallocable to fire service is negligible in comparison to total system water use, andtherefore, no cost is allocated to the commodity component.

Total costs of service to be recovered from general water service rates aresummarized in line 6 of Table 5-3.

RATE DESIGN

GeneralTwo types of rate structures are recommended for consideration by small waterutilities. A schedule consisting of an initial charge related to customer costs and asingle-block rate structure is best suited for water utilities with primarily residentialuse and little commercial use. Utilities with significant commercial use should use aninitial customer service charge and a two-block rate structure. Fire-service chargesshould also be considered and are discussed subsequently.

Generally speaking, water utilities serving fewer than 500 customers are likelycandidates for a single-block rate structure, whereas utilities serving from 500 to5000 customers should probably use a two-block rate structure. It should be noted,however, that many water utilities at the upper end of this range could havesignificant industrial users, and a two-block rate structure may be unduly discrimina-tory. In such a case, the preparation of the detailed studies described in earlierchapters should be considered. A comparison of average water use for residential andcommercial customers can serve as a guide to the number of rate blocks to be used. Ifthe average use of residential and commercial customers is close, a one-blockstructure can be adequate. If the average commercial use is substantially higher thanthe average residential use, by perhaps three times or more, a two-block structuremay be needed to provide equitability between the classes.

Single-Block Rate DesignIf a single-block rate structure is to be used, the entire revenue requirement lesscustomer costs will be recovered through a volumetric charge. This is calculated bydividing the revenues to be recovered by the total water sales, as shown in thefollowing example:

To recover customer costs, a service charge with no water allowance can bedeveloped. Table 5-4 demonstrates how to calculate the number of equivalent 5/8-in.meters. If the 2587 equivalent 5/8-in. meters calculated in Table 5-4 are to recover the$76,500 of customer costs calculated in Table 5-3, an annual charge of $29.57, or amonthly charge of $2.46, is indicated for an equivalent 5/8-in. meter. Development of asuitable monthly service charge for any size meter is accomplished by multiplying theappropriate equivalent meter and service ratio shown in Table 5-4 by the $2.46/monthequivalent 5/8-in. meter service charge. For example, the monthly service charge for a1½-in. meter would be 1.8 times the 5/8-in. charge, or $4.43.


60 WATER RATES

Table 5-4 Small Utilities—Equivalent 5/8-in. Meters

A minimum charge consisting of the service charge plus the volume cost of anamount of water allowed under the minimum is also acceptable. Details forcalculating minimum charges are shown in chapter 4.

Two-Block Rate DesignIf a two-block rate schedule is considered appropriate, it is necessary to establish thefirst-block water usage limit. This limit is needed in order to determine the totalvolume of water use in each rate block and to allocate the commodity and demandcosts between the first and second rate blocks.

One method for selecting rate blocks is to develop a bill-frequency analysis andprepare curves depicting the percentage of total water use by customer class and thetotal water use by the class. The appendix to this manual illustrates procedures fordeveloping a bill-frequency analysis and curves. Once the curves are prepared, theinitial usage block would be selected to include about 80 to 90 percent of residentialusage. The second usage block would include all usage beyond the first block.

In the absence of a bill-frequency analysis, a generally accepted practice is to setthe water usage limit of the first rate block so that it will include almost all of theresidential use. Generally, a first-block water usage limit of two to three times theaverage residential customer’s use is reasonable. Once established, a check of thecustomer bills for several months to determine the total use within the first blockwould be made in order to evaluate the percentage of annual water use that would bebilled at the first-block rate. All other water would then be billed at the second-blockrate. If less than a full year’s bills are analyzed, selection of bills should be for periodswhen a customer’s average water usage is not abnormally high or low, i.e., anall-winter period or an all-summer period.

The next step is the allocation of the commodity and demand costs between thetwo rate blocks. A simple approach suitable for small water utilities is as follows:

1. Allocate the commodity costs between the first and second blocks based onthe percentage of the volume of water sold in each block.

2. Allocate the demand costs between the first and second blocks based on thevolume of water sold in each block but giving twice the weight to water sales in thefirst block. This assumes that water sales in the second block have a peaking factor ofone half that of water sales in the first block, indicating a more uniform usage ofwater at higher use levels.

Commodity and demand costs allocated to each rate block are then divided bytotal estimated water sales in each block to produce the block rate for each block. Thiscalculation is illustrated in Table 5-5.



Table 5-5 Small Utilities—Allocation of Costs of Service to Rate Blocks and Calculation of WaterRates (Test Year)

If a study of the usage patterns in a particular utility indicates that apeaking-factor ratio different from that used in Table 5-5 is appropriate, then such aratio should be used in the allocation of demand costs.

Unmetered RatesProcedures for designing water rates for unmetered customers are included becausemany small water systems serve unmetered customers. In cases where the waterutility has both metered and unmetered customers, an allocation of the revenuerequirement between these types of customers must be made. For a small utility, it isan acceptable procedure to design metered rates and unmetered rates to produceabout the same average revenue per customer from similar classes of customers.Unmetered rates should potentially reflect the greater costs required to serve thesecustomers because they generally exhibit higher water use. However, the rates shouldalso reflect lower customer costs resulting from the fact that the unmeteredcustomers do not incur costs related to the increment of meter ownership andmaintenance and meter reading expense.

After determining the revenue requirements for unmetered customers, it isnecessary to design rates to produce this revenue. Because the water use is unknown,the rates must be based on estimates of such customers’ demand for water. Acommonly used basis for establishing rates of charge is the number of water-usingfixtures in the structure served. This requires an inventory or count of all the fixturesand an estimation of their demand- capability. The demand characteristics of variouswater-using fixtures is published information, but it must be remembered that as thenumber of fixtures increases, the probability of using all fixtures coincidentallydiminishes. Therefore, a customer’s first faucet is given substantially more weightand a higher charge than the balance of the customer’s fixtures. Thus, the first-faucetcharge can become the minimum charge. The first-faucet or minimum charge shouldproduce a substantial (25 to 50) percent of the total revenue requirements from thesecustomers. Additional fixtures owned by the same customers are generally assigned alower charge, which should be related to their rated capacity use.


62 WATER RATES

The following example demonstrates a method used to calculate unmetered orflat rates:

Assume the totalresidential customersrequirement is to come

test-year annual revenue requirements from 2500 flat-rateis $232,500. Assuming that 40 percent of the revenuefrom the first faucet, the first-faucet annual rate will be:

$232,500 × 40%= $37.20/year

2500 first faucets

Assuming an average of 12 fixture units per customer in excess of the firstfaucet, which indicates the relative water-demand potential of all water-usingdevices installed per customer, the rate per fixture unit would be:

$232,500 × 60%2500 × 12 = $4.65/year per fixture unit

If a fixture has a weighting of 3 due to its rate of water use, the fixture ratesfor this type of fixture would be $4.65 × 3, or $13.95/year.

Fixture rates are difficult to establish and administer because they requirefrequent fixture counts for all customers. Alternative rate-setting methods should beexplored. Family units or equivalent family units are often used as a basis forcharges. Nonresidential customers can be billed on the basis of equivalent familyunits, eliminating the need for a large number of fixture rates.

It is the general policy of the American Water Works Association that allcustomers be metered, and this simplified discussion of flat rates should not beconsidered as a waiver of the advisability of this policy.

Public Fire-Protection RatesPerhaps the simplest method for recovering fire-protection costs is on a per-hydrantbasis. This is accomplished by dividing total fire-protection costs by the total numberof hydrants. The direct per-hydrant charge would then be billed to a fire district orother governmental agency.

In some instances, the cost of public fire-protection service is collected as part ofthe basic water rates rather than through a separate charge. In this case, publicfire-protection costs of service maybe distributed to all customers benefitted by publicfire protection as an addition to the customer service charge. While there areoccasional reasons for such practice, the preferred method is to charge separately forfire-protection service.


Appendix A

AWWA MANUAL

Bill Tabulation Methodology

INTRODUCTIONThe summarization or tabulation of customer bills provides a useful basis foridentifying and analyzing customer usage patterns, selecting water-usage rate blocks,and determining utility billing revenue under any rate schedule. Tabulation ofcustomer bills and usage, commonly referred to as a bill-frequency distributionanalysis or simply a bill tabulation, may be accomplished either manually or by dataprocessing. Normally, it is best to initiate bill tabulation procedures during the earlystages of a cost-of-service rate study due to the potentially time-consuming workinvolved in summarizing billing data and in testing the completeness and accuracy ofthe results of the bill tabulation. If the utility billing system is computerized, the timerequired for the preparation of the bill tabulation may be relatively short, perhapsonly one or two weeks. The computer staff may, however, be required to developspecific programs to extract and summarize data in the form required, and delays areoften encountered because computer time is not readily available when needed. Bybeginning the bill tabulation early in the cost-of-service study, the results should beavailable to avoid delay both in the design of rates and in the evaluation of theadequacy of proposed rates to recover allocated costs of service from customer classes.

A bill tabulation shows the number of customer bills rendered at various levelsof water usage during a specified period of time for each customer class served by theutility. The tabulation of bills for a historical period provides the basis for identifyingtypical customer-class usage patterns and aids in the development of ratesrecognizing such usage patterns. Rate schedules that are intended to be applicablethroughout an entire year generally require a bill tabulation for a historical 12-monthperiod in order that annual usage patterns are properly identified. On the other hand,if a seasonal rate schedule is to be developed, separate bill tabulations would need tobe made to coincide with the periods for which each part of the seasonal rates are tobe effective. For instance, if a summer–winter seasonal rate were to be developedwith one rate applicable for usage during the 6-month summer period and another forthe 6-month winter period, the bill tabulation would need to be made in two parts soas to coincide with the summer and winter periods as defined. This permitsrecognition of customer usage patterns and variations in use between seasons.

In the example presented here, bills are tabulated for one customer class for acontinuous 12-month period. Tabulating bills for a continuous 12-month period isstrongly recommended in order to properly account for seasonal variations incustomer water-usage patterns. In addition, the selection of the 12-month period

63


64 WATER RATES

should coincide as closely as possible with the utility’s fiscal accounting period so thatthe accuracy of the bill tabulation in generating revenue can be more easilyascertained. The possibility that the period selected for study may represent a year inwhich water usage was abnormally high or low, due to climatic or other conditions,should be considered when utilizing the bill tabulation for rate-design purposes. Ifpossible, the selection of bills for tabulation should reflect a year in which averageconditions prevail.

BILL TABULATION

Bill SummarizationThe first step in tabulating customer bills is to separate billing records into customerclasses, if available, and into meter sizes. Next, a manual bill-tabulation processinvolves entering individual customer usage for each billing period on summarysheets that are separated into various levels of usage. If a computer is utilized for thesummarization of bills, the manual process described herein would be simulated onthe computer. For small utilities, each customer’s usage may be tabulated for the12-month period. However, for larger utilities, a sample tabulation of the residentialclass, on the order of 10 to 20 percent of the total number of customers in the class,may be adequate to establish usage patterns for that class. It is suggested that a100 percent tabulation be made for other customer classes, because the use percustomer in other classes is likely to be much more variable than for the residentialclass. A less than 100 percent sample, particularly for large customers, may notprovide a representative distribution of water-usage patterns. If a sample ofcustomers is to be made, random sampling procedures should be used.

The bill-tabulation process is initiated by selecting the smallest meter size for aparticular customer class and tabulating identified individual customer usage ontothe summary sheet for that meter size and class. This procedure is continued for eachmeter size until all customer bills in the class have been summarized. The sameprocess would be repeated for every other customer class.

It is important to summarize bills for each identified customer in all customerclasses unless a sample for the class, as previously discussed, has been selected. Billsissued to inactive accounts should be excluded. Bills issued to active customeraccounts with zero usage during any billing period should be included as “zero-usage”bills.

To illustrate the bill summarization procedure, hypothetical customer-billingaccount records and a bill tabulation sheet are shown in Figures A-1 and A-2,respectively. Figure A-1 shows two customer billing accounts, presenting eachcustomer’s monthly water use and the amount billed. Both customers are inside-cityresidential customers with 5/8-in. meters, as indicated on the billing record. FigureA-2 shows an example of the type of sheet on which the usage for each monthly bill istabulated when a manual bill tabulation is necessary. As indicated at the top of thesheet, the usage for inside-city residential customers with 5/8-in. meters is to besummarized on this sheet. In the left-hand margin of the tabulation sheet appear thevarious possible levels of customer usage for each billing period in terms of hundredcubic feet (Ccf). Thus, in the example in Figure A-2, the number “2” is equal to amonthly usage of 200 ft3. It is noted that usage levels or use blocks should beestablished to cover the largest monthly usage in each class. Several summary sheetsmay be required for a given customer class and meter size in order to accommodatethe range of monthly usage by customers in the class.


APPENDIX A 65

Figure A-1 Hypothetical customer-account billing records.


66 WATER RATES

Figure A-2 Example of a water-bill tabulation sheet.


APPENDIX A 67

Beginning with customer account number 115147, shown in Figure A-1, a tickmark is made on the line in Figure A-2 that corresponds to the usage billed in a givenmonth. Each tick mark is equivalent to one bill. From Figure A-1, for the Januarybilling period, the usage for customer account 115147 is indicated to be 5 Ccf.Therefore, a tick mark is made on the usage-block line marked “5” on Figure A-2, asshown. A tick mark is made for each monthly usage quantity on the appropriate lineon Figure A-2 for both customers’ monthly usage quantities. This procedure would berepeated for all 5/8-in. residential inside-city accounts billed during the 12-monthperiod. Similarly, a separate tabulation sheet or sheets for each meter size bycustomer class would be completed.

Once the bill tabulation is complete for each meter size by class, the number oftick marks or bills is totaled for each usage block and summarized at the bottom ofthe appropriate column on each sheet. Usage associated with the bills tabulated ineach usage block is determined by multiplying the number of bills by the usageamount—shown in the left-hand column of each line. If the two hypotheticalcustomers shown in Figure A-1 were the only 5/8-in. residential inside-city customers,the total number of bills and usage would be those shown in Figure A-2 at the bottomof the two right-hand columns.

After all bills and associated usage have been summarized for each meter sizeand class, total customer-class usage and bills would be determined by adding thebills and usage for all meter sizes for a given customer class. The selection of theperiod for which bills are to be summarized to coincide with the utility’s fiscalaccounting period greatly enhances the ability to check the accuracy of the billtabulation since cumulative data as to the number of bills, total water sales, andrevenue for that period would be readily available. The final check as to the accuracyof the bill tabulation is based on the revenue that the tabulation generates whenapplied to the existing schedule of rates.

Development of Cumulative Billed UsageAfter tabulating the number of bills and usage for each customer class by meter size,the next step is to determine the cumulative billed water usage by various usageblocks or increments for each customer class and meter size. The procedure includesseveral steps and is best accomplished by using a computation table similar to the oneshown in Figure A-3. The data summarized in Figure A-3 are for a hypotheticalresidential customer class. Column 1 shows the usage blocks for which water-usageand bill data are summarized. Selection of usage blocks for summarizing cumulativebilling data does not need to set forth all usage blocks used in the bill-tabulation sheetdescribed earlier. The usage blocks used in summarizing cumulative billed usage aregenerally established to include single-unit increments at the lower usage levels tocoincide with the use of smaller users and larger increments or groupings of severalunit increments at the higher usage levels. As shown in Figure A-3, increments ofusage from 1 Ccf up to 10 Ccf are used, and larger increments are utilized thereafter.For example, the bills and usage recorded for the unit increments of 11 through 15Ccf from the bill tabulation sheet (see Figure A-2) would be combined for the purposes,of Figure A-3 and would be recorded on the line opposite the usage-block categorymarked “11–15” in columns 2 and 4, respectively. The numbers entered on this linewould represent the total number of bills and associated usage for customer usage of11 through 15 Ccf per billing period.

Usage blocks summarized should be selected in part to coincide with the existingrate blocks. This will result in a readily identifiable cumulative level of usage in eachrate block against which existing rates may be applied for purposes of checking the


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APPENDIX A 69

accuracy of revenue generated by the bill tabulation. Other usage blocks should besummarized in sufficient detail to prepare a representative graphical curve.

The number of bills issued for water usage corresponding to the variousconsumption blocks is shown in column 2. The number of bills issued for each usageblock would be taken directly from bill tabulation sheets similar to the one shown inFigure A-2. In this example, total bills represent the summation of bills issued toresidential-class customers with 5/8-in. meters. For example, during the 12-monthperiod represented by the bill tabulation, 24,317 bills were issued to the group ofcustomers having a monthly usage of 3 Ccf. Bills for each usage block aresummarized in this manner for each customer class and each meter size individually.

Once the number of bills is summarized by usage block, the bills areaccumulated up in column 3 of Figure A-3 by starting with the bills in the largestusage block and adding the next above usage block’s number of bills to it. As shownin Figure A-3, beginning with the “251 and over” Ccf usage block and summing up thenumber of bills, a total of 187,836 bills issued to the residential class is representedin the figure. The number of cumulative bills in any particular usage block representsthe number of bills issued for the amount of water use shown in that block or more.For instance, at the 3 Ccf consumption block, 154,158 bills have been issued for usageof 3 Ccf or more.

Column 4 represents the total use of bills stopping in each usage block andcorresponds to the number of bills listed in column 2. These numbers are taken fromthe far right-hand column of each bill-tabulation sheet (an example of which is shownin Figure A-2). In the example in Figure A-3, 24,317 bills are issued for the 3 Ccfusage block for a total of 72,951 Ccf in total water use.

The total water use of bills stopping in each usage block shown in column 4 isaccumulated, beginning with the 0 Ccf usage block, as shown in column 5. The valuein column 5 for a given usage block represents the cumulative billed usage of all billswith monthly usage less than or equal to the usage represented by the usage block.Consequently, the summarization of usage for all usage blocks yields the total use ofthe customer class for the meter size during the bill tabulation period. In theexample, 5/8-in. residential-class customers used 1,254,308 Ccf during the 12-monthbill tabulation period, as shown in the last line of column 5.

While the accumulated usage shown in column 5 provides a measure of totalcustomer-class water use, it does not indicate the quantity of water used in a givenusage block by bills that exceed that usage level. That is, at the 3 Ccf usage block,column 5 indicates that a total of 120,508 Ccf of water was used by those customersbilled for 0, 1, 2, and 3 Ccf. This quantity does not include water used by customerswho use more than 3 Ccf. For rate-design purposes, the total quantity of water usedat a particular usage block needs to be determined, including the usage in the blockby customers whose usage exceeds the block. Therefore, the next step is to determinethe total use in the block of all billed usage passing beyond each block. This quantitymay be determined from data in columns 1 and 3 and is summarized in column 6. Thevalues shown in column 6 are calculated for each usage block by multiplying theusage block value in column 1 by the number of cumulative bills through blockcorresponding to the next larger usage block, as shown in column 3. For example, thecolumn 6 value for the 31–50 Ccf usage block is calculated by multiplying 50 Ccf bythe number of cumulative bills for the 51–100 Ccf block of 645 and totals 32,250 Ccf.The 32,250 Ccf of water use is the quantity of usage in the 31–50 Ccf block of monthlyuse for the 645 bills whose usage exceeds this block.

The cumulative billed usage of all 5/8-in. residential customers maybe developedat this point by adding the values shown in columns 5 and 6 for each usage block.


70 WATER RATES

Total cumulative usage for the 5/8-in. residential class is shown in column 7. Thecumulative usage figures in column 7 indicate the total usage that would be billed atany given usage block. To determine the usage at interim blocks (for example, theusage between 3 Ccf and 10 Ccf), the cumulative usage corresponding to the smallerblock would be subtracted from the cumulative usage of the larger block. In thisexample, 1,050,229 Ccf less 510,031 Ccf, or 540,198 Ccf, would be the use in a rateblock of 4–10 Ccf.

Once the bill tabulation has been completed for all customer classes, thecumulative usage (shown in column 7 of Figure A-3) for each existing rate block wouldbe determined. Application of existing rates to the cumulative usage in each rateblock as determined from the bill tabulation would result in the indicated“bill-tabulation” revenue under existing rates, which is related to existing volume-related charges. Applying existing service charges to the number of bills by meter sizeand adding the volume-charge revenue produced from the bill tabulation would yieldthe total bill-tabulation revenue under existing rates. This revenue figure can then becompared with the billed revenue recorded by the utility to test the accuracy of thebill tabulation. A correlation of bill-tabulation revenue to actual billed revenue of3 percent or less generally indicates that the bill tabulation is sufficiently accurate forrate-design purposes. Where initial charges in the form of a minimum bill areutilized, precaution must be taken to avoid multiple counting of minimum usage incomputing revenues.

Application of Bill Tabulation for Rate DesignThe bill analysis, once verified for accuracy, provides a useful tool for rate design. Theusage pattern of each class of customers, as determined from bill tabulation, isgenerally considered to remain relatively stable over a period of several years. Indesigning rates for future study periods, the usage pattern from the bill tabulationmay be applied to projected water usage of various classes to determine estimatedwater usage applicable to each rate block.

If it becomes necessary to change existing blocks in order to more equitablyrecover allocated costs of service from the various customer classes, the bill tabulationprovides a means for selecting alternative rate blocks and the associated amount ofwater usage with the new blocks. To aid in the selection of the proposed rate blocks,cumulative usage curves may be derived from the bill analysis. To construct thenecessary curves, the percentage of cumulative billed usage must be determined.Column 8 of Figure A-3 presents the percent of cumulative billed usage for each usageblock and is determined by dividing the cumulative billed usage for each block incolumn 7 by the total cumulative usage times 100.

Construction of a curve for the hypothetical residential customer class is shownin Figure A-4. The curve is constructed on semilogarithmic graph paper withcumulative billed percent usage shown on the vertical linear axis and monthly usagelevels shown on the horizontal logarithmic axis. To construct the curve representingcumulative usage for the hypothetical residential class shown in Figure A-3, thecumulative billed percent usage figures from column 8 are plotted for each level ofusage, and a line is drawn through all plotted points. The resulting curve may thenbe used to determine an estimate of the cumulative percent of future water usage thatwill occur at a given usage level. For example, if a proposed rate block is chosen at amonthly usage of 3 Ccf, from the curve it is determined that approximately 40 percentof the total water use of customers in this class for this meter size would be expectedto be billed in the 0–3 Ccf block.


APPENDIX A 71


72 WATER RATES

Similar curves can be developed for each customer class and meter size. In someinstances, it may be more desirable to determine the cumulative billed usage andgraph the curve for the combination of all meter sizes in each class. This may beaccomplished simply by adding together the cumulative billed usages (similar to thoseshown in column 7 of Figure A-3) determined for each meter size in a class for eachrespective usage block. In order to add cumulative billed usages for each meter size,the usage blocks established for each meter size must be exactly the same. The valuedetermined from the summation would represent the cumulative billed usage of allcustomers in the class and would be used to calculate cumulative billed usagepercentages and, subsequently, to graph the customer-class curve.

It is generally useful to plot all customer-class curves on the same graph as anaid in the selection of proposed rate blocks for rate design. Trial rate blocks may bechosen that effectively separate the majority of the usage for each class into one ormore rate blocks simply by visual inspection of the family of customer-class curves. Amore complete discussion of the use of curves in rate design is included in chapter 4.


Glossary

annual operating revenue requirement The total revenues required on anannual basis adequate to meet all expenses and capital requirements of theutility.

base costs Costs that tend to vary with the total quantity of water used and opera-tion under average load conditions. Costs included are operation and mainte-nance expenses of supply, treatment, pumping, and transmission anddistribution facilities, and capital costs related to plant investment associatedwith serving customers at a constant, or average, annual rate of use (100 per-cent load factor).

base–extra capacity The method of cost allocation in which the costs of serviceare classified to the functional cost components of base, extra capacity, andcustomer costs.

bill frequency analysis A tabulation and summarization of customer bills andusages showing the number of bills rendered at various levels of water usageduring a specified period of time.

bond covenants Terms of obligations incurred as conditions of the issuance ofbonds.

bonded debt Indebtedness represented by outstanding bonds.capacity The ability of available water utility resources to meet the quantity, qual-

ity, peak loads, and other service needs of the various customers or classes ofcustomers served by the utility.

capacity factor Ratio of peak rate of demand to the average rate of demand overa specified period of time (hour, day, etc.) for a customer, class, or system. It isgenerally greater than 1.

capital expenditures Expenditures that result in the acquisition of or addition offixed assets.

cash-needs approach The method of determining annual operating revenuerequirements based on all cash needs, including but not limited to, operationand maintenance expense, debt service, and capital expenditures from currentrevenues.

commodity costs (variable costs) Costs that tend to vary with the quantity ofwater produced, including the costs of chemicals, a large part of power costs,and other elements that follow, or change almost directly with, the amount ofwater produced. Purchased water costs, if the water is purchased on a unitvolume basis without minimum charges or any associated demand charges,may also be considered as commodity costs.

commodity–demand The method of cost allocation in which the cost of service isallocated to the functional cost components of commodity, demand, and cus-tomer cost. Variable costs are allocated to the commodity component, with thebalance of costs being allocated to the demand and customer components.

commodity–demand rate A multiple-part rate containing both fixed and variablecomponents, generally requiring the fixed portion (or a percentage of it) to bepaid independent of volume of water usage, while the variable portion is basedon the volume of water usage. The fixed portion is generally based on thecustomer’s peak demand requirements; it may also include customer charges(billing, metering, etc.).

73


connection charge The charge made by the utility to recover the cost of connect-ing the customer’s service line to the utility’s facilities. This charge is oftenconsidered as a contribution of capital by the customer or other agency receiv-ing the service.

contribution in aid of construction (CIAC) Any amount of money, services, orproperty received by a water utility from any person or governmental agencythat is provided at no cost to the utility. It represents an addition or transfer tothe capital of the utility, and is used to offset the acquisition, improvement, orconstruction costs of the utility’s property, facilities, or equipment used to pro-vide utility services to the public. It includes amounts transferred fromadvances for construction representing any unrefunded balances of expiredrefund contracts or discounts resulting from termination of refund contracts.Contributions received from governmental agencies and others for relocation ofwater mains or other plant facilities are also included. Contributions are gener-ally carried as equity capital on the balance sheets of government-ownedutilities.

cost allocation The procedure for classifying or assigning the costs of service tofunctional cost components for subsequent distribution to respective customerclasses.

costs of service The operating and capital costs incurred in meeting variousaspects of providing water service, such as customer billing costs, demandre-lated costs, and variable costs.

coverage ratios The margin of safety ratios associated with bonded indebtednessand preferred stocks, reflecting the ratio of the actual or projected net revenueavailable for debt service to debt service or other costs. These ratios range fromdebt-service coverage of principal and interest, to interest only, to all fixedcharges, including preferred stock dividends and lease payments. Coveragemay be expressed as a ratio or as a percentage.

customer classification The grouping of customers into homogeneous classes.Typically, water utility customers may be classified as residential, commercial,and industrial for rate-making and other purposes. For specific utilities, theremay be a breakdown of these general classes into more specific groups. Forexample, the industrial class may be subdivided into small industry, largeindustry, and special. Some water systems have individual customers (largeusers) with unique water-use characteristics, service requirements, or otherfactors that set them apart from other general customer classes and thus mayrequire a separate class designation. This may include large hospitals, univer-sities, military establishments, wholesale service districts, and other suchcategories.

construction work in progress (CWIP) The utility’s investment in facilities un-der construction, but not yet dedicated to service. The inclusion of CWIP inrate base varies from one agency to another.

customer costs Costs directly associated with serving customers, irrespective ofthe amount of water use. Such costs generally include meter reading, billing,accounting, and collecting expense, and maintenance and capital costs relatedto meters and associated services.

debt An obligation resulting from the borrowing of money or from the purchase ofgoods and services.

debt-service requirement The amounts of money necessary to pay interest andprincipal requirements for a given series of years.

74 WATER RATES


declining-block rates A schedule of rates applicable to blocks of increasing usagein which the usage in each succeeding block is charged at a lower unit ratethan in the previous blocks. Generally, each successive block rate is applicableto a greater volume of water delivery than the preceding block(s).

demand costs Costs associated with providing facilities to meet demands placedon the system by customers. They include capital-related costs associated withthose facilities plus related operation and maintenance expenses.

demand patterns Profiles and characteristics of the demand requirements of thesystem, specific customer class or classes, or an individual customer, indicatingthe frequency, duration, and amount of demand placed on the water productionand delivery system.

depreciation The loss in service value not restored by current maintenance asapplied to depreciable plant facilities. Depreciation is incurred in connectionwith the consumption or prospective retirement of plant facilities in the courseof providing service. This depreciation is the result of causes known to be incurrent operation and against which the utility is not protected by insurance.Among the causes are wear and tear, decay, action of the elements, inade-quacy, obsolescence, changes in technology, changes in demand, and require-ments of public authorities. The proper level of depreciation expense at anygiven time should be based on the costs of depreciable plant in service. Thefunds resulting from depreciation are available for replacements,improvements, expansion of the system, or for repayment of the principal por-tion of outstanding debt.

depreciation rate The annual rate at which capital facilities are depreciated,based on the estimated loss in value of the facilities, not restored by currentmaintenance, that occurs in the property due to wear and tear, decay, inade-quacy, and obsolescence. It provides for the recovery of a utility’s capital invest-ment over the anticipated useful life of the depreciable assets.

dividend payment Payment made by an investor-owned water utility to its share-holders, based on its earnings.

equity The net worth of a business, consisting of capital stock, capital (or paid in)surplus, earned surplus (or retained earnings), and, occasionally, certain networth reserves.

equivalent meter-and-service ratio The ratio of the cost of investment in largermeters and services to those of a base meter size, such as the 5⁄8-in. metertypically used for residential customers. Meter capacities may be used ratherthan investments.

expenditures Amounts paid or incurred for all purposes, including expenses, pro-vision for retirement of debt, and capital outlays.

extra capacity costs Costs of capital and operation and maintenance associatedwith meeting rate-of-use requirements in excess of average rate-of-userequirements.

fire-protection charges Charges made to recover the cost of providing fireprotec-tion service to the area served by the utility.

firm service Dependable service in the amounts and at times as desired by thecustomer.

GLOSSARY 75


functional cost components The distinct operational components of a water util-ity to which separate cost groupings are typically assigned. In the base–extracapacity method of cost allocation, these are usually the components of base,extra capacity, customer, and direct fire-protection costs. In the commodity–de-mand method, they are the components of commodity, demand, customer, anddirect fire-protection costs.

government-owned water utility A water utility created by state or othergovernment-agency legislative action, with the mandate that the purposes ofthe utility are public purposes and that its functions are essential governmen-tal proprietary functions. Its primary purpose is to provide its designatedservice area with potable water in an adequate supply at reasonable costs sothat people of the area may promote their health, safety, and welfare. Agovernment-owned water utility may be part of a municipal government opera-tion, a county agency, a regional authority, or take such other form as is appro-priate for its service area.

gross receipts tax Payments made to a government entity based on the grossrevenues received by the water utility from its revenues.

inverted block rates A schedule of rates applicable to blocks of increasing usagein which the usage in each succeeding block is charged at a higher unit ratethan in the previous blocks. Generally, each successive block rate may be appli-cable to a greater volume of water delivery than the preceding block(s).

investor-owned water utility A utility owned by an individual, partnership, cor-poration, or other qualified entity with the equity provided by shareholders.Regulation may take the form of local or state jurisdiction.

lifeline rates Rates applicable to usage up to a specified level that are below thecost of service for the purpose of meeting the social goal of providing so-calledminimum annual water requirements to qualified customers at a below-costprice.

marginal cost rates Rates based on the cost of providing the next unit ofproduction.

minimum bill A minimum charge to a customer that includes a fixed volume ofwater delivered to the customer during the applicable period of time.

off-peak rates Rates charged for usage during certain designated off-peak periods.payment in lieu of taxes A payment made to a governmental entity by the

government-owned utility instead of taxes.peak-load pricing rates A multiple-part rate structure in which charges vary and

are based on the higher costs of providing water during the system peakperiods of use and on the lower cost of providing water during the systemoff-peak periods.

rate base The value of a water utility’s property used in computing an authorizedreturn under the applicable laws and/or regulatory policies of the agency set-ting rates for the utility.

rate blocks Elements of a schedule of charges for specific usages within certaindefined volume and/or demand boundaries.

rate-making process The process of developing and establishing rates andcharges. The process is comprised of four phases: (1) determination of revenuerequirements; (2) allocation of costs to the functional components of the cost ofservice; (3) distribution of the function costs of service to customer classes; and(4) development and design of a schedule of rates and charges to recover therevenue requirements.

76 WATER RATES


rate schedule Schedule of the rates and charges to the various customer classesand customers.

raw water Water that is obtained directly from the supply sources, such as wells,reservoirs, rivers, etc., that has not been treated to produce potable water.

return on rate base The percentage of earnings on the rate base.seasonal excess-use charges Charges for usage above pre-established levels,

typically used during periods of peak use relative to use during off-peak peri-ods.

seasonal rates Rates based on the cost of service variations with respect to systemseasonal requirements. For example, higher rates may be charged during thesummer months when a system peak occurs, which requires facilities notneeded to meet lower winter loads.

self-sustaining water enterprise A water utility operating without subsidiesgiven to or received from non-water utility operations.

service charge A fixed charge usually designed to recover customer costs.standby service Service provided occasionally under certain defined conditions,

such as in the event of failure of the customer’s normal water supply system.Fire protection is another form of standby service.

test year The annualized period for which costs are to be analyzed and ratesestablished.

treated water Water that has been obtained from supply sources and treated toproduce potable water.

unit cost The cost of producing a unit of a product or service. An example wouldbe the cost of treating a thousand gallons of potable water for use by the waterutility’s customers.

unit of service An element of service for which a cost can be ascertained, such asthousand gallons, hundred cubic feet, million gallons per day, monthly bill, etc.

uniform volume charge A single charge per unit of volume for all water used.unmetered or flat rate A fixed charge for unmetered service, often simply based

on the number of fixtures and water-using devices of the customer.utility approach The method of determining annual operating revenue require-

ments, which includes operation and maintenance expense, depreciationexpense, and return on rate base.

wholesale service customers Service in which water is sold to a customer at oneor more major points of delivery for resale within the wholesale customer’sservice area.

working capital Cash, materials, supplies, and other similar current assets neces-sary in the operation of the enterprise. It is usually measured by the excess ofcurrent assets over the current liabilities, or sometimes as a percentage ofannual operation and maintenance expense levels.

GLOSSARY 77


NOTE: An f. following a page number refers to a figure; a t. refers to a table.

Air conditioning and refrigeration, 22AWWA Water Rates and Charges

Subcommittee, 46

Base cost component, 13, 14Base costs, 11 and extra capacity costs, 11Base–extra capacity method, 10–11 base costs, 11 and commodity–demand method, 45–46 cost components, 11 cost distribution to customer classes, 28–30, 29t. customer costs, 11–12 depreciation allocation, 14, 15t. direct fire-protection costs, 12 extra capacity costs, 11 O&M allocation, 14, 15t. rate base, 12–14, 13t. rate design for, 45–46 unit costs of service, 27t. units of service, 25, 25t.Bill tabulation, 63–64 bill summarization, 64–67 billing records, 64, 65f. cumulative billed usage, 67–70, 68f., 70, 71f. and meter size, 64, 65f., 67 and rate design, 70–72 tabulation sheet, 64, 66f.Bill-frequency distribution analysis. See Bill tabulationBilling records, 64, 65f.Block-rate design, 40–44. See also Rate blocks

Capital costs, 10Capital expenditures and cash-needs approach, 2Cash-needs approach capital expenditures, 2Cash-needs approach debt-service requirements, 2Cash-needs approach described, 1Cash-needs approach O&M expense, 2City limits service outside, 22–23Commercial customers, 21Commodity costs, 16Commodity–demand method, 10–11 and base–extra capacity method, 45–46 commodity costs, 16 cost components, 16

cost distribution to customer classes, 30–31, 30t. customer costs, 16 demand costs, 16 depreciation allocation, 16, 18t. direct fire-protection costs, 16 in small utilities, 57–59, 57t., 58t. O&M allocation, 16–19, 18t. rate base, 16, 17t. rate design for, 45–46 unit costs of service, 28t. units of service, 25, 26t.Commodity–demand rates, 49Connection charges, 51–52Construction work costs, 14Cost allocation base–extra capacity method, 10–11, 11–16 commodity–demand method, 10–11, 16–19 and costs of service, 10 functional-cost method, 10–11Cost components related to customer classes, 23–26Cost distribution to customer classes base–extra capacity method, 28–30, 29t. commodity–demand method, 30–31, 30t.Costs of service components in base–extra capacity method, 11 and cost of allocation, 10 and customer needs, 9 firm water service, 19 inside-city and outside-city users, 19 nonfirm service, 19 pressure zones, 19 principal elements, 12 and rate design, 32–33 and rates, 9 reserve capacity, 19 seasonal uses, 19 small utilities, 55 special considerations, 19 unit costs, 26–28Cumulative billed usage, 67–70, 68f., 70, 71f.Customer costs, 11–12, 16, 34. See also Service chargesCustomers air conditioning and refrigeration, 22 classes of related to cost components, 23–26

Index

79


commercial, 21 differences among, 20–21 distribution of costs to, 28–31 fire-protection, 21–22, 24 general classes, 21 industrial, 21 lawn irrigation, 22 meter-and-service costs, 24 residential, 21 special classes, 21–22 uniform rates by class, 47–48 units of service, 25t., 26t. water use by classes, 35–37, 36f. wholesale, 21

Debt-service requirements and cash-needs approach, 2Declining-block rate schedules, 34–35, 47Demand costs, 16 small utilities, 55Depreciation, 3, 12 allocation in base–extra capacity method, 14, 15t. allocation in commodity–demand method, 16, 18t.Direct fire-protection costs, 12, 16“Disappearing” charge, 34

Excess use, 48Extra capacity component, 13, 14Extra capacity costs, 11 and base costs, 11

Fire-protection costs small utilities, 55, 56f., 57–59Fire-protection service, 21–22, 24 rate design for, 37–38, 44, 62Flat rates, 51Functional-cost method, 10–11

General plant costs, 14General service rates, 33–34Government-owned utilities capital improvements, 6 debt-service requirements, 6 O&M expense, 6 and outside-city customers, 23 projected revenue requirements, 5t.

Industrial customers, 21Inverted-block rates, 50Investor-owned utilities projected revenue requirements, 8 taxes, 4 utility approach to revenue requirements, 3

Lawn irrigation, 22Lifeline rates, 51

Marginal cost rates, 49–50Meter-and-service costs, 24Minimum charge, 34, 44, 45t.

O&M expense, 10, 12 allocation in base–extra capacity method, 14, 15t. allocation in commodity–demand method, 16–19, 18t. and cash-needs approach, 2Off-peak rates, 49Operation and maintenance expense. See O&M expense

Peak-load pricing, 49Prospective rates, 4Pumping facilities, 13Rate base, 3–4 base–extra capacity method, 12–14, 13t. commodity–demand method, 16, 17t.Rate blocks. See also Block-rate design and use costs, 41–42, 41t., 43, 43t. and water meters, 47Rate design, 46–47 base–extra capacity and commodity– demand methods compared, 45–46 block rates, 40–44 commodity–demand rates, 49 connection charges, 51–52 and costs of service, 32–33 “disappearing” charge, 34 factors affecting, 33 for fire-protection service, 37–38, 44, 62 flat rates, 51 general service rates, 33–34 and income lag, 38 inverted-block rates, 50 lifeline rates, 51 marginal cost rates, 49–50 minimum charge, 34, 44, 45t. off-peak rates, 49 peak-load pricing, 49 and record keeping, 52 recovering costs related to volume and extra capacity, 34–37 recovering customer costs, 34 seasonal rates, 48 service charges, 39–40, 39t. for small utilities. See Small utilities uniform rate by customer class, 47–48 uniform rates, 50–51 unmetered rates, 51 and user conservation, 38 for wholesale service, 38Rate schedules declining-block, 34–35, 47 single-rate, 35Rates and costs of service, 9Record keeping and rate design, 52Residential customers, 21Return, 3, 12Revenue requirements, ixf., 1, 8. See also Cash-needs approach, Utility approach government-owned utilities, 5t.

80 WATER RATES


projected, 5t. prospective basis, 4 small utilities, 54Revenues from nonrate sources, 6

Seasonal rates, 48Service outside city limits, 22–23Service-charge design, 39–40, 39t.Small utilities and commodity–demand method, 57–59, 57t., 58t. costs of service, 55 costs-of-service allocation, 57, 58t., 60, 61t. customer costs, 55 demand costs, 55 fire-protection costs, 55, 56f., 57–59 fire-protection rates, 62 information needed for rate design, 54 meter equivalents, 59–60, 60t. O&M allocation, 57, 58t. plant value allocation, 57, 57t. rate design, 53–54, 59–62 revenue requirements, 54 service charges, 59–60, 60t. single-block rate design, 59–60 two-block rate design, 60–61, 61t. unmetered rates, 61–62

Test year, 6 revenue requirements, 7t.Treatment facilities

Uniform rates, 50–51 by customer class, 47–48Unit costs of service, 26–28 base–extra capacity method, 27t. commodity–demand method, 28t.Units of service base–extra capacity method, 25, 25t. commodity–demand method, 25, 26t.Unmetered rates, 51Utility approach depreciation, 3 and investor-owned utilities, 3 rate base, 3–4 return, 3 taxes, 4

Water meters and rate design, 47 in small utilities, 59–60, 60t.Water use by customer classes, 35–37, 36f.Wholesale service, 21 rates, 38

INDEX 81


Documents

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