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5 reasons to annually update electric construction overhead rates - the icing on the cake

Russ Hissom's picture
Owner Utility Accounting Education Specialists

Russ is the owner of Utility Accounting Education Specialists (UAES) a firm that provides online and in-person courses on power and utilities finance, accounting, and business process...

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  • Jun 10, 2021 10:44 am GMT
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Electric overhead costs are the icing on the cake of an electric project - while the cake contains most ingredients, a cake is not a cake without frosting. This frosting is made up of the overhead costs that make the construction process possible. These include:

  • Labor overheads

  • Stores expense, aka. materials management costs

  • Equipment costs

  • Cost of capital - the Allowance for Funds Used During Construction

  • Administrative and general overheads

If all project costs are not recorded, including these overheads, customers will not fully reimburse your electric utility or cooperative for the total costs of capital replacement. Cash flow will suffer, directly impacting customer service and system reliability.

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Why should these costs be reviewed annually?

Here are five quick reasons in support of a regular review of overhead rates.

The case for adjusting overhead rates annually

1. Labor costs and benefits change annually - as labor costs change, the ratio of benefit costs to labor costs will also change. Also, benefit programs may change from year to year, and labor overhead rates should reflect those changes.

2. Business processes may change from year to year - in some areas, materials management, for example, changes in processes that result in greater efficiencies, i.e., how materials are handled, storage practices, and perhaps movement in the area of inventory reduction impacts stores expense rates.

3. Equipment costs change with age and technology - as utilities introduce more field technical tools and replace equipment, the cost of ownership changes.

4. Cost of capital is not static - interest rates change annually, as does the mix of financing for projects. Inflation will also impact the cost of capital. The changes in interest rates, financing mix, and inflation should be reflected in the cost of capital rate. 

5. General and administrative costs reflect the current make-up of your organization - as your organization changes, so does the make-up of its supporting functions. Perhaps your utility or coop is implementing more Automated Intelligence (AI) practices in the finance area. Long-term, this should reduce costs and change processes, but up-front software and programming costs should be reflected in overhead rates. 

6. Bonus comment. It is not a best practice to adjust overhead rates monthly. Costs will fluctuate over the ebb and flow of the year, and changing overhead rates monthly will over charge some projects with additional overhead costs and under charge other projects. Timing is everything in this scenario, and an annual rate reflects a smoothness to the application of overheads over the year. 

Next steps

Updating overhead rates should be part of the normal business planning cycle. As your utility or electric cooperative’s cost structure changes, projects in any given year should reflect those structural adjustments. Provide reliable customer service, but make sure those customers pay for the privilege of being served. 

 

Russ Hissom is the owner of Utility Accounting Education Specialists (UAES), a company that offers online, on-demand, and custom utility accounting and finance business process courses and thought leadership. You can reach him at russ.hissom@puaes.com. The puaes.com website has a wealth of classes, articles, and other online resources that will benefit your utility’s accounting and customer ratemaking strategies.

 

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Matt Chester's picture
Matt Chester on Jun 10, 2021

It is not a best practice to adjust overhead rates monthly. Costs will fluctuate over the ebb and flow of the year, and changing overhead rates monthly will over charge some projects with additional overhead costs and under charge other projects. Timing is everything in this scenario, and an annual rate reflects a smoothness to the application of overheads over the year. 

Is it better, then, to identify current monthly rates and use that for the coming year or to try to anticipate what the high point will be in the coming months and use that as the monthly rate? 

Russ Hissom's picture
Russ Hissom on Jun 10, 2021

Thanks for your question Matt. What we've seen as a best practice is to base the overhead rates for the coming year on the annual budget. That should smooth out month to month fluctuations.

Audra Drazga's picture
Audra Drazga on Jun 11, 2021

Love the quick 5 - with a bonus of 6 :).  Thanks for sharing with the community. 

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