Harmony in Allocating Inter-Departmental Costs with the Three-Point Formula

Power and utilities best practices - the Three-point Formula

The 3-pointer? Do you mean in basketball or a field goal? Game winner? We could talk about all of these, but this topic is even more enjoyable. We're talking about the 3-point formula for allocating interdepartmental utility costs. Implementing a 3-point approach to allocating interdepartmental costs in a multi-service utility (electric, gas, and water, for example) can be comforting, especially if you remember your latest budget meeting, discussing allocating human resource and finance costs.

This article will discuss how using a cost allocation method based strictly on math, and metrics can smooth budget discussions and bring equitable allocations to your business units (doesn't sound exciting, but you'll be glad you read on).

Key article takeaways

1. Cost allocation rules made simple - (1) direct charge a department whenever the cause and effect can be shown, and (2) use an industry allocation method for all remaining common costs

2. Cost that should be allocated to all company departments are "shared services." The customer of these shared services is internal to the organization.

3. The Three-point formula is a power and utilities industry standard used to allocate shared services.

The rules for allocating costs

There are two simple rules for allocating costs:

1. If your department causes a cost to occur, then the department should pay for the cost (aka, direct assign the cost to the department)

2. If rule #1 doesn’t apply, use an industry common method to spread (allocate) the cost

Simple, right? Maybe in theory, but you probably need more support than this. We’ll provide it.

 

Cost allocation theory

While the cost allocation rules are short and simple, cost allocation theory goes more deeply. Costs to be allocated should have these characteristics:

- Cost-causative: Relationship between the cause for the expense being incurred and the effect that the activity had on the benefiting business unit

- Measurable: Amounts from financial data – subject to internal controls and auditable

- Objective: Method should be determined without bias

- Stable/predictable: Methods should not produce variations that are not in line with service level variations

- Consistently applied: Cost per unit should be the same for all users of that service

The premise of the costs are that they should be allocated fairly and equitably. The great equalizer for that approach is math.

Shared services

Shared services are the costs that are alllocated to the different departments of the organization. These are services provided to internal customers, and so, must be paid for by the departments who are the customers of the services.

Functional characteristics of shared services include:

- High volume and routine transactions

- Specialized skills to provide the services

- Company-wide services delivery

Functional areas to review for shared services

Departments that are candidates for inclusion in a shared services allocation include:

Many of these areas have the cost characteristics of being common and not critical to a specific utility department or service line. As in any case, directly assignable costs should be directly charged to a project or department, all others could be considered for a shared services allocation.

Three-point formula

The three-point formula is the secret sauce used to allocate interdepartmental costs. The formula is based on math and these industry drivers that determine the service level provided to internal customers, regardless of utility size: 6

1. Utility plant in service

2. Revenues

3. Total direct labor

The weighted average of these drivers of the utility business in a multiple service utility are calculated and used to allocate interdepartmental costs.

Example of the Three-point formula in action

This utility provides electric, water, and communications services to customers. The utility has not used the Three-point formula prior to now. Here’s how they calculated the Three-point formula:

[1] The weighted average for electric distribution is calculated as (63% + 43% + 75%)/3 = 60%

Upon performing the calculation, the utility would take these steps:

1. Direct charge any shared services costs to a utility if identified as caused by that utility

2. Allocate remaining shared services costs after they are pooled to electric distribution (60 %), water (20%), wastewater (15%) and broadband (5%).

The allocation for interdepartmental cost allocations used by the utility in prior years was 75%,10%,10%, and 5%. Budget concerns by the department heads for the water and wastewater utilities as to greater costs being allocated to their departments lead to a 2-year phase-in for the new allocation percentage.

 

Other formula variations

There are other variations on the Three Point formula, such as:

 

Each of the above methods applies to a co-op or utility of any size, as the relationship between the factors remains relevant as the entity grows or shrinks its business.

Other allocation methods

Other common cost allocation methods can differ by allocation area, but the allocation is generally driven by the activity. Below are common allocation methods for shared services:

Other common cost allocation methods can differ by allocation area, but the allocation is generally driven by the activity. Below are common allocation methods for shared services:

Remember the allocation rules

There are two simple rules for allocating costs:

1. If your department causes a cost to occur, then the department should pay for the cost (aka, direct assign the cost to the department)

2. If rule #1 doesn’t apply, use an industry-common method to spread (allocate) the cost

These allocations directly impact rates for all utility services.

Will we have more productive budget meetings?

There are no guarantees that your department head budget meetings will be more productive. But, basing an allocation factor on industry standards and math is a very supportable position when allocating common interdepartmental costs.

What should you do next?

Calculate your co-op or utility's Three-point formula for allocating interdepartmental costs and compare it to your current allocation percentages.

1. Meet with department heads to discuss the calculation findings. Discuss the approach and industry standards, and get buy-in for a change.

2. Develop a transition plan for departments with significant changes from your current allocation method.

3. Develop a policy that details and documents your organization's approach.

4. Calculate the Three-point formula annually as part of the budget process and adjust as needed.

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About Russ Hissom - Article Author

Russ is the owner of Utility Accounting Education Specialists a firm that provides power utilities consulting services and online/on-demand courses on accounting, finance, FERC best-practices, improving business processes, and implementing strategy. Russ is passionate about the Power and Utilities Industry and his goal is to share industry best practices to help better your business and enhance your career knowledge. He has over 35 years serving electric investor-owned and public power utilities, electric cooperatives, broadband providers, and water, wastewater, and gas utilities as a past partner in a national public accounting and consulting firm's power and utilities practice. Russ was named one of the 2021 Top Voices in the Energy Central Community by EnergyBiz Network.

Find out more about Utility Accounting Education Specialists here or you can reach Russ at [email protected]

The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by UAES. You should seek formal advice on this topic from your accounting advisor.