FERC | RUS Accounting | Cost of Service & Rates
Harmony in Allocating Inter-Departmental Power and Utilities Costs with the Three-Point Formula
Power and Utilities Best Practices — The Three-Point Formula
Implementing a three-point approach to allocating interdepartmental costs in a multi-service utility — electric, gas, water, for example — can transform the budget conversation from contentious to objective. This formula has been a proven industry standard since the 1950s and is as true today as it was then. The formula can be used by a co-op or utility of any size, from $10 million in revenues to billions.
Using a cost allocation method based strictly on math and metrics removes subjectivity from the discussion — and that's exactly what makes budget meetings more productive.
Key Article Takeaways
- Two allocation rules: (1) Direct-charge a department whenever cause and effect can be shown, and (2) use an industry allocation method for all remaining common costs.
- Shared services are costs that benefit all departments — the internal departments are the customers of these services and must pay their share.
- The Three-Point Formula is the power and utilities industry standard for allocating shared services, used by electric cooperatives and utility organizations of all sizes.
The Two Rules for Allocating Costs
Cost Allocation Theory
While the allocation rules are short and simple, cost allocation theory goes deeper. Costs to be allocated should have all of these characteristics:
- Cost-causative — A clear relationship between the cause of the expense and its effect on the benefiting business unit
- Measurable — Amounts derived from financial data, subject to internal controls and auditable
- Objective — Method determined without bias
- Stable and predictable — Methods should not produce variations inconsistent with actual service level changes
- Consistently applied — Cost per unit should be the same for all users of the same service
The premise is that costs are allocated fairly and equitably. The great equalizer for that approach is math.
Shared Services
Shared services are the costs allocated across the different departments of the organization. These are services provided to internal customers — so the departments who benefit must pay for them.
Functional characteristics of shared services include high-volume and routine transactions, specialized skills required to provide the services, and company-wide service delivery. Departments that are strong candidates for a shared services allocation include:
Many of these areas have cost characteristics that make them common across departments rather than specific to any single service line. As always, directly assignable costs should be direct-charged; only the remainder enters the shared services allocation pool.
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The Three-Point Formula is the secret sauce used to allocate interdepartmental costs. It is based on three industry drivers that determine the service level provided to internal customers — drivers that remain relevant regardless of utility size:
The weighted average of these three drivers, calculated separately for each utility service line, becomes the allocation percentage for shared services costs. This formula has been used as a best practice since the 1950s — the drivers have been repeatedly analyzed, and the Three-Point Formula remains the proven industry standard.
Example: Three-Point Formula in Action
This utility provides electric distribution, water, wastewater, and broadband communications services. They have not previously used the Three-Point Formula. Here is how they calculated it:
| Service Line | % of Plant in Service | % of Revenues | % of Labor Hours | Weighted Average ① |
|---|---|---|---|---|
| Electric Distribution | 63% | 43% | 75% | 60% |
| Water | 22% | 25% | 12% | 20% |
| Wastewater | 12% | 22% | 10% | 15% |
| Broadband | 3% | 10% | 3% | 5% |
| Total | 100% | 100% | 100% | 100% |
① Weighted average = (% Plant in Service + % Revenues + % Labor Hours) ÷ 3. Example for Electric Distribution: (63% + 43% + 75%) ÷ 3 = 60%
Upon performing the calculation, the utility takes these steps:
- Direct-charge any shared services costs to a specific utility service when the cause is clearly identified.
- Pool the remaining shared services costs and allocate them: Electric Distribution 60% , Water 20% , Wastewater 15% , Broadband 5% .
The utility's prior allocation was 75% / 10% / 10% / 5%. The increase in water and wastewater shares produced budget concerns from those department heads — leading to a two-year phase-in of the new allocation percentages. This is common and reasonable: the Three-Point Formula is the destination, and a phased transition manages the organizational change.
Alternative Formula Variations
Other variations of the Three-Point Formula exist — some utilities substitute or add different drivers depending on their specific operations:
Classic Three-Point
The original and most widely used variation. Approved by FERC and RUS. Proven industry standard since the 1950s.
O&M Expense Variation
Substitutes operating & maintenance expenses for revenues. Useful when O&M is a better proxy for service consumption than revenues.
Customers Variation
Substitutes customer count for labor hours. Useful when customer service volume drives shared services demand more than workforce size.
Four-Point Variation
Adds a fourth driver for additional precision. Each driver is weighted at 25%. Used by some larger multi-service utilities.
Each of the above methods applies to a co-op or utility of any size — the relationship between the factors remains relevant as the entity grows or contracts.
Other Direct Cost Allocation Methods
Beyond the Three-Point Formula for pooled shared services, many specific cost areas are best allocated using a direct activity driver. The following table shows common allocation methods by shared service area:
| Shared Service Area | Preferred Allocation Driver | Rationale |
|---|---|---|
| Information Technology | Number of users / workstations | IT support and licensing scale with users, not plant size |
| Human Resources | Number of employees (FTEs) | HR activity — hiring, benefits, training — driven by headcount |
| Finance / Accounting | Three-Point Formula or number of transactions | Finance serves all departments; transaction count reflects effort |
| Fleet / Vehicles | Miles driven or vehicle usage hours | Fleet costs directly traceable to vehicle use by department |
| Facilities / Building | Square footage occupied | Building cost causation is space consumed by each department |
| Customer Service | Number of customer accounts by service line | Customer interactions scale with account count per service |
| Purchasing / Procurement | Number of purchase orders or dollar volume | Purchasing workload driven by transaction count or dollar value |
| Power Dispatch | Direct charge to electric service | Power dispatch is specific to electric operations — directly assignable |
| Executive / General Management | Three-Point Formula | Management oversight benefits all service lines proportionally |
Remember the Two Allocation Rules
Will Budget Meetings Be More Productive?
There are no guarantees — but basing allocation factors on industry standards and math is a very defensible position when allocating common interdepartmental costs. Numbers don't take sides, and a formula that has been an industry standard for 70+ years is hard to argue with.
What Should You Do Next?
- Calculate your Three-Point Formula using current plant, revenue, and labor data, and compare it to your existing allocation percentages.
- Meet with department heads to discuss the calculation findings, the approach, and the industry standard — and get buy-in for any change.
- Develop a transition plan for departments with significant changes from the current allocation method, including any needed phase-in period.
- Write a policy that documents your organization's approach, approved by the Board.
- Recalculate annually as part of the budget process — plant, revenues, and labor all shift over time, and the formula should reflect current reality.
About the Author
Russ Hissom, CPA is a principal of UtilityEducation.com , providing on-demand professional education classes in FERC, RUS, FASB, and GASB accounting, finance, ratemaking, artificial intelligence, and management for electric, gas, wastewater, and water utilities and electric cooperatives.
Contact 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 Utility Accounting & Rates Specialists, LLC. You should seek formal advice on this topic from your accounting or legal advisor.