How can I jump, when I have no place to stand? Accounting to meet the needs of a changing market.

Sale, Martha Lair

CASE DESCRIPTION

This case, based on the Fleming-Mason Energy electric cooperative, is the result of the personal experience and commitment of Mr. David E. Smart who at the time of the case was employed with Fleming-Mason Energy as Engineering Superintendent. The case is set when the company must examine the costs of providing "unbundled" individual services due to competition brought about by deregulation. It leads the student to examine the activities necessary to provide the services offered by the company and possible Activity Based Cost pools into which the costs of these activities might be grouped. It also asks the student to consider the competitive impact of deregulation and formulate an analysis of the strengths and weaknesses of the company to assess the possibility that the company will not be able to provide all its current services at a competitive cost once consumers are able to pick and choose service providers. The case is appropriate for students at any level who have completed an introduction to Activity Based Costing. Students with a deeper knowledge of costing will be able to do a more in-depth analysis. The case can be covered in a single fifty-minute class for use in an undergraduate class, or it may be analyzed in enough detail to occupy twice that time in an advanced management accounting or masters level class. The solution should take no more than ninety minutes of outside preparation by the student.

CASE SYNOPSIS

The primary focus of this case is the development of Activity Based Costing (ABC) cost pools. The company upon which the case is based is facing heightened competition due to deregulation. Traditionally, the company's services have been priced on a cost basis calculated on the overall cost of providing the complete bundle of services offered. Due to deregulation, customers will be allowed the opportunity to choose other providers for individual services based on the cost of these services. Management plans to use ABC as a tool to determine more accurate costs of the various services they offer and help determine the areas in which the company can be most competitive. A secondary focus of the case is the development of a SWOT analysis.

INDUSTRY BACKGROUND

Electric utility companies provide their customers with a wide range of services that are essential in delivery of the electricity. These services are broadly grouped into the areas of generation, transmission, and distribution. Generation includes the building and maintenance of generation stations to produce power from any of a wide variety of fuels. Transmission is the process of moving the power in high-voltage lines over what may be long distances to get it to the general area of the customer and includes provision and maintenance of the lines and other equipment necessary to the process. Distribution includes transforming the power to lower voltage and distributing it over smaller lines to the individual customer, installing and maintaining power distribution lines to new and existing customers and providing emergency response in the event of disruption of service. Distribution services include metering, billings, and marketing.

The electric utility industry is changing dramatically. Traditionally customers were compelled to purchase power from the company that provided the distribution service to the customer's location. Deregulation is removing this restriction and removing the monopolistic hold the distribution company exerted in its service area. It will allow service providers to compete for individual customer's business, and allow the customer to determine which service provider best fills individual needs. These changes will certainly affect the cost, the price, and the reliability of electric service. It will also necessitate changes to the ways utility providers account for and report the cost of providing their services to both the regulating agencies that had been charged with protecting the customer and to the customer.

For those in the electric business, retail wheeling has been a hot topic for several years now, and is one of various proposals to dramatically change how customers buy their power. Retail wheeling refers to the ability of the customer to contract for electric power in the open market. Deregulation to allow retail wheeling would allow the customer to "wheel in" power from various sources. Under retail wheeling, power owned by a supplier is delivered to the customer over transmission and distribution lines owned by a third, unrelated party. The owner of the lines charges a fee for letting others use them. A wheeling charge is levied for both transmission and distribution line usage. Today, few utilities have any retail wheeling transactions, because each utility actually has purchased and owns the electricity that flows across its lines to retail customers. However, some of the larger commercial and industrial electricity customers, especially in states with high power costs, believe that they can save money by wheeling in less expensive electricity from a supplier other than their existing source. To save money under these conditions the combined price for the power plus the wheeling charge would be less than the cost currently incurred for power from the owner of the transmission and distribution lines servicing the buyer.

This apparent boon to purchasers in high rate areas could conceivably divert power from areas with low power rate structures to areas where the power might be sold more profitably. It also has implications for utility companies such as customer-owned electric cooperatives that exist with the purpose of providing low-cost electricity to low volume users. These users traditionally are widely dispersed and the cost of installing and maintaining transmission and distribution lines is relatively higher than in areas of greater customer concentration.

Investor-owned utilities and customer-owned utilities, such as these electric cooperative, are preparing for a market based on customer choice. California, Pennsylvania, and Illinois, are all states that have enacted some form of legislation allowing competition in the power industry within the state. In order to remain the supplier of choice, each utility will need to determine ways to keep their electric rates as low as possible, but they must also continue to assure that their customers have access to the wide range of services necessary for power delivery. All electric suppliers will be forced to analyze the cost and range of services they provide to their customers.

FLEMING-MASON ENERGY

Fleming-Mason Energy was incorporated in 1937, and currently provides electric service to more than 20,000 customers in eight Kentucky counties. Like most rural electric cooperatives, it was formed in the 1930's with funding provided by the Rural Electrification Administration (REA). Throughout the years, REA provided low-cost government loans to help ensure that all Americans have access to electric power. The major purpose of the non-profit cooperatives funded by these loans was to provide electric service to areas where customers were dispersed so widely, and the cost of providing transmission lines was so large compared to the volume of power used, that investor-owned utility services could not profitably operate. The major difference between an investor-owned utility and a cooperative is that the investor-owned utility has a mission to maximize shareholder wealth, while the cooperative is a customer-owned non-profit company committed to providing good service at the lowest possible cost.

RUS (Rural Utilities Services), which in 1995 combined the former REA with services to provide other rural utilities such as water and fiber-optics, provides loan funds for a variety of utility cooperatives throughout the United States. The uniform system of accounts established by RUS, is required for all RUS electric borrowers so that comparability can be maintained. The RUS accounting system is primarily concerned with providing information to the creditors and customer members of the cooperatives. Like most electric cooperatives, Fleming-Mason Energy currently uses the financial accounting system established by RUS to manage and report their financial activities.

In the competitive environment, in which Mason-Fleming now finds itself, this accounting system is inadequate. As a financial accounting system, it does not focus on where and why costs occur. In general, costs are incurred because of activities that must be performed to provide services. Using a traditional accounting system, service costs may be allocated without sufficient consideration of what activities are needed to perform those services. In addition, there is no consistent relationship between the cost of labor to provide the service and the total cost of the service. This makes traditional product costing using direct labor as the allocation base for indirect cost especially inaccurate.

Managers of Fleming-Mason Energy think that in order to compete in an open market, a more detailed management accounting system must be established. Therefore, Fleming-Mason Energy is implementing an activity-based costing (ABC) system. ABC helps establish a link between the services offered, the activities that are necessary to provide these services and the expenditures necessary to perform the activities. By establishing this link, costs can be tracked and assigned to processes and activities performed by the cooperative. By examining the services that require these processes and activities the costs can be assigned more accurately to different services. Once a clear picture emerges of which services require which activities and the cost of these activities is established, managers can make better choices on which services to offer and how to price them. ABC systems assist managers in determining what causes costs, and how they can manage activities or processes to reduce these costs.

With the emergence of a competitive marketplace, Fleming-Mason Energy will re-evaluate policies as well as cost structures. Currently, the electric rates paid by members are determined by the costs required to provide a bundle of services including many of those mentioned above such as installing and maintaining power transmission and distribution lines to new and existing customers and providing emergency response in the event of disruption of service. Other services offered by Fleming-Mason Energy, such as metering, billings, and marketing, are already open to outside competition. After deregulation, all the services will be open to competition.

Another change to the accounting system that will be brought about by deregulation will be unbundled billing. Cooperatives under state utility commissions will be forced to file cost reports based on known and measurable unbundled costs. Fleming-Mason Energy's current rates consist of a customer meter charge, a kWh charge, and in larger commercial installations, a demand charge. Fleming-Mason Energy currently purchases all of its' power requirement needs from one power generation and transmission cooperative. This power supplier charges Fleming-Mason Energy substation charges, energy charges, and demand charges. As a generation and transmission company this power supplier's costs are affected by changes in the cost of fuel. Therefore, the customers' bills are subject to an increase or decrease from the approved rate, depending upon the current cost of fuel. In an unbundled billing system, it will be necessary to present the costs in more detail. What was a simple billing method will become very complex for the utilities and for the customers. Under an unbundled billing system, the customer bill will include charges for the following: electric energy generation, transmission wheeling, distribution facilities, distribution line, distribution service, meter reading, and billing. The new bill will also include a stranded cost recovery charge. Under deregulation, customers will be able to choose their electric supplier. However, the chosen supplier will be forced to pay the owner of the transmission and distribution lines servicing the customer for the use of distribution facilities. The charges paid by the new supplier to the old supplier will include a stranded investment recovery cost to allow the owner of the transmission and distribution system to recover the cost of installing the system. The existing supplier has made an investment to provide service to that customer. When the customer changes suppliers, the new supplier has no investment in the distribution service. Therefore, the new supplier must reimburse the old supplier for their stranded costs. In states that have deregulated the electric industry, the recovery of stranded investments has given rise to the most heated discussion and been the most difficult portion of the deregulation process upon which to reach an agreement. Fleming-Mason Energy, as well as every other utility, will be forced to put a price on stranded investments. Unbundled billing through deregulation is forcing every utility to rethink the way they keep their financial records.

Fleming-Mason Energy will be forced to determine the strengths and weaknesses within the range of services offered. In the event Fleming-Mason Energy cannot compete effectively in a given area of the business, they will be forced to cede that process to a third party provider. Losing any of these processes could be harmful to the relationships Fleming-Mason Energy has with its cooperative member customers. Therefore, Fleming-Mason Energy must determine cost and performance measures in the critical areas of their business, to ensure that they can retain control of their core business activities and processes. As an example, many investor-owned utilities are going through the process of determining what areas of the business they perform best, and what areas provide the most profit. Many investor-owned utilities are merging in order to reduce operating costs, and in order to gain a larger market share. Other investor-owned utilities have determined that it is best for them to be in the generation and transmission business, not the distribution business. Therefore, they have sold portions of their distribution systems to other utilities. In order to make these decisions with confidence, the managers of these utilities relied widely upon ABC accounting information instead of traditional cost accounting information. The cooperatives that have not implemented an ABC system will be forced to make uninformed decisions in the future. The companies that will succeed in a competitive market are the companies who fully understand their costs, and make sound decisions based upon their cost data.

Managers can work toward understanding the optimum mix of services they must provide to maximize customer satisfaction and work toward improving the efficiency of the underlying activities necessary in providing these services. They can then consider outsourcing essential services that they cannot provide competitively and the possibility of eliminating services that are both non-essential to customer relationships and which they cannot perform at a competitive cost. During this process, they might find that they are especially efficient at providing certain services. Services that fall into this category are core competencies that should be identified for maximum expansion. Through this process the ABC system will provide cooperative managers with the cost information needed to make sound economic and strategic decisions.

Fleming-Mason Energy recently participated in a performance-benchmarking workshop in which utilities of similar sizes were benchmarked against one another and the industry at large. Benchmarking is the practice of identifying which companies are the best performers in certain areas of their business. The electric power distribution benchmarking process included a variety of areas such as engineering design, outage response and restoration, right-of-way maintenance, line construction, and line maintenance. The benchmarking process involved compiling the accounting cost data into an ABC accounting format.

According to Fleming-Mason Energy management, the idea of the benchmarking process was to establish a database that would allow extraction of relevant cost data through the use of uniform definitions. For example, Fleming-Mason Energy had always expensed outages based on the amount of time elapsed from the initial customer call until power was restored and the employees returned home. The benchmarking process required that they break the outage time into three distinct areas. The first area was response time. How long did it take the on-call crews to arrive at the office after the outage call was received? The second area was travel time. How long did it take the crews to drive from the office to the location of the outage, and to return home after repairing the outage? The third area was repair time. How long did it actually take the crews to find the cause of the outage, and to repair and restore electric power? Breaking the outage information into three different areas offered a better understanding of the distinct activities performed and highlighted possible inefficiencies.

The method of computing the cost of running a service to a new customer was revised. In the past, all costs to provide the service drop were grouped together in the same account. Under the benchmarking process, Fleming-Mason Energy managers broke the cost of providing a new service drop into two areas. Services that included the addition of a pole were grouped together, and services that included just running additional wire were grouped together. With the added knowledge gained by breaking down these costs, the engineering department was able to make better decisions when determining how service should be provided to a customer.

As a result of the benchmarking program, Fleming-Mason Energy managers learned several ways in which cost data could accurately be grouped by activity then tied to the services provided. Because many of the companies participating in the benchmarking workshop did not keep records with as much detail as those required for the workshop, some of the benchmarking comparisons were inaccurate. However, Fleming-Mason Energy management learned that if Fleming-Mason Energy had performed at a level equal to the best performer in all the benchmarked areas their savings would have been over $1.2 million for the year.

In conclusion, the electric utility industry is changing, and will continue to change over the next decade. Territorial boundaries will be broken down, as competition begins dictating the electric market. Many utilities are still using financial cost accounting records for their primary financial data. In a deregulated industry, the utilities that learn to implement an advanced cost management system will have an advantage over their competition. Fleming-Mason Energy is currently implementing ABC in hopes of being able to make sound decisions in their changing environment. Small cooperatives like Fleming-Mason Energy may not survive in a deregulated marketplace. Many utility experts believe that deregulation will lead to an industry with only a few extremely large power companies. The cooperatives working together are striving to become one of those large power companies. Many cooperatives have joined forces and created Touchstone Energy. As a group, Touchstone Energy Cooperatives are the largest provider of electric service in the United States. Through the use of marketing and management decisions based upon actual cost data, the cooperatives, including Fleming-Mason Energy, are preparing for the future.

DISCUSSION QUESTIONS

1. In as much detail as possible given the information provided, make a list of services that are likely provided by Fleming-Mason Energy.

2. What are the activities that Fleming-Mason Energy is likely to perform in providing these services?

3. What are the cost pools to which you would suggest these actives be assigned?

4. Are these cost pools sufficiently detailed to provide information for unbundled billing? What additional information do you think will be necessary to provide this type of billing? Choose one of the cost pools identified above and show how the cost collected in that cost pool could be traced to specific services. It may be helpful to use assumed amounts and demonstrate the process.

5. What is Fleming-Mason Energy's strategy?

6. What services do you think are core to this strategy?

7. Are other services provided by Fleming-Mason Energy that are not core to their strategy that they might consider outsourcing?

8. What are some of the considerations that they should examine when making outsourcing decisions?

Martha Lair Sale, Sam Houston State University