How rates are set
What is a cost-of-service study?
The cost-of-service study is the analytical core of utility ratemaking — the step that decides how much of a utility's costs each group of customers should carry. Here is what it is and how it works.
The short answer: a cost-of-service study (COSS) takes a utility's total revenue requirement and divides it among customer classes — residential, commercial, industrial, and so on — in proportion to what each class costs to serve. It does this in three steps: functionalize costs by part of the system, classify them by what drives them, and allocate them to classes. The result shows who is paying more or less than the cost to serve them today.
Why utilities do them
A utility serves customers who impose very different costs — a home, a factory, a streetlight, a data center. Charging them all the same way would mean some subsidize others. A cost-of-service study applies the principle of cost causation (whoever causes a cost should pay it) so that rates are fair, defensible, and grounded in each class's actual use of the system. It is the evidence base a utility brings to its board or commission when it proposes a rate change.
The three steps
1. Functionalization
Sort every cost by the function it serves: power supply (generation or purchased power), transmission (moving power at high voltage), and distribution (the local poles, wires, and transformers that deliver it). This organizes the revenue requirement by the parts of the system.
2. Classification
Within each function, sort costs by what drives them: customer-related (costs of connecting and billing an account, regardless of usage), demand-related (costs of building capacity to meet peak load), and energy-related (fuel and per-kWh costs).
3. Allocation
Spread each classified cost across customer classes using allocation factors that reflect real usage — a class's share of system peak demand for capacity costs, its share of energy for fuel, its customer count for customer costs. Methods like the 12-CP (twelve monthly coincident peaks) and the minimum-system approach live in this step.
What it produces
The output is a clear picture of class cost responsibility: how much revenue each class should provide to cover the cost of serving it, and how that compares to what each class pays today. Gaps reveal cross-subsidies — classes paying more or less than their cost. That picture is the starting point for the next stage, rate design, and the documentation a utility needs to defend its rates. In the United States, this methodology follows the long-established practice in the NARUC Cost Allocation Manual.
Frequently asked questions
What is the difference between a cost-of-service study and rate design?
A cost-of-service study determines how much of the utility's revenue requirement each customer class is responsible for, based on the cost to serve it. Rate design is the separate, later step that turns that responsibility into the actual customer, demand, and energy charges on a tariff. The study answers 'who should pay how much'; rate design answers 'through which charges.' Conflating the two is a common source of error.
How long does a cost-of-service study take?
A traditional consultant-led study often runs several months and costs a utility tens of thousands of dollars, largely because of data gathering and spreadsheet modeling. Software that structures the inputs and automates the allocation math can compress that substantially, but the quality of the result still depends on clean billing, plant, and load data.
How often should a utility run one?
Many utilities run a full cost-of-service study every three to five years, and sooner when something material changes — a large capital project, a jump in wholesale power costs, significant load growth, or a shift in customer mix. Between full studies, utilities often refresh key inputs to keep rates aligned with cost.
Who uses the results?
Utility management uses them to propose rates; boards, city councils, or state commissions use them to review and approve rate changes; and lenders such as the USDA's Rural Utilities Service rely on them to confirm rates support the utility's financial obligations. A defensible study is what makes a rate change credible to all of them.
Keep reading
What is rate design?
The next step — turning class cost responsibility into real charges.
What is a revenue requirement?
The total dollars a study starts from — where it comes from.
Rate360 runs cost-of-service studies on the same methodology described here. See the methodology