Use of a future test year (that is, cost and revenue projections) in the regulatory process is now common. Once the test year has been selected, the firm’s operating expenses, annual depreciation, annual taxes, and allowed profit are evaluated. The revenue requirement is determined by adding up these items. The second guiding principle is cost allocation.
Cost allocation refers to the distribution of costs among consumer classes. Utility service is produced for different customer classes using the same facilities. As a result, it is difficult to indentify separate marginal costs for each customer class because a large part of the costs are common or joint.