Business essentials for utility engineers

329 Pages·2010·14.774 MB·English

by  Richard E Brown

Business
essentials
for utility
engineers
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BusinEss
EssEntials
foR utility
EnginEERs
RichaRd E. BRown
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CRC Press
Taylor & Francis Group
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Boca Raton, FL 33487-2742
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Library of Congress Cataloging‑in‑Publication Data
Brown, Richard E., 1969-
Business essentials for utility engineers / Richard E. Brown.
p. cm.
Includes index.
ISBN 978-1-4398-1196-2 (hbk. : alk. paper)
1. Public utilities--Management. 2. Public utilities--Finance. I. Title.
HD2763.B684 2010
363.6068’1--dc22 2009044119
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Contents

Preface ix

Author xv

1. UTILITIES 1
1.1. Types of Utilities 2
1.2. Natural Monopolies 15
1.3. Utility Ownership 16
1.4. Utility Regulation 20
1.5. Utility Rates 23
1.6. Service Standards 25
1.7. Deregulation 28
1.8. Summary 30
1.9. Study Questions 31

2. ACCOUNTING 33
2.1. The Basic Accounting Equation 33
2.2. Journals, Ledgers, and Accounts 38
2.3. Accounting Principles 41
2.4. Financial Statements 55
2.5. Other Types of Accounting 74
2.6. Summary 82
2.7. Study Questions 82

3. ECONOMICS 85
3.1. Supply and Demand 86
3.2. Market Pricing 90
3.3. Producer Surplus 95
3.4. Monopolistic Pricing 97
3.5. Business Cycles 101
3.6. Summary 106
3.7. Study Questions 107

v
vi Business Essentials for Utility Engineers

4. FINANCE 109
4.1. Time Value of Money 110
4.2. Company Valuation 121
4.3. Market Efficiency 124
4.4. Capital Structure 136
4.5. Tax Shields 140
4.6. Bankruptcy 141
4.7. Summary 145
4.8. Study Questions 145

5. RISK 147
5.1. Probability and Statistics 148
5.2. Stock Price Movement 158
5.3. Diversification 160
5.4. Portfolio Theory 165
5.5. Capital Asset Pricing Model 173
5.6. Financial Options 180
5.7. Real Options 191
5.8. Summary 192
5.9. Study Questions 194

6. FINANCIAL RATIOS 195
6.1. Profitability Ratios 196
6.2. Activity Ratios 200
6.3. Leverage Ratios 203
6.4. Liquidity Ratios 204
6.5. Market Ratios 205
6.6. DuPont Analysis 209
6.7. Residual Income and EVA 211
6.8. Summary 213
6.9. Study Questions 214

7. RATEMAKING 215
7.1. Regulatory Goals 216
7.2. Revenue Requirements and the Rate Base 219
7.3. Rate Design 222
7.4. Rate Cases 237
7.5. Rate Base Misconceptions 240
7.6. Summary 244
7.7. Study Questions 245
Contents vii

8. BUDGETING 247
8.1. Top-Down Budgeting 248
8.2. Bottom-Up Planning 256
8.3. Types of Budgets 261
8.4. Project Prioritization 264
8.5. Business Case Justification 280
8.6. Summary 300
8.7. Study Questions 301

9. ASSET MANAGEMENT 303
9.1. What Is Asset Management? 304
9.2. History of Utilities 306
9.3. History of Asset Management 309
9.4. Organizational Functions 311
9.5. Asset Management Process 313
9.6. Summary 316
9.7. Study Questions 317

Index 319
Preface

This is a book for utility engineers. Typical readers will have studied engineer-
ing in college, received an engineering degree, and somehow ended up pursuing
a career within a utility or taken a job associated with utilities. Academic cre-
dentials for most of these readers will include advanced mathematics,
probability, statistics, chemistry, physics, and materials science. Most will have
further specialized in a specific area such as electrical engineering, mechanical
engineering, or civil engineering. These types of readers are well-educated and
intelligent, an assumption made by the author when presenting material, some-
times difficult material, throughout the book.
Utilities have many challenging engineering problems to be solved. New
customers must be served. Old equipment must be maintained. New technolo-
gies must be assessed and adopted. To solve these challenges, engineers find
themselves responsible for planning, engineering, system analysis, system de-
sign, equipment specification, maintenance management, operations, and a host
of other functions.
Whatever their role, utility engineers make many decisions. Some of these
decisions result from extensive and careful analyses. Others are made quickly
during everyday activities. In virtually all cases, decisions have cost and other
implications for the utility. Some options are cheap. Others options are expen-
sive. Some options spend as little as possible now. Others options spend money
now in order to save money later. Some options result in high safety margins.
Other options are more risky. With so many choices, it is valuable for utility

ix
x Business Essentials for Utility Engineers

engineers to understand the criteria for deciding which decisions are best from a
business perspective.
Typical businesses prefer engineering decisions that result in higher profits.
A cheaper engineering solution may produce higher profits if a resulting lower
price causes an increase in sales. It is also possible that a more expensive engi-
neering solution will produce higher profits if the resulting higher quality
product can command a premium price. In both cases, the business objective is
clear: while acting legally and ethically, maximize profits whenever possible.
Do utilities want their engineers to maximize profits whenever possible?
Stockholders of publicly traded utilities would answer with a resounding “yes.”
However, the profits of utilities are essentially controlled by regulators, making
profit maximization for utilities somewhat different than for other industries.
There is a large body of literature on every imaginable business topic, but few
address the application of these business topics to utilities in an effort to de-
scribe similarities, differences, and why these differences are important.
Business Essentials for Utility Engineers hopefully fills this gap.
This book does not address a variety of topics that are typically covered in a
business curriculum. Examples include strategy, marketing, organizational de-
sign, human resources, and business ethics. These topics are important in a
general sense, but tend to be peripheral to most issues facing utility engineers.
Their application to utilities is similar to other types of businesses, allowing the
interested reader to effectively study these topics through general business pub-
lications that are not specific to utilities.
The author spent about six years writing this book. The material evolved
from a large number of asset management and business consulting engagements
between the author and utilities, including numerous seminars and short courses.
Hopefully, this collaborative process has resulted in a book that is both interest-
ing and practical for utility engineers. An exhaustive academic approach has
been intentionally avoided so that the focus can be on essential material rather
than on details and nuances. Even with this approach, the book is suitable for
self-study, undergraduate study, graduate study, and desk reference. It will be
most useful for utility engineers, but will also have value for utility managers,
regulators, and others associated with utilities such as vendors, consultants, and
for engineers and consultants working with non-utility companies with a utility-
like infrastructure.
Although this book mostly focuses on practical issues, the reader should be
prepared for a generous amount of business theory and the periodic use of ad-
vanced mathematics. The reader should also be prepared for an extensive
vocabulary lesson. For the reader’s benefit, the first instance of each important
business term is presented in italics.
Like engineering, business has a large number of words and phrases with
precise meanings. Many of these words and phrases represent simple concepts,
and can be easily learned and understood. Although some terms represent diffi-
Preface xi

cult or confusing concepts, this book will remove much of the mystery and serve
as a reference when necessary. For many utility engineers, much of the value of
this book will derive from an increased ability to communicate with senior man-
agement using business jargon.
Chapters are organized, for the most part, to build sequentially upon each
other. This is not always possible since topics overlap. For example, accounting
sometimes uses financial concepts and finance sometimes uses accounting con-
cepts, resulting in the periodic need for forward referencing. Many terms and
concepts presented in earlier chapters are used in later chapters. Therefore, the
first-time reader will benefit from reading each chapter in order, from Chapter 1
through Chapter 9.
This book starts in Chapter 1 by addressing the special aspects of public utili-
ties that affect their characteristics as a business. Specific topics include the
main types of utilities, the nature of monopolies, different utility ownership
structures, regulation, rates, service standards, and utility deregulation. It does
not address any business topics. To do so would be premature and not helpful to
the reader. Instead, the information in Chapter 1 provides the reader with a gen-
eral overview of utilities and introduces terminology and context that are
required for a full comprehension of future chapters.
Accounting, covered in Chapter 2, is chosen as the first business topic be-
cause it is difficult to address other aspects of business without using accounting
concepts and terminology. Accounting is covered from an engineering and tech-
nical management perspective; detailed treatment of accounting mechanics,
rules, nuances, and processes is beyond the scope of this book and is avoided.
The focus is to present the theory and principles underlying financial account-
ing, provide a sound basis for the interpretation of financial reports, and
demonstrate an array of key accounting issues that are important for utility engi-
neers to understand.
The subject of “engineering economics” typically deals with the time value
of money and net present value calculations. In the business world, these topics
are included in the subject of finance. Business economics, the subject of Chap-
ter 3, may occasionally use these tools, but addresses topics very different from
traditional engineering economics. Economics can broadly be classified into
microeconomics and macroeconomics. Most of Chapter 3 focuses on microeco-
nomics, as only a few aspects of macroeconomics are important for utility
engineers. Specific topics include supply and demand, market pricing, producer
surplus, monopolistic pricing, and business cycles.
Chapter 4 is the first of three chapters on the subject of corporate finance. It
begins by discussing the time value of money, a subject most likely familiar to
many readers. It builds on this concept by showing how investors determine the
value of a business, including the ability of markets to efficiently determine the
fair price of a publicly traded stock. Included in this discussion are the sources
of financial capital, capital structure, tax shields, and bankruptcy.