If you’ve ever found yourself in a utility meeting where someone throws out the terms embedded cost and marginal cost like everyone should already know what they mean, don’t worry, you’re not alone.
These two concepts come up all the time in utility regulation, especially during cost studies and rate design. And while they sound technical, understanding the difference between them is key to grasping how utility rates are built, and why they can vary so much depending on who’s doing the math.
So let’s unpack them in plain English.
What Are Embedded Costs?
Embedded costs (sometimes called historical or accounting costs) refer to the actual costs that a utility has already incurred over time to provide service. Think of it as a financial scrapbook of everything the utility has spent money on: infrastructure, labor, equipment, maintenance, and so on.
Embedded costs are typically based on what the utility paid for assets in the past, not what those assets are worth today. They’re often used when regulators calculate the revenue requirement, which is the total amount a utility needs to recover through customer rates to stay solvent and keep the lights on.
Real-World Example
Let’s say a utility built a substation 20 years ago for $5 million. That $5 million becomes part of the embedded cost, even if building that same substation today would cost $8 million. The focus is on what was spent, not what would be spent now.
What Are Marginal Costs?
Marginal costs, on the other hand, look forward. They ask: What is the cost of providing one more unit of service?
In the utility world, this might mean the cost of serving one more kilowatt-hour of electricity or adding one more customer to the system. Marginal costs help policymakers understand the incremental cost of expanding or changing a service.
Real-World Example
If adding one more customer to the grid will cost $1,200 in equipment, connection, and ongoing service, that’s the marginal cost. It doesn’t matter what was spent in the past, it’s all about what it will cost next.
So, Why Does the Difference Matter?
Here’s where things get interesting.
When setting rates, some regulators prefer embedded costs because they’re based on what the utility actually spent and are easier to audit and defend. Others lean toward marginal costs because they align better with economic efficiency and real-time decision-making.
But using one over the other can drastically change the outcome of a cost study or rate case. You might end up with two very different views of what it costs to serve a customer, both technically “correct,” but serving different goals.
That’s why understanding the assumptions behind any cost study is so important. As Clark Kaml explains in Don’t Fear the Cost Study, numbers alone don’t tell the full story, you have to know what kind of cost is being measured and why.
Bottom Line
Embedded costs look backward. Marginal costs look forward. Both have value, but they answer different questions.
If you’re making decisions about utility rates, infrastructure investments, or policy priorities, knowing which lens you’re using can make all the difference. Because when it comes to cost studies, it’s not just about the math, it’s about the meaning behind it.
Need help applying these concepts to your utility’s challenges? CDK Consulting is here to help you sort through the details and make smarter, well-informed decisions.
