Allowance for funds used during construction, commonly called AFUDC, is a regulatory method of compensating a utility for the financing costs it incurs during construction of new facilities. This is considered critical for utilities because their business is capital-intensive, and it often takes lots of money and time to build large facilities. Since typical utility regulation does not allow the utility to put the cost of a new facility into rates until it is in service, AFUDC offers a way for the utility to recover its pre-operational financing costs.
Utilities finance construction of facilities with both borrowed funds (debt) and retained earnings (equity), thus the financing costs must account for both the cost of debt and a reasonable return on equity. AFUDC is calculated by determining a cost of capital, consisting of weighted debt and equity components, and multiplying this by the construction costs (called construction work in progress or CWIP) accumulated during the construction of an asset.
Here's a example of calculating AFUDC: