cost modeling and price regulation in telecommunications: methods and experiences sandra cohen...

Cost modeling and Price Regulation in telecommunications: Methods and Experiences

Sandra CohenLecturer of AccountingAthens University of Economics and Business

1/7/2004 Sandra Cohen 2

Presentation overview

Goals of EU directivesCosting and pricing principles for regulated

servicesPresentation of the basic steps in costing

methodologyAsset valuation alternatives (HC- CC)Cost standard alternatives (FDC- LRAIC)Cost accounting systems used by the

incumbents in member statesCommon deviations from cost orientation


EU objectives pursued

Liberalisation of the telecoms market Restriction of the monopolistic power of

the incumbent Protection of the newcomers Improvement of the quality of services

offered, decrease of prices, increase of consumers’ options and introduction of new innovative services


EU directives

Fixed Telephony directive 98/10 (previous 95/62)

Leased lines directive 92/44 Interconnection directive 97/33

Recommendation 98/322/EC, 8/4/1998 (costing)Proposed amendments included in a new ERG Document

Recommendation 98/195/EC, 8/1/1998 (pricing)Assess directive 2002/19Framework directive 2002/21USO directive 2002/22


Basic pricing goals (non competitive services)

Encouragement of the effective competition Avoidance of:

price squeezepredatory pricing and excessive pricing practices

Transmission of the «correct» economic signals

Coverage of the incumbent's accounting cost and allowance for a reasonable rate of return


Basic pricing principles

The prices have to be: Adequately unbundled Publiced Competition oriented Non descriminatory Cost orientated


Why cost orientated ?

Cost is an adequate benchmark when competition doesn’t exist

As soon as three factors are taken into consideration Incumbent’s efficiency

Bottom -up models can be used as benchmarks

Network technology Cost of capital (“Reasonable profit margin”)

In case cost orientation cannot be obtained:Then use best Then use best

practicepractice


Basic costing principles (for regulatory purposes)

Cost causation principle Activity based costing Network costing

Objectivity principleConsistency principleTransparency principle

Auditability Accounting Separation

Access Network

RetailOther

services


Accounting Separation - Access

Access Network

RetailOther

services

OLOs

Customers

Revenues for AccessCost for Retail

Transfer prices


Accounting Separation - Network

Access Network

RetailOther

services

Customers

OLOs

Revenues for NetworkCost for Retail

Transfer prices


Accounting Separation Reports

Network

Revenues(1) OLOs

Local Interconnection XXX Single Interconnection XXX Double Interconnection XXX Leased lines XXX Other XXX

OTE Local calls XXX Trunk calls XXX National calls XXX Land to mobile XXX Land to fixed XXX Other XXX

Total Costs (2) XXX Operating Income (1)-(2) XXX


Basic cost elements

Salaries of personnelDepreciation of network elementsDepreciation of buildings and vehiclesTransport costsMarketing costOverheadetc.


Depreciation

Depreciation is the yearly recognition of the cost of assets usage and corresponds to the decrease of asset value

Historical cost - cumulative depreciation = Net book value


Depreciation - ExampleLinear method

Historical cost = € 1.000.000Depreciation rate = 20%

useful life = 5 yearsDepreciation year 1 = € 200.000

(1.000.000 x 20%)Depreciation year 2 = € 200.000

(1.000.000 x 20%)Net book value year 2 = € 600.000

(1.000.000 - 200.000 - 200.000)


Cost objects

Commercial services Local calls long distance calls International calls Leased lines Monthly rentals

Wholesale products Interconnection services Local Loop unbundling

Non regulated Services E.g. telex, internet

The regulator does not

care about them


From cost elements to cost of services

Cost elements

Cost of

services

• Cause causalityprincipleapplication

• Asset valuation method

• Cost standardselection


Methods of cost causation principle application

Linking cost elements with cost

objects

Activity based costing

Network costing



Personnel cost

Business processes - departments

Activities

Cost drivers

SERVICE

COST

General Ledger and Salary database

Questionnaires- Time spend to activities

What is the reason for the activity tobe performed

Allocation to services

Overheads Allocation to services



Personnel cost

Customer service

Activities related to customer service- access

Number of lines

ACCESS

SERVICE

COST


Allocation to services

Overheads Already allocated cost



Personnel cost€10.000.000

Customer service30%, € 3.000.000

Activities related to customer service- access50%, € 1.500.000

Number of lines - 2.000.000 € 0,75 /line

ACCESS

SERVICE

COST


Allocation to servicesOverheads € 20.000.000

Assume 5%, € 100.000 or € 0,05/line

Already allocated cost


Network costing

Cost of assets

Physical network elements

Cost drivers

Network entities

Routing factors

SERVICE

COST

General Ledger and Fixed Assets Register

What is consuming the capacity of the element: Minutes, calls,

subscribers?

Grouping of elements based on cost driver analysis

Service recipes, volume per service and total volume


Routing Factors - 10.000 min of local call

TelephoneSub.

Local Switch Local Switch

TelephoneSub.

TandemSwitch

RSU - Local Link

Tandem LocalLink

1

1 1

1

1

Routing factor

Actual min

Equivalent minutes

Cost per component

Cost/equivalent minute

Cost per minute

RSU- Local Link 2 10.000 20.000 2.000 0,100 0,200Tandem - local link 2 10.000 20.000 5.000 0,250 0,500Local switch 2 10.000 20.000 4.000 0,200 0,400Tandem switch 1 10.000 10.000 1.000 0,100 0,100

Total cost minute 1,200


Routing Factors - 1 min of local call

TelephoneSub.

Local Switch Local Switch

TelephoneSub.

TandemSwitch

RSU - Local Link

Tandem LocalLink

1

1 1

1

1

RSU- Local Link- 2 min.

Tandem - local link - 2min

Local switch - 2min

Tandem switch - 1min


Network costing- example switches

Cost of local switches

Local switch components accessand local switch components traffic

Cost driver = minutes

local switch traffic(actual min. x routing factors per service)

local switch traffic minutes used for local calls

LOCAL

CALL

SERVICE

Depreciation, Air conditionBuildings, power,

network management, etc.

RSU - traffic costTandem switch cost

RSU-local transmission linkLocal - Local transmission link

Local -Tandem transmission linkTandem - Tandem transmission link


Network costing- example switches

Cost of local switches€ 10.000

Local switch components accessand local switch components traffic - 70% € 7.000

Cost driver = minutes

local switch traffic = 20.000 actual x 1,8 = 36.000cost per minute = € 0,195/min.

local switch traffic minutes used for local calls

assume 16.000 x 1,1 x 0,195 = € 3.432

LOCAL

CALL

SERVICE

Depreciation, Air conditionBuildings, power,

network management, etc.

RSU - traffic costTandem switch cost

RSU-local transmission linkLocal - Local transmission link

Local -Tandem transmission linkTandem - Tandem transmission link Assume 0,215 (1.1x 0.195) + 0,10 +…+ 0,05 =


Cost of capital

The total cost of a service also includes a rational rate of return (profit margin)

This rate of return is based on the cost of capital of the incumbent (WACC)

The cost of capital that corresponds to each service equals the capital employed for this service multiplied by the rate of return (WACC)


Balance SheetTotal Assets Total liabilities

TOTAL ASSETS TOTAL LIABILITIES

EQUITY

LONG TERM LIABILITIES

=

Accounting Equation

SHORT TERM LIABILITIES

FIXED ASSETS

CURRENT ASSETS

Capital employed


WACC (Weighted Average Cost of Capital)

WACC =

Cost of debt debt Χ

Cost of equtiy equityΧ+

Debt +Equity

Example: Cost of debt =7%, debt € 100.000, cost of equity 15%, Equity € 200.000 (Market Value or Book value)

7% Χ 100.000 + 15% Χ 200.000

100.000 + 200.000=

37.000300.000

= 12,34%


Cost Model Structure

Cost element 1 Cost element 2 Cost element n

Activity 1 Activity 2Activity n

Network element 1 Network element n

Service Α Service Β

Capital employed

Service Α x WACC

Capital employedService B

x WACC


Asset valuation

Asset valuation influences cost in two ways: Depreciation cost (directly influences

the cost of service) Net book value (indirectly influences the

cost of service via working capital)Two alternatives:

Historical cost Current cost


Historical prices

The cost of asset acquisition when the asset was bought or constructed

The cost of the asset corresponds to a past decision that may be obsolete due to technology changes or other reasons


Current prices

There are a lot of alternative ways in order to calculate current cost Modern equivalent asset: An asset that has the

same functionality as the existing one and uses the most efficient and economic technology established in the market place (forward looking)

Replacement cost Secondary market Cost adjusted to inflation

The usage of current prices sends the correct signals to the market


Cost calculation

There are two main approaches in service costing (cost standards) Fully distributed cost (FDC) Long Run Average Incremental cost (LRAIC)

EU is in favour of LRAIC because it is theoretically suitable for efficient pricing

Both cost standards permit incumbent’s cost coverage


Fully distributed cost

According to the FDC standard the cost of a service derives from the usage of a set of algorithms that allocate both direct and indirect costs to it

Some of the indirect allocations are arbitrary and may cause cost distortion


Long run average incremental cost (1)

The long run average incremental cost (LRAIC) of a service equals to the total cost of the company minus the cost of the total company if it continues to provide all the other currenty provided services but the specific one

The sum of LRAIC of all services is less than the total cost of the company due to the existance of common costs


Long run average incremental cost (2)

The cost of a service on the basis of LRAIC is: lower than the SAC (Stand Alone Cost)

of the service and higher than the IC (Incremental Cost) of

the service This is because the common cost

has to be allocated to services Mark - ups LRAIC+ SACLRICLRICIC


Total cost 2 services

Tot

al c

ost

Total volume


Total cost - 2 servicesFDC - Cost per service

Tot

al c

ost

Total volume

Α

Β


Total cost - 2 servicesAverage ΙC- Cost per service

Com

mon

Cos

t

Total volume

Α

Β

Ave

rage

IC

- A

A

vera

ge

IC -

B

Incremental cost


Floors and Ceilings

Ceiling

Floor

SAC

LRAIC

LRAIC +


Total cost - 2 servicesSAC Service A & IC Service Β

Total volume

Α

Β

SA

C A

IC

- B


Fixed vs. Variable costs

Fixed are the costs that remain unchanged for a relevant range of activity Depreciation Management remuneration

Variable are the costs that fluctuate relatively to the level of activity Linear or no linear relationships (economies of

scale) Power Direct labour


Cost accounting systems currently used for interconnection

LRAIC Greece Austria Denmark France Germany Ireland Luxembourg Spain (FDC mix) Switzerland (FDC mix) Great Britain

FDC

Belgium (CC)

Italy (CC)

Norway

Portugal

Source:Cullen International February 2004


WACC rates currently used

Austria 9.34% Belgium 12.46% Denmark 12% France 12.1% Germany 10.6 % Ireland 12 % Italy 13.5% Holland 10.7%-12.3%

Norway 13%

Spain 12.6%

Sweden 15%

Swetzerland 11.75%

Great Britain 12.5%

Greece 12.1%Source:Cullen International November 2001


Common deviations from cost orientation

Cross subsidisation of servicesUnbalanced tariffsGeographically averaged tariffsUniversal service (affordability)


Bibliography BT, ‘‘LRIC Methodology’’, 6 May 1997, p. 13/52 Official Journal, 98/195/EC: Commission Recommendation of 8 January 1998

on interconnection in a liberalised telecommunications market (Part-1- Interconnection Pricing), L 141, 13/05/1998, p. 0006-0035.

Official Journal, 98/322/EC: Commission Recommendation of 8 April 1998 on interconnection in a liberalised telecommunications market (Part-2- Accounting Separation and cost accounting), L 073, 12/03/1998, p. 0042-0050.

OFTEL, “Draft guidelines on the application of the competition act in the telecommunication sector – Consultation”, January 1999.

WIK, “Network Interconnection in the Domain of ONP” Study for DG XIII of the European Commission, Final report, November 1994

Telecom Reform: Principles, Policies and Regulatory Practices, Editor W. Melody, Technical University of Denmark, 2001.

Hilton, R., M. Maher and F. Selto, “Cost management: Strategies for Business Decisions”, International Edition, second version, Mc Graw Hill, 2002.

cost modeling and price regulation in telecommunications: methods and experiences sandra cohen...

Documents

cost slide

access cost

cost orientation slide

cost modeling

incumbents accounting

business slide

costing ynetwork costing

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