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Cost modeling and Price Regulation in telecommunications: Methods and Experiences

Cost modeling and Price Regulation in telecommunications: Methods and Experiences . Sandra Cohen Lecturer of Accounting Athens University of Economics and Business. Presentation overview. Goals of EU directives Costing and pricing principles for regulated services

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Cost modeling and Price Regulation in telecommunications: Methods and Experiences

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  1. Cost modeling and Price Regulation in telecommunications: Methods and Experiences Sandra Cohen Lecturer of Accounting Athens University of Economics and Business

  2. Presentation overview • Goals of EU directives • Costing and pricing principles for regulated services • Presentation of the basic steps in costing methodology • Asset valuation alternatives (HC- CC) • Cost standard alternatives (FDC- LRAIC) • Cost accounting systems used by the incumbents in member states • Common deviations from cost orientation Sandra Cohen

  3. 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 Sandra Cohen

  4. 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 2002/19 • Framework directive 2002/21 • USO directive 2002/22 Sandra Cohen

  5. Basic pricing goals (non competitive services) • Encouragement of the effective competition • Avoidance of: • price squeeze • predatory 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 Sandra Cohen

  6. Basic pricing principles • The prices have to be: • Adequately unbundled • Publiced • Competition oriented • Non descriminatory • Cost orientated Sandra Cohen

  7. 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 practice Sandra Cohen

  8. Network Access Retail Other services Basic costing principles (for regulatory purposes) • Cost causation principle • Activity based costing • Network costing • Objectivity principle • Consistencyprinciple • Transparencyprinciple • Auditability • Accounting Separation Sandra Cohen

  9. Network Access OLOs Transfer prices Revenues for Access Cost for Retail Retail Other services Customers Accounting Separation - Access Sandra Cohen

  10. Network Access Transfer prices Revenues for Network Cost for Retail OLOs Retail Other services Customers Accounting Separation - Network Sandra Cohen

  11. Accounting Separation Reports Sandra Cohen

  12. Basic cost elements • Salaries of personnel • Depreciation of network elements • Depreciation of buildings and vehicles • Transport costs • Marketing cost • Overhead • etc. Sandra Cohen

  13. 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 Sandra Cohen

  14. Depreciation - ExampleLinear method • Historical cost = € 1.000.000 • Depreciation rate = 20% • useful life = 5 years • Depreciation 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) Sandra Cohen

  15. The regulator does not care about them Cost objects • Commercial services • Local calls • long distance calls • International calls • Leased lines • Monthly rentals • Wholesale products • Interconnection services • Local Loop unbundling • Non regulatedServices • E.g. telex, internet Sandra Cohen

  16. Cost of services Cost elements • Cause causality • principle • application • Asset valuation • method • Cost standard • selection From cost elements to cost of services Sandra Cohen

  17. Methods of cost causation principle application • Linking cost elements with cost objects • Activity based costing • Network costing Sandra Cohen

  18. Activity based costing S E R V I C E C O S T General Ledger and Salary database Personnel cost Business processes - departments Questionnaires- Time spend to activities Activities Cost drivers What is the reason for the activity to be performed Allocation to services Allocation to services Overheads Sandra Cohen

  19. Activity based costing A C C E S S S E R V I C E C O S T General Ledger and Salary database Personnel cost Customer service Activities related to customer service- access Number of lines Allocation to services Already allocated cost Overheads Sandra Cohen

  20. Activity based costing A C C E S S S E R V I C E C O S T Personnel cost €10.000.000 General Ledger and Salary database Customer service 30%, € 3.000.000 Activities related to customer service- access 50%, € 1.500.000 Number of lines - 2.000.000 € 0,75 /line Overheads € 20.000.000 Assume 5%, € 100.000 or € 0,05/line Allocation to services Already allocated cost Sandra Cohen

  21. Network costing S E R V I C E C O S T General Ledger and Fixed Assets Register Cost of assets Physical network elements What is consuming the capacity of the element: Minutes, calls, subscribers? Cost drivers Grouping of elements based on cost driver analysis Network entities Routing factors Service recipes, volume per service and total volume Sandra Cohen

  22. Tandem Local Link 1 Tandem Switch 1 1 RSU - Local Link Local Switch Local Switch 1 1 Telephone Sub. Telephone Sub. Routing Factors - 10.000 min of local call Sandra Cohen

  23. Routing Factors - 1 min of local call Tandem Local Link 1 Tandem Switch 1 1 RSU - Local Link Local Switch Local Switch 1 1 RSU- Local Link- 2 min. Tandem - local link - 2min Local switch - 2min Tandem switch - 1min Telephone Sub. Telephone Sub. Sandra Cohen

  24. Network costing- example switches L O C A L C A L L S E R V I C E Depreciation, Air condition Buildings, power, network management, etc. Cost of local switches Local switch components access and local switch components traffic Cost driver = minutes local switch traffic (actual min. x routing factors per service) RSU - traffic cost Tandem switch cost RSU-local transmission link Local - Local transmission link Local -Tandem transmission link Tandem - Tandem transmission link local switch traffic minutes used for local calls Sandra Cohen

  25. Network costing- example switches L O C A L C A L L S E R V I C E Depreciation, Air condition Buildings, power, network management, etc. Cost of local switches € 10.000 Local switch components access and local switch components traffic - 70% € 7.000 Cost driver = minutes local switch traffic = 20.000 actual x 1,8 = 36.000 cost per minute = € 0,195/min. RSU - traffic cost Tandem switch cost RSU-local transmission link Local - Local transmission link Local -Tandem transmission link Tandem - Tandem transmission link local switch traffic minutes used for local calls assume 16.000 x 1,1 x 0,195 = € 3.432 Sandra Cohen Assume 0,215(1.1x 0.195)+ 0,10 +…+ 0,05 =

  26. 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) Sandra Cohen

  27. Capital employed = Accounting Equation Balance Sheet Total Assets Total liabilities EQUITY FIXED ASSETS LONG TERM LIABILITIES CURRENT ASSETS SHORT TERM LIABILITIES TOTAL ASSETS TOTAL LIABILITIES Sandra Cohen

  28. 37.000 300.000 7% Χ 100.000 + 15% Χ 200.000 12,34% = = 100.000 + 200.000 WACC (Weighted Average Cost of Capital) Cost of debt debt Cost of equtiy equity + Χ Χ WACC = Debt +Equity Example: Cost of debt =7%, debt € 100.000, cost of equity 15%, Equity € 200.000(Market Value or Book value) Sandra Cohen

  29. Capital employed Service B Capital employed Service Α x WACC x WACC Cost Model Structure Service Α Service Β Network element 1 Network element n Activity 1 Activity 2 Activity n Cost element 1 Cost element 2 Cost element n Sandra Cohen

  30. 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 Sandra Cohen

  31. 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 Sandra Cohen

  32. 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 Sandra Cohen

  33. 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 Sandra Cohen

  34. 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 Sandra Cohen

  35. Long run average incremental cost (1) • The long run average incremental cost (LRAIC) of a service equals to the totalcost of the company minusthe 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 Sandra Cohen

  36. 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+ Sandra Cohen

  37. Total cost 2 services Total cost Sandra Cohen Total volume

  38. Total cost - 2 servicesFDC - Cost per service Α Β Total cost Sandra Cohen Total volume

  39. Total cost - 2 servicesAverageΙC- Cost per service Incremental cost Average IC - B Α Β Average IC - A Common Cost Sandra Cohen Total volume

  40. Floors and Ceilings Ceiling SAC LRAIC + Floor LRAIC Sandra Cohen

  41. Total cost - 2 servicesSAC Service A & IC Service Β IC - B Α Β SAC A Sandra Cohen Total volume

  42. 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 Sandra Cohen

  43. LRAIC Greece Austria Denmark France Germany Ireland Luxembourg Spain (FDC mix) Switzerland (FDC mix) Great Britain FDC Belgium (CC) Italy (CC) Norway Portugal Cost accounting systems currently used for interconnection Source: Cullen International February 2004 Sandra Cohen

  44. 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% WACC rates currently used Source: Cullen International November2001 Sandra Cohen

  45. Common deviations from cost orientation • Cross subsidisation of services • Unbalanced tariffs • Geographically averaged tariffs • Universal service (affordability) Sandra Cohen

  46. 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. Sandra Cohen

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