Transcript Cost modeling and Price regulation in telecommunications
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 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 1/7/2004 Sandra Cohen 2
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 1/7/2004 Sandra Cohen 3
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 1/7/2004 Sandra Cohen 4
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 1/7/2004 Sandra Cohen 5
Basic pricing principles
The prices have to be: Adequately unbundled Publiced Competition oriented Non descriminatory
Cost orientated
1/7/2004 Sandra Cohen 6
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 1/7/2004 Sandra Cohen 7
Basic costing principles (for regulatory purposes)
Cost causation principle Activity based costing Network costing Objectivity principle Consistency principle Transparency principle Auditability Accounting Separation
Access Retail
1/7/2004 Sandra Cohen
Network Other services
8
Accounting Separation Access
OLOs
Access Network
Transfer prices Revenues for Access Cost for Retail
Retail Other services
Customers Sandra Cohen 1/7/2004 9
Accounting Separation Network Access Network
Transfer prices
Retail
Revenues for Network Cost for Retail
Other services
OLOs 1/7/2004 Customers Sandra Cohen 10
Accounting Separation Reports
Network
Revenues(1)
OLOs Local Interconnection Single Interconnection Double Interconnection Leased lines Other OTE Local calls Trunk calls National calls Land to mobile Land to fixed Other
Total Costs (2)
Operating Income
(1)-(2)
XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX
XXX
XXX Sandra Cohen 11
Basic cost elements
Salaries of personnel Depreciation of network elements Depreciation of buildings and vehicles Transport costs Marketing cost Overhead etc.
1/7/2004 Sandra Cohen 12
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 1/7/2004 Sandra Cohen 13
Depreciation - Example Linear 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) 1/7/2004 Sandra Cohen 14
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 1/7/2004 Sandra Cohen
The regulator does not care about them
15
From cost elements to cost of services
Cost elements
• Cause causality principle application • Asset valuation method • Cost standard selection 1/7/2004 Sandra Cohen
Cost of services
16
Methods of cost causation principle application
Linking cost elements with cost objects Activity based costing Network costing 1/7/2004 Sandra Cohen 17
Activity based costing
Personnel cost General Ledger and Salary database Business processes - departments Activities Questionnaires- Time spend to activities S E R V I C E What is the reason for the activity to be performed Cost drivers Allocation to services C O S T 1/7/2004 Overheads Allocation to services Sandra Cohen 18
Activity based costing
Personnel cost 1/7/2004 Overheads General Ledger and Salary database Customer service Activities related to customer service- access Number of lines Already allocated cost Sandra Cohen Allocation to services 19 C O S T S E R V I C E A C C E S S
Activity based costing
Personnel cost €10.000.000
General Ledger and Salary database Customer service 30%, € 3.000.000
Overheads € 20.000.000
Assume 5%, € 100.000 or € 0,05/line 1/7/2004 Activities related to customer service- access 50%, € 1.500.000
Number of lines 2.000.000 € 0,75 /line Allocation to services Already allocated cost Sandra Cohen 20 A C C E S S C O S T S E R V I C E
Network costing
Cost of assets 1/7/2004 General Ledger and Fixed Assets Register Physical network elements Cost drivers Grouping of elements based on cost driver analysis What is consuming the capacity of the element: Minutes, calls, subscribers?
Network entities Routing factors C O S T Service recipes, volume per service and total volume Sandra Cohen 21 S E R V I C E
Routing Factors 10.000 min of local call
1 Tandem Local Link
Tandem Switch
1 1 RSU Local Link Local Switch Local Switch 1 1
Telephone Sub.
RSU- Local Link Tandem - local link Local switch Tandem switch 1/7/2004
Telephone Sub.
Routing factor 2 2 2 1 Actual min 10.000
10.000
Equivalent minutes 20.000
20.000
Cost per component 2.000
5.000
Cost/equi valent minute 0,100 0,250 10.000
10.000
20.000
10.000
Sandra Cohen 4.000
0,200 1.000
0,100
Total cost minute Cost per minute
0,200 0,500 0,400 0,100
1,200
22
Routing Factors 1 min of local call
RSU Local Link Local Switch 1 Tandem Local Link 1
Tandem Switch
1 Local Switch 1 RSU- Local Link- 2 min.
1
Telephone Sub.
Tandem - local link - 2min
Telephone Sub.
Local switch - 2min 1/7/2004 23
Network costing- example switches
Cost of local switches Depreciation, Air condition Buildings, power, network management, etc.
Local switch components access and
local switch components traffic
Cost driver = minutes RSU - traffic cost Tandem switch cost RSU-local transmission link Local - Local transmission link Local -Tandem transmission link local switch traffic (actual min. x routing factors per service) local switch traffic minutes
used for local calls
S E R V I C E L O C A L C A L L Sandra Cohen 24
Network costing- example switches
Cost of local switches € 10.000
Depreciation, Air condition Buildings, power, network management, etc.
Local switch components access and
local switch components traffic - 70% € 7.000
Cost driver = minutes RSU - traffic cost Tandem switch cost RSU-local transmission link Local - Local transmission link local switch traffic = 20.000 actual x 1,8 = 36.000
cost per
minute
= € 0,195/min.
Local -Tandem transmission link local switch traffic minutes used for
local calls
assume 16.000 x
1,1
x 0,195 = € 3.432
Assume
0,215 (1.1x 0.195)
S E R V I C E L O C A L C A L L
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) 1/7/2004 Sandra Cohen 26
Balance Sheet
Capital employed Total Assets Total liabilities
1/7/2004 FIXED ASSETS CURRENT ASSETS TOTAL ASSETS EQUITY LONG TERM LIABILITIES SHORT TERM LIABILITIES
=
TOTAL LIABILITIES
Accounting Equation
Sandra Cohen 27
WACC (Weighted Average Cost of Capital)
Cost of debt Χ debt + Cost of equtiy Χ equity WACC = Debt +Equity
Example:
Cost of debt =7%, debt € 100.000, cost of equity 15%, Equity € 200.000
7% Χ 100.000 + 15% Χ 200.000 (Market Value or Book value) = 37.000
300.000
=
12,34%
100.000 + 200.000
1/7/2004 Sandra Cohen 28
Cost Model Structure
Capital employed Service Α x WACC
Service Α Service Β
Capital employed Service B x WACC
Network element 1 Network element n Activity 1 Activity 2 Activity n Cost element 1 1/7/2004 Cost element 2 Sandra Cohen Cost element n 29
Asset valuation
Asset valuation influences cost in two ways: Depreciation cost ( of service ) directly influences the cost Net book value ( indirectly influences the cost of service via working capital ) Two alternatives: Historical cost Current cost 1/7/2004 Sandra Cohen 30
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 1/7/2004 Sandra Cohen 31
Current prices
There are a lot of alternative ways in order to calculate current cost Modern equivalent asset market place ( : An asset that has the same functionality as the existing one and uses the most efficient and economic technology established in the forward looking ) Replacement cost Secondary market Cost adjusted to inflation The usage of current prices sends the correct signals to the market 1/7/2004 Sandra Cohen 32
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 1/7/2004 Sandra Cohen 33
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 1/7/2004 Sandra Cohen 34
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 1/7/2004 Sandra Cohen 35
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+
IC
LRIC
LRIC
SAC
1/7/2004 Sandra Cohen 36
Total cost 2 services
1/7/2004 Total volume Sandra Cohen 37
Total cost - 2 services FDC - Cost per service
Α Β 1/7/2004 Sandra Cohen Total volume 38
Total cost - 2 services Average ΙC- Cost per service
Incremental cost
Α Β 1/7/2004 Sandra Cohen Total volume 39
Floors and Ceilings
Ceiling SAC
LRAIC +
Floor LRAIC Sandra Cohen 1/7/2004 40
Total cost - 2 services SAC Service A & IC Service Β
Α Β 1/7/2004 Sandra Cohen Total volume 41
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 1/7/2004 Sandra Cohen 42
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 1/7/2004 Sandra Cohen 43
WACC rates currently used
Austria Belgium 9.34% 12.46% Denmark 12% France 12.1% Germany 10.6 % Ireland 12 % Italy 13.5% Holland 10.7%-12.3% 1/7/2004 Norway 13% Spain 12.6% Sweden 15% Swetzerland 11.75% Great Britain 12.5% Greece 12.1% Sandra Cohen Source: Cullen International November 2001 44
Common deviations from cost orientation
Cross subsidisation of services Unbalanced tariffs Geographically averaged tariffs Universal service (affordability) 1/7/2004 Sandra Cohen 45
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.
1/7/2004 Sandra Cohen 46