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

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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

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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

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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

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Basic pricing principles

 The prices have to be:

 Adequately unbundled
 Publiced
 Competition oriented
 Non descriminatory
 Cost orientated

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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
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Basic costing principles
(for regulatory purposes)
 Cost causation principle
 Activity based costing
 Network costing
 Objectivity principle
 Consistency principle
 Transparency principle Access Network

 Auditability
 Accounting Separation
Other
Retail
services
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Accounting Separation -
Access

Access Network
OLOs
Transfer Revenues for Access
prices Cost for Retail

Other
Retail
services

1/7/2004 Customers
Sandra Cohen 9
Accounting Separation -
Network

Access Network
Transfer Revenues for Network
prices Cost for Retail
OLOs
Other
Retail
services

Customers
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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

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Basic cost elements

 Salaries of personnel
 Depreciation of network elements
 Depreciation of buildings and vehicles
 Transport costs
 Marketing cost
 Overhead
 etc.
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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

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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)

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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
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From cost elements to
cost of services

• Cause causality
principle
application Cost
Cost • Asset valuation of
elements method
services
• Cost standard
selection

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Methods of cost causation
principle application

 Linking cost elements with cost objects

 Activity based costing

 Network costing

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

Allocation to services
Overheads
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Activity based costing A
C
C
E
S
Personnel cost General Ledger and Salary database S

Customer service
S
E
R
Activities related to customer service- access V
I
C
Number of lines E

C
Allocation to services O
S
Already allocated cost
Overheads T
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Activity based costing A
C
C
E
Personnel cost
S
€10.000.000 General Ledger and Salary database S
Customer service
30%, € 3.000.000 S
E
R
V
Activities related to customer service- access
I
50%, € 1.500.000 C
E
Number of lines -
2.000.000
C
€ 0,75 /line
O
Allocation to services S
Overheads € 20.000.000
T
Assume 5%, Already allocated cost
€ 100.000 or € 0,05/line
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Network costing
S
E
Cost of assets General Ledger and Fixed Assets Register R
V
Physical network elements I
C
What is consuming the capacity of E
Cost drivers the element: Minutes, calls,
subscribers?
C
Grouping of elements Network entities O
based on cost driver analysis
S
T
Routing factors
Service recipes, volume per service and
total volume
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Routing Factors -
10.000 min of local call
Tandem
1
Local
Tandem Link
Switch

1 1
RSU - Local Switch Local Switch
Local
Link 1
1
Telephone Telephone
Sub. Sub.

Cost/equi
Routing Actual Equivalent Cost per valent Cost per
factor min minutes component minute minute
RSU- Local Link 2 10.000 20.000 2.000 0,100 0,200
Tandem - local link 2 10.000 20.000 5.000 0,250 0,500
Local switch 2 10.000 20.000 4.000 0,200 0,400
Tandem switch 1 10.000 10.000 1.000 0,100 0,100
1/7/2004 Sandra Cohen Total cost minute 1,200 22
Routing Factors -
1 min of local call
Tandem
1
Local
Tandem Link
Switch
1 1
RSU - Local Switch Local Switch
Local
Link 1
1
RSU- Local Link- 2 min. Telephone
Telephone
Sub. Tandem - local link - 2min Sub.

Local switch - 2min

1/7/2004
Tandem switch - 1min
Sandra Cohen 23
 Network costing- example
switches L
O
Depreciation, Air condition C
Buildings, power, A
Cost of local switches network management, etc. L

Local switch components access C

and local switch components traffic A
L
L
Cost driver = minutes
S
E
local switch traffic R
RSU - traffic cost (actual min. x routing factors per service) V
Tandem switch cost I
RSU-local transmission link local switch traffic minutes C
Local - Local transmission link used for local calls E
Local -Tandem transmission link
Tandem - Tandem transmission link
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 Network costing- example
switches L
O
Depreciation, Air condition C
Cost of local switches Buildings, power, A
L
€ 10.000 network management, etc.
C
Local switch components access
A
and local switch components traffic - 70% € 7.000
L
L

Cost driver = minutes S

E
local switch traffic = 20.000 actual x 1,8 = 36.000 R
RSU - traffic cost cost per minute = € 0,195/min. V
Tandem switch cost local switch traffic minutes
I
RSU-local transmission link C
used for local calls
Local - Local transmission link assume 16.000 x 1,1 x 0,195 = € 3.432 E
Local -Tandem transmission link
Tandem - Tandem transmission link
1/7/2004 Assume
Sandra Cohen0,215 (1.1x 0.195) + 0,10 +…+ 0,05
25 =
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)

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 Capital employed
Balance Sheet
Total Assets Total liabilities

FIXED ASSETS EQUITY

LONG TERM
LIABILITIES
CURRENT ASSETS SHORT TERM
LIABILITIES

TOTAL ASSETS = TOTAL LIABILITIES

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Accounting
Sandra Cohen
Equation 27
 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)
7% Χ 100.000 + 15% Χ 200.000 37.000 = 12,34%
=
100.000 + 200.000 300.000

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Cost Model
Capital employed
Structure Capital employed
Service B
Service Α x WACC
x WACC
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

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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

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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

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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

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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

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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

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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
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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
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 Total cost 2 services
Total cost

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 Total cost - 2 services
FDC - Cost per service

Α
Β
Total cost

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 Total cost - 2 services
Average ΙC- Cost per service
Incremental cost
Average
IC - B

Α
Β
Common Average
Cost IC - A

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Floors and Ceilings

Ceiling SAC

LRAIC +

Floor
LRAIC

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 Total cost - 2 services
SAC Service A & IC Service Β
IC - B

Α
Β
SAC A

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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

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

 Austria 9.34%  Norway 13%

 Belgium 12.46%  Spain 12.6%
 Denmark 12%
 Sweden 15%
 France 12.1%
 Swetzerland 11.75%
 Germany 10.6 %
 Ireland 12 %  Great Britain 12.5%
 Italy 13.5%  Greece 12.1%
 Holland 10.7%-12.3%
Source:
Cullen International November 2001
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Common deviations from
cost orientation

 Cross subsidisation of services

 Unbalanced tariffs
 Geographically averaged tariffs
 Universal service (affordability)

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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.

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