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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 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
 Auditability
 Accounting Separation
Access
Retail
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Network
Other services
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Accounting Separation -
Access
OLOs
Access Network
Transfer prices
Revenues for Access
Cost for Retail
Retail
Other services
Customers
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Accounting Separation -
Network
Access Network
Transfer prices
Retail
Revenues for Network
Cost for Retail
Other services
OLOs
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Customers
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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)
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XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
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
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The regulator does not care about them
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From cost elements to cost of services
Cost elements
• Cause causality principle application
• Asset valuation method
• Cost standard selection
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Cost of services
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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
Personnel cost General Ledger and Salary database
Business processes - departments
Activities
Questionnaires- Time spend to activities
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What is the reason for the activity to be performed
Cost drivers
Allocation to services
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Overheads
Allocation to services
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Activity based costing
Personnel cost
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Overheads
General Ledger and Salary database
Customer service
Activities related to customer service- access
Number of lines
Already allocated cost
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Allocation to services
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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
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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
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Network costing
Cost of assets
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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
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Service recipes, volume per service and total volume
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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
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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
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4.000
0,200
1.000
0,100
Total cost minute
Cost per minute
0,200
0,500
0,400
0,100
1,200
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Routing Factors -
1 min of local call
Local Switch
1
Tandem
Local
Link
1
Tandem
Switch
1
Local Switch RSU -
Local
Link
1
RSU- Local Link- 2 min.
1
Telephone
Sub.
Tandem - local link - 2min
Telephone
Sub.
Local switch - 2min
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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
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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)
+ 0,10 +…+ 0,05 =
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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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Balance Sheet
Capital employed
Total Assets Total liabilities
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FIXED ASSETS
CURRENT ASSETS
TOTAL ASSETS
EQUITY
LONG TERM
LIABILITIES
SHORT TERM
LIABILITIES
= TOTAL LIABILITIES
Accounting Equation
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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
(Market Value or Book value)
7% Χ 100.000 + 15% Χ 200.000
=
37.000
300.000
=
12,34%
100.000 + 200.000
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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
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Cost element 2
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Cost element n
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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
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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 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
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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
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Total volume
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Total cost - 2 services
FDC - Cost per service
Α
Β
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Total cost - 2 services
Average ΙC- Cost per service
Incremental cost
Α
Β
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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
Α
Β
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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
 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
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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%
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

Norway 13%
Spain 12.6%
 Sweden 15%
 Swetzerland 11.75%
 Great Britain 12.5%
 Greece 12.1%
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Source:
Cullen International November 2001
44

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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