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Methodologies for Computing Telecom Costs. Rural Task Force Workshop Richard N. Clarke Portland, Maine AT&T - Public Policy 29 September 1999 908-221-8685. Presentation overview. Evaluating costing methodologies: Historical embedded costs (HEC) Fully distributed costs (FDC)

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methodologies for computing telecom costs

Methodologies for Computing Telecom Costs

Rural Task Force Workshop Richard N. Clarke

Portland, Maine AT&T - Public Policy

29 September 1999 908-221-8685

presentation overview
Presentation overview
  • Evaluating costing methodologies:
    • Historical embedded costs (HEC)
    • Fully distributed costs (FDC)
    • Forward-looking economic cost (FLEC)
  • What are the benefits from using FLEC versus other methodologies in terms of:
    • Economic efficiency
    • Competitive neutrality
    • Regulatory efficiency
  • How FLEC can be modeled and computed
  • Role for embedded cost or network information

AT&T

evaluating costing methodologies
Evaluating costing methodologies
  • Historical embedded costs (HEC)
    • Calculates costs using historical books of account
      • accounting cost categories typically are functional categories
      • these functional categories are used by many services
      • thus, many of these costs are “joint or common”
    • Embodies profile of network designs, efficiency levels, costs and qualities that exist today and in the past
    • Burdensome or unrepresentative for regulators in a multi-carrier market
    • Does not give business managers or regulators correct long run price signals
    • May not be competitively neutral

AT&T

evaluating costing methodologies1
Evaluating costing methodologies
  • HEC example 1
    • It cost $300/line for end office switching ten years ago
    • Now, it costs $150/line
    • How can an ILEC base its local service prices on a switching HEC of $300/line if a new CLEC competitor is basing its prices on $150/line?
    • A business or a regulatory decision to price based on HEC will invite customers to either:
      • use an alternative vendor’s service, or
      • forgo completely purchasing these services

AT&T

evaluating costing methodologies2
Evaluating costing methodologies
  • HEC example 2
    • It cost $800/line to install loop OSP ten years ago
    • Because the area is now more developed and paved, it now costs $1200/line
    • Why should an ILEC base its local service prices on a HEC of $800/line if the replacement cost of these loops is $1200/line?
    • A business or a regulatory decision to price based on HEC will:
      • not be competitively or profit-optimal, and will
      • incent customers to buy “too many” of these services

AT&T

evaluating costing methodologies3
Evaluating costing methodologies
  • Fully distributed costs (FDC)
    • Cost information may be collected by accounting classifications that differ from service classifications, thus these costs must be allocated across services
      • such “overhead” costs are “joint or common”
      • while certain of these allocations may be driven by relative use, many are intrinsically arbitrary
    • Portion of costs that must be allocated arbitrarily depends on how well accounting categories match service categories
    • Because resulting FDCs are arbitrary, they may not give business managers or regulators correct price signals

AT&T

evaluating costing methodologies4
Evaluating costing methodologies
  • FDC example
    • A conduit is installed that carries:
      • copper and fiber loop feeder cables
      • fiber cables that connect two local switches
      • fiber cables that connect a local switch to a toll switch
    • How should the cost of the conduit be allocated:
      • equally to each cable?
      • equally to each circuit carried on the cables?
      • disproportionately to the cable/circuits that carry high revenue traffic (i.e., more to the toll cable and less to the feeder cable)?
      • in proportion to the relative diameter of each cable?
      • other?
    • Result is possibly arbitrary

AT&T

evaluating costing methodologies5
Evaluating costing methodologies
  • Forward-looking economic cost (FLEC) is designed to represent the cost level experienced by an efficient competitor that supplies the market with newly constructed facilities and:
    • Operates efficiently using the best currently-available technologies
    • Serves the total demand for the costed item
    • Earns a “normal” return

AT&T

evaluating costing methodologies6
Evaluating costing methodologies
  • FLEC is the sum of:
    • Forward-looking incremental costs
      • both fixed and variable costs that are specific to the product
      • computed over the complete, long-run life cycle of the product
    • A “reasonable” allocation of forward-looking joint and common costs
      • these costs occur when the costed item is only produced efficiently as part of a family of related items
      • there is no single “correct” way to allocate these costs
      • goal is to calculate the costs of network elements that share minimal joint and common costs

AT&T

benefits from using flec
Benefits from using FLEC
  • FLEC provides the appropriate cost guide for decision making when:
    • Production decisions have substantial lead times and/or investments are long-lived
    • Markets are competitive -- or are intended to perform competitively (will maximize carrier profits)
  • Business or regulatory decisions based on FLEC:
    • Promote efficient resource use
    • Support efficient multi-carrier competition

AT&T

benefits from using flec1
Benefits from using FLEC
  • Failing to use FLEC as the cost measure can institutionalize:
    • Inefficient or static production processes
    • Non-competitive supply
  • Examples
    • Preserve efficient use of in-place resources by repricing switching at its FLEC of $150/line, and loops at their FLEC of $1200
    • If fiber-fed broadband networks are the forward-looking technology, would allocate costs equally to each (assumed fiber) cable diameter

AT&T

methods of computing flec
Methods of computing FLEC
  • Historical accounting methods, possibly projected forward
  • Activity based methods based on currently used combinations of disaggregated component costs
  • Explicit modeling (or “proxying”) of the actual cost-generating processes:
    • Engineering-generated
    • Economics-generated

AT&T

advantages of proxy modeling
Advantages of proxy modeling
  • Proxy modeling is a more accurate methodology for computing FLEC because:
    • Historical accounting records are often inaccurate
    • In a dynamic industry, historical accounting records cannot capture forward-looking costs
    • Rigid mathematical projections of current cost levels are also inconsistent and inaccurate
    • Proxy modeling is most capable of capturing costs consistently across the life cycles of the company’s capital equipment and the products that it is used to manufacture

AT&T

advantages of proxy modeling1
Advantages of proxy modeling
  • Proxy modeling is also superior because:
    • It allows costs to be calculated efficiently for families of interrelated products
      • minimizes the need for repetitive data collection
      • ensures that costs that are joint or common across individual products within a family are treated consistently
    • It allows a single model to be used to determine many different firms’ costs of producing the product
      • facilitates market-wide competitive cost analysis
      • helps ensure that all firms receive equal treatment from a regulator
      • the process of cost development is more transparent

AT&T

advantages of proxy modeling2
Advantages of proxy modeling
  • Carriers and regulators using proxy models to establish costs can avoid the cost of setting up or operating an accounting system for that purpose
    • In the U.S., most new entrant carriers have no established Part 32/USOA accounting system
    • Even established carriers are looking to dispose of these systems
    • Many have adopted proxy models in lieu of setting up, or in order to get rid of accounting-based cost tracking systems

AT&T

fl embedded costs in fcc synmod
FL/embedded costs in FCC SynMod

Sources: 1997 ARMIS and 6/2/99 release of FCC Synthesis Model

AT&T

uses for embedded information
Uses for embedded information
  • Even in FLEC models some embedded information remains useful
    • Input prices are assumed to be today’s best price -- can be provided by accurate current data
    • If regulators may not require recipient LECs to provide a network equal in quality to the one modeled
      • Information about the cost and quality of the embedded network may allow regulators to prevent the LEC from receiving an undeserved windfall
      • Embedded costs could be a ceiling, or the model could perhaps be adjusted to suggest the FLEC of the actually provided service quality

AT&T

summary
Summary
  • FLEC is the appropriate costing methodology to be used by regulators and business managers
    • In dynamic, competitive markets
    • To ensure rational decision-making over the entire life cycle of individual products, and families of products
  • Proxy models can be used reliably and flexibly to estimate the FLECs of complex underlying engineering and economic production processes
  • Embedded information should only be used as an adjunct

AT&T

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