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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


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


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


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


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


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


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


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


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


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


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


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


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


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


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

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


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



  • 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