1. Methodologies for Computing Telecom Costs Rural Task Force Workshop Richard N. Clarke Portland, Maine AT&T - Public Policy 29 September 1999 908-221-8685

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. FL/embedded costs in FCC SynMod Sources: 1997 ARMIS and 6/2/99 release of FCC Synthesis Model AT&T

17. 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

18. 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