Printed in the Business Monday newspaper on July 12th, 2010 

The telecommunications industry has evolved from a basic telephone service monopoly into competitive provision of some services and the availability of user mobility. During the monopolistic days tariffs were often not in line with cost. International services generally subsidised domestic services. In other words, revenue from international services acted as a prop for the cost of domestic services.

Given the strong link between telecommunications and economic and social development, it is important that tariffs be related to cost. The liberalisation of telecommunications markets in most countries including Barbados and the evolution of new services also resulted in the need for regulation of interconnection between competing service providers, and heightened the importance of costing and cost modelling.

Recently, the Fair Trading Commission issued a decision which approved the Consolidated Reference Interconnection Offer (RIO) submitted by Cable & Wireless (Barbados) Limited (C&W). A common theme during the process was that interconnection rates should be based on Long Run Incremental Cost (LRIC) rather than on fully allocated historical cost. In its decision the Commission stated that it will be developing a set of guidelines for a Long Run Incremental Cost (LRIC) to determine interconnection cost. These guidelines would then be used by C&W to develop a LRIC model.

The Commission will also be reviewing the cost model referred to as the Enhanced Allocation Model (EAM) which is currently used by C&W. The EAM is based on an excel workbook which fully allocates all costs that are directly attributable or common to the company’s retail services. The allocation criteria for joint cost is based on appropriate drivers which may be formulas based on usage or other factors. The network charges are calculated on the basis of operating expenditure, other non-capital related cost, and the depreciation associated with elements of the network, plus an appropriate return on capital employed.

The distinction between the two cost models is that the EAM uses historic data and the LRIC uses a forward-looking approach. Let’s look a little closer at these costing issues.

• Historical Cost refers to the costs actually recorded and accounted for in the company’s books, without any additions. This reflects the costs actually incurred. It uses actual information of the telecommunications operator under study but fails to encourage efficiency and therefore tariffs based on historical cost may not be optimal.
• Forward-Looking Cost estimates the cost of services by means of an engineering method based on the best process using the most up-to-date technology, that is, as if the company were starting up production from the point in time at which the study was conducted. This seeks to encourage efficiency as the costs that are used for the purpose of price-setting do not take account of the higher costs resulting from technology or management inefficiencies. The difficulty is in designing a model that describes a company that is both ideal and non-existent.
• Long Run Incremental Cost approach examines the change in cost that results from the provision of a discrete additional amount (increment) of a given service, including all of the direct and indirect costs that can be attributed to that change or increment. The incremental cost includes a reasonable rate of return on the capital invested and is calculated over the long term, that is, over a discrete period of time. LRIC is generally calculated using current technology and is based on the cost of an “efficient firm”.

When costs are shared or common and cannot be allocated directly or indirectly to the service giving rise to it, appropriate allocation techniques have to be applied. Two allocation techniques – fully allocated cost and activity based – are explained below:

• Fully Allocated Cost allocates historical cost in full to the services provided, thus establishing a criteria for the distribution of both direct and indirect costs and of non-allocatable common costs. A criticism of this approach is that it does not encourage efficiency and allocation of cost may be arbitrary.
• Activity Based Cost (ABC) seeks to establish objective causal relationships between costs and services. It views the services in question as a set of activities, each of which consumes resources and hence generates costs. The ABC methodology uses drivers to establish the causal links between costs and activities, thereby strengthening the ultimate linkage between costs and the services which constitute the end output of the production process.

Both the EAM and LRIC models referred to previously are based on the general principle of “cost-causality” established by the World Trade Organisation. Simply stated this means that in the costs to be recovered, the price should reflect only the cost of producing the service and no other cost.

The use of cost models is a means of broadening the scope of regulatory policy to determine the most appropriate costs. The Commission is cognisant that cost models may yield different results. Often, when significantly different cost estimates are presented to a regulatory Commission, these differences can be traced in large part to fundamentally different definitions of cost, different cost methods and model and the data sources.

Therefore, the Commission takes a great deal of care when assessing cost information. Generally the matter being addressed and the purpose of the costing exercise, whether, for example, price cap information or interconnection costing, will determine the most appropriate approach to use.