SERVICE COSTING AND PRICING

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SERVICE COSTING AND PRICING

• By MUGISHA Fred
• National University of Rwanda

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SERVICE COSTING AND PRICING

• SESSION OUTCOMES
• At the end of this course, participants should be
  able to
•  Appreciate the purpose of costing
•  Reflect on Costing methods/models
•  Appreciate the purpose of pricing
•  Reflect on pricing methods/models
•  Explore the challenges in costing and pricing
  challenges in and effort to identify solutions

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SESSION CONTENT

• 1.0 INTRODUCTION TO THE SESSION
• 2.0 SERVICE COSTING
• 2.1. Introduction
• 2.2. Distinction between economic, accounting,
  and engineering cost definitions
• 2.3.  Important cost Concepts      
• Direct and indirect costs
• Fixed and Variable costs
• Common and joint cost

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SESSION CONTENT Ctd..

• 2.4. Costing methodologies       
• Main costing methodologies
•   Fully Distributed Costing
• Long-Run Average Incremental Costing
• Other costing methodologies
• Activity Based Costing (ABC)
• Marginal costing

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SESSION CONTENT Ctd..

• 3.0 SERVICE PRICING
• 3.1 Introduction
•     Price Regulation Objectives
•     Basic Pricing Goals
•     Basic Pricing Principles

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SESSION CONTENT Ctd..

• 3.2 Factors that affect pricing decision
• 3.3.  Pricing Methodologies
• 3.3.1.Two-common approaches to pricing
• -Rate of Return
• -Price Cap
• 3.3.2 Other Methodologies
•      -Prices based on costs
•     -Subsidized pricing
•    -Demand-based pricing
• -Price floors and ceiling
• 4.0 Challenges in costing and pricing regulation

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GENERAL INTRODUCTION

• The major purpose of this session is to
  provide a basis for comments and suggestions from
  telecom regulators to look at the process of
  costing and pricing for telecom services.
• It is expected that by sharing experiences,
  regulators, and/ or operators will gain much in
  identifying key telecom service costing and
  pricing challenges, and relevant solutions.

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GENERAL INTRODUCTION ctd

• In environments where there is insufficient
  competition, tariff regulation is more useful in
  guarding against imposition of unreasonable
  terms, especially on tariffs.
• In cases where the market is young and growing it
  qualifies to be subject to tariff regulation
  until such time that more operators are licensed
  to compete in the fixed line and mobile
  operations. However, for efficient tariff
  regulation, a suitable costing and pricing
  information is indispensable.

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GENERAL INTRODUCTION ctd

• Regulators have to be concerned with respect
  to determining the principles that the
  telecommunications operators must follow in the
  costing and pricing of their services.
• This essentially refers to the formulation of the
  general framework governing costing and pricing
  for these services, through the definition of the
  general principles that the obliged operators
  must follow in costing and pricing the services.

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Distinction Between The Concepts Of Costing And
Pricing

• Costing involves determining the value of
  resources consumed in the production of goods or
  the provision of a service. Its role in pricing
  is to act as a benchmark against which pricing
  and production decisions can be made.
• Pricing refers to the process of determining a
  figure at which products or services will be
  exchanged in the marketplace.

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SERVICE COSTING

• 2.1. INTRODUCTION
• There is need for the application of appropriate
  cost accounting methodologies to calculate the
  actual cost of telecommunication services. This
  is to ensure that tariffs are reflective of
  associated costs.
• Detailed cost accounting in telecommunications,
  is no longer an elective pursuit, it is a
  compulsory exercise. However, telecom service
  enterprises do not tend to have such an easily
  identifiable cost unit, nor is it easy to trace
  costs to specific output.

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SERVICE COSTING ctd..

• 2.2. Distinction between Economic, accounting,
  and engineering cost definitions
• Which costs are we talking about? The regulator
  must decide on the relevant definition of costs
  to be considered in cost models. The term "cost"
  is used in different contexts (and by different
  individuals) with different meanings.
• When economists talk about costs they are always
  concerned with economic cost, which can be very
  different from accounting cost for example.

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SERVICE COSTING ctd..

• Accountants are concerned primarily with the
  proper recording and measuring of historical
  costs based upon a uniform set of rules.
• Engineering methods of analyzing cost behavior
  are based on the use of engineering analyses of
  technological relationships between inputs and
  outputs. The method is appropriate when there is
  a physical relationship between costs and cost
  driver.

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2.3 Costing methodologies

• There are important costing principles which a
  costing model should observe and these include
  Cost causation principle (like an Activity based
  costing,), Objectivity principle, Consistency
  principle, Transparency principle (Auditability
  and Accounting Separation), practicality,
  efficiency, and contribution to common costs,
  present value.
• However, objective costs can not be calculated
  without sufficiently detailed cost data.

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Costing methodologies ctd..

• 1.The Fully Distributed Cost(FDC) approach
• Here, the cost of a service derives from the
  usage of a set of algorithms that allocate both
  direct and indirect costs to it. However, some of
  the indirect allocations are arbitrary and may
  cause cost distortion.
• The idea of the FDC approach is to simply divide
  the total cost that the firm incurs amongst the
  services that it sells. Both fixed and variable
  costs are used in the production of the output
  and therefore both contribute to the revenue
  generated by these products or services.

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The fully distributed cost(fdc) approach ctd

• Its simplicity in directly relating prices to
  information that is available in the accounting
  and billing system makes the model auditable.
• FDC is naturally based on historic costs. This is
  because accounting data concerns the firms
  actual costs. It is not impossible to use current
  costs, but this requires modifications to the
  accounting.

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2. Long Run Average Incremental cost (LRAIC)

• The method equates tariff to cost of production
  of the additional unit of the service. Added to
  unit cost is an allocated share of common costs,
  excluding administrative costs.
• The cost of the services is computed by
  apportioning the cost of the network elements
  (similarly as in the activity-based approach),
  and by adding the cost of labor and the rest of
  the overheads as a simple markup on the cost of
  the infrastructure. Such a markup follows the
  trends observed in actual networks.

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LRAIC ctd..

• 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
  currently 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 existence of
  common costs.

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LRAIC ctd..

• It is natural to use current cost with LRAIC
  because the aim is to construct prices that would
  prevail in a competitive market.
• The use of current rather than historic costs
  does not pass on the inefficiencies of the
  operator due to high historical costs and
  inefficient out-of-date technologies.

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LRAIC ctd..

• Where pricing is the focus of interest, the more
  appropriate measure of cost is likely to be the
  "incremental service incremental cost," because
  this measure can provide a close approximation to
  marginal cost, if it is properly estimated.

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LRAIC ctd..

• However, it is difficult to calculate the
  incremental costs. Sometimes, studies provided by
  telephone utilities include an amalgamation of
  embedded, reproduction, and forward-looking
  costs, blended together and computed on an
  average cost basis and such should not be called
  incremental cost.

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Activity Based Costing (ABC)

• ABC is the methodology by which costs are
  assigned based on the activities required to
  deliver a service and the resources these
  activities absorb.
• The key to this methodology lies in two aspects
  (1) What is causing the activity (2) What is
  causing the costs. Simply put, ABC works on the
  premise that the budget is absorbed by resources
  and the resources are absorbed by services.

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ABC ctd..

• ABC is one way of trying to make a more accurate
  determination of the true time, cost and value of
  specific activities, and thereby evaluate their
  real contribution to meeting the overall
  objective.
• Some organizations are therefore starting to use
  this approach in formulating their cost
  estimates, rather than simply relying on the
  traditional cost-accounting elements.

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ABC ctd..

• Through early involvement, the cost estimator
  can not only influence the final design by
  feeding in the relevant cost information, but can
  also actively contribute to cost reduction by
  identifying cost drivers and to highlight how,
  for instance, a relatively small increase in
  system performance can have a disproportionately
  heavy impact on final cost.

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ABC ctd..

• Costs are assigned based on the activities
  required to deliver a service and the resources
  these activities absorb.
• The major cost drivers are the number of
  subscribers, the volume of traffic (call attempts
  and call minutes) and the geographical area
  covered by the network. For many of the elements,
  there is more than one cost driver.

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ABC ctd..

• It is based upon a hierarchy of four levels and
  is a refinement of the traditional FDC approach.
• The bottom level consists of the input factors
  that are consumed by the network operator, e.g,
  salaries of personnel, depreciation of network
  elements, cost of capital, depreciation of
  buildings and vehicles, marketing cost, overhead,
  power consumption, and the cost of renting raw
  bandwidth. The goal is to apportion these cost
  elements to the services that the network
  provides.

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ABC ctd..

• Instead of a one-stage assignment where costs are
  assigned directly to Products and Services, ABC
  assigns costs from the General Ledger
  (Resources) to Activities. Costs in
  Activities are then assigned to Products and
  Services (Cost Object).
• ABC does not replace the accounting system. ABC
  draws data from the General Ledger an
  Accumulator, focuses it for analysis and turns
  those data into Operational and Strategic
  management decision support information.

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ABC ctd..

• In theory, ABC has no conflict with FDC and
  LRAIC either. ABC can be used to replace the
  arbitrary cost absorption method that is used to
  calculate to say, LRAIC.
• The use of ABC might bring much more transparency
  in the calculation of transferred cost, making
  the current costing practice look redundant. But
  ABC does not necessarily judge or replace the
  economic thinking behind LRAIC.

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ABC ctd..

• ABC however, hides potential inefficiencies of
  the network provider. Even if a network element
  is underutilized, its cost is completely shared
  by the services that use it and there is no
  incentive for the provider to improve its
  efficiency.
• If the provider were only allowed to recover the
  cost of a network element in proportion to its
  actual utilization, he would have a clear
  incentive to improve the efficiency of his
  network (by for example better routing,
  resolving potential bottlenecks, and reselling
  spare capacity,).

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MARGINAL COSTING

• Marginal cost is one of the most important
  concepts in standard microeconomic theory.
• It focuses attention not on the total level of
  cost, nor the average level of cost but rather on
  the change in costs that occurs as the volume of
  output is increased or decreased.

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MARGINAL COSTING ctd..

• Marginal cost is defined as the change in the
  total cost of production resulting from an
  extremely small change (upward or downward) in
  the level of output. To be strictly technical
  about it, marginal cost is the first derivative
  of the total cost function with respect to
  output.
• The minimal measurable change can be extremely
  small e.g, one more mill watt of electricity, one
  more second of calling duration, or one more
  local loop.

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MARGINAL COSTING ctd..

• In attempting to estimate marginal costs, the
  analyst often encounters practical difficulties
  when the measurements are directly calculated at
  the smallest possible level. Accordingly, most
  practical estimates of marginal cost are based at
  least in part on a slightly larger increment of
  output than what is envisioned in economic
  theory.
• The incremental cost can be viewed as an
  "average" level of marginal cost, if it is
  computed over a narrow increment in the immediate
  vicinity of the current volume of production.

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Conclusion on service costing

• There are various methodologies used in service
  costing but these are the common ones in
  literature. However, FDC and LRAIC are the most
  used.
• Efforts should be made to encourage operators to
  use ABC especially in apportioning the indirect
  costs.

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 3.0 SERVICE PRICING

• 3.1. INTRODUCTION
• Pricing is a key strategic lever for telecom
  operators, with a direct impact on customer
  acquisition, retention, revenues and margins.
• In a fully competitive environment, market forces
  are more effective than regulations in providing
  consumers with a wide choice of services at
  reasonable prices. Hence, price regulation is
  imposed only on dominant operators that have the
  potential to abuse their market power and engage
  in anti-competitive practices.

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INTRODUCTION ctd..

• Prices are an important means to achieve policy
  objectives. For achieving these objectives, there
  is an increasing focus on efficient cost-based
  pricing, with a forward-looking perspective. At
  the same time, flexibility of prices and
  competitive pressure on prices are also
  emphasized. Price floors and ceiling, together
  with unbundling of the various services, have
  been considered for addressing the issue of
  unfair competition.

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3.1.1 Price Regulation Objectives

• Regulators are interested in price regulation to
  achieve three primary objectives namely
• Financing Objective regulated operators
  permitted to earn sufficient revenue to finance
  on going operations and future investments.
• Efficiency Objective Efficiency is achieved when
  prices equal marginal cost of producing the
  service and/or when increased levels of output
  are realized through unchanged levels of input.
• Equity Objective Equity objectives generally
  relate to the fair distribution of welfare
  benefits among members of society.
  Operator-consumer equity and Consumer to consumer
  equity is desirable.

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Principles in pricing

• For the telecom sector, the key principles in
  setting price/tariffs can include the following
• Cost basis
• Unbundling
• Transparency
• Non discrimination

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Principles in pricing ctd

• Cost basis Tariffs must reflect the underlying
  cost of providing service. Operators should
  provide justification of how they arrived at the
  proposed tariff by reflecting the underlying cost
  of providing service.
• Unbundling The tariffs offered by the operators
  have to be sufficiently unbundled, so that
  customers do not pay for facilities, which are
  not part of their service package.

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Principles in pricing ctd

• Transparency operators must publish details of
  tariffs and fees and make them available to the
  public or any interested parties.  
• Non-discrimination An operator should offer
  customers the same tariff for identical services
  and should offer discounts where it makes
  commercial sense, and the discounts should be
  clearly reflected as discount on the published
  tariff.

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Factors that affect pricing decision

• Organizational goals e.g. cash maximization,
  setting of selling prices must be seen as a means
  of achieving this end.
• Product mix
• Price/demand relationship
• Competitors and markets
• Peak and off-peak
•  Cost

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Peak/off-peak pricing

• Prices are set at a higher level in peak time to
  discourage use of facilities and transfer demand
  to off-peak periods.
• Advantages
• Capacity utilization maximized
• Traffic congestion reduced
• Quality of service improved,
• Purchase of additional equipment avoided.

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PRICING METHODOLOGIES

• There are two main approaches to preventing firms
  from charging excessively high prices price cap
  regulation and rate of return regulation.
• 1. Rate-of-return approach
• This is the traditional method of utility
  regulation. The regulator allows the company to
  charge the prices expected to produce profits
  equal to a fair rate of return on the fair value
  of the capital invested in the company.

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Rate of return ctd..

• The regulatory agencies fix the rate of return
  that a utility can earn on its assets. They set
  the price the utility can charge so as to allow
  it to earn a specified rate of return and no
  more.
• The regulated price can be adjusted up-ward if
  the utility starts making a lower rate of return,
  and it will be adjusted downward if the utility
  makes a higher rate.

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Rate of return ctd..

• In this regulation the allowable revenue to the
  company is fixed. This system ensures that the
  utility can continue to provide the service,
  ensuring security of supply to the consumer. It
  however provides no incentive for the company to
  become more efficient and reduce production
  costs.

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Disadvantages of ROR

• There is lack of incentive to minimize costs. In
  ROR regulation, the operators prices are set at
  a level sufficient to cover its costs. This is
  why ROR regulation is often referred to as cost
  plus regulation. From a dynamic perspective,
  therefore, the operator has little incentive to
  reduce its rate base or its operating costs.

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Disadvantages of ROR ctd..

• Overtime, ROR regulation of a monopoly operator
  will lead to a lower rate of productivity
  improvement than would occur under effective
  competition. ROR regulation does not provide the
  operator with a strong incentive to increase its
  productivity.

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Disadvantages of ROR ctd..

• ROR regulation requires the operator and the
  regulator to spend significant amounts of time
  and money. The rate base reviewed by the
  regulator, the cost of capital must be
  calculated, and so on. Rate reviews on hearings
  must be held on a regular basis, incurring costs
  to the regulator, the operator, and other
  participants in the process.

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2. Price cap approach

• This is the preferred form of rules based price
  regulation around the world. A flexible price
  range is usually provided under a price cap
  methodology, which imposes an upper limit on the
  average price increase for a basket of telecom
  services.
• Price cap regulation uses a formula to determine
  the maximum allowable price increases for a
  regulated operators services for a specified
  number of years. The formula is designed to
  permit an operator to recover its unavoidable
  cost increase(e.g inflation, tax increase, etc)
  through price increases.

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Price cap approach ctd..

• The price cap regulation is founded on a
  principle that efficiency and productivity gains
  by the operator should be passed on to the
  consumers through reduced prices i.e.
  Operator-consumer equity is realized. The Price
  cap provides incentive for operator to improve
  efficiency hence mimicking an operator in a
  competitive market.

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Price cap approach ctd..

• The Price Cap formula is defined as PI (t)CPI
  (t-1)X, where PI (t) is the maximum allowable
  price increase (measured as revenue increases) in
  the relevant year(s), for a given basket of
  regulated services as determined by the
  Regulator.

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Price cap approach ctd..

• (t) is year. CPI(t-1), the Consumer Price Index,
  is the inflation measure averaged for the
  previous calendar year ( t-1). The average CPI in
  the previous calendar year has sole influence on
  the future CPI and is therefore a good predictor
  of future CPI.
• X represents expected productivity gain of the
  operator over the relevant period. The Regulator
  determines such period.

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Price cap approach ctd..

• The X factor is usually determined by the
  Operator and approved by the regulator. The X
  factor is such that it poses a challenge to the
  operator to improve efficiency whilst also
  ensuring that the operator meets its revenue
  requirements without earning excess profits.
•  

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Price cap approach ctd..

• Each price cap is for a specific period. Before
  the end of each given period, a review should be
  carried out by the Operator to determine the new
  X factor to be filed with the Regulator for
  approval.
• As the telecommunication market moves towards
  competition, the implementation of a form of
  regulation with incentive to increase
  productivity was considered more desirable.

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Price cap approach ctd..

• In the Price Cap regulatory framework, the
  company will be encouraged to operate the
  business in a manner that would be similar to
  what would obtain if it were in a competitive
  market, constantly seeking to improve efficiency.
  
• When this market opens up to allow full
  competition, the incumbent operator will be more
  easily able to adapt than if he was required to
  change immediately from a Rate of Return scheme
  to full liberalization.

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Price cap regime advantages

• 1. Productivity gains in the market are shared
  between operators and consumers
• 2. Greater pricing flexibility and
• 3. Incentive for greater efficiency.

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price cap and rate of return pricing-comparison

• The price cap approach has become increasingly
  common internationally because it is thought to
  give firms stronger incentives to be efficient.
• The regulator naturally takes into account the
  regulated utilitys rate of return. If it is
  high, the price cap is likely to be reduced if
  it is low, the price cap may be relaxed.

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price cap and rate of return pricing-comparison
ctd

• As long as price cap reviews are sufficiently
  infrequent (say, every five years), price cap and
  rate of return regulation should have different
  effects on regulated firms.
• Under price cap regulation, if a firms costs
  rise, its profits will fall because it cannot
  raise its prices to compensate for the cost
  in-creasesat least until the next price review,
  which may be several years away.
•  

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price cap and rate of return pricing-comparison
ctd

• Under rate of return regulation, however, the
  business would seekand typically be granted
  within a year or soa compensating price rise, so
  its profits would not change much.
• But if the firms costs fall, price cap
  regulation is more advantageous to the firm than
  rate of return regulation, because it would
  retain more of the resulting benefits as profits.

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price cap and rate of return pricing ctd..

• Under rate of return regulation, consumers bear
  some of the risk that firms bear in price cap
  systems. This difference means that firms subject
  to price cap regulation have a stronger incentive
  to lower their costs because they keep more of
  the cost savings than they would if they were
  subject to rate of return regulation. But the
  increased risk they bear tends to raise their
  cost of capital.

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price cap and rate of return pricing ctd..

• Unlike ROR regulation, the formula does not
  permit the operator to increase rates to recover
  all costs. The formula also requires the operator
  to lower its prices regularly to reflect
  productivity increases that an efficient operator
  would be expected to experience.

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Other Pricing Methodologies

• 1) Prices based on costs Prices may be based on
  short run marginal (or variable) costs, long-run
  incremental costs (which include investment
  costs), and fully allocated costs have been
  considered for specifying prices based on costs.
• All cost-based pricing requires considerable
  information and monitoring, and a number of
  conceptual and practical problems arise in
  properly measuring and assigning costs to the
  various telecom services.

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Other Pricing Methodologies ctd..

• A firms prices must ensure that it is
  profitable, or at least that it covers its costs.
  Cost-based pricing focuses on this consideration.
  Unfortunately, a fundamental difficulty in
  defining cost-based prices is that services are
  usually produced jointly. A large part of the
  total cost is a common cost, which can be
  difficult to apportion rationally amongst the
  different services.

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Other Pricing Methodologies ctd..

• The issue for the Mark-up
• A mark-up is required to cover the deficit that
  would arise if an efficient cost-based price were
  determined. Different methods for ascertaining
  the mark-up include mark-up varying inversely
  with elasticity of demand of different users or
  services (Ramsey rule) applying a rule-of-thumb,
  such as a risk-adjusted reasonable commercial
  return and applying different price slabs to
  different units of usage, or obtaining the
  requisite revenue through rentals.

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Other Pricing Methodologies ctd..

• The rule-of-thumb is the most straightforward of
  the mark-up methodologies. Since demand is not
  easy to estimate, Ramsey rule provides at best a
  rough guide on the nature of the mark-up.

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The advantages of cost-plus pricing

• They offer a means by which plausible prices can
  be found with ease and speed, no matter how many
  products the firm handles. They are easier to
  develop since they are based on linear relations
  with the actual cost information and are easier
  to understand by accountants
• They are based on accounting data that are
  retrieved and kept any way in the information
  system of the firm and they are also easy to
  audit by regulators.

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Limitations of Cost-plus pricing

• Demand is ignored the price is set by adding a
  mark-up to the cost.
• They do not provide incentives for improving the
  efficiency of the provider and deploying newer
  technologies since they cover his full historic
  cost.
• They are not always based on causal relations but
  depend on arbitrarily chosen coefficients for
  sharing the non-directly attributable cost hence
  these do not reflect the actual cost of services.

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2) Subsidized pricing

• Subsidies to price are given normally for
  achieving social objectives such as promoting the
  provision of universal service in telecom or
  providing preferential telecom access to specific
  users such as hospitals or those living in remote
  areas. The subsidy could be given, for example,
  in terms of access charges, rentals or price of
  the calls made.

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 3) Demand-based pricing

• Under this methodology, prices reflect
  willingness to pay for the use of a product, or
  the value given to a particular product. These
  prices are shown by the demand curve. In
  assessing the social value from a demand-price,
  it would be necessary to specify the social value
  of consumption of the service by different
  customer groups. Demand-based prices are not easy
  to determine on account of the difficulty of
  determining the demand curve.

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4) Price floors and ceilings

• They can be used for providing flexibility, and
  to limit an operator from abusing its dominant
  market position.

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4.0 Challenges in costing and pricing regulation

• Cost models deliver a number of benefits to a
  regulator willing to apply them, but they also
  ask for something in advance Information.
  Without this vital element, one can hardly rely
  on the models.
• A main concern in most reforming developing
  countries is the limited access to data. A
  careful assessment of data capacity of a
  regulator is probably the first stage in
  development of a toolkit for any regulator. In
  general, however,reliable and detailed
  information (as required by cost modules) is a
  scarce good in developing countries.

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Challenges in costing and pricing regulation ctd..

• The accounting approach is based exclusively on
  information provided by the firms, sometimes with
  no independent checking. This is typically all
  the information that the license or the regulator
  himself asks the companies for, and it is of
  course not enough, if the regulator wants to
  minimize the asymmetric information problem and
  the informational rents the firms can earn. So to
  improve regulation, more information is needed.
•  

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Challenges in costing and pricing regulation ctd..

• The main challenges of price regulation involve
  the design and implementation of low-cost and
  effective regulatory approaches that induce the
  regulated operator to achieve the socially
  desirable objective.
• Regulation imposes a burden on the economy in the
  form of direct costs to telecom operators for
  enforcement and compliance.

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Challenges in costing and pricing regulation ctd..

• Another complication with comparing prices to
  costs is that firms are operating in a dynamic
  environment. Their pricing decisions, as with
  their investment decisions, will be set to
  optimize profits over a period of time rather
  than at a single point in time.

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Challenges in costing and pricing regulation ctd..

• To insist on prices equal to costs at all dates
  would be to deter investments in new
  technologies. The prospect of earning profits in
  the future on an investment is necessary for the
  firm to invest in the first place and risk making
  a loss.

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GROUP ACTIVITIES

• The participants will be organized into groups
  and given the following questions
•  Which costing models/methods are used in Telecom
  Companies in your country and what is the impact
  in regulation?
• Which pricing models are used by Telecom in your
  country and how you Regulate them?
• What costing and pricing challenges do you meet
  in your countries and propose solutions
•  
•