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ERNST & YOUNG BALTIC UAB Ryšių reguliavimo tarnyba Reference paper for creating top down long run average incremental cost model (non binding English translation) 2005, June 13 Table of contents 1 INTRODUCTION ............................................................................................................4 1.1 1.2 1.3 1.4 1.5 2 SCOPE OF THE MODEL .................................................................................................4 DIVISION OF CORE AND ACCESS NETWORKS...............................................................4 BASIC PRINCIPLES IN LRAIC ......................................................................................5 FLOW OF TD-LRAIC MODELLING ..............................................................................5 STRUCTURE OF THE DOCUMENT .................................................................................6 VALIDATION OF MODEL ASSUMPTIONS..............................................................7 2.1 RULES FOR ESTABLISHING LIST OF HCC ....................................................................7 2.1.1 Distinction between operating expenditure and capital expenditure ................7 2.1.2 CAPEX related HCC ..........................................................................................8 2.1.3 OPEX related HCC ..........................................................................................10 2.1.4 Common remarks..............................................................................................10 2.1.5 List of principles ...............................................................................................11 2.2 RULES FOR ESTABLISHING NETWORK ELEMENTS .....................................................13 2.2.1 Core network ....................................................................................................13 2.2.2 List of network elements ...................................................................................14 2.2.3 List of principles ...............................................................................................15 2.3 RULES FOR ALLOCATION SCHEME ............................................................................16 2.3.1 Separation of Independent and dependent HCC’s ...........................................16 2.3.2 Allocation of independent HCC .......................................................................19 2.3.3 Allocation of dependent HCC...........................................................................19 2.3.4 Specific cases ....................................................................................................20 2.3.5 Allocation of costs of transmission network.....................................................20 2.3.6 Allocation of costs of switching network ..........................................................20 2.3.7 List of principles ...............................................................................................21 2.4 RULES FOR CONSTRUCTING COST VOLUME RELATIONSHIPS ....................................23 2.4.1 Cost concepts ....................................................................................................23 2.4.2 Shapes of CVR curves.......................................................................................24 2.4.3 Deriving CVR shapes .......................................................................................26 2.4.4 Verification of CVR shapes ..............................................................................27 2.4.5 List of principles ...............................................................................................28 3 COST MAPPING ...........................................................................................................30 3.1 RECONCILIATION OF INPUT TO PROFIT AND LOSS STATEMENT .................................30 3.1.1 OPEX reconcilation .........................................................................................30 3.1.2 CAPEX reconcilation .......................................................................................31 3.1.3 List of principles ...............................................................................................32 3.2 RECONCILIATION OF INPUT TO BALANCE SHEET.......................................................32 3.2.1 Basics................................................................................................................32 3.2.2 Reconcilation of fixed assets ............................................................................33 3.2.3 Classification of working capital .....................................................................33 3.2.4 List of principles ...............................................................................................36 4 CURRENT COST ACCOUNTING ..............................................................................38 4.1 ASSET REPLACEMENT METHOD ................................................................................39 4.1.1 Application of SAPI ..........................................................................................39 4.1.2 Application of DAR ..........................................................................................40 4.1.3 List of principles ...............................................................................................41 4.2 NETWORK REVALUATION AND ADJUSTMENT ...........................................................42 2 4.2.1 Modern equivalent asset...................................................................................42 4.2.2 Modern equivalent asset in switching network ................................................43 4.2.3 Modern equivalent asset in transmission network ...........................................43 4.2.4 Impact of modern equivalent assets on other costs ..........................................45 4.2.5 Capacity and equipment optimization ..............................................................45 4.2.6 List of principles ...............................................................................................46 4.3 MAPPING OF INVESTMENTS ......................................................................................47 4.3.1 List of principles ...............................................................................................48 4.4 CALCULATION OF HOLDING GAIN AND BACKLOG DEPRECIATION ............................49 4.4.1 List of principles ...............................................................................................53 4.5 REVALUATION OF OPERATING EXPENDITURES .........................................................54 4.5.1 List of principles ...............................................................................................55 4.6 REVALUATION OF WORKING CAPITAL ......................................................................55 4.6.1 List of principles ...............................................................................................55 5 ROUTING MATRIX .....................................................................................................56 5.1 CALCULATION OF TOTAL CALL ATTEMPTS ...............................................................56 5.2 CALCULATION OF TOTAL MINUTES ...........................................................................57 5.2.1 Set A of routing matrixes ..................................................................................57 5.2.2 Set B of routing matrixes ..................................................................................59 5.3 CALCULATION OF AVERAGE NUMBER OF NETWORK ELEMENTS...............................62 5.3.1 Set A of routing matrixes ..................................................................................62 5.3.2 Set B of routing matrixes ..................................................................................63 5.4 LIST OF PRINCIPLES ..................................................................................................64 6 REQUIREMENTS FOR MODEL FUNCTIONALITY .............................................66 7 APPENDIX NO. 1. CALCULATING COST OF LEASED LINES ..........................67 7.1 7.2 GENERAL SECTION ....................................................................................................67 LIST OF PRINCIPLES ..................................................................................................71 8 APPENDIX NO. 2. CALCULATING COST OF POINT OF INTERCONNECTION ..........................................................................................................72 8.1 PHASE ONE ................................................................................................................72 8.2 PHASE TWO ...............................................................................................................73 8.3 NUMERICAL EXAMPLE .............................................................................................74 8.3.1 Providing capacity for IC link (one-time fee) ..................................................74 8.3.2 Providing capacity for IC link (monthly costs) ................................................74 9 APPENDIX NO. 3. CALCULATING COST OF CARRIER SELECTION, CARRIER PRESELECTION AND NUMBER PORTABILITY ......................................76 9.1 PHASE ONE ................................................................................................................76 9.2 PHASE TWO ...............................................................................................................77 9.3 NUMERICAL EXAMPLE .............................................................................................77 9.3.1 Set-up costs .......................................................................................................77 9.3.2 Consumption costs ............................................................................................79 3 1 INTRODUCTION 1.1 Scope of the model The purpose of this document is to provide guidelines for building top-down long run average incremental cost (TD-LRAIC) model to estimate fixed line voice interconnection services. Interconnection services that are covered in this document comprise: call set-up; call origination; call termination; call transit. Guidelines for calculating LRAIC costs for providing leased lines services are presented in appendix 1. Guidelines for calculating costs of point of interconnection are provided in appendix 2. Guidelines for calculating costs of additional core network services are provided in appendix 3. 1.2 Division of core and access networks Fixed line telecomunnications network consist of core and access networks. Access network connects subscriber to core network. Core network switches and transmits traffic that is generated by subscribers. Scheme 1. Fixed line network structure Fixed line network Access network Cables Ducts Subscriber units Core network Line cards Switches Multiplexers Cables Power plant According to LRAIC methodology it is important to distinguish between subscriber and traffic driven parts of the network. The costs of access network elements are driven by the 4 number of subscribers while the costs of core network elements are driven by the traffic generated by subscribers. Normally line card which is part of subscriber unit constitues boundary between the core and access networks. The scope of the LRAIC model is the core network – interconnection costs are determined by costing core network elements that are needed to provide interconnections services. 1.3 Basic principles in LRAIC All calculations in model are based on long run average incremental cost (LRAIC) methodology. The principle of average incremental costs involves estimating a change in costs which is caused by the provision of defined increment and allocating estimated costs to to one unit of service. Incremental costs for interconnection service can be defined as costs that can be avoided if interconnection service were no longer be provided1. In the short incremental costs can de split into fixed and variable incremental costs, however, in the long run all costs are variable, which is the principle of LRAIC. There are two different approaches while creating long run average incremental cost models – “top down” (TD) approach and “bottom-up” (BU) approach. Objective of TD-LRAIC is to define the costs that operator would incur using current network structure but accordingly with demand optimised network equiment and support (network optimisation issues in detail are adressed in section 4.2). 1.4 Flow of TD-LRAIC modelling The fundamental principle of LRAIC models – costs are allocated to network elements, network elements are mapped with network services and in this way interconnection costs are calculated. Scheme 2. Basic flow in TD-LRAIC model Cost categories Network elements Services The process of TD-LRAIC modelling and its main stages are presented below: 1 In international literature the concept of decremental costs can be used, which in pirnciple is the same as incremental cost. 5 Scheme 3. TD-LRAIC model steps List of cost categories List of network elements Cost allocation scheme Mapping of financial data into LRAIC model Current cost accounting Network optimisation Routing matrix Interconnection costs First step involves deriving list of homogenous cost categories, network elements and determining cost allocation scheme. Second step requires mapping financial data into LRAIC model. Third step involveds revaluation of financial statement items using current cost accounting methodology and optimisation of operators core network. Finally, interconnection costs are determined with the help of routing matrix. 1.5 Structure of the document The document is divided into four parts: chapter 2 describes model assumptions - rules for establishing HCC, rules for establishing network elements, rules for allocation scheme, rules for constructing cost-volume relationships, cost calculation; chapter 3 describes the principles of cost mapping - reconciliation of input to profit and loss statement, reconciliation of input to balance sheet, classification of working capital, mapping of investments; chapter 4 relates to current cost accounting - application of different types of revaluation methods, application of MEA, calculation of holding gain and backlog depreciation; chapter 5 relates to routing matrix - validation of routing matrix and routing factors; chapter 6 describes requirements for TD-LRAIC model functionality; appendix 1 describes cost calculation principles for leased lines services; appendix 2 describes cost calculation principles for point of interconnection; appendix 3 describes cost calculation principles for additional core network services; appendix 4 defines terms used in this document. 6 2 VALIDATION OF MODEL ASSUMPTIONS 2.1 Rules for establishing list of HCC Homogenous cost category (HCC) is a set of costs, which have the same driver, the same cost volume relationship (CVR) pattern and the same rate of technology change. List of HCCs is unique for every single telecom operator – it depends on operators financial system used and peculiarities of accounting principles. General features that could characterize an optimal list of HCCs are presented below. 2.1.1 Distinction between operating expenditure and capital expenditure In TD-LRAIC model we distinguish between: capital expenditure related costs (CAPEX); operating expenditure related costs (OPEX). Scheme 4. Costs in TD-LRAIC model TD-LRAIC costs CAPEX Depreciation OPEX ROI Salaries Short term expenditures Materials External services Long term expenditures CAPEX costs are cost of capital (ROI), depreciation and other fixed assets related costs. OPEX costs consist of salaries (including social insurance), material and costs of external services (external services – transportation, security, utilities, payments to other operators, etc) Alternatively, OPEX costs are all operational costs except depreciation and ROI. OPEX costs are linked to costs related to short-term expenditures, while CAPEX related costs are linked to costs related to long-term expenditures. Therefore an optimal list of HCCs should have separate HCCs for OPEX related costs and separate HCCs for CAPEX related costs. 7 2.1.2 CAPEX related HCC CAPEX costs are depreciation and ROI. Depreciation represents decline of value of assets over a period of time, ROI represents cost of capital which is tied in company’s assets. To distinguish between ROI and depreciation the operators usually set different HCCs for cost of capital and depreciation related to the same fixed assets. In this case list of HCCs related to cost of capital of fixed assets has to be mirrored by the list of HCCs related to depreciation of fixed assets. It has to be noted that not all fixed assets bear the cost of depreciation. List of fixed assets that bear no depreciation is set by Lithuanian law. List of fixed assets should be grouped as described in the scheme below: Scheme 5. Grouping of fixed assets Fixed assets Network related fixed assets General fixed assets Access network fixed assets Core network fixed assets Common fixed assets Interconnection related fixed assets Other service related fixed assets Common fixed assets Fixed assets can be classified into network related fixed assets and general fixed assets (office building, fixtures and fittings, vehicles). Network related fixed assets can be classified into access network fixed assets (cables, distribution frames), core network fixed assets and fixed assets that are common to core and access networks (cables, subscriber units). Core network fixed assets can be classified into telecommunications equipment, which is directly used in providing interconnection services (switches, multiplexers), other service related fixed assets, which is directly used in providing other core network services (i.e. dedicated data transmission systems) and telecommunications equipment, which is common to several core network services (i.e. transmission network equipment). 8 List of HCCs of fixed assets should be grouped into: Interconnection related core network fixed assets; Other service related core network fixed assets; Core network fixed assets common to several services; Network related fixed assets common to core and access network; General fixed assets. List of HCCs should be defined for at least the following group of assets: cables; multiplexers; other transmission network equipment; remote subscriber units; colocated subscriber units; local switches; transit switches; international switches; other switching network equipment. In addition it has to be noted that particular fixed assets of identical functionality differ in terms of cost volume relationship patterns or even cost drivers. Switches of two different suppliers may have two different cost-volume relationships (CVRs), likewise switches of two different hierarchical levels for example local switch or primary switch. From this perspective every properly defined list of HCCs should have separate HCCs for: technologically diverse assets (i.e. different HCC for copper cables and optical cables, different HCC for EWSD, AXE or 5ESS switches etc.); hierarchically diverse assets (i.e. different HCC for local switches and primary switches, different HCC for access cables and long-distance cables). Dividing HCCs for technologically and hierarchically diverse assets is needed in order to make proper revaluation of fixed assets. Revalualion process itself is presented in detail in chapter 4. 9 2.1.3 OPEX related HCC OPEX costs are all operational costs except depreciation and ROI . OPEX costs include: salaries including social insurance; materials; external services (transport, utilities, etc); Every telecommunication operator should distinguish between these activities: retail; core network management ; supporting . Retail activities are related to transforming and selling wholesale products or services to end customers encompassing marketing, distribution and customer care. . Core network management activities are related to operation and maintenance of network assets. Supporting activities are related to any activities that support core activities of the operator (i.e. marketing or network), like accounting, human resources, administration, asset management etc. Scheme 6. OPEX costs OPEX Core network management Retail Materials Salaries External services Materials Supporting External services Salaries Materials Salaries External services Due to their different functions it is very unrealistic that some retail, network or supporting activities would be homogenous in drivers, cost volume relationship and time changes in technology. Therefore cost of retail, network or supporting activities should be allocated to different HCCs. 2.1.4 Common remarks The scope of LRAIC model is network elements that are used to provide interconnection services. On the other hand, HCC list should consist of HCCs that are related to 10 interconnection services and HCCs that are not related to interconnection services. HCCs, that are not related to interconnection services by no means can be allocated to network elements that are used to provide interconnection services. In any case, there are several reasons to have a list of HCCs not related to interconnetion services. First, this will simplify the allocation process of dependend and independent HCCs (this issue is adressed in section 2.3). Second, it will simplify the reconcilation of LRAIC data with financial statements. It is important to ensure that payments made to other operators for calls originated or terminated in their networks, fixed asset write-offs and inventory write-offs by no means can be included into calculations of interconnection costs. It has to be stressed that an optimal structured list of HCCs has to be characterized by well distribution between different HCCs. Ussualy HCC list holds around 200 to 400 HCCs. At maximum one HCC should contain around 5% of total costs, whereas most HCCs should concentrate less than 1% of total costs. HCCs for “other costs” should not represent more than 3% of all costs. If so, they should be broken down into more detailed HCCs. 2.1.5 List of principles 1. Define separate HCCs for OPEX and CAPEX related cost (obligatory). 2. Define separate HCC for working capital and fixed assets related cost (obligatory) 3. Define separate HCCs for ROI and depreciation related to the same fixed asset (obligatory). 4. List of HCCs of fixed assets should be grouped into (obligatory): Interconnection related core network fixed assets; Other service related core network fixed assets; Core network fixed assets common to several services; Network related fixed assets common to core and access network; General fixed assets. 5. List of HCCs should be defined for at least the following group of assets (obligatory): cables; multiplexers; other transmission network equipment; 11 remote subscriber units; colocated subscriber units; local switches; transit switches; international switches; other switching network equipment. 6. Define separate HCCs for technologically diverse switches (obligatory). 7. Define separate HCCs for copper cables and fiber optic cables (obligatory). 8. Define separate HCCs for retail, network and supporting activities (obligatory). 9. Ensure that one HCC does not concentrate more than 5% of total costs. Most of the HCCs should concentrate less than 1% of total costs (recommended). 10. Ensure that HCC for “other costs” does not represent more than 3% of total costs (obligatory). 11. Optimal list should consist of around 200 to 400 HCC (recommended). 12. HCCs not related to interconnection services network cannot be included in interconnection cost calculations (obligatory). 12 2.2 Rules for establishing network elements 2.2.1 Core network Core network consist of different network elements. Network element is an object, equipment, hardware or software that logically or physicaly can be identified as independent network unit (segment). Scheme 7. Structure of fixed line telecommunications network International switch Core network Transit switch Transit switch Switching network Transmission network Local switch Local switch Local switch Local switch Remote subscriber unit Remote subscriber unit Remote subscriber unit Remote subscriber unit Subscriber Subscriber Subscriber Subscriber Subscriber Subscriber Access network Subscriber Core network consists of switching and transmission networks. Switching network consists of switches and related equipment that ensures switching of and termination of calls among end points of the network. Transmission network consist of equipment, ensuring transmission of electric and optic signals among different network elements. In other words, telecommunication networks represent a kind of hierarchy. Such network hierarchy consists of nodes (i.e.: in fixed-telephony core network nodes are switches) and paths between them (i.e.: transmission links in fixed-telephony core network). Network nodes can be grouped into these categories: subscriber unit; local switch; transit switch; international switch. 13 Subscriber unit separates access and core network. Subscriber units are functional units providing access to subscribers (via line card) on one hand and access to switching host (via 2Mbps ports) on the other. Subscriber units may be co-located or remotely located to a switch. Costs of subscriber unit are allocated partly to access and partly to core network (cost allocation is described in section 2.3.6). 2.2.2 List of network elements From the perspective of cost calculation of interconnection services only newtork elements (NE) representing fixed-telephony core network are of interest. On the other hand list of NE may include network elements not related to interconnection services. HCCs, which cannot be mapped to interconnections services will be allocated to these network elements. From LRAIC perspective, network elements is understood as a logical elements that may be different from physical network elements. For example, one physical network element subscriber unit could be split into two logical network elements: “part of switch driven by traffic” and “part of switch driven by a number of subscribers”. In consequence the list of NEs in LRAIC model should consist at least of: subscriber units; local switches; transit switches; international switches; signalling; transmission link between remote concentrators units and local switches; transmission link between local and transit switches transmission link between and local and local switches; transmission link between local swiches and other network; transmission link between transit switches and international switches; transmission link between transit switches and transit switches; transmission link between transit switches and other network; wholesale specific cost; 14 wholesale billing systems. The above list of network elements can be grouped into call set-up related NEs and call duration related NEs. Call set-up related group of NEs consist of Signaling and Wholesale billing systems which cost is driven by busy hour call attempts (BHCA). Call duration related group of NEs consist of remaining network elements which cost is driven by busy hour traffic (BHT). The essential step in calculation separate fee for call set-up is the separation of switch cost between defined NE that is described in details in section 2.3.6. Additionally list of NEs can be extended by any new NE. The new NE could be created mainly in order to calculate cost of providing regulated supplementary services. The presented list of NE could be extended by specific NE related to Preselection, Number Portability and other. It should be noticed that top-down approach has some limitations concerning the granularity of the NE. Increasing extensively the number of NE by specific network components will result in less accuracy in cost allocation and furthermore in cost calculation. 2.2.3 List of principles 1. Ensure that the list of NEs consists at least of (obligatory): subscriber units; local switches; transit switches; international switches; signaling; transmission link between remote concentrators units and local switches; transmission link between local and transit switches transmission link between and local and local switches; transmission link between local swiches and other network; transmission link between transit switches and international switches; transmission link between transit switches and transit switches; transmission link between transit switches and other network; wholesale specific cost; 15 wholesale billing systems. 2.3 Rules for allocation scheme Allocation scheme is a set of rules determining how homogenous cost categories are allocated to NEs. 2.3.1 Separation of Independent and dependent HCC’s The first step in setting the allocation scheme is to decide which HCCs are independent and which are dependent. A HCC is called independent when its cost driver is exogenous. An example of an independent HCC can be cost of transmission multiplexer. The cost driver of transmission multiplexer HCC is number of 2Mbps circuits – the larger the volume of 2 Mbps circuits the higher is the cost of transmission multiplexer. Since the number of 2 Mbps circuits is an exogenous driver (it does not depend on the cost of any other HCC) the cost of transmission multiplexer is an independent HCC. A HCC is called dependent when its cost driver is a cost of another HCC. An example of a dependent HCC can be power plant. The cost driver of power plant is power consumption of telecommunication equipment – the larger the power consumption, the larger is the capacity of the power plant and hence the higher is its cost. Since it is very difficult and timeconsuming to derive power consumption of individual telecommunication equipment, in practice power consumption is proxied by cost of the equipment it powers. In consequence it is assumed that the cost of telecommunication equipment drives the cost of power plant, or in other words the cost of power plant depends on the cost of telecommunication equipment i.e. on the cost of another HCC. Therefore power plant HCC is a dependent HCC. The dependent cost categories can be further classified as first-, second- or higher-order dependent HCCs. Since first-order dependent HCC depends on cost of independent HCCs, therefore in order to allocate the cost of first-order dependent HCC first the cost of independent HCC has to be allocated on NEs. Similarly in order to allocate the cost of second-order dependent HCC first the cost of first-order dependent HCC has to be allocated and so on. In most of models only first-order dependent categories are in use, as usage of higher-order dependency makes calculations more cumbersome. Circular references should be avoided while defining independent and dependent HCCs in TD-LRAIC model. A simple example of circular reference could be a situation when firstorder dependent HCC depends on second-order dependent HCC, which depends on the same first-order HCC. As a consequence, lower-order dependent HCC should not be dependent on 16 higher-order dependent HCC. A threat of circular reference is also eliminated when only first-order dependent HCCs are used. It should be noted that a number of HCCs can be defined as either dependent or independent ones, it depends on how the driver for this HCC will be defined. If the cost driver for power plant is defined as power consumption of individual NE then the HCC for power plant will become independent one. However, if the cost driver for power plant is defined as cost of other HCC allocated to individual NEs then the HCC for power plant will become dependent one. In theory every HCC could be defined as independent, this would however complicate the TD-LRAIC model extremely. Defining HCC as independent or dependent is at discretion of TD-LRAIC model developer – is he willing/able to construct appropriate engineering model and to collect appropriate data? The lower is the number of dependent HCCs the better testimony for TD-LRAIC model developer, a good hint is that around two thirds of all HCCs should be independent. In general most of HCCs related to telecommunication equipment should be independent, while dependent HCC may prevail for network support HCCs and non-network HCCs. HCCs that are usually independent: cables, ducts, poles, cabinets etc. – both CAPEX and OPEX related; switches (all hierarchical levels of switching network) - both CAPEX and OPEX related; transmission equipment (SDH/PDH nodes) - both CAPEX and OPEX related; wholesale billing systems; other dedicated telecommunication equipment/software software, number portability related equipment). HCCs that are usually dependent: power plant; air conditioning; operational and management systems. IT equipment (mainframes, PCs, LANs etc.); vehicles; 17 (carrier preselection buildings (office, technical, warehouse), office equipment, fixtures; wages and material type costs of supporting groups, like: human resource management, legal activities, accounting and financial support or high level management etc. Independent HCC can be allocated to one ore several network elements. Sections 2.3.2-2.3.5 provide practical examples on principles of HCC allocation to network elements. HCC are allocated on NE by mean of CVR, whereas CVR presents cost behavior in respect of changing volume of cost driver. Incremental costs of HCC are allocated to NEs. Incremental cost is measured as a decrease in cost as a result of decrease in cost driver volume. The relationship between cost and volume is presented by CVR, which is presented in figure 8. Scheme 8. Cost volume relationships cost 15% IC(C) 20% IC(B) 40% IC(A) C 20% B 30% A 50% usage As shown on scheme 8. decreasing the volume by 50% caused by eliminating service A results in 40% cost decrease of HCC and equals to incremental cost of service A (IC(A)). Decreasing the volume by 30% caused by eliminating service B results in 20% cost decrease of HCC and equals to incremental cost of service B (IC(B)). Decreasing the volume by 20% caused by eliminating NE C results in 15% cost decrease of HCC and equals to incremental cost of NE C (IC(C)). The sum of incremental costs IC(A) + IC (B) + IC (C) amounts to 75% of total HCC cost. The remaining part of HCC cost constitutes common and joint cost (CJC). CJC are the effect of economy of scope and economy of scale. 18 2.3.2 Allocation of independent HCC Independent HCCs should be allocated in the following way: HCC for local switches should be allocated to NE for local switch and NE for signaling (allocation of switches is further described in section 2.3.6); HCC for transit switches schould be allocated to NE for transit switches and NE for signaling (allocation of switches is further described in section 2.3.6); HCC for international switches should be allocated to NE for international switches and NE for signaling (allocation of switches is further described in section 2.3.6); HCC for subscriber units should be allocated to following NE: access and subscriber units (allocation of subcriber units is further described in section 2.3.6); HCC for transmission devices should be allocated to following NE: all hierarchical levels of transmission, other network (allocation of transmission is further described in section 2.3.5); HCC for ducts and cables should be allocated to following NE: all hierarchical levels of transmission, other network, access. HCCs, like depreciation and ROI of the same asset should be allocated to the same NE, while the same cost driver have to be applied. 2.3.3 Allocation of dependent HCC The cost drivers of dependent HCC are costs of other HCCs (e.g. independent HCC). The proportion in which these costs were allocated on NE sets the effective cost driver values, based on which the cost of dependent HCC is alocated. Therefore allocation of dependent HCCs is limited to the assignment of the HCCs that should drive the dependent one. Independent HCCs that drive dependent HCC are: for operating and management PDH and SDH systems these are CAPEX related HCC of transmission equipment; for operating and management switch systems these are CAPEX related HCC of switches; for power plant these are CAPEX related HCC of power consuming telecom assets (transmission, switches, routers). HR, IT, vehicles, office equipment could be driven by wages related HCCs; 19 accounting, asset management, purchasing could be driven by both OPEX and CAPEX related HCCs. 2.3.4 Specific cases Operators experience some specific costs, which under no circumstances should be allocated to network elements that are used to provide interconnection services. These costs are: payments to other operators for call termination or origination, retail, fixed assets write-offs, current assets write-offs. In specific cases GSM service is used to reach operator’s own remotely located customer’s in rural areas. Payments to other operators (attributable to core network) can be included in calculating costs of interconnection services only if GSM service is used to reach operator’s own remotely located customers in rural areas. Payments to other operators (attributable to access network) cannot be included in calculating costs of interconnection services. 2.3.5 Allocation of costs of transmission network It has to be noticed that the transmission systems is used for several different services: voice services, leased lines, data transmission. Therefore the cost driver has to be found in order to split the cost between services. Although the SDH transmission systems operates basically at three transmission rates STM-1, STM-4 and STM-16 the smallest homogenous rate is terms of utilized service is 2Mbps stream (circuit). The larger the volume of 2Mbps circuits the higher the cost of transmission systems. In such a case transmission network related HCCs should be allocated to transmission network related NEs based on 2Mbps circuits. 2.3.6 Allocation of costs of switching network It has to be noticed that the switch consist of cost of subscriber units and cost of switching network. Switching network In order to calculate call setup fee the switching network part of the switch should be separated between the part driven by busy hour traffic (BHT) and the part driven by busy hour call attempts (BHCA). The switching network consists of four main components: trunk group, switching group, SS7 signaling group and central processor group. The trunk group is driven by BHT whereas the switching group, SS7 signaling group and central processor group is driven by BHCA. The separation between BHT driven part and BHCA driven part 20 should be done on the level of HCCs definition (in order to fulfill the principle of homogenous cost driver). Therefore there should be separate HCCs for BHT driven part of the switch and BHCA driven part of the switch. The BHT driven part of the switch should be allocated to corresponding NE for Local Switch or Transit Switch and BHCA driven part should be allocated to NE for Signaling. Subscriber units The subscriber units should be allocated to NE for Access and NE for Subscriber Units. The separation between subscriber driven part and BHT driven part should be done on the level of HCCs definition (in order to fulfill the principle of homogenous cost driver). Therefore there should be separate HCCs for subscriber driven part of the subscriber unit and BHT driven part of the switch. In order to separate the cost first the total cost of subscriber units has to be calculated. In the second step the cost of subscriber unit has to be calculated assuming that there in no traffic but the amount of subscribers should be frozen. The difference between total cost and cost of subscriber unit with no traffic equals to incremental cost of BHT driven part. In the third step the cost of subscriber unit has to be calculated assuming that there in no subscribers but the traffic value should be frozen. The difference between total cost and cost of subscriber unit with no subscribers equals to incremental cost of subscriber driven part. In the fourth step common and joint costs are allocated to NE for Access and NE for Subscriber Units by equal parts, according to the incremental cost volumes or using another cost drivers. 2.3.7 List of principles 1. Ensure that at least two thirds of total cost of HCCs is mapped to independent HCCs (recommended). 2. Define at least the following HCCs as independent (recommended): cables (cables, ducts, poles, cabinets etc.) – both CAPEX and OPEX related; switches (all hierarchical levels of switching network) - both CAPEX and OPEX related; transmission equipment (SDH/PDH nodes) - both CAPEX and OPEX related; wholesale billing systems; 21 other dedicated telecommunication equipment/software (carrier preselection software, number portability related equipment). 3. Allow the following HCCs to be dependent (recommended): power plant; air conditioning; operational and management systems; IT equipment (mainframes, PCs, LANs etc.); vehicles; buildings (office, technical, warehouse), office equipment, fixtures; wages and material type costs of supporting groups, like: human resource management, legal activities, accounting and financial support or high level management etc. 4. Independent HCCs should be allocated in the following way (obligatory): HCC for local switches schould be allocated to NE for local switches and NE for signaling; HCC for transit switches schould be allocated to NE for transit switches and NE for signaling; HCC for international switches should be allocated to NE for international switches and NE for signaling; HCC for subscriber units should be allocated to following NE: access and subscriber units; HCC for transmission devices should be allocated to following NE: all hierarchical levels of transmission, other ntwork; HCC for ducts and cables should be allocated to following NE: all hierarchical levels of transmission, other ntwork, access . 5. Dependent HCCs that drive dependent HCC are (recommended): for operating and management PDH and SDH systems these are CAPEX related HCC of transmission equipment; for operating and management switch systems these are CAPEX related HCC of switches; 22 for power plant these are CAPEX related HCC of power consuming telecom assets (transmission, switches, routers). HR, IT, vehicles, office equipment could be driven by wages related HCCs; accounting, asset management, purchasing could be driven by both OPEX and CAPEX related HCCs. 6. HCCs related to some specific costs that under no circumstances should be allocated to network elements (obligatory): payments to other operators for call termination or origination; retail; fixed assets write-offs; current assets write-offs. 2.4 Rules for constructing cost volume relationships Cost Volume Relationships (CVR) are at the core of developing a LRIC model. Incremental costing bases fundamentally on CVR concept, because CVRs: identify all variable costs; identify all fixed costs; trace how individual costs vary with underlying cost drivers. 2.4.1 Cost concepts In general costs can be divided into: variable costs and; fixed costs. Variable costs (VC) are costs, which varies with the changes in output level. Fixed costs (FC) are costs, which do not vary with the changes in output level i.e. are incurred regardless of what output is produced. A crucial thing, which determines if a cost can be perceived as fixed or variable one, is a time horizon, in which costs is considered. We distinguish between short run and long run. Where short run is a length of time in which at least one input in production process is fixed in scale. It means that in a short run total output is limited by fixed resources. Long run is a length of 23 time in which all inputs are variable in scale. It means that in a long run the output is unlimited as all resources are variable in scale. Wages related to customer care can be regarded as fixed in a very short-term (let us say one month horizon). Assuming the number of subscribers drops, the wages related to customer care will remain at unchanged level in a very short-term since the employees are protected by appropriate employment agreements and can not be dismissed at once. But if the time horizon becomes longer (let say one year) the wages related to customer care can be regarded as variable. Similar the cost of a switch can be regarded as fixed in one year time, but in longterm (i.e. in time horizon corresponding to the useful life of the switch) the cost can be perceived as variable. If the traffic drops the switch can be replaced by new, smaller one when the older will depreciate and so will change the cost of the switch. It is assumed that short-term horizon correspond to one year time, while long-term horizon is assumed to be enough long to may assume that all resources can be flexible adjusted to the required capacity. Incremental cost is defined as a change in cost due to a change in cost driver. The principles of incremental cost were presented in section 2.3.1. Incremental costs can be divided to variable incremental cost and component specific cost. In regulatory cost accounting we are not interested in break down of incremental cost into variable incremental cost and component specific fixed cost of an activity. Therefore, in practice, it is enough to calculate incremental cost itself. Incremental cost is a fundamental base for all LRAIC model. Only incremental (not total HCC) costs are allocated in TD-LRAIC model. In addition to incremental costs part of common and joint costs are allocated to NEs and consequently to interconnection services. 2.4.2 Shapes of CVR curves Incremental costs of all activities do not sum up to the total cost, that operator incurs. The reason is that there is an additional cost category of common and joint costs which are common to several activities. Common and joint costs are costs which cannot be directly attributed to a single activity and are the effect of economy of scale and economy of scope. Economy of scale is a phenomenon of reduction of cost per unit resulting from increased output, realized through operational efficiencies. Due to economies of scale the cost of producing each additional unit falls with production increase. Economy of scope is a phenomenon, that arises when the cost of performing multiple business functions simultaneously proves more efficient than performing each business function independently. 24 Below we provide possible shapes of CVR curves. Figure 1 Lt Lt Figure 2 Volume Volume Figure 1 – straight line through the origin, hence no economy of scale / scope nor fixed costs; Figure 2 – straight line with an intercept point indicating fixed costs and no economy of scale / scope for variable costs. Figure 3 Lt Lt Figure 4 Volume Volume Figure 3 – curved line through the origin. This CVR indicates on purchasing power (convexity of line) which provide economy of scale; Figure 4 – curved line with an interception point. This CVR indicates on fixed costs and purchasing power (convexity of line) which provide economy of scale / scope; 25 Figure 5 Lt Lt Figure 6 Volume Volume Figure 5 – curved, concave line with or without an intercept point. This CVR indicates that cost per unit rises with output. It would point at case contrary to economy of scope; Figure 6 – curved, concave line with or without an intercept point. This CVR indicates that cost per unit rises with output. It would point at case contrary to economy of scope. 2.4.3 Deriving CVR shapes There are three methods commonly in use to develop a particular CVR: engineering model; expenditure analysis; judgmental assessment. CVR is derived by an engineering model if the input (cost of resources) is linked to the output (volume of service) by a set of algorithms. These algorithms are sets of engineering rules and engineering assumptions, that allow to model the exact capacity of telecommunication equipment to meet a given service demand. The engineering model yields in the best approximation of CVR shape, therefore they should be applied wherever it is possible. In fact this method of deriving the shape of CVR is applicable only in case of the primary telecommunication infrastructure. Supporting network infrastructure, non-network related assets as well as operating expenditures are too complicated in their nature to be able to dimension their costs by a limited set of objective rules. Engineering models should be applied for: subscriber units; 26 switches; transmission network; ducts and cables. Expenditure analysis is applied to derive CVRs of OPEX HCCs. Using this method costs ere linked to service volumes on a basis of some historic cost structure. Expenditure analysis is characterized by best approximation of CVR shape. On the other hand, application of this method is very limited since it can be applied only there, where the relation between input and output is explicitly presented. It can be applied to HCC representing some external services, like operation and maintenance of telecommunication equipment. Where neither an engineering model nor an expenditure analysis could be applied there is judgmental assessment in use. It is based on employees knowledge and internal assumptions and thus it is unverifiable for external experts. Judgmental assessments prevail in case of developing CVR for non network related fixed assets and OPEX related HCC. 2.4.4 Verification of CVR shapes Verifying CVR shapes we ask following questions: Are the economies of scale or economies of scope in this HCC? Are the fixed costs significant or negligible? Is a CVR a straight line, or a concave line, etc? Below we provide some hints on common CVR shapes for various HCCs. Examples of network related fixed assets HCCs could be: switches – economy of scale resulting in convexity of line, economy of scope resulting in large amount of fixed costs, thus Figure no. 4; transmission equipment - economy of scale resulting in convexity of line, economy of scope resulting in large amount of fixed costs, thus Figure no. 4; cables – economy of scope resulting in large amount of fixed costs, no change in respect of volume, thus straight horizontal CVR line; power plant – no economy of scale and no economy of scope, thus Figure no. 1; Examples of non network related fixed assets HCCs could be: IT equipment - no economy of scale and no economy of scope, thus Figure no. 1; 27 office equipment - no economy of scale and no economy of scope, thus Figure no. 1; Examples of OPEX network related HCCs could be: switches operation and maintenance - economy of scale resulting in convexity of line, economy of scope resulting in large amount of fixed costs, thus Figure no. 4; transmission equipment operation and maintenance - economy of scale resulting in convexity of line, economy of scope resulting in large amount of fixed costs, thus Figure no. 4; cables operation and maintenance - economy of scope resulting in large amount of fixed costs, no change in respect of volume, thus straight horizontal CVR line; power plant operation and maintenance - no economy of scale and no economy of scope, thus Figure no. 1; Examples of OPEX supporting HCCs could be: related to IT support - no economy of scale and no economy of scope, thus Figure no. 1; related to HR - no economy of scale and no economy of scope, thus Figure no. 1; related to financial and accounting - no economy of scale and no economy of scope, thus Figure no. 1; 2.4.5 List of principles 1. Ensure that the incremental cost is presented separately for each NE (obligatory). 2. Ensure that the common and joint cost is presented separately for each NE (obligatory). 3. Economy of scope is common for these HCC’s (recommended): cables - both CAPEX and OPEX related; switches - both CAPEX and OPEX related; transmission equipment - both CAPEX and OPEX related. 4. Economy of scale is common for these HCCs (recommended) switches - both CAPEX and OPEX related; transmission equipment - both CAPEX and OPEX related. 28 5. Estimate the CVR shape for HCCs with one of the three methods commonly in use (obligatory): engineering model – for network related HCCs both OPEX and CAPEX; expenditure analysis – for non-pay OPEX; judgmental assessment – for other. 29 3 COST MAPPING It is important to ensure that data used in TD-LRAIC model is mapped with data in the statutory financial statements. The process of cost mapping can be divided into two parts: reconciliation of input data to profit and loss statement. reconciliation of input data to balance sheet. 3.1 Reconciliation of input to profit and loss statement Calculation of LRAIC requires to set the economical costs of an operator on a forward looking and current cost base: current costs means that cost is stated in terms of current values rather than in terms of actual acquisition cost; economical costs cover accounting cost reported in profit and loss account and ROI; forward looking costs means that cost is stated in terms of approximated, future values. Only a part of economical costs is reported in profit and loss statement of the operator, these are the operational costs, while the ROI, in the sense presented in the definition of economical costs, is not reported in profit and loss statement. The ROI is calculated as product of mean capital employed times weighted average cost of capital (WACC). The capital employed is reported in balance sheet of the operator. Theoretically, in profit and loss account one can distinguish between: short-term related items - operating costs (OPEX); long-term related items - depreciation and other fixed asset related costs (CAPEX without ROI). 3.1.1 OPEX reconcilation The total OPEX costs should be reconciliable with the sum of the following positions from profit and loss statement: costs of goods sold (position II in Lithuanian profit and loss account); administrative costs (position IV in Lithuanian profit and loss account); 30 Depreciation costs should be eliminated from the positions that are mentioned above. It should be noted, that OPEX are reconcilable only with a part positions in profit and loss account. Eliminated positions in profit and loss account are: financial activity expenditures (position VII in Lithuanian profit and loss account); extraordinary expenses (position X in Lithuanian profit and loss account); profit tax (position XII in Lithuanian profit and loss account). While reconciling the operating costs related to operating expenditures it should be assured that no fixed assets related costs are included in profit and loss account aswell. 3.1.2 CAPEX reconcilation The historical depreciation (HD) is mapped into the LRAIC model in order to calculate the HD/GBV ratios for individual asset related HCCs. Ideally to every fixed asset related HCC its historic figures should be assigned. It means HD of the assets mapped into one HCC should be assigned to this HCC. In consequence total HD of all fixed assets related HCCs should reconcile with total HD recorded in financial statement. In practice the detail level of fixed asset register does not provide enough information to assign to each HCC its historic figures one to one. In such a case for the purpose of calculating HD/GBV ratios the HCC should be grouped into broader fixed assets categories that can be matched with fixed asset register. Identical ratios should be applied to all HCC falling into one of broader fixed asset categories. The appropriate mapping is very important since methodology used for calculation of fixed assets depreciation in TD-LRAIC model should be the same as in financial accounting. This methodology should be aligned with Lithuanian law and reflect optimal economic decisions. The formula for calculating current depreciation is discussed in details in section (4.3). In practice, significant part of other fixed assets related costs are cost of fixed assets sold. It should be stressed that the difference on cost of fixed assets sold and revenue on fixed assets sold should correct the cost of depreciation. Is the fixed asset sold above its net book value it give raise to assume the fixed asset has been depreciated in the company’s books too aggressively. Therefore the resulting gain from sales of fixed assets should adjust down the depreciation figure. Vice versa is the fixed asset sold below its net book value it means the market value of fixed asset is less than its net book value and presumably the depreciation 31 rate was too low in the books of the company. Similarly the resulting loss from sales of fixed assets should adjust up the depreciation figure. It should be stressed that it is not the cost of fixed assets sold that adjust the depreciation figure, but the difference between revenue and cost. 3.1.3 List of principles 1. Ensure that operating costs related to operating expenditures in the TD-LRAIC model is reconcilable with sum of the following positions in profit and loss statement (obligatory): costs of goods sold (position II in Lithuanian profit and loss account); administrative costs (position IV in Lithuanian profit and loss account); Depreciation costs should be eliminated from the positions that are mentioned above. 2. Ensure that operating cost in TD-LRAIC model does not include the following positions in profit and loss account (obligatory): other activities (position VI in Lithuanian profit and loss account); financial activity expenditures (position VII in Lithuanian profit and loss account); extraordinary expenses (position X in Lithuanian profit and loss account); profit tax (position XII in Lithuanian profit and loss account). 3. Ensure that the historic depreciation (HD) that are assigned to HCCs match with corresponding figures in profit and loss account (obligatory). 4. Ensure that costs of sales of fixed asset are not included calculating interconnection costs (obligatory). 3.2 Reconciliation of input to balance sheet 3.2.1 Basics In balance sheet one can distinguish between: short-term related items – current assets and current liabilities (often referred as working capital); 32 long-term related items – fixed assets, equity and long term liabilities. 3.2.2 Reconcilation of fixed assets The net book value (NBV) and gross book value (BGV) are mapped into the LRAIC model in order to calculate the NBV/GBV and HD/GBV ratios for individual asset related HCCs. Ideally to every fixed asset related HCC its historic figures should be assigned. It means NBV and GBV of the assets mapped into one HCC should be assigned to this HCC. In consequence total NBV and total GBV of all fixed assets related HCCs should reconcile with total NBV and total GBV recorded in financial statement. In practice the detail level of fixed asset register does not provide enough information to assign to each HCC its historic figures one to one. In such a case for the purpose of calculating NBV/GBV and HD/GBV ratios the HCC should be grouped into broader fixed assets categories that can be matched with fixed asset register. Uniform ratios should be applied to all HCC falling into one of broader fixed asset categories. 3.2.3 Classification of working capital TD-LRAIC model involves estimating economic costs, which comprise: operational costs reported in profit and loss statement of the operator; ROI calculated as a product of mean capital employed times WACC. Therefore calculating LRAIC of NE would require to allocate ROI on individual NEs. Since decisions about debt finance are largely corporate decisions determined by a number of factors, such as historical borrowing facilities, tax planning considerations and importance of corporate treasury function, hence the debt position of the corporate may not relate specifically to the funding requirements of individual NEs. Therefore allocation of capital employed to individual NEs seems to be unfeasible process. In order to make this process feasible it has to be traced what does the capital employed finance. This can be answered by rearranging the balance sheet equation. In the balance sheet equation we have: Assets = Shareholders Founds + Liabilities Or in more details: FA CA E D CL (1) Where: 33 FA – fixed assets; CA – current assets; CL – current liabilities; D – long term liabilities / debt; E – equity. Rearranging previous formula yields in: FA CA CL E D (2) Since (CA – CL) is defined as working capital (WC), we have: FA WC E D (3) The right hand side of formula is simply one of the possible definitions of capital employed of the operator – long term funds invested by shareholders (equity) and long term funds invested by external providers of finances. The left side is basically its equivalent – fixed assets and working capital employed to provide the services. This shows that the capital employed finances fixed assets and working capital. Hence, allocation of capital employed on NEs is equivalent to allocation of fixed assets and working capital on the NEs. Working capital is by definition current assets less current liabilities, the definition however evokes in practice much controversy. It is often not so clear which items should be regarded as current assets less current liabilities. Below we provide a list all balance sheet items and point out which of them should be regarded as working capital: equity (position C. in Lithuanian balance sheet) - none of these balance sheet items constitute working capital; fixed assets (position A. in Lithuanian balance sheet) – none of these balance sheet items constitute working capital; long-term liabilities (position E.I. in Lithuanian balance sheet) - none of these balance sheet items constitute working capital; current liabilities (position E.II. in Lithuanian balance sheet)- except of items specified below, all other balance sheet items constitute working capital: o Current portion of long-term debt (position E.II.1. in Lithuanian balance sheet). This balance sheet item relates to current liabilities representing part 34 of long-term debt (including interests) that is due within one year. Clearly the whole amount of long-term debt (including its short term part) should be treated consistently. Since long-term debt is in general incurred to finance the operations of the company it constitute capital employed. Similarly current liabilities representing part of long-term debt due within one year should be treated as capital employed, therefore they are not part of working capital. Reporting of this part of long-term debts as current liabilities is just an accounting requirement and is not related to any financial or economic considerations. o Permanent core of overdrafts (position E.II.2. in Lithuanian balance sheet). Companies enter overdrafts either for financing purposes or for liquidity purposes. The overdraft due to financing reasons is always permanent and does not appear and disappear as a consequence of temporary surplus or deficit on cash. If overdraft occurs due to financing reasons it should be treated as capital employed and it is not part of working capital. If overdraft occurs due to liquidity reasons it should be treated as working capital. o Current obligations from finance leases (position E.II.1. in Lithuanian balance sheet). Both, current and non current part of obligations from finance leases should be treated as a part of long-term financing therefore it is not part of working capital. The reason for such treatment is that, from the economical point of view finance leases are simply a form of a loan given by lessor to a lessee. o Liabilities from derivatives that are being used to hedge operators long-term debt (position E.II.2. in Lithuanian balance sheet). Liabilities aroused from entering derivative contracts should be treated consistently with the corresponding losses. If derivatives are used to hedge sources of finance they should be treated as capital employed therefore they should not be a part of working capital. o Corporate Income Tax (CIT) payable (position E.II.5 in Lithuanian balance sheet), dividend payable (position E.II.8 in Lithuanian balance sheet). Liabilities for taxation and dividends are short-term liabilities that arise because taxation and dividends have not yet been paid. When these liabilities become payable by an operator, either its cash balances will fall or its debt will increase (or a combination of the two). Their balances come into being 35 only for the very short period of each year. We suggest that these liabilities are not treated as working capital. Current assets - except of items specified below, all other balance sheet items constitute working capital: o Dividends receivable (position B.III in Lithuanian balance sheet). When these assets become payable by debtor, either its cash balances will rise or operators debt will decrease (or a combination of the two). Their balances come into being only for the very short period of year. We suggest that these receivables are not treated as working capital. o Balance sheet assets from derivatives that are being used to hedge operators long-term debt (position B.III in Lithuanian balance sheet). Assets aroused from entering derivative contracts should be treated consistently with the corresponding profits. If derivatives are used to hedge sources of finance they should be treated as capital employed therefore they should not be a part of working capital. Averaged values of the balance sheet positions are used in calculations of working capital (i.e. opening balance plus closing balance divided by two). 3.2.4 List of principles 1. Ensure that GBVand NBV that are assigned to HCCs match with corresponding figures in balance sheet statement (obligatory). 2. Ensure that averaged value of balance sheet position are used in calculations of HD/GBV and NBV/GBV ratios (obligatory). 3. Ensure that working capital in TD-LRAIC model include following positions from balance sheet statement (obligatory): current liabilities except of current portion of long term debts, permanent core of overdrafts entered due to financing reasons, current obligations from financial leases and liabilities from derivatives that are being used to hedge operators long-term debt; current assets except of dividend receivable and assets from derivatives that are being used to hedge operators long-term debt. 36 4. Ensure that working capital in TD-LRAIC model does not includes the following positions from the balance sheet statement (obligatory): fixed assets (position A. in Lithuanian balance sheet); equity (position C. in Lithuanian balance sheet); long term liabilities (position E.I. in Lithuanian balance sheet). 5. Ensure that averaged values of the balance sheet positions are used in calculations of working capital (obligatory). 37 4 CURRENT COST ACCOUNTING It has to be noted that costs in statutory financial statements is reported on a historic cost and actual basis while the cost base in TD-LRAIC calculation is set on a current cost and forward looking basis. Therefore, HCC that are taken from profit and loss acount and balance sheet are to be revalued appropriately. CAPEX costs in financial statements are reported on acquisition basis, thus revaluation is performed in two steps. First, costs are revalued using current cost accounting principles. Second, allowance reflecting forward looking costs is made. OPEX costs in financial statements reflect their current values, thus, revaluation is limited to making allowance for forward looking values. The current cost accounting theory recognizes three different decisions on use of assets, which might be considered by operators, and consequently three alternatively methods of valuation: Comparative transactions method. Net realizable value (NRV) is the value the asset would realize if sold (less all discounts and sale costs); Asset replacement method. Net replacement cost (NRC) is the cost of replacing an asset by another one of similar characteristics and age; Discounted cash flows method. Economic value (EV), also called “value in use” is the net present value of future cash flows arising from the asset. Based on the above definitions it is possible to estimate current cost of an asset by reference to its “deprival value”. Deprival value of an asset is defined as the loss, the operator would suffer if deprived of an asset. The deprival value must be calculated as the lower from Net Replacement Cost (NRC) and Recoverable Amount (RA), whereas Recoverable Amount is defined as the higher of Net Realizable Value (NRV) and Economic Value (EV). This can be illustrated graphically as a decision tree presented in a figure below: 38 Scheme 9. Calculation of current asset costs Current cost MIN Net Replacement Cost (NRC) Recoverable Amount (RA) MAX Net Realisable Value (NRV) Economic value (EV) In practice the revaluation of an asset is usually limited to calculation of NRC. Therefore we recommend, that while calculating current cost of fixed assets the calculation of RA can be ignored unless the NRC is not significantly higher than a corresponding historic value, say 150% of historic value. Additionally EV and NRV methods can be used in order to determine the current value of operators real estate. Revaluation of fixed assets can be performed by operator internally or with the help of external experts. 4.1 Asset replacement method All assets in TD-LRAIC model should be revaluated to the Gross Replacement Cost. For each HCC the operator has to choose between two methods: Specific Asset Price Indexation (SAPI); Detailed Asset Revaluation (DAR). 4.1.1 Application of SAPI Under SAPI the GBV of a group assets is revaluated to GRC by applying yearly price change indices that are specific for each group of assets. Theoretically there are many sources to derive appropriate prices change indices. The indices may be based on an average cost changes of fixed assets, information from statistical office or from telecommunication regulatory authority data, but in practice it is difficult to find a comprehensive database to calculate the indices. Therefore the major challenge in this method is to find appropriate prices change indices. SAPI can be applied, if all below listed conditions are fulfilled: technological standards for the particular group of fixed assets have not changed significantly; 39 the particular group of fixed assets is internally homogenous, i.e. price trends of all fixed assets within the group do not differ significantly from each other; the Gross Book Value has been accurately recorded in the Fixed Asset Register and is available for the last number of accounting periods that covers the whole useful life of the particular group of fixed assets; the accuracy of revaluation depends on method of assets grouping and on index application. Different assets that have different indexes through years must not be grouped together. Applying SAPI allows two alternative treatments of fully depreciated assets. One treatment is that only assets not fully depreciated are revalued. In this case price change indices are applied n years backwards, where n equals the useful life of an asset. It means that the GBV where price change index has been applied may be lower than the total GBV recorded in the books. The other treatment is that all the assets are revalued and then an appropriate allowance for fully depreciated assets is applied. In this case price change indices are applied to all purchase years backwards. The revalued figure is then adjusted like in the DAR method. 4.1.2 Application of DAR Under DAR the GBV of a group assets is revalued to GRC by assigning current purchase price to each single asset of these group one by one. DAR is a common fixed asset revaluation method used in TD-LRAIC model. As a rule, around 80% of total fixed asset value is revalued using DAR. DAR can be applied, if all below listed conditions are fulfilled: operator must have a reliable database with physical volume of fixed assets; reliable information about current purchase prices must be available. They can be gained from public source or from operator data. Again two alternative approaches to the treatment of fully depreciated assets have to be discussed. The first one revaluating only the assets that have not been fully depreciated is rather not applicable in DAR method, since it is very difficult to identify in physical count the assets that have not been fully depreciated yet – this kind of information is usually not stored in the database where the physical volumes come from. Therefore in DAR method the other treatment of fully depreciated assets is applied, namely the one where all the assets are revalued and then an appropriate allowance for fully depreciated assets is applied. 40 Since most of the assets of telecommunication network operator undergo rapid technological changes (this relates in first line to telecommunication network) DAR is the common method applied in the revaluation process. In practice DAR method is a must in revaluation of telecommunication equipment, while SAPI is applied in most of other group of assets. It has to be noticed however that everywhere where physical volume can be obtained from reliable sources DAR should be the preferable method. Below we list a full list of group of assets together with preferable revaluation method: ducts and cables – DAR; switches – DAR; transmission equipment – DAR; power plant – DAR; support and inventory systems – SAPI; fixtures, fittings and office equipment – SAPI; PC and IT equipment – SAPI. 4.1.3 List of principles 1. For DAR revaluation ensure that all below listed conditions are fulfilled (obligatory): there is a database with exact physical volumes of fixed assets; reliable information about each asset current purchase prices are available. Gain them from own data or from public source. 2. For SAPI revaluation ensure that all below listed conditions are fulfilled (recommended): technological standards for the particular group of fixed assets have not changed significantly; the particular group of fixed assets is internally homogenous; the Gross Book Value has been accurately recorded in the Fixed Asset Register and is available for the last number of accounting periods that covers the whole useful life of the particular group of fixed assets; the accuracy of revaluation depends on method of assets grouping and on index application. 41 3. If possible the following fixed assets groups revaluate with DAR method (recommended): ducts and cables; switches; transmission equipment; power plant. 4. Following assets group may be revaluated with SAPI method (recommended): support and inventory systems; fixtures, fittings and office equipment; PC and IT equipment. 5. Ensure the proper value of price change indices. The indices may be based on an average cost changes of fixed assets, information from statistical office or from telecommunication regulatory authority data (obligatory). 4.2 Network revaluation and adjustment The TD-LRAIC model is based on current cost of an efficient operator. This sentence has a significant impact on valuation of network related fixed assets. Valuation of a network at current costs requires application of modern equivalent asset concept, while valuation of a network of an efficient operator requires application of capacity and optimization adjustments. 4.2.1 Modern equivalent asset In the situation, when fixed assets that are still in use are outdated or no longer available on the market, it may be difficult to assign their current price. In this situation the concept of Modern Equivalent Asset (MEA) has to be adopted. MEA means an asset that would perform the same function as the asset to be replaced and is currently available on the market. In an environment as telecommunication market that is characterized by rapid technological changes it is critical to state what is the modern equivalent asset. Certainly any analogue switches should be regarded as outdated technology and should be replaced by some modern equivalents, but what is the modern equivalent in a switching network. Is it a CCS switch or ATM/IP switch? Today packet networks – Asynchronous Transfer Mode (ATM) and Internet Protocol (IP) – are increasingly replacing traditional circuits networks – Common Channel 42 Signalization (CCS). Many operators have installed or are planning to install ATM/IP switches. These switches increase efficiency of transmission networks and hence lower the costs. Does it mean that not only analogue switches but also traditional digital switches have to be regarded as outdated and be replaced by ATM/IP network? These are the strategic assumptions that have to be agreed before building the TD-LRIC model. In the remaining part of the section we will address most of the specific MEA cases that may occur at fixedline operator. 4.2.2 Modern equivalent asset in switching network Although as stated above many operators have installed or are planning to install ATM/IP switches as a platform to carry voice traffic, we understand that the traditional circuits network are still prevailing across the world and can be regarded as a standard technology to convey voice traffic. Therefore we suggest that the MEA in switching network be a traditional circuit based, digital network. This network consists of few large digital hosts that concentrate traffic from disperse located remote units or optical network units (ONU), whereas the ONU are increasingly dislodging the remote units, since they come closer to the customer premises. The remote units are connected to the hosts by producer’s own interface, while ONU are connected to the hosts by V 5.1 or V 5.2 interface. The current standard is to connect ONU by V 5.2 interface. All in all we recommend that all digital hosts and larger digital remote units (above 1024 subscribers) should be revalued by applying the same digital technology. Smaller remote units (below 1024 subscribers) should be replaced by ONU. Larger analogue switches (above 1024 subscribers) should be replaced by digital remote units of the same produces as the producer of the digital hosts to which the analogue switch is currently connected. Smaller analogue switches (below 1024 subscribers) should be replaced by ONU. The ONU should be connect to digital hosts by V 5.2 interface. In some specific cases MEA could be chosen after the analysis of several alternatives. 4.2.3 Modern equivalent asset in transmission network We understand the current standard in transmission networks remain still SDH, although similarly as in switching networks the operators install or are planning to install ATM/IP networks as a transmission platform. Therefore we suggest that the MEA in transmission network be a fiber optics SDH network. This network consists of SDH add-drop multiplexers (ADM) or termination multiplexers (TM) that form nodes and optical cables. Usually ADM and TM operate at three basic transmission rates – STM-1, STM-4 and STM-16. In addition in locations of very low traffic demand TM can operate at additional rate – VC-TM. We 43 recommend that all SDH and PDH nodes should be revalued by applying the SDH technology. All the long-distance copper cables should be replaced by fiber optics. Long-distance cables in TD-LRAIC model are defined as all cables that are in local and higher topological levels of core network: cables between local switches; cables between local and transit switches; cables between transit switches; cables between transit and international switches; cables between international switches. The revaluation process itself follows basically the same path as DAR. The revaluation is proceeded by the selection of an appropriate device to replace the asset to be revalued. The revaluation is performed in the following phases: selecting MEA for each fixed asset to be replaced performing revaluation of MEA based on DAR method. Adoption of the MEA concept has an implication in both identifying suitable replacement costs for old technology assets and ensuring that the asset exhibits the same level of capacity and functionality. Therefore the costs of the modern equivalent have to be adjusted proportionally to the extent to which it surpasses the old replaced asset. Such adjustment is called abatement. There are two types of abatements – qualitative abatements and quantitative ones. The qualitative abatement arises when MEA exceeds the functionality of the asset to be revalued. The quantitative abatement arises when MEA exceeds the capacity of the asset to be revalued. Since the digital technology is very modular it allows to adjust the capacity of MEA to the capacity of the asset being replaced accurately. Therefore in practice there are few cases where the quantities abatements arise. In consequence we recommend the quantities abatements can usually be ignored. Quality of MEA usually far excels the quality of the asset being replaced. The qualitative abatements however are often very judgmental and very difficult to estimate properly and may influence negatively current cost of revaluated fixed assets. Therefore we similarly recommend the qualitative abatements be in practice ignored. 44 4.2.4 Impact of modern equivalent assets on other costs The application of MEA concept has not only impact on the costs of the assets being actually replaced but on other costs as well: costs of supporting assets ; operation and maintenance costs In order to reflect this impact appropriate MEA adjustments are to be calculated. Digital technology requires less maintenance and occupies less space. Therefore typically application of MEA results in lower operation and maintenance costs of switches and transmission and on lower building costs. The impact of MEA on power plant costs can be argued. The analogue switches consume much more energy than their digital equivalents. On the other hand digital switches requires air-conditioning that constitute additional power plant costs. Both effects are considered to set-off. Therefore we suggest to ignore the calculation of MEA adjustments on the costs of power plant and power consumption. 4.2.5 Capacity and equipment optimization Spare capacity correction. This correction may appear in case of oversized network having spare capacity. Spare capacity is justified if they are results of: providing the same quality of services; technical reserves; equipment modularity; operational reserves that allows fluent network development. Spare capacity that is in excess of the justified spare capacity represents unjustifiable costs and thus should be excluded from the revaluation of the fixed assets. Inefficiency correction. This correction may appear when the existing processes are inefficient. The process is inefficient when too much resources are assigned to perform the process. The inefficiency of the processes may be quantified based on benchmarks and Key Performance Indicators (KPIs). Optimization correction. This correction appears when the network topology or structure is not optimally designed. The network of the operator is the result of historic network development and further changes. In many cases the network design is not optimal. 45 Let’s assume that the exchange have built up the excess capacity in the trunk group. The amount of trunks that are not in service is too large and the amount is not justified. Applying correction that reduces cost by reducing number of trunks will be named as spare capacity correction. Additionally let’s assume that the amount of technicians that overlook the exchange is too large. The definition of processes and responsibilities causes inefficient use of personal recourses. Organisation can solve the problem by reorganisation and controlling the performance of individuals e.g. increasing the amount of subscriber lines that have to be overlooked by one technician. Applying correction that reflects the reduced need for resources will be named as inefficiency correction. Local exchange switching low traffic volume is not an optimal solution. Instead one should consider connecting all subscribers directly to the upper level exchange, like primary exchange, and eliminating the local exchange. This would optimize the cost by reducing the redundancy and is named as optimization correction. 4.2.6 List of principles 1. Ensure that in revaluation process all analogue switches are substituted by digital switches (obligatory). 2. Ensure that in revaluation process all digital hosts and larger digital remotes units (above 1024 subscribers) are revalued by applying the same digital technology (obligatory). 3. Ensure that in revaluation process smaller remote units (below 1024 subscribers) should be replaced by ONU (access system) (recommended). 4. Ensure that in revaluation process larger analogue switches (above 1024 subscribers) are replaced by digital remote units of the same producer as the producer of the digital hosts to which the analogue switch is currently connected (obligatory). 5. Ensure that in revaluation process smaller analogue switches (below 1024 subscribers) are replaced by ONU (access system). The ONU should be connected to digital hosts by V 5.2 interface (recommended). 6. ONU should be connected to digital hosts by V 5.2 interface (obligatory). 7. Ensure that in revaluation process all PDH transmission equipment is substituted by SDH equipment (obligatory). 46 8. Ensure that in revaluation process all long-distance copper cables are substituted by fiber optics (obligatory). 9. Apply operational MEA adjustments for correction of operation and maintenance cost in case of PDH and analogue switches (obligatory). 10. Perform capacity adjustment and allow spare capacity in case of (obligatory): providing the same quality of services; technical reserves; equipment modularity; operational reserves that allows fluent network development. 11. Perform efficiency analysis for operational activities and apply the efficiency adjustments where is applicable (obligatory). 12. Perform the optimization analysis for network design and apply the optimization adjustments. Check whether (obligatory): the local switch can be substituted by remote unit; the local switch can be merged with upper level switch. 4.3 Mapping of investments As it has been discussed figures in the statutory financial statements are reported on a historic and actual basis while the cost base in LRAIC calculation is set on a current cost and forward looking basis. It is fairly easy to calculate the forward looking cost of short-term nature i.e. forward looking operating cost other than depreciation and forward looking capital cost of working capital. Calculation of forward looking cost of long-term nature (i.e. forward looking depreciation cost and forward looking capital cost of fixed assets) requires to estimate the forward looking values of GRC and NRC. It is the average GRC and NRC values that will be in the year when interconnection rate will be valid. In order to calculate the forward looking values of GRC and NRC it is not enough to know the future price of the assets, but their future capacity as well. The way to estimate future capacity of the assets is to project current capacity by the increase or decrease in the demand, as presented in the figure below. 47 Scheme 10. Estimation of assets capacity Forward looking cost Actual cost Actual demand Forward looking demand Since the estimation of future demand and therefore future capacity of the assets is quite complex process. That is why LRIC models very often refer to budgeting process that any way covers this issue, in addition budgeted numbers are blessed by the shareholders (i.e. they are often accepted by the supervisory board) providing assurance for proper projection. Therefore calculation of forward looking values of GRC and NRC can be limited to calculation of actual values of GRC and NRC and then adjusting them by future investment i.e. budgeted capital expenditures. It has to be noted that budgeted capital expenditures covers expenditures that are planned to replace existing assets since the assets will fully depreciate in the near future and expenditures that are planned to increase current capacity. While mapping investment values into the LRIC model of course only the investments have to be taken into account that are planned to increase current capacity. 4.3.1 List of principles 1. Ensure that the future investments have reference to budgeting process providing assurance for proper projection (recommended). 2. Ensure that the future investments constitute only those expenditures that are planned to increase current capacity (obligatory). 48 4.4 Calculation of holding gain and backlog depreciation Basically there are two concepts to calculate the costs of fixed assets – Operating Capital Maintenance and Financial Capital Maintenance: Operating Capital Maintenance (OCM) considers the operating capability of an operator. Capital maintenance under this approach requires the operator to have as much operating capability (or productive capability) at the end of the period as at the beginning. In OCM depreciation cost equals Current Depreciation. Financial Capital Maintenance (FCM) assumes that the financial capital of an operator is maintained in current price term. This will be the case if shareholder’s funds at the end of the period are, in real terms, at the same level as at the beginning of the period. In FCM depreciation cost equals the difference between NRC at the beginning and at the end of the accounting period. Therefore, in conditions of rising/falling assets prices, capital maintenance cost is lower/higher than current depreciation. FCM is considered as the appropriate capital maintenance concept to use. The formula for the cost of fixed assets under FCM concept is presented below: C (n) NRC (n) WACC CD(n) HG (n) (5) Whereas: NRC (n) – average net replacement cost; WACC – weighted average cost of capital; CD(n) – current depreciation in period n; HG(n) – holding gain in period n, please note that the holding gain refers to only one year interval. Index n refers to the period for which costs are calculated in TD-LRAIC. Index n-1 refers to the period when LRAIC calculation is performed. Index n-2 refers to a period from which data is taken. For example, if model which is done in 2005 and it calculates costs of 2006 on a basis of data of 2004, n-2 means 2004, n-1 means 2005 and n means 2006. GRC (n) NRC (n) CD(n) GRC (n) NBV (n) NBV (n 1) GRC (n 1) GBV (n) GBV (n 1) 2 HD (n) GBV (n) (6) (7) 49 Whereas: GBV(n) – gross book value at the end of period n; NBV(n) – net book value at the end of period n; GRC(n) – gross replacement cost at the end of period n; HD(n) – historical depreciation in period n. Holding Gain (HG) represents the gains or loses from changes in asset current value resulting from asset price changes and not related to asset operating capacity. In conditions of rising asset prices, current depreciation cost is lowered by asset revaluation. It means that in order to maintain asset value, revenues should cover only that part of current depreciation that is not covered by HG. In conditions of falling asset prices, asset value is lowered by current depreciation as well as by decrease of asset price. So, in order to maintain value of assets, revenues should cover both depreciation and decrease in asset price. The formula for HG is not so simply and straight forward as for NRC or CD. In academic documents there is a number of formulas to calculate the holding gain each of these formulas is mutually equivalent to each other. Below are presented four alternative formulas to calculate the holding gain: GRC (n) GRC (n 1) HG (n) NBV (n 1) GBV (n) GBV (n 1) HG (n) NBV (n 1) GRC (n) GRC (n 1) GBV (n 1) (8) (9) HG (n) NRC (n) NRC (n 1) CD(n) (10) HG (n) GRC (n) GRC (n 1) BD (n) (11) Whereas: BD(n) – backlog depreciation in period n. Backlog depreciation in period n accounts for the difference between GRC at the end of period n less NRC at the end of period n, accumulated current depreciation at the beginning of period n and current depreciation for period n, as presented below: BD (n) GRC (n) NRC (n) CAD(n 1) CD(n) Where: CAD(n-1) – current accumulated depreciation 50 (12) CAD(n 1) GRC (n 1) CD(n) GRC (n) AD(n 1) GBV (n 1) (13) HD (n) GBV (n) (14) The concept of backlog depreciation can be best explained in reference to the relations between GBV, NBV and accumulated depreciation in HCA. In HCA NBV at the end of period n equals GBV at the end of period n less accumulated depreciation at the end of period n. Whereas accumulated depreciation is a sum of historic values for depreciation accounted since initiation of fixed asset, in specific accumulated depreciation at the end of period n equals accumulated depreciation at the beginning of period n plus depreciation in period n. As presented in formula: HD (n) AD(n 1) HD (n) (15) Since GBV in HCA is constant the relation between GBV, NBV and accumulated depreciation holds always. In CCA GRC undergo continuous changes, therefore backlog depreciation is introduced to reflect the change of GRC in past accumulated depreciation. Four previously presented formulas for holding gain are mutually equivalent. This is true if GBV is constant. The GBV of one asset is clearly constant over its useful life. This is however not valid for the whole HCC. The GBV of assets grouped in one HCC is a sum of GBV of each asset separately. This means that in order to hold the above assumption of constant GBV none of the assets could be replaced or purchased during the calculation period. In practice some of the assets may be replaced or some assets may be purchased during the calculation period. Hence in order to get correct results, calculating period has to be divided into separated sub-periods. The approach to sub-dividing calculating period into infinitesimal sub-periods would be very laborious and would require access to very detailed information. In practice the formulas for holding gain are applied for the whole calculating period and in consequence yield in different results. To avoid any misunderstandings or misinterpretation of the concept of holding gain we recommend the regulator to announce one formula for holding gain. We suggest the following formula for holding gain: HG (n) NBV (n 1) GRC (n) GRC (n 1) GBV (n 1) 51 (16) Another practical problem while calculating the cost of fixed asset is that GRC, GBV and NBV are forward looking figures. At the moment of cost calculation none of the figures are known. Estimation of all figures is very difficult and constraints by a number of subjective assumptions. Therefore we recommend that both ratios of NBV to GBV (i.e. NBV n NBV n 1 and ) GBV n GBV n 1 are assumed to be the same and be equal to the average ratio of NBV to GBV at the end and at the beginning of the last audited accounting period. NBV (k ) NBV (k 1) NBV (n) NBV (n 1) GBV (k ) GBV (k 1) GBV (n) GBV (n 1) 2 (17) Whereas: k denotes last audited accounting period or alternatively use the NBV k NBV k 1 ratio for GRC n and ratio for GRC n 1 . GBV k GBV k 1 The forward looking value of GRC is much more critical and represents a product of future assets quantity of future assets prices. Since fixed line operators do not develop their voice network very rapidly the difference between future and current assets quantities have insignificant impact on cost calculation, therefore we recommend that the difference between current and forward looking figures of GRC related to increase in assets quantities can be obtained directly from operator’s budget. GRC (n) GRC (Vn2 , Pn ) I n1 I n (18) GRC (n 1) GRC (Vn2 , Pn1 ) I n1 (19) Whereas: GRC (Vn2 , Pn ) - current assets quantity calculated at forward looking prices for period n. I n 1 - planned investments for period n-1 that are related to extension of the network (are not related to replacement of old assets); I n - planned investments for period n that are related to extension of the network (are not related to replacement of old assets). In consequence the formula for average NRC is one of the following: 52 NRC n NRC n ( GRC Vn 2 , Pn I n 1 I n ) NBV k NBV k 1 (GRC Vn 2 , Pn 1 I n 1 ) GBV k GBV k 1 (20) 2 ( GRC Vn 2 , Pn I n 1 I n ) (GRC Vn2 , Pn1 I n 1 ) NBV k 2 GBV k (21) In consequence the formula for HG is as follows: HG (n) NBV (k 1) GRC (n) GRC (n 1) GBV (k 1) In consequence the formula for CD is as follows: CD(n) GRC (n) HD (k ) GBV (k ) 4.4.1 List of principles 1. Apply the following formula for current cost related to fixed assets calculation (obligatory): C (n) NRC (n) WACC CD(n) HG (n) Whereas: NRC (n) – average net replacement cost for period n; WACC – weighted average cost of capital; CD(n) – current depreciation in period n; HG(n) – holding gain in period n. 2. Apply the following formula for average net replacement cost calculation (obligatory): NRC n ( GRC Vn 2 , Pn I n 1 I n ) NBV k NBV k 1 (GRC Vn 2 , Pn 1 I n 1 ) GBV k GBV k 1 2 Whereas: GRC (Vn2 , Pn ) - GRC of current assets quantity calculated at forward looking prices for period n; 53 I n planned investments for period n that are related to extension of the network (are not related to replacement of old assets). 3. Apply the following formula for holding gain calculation (obligatory): HG (n) NBV (k 1) GRC (n) GRC (n 1) GBV (k 1) 4. Apply the following formula for current depreciation calculation (obligatory) CD(n) GRC (n) HD (k ) GBV (k ) 4.5 Revaluation of operating expenditures Operating expenditures are incurred in the same year in which they are expensed. Since expenditures are always at current prices, the costs incurred in the same year in which they are expensed, are recorded at current prices too. Therefore operating expenditures are always recorded at current cost. It should be noticed however that usually operating expenditures recorded in profit and loss account are incurred (and recorded at current prices) in the year prior to year of cost calculation, while the operating expenditures that should be mapped to HCCs are incurred in the year after the year of cost calculation. It results in a two year time span between the operating expenditures recorded in profit and loss account and the operating expenditures allocated to HCCs. It means that in order to set current costs the operating expenditures are to be appropriately revalued. The revaluation is usually done by indexing the operating expenditures mapped from profit and loss account by appropriate inflation rate. Certainly the inflation rate may be different for different HCCs. therefore different indexes should be applied to different HCCs. Since in low inflationary environment, the indexation would have negligible impact on change of cost base, therefore in practice the same indexes are applied to groups of HCC. This is usually forecasted consumer product inflation rate for non-pay type HCCs and forecasted salary increase index for pay type HCCs. Similarly due to the two year time span between the figures reported in financial statement and the figures allocated to HCCs, the operating expenditures recorded in profit and loss account correspond to a different service volume than the operating expenditures that should be allocated to HCCs. 54 It means that in order to set forward looking values the operating expenditures are to be appropriately adjusted by the increase of service volume. It has to be noted, that the service volume in fixed networks is stable, therefore the forward looking adjustment could be completely neglected. 4.5.1 List of principles 1. Ensure that cost indexation has been applied to operating expenditures (obligatory). 4.6 Revaluation of working capital Working capital is due to the same year in which they are invested. Therefore working capital always reflects current value. It should be noticed however that usually working capital recorded in balance sheet is due to (and recorded at current prices) prior year of cost calculation, while the working capital that should be mapped to HCCs is due to year after the year of cost calculation. It results in a two year time span between the working capital recorded in balance sheet and the working capital allocated to HCCs. It means that in order to reflect current value the working capital is to be appropriately revalued. The revaluation is usually done by indexing the working capital mapped from balance sheet by appropriate inflation rate. Certainly the inflation rate may be different for different HCCs therefore different indexes should be applied to different HCC. Since in low inflationary environment, the indexation would have negligible impact on change of short term capital, therefore in practice the same indexes are applied to groups of HCC. This is usually forecasted by consumer product inflation rate for working capital type HCC. Similarly due to the two year time span between the figures reported in financial statement and the figures allocated to HCC, the working capital recorded in balance sheet correspond to a different service volume than the working capital that should be allocated to HCC. It means that in order to set forward looking values the working capital is to be appropriately adjusted by the increase of service volume. It has to be noted, that the service volume in fixed networks is stable, therefore the forward looking adjustment could be completely neglected. 4.6.1 List of principles 1. Ensure that cost indexation has been applied to working capital (obligatory). 55 5 ROUTING MATRIX Routing matrixes determine the intensity of network element usage providing interconnection services. Equipment usage intensity serves as a basis for cost allocation to services. In TDLRAIC routing matrixes are formed to calculate the cost of the following services in fixed line network: call set-up; origination; termination; transit. The routing matrixes are used for two purposes: calculation of total minutes or total call attempts on particular network elements; calculation of average number of network elements in providing interconnection services. 5.1 Calculation of total call attempts In order to calculate set-up fee it is required to calculate unit cost of NE which cost is driven by busy hour call attempts (BHCA). The unit cost could be calculated applying simplified or more complex approach. In simplified approach the NE cost has to be divided by total call attempts in the network in the year. The resulting value represents average unit cost for call set-up across all services. In more complex approach the NE cost has to be divided by total call attempts weighted by service consumption of signaling resources. The signaling resources of the network that is driven by BHCA can be consumed in different extent by different services. The extent in which the service consumes the resources of the NE for Signaling can be expressed in the amount of information that is required to set-up a call. The calculation of unit cost of NE for Wholesale billing should be performed by applying simplified approach, that is dividing wholesale billing costs by total call attempts. 56 5.2 Calculation of total minutes In order to calculate total minutes on particular network elements the operator has to construct two sets of matrixes. The first set of matrix (set A of routing matrixes) is to calculate total number of minutes on subscriber units and total number of minutes on transmission links between remote units and switches. The second set of matrix (set B of routing matrixes) is to calculate total number of minutes on switches and on transmission links between switches. Both A and B sets of matrixes have minute matrixes to represent annual traffic volumes (in minutes) and traffic structure. Traffic structure operator can base on a monthly (or several months) basis. Monthly data on traffic structure is annualised using data on annual traffic volumes (in minutes). 5.2.1 Set A of routing matrixes Set A of routing matrixes consists of the following matrixes: minute matrix; subscriber unit matrix; intraswitch transmission link matrix. The size of all matrixes is the same, in these matrixes each row represents separate traffic source and each column represent separate traffic destination. The traffic source can be a remote unit, switch, point of interconnection with other national (e.g. mobile networks) or international telecommunication network. A remote unit is defined as traffic source if originating subscriber is connected to remote unit. Switch is defined as traffic source if originating subscriber is connected directly to switch. Point of interconnection with other national or international telecommunication network is defined as traffic source if originating subscriber is located in these telecommunication networks. The traffic destination can be a remote unit, switch, point of interconnection with other national (e.g. mobile networks) or international telecommunication network. A remote unit is defined as traffic destination if terminating subscriber is connected to remote unit. Switch is defined as traffic destination if terminating subscriber is connected directly to switch. Point of interconnection with other national or international telecommunication network is defined as traffic destination if terminating subscriber is located in these telecommunication networks. 57 It has to be noted that some of originating points and some of terminating points can be aggregated. It is enough to list four separate originating points and four separate terminating points: remote units; switches; points of interconnections with other national networks; points of interconnections with other international networks. The format of all routing matrixes is depicted in the following figure. Scheme 11. A set of routing matrixes RU POI international POI international Switch RU POI national POI national Switch Filling out minute matrix This matrix provides information about minute volumes. The total traffic originated in one traffic source has to be reported in Minute Matrix in its corresponding row and be spread across diverse columns according to the traffic destination. In specific traffic originated in traffic source A and terminated in traffic source B should be reported on the intersection of row A and column B. Filling out subscriber unit matrix This matrix provides information about number of subscriber units involved in individual traffic flows. Number of subscriber units involved in telephone connection between traffic source A and traffic destination B should be reported on the intersection of row A and column B. It has to be noted that on the intersection of row A and column B where both originating and terminating point is remote unit or the switch the number of subscriber units involved in traffic flows equals to 2. In case where one from originating and terminating points is remote unit or switch and the other is point of interconnection with other network 58 the number of subscriebr units involved in traffic flows equals to 1. In all other cases the number of susbcriber units equals to zero (transit). Filling out intraswitch transmission link matrix This matrix provides information about number of intraswitch transmission links involved in individual traffic flows. Intraswitch transmission link is defined as a link between remote concentrators units and local switches. Number of intraswtich transmission links involved in telephone connection between traffic source A and traffic destination B should be reported on the intersection of row A and column B. It has to be noted that on the intersection of row A and column B where both originating and terminating point is remote unit the number of intraswitch transmission links involved in traffic flows equals to 2. In case where one from originating and terminating points is remote unit and the other is switch or point of interconnection with other network the number of intraswitch transmission links involved in traffic flows equals to 1. In all other cases the number of intraswitch transmission links equals to zero. Calculation of total minutes In order to calculate the total minutes on subscriber units every cell of minute matrix has to be multiplied by corresponding cell in subscriebr unit matrix. In general cell on intersection of row n and column m in minute matrix has to be multiplied by cell on intersection of row n and column m in subscriber unit matrix. The sum of the products of these multiplications represents total minutes on subscriber units. In order to calculate the total minutes on intraswtich transmission links the similar calculations has to be performed as for subscriber units. 5.2.2 Set B of routing matrixes Set B of routing matrixes consists of the following matrixes: minute matrix; local switch matrix; transit switch matrix; local transmission link matrix; long-distance transmission link matrix. The size of all matrixes is the same, in these matrixes each row represents separate traffic source and each column represent separate traffic destination. 59 The traffic source can be a switch, point of interconnection with other national (e.g. mobile networks) or international telecommunication network. A switch is defined as traffic source if originating subscriber is connected directly or through a remote unit to this switch. Point of interconnection with other national or international telecommunication network is defined as traffic source if originating subscriber is located in these telecommunication networks. The traffic destination can be a switch, internet, point of interconnection with other national (e.g. mobile networks) or international telecommunication network. A switch is defined as traffic destination if terminating subscriber is connected directly or through remote unit to this switch. Point of interconnection with other national or international telecommunication network is defined as traffic destination if terminating subscriber is located in theses telecommunication networks. It has to be noted that every originating point of interconnection with other national telecommunication network should represent a separate row in the routing matrixes and every terminating point of interconnection with other national telecommunication network should represent a separate column in the routing matrixes. On the other hand all originating points of interconnection with international telecommunication networks can be jointed into one row in the routing matrixes and all terminating points of interconnection with international telecommunication networks can be jointed into one column in the routing matrixes. The format of all routing matrixes is depicted in the following figure. Scheme 12. B set of routing matrixes Switch POI international POI international POI national Internet Switch POI national Filling out minute matrix This matrix provides information about minute volumes. The total traffic originated in one traffic source has to be reported in Minute Matrix in its corresponding row and be spread across diverse columns according to the traffic destination. In specific traffic originated in traffic source A and terminated in traffic source B should be reported on the intersection of row A and column B. 60 Filling out local switch matrix This matrix provides information about number of local switches involved in individual traffic flows. Number of local switches involved in telephone connection between traffic source A and traffic destination B should be reported on the intersection of row A and column B. While determining the number of local switches involved in individual traffic flows only first order routes has to be taken into account. It has to be noted that assuming the same route is for a traffic flow from a traffic source A to a traffic destination B and from a traffic source B to a traffic destination A the local switch matrix should be diagonally symmetric. Filling out transit switch matrix This matrix provides information about number of transit switches involved in individual traffic flows. Number of transit switches involved in telephone connection between traffic source A and traffic destination B should be reported on the intersection of row A and column B. While determining the number of transit switches involved in individual traffic flows only first order routes has to be taken into account. It has to be noted that assuming the same route is for a traffic flow from a traffic source A to a traffic destination B and from a traffic source B to a traffic destination A the transit switch matrix should be diagonally symmetric. Filling out local transmission link matrix This matrix provides information about number of local transmission links involved in individual traffic flows. Local transmission link is defined as a link between two local switches or between local and transit switch or between local switch and point of interconnection with other national network. Number of local transmission links involved in telephone connection between traffic source A and traffic destination B should be reported on the intersection of row A and column B. While determining the number of local transmission links involved in individual traffic flows only first order routes has to be taken into account. It has to be noted that assuming the same route is for a traffic flow from a traffic source A to a traffic destination B and from a traffic source B to a traffic destination A the local transmission links matrix should be diagonally symmetric. Filling out long-distance transmission link matrix This matrix provides information about number of long-distance transmission links involved in individual traffic flows. Long-distance transmission link is defined as a link between two 61 transit switches, between transit and international switch or between transit switch and point of interconnection with other national network. Number of long-distance transmission links involved in telephone connection between traffic source A and traffic destination B should be reported on the intersection of row A and column B. While determining the number of longdistance transmission links involved in individual traffic flows only first order routes has to be taken into account. It has to be noted that assuming the same route is for a traffic flow from a traffic source A to a traffic destination B and from a traffic source B to a traffic destination A the long-distance transmission links matrix should be diagonally symmetric. Calculation of total minutes In order to calculate the total minutes on local switches every cell of minute matrix has to be multiplied by corresponding cell in local switch matrix. In general cell on intersection of row n and column m in minute matrix has to be multiplied by cell on intersection of row n and column m in local switch matrix. The sum of the products of these multiplications represents total minutes on local switches. In order to calculate the total minutes on transit switches, local transmission links and longdistance transmission links the similar calculations has to be performed as for local switches. 5.3 Calculation of average number of network elements 5.3.1 Set A of routing matrixes In order to calculate average number of intraswtich transmission links involved in providing interconnection service in the first step total number of minutes of individual interconnection services (e.g. origination, termination and transit) has to be calculated. Further it will be referred as total service minutes. In the second step total number of minutes of individual interconnection services weighted by number of intraswtich transmission links involved in that service has to be calculated. Further it will be referred as weighted service minutes for intraswtich transmission links. In the last step a ratio of weighted service minutes for intraswtich transmission links to total service minutes has to be calculated. The ratio represents average number of intraswtich transmission links involved in individual interconnection service. In order to calculate weighted service minutes for intraswtich transmission links the intraswtich transmission links matrix has to be modified. For example in order to calculate weighted termination service minutes for intraswtich transmission links all cells in intraswtich transmission links matrix related to other services than termination interconnection has to be set to zero. Further every cell of minute matrix has to be multiplied 62 by corresponding cell in intraswtich transmission links matrix (like it has been done in the process of calculating total minutes on network elements). The sum of the products of these multiplications represents weighted termination service minutes for intraswtich transmission links. Calculation of weighted origination or transit service minutes is calculated similarly. In order to calculate average number of susbcriber units involved in providing interconnection service the similar calculations has to be performed as for intraswtich transmission links. It has to be noted that the result of average number of subscriber units is easy to predict. For all calls originating and terminating inside the network (on-net calls) the average number of subscirber units will be equal to 2. For all calls originating or terminating in other telecommunication network (off-net calls) the average number of subscirber units will be equal to 1. For all transit calls the average number of subscirber units will be equal to zero. This is why the calculation of the average amount of subscirber units could be omitted from the calculation. 5.3.2 Set B of routing matrixes In order to calculate average number of local switches involved in providing interconnection service in the first step total number of minutes of individual interconnection services (e.g. origination, termination and transit) has to be calculated. Further it will be referred as total service minutes. In the second step total number of minutes of individual interconnection services weighted by number of local switches involved in that service has to be calculated. Further it will be referred as weighted service minutes for local switches. In the last step a ratio of weighted service minutes for local switches to total service minutes has to be calculated. The ratio represents average number of local switches involved in individual interconnection service. In order to calculate weighted service minutes for local switches the local switch matrix has to be modified. For example in order to calculate weighted termination service minutes for local switches all cells in local switch matrix related to other services than termination interconnection has to be set to zero. Further every cell of minute matrix has to be multiplied by corresponding cell in local switch matrix (like it has been done in the process of calculating total minutes on network elements). The sum of the products of these multiplications represents weighted termination service minutes for local switches. Calculation of weighted origination or transit service minutes is calculated similarly. In order to calculate average number of transit switches, local transmission links and longdistance transmission links involved in providing interconnection service the similar calculations has to be performed as for local switches. 63 5.4 List of principles 1. The routing matrixes are used for two purposes (obligatory): calculation of total minutes or total call attempts on particular network elements; calculation of average number of network elements in providing interconnection services. 2. In order to calculate total call attempts on network elements for Signaling the operator should use call attempts weighted by service consumption of signaling resources (recommended). 3. In order to calculate total call attempts on network elements for Wholesale billing the operator should use total call attempts (recommended). 4. In order to calculate total minutes on particular network elements the operator has to construct two sets of matrixes (set A and set B) (obligatory). 5. Set A of routing matrixes consists of the following matrixes (obligatory): minute matrix; intraswitch transmission link matrix. 6. The format of all set A routing matrixes is depicted in the following figure (obligatory). RU POI international POI international Switch RU POI national POI national Switch 7. Set B of routing matrixes consists of the following matrixes (obligatory): minute matrix; local switch matrix; transit switch matrix; 64 local transmission link matrix; long-distance transmission link matrix; 8. The format of all routing matrixes is depicted in the following figure (obligatory). Switch POI international POI international POI national Internet Switch POI national 9. The ratio of weighted service minutes for a particular network element to total service minutes represents average number of a particular network element involved in individual interconnection service (obligatory). 65 6 REQUIREMENTS FOR MODEL FUNCTIONALITY TD-LRAIC modeling consists of several complex and complicated calculation steps. In practice this often yields in big and hardly understandable for outside experts TD-LRAIC models with complicated internal links. Transparency of the model should be an objective of top priority for operator. The main requirements for model functionality are as follows: TD-LRAIC model should be created on a basis of standard software. The model should produce reports that will be agreed upon with the Regulator. Model should clearly separate each interconnection service LRAIC cost calculation step, point out final and intermediate results. TD-LRAIC model should contain ability to perform sensitivity analysis examining the impact on intermediate and final model results of change in separate factors like NRC, WACC, revaluation methodologies, length of asset lives and other. We recommend thorough model documentation, which contains but not limits itself to detailed descriptions of the structure of the model, data sources, model assumptions, calculation steps, list of HCCs, list network elements and other. 66 7 APPENDIX NO. 1. CALCULATING COST OF LEASED LINES 7.1 General section The purpose of this appendix is to provide guidelines to calculate the LRAIC of trunk segment of leased lines (referred further as leased lines). End to end leased lines consist of two network segments: terminating segment - the connections between customer's sites and telecom operator transmission network; trunk segment – conveyance part of the transmission network. Generally the calculation of LRIC of leased lines can be divided into two consecutive phases: in the first phase, the total incremental cost of all leased lines has to be calculated; the second phase is concerned on de-averaging the costs by types and distances. The first phase – focused on calculating the total incremental cost of all leased lines – can be almost deemed as a by-product in the model for calculating LRIC of voice interconnection services. At this point it has to be noted that the incremental cost of all leased lines can be classified in three separate NE: leased lines transmission; leased lines dedicated systems; leased lines wholesale. The NE for leased lines transmission relates to the incremental costs of the overall transmission capacity that is consumed by leased lines, in specific it covers the costs of multiplexers and cables. The NE for leased lines dedicated systems relates to the costs of specific systems that are used to provide leased line services, in specific it covers leased lines management systems like MainStreet™. The NE for leased lines wholesale covers all specific costs especially labor costs that are related to provision of leased line services like: billing, service set-up, service termination etc. It has to be noted that calculating LRAIC of NE for leased lines transmission does not require any additional HCC above those, which should be defined for the purposes of calculating LRIC of voice interconnection. The transmission platform is common to voice services, data services and leased lines services, therefore the same transmission costs (e.g. HCCs) are to be 67 taken into account while calculating the LRAIC of transmission capacity consumed by either voice, data or leased lines services based on 2Mbps circuits. The second phase – concerned on de-averaging the costs by types and distances – is independent to calculating LRIC of interconnection services and may be performed in a separate model. Cost de-averaging by types and distances is performed in three steps. In the first step the total incremental costs of all leased lines services is allocated into following types of services: Narrow-band leased line services – n x 64kbps; Broad-band leased line services - < 2Mbps; Broad-band leased line services – 2Mbps; Broad-band leased line services – 34Mbps; Broad-band leased line services – 155Mbps; Other. In the second step average unit cost of leased line is calculated. Allocating total incremental costs of all leased lines services requires to separate the costs of transmission systems into: the I/O part; the capacity part. At this point it has to be noted that every transmission multiplexer can be presented as: I/O module which constitutes an interface between the multiplexer and other telecommunication systems, in specific the I/O module may be represented by tributary cards 21x2Mbps, 32x21Mbps, or electric or optic line cards STM-1, STM-4 or STM-16 (in this context the line cards should be viewed as I/O module); line module which constitutes an interface with transmission medium in specific the line module may be represented by optic line cards STM-1, STM-4 or STM-16 (in this context the line cards should be viewed as line module); cross-connect which constitutes the rest of multiplexer from the perspective of leased line cost calculation. Based on the principles described above: the I/O part can be defined as I/O module of transmission multiplexer; 68 the capacity part can be defined as cross-connect, line module, and transmission medium (e.g. cables or radio links). Since the total incremental costs of all leased lines services represent the cost of multiplexers and cables themselves and other costs like operation and maintenance, supporting activities, supporting fixed assets, the allocation to I/O part and capacity part should be done as follow. The total leased lines transmission costs should be separated into two categories: costs of multiplexers and all other costs that can be attributed to the multiplexers costs of cables and all other costs that can be attributed to the cables Next the costs of multiplexers has to be separated into: the I/O part the capacity part, Other costs attributable to multiplexers have to be allocated to I/O part and capacity part in the same proportion as the cost of the multiplexers. The costs of cables together will all other attributable costs constitute the cost of capacity part. After the total incremental cost of transmission has been separated into I/O part and capacity part, it can be allocated to different types of leased lines. The capacity part should be allocated to different types of leased lines proportional to the consumption of 2Mbps circuits. The I/O part should be allocated proportional to the consumption of I/O cards. Similarly the cost of leased lines dedicated systems and leased lines wholesale should be allocated to different types of leased lines proportionally to their consumption. Average unit cost of leased line has to be calculated, in order to do this the total incremental costs allocated to one type of leased line service have to be divided by number of provided leased line circuits. This results in an average cost of leased line service in course of length. It has to be noted that in case of narrow-band the result has to be adjusted by utilization rate. Whereas the utilization rate is a ratio of sold transmission capacity of narrow-band leased lines to total transmission capacity assigned to provide narrow-band leased lines. Next step involves deriving relationship between length of leased line and its cost. For this purpose it can be assumed that the costs of I/O cards and wholesale are not distance sensitive Dist _ fixed , while capacity part and leased lines dedicated systems can be viewed as distance sensitive Dist _ var . To find the link between length and costs the following has to be done, separately for each type of leased line service: 69 First, distance ranges have to be defined for leased line services. Second, the number of network segments of each leased line has to be determined. Third, each leased line has to be assigned to the defined distance ranges and the average number of network segments for each distance range has to be calculated . Fourth, the average number of network segments for all leased lines has to be calculated Segm range Segm total . Finally, the cost of providing the leased line for given range is defined by the following equation: LLrange Dist _ var* Segm range Segm total Dist _ fixed A one network segment is defined as continues system of optic fiber with transitional adddrop multiplexers. A one network segment can be build of one or more fiber segments. A fiber segment is defined as the optic fiber between two adjacent multiplexers. A network segment can be represented as one SDH physical ring, or one PDH/SDH line system. Example: A B Network Segment 1 Network Segment 2 Network Segment 3 In this example we utilized 3 network segments in order to provide leased line service between point A and B. 70 7.2 List of principles 1. The list of NE in the voice interconnection model has to be extended by the following three elements (obligatory): NE for leased lines transmission; NE for leased lines dedicated systems; NE for leased lines wholesale. 2. Define separate independent HCCs for cost of systems dedicated for leased lines and leased lines wholesale cost (recommended). 3. Allocate total incremental costs of all leased lines services into following types of services (recommended): Narrow-band leased line services – n x 64kbps; Broad-band leased line services - < 2mbs; Broad-band leased line services – 2Mbps; Broad-band leased line services – 34Mbps; Broad-band leased line services – 155Mbps; Other. 4. Separate the costs of transmission systems into I/O part and capacity part (recommended). 5. Allocate the capacity part to different types of leased lines proportionally to the consumption of 2Mbps circuits (obligatory). 6. Allocate the I/O part to different types of leased lines proportionally to the consumption of I/O cards (obligatory). 7. Allocate the dedicated systems and leased lines wholesale cost to different types of leased lines proportionally to their consumption (obligatory). 8. Perform de-averaging of the unit cost by deriving relation between number of network segments and length of the leased line (recommended). 71 8 APPENDIX NO. 2. CALCULATING COST OF POINT OF INTERCONNECTION The purpose of this appendix is to provide methodology for calculating cost of point of interconnection using simplified LRAIC approach. The supporting interconnection link services comprise: providing capacity in interconnection point; rendering local network level interconnection point; rendering national network level interconnection point; The cost calculation of services can be performed in two phases. 8.1 Phase one In the first phase costs of service components should be determined. The service components are either specific fixed asset required to provide the services or man-hours. The example of fixed assets required to provide the services are listed below: air conditioning (cooling aggregators 2.5kW, 5.0kW, 10.0kW and 20.0kW cooling power); rectifiers (DC 40A, 80A, 160A and 320A); batteries (loading capacities 160Ah, 320Ah, 640Ah and 1,280Ah); multiplexer cross connect; multiplexer line module; multiplexer I/O part; additional transmission equipment; ducted optical cable (costs per 1 km). The costs of the fixed assets should be calculated in the following way. In the first step GRC should be assigned to each of the fixed assets. The GRC for power plant and transmission devices should be derived directly from price list obtained from suppliers operating on local market or based on the existing frame contracts. Additional transmission equipment should be calculated by applying mark-up on GRC of transmission devices based on values in the 72 main TD-LRAIC model (for example derived by dividing additional transmission equipment cost like DDF or ODF by transmission devices cost). In the second stage annual costs of the specific fixed assets should be calculated. The calculation of annual costs followed the same rules as presented in section 4.4. In the third stage mark-up for cost of building, other fixed assets, operation and maintenance and supporting activities should be calculated. It has to be noticed that if the benchmarks applied to calculate mark-up represents some averaged figures (for example derived by dividing total building costs by total telecommunication asset costs), hence the same benchmarks has to be applied to all telecommunication assets. The cost of man-hours should be calculated in three stages. In first stage the total operational cost related to payroll should be mapped from the profit and loss accounts. The cost related to payroll should include salary and salary related costs like social security and other taxes. In the second stage an average payroll of employee in telecommunication sector in a year should be calculated by dividing the total operational cost related to payroll by number of average number of employees in corresponding year. In the last stage an average man-hour cost should be calculated by dividing average payroll of employee in a year by average number of working hours in a year. In the last stage mark-up for building, other fixed assets and supporting activities should be calculated. In case estimated costs significantly differs from the costs incurred by efficient operator, which can be estimated by using appropriate benchmarks, according to LRAIC methodology efficiency corrections have to be made. 8.2 Phase two In the second phase the costs of services should be calculated. The calculation should be performed by applying relevant number of service components per each service. The calculations should assume some utilization of the service components presented in phase one. In fact the utilization of these components relates very much on the organization of an operator, the specificity of interfaces with other operators, quality of service and other factors. Therefore the specific list of activities and utilization factors for each service should be prepared by the operators individually. 73 8.3 Numerical Example Let’s analyze the calculation of cost of service based on below examples for one-time and annual fee service. 8.3.1 Providing capacity for IC link (one-time fee) IC link installation requires: receiving and proceeding of order, installation of transmission equipment, cross-connection of cables on DDF and ODF, setting billing and the link on a switch. Following assumptions could be done to calculate the utilization rate of man-hours: Activity Man-hours Explanation Receiving and proceeding order A hr It is assumed that receiving and proceeding of IC link order is not day-to-day and not automated procedure, it requires to coordinate a wide range of activities – ordering installation of additional transmission equipment, ordering crossconnections, ordering set-up on switch, ordering changes in billing system. Installation of transmission equipment B hr It has to be noted that cost of installation is included in GRC of transmission devices and cost of supervising and receipt of installation work is included in mark-up for operation and maintenance. Therefore in the cost of IC link installation only additional administrative resources related to contact the supplier and ordering transmission devices are to be considered if any. Crossconnection of cables C hr Cross-connection of cables is a routine operation. It requires to cross-connect cables on DDF and ODF. An additional mark-up for administration and mobilization of resources can be included. Setting link on switch, setting billing and link tests D hr Setting link on a switch. Setting billing. Tests of ITAD records. Total F hr 8.3.2 Providing capacity for IC link (monthly costs) IC link operation requires number of transmission equipment. The cost of this service should represent incurred capital cost together with operation and maintenance cost. It has to be noted that cost of installation is included in GRC of transmission devices and cost of 74 supervising and receipt of installation work is included in mark-up for operation and maintenance. While calculating the cost of IC link the following equipment is required: multiplexer cross connect; multiplexer line module; multiplexer I/O part; A unit base (STM-1); B optical interface (STM-1); C tributary card (32 x 2Mbps); D km of ducted cable. The utilization rates for unit base and tributary cards should corresponds to an average number of 2Mbps circuits on an IC link with alternative operators. The figures should represent totals of transmission components at incumbent and new entrant side. For example assuming that an IC link comprises in average 16 2Mbps circuits and 1 km of cable and assuming that there is no possibility for sharing infrastructure with other operators the following utilization rates could be set: two STM-1 units; two STM-1 optical interfaces assuming transmission nodes operate in TM mode; two 32x2 Mbps tributary cards; one km of ducted cable (assuming a distance of 1km between two sides). In order to derive unit cost of service (per 2Mbps) the above utilization rates should be divided by assumed average number of 2 Mbps circuits per IC link (in this example by 16). 75 9 APPENDIX NO. 3. CALCULATING COST OF CARRIER SELECTION, CARRIER PRESELECTION AND NUMBER PORTABILITY The purpose of this appendix is to provide guidelines for calculating cost of supporting services using simplified LRAIC approach. Services that are covered in this appendix comprise: Carrier preselection (CPS); Carrier selection (CS); Number portability (NP). Costs involved in providing NP, CS and CPS are most usefully be categorized as either “setup costs”, being the costs incurred in making the services available, or “consumption costs” which are the additional costs incurred when customers make use of the services. The cost calculation of services can be performed in two phases. 9.1 Phase one In the first phase costs of service components should be determined. The service components are either specific fixed asset required to provide the services or man-hours. The example of fixed assets involved in providing CS, CPS and NP services is IN platform – software, hardware and related equipment. The costs of the fixed assets should be calculated in the following way. In the first step GRC should be assigned to each of the fixed assets. In the second stage annual costs of the specific fixed assets should be calculated. The calculation of annual costs followed the same rules as presented in section 4.4. In the third stage mark-up for cost of building, other fixed assets, operation and maintenance and supporting activities should be calculated. It has to be noticed that if the benchmarks applied to calculate mark-up represents some averaged figures (for example derived by dividing total building costs by total telecommunication asset costs), hence the same benchmarks has to be applied to all telecommunication assets. The cost of man-hours should be calculated in three stages. In first stage the total operational cost related to payroll should be mapped from the profit and loss accounts. The cost related to payroll should include salary and salary related costs like social security and other taxes. 76 In the second stage an average payroll of employee in telecommunication sector in a year should be calculated by dividing the total operational cost related to payroll by number of average number of employees in corresponding year. In the last stage an average man-hour cost should be calculated by dividing average payroll of employee in a year by average number of working hours in a year. In the last stage mark-up for building, other fixed assets and supporting activities should be calculated. In case estimated costs significantly differs from the costs incurred by efficient operator, which can be estimated by using appropriate benchmarks, according to LRAIC methodology efficiency corrections have to be made. 9.2 Phase two In the second phase the costs of services should be calculated. The calculation should be performed by applying relevant number of service components per each service. The calculations should assume some utilization of the service components presented in phase one. In fact the utilization of these components relates very much on the organization of an operator, the specificity of interfaces with other operators, quality of service and other factors. Therefore the specific list of activities and utilization factors for each service should be prepared by the operators individually. 9.3 Numerical Example 9.3.1 Set-up costs CPS and CS services This section describes basic principles of estimating CS and CPS set-up costs. Pre-selection setting requires: receiving and proceeding of order; checking authorization; setting changes on switch and billing system. 77 Following could be done to calculate the duration of activities: Activity Duration Explanation Receiving and proceeding order A min Additional costs related to receiving and processing order. Checking authorization B min Additional costs related to checking authorization. For the purpose of calculation the detail description of the process should be provided. Setting changes on switch and in billing system. C min Additional costs related to setting changes on switch and in billing system. Total D min Setting subscriber changes on switch and in billing systems are routine and simple operations. If these operations are done case by case they can take a few minutes each. If, however, the operations are done in batches (in hundreds of subscribers) then the time calculated per subscriber is negligible. Batch based change settings require automation of procedures, which in turn requires appropriate interface with new entrants. Number portability per subscriber set up cost Setting up number portability for subscriber requires: receiving and proceeding of order; checking possibility to provide service; setting changes in CRM database; setting changes on switch and billing system. Following assumptions could be done to calculate the utilization rate of man-hours: Activity Duration Explanation Receiving and proceeding order A min Additional costs related to receiving and processing order. Checking possibility to provide service B min Additional costs related to checking possibility to provide service. The information required to check the possibility of number portability can be derived from basic databases used for other day-to-day operations, therefore no additional allowance for maintenance of dedicated databases is required. 78 Activity Duration Explanation Changing subscriber data in CRM database C min Additional costs related to changing subscriber data in CRM database. Setting changes on switch and in billing system. D min Additional costs related to setting changes on switch and in billing system. Total E min 9.3.2 Consumption costs In order to estimate consumption costs of CS, CPS and NP the new NE should be created. The NE related to CS, CPS and NP should comprise the cost of specific systems used for providing the service, in specific, systems used for assesing routing information for the selected carrier. This query can be achieved using Intelligent Network (IN) techniques as it is a case in Lithuania. In LRAIC model at least three additional NEs should be created: NE related to CS; NE related to CPS; NE related to NP. CPS and CS services The additional charge for CS and CPS should be based on network charges (per minute) and incorporated into the interconnection regime. In Lithuania, additional per minute costs are caused by utilization of Intelligent Network system. In order to calculate these costs Intelligent Network costs mapped to NE for preselection should be divided by number of pre selected traffic. It is important to note that IN platform is used to provide other services (i.e. 900 number 800 number services). Thus, CS and CPS services should bear only part of IN costs that is attributable to the particular services. Number portability It has to be noted that number portability service can be implemented in two ways: as on – switch or off switch solution. This paper refers to on switch solution as it was established in Lithuania. 79 The choice of technical solution have cost implications which affects the cost burden of different operators and the balance between the establishment and consumption costs that operator will face. On-switch solutions rely on information in the donor switch (i.e. the switch where the subscriber was initially located). Therefore, the calls for ported number are firstly routed to donor switch and after that routed forward to recipient network (call forwarding). Therefore there is additional conveyance costs for traffic to ported numbers that are caused by longer transmission route for ported calls. In order to reflect the longer transmission and switching route for ported calls the separate routing matrix for traffic to ported numbers has to be created. The principles of creating routing matrix are explained in section 5. 80 No. Abbreviation Term Description Access network Portion of a public telecommunications network that connects access nodes of core network to individual subscribers. Accumulated depreciation Depreciation accumulated from the period the asset was acquired. 3. Backlog depreciation The difference between accumulated depreciation in historic cost accounting and accumulated depreciation in current cost accounting. 4. Broadband Bandwidth in a communication channel not lower than 144 kbps. 1. 2. AD 5. BHCA Busy hour call attempts Number of call attempts in a busy hour. 6. BHT Busy hour traffic Amount of traffic in a busy hour. Call Connection established by means of a publicly available telephone service allowing two-way communication in real time. 7. 8. CAPEX CAPEX Capital expenditure costs. CAPEX costs comprise depreciation and ROI. 9. CE Capital employed Capital employed to finance activities of a company. Capital employed comprise equity and long term liabilities. 10. CPS Carrier preselection Carrier selection pre-selection service, which enable the subscriber to use the service of alternative operator in the field of fixed line telephony without dialing a special code. 11. CS Carrier selection Individual carrier selection service, which enable the subscriber to use the service of alternative operator in the field of fixed line telephony by dialing a special code. 12. Common and joint costs Cost that need to be allocated to several service. 13. Core network Group of network components switching and transmitting voice traffic. Core network comprise switches, local and remote subscriber units as well as transmission equipment between network nodes. 81 No. Abbreviation Term Description 14. Cost driver A factor that influences the existence and amount of costs. 15. CVR Cost volume relationship Relationship between total value of cost and cost driver. 16. Costs Decrease in economic value for a company due to usage of fixed assets, sale of assets, loss of assets, decrease in asset value or increase in liabilities over a period, which results in decrease in equity capital. 17. CAD Current accumulated depreciation Depreciation accumulated from the period the asset was acquired expressed in current cost accounting terms. 18. CA Current assets Asset that is consumed by a company to gain economic benefit during one year or one accounting period. 19. CCA Current cost accounting Accounting of costs in terms of current costs and prices of products and services. 20. CD Current depreciation Depreciation cost expressed in current cost accounting terms. 21. CL Current liabilities Liabilities which have duration shorter than one year or one accounting period. 22. D Debt / Long term liabilities Liabilities with a maturity longer than a year. 23. DAR Detailed asset revaluation Revaluation method which involved detailed revaluation of each asset component using current values. 24. DDF Digital distribution frame A device that switches incoming and outgoing signals. 25. Direct costs Costs that can be directly attributable to separate products or services. 26. Duct 60 mm or larger duct for laying cables built between two manholes or between a manhole and other equipment. 27. EV Economic value Value of an asset estimated using discounted cash flow principle. 82 No. Abbreviation Term Description 28. Exogenous driver Variable that is not influenced by inner model variables. 29. FCM Financial capital maintenance Cost incurred to maintain current level of financial capital. 30. FA Fixed assets Material assets that gives economic benefit to the company having a lifetime of more than a year and the minimal acquisition cost of the asset is not lower than the minimal value of material asset set by the company. 31. FC Fixed costs Costs that are fixed and not influenced by change in volume of service. 32. Fixed line telecommunicati ons network Public telecommunications network having fixed end points. 33. Forward looking cost accounting Accounting of costs in terms of forward looking costs and prices of products and services. 34. GBV Gross book value Acquisition cost of an asset. 35. GRC Gross replacement cost Cost incurred for replacing object of similar type and characteristics not taking into account accumulated depreciation. 36. Historic cost accounting Accounting of costs in terms of historic (actual) costs and priced of products and services. 37. HD Historic depreciation Depreciation cost expressed in historic cost accounting terms. 38. HG Holding gain Income that results due to increase in asset value. 39. HCC Homogenous cost category A set of costs, which have the same driver, the same cost volume relationship pattern and the same rate of technology change. 40. Incremental cost Increase in costs due to increase in volume of service. 83 No. Abbreviation Term Description 41. Indirect costs Costs that are indirectly related to a specific product and service and that need to be allocated to different using economically justifiable drivers. 42. I/O Input output Input output part of a device 43. Leased line A dedicated telephone line connecting two end-points. 44. LLTS Leased lines trunk segment Part of the leased line in Operator’s core network. 45. Local subscriber unit Subscriber unit that is physically located in the same place as a switch. 46. LRAIC Long run average incremental costing The principle of long run average incremental costing – estimating change in costs as a result of change in cost driver volume and dividing them over a unit of service. The costs are measured in the long run, which means that the company based on the level of demand can change the amount of resources involved in providing a service i.e. all costs become variable. 47. MEA Modern equivalent asset Asset of the same functionality as the old asset but based on new most popular technology which would be used by new market player. 48. Multiplexer A device that enables more than one signal to be sent simultaneously over one physical channel. 49. Narrowband Bandwidth in a communication channel lower than 144 kbps. 50. NBV Net book value Remaining value of an asset calculated as a difference between gross book value and accumulated depreciation plus changes in asset revaluation over time. 51. NRV Net realizable value Price of an asset less potential selling costs. 52. NRC Net replacement cost Cost incurred for replacing object of similar type and characteristics taking into account accumulated depreciation. 53. NE Network element Any network object which physically or logically can be identified as an independent network unit. 84 No. Term Description 54. Network interconnection Physical and logical linking of public communications networks used by the same or a different undertaking in order to allow the users of one undertaking to communicate with users of the same or another undertaking, or to access services provided by another undertaking. Interconnection is a specific type of access. 55. NP Number portability Service enabling the customer to maintain the same number while changing fixed line telephone service provider. 56. OCM Operating capital maintenance Cost incurred to maintain operational capacity not lower than in the beginning of the year. 57. Operator An undertaking providing or authorised to provide a public communications network or an associated facility. 58. OPEX OPEX Operating expenditures that comprise salaries, material and other external service costs. 59. ODF Optical distribution frame Device that is used to physically group several cables to one cable. 60. ONU Optical network unit Alternative network components for subscriber switches. Examples include: Anymedia, Fastlink, Lucent. 61. Origination Transmission of a call from a network point where the call was originated to the switch (including switch) where interconnection can be established located closest to the subscriber originating the call. Point of Interconnection A location where different telecommunication networks are physically connected to allow the users of one undertaking to communicate with users of the same or another undertaking, or to access services provided by another undertaking. Interconnection is a specific type of access. 63. Provision Liability the amount and timing of which cannot be precisely measured but can be reliably estimated. 64. Public phone Telephone available to the general public, for the use of which the means of payment may include coins and/or payment instruments. 65. Recoverable amount Maximum amount of money that can be obtained by selling an asset of using in day to day activities. 62. Abbreviation POI 85 No. Abbreviation Term Description 66. Remote concentrator unit Subscriber unit remotely located to a switch and connected to a switch via 2 mbps link. 67. Required rate of return Rate of return covering ROI. 68. Retail activity Activities necessary to transform wholesale services to retail services encompassing such activities as customer care, billing, payment collection, marketing and other. 69. Retail service Service (product) provided for the final users of telecommunication service. 70. ROI Return on investment Required return on investment calculated by multiplying WACC and capital employed. 71. Routing matrix Matrix which represents the intensity of NE usage for different services. 72. Service Telecommunication service means service which consists wholly or mainly in the conveyance of signals on electronic communications networks. 73. E Shareholders funds Part of company’s assets calculated as a difference between total assets and liabilities. 74. SAPI Specific asset price indexation Method of revaluation asset with the help of change in price indexes. 75. Subscriber Person who or which is party to a contract with the provider of publicly available electronic communication services for the supply of such services. 76. Subscriber unit Functional network component from one side connected to access network (via line card) and from the other side to switch (via 2 mbps port). 77. Supporting activity Supporting activity comprise administration, accounting, planning, human resource management and other supplementary activities. 78. Switch (switching host) Network element that switches calls between two network nodes. 86 No. Abbreviation Term Description 79. Switching network Network of switches that ensures connection among separate fixed line telephony network nodes. 80. Telecommunicati ons network Telecommunication network used to provide public telephone service including transmission of voice between network end points and other services such as fax or data transmission. 81. Termination Transmission of a call from a switch (including switch) where interconnection can be established located closest to the subscriber receiving the call to the final network point where the call ends. 82. Transit Transmission of a call from a switch where interconnection can be established located closest to a subscriber initiating a call (excluding the switch ) to a switch where interconnection can be established located closest to a subscriber receiving a call (excluding the switch) via one or more switches. 83. Transmission link A link which ensures transmission of optical and electric signal between two remote geographic units. 84. Transmission network Telecommunication equipment which ensures transmission of optical and electric signals among separate core network components. 85. Tributary card Component of a multiplexer constituting interface between multiplexer and other telecommunication equipment. 86. VC Variable costs Costs that are directly related to change in volume of services. 87. WACC Weighted average cost of capital Cost of capital calculated as a weighted cost of borrowed and equity capital. 88. Wholesale billing system Information system which involves estimating and invoicing for wholesale services. 89. Wholesale service Service provided to other telecom operators who use the service as raw material for providing retail services. 90. WC Working capital Difference between current assets and current liabilities. 87