Comparing prices with costs is a most enlightening exercice. Unfortunately, service costing being as much an art as a science, many telecom service providers don’t do much service costing; and as a result, they don’t understand their service costs and their sources of profitability well enough.
In many cases, prices for telecom services are set too low by the marketing team. Under pressure to gain new customers and increase market share, setting low prices is certainly one of the easiest strategy to implement for new entrants. The thinking is the following: “in our business, almost all costs are fixed, so we need to build up market share quickly to reach profitability” (true) and “we have to be cheaper than the competition” (false) as well as “the marginal cost of our services is zero, so we can price our services very low” (false).
In the telecom service provider business, more than in any other business, most costs are fixed in the short-term. However all costs are variable in the long-term. If most costs are fixed in the short-term, this does not mean that the marginal costs of services are zero. In particular, for prepaid customers, commissions have to be paid to the sales channels (e.g. dealers) typically as a percentage of scratch card value. Also, off-nets call lead to interconnection charges.
In any case, however low they might be, all telecom services have a marginal cost that is greater than zero. As a minimum, service prices should be higher than their marginal costs. If not, then there is no way that these services will ever be profitable and the service provider is not only losing money but destroying value.
In theory, there is nothing against certain type of services subsidising other type of services, as long as the majority of customers are individually profitable (the ideal case) or if not, at least the overall business is profitable. The issue become acute when 80% of services are priced below marginal costs. Then the remaining 20% of services have to generate extraordinary high profits to compensate – which is very difficult.
But before discussing further how to apply service costing for pricing purposes, let us briefly step back and review what service costing is all about. If you are a telco, costing of end-user services has three main applications:
- Wholesale price setting: calculating the cost of interconnection e.g. termination of voice calls on mobile networks, usually for regulatory reasons. A commonly used methodology is called ‘LRIC’, which stands for ‘Long-Run Incremental Costs’. ‘Long-Run’ is about including all costs as far as possible (but excluding common costs such as inefficiencies, joint costs for which there is no ‘reasonably’ attributable method, and overhead also born by the competition).
- In a new product launch context, estimate ‘ex-ante’ how high end-user prices should be set now and in the future in order to make the business case positive over a 3, 5 or 7 year period. The approach here is to set up a product business plan and reverse engineer prices to reach a certain level of profit over time.
- for existing services, calculating the profit margin (EBIT) and value creation (Economic Value Added, Customer Lifetime Value) for individual retail or wholesales services (voice calls, data applications) as well as individual users. The profitable customers are not necessarily those that you would expect. A typical finding is that 20% of users generate all the profit of the company; 60% of users are breaking even; and 20% of users are loss-making / value destroying. This kind of results will generate much scepticism and intense internal debate. However, once accepted, telcos have to take action and review:
- where cost improvement measures can be implemented (e.g. supplier selection, sales channel optimisation, process improvement, outsourcing)
- whether customer behaviour (e.g. buying more profitable products and services, increasing customer lifetime cycle) as well as revenues can be increased (cross-selling, up-selling)
- whether prices can be modified; more often than not, some services are simply priced too low and are a drain on the telco overall profitability.
So what are the implications for service pricing purposes? In a service costing exercice, we recommend that three costing numbers rather than one be reported for each individual service:
- the marginal cost, excluding contribution to fixed and common costs
- the average cost, including contribution to fixed and common costs
- the average cost with mark-up to account for the cost of capital WACC.
When service prices are above their average costs with mark-up, operators are in the value creation zone and exceed their shareholders’ expectations. When services prices are lower than the average costs with mark-up but remain above the average costs, operators are in the profit zone – but they are not meeting their shareholders’ expectation in terms of value creation. When prices are below average costs, operators are in the danger zone: services are unprofitable today – but might become profitable in the future as the business grows in size, if there are still sufficient economies of scale to tap into. Finally, when a service provider is pricing its services lower than its marginal costs, then it is in the death zone.
So in short:
- never price your services below marginal costs
- as far a possible, your services should contribute to covering your fixed and common costs, so you should price them at average cost and above. If some services have to be charged below average costs, then others have to be priced higher accordingly, in order to ensure that your business remains profitable
- your long-term target must be that prices cover average costs including a mark-up for the cost of capital. In this case you will meet your shareholders’ expectations.
If your business today charges tariffs above average costs but does not cover its cost of capital yet, then you should calculate what the number of customers and volume of traffic should be for the mark-up to become small enough on a per sub or per min basis. If this level of demand is not reachable in your current operating model, then you have a problem with your existing cost base. This should open the door to the analysis of potential cost optimisation measures, and if this is not sufficient, potential M&A activities to gain further market share and improve the economics of your business.