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on the basis of economic allocation methods the remaining joint and common costs among all the various services. In the case of FDC-1 this allocation was to be made on the basis of the "relative use" each service made of the cost element in question. Statistical and/or judgmental determinations (i.e., special studies) measured relative use. Under FDC-7 the allocation of joint and common costs was not made on the basis of relative use but rather on the principle of "historical cost responsibility." Measuring historical cost responsibility involved determining the extent to which increases in total costs resulted from provision. of a particular service.

To address the issue of cross-subsidy the incremental approach was supposed to use a "burden test." This test was used to determine whether a competitive service's additions to total revenue exceeded the combination of (1) the costs saved in the service's absence and (2) the revenues flowing to this service from other services due to crosselasticity (i.e., their substitutability). If it did, it was presumed there was no crosssubsidy; however, this test was purely hypothetical.

For both FDC approaches, once all costs and revenues had been allocated to all of the services, a rate of return was calculated for each service. Cross-subsidy was assumed to have occurred whenever some services earned substantially less than the average overall rate of return.

The Docket 18128 decision

The decision to select FDC-7 as the appropriate costing methodology was a compromise. It arose because AT&T supported the incremental approach while the Common Carrier Bureau staff supported the fully distributed approach. The Common Carrier Bureau staff opposed the incremental approach on two grounds. First, they felt it was not true to the theoretical constructs of marginal costing because it only applied to AT&T's competitive services. Second, because of the large amount of judgment involved in distributing common costs and determining whether a service had been a "burden," they felt FCC would not be able to hold AT&T accountable for the prices it set for its services under such an approach. The Bureau recommended FDC-1 as the most implementable and correct method for preventing crosssubsidy.

At the same time, AT&T stressed the apparent theoretical correctness of its incremental costing properties. The Commission was at an impasse. It could not approve the incremental approach because of the staff's objections, yet it was apparently attracted by the theoretical arguments in favor of an incremental costing approach.

FDC-7 appeared to be the only method in the hearing record which could bridge this disagreement. It distributed costs fully, yet at the same time the assignment of common costs on the basis

of their historic causation of costs appeared to capture the forward looking aspects of the incremental methodology. This was particularly the case after FCC ordered certain "infirmities" in FDC-7 corrected. These included (1) the assignment of facilities to services under the proposed FDC-7 was too fluid, and without a fixed assignment AT&T could construct a variety of facility assignments in response to competition (and thus generate the costs needed to justify rates necessary to meet competition); (2) the proposed FDC-7 did not fully reflect the expected use of facilities in making the initial assignment of facilities to particular services; and (3) FDC-7 could not truly be based on historic causation unless it involved the projection of intended uses of facilities and fixed assignments of plant by service. 1/

To correct the problem of fluid facility assignment, FCC mandated that a fixed facilities "datum" be established as of a particular point in time. The datum would be developed by recording AT&T's assignments of existing and new facilities by service. Such shares of total facilities (rate base) would be used in determining service costs and rates. To establish an initial datum the Commission "suggested" AT&T go back to the Seven Way Cost Study and work forward matching facility cost assignments with the uses (services) for which facilities were constructed.

Forecasts were to be used to assign newly completed common facilities. These facilities were to be assigned on the basis of the projected use of the facility by each service. However, once these facilities were assigned based on either historical causation or forecasts they were to remain fixed. AT&T was placed on notice that although the datum would partially contain prospective cost causation estimates, variance from such projections would ultimately have to be reconciled.

To facilitate such a reconciliation, FDC-1 was selected for use as a check on the modified FDC-7 results. The FDC-1 relative use assignment of costs would be compared with FDC-7's historical causation assignment on a periodic basis for evidence of "gross imbalances."

On the issue of cross-subsidization, FCC stated that

"*** we find that the existence of levels of
return that are unjustly and unreasonably high
or too low, indicate a return level relationship
which embodies cross-subsidization. In absence

1/In the FDC methodologies the allocation of expenses was derived from the allocation of facility costs to the particular services. Consequently, the allocation of facility costs was area of critical concern.

of proper justification we hold this cross-sub-
sidization unlawful within the meaning of Section
201(b); it must be eliminated." [1/]

FCC directed AT&T to file revised rates and cost support material for its interstate services so that each service earned a return equal to the company's prescribed overall rate of return.

To correct the infirmities and implement Docket 18128, FCC ordered its staff and AT&T to work together to revise FDC-1 and FDC-7 and develop appropriate forecasting techniques. 2/

THE IMPLEMENTATION OF FDC-7-

A TROUBLED AND ULTIMATELY

FUTILE EXERCISE

Following the decision in Docket 18128, FCC spent over 4 years trying to successfully implement the FDC-7 costing methodology. In December 1980, FCC abandoned this effort in favor of a costing approach which did not rely on cost causation and allocated costs to significantly fewer categories. Numerous factors contributed to FDC-7's demise; however, the major elements contributing to its unsuccessful implementation were

--it contained two intrinsic flaws and

--FCC did not follow through with the implementation of
FDC-7 in areas which would have enhanced its opportunity
for success.

Key events during FDC-7 implementation

In response to the Commission's direction in the Docket 18128 decision, the Common Carrier Bureau in October 1976 formed a Cost Analysis Task Force. The task force and AT&T personnel met in working sessions over the next several months. In January 1977 the task force issued an interim report and a Cost Allocation Manual (known as the January Manual). Manual). This manual was used for AT&T's June 1977 submission required by Docket 18128. sultative process continued and in August 1977 the task force issued a final report along with a refined manual (the August Manual). This manual was to be used in later tariff filings.

1/FCC was vague on the issue of what services were actually subsidizing what other services. Rather, it found return levels too low on some services--indicative of crosssubsidization.

2/Certain aspects of the decision were supposed to apply to Western Union. Discussions with FCC staff indicate little was done in this regard and, consequently, our discussion focuses on FCC's activities regarding AT&T.

The

Use of the term manual is something of a misnomer. manual did not present a step-by-step procedure for allocating costs. Rather, it can best be characterized as guidelines regarding how certain segments of the cost allocation process should be handled. These guidelines vary in specificity, some being very detailed, others stating that AT&T can use a variety of approaches so long as they fully document their procedures.

The final task force report noted major areas of disagreement between FCC and AT&T over the implementation of Docket 18128. The Commission "took note of" but never officially approved the manuals.

Following the development of the cost manual AT&T filed new cost studies in Docket 20814 using the manual. This Docket was established in 1976 to look at the lawfulness of AT&T's Multischedule Private Line Tariffs. As a result, in March 1978 FCC changed the direction of this proceeding to examine the consistency of AT&T's costing approach with the principles of the Docket 18128 decision.

In March 1979, an FCC administrative law judge issued his initial decision on Docket 20814. In it he made a series of negative findings on AT&T's implementation of Docket 18128 and based on these findings he rejected the tariff. He also developed and recommended for Commission approval a new cost allocation manual and recommended that AT&T file a new cost study based on the new manual. He saw the recommended manual as giving FCC the control necessary to accurately audit AT&T's costing methods.

In the final decision in Docket 20814 the Commission did not address all of the initial decision's findings. Rather, it focused on the finding that AT&T used the "basic service" approach of residual costing for certain parts of its plant--a clear violation of Docket 18128--using it to reject the tariff. The Commission also concluded that AT&T's cost allocation methodology was inconsistent with Docket 18128. Instead of using the initial decision's manual FCC decided to begin a new proceeding to prescribe a cost allocation manual. It stated:

"The record in this proceeding leaves little doubt
that a Commission-prescribed FDC manual is needed
if we are to have reliable, accurate information as
to AT&T's cost of service.

FDC-7 contained two intrinsic flaws

The selection of FDC-7 represented a compromise. With this compromise came two inherent flaws which FCC could ultimately not overcome. First, FDC-7 relied on forecasting to allocate plant costs among service categories. Second, FDC-7 produced total costs for AT&T's interstate services which could not be reconciled with the total costs AT&T was allowed to recover as a regulated firm.

FCC has experienced several problems in implementing its desire to use forecasting to allocate facility costs among service categories. Initially, in the meetings with the Cost Analysis Task Force AT&T stated that it did not engage in planning and procuring facilities on a service-by-service basis. Rather, reflecting the fungible nature of its plant, AT&T stated that it forecasted the demand for its aggregate plant and then built the plant to provide the mix of services eventually demanded by users. This meant that using forecasts to allocate costs among services was an artificial process and not related to how AT&T decided to acquire facilities.

Forecasting requires significant management judgment. This is particularly the case with AT&T where many of its services are close substitutes for one another. For example, forecasting rapid growth in one service may mean forecasting slower growth for a complimentary service. Balancing these forecasts requires judgment and makes the forecasting process more difficult. The substitutability of services also reinforces the tendency to forecast only aggregate demand and to build fungible plant.

In an environment where forecasts are not used by the carrier in its procurement decisionmaking and where significant management judgment is involved, there may be an incentive to under allocate plant to competitive services and overallocate plant to monopoly services--in other words, to cross-subsidize. FCC officials and industry observers feel this has been the net result of using forecasting to implement FDC-7. As evidence of this, they cite the inaccuracies of AT&T's forecasts and the considerable difficulty FCC has experienced in getting AT&T to satisfactorily specify the effects of assumptions made whenever managerial judgment is used in the forecasting process. This has led some FCC officials to favor removing forecasting from the costing process.

The Commission does have, however, the ability to exercise control over the quality of forecasting by holding the carrier accountable for the accuracy of its forecasts. We believe two methods are available. One is the reconciliation of the relative use FDC-1 with the FDC-7 results as was contemplated in Docket 18128. This has never been done, despite findings in Docket 20814 that discrepancies in plant allocation and actual plant use did exist. The other method involves the reconciliation of forecasts from the costing process with forecasts required as part of the section 214 facilities authorization process. As described in chapter 3, carriers must get FCC approval before constructing transmission facilities. As part of their application, FCC requires facility forecasts. Both the Cost Allocation Task Force and Docket 20814 recognized that the facility authorization process could be used as a "check" on the costing process but no such reconciliation was ever attempted.

When asked why neither of the two methods has been used, the Chief of the Policy and Program Planning Division and an economist and an attorney in the same division noted that even

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