Case Summary In the fall of 1989, the Texas Division of Southwestern Bell Telephone Company (SWBT) was facing considerable earnings uncertainty. Nine months had passed since the Texas Public Utilities Commission (PUC) had initiated an inquiry into SWBT's earnings in Texas. The Company was having difficulty reaching an agreement with the commission staff and other interested parties. At the same time that the PUC was investigating alleged overearnings related to SWBT's Texas intrastate operations, company officers in Texas were trying to meet budgeted net income objectives. These targets were necessary to keep earnings growing at a conservative yet steady rate. With actual data already available for much of the year, it was apparent that the overall target for 1989 might not be met. One of the main causes of this probable shortfall was the decrease in revenues from long distance telephone calls. This decrease was due largely to increased payments to other local exchange telephone companies in Texas, as explained below. Industry Background In January 1984, SWBT and six other regional telephone companies were divested from American Telephone and Telegraph Company (AT&T). AT&T was allowed to retain ownership of interstate long distance services and a portion of intrastate long distance. Under the provisions of the Justice Department's Modified Final Judgment decree, each state was divided into Local Access Transport Areas (LATAS). Texas was divided into seventeen LATAS. Local exchange carriers (LECs) such as SWBT provide basic telephone service and long distance calling within each LATA (intraLATA is the term used for "within a LATA). In Texas, there are 59 LECs. SWBT is by far the largest. Because long-distance carriers access their customers through LEC facilities, LECs charge the carriers for using their local networks. Theoretically, these per-minute-of-use charges are based on LEC costs. However, state commissions often inflate the rates to subsidize basic telephone rates, thus keeping them priced below cost. IntraLATA Long Distance When a customer of an LEC makes an intraLATA long distance call, completion of the call often requires the use of another LEC's facilities. For example, a call from Dallas to Denton is an intraLATA call that originates in a Southwestern Bell area (Dallas) but terminates in another LEC area (Denton). The originator of the call is billed by Southwestern Bell, which must reimburse the other LEC for costs incurred in assisting in the call. In Texas, this reimbursement is currently handled through a revenue pooling agreement among the LECS. The pooling of intraLATA revenues is administered by the Texas Exchange Carrier Association (TECA). Each LEC reports monthly to the TECA administrator not only its billed revenues but also its expenses and investment incurred in providing telephone service. TECA combines the revenue, expense, and investment information for all 59 LECs and calculates a rate of return equal to billed revenues less expenses (including taxes) divided by investment. Each LEC is allowed to recover its expenses plus the pool rate of return on its investment. In 1987 the pool rate of return was approximately 19%. Although SWBT billed $555.3 million in toll revenues, it was allowed to retain only the total of its expenses ($285.4 million) and return ($147.9 million). The $122 million difference between what SWBT billed and what it was allowed to keep was paid to the pool administrator for disbursement to those companies whose costs exceeded their billed revenues. Concerns with the Pooling Process Southwestern Bell's managers have several concerns with the current pooling process. One of their major concerns is that few incentives exist for companies to control costs. IntraLATA toll service is a much larger portion of the total operations of many of the smaller LECs than of SWBT. Consequently, each dollar of additional cost incurred by the smaller companies results in approximately one dollar of additional settlements. The company's managers also are concerned about the manner in which total expenses and investment related to intraLATA toll service are calculated. Each company's accountants compute these amounts using procedures developed by the Federal Communications Commission (FCC). The very complex procedures, referred to in the industry as "separations," allocate monthly expense and investment amounts to various categories of telephone service based on factors developed from studies of call traffic patterns and studies showing how telephone plant resources are utilized. The separations process was developed to provide a means of dividing expenses and investment amounts between state and interstate jurisdictions to facilitate rate setting by regulatory agencies. It never was intended to represent an accurate allocation system. A third concern of Southwestern Bell managers is that revenues from non-joint-provided toll calls are included in the pooling process. For example, consider that the largest intraLATA toll market in Texas is between Dallas and Ft. Worth. Most toll calls between the two cities use only SWBT facilities, but through the pooling process revenues from the calls are shared with the state's other LECs. Company officials believe both revenues and costs of single-company toll calls should be excluded from the pool, but currently there is no means to isolate those amounts. A final concern relates to the telecommunications industry goal of providing adequate telephone service to all U.S. citizens at reasonable rates. All telephone companies as well as the entire nation have benefited from the subsidies that higher cost companies have received from lower-cost companies. If local telephone service, especially in rural areas, were priced to cover its costs, the number of residences with service would be substantially lower. The concern at Southwestern Bell is that subsidization of high-cost companies has exceeded its historical intent; publications of the Texas PUC show that many high-cost LECs are earning well over their authorized rates of return. After reviewing the situation, Southwestern Bell's senior managers realized they had their work cut out for them. They know that the course of action they recommended would have to effectively address both the concerns of SWBT and the financial needs of the other companies. Definitions: Types of Service Local (intraLATA) Service provides calling within a geographic area known as a Local Access and Transport Area (LATA). Long Distance (interLATA) Service includes all calls outside the local exchange and local toll service areas, calls that originate in one LATA and terminate in another, and international calls. Long-distance toll calls can be between two LATAs in the same state, such as a call from San Diego to San Francisco, or between LATAs in different states. A LATA (Local Access and Transport Area) is a geographical area that is the responsibility of one of the Regional Bell Operating Companies. These boundaries were established after the breakup of AT&T in 1984. An LEC is a local exchange carrier, for example, in this case SWBT is an LEC. Below is an example graphic of LATA boundaries that currently exist within the state of Texas. (See: http://www.telecomauditguide.com/long-distance/lata-intralata-and-interlata-explained/, and https://www.fcc.gov/consumers/guides/local-local-toll-and-long-distance-calling) Required: 1. Which of the following is not a concern of SWBT managers? The pooling of intraLATA revenues and expenses is administered by the Texas Exchange Carrier Association (TEAC) for all 59 LECS. The rate setting (pooling) process is very complex and was never intended to represent an accurate allocation system. Revenues and expenses from non-joint calls are included in the pooling process which tends to distort to true relationship of revenues and costs for those calls for which joint costs are involved and for which the allocation process is needed. The subsidies for local and especially rural telephone service has exceeded its historical intent, that is, to support the goal of providing adequate telephone service to all U.S. citizens. 2. How would your recommendation SWBT managers address the four concerns explained above? Case Summary In the fall of 1989, the Texas Division of Southwestern Bell Telephone Company (SWBT) was facing considerable earnings uncertainty. Nine months had passed since the Texas Public Utilities Commission (PUC) had initiated an inquiry into SWBT's earnings in Texas. The Company was having difficulty reaching an agreement with the commission staff and other interested parties. At the same time that the PUC was investigating alleged overearnings related to SWBT's Texas intrastate operations, company officers in Texas were trying to meet budgeted net income objectives. These targets were necessary to keep earnings growing at a conservative yet steady rate. With actual data already available for much of the year, it was apparent that the overall target for 1989 might not be met. One of the main causes of this probable shortfall was the decrease in revenues from long distance telephone calls. This decrease was due largely to increased payments to other local exchange telephone companies in Texas, as explained below. Industry Background In January 1984, SWBT and six other regional telephone companies were divested from American Telephone and Telegraph Company (AT&T). AT&T was allowed to retain ownership of interstate long distance services and a portion of intrastate long distance. Under the provisions of the Justice Department's Modified Final Judgment decree, each state was divided into Local Access Transport Areas (LATAS). Texas was divided into seventeen LATAS. Local exchange carriers (LECs) such as SWBT provide basic telephone service and long distance calling within each LATA (intraLATA is the term used for "within a LATA). In Texas, there are 59 LECs. SWBT is by far the largest. Because long-distance carriers access their customers through LEC facilities, LECs charge the carriers for using their local networks. Theoretically, these per-minute-of-use charges are based on LEC costs. However, state commissions often inflate the rates to subsidize basic telephone rates, thus keeping them priced below cost. IntraLATA Long Distance When a customer of an LEC makes an intraLATA long distance call, completion of the call often requires the use of another LEC's facilities. For example, a call from Dallas to Denton is an intraLATA call that originates in a Southwestern Bell area (Dallas) but terminates in another LEC area (Denton). The originator of the call is billed by Southwestern Bell, which must reimburse the other LEC for costs incurred in assisting in the call. In Texas, this reimbursement is currently handled through a revenue pooling agreement among the LECS. The pooling of intraLATA revenues is administered by the Texas Exchange Carrier Association (TECA). Each LEC reports monthly to the TECA administrator not only its billed revenues but also its expenses and investment incurred in providing telephone service. TECA combines the revenue, expense, and investment information for all 59 LECs and calculates a rate of return equal to billed revenues less expenses (including taxes) divided by investment. Each LEC is allowed to recover its expenses plus the pool rate of return on its investment. In 1987 the pool rate of return was approximately 19%. Although SWBT billed $555.3 million in toll revenues, it was allowed to retain only the total of its expenses ($285.4 million) and return ($147.9 million). The $122 million difference between what SWBT billed and what it was allowed to keep was paid to the pool administrator for disbursement to those companies whose costs exceeded their billed revenues. Concerns with the Pooling Process Southwestern Bell's managers have several concerns with the current pooling process. One of their major concerns is that few incentives exist for companies to control costs. IntraLATA toll service is a much larger portion of the total operations of many of the smaller LECs than of SWBT. Consequently, each dollar of additional cost incurred by the smaller companies results in approximately one dollar of additional settlements. The company's managers also are concerned about the manner in which total expenses and investment related to intraLATA toll service are calculated. Each company's accountants compute these amounts using procedures developed by the Federal Communications Commission (FCC). The very complex procedures, referred to in the industry as "separations," allocate monthly expense and investment amounts to various categories of telephone service based on factors developed from studies of call traffic patterns and studies showing how telephone plant resources are utilized. The separations process was developed to provide a means of dividing expenses and investment amounts between state and interstate jurisdictions to facilitate rate setting by regulatory agencies. It never was intended to represent an accurate allocation system. A third concern of Southwestern Bell managers is that revenues from non-joint-provided toll calls are included in the pooling process. For example, consider that the largest intraLATA toll market in Texas is between Dallas and Ft. Worth. Most toll calls between the two cities use only SWBT facilities, but through the pooling process revenues from the calls are shared with the state's other LECs. Company officials believe both revenues and costs of single-company toll calls should be excluded from the pool, but currently there is no means to isolate those amounts. A final concern relates to the telecommunications industry goal of providing adequate telephone service to all U.S. citizens at reasonable rates. All telephone companies as well as the entire nation have benefited from the subsidies that higher cost companies have received from lower-cost companies. If local telephone service, especially in rural areas, were priced to cover its costs, the number of residences with service would be substantially lower. The concern at Southwestern Bell is that subsidization of high-cost companies has exceeded its historical intent; publications of the Texas PUC show that many high-cost LECs are earning well over their authorized rates of return. After reviewing the situation, Southwestern Bell's senior managers realized they had their work cut out for them. They know that the course of action they recommended would have to effectively address both the concerns of SWBT and the financial needs of the other companies. Definitions: Types of Service Local (intraLATA) Service provides calling within a geographic area known as a Local Access and Transport Area (LATA). Long Distance (interLATA) Service includes all calls outside the local exchange and local toll service areas, calls that originate in one LATA and terminate in another, and international calls. Long-distance toll calls can be between two LATAs in the same state, such as a call from San Diego to San Francisco, or between LATAs in different states. A LATA (Local Access and Transport Area) is a geographical area that is the responsibility of one of the Regional Bell Operating Companies. These boundaries were established after the breakup of AT&T in 1984. An LEC is a local exchange carrier, for example, in this case SWBT is an LEC. Below is an example graphic of LATA boundaries that currently exist within the state of Texas. (See: http://www.telecomauditguide.com/long-distance/lata-intralata-and-interlata-explained/, and https://www.fcc.gov/consumers/guides/local-local-toll-and-long-distance-calling) Required: 1. Which of the following is not a concern of SWBT managers? The pooling of intraLATA revenues and expenses is administered by the Texas Exchange Carrier Association (TEAC) for all 59 LECS. The rate setting (pooling) process is very complex and was never intended to represent an accurate allocation system. Revenues and expenses from non-joint calls are included in the pooling process which tends to distort to true relationship of revenues and costs for those calls for which joint costs are involved and for which the allocation process is needed. The subsidies for local and especially rural telephone service has exceeded its historical intent, that is, to support the goal of providing adequate telephone service to all U.S. citizens. 2. How would your recommendation SWBT managers address the four concerns explained above