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Fortnightly Magazine - September 1 1996

on individual services must be "small" to be "reasonable."

Myth #3:

Margin, Markup, and Return are Interchangeable

In attempting to add a "reasonable" contribution margin to a service's incremental cost, one common pitfall is to confuse three concepts:

s A contribution margin expressed as a percentage of price

s A percentage markup over cost to arrive at a price

s A reasonable rate of return on investment.

These three measurements yield strictly noncomparable numbers, yet they are casually used as interchangeable in telecommunications. However, a service with a high contribution margin or percentage markup over cost can have a low rate of return. Confusing rate of return for contribution margin or markup over cost tends to lead to prices that are too low. In telecommunications, regulators often recommend a 5 to 10 percent markup above incremental cost to arrive at a price, but such markups actually seem generated with rates of return in mind.

Consider a simple example. Suppose a product has a production cost of $5 per unit, and a price of $25. Its contribution margin would be 80 percent when expressed as a percentage of price (em in other words, a markup of 400 percent over cost. Now assume that the total level of sales the first year is 1,000 units, and that it cost $200,000 to buy the manufacturing equipment required to produce the product. In this example, the annualized rate of return on investment is 10 percent. Marking up the $5 cost by just 10 percent instead of 400 percent would yield a price of only $5.50, even though the market price is $25.

Myth #4: Prices Differ Only if Costs Do Too

Regulators expect service prices to vary as costs vary, and this notion seems to be a basic condition of formula-based pricing. Thus, if a service always costs the same amount to produce, but is offered at two sets of prices (e.g., two differing multipart tariffs), one could conclude erroneously that one or both sets of prices are not cost-based. However, given any significant differences in consumers' demand characteristics, it is economic naiveté to conclude that service prices should maintain the same ratios as their respective costs. Competitive markets just don't operate that way.

Efficient pricing in telecommunications usually requires price discrimination, in the economic sense. In fact, the practice is as pervasive in telecommunications as in other industries. Clear proof lies no further than the optional calling plans offered by interexchange carriers, or the simultaneous LEC pricing of basic local service at both flat and measured rates.

Microeconomics teaches that optional multipart tariffs are usually more efficient than pricing a service at a simple per-unit price.20 An insistence on strict formula-based pricing may preclude efficient price discrimination, such as volume and term discounts or discounts on packages of services.

The Cold, Hard Facts

Telecommunications pricing exhibits a disturbing trend of late: the belief that one can set "cost-based" prices by applying a multiplier to an LEC's incremental cost data. The multiplier is designed to build a "competitive" level of contribution into prices, and one can