ISP Economy of Scale

I’ve worked for numerous small communities over the last few years and the first question they always ask me is if their community is large enough to support a standalone fiber ISP business. What they really want to know is if they can somehow operate their own local ISP and still have affordable broadband rates.

The question about how big an ISP must be (in terms of customers) is really a question about economy of scale. The textbook definition of economy of scale is a business where costs decrease per unit through increased output. The ISP business is clearly an economy of scale business since the cost per customer decreases as an ISP adds more customers.

The example I usually use to demonstrate this is to look at the cost of paying for a general manager for an ISP business. The cost of the general manager is what economists would call a fixed cost – it doesn’t vary as you add or lose customers. However, the amount of the general manager salary that must be covered by each customer gets smaller as the customer base grows larger.

A large part of the costs of operating an ISP are fixed like the GM salary. Costs like operating a business office, doing the needed accounting, buying a billing system, etc. are largely fixed. The largest fixed cost is often the debt service required to pay off the cost of building the network.

I have done hundreds of business plans for communities of all sizes and I have developed a few rules of thumb for operating a traditional ISP – one that has the expected number of employees, charges normal industry rates and has to finance the cost of their network.

  • It’s hard to justify a new standalone ISP with fewer than 2,000 customers.
  • Economy of scale kicks in at that point and the business gets more efficient, when measured on a per customer cost up until an ISP reaches between 20,000 and 25,000 customers.
  • After 20,000 customers the cost curve reaches relative stasis – adding customers increases efficiency but also drives additional fixed costs. For example, companies find they need to hire extra accountants; they might need backoffice positions for functions like personnel or benefits management.
  • At some fairly large size, say 100,000 customers, ISPs tend to become less efficient. Large companies tend to become bureaucratic, hire significant middle management and become less functionally efficient as centralize functions and put them into silos.

There are ways defeat the economy of scale curve to some extent and I have clients who used the following ways to be more efficient than other ISPs of the same size:

Reduce Costs. There are various ways to spend less on needed functions than the average ISP.

  • Use existing excess capacity. A City or an electric company can open an ISP and not have to spend money for a business office since they are already operating one. An existing business like an electric company or a telco might be able to use underutilized customer service reps or line technicians without having to hire a whole new staff for a new ISP venture. A utility or city might be able to use the existing billing systems from their water or electric utilities to support the ISP functions.
  • Reduce Expectations. Small ISPs often can save a lot of money by reducing customer expectations. For instance, they might elect to not have repair service on evening and weekends unless there is a real emergency. Small ISPs also don’t need to offer all of the bells and whistles of larger ISPs and can have a simple product offering. A small ISP might elect to not offer cable TV, which for small ISPs usually has a negative margin. This concept can only be taken so far and works best in communities where an ISP is competing against a decent giant ISP.

Avoid Costs. It’s not easy to avoid the cost of being an ISP, but it can be done.

  • Financing from Other Revenues. I have a client with only 600 potential customers that is successful since they decided to fund their network using property taxes rather than having to pay debt from ISP revenues. This allows them to have broadband rates far lower than surrounding communities by avoiding ISP debt payments. I know municipal and cooperatives power companies that have raised electric rates to help cover the cost of an ISP business since that’s what their customers wanted.

Grow Efficiently. The most obvious strategy to beat the economy of scale curve is to get more customers in an efficient manner.

  • Increase Penetration Rates. For a small ISP the difference between a 50% and a 70% penetration rate can be dramatic. Many ISPs become complacent once they generate enough cash to pay the bills while the smart ones continue to sell hard every year to maximize the customers in their footprint.
  • Expand to Another Market. Most small telcos figured this out years ago and operate a CLEC business outside their regulated footprint.
  • Partnering. There are several examples today of cities that have banded together to create a larger ISP. There are numerous cities and electric cooperatives that are partnering with telcos to gain the economy of scale. We are still seeing small telcos getting purchased by larger ones.

2015 Broadband Growth

S vurveOne of the things I’ve figured out about the telecom industry is that statistics are often used to tell very different stories. Consider this example regarding wireline broadband adoption:

In December Pew Research released the results of a survey that suggested that overall wireline broadband adoption had dropped to 67% in 2015, down from a high of 70% in 2013. This was the first time I had ever heard any suggestion that the total number of landline broadband connections have flattened out, let alone dropped.

Pew went on to say that main culprit for the drop in broadband adoption is broadband prices and that a lot of homes feel they cannot afford a broadband connection, and instead rely solely upon broadband from their smartphone. That sounds plausible, and Pew was comparing to a very similar survey they had given in 2013.

But the Leichtman Research Group just released a report saying that the big cable companies added 3.3 million broadband customers in 2015. They said that during the year that the large telcos lost 187,000 landline broadband connections, meaning an overall net increase of over 3.1 million new broadband connections for the year.

The Census estimates there were 124.6 million housing units in the country in 2015, so the big companies in total brought broadband to an additional 2.5% of the total market. That sure does not sound like a year in which broadband has declined as suggested by Pew. And Leichtman has shown total market growth for the last several years as well.

In this case you have to believe the Leichtman numbers. They gather total subscriber numbers from all of the large carriers – cable companies and telcos. Since almost all of these companies are publicly traded, and since Wall Street keeps a close eye on subscribers, one has to think that the Leichtman numbers are pretty accurate.

On the other hand the Pew numbers come from nationwide surveys. Pew did three surveys in 2015 with a total of 6,687 adult respondents. The 2013 numbers they are comparing to was based on surveys of 6,010 adults.

I have always been suspicious of nationwide surveys. Our firm gives surveys and I have found that local surveys can be very accurate and the results can often be correlated with externally collected facts. For instance, I’ve had clients do surveys to find out how many customers their competition has in a market, and these surveys often prove themselves to be valid by also accurately showing the market penetration of my clients. That makes it easy to believe that the numbers for the other competitors in the market are also accurate.

I know that Pew is very careful about how they randomly choose survey subjects. For instance they will call people with cellphones as well as those with landline telephones. If you crunch through the statistical formulas that describe the predicted accuracy of a nationwide survey, then the Pew surveys should be very accurate.

The Liechtman numbers are not a 100% count of broadband customers and only count the customers of the biggest broadband providers – but those providers are something like 95% of the whole market. I know enough about a lot of companies in the rest of the market, the smaller carriers, to know that many of them are still seeing healthy broadband customer growth.

I have no way to explain this difference and I suspect that Pew can’t either. Their survey should be pretty accurate. Yet sometimes nationwide surveys just don’t give accurate results. This can often be seen with elections where different surveys given at almost the same time show fairly disparate predictions. The trouble is that surveys from groups like Pew influence decision makers and there are now going to be those who think that broadband growth has topped out. I was just on a call last week where somebody mentioned the Pew numbers. And while the Pew numbers of total broadband users might not be totally accurate, one can still believe that  their observation that some people are finding broadband increasingly expensive probably is valid. The problem is, you just can’t really know how many people that might be.