Anna Mae L.

Cortez

CASE ANALYSIS OF PRESTIGE TELEPHONE COMPANY

I.

Situational Analysis In April 1997, Daniel Rowe, president of Prestige Telephone Company, was preparing for a meeting with Susan Bradley, Manager of Prestige Data Services, a company subsidiary. Partial deregulation and an agreement with the state Public Service Commission had permitted Prestige Telephone to establish a computer data service subsidiary to perform data processing for the telephone company and to sell computer service to other companies and organizations. Mr. Rowe had told the commission in 1994 that a profitable computer services subsidiary would reduce pressure for telephone rate increases. However, by the end of 1996 the subsidiary had yet to experience a profitable month. Ms. Bradley felt only more time was needed, but Rowe felt action was necessary to reduce the drain on company resources.

EXHIBIT 1.Prestige Data Services Summary Results of Computer Utilization, First Quarter 1997

EXHIBIT 2.Prestige Data Services Summary Results of Operations, First Quarter 1997

II. Identification of the Problem The summary results of operation of Prestige Data Services for the first quarter of 1997 revealed a net loss which opted top management to appraise what alternative courses of action should be undertaken to it since it is not generating profit.

III. Setting of Objective y To analyze the results of operations as they have been reported, and to understand the origin and nature of receipts, revenues, expenditures and expenses. y To develop an understanding of the economics of a business and to use that understanding to forecast the potential change in income which would occur if various alternative courses of action were selected by management. y To understand the importance of the way in which cost information is reported, and the way in which accounting and reporting systems can be used to highlight the factors which are important to management and for appraisal of operations.

IV. Alternative courses of action y To continue the subsidiary and prepare Cost-volume-profit analysis  Cost-volume-profit analysis of the subsidiary requires a breakup of the costs into fixed and variable costs. The only variable costs are power and part of the operations wages paid to hourly workers. It can be estimated that power costs are about $4.50 per hour and the variable portion of the operations wages is $24 per hour and the fixed portion of the operations wages is $21,600. We will assume that materials are offset by other revenue and therefore, can be excluded from analysis. We will also assume that for the purposes of planning, sales promotion expenses are about $8,000 per month. Further we will assume that $15,000 reimbursement for corporate services provided by Prestige to its subsidiary can be a reasonable estimate of the long run consumption of administrative resources by Prestige Data. The total relevant monthly fixed costs for the subsidiary are: 9,240+95,000+5,400+25,500+680+21,600+12,000+9,000+11,200+8,000+15,000= 212,620. Power ($4.50 per hour) and part of the operations wages ($24 per hour) are the only variable costs. With low variable costs ($28.50 per hour) to deduct from the commercial revenues per hour ($800 per hour) each commercial hour sold generates a high contribution to fixed costs and profit. In addition, the assumption that Prestige Telephone Company can always cover $82,000 of the cost under its agreement with the Public Service Commission enables that amount to be deducted directly from fixed cost in determining break-even volume. Hence, from this analysis, it is easy to calculate a break-even volume as follows:

(Total Fixed Costs - Allowed Costs after Variable Costs of Intercompany Operations) =Breakeven Hours Contribution per Hour (800-4.50-24)

$212,620 [$82,000 (205 Hours x $28.50 = $5,843)] = 176.88 Hours $771.50 176.88 hours at $800 per hour is equal to $141,504 of commercial revenue per month.

To shutdown the subsidiary and outsource the data services from outside if the incremental cost of shutting down (relative to keeping the subsidiary) is negative i.e., incremental benefits are positive. To analyze the effects of possible changes in demand due to changing price, promotion or operating conditions. The analyses are dependent upon the cost analysis previously completed. Once that analysis is accepted, each calculation is straightforward. A summary follows: a. Increasing the price to commercial customers to $1,000 per hour would reduce demand by 30%. In March 1997, demand was for 138 hours, and a 30% reduction would leave demand of 97 hours (138 hours x .70 = 96.6 hours). Demand x Contribution per hour = Contribution 97 hours x ($1,000 - $28.50) = $94,236

Compare to present: 138 hours x ($800 - $28.50) = $106,467 The monthly contribution to fixed costs and income at $800 is greater by $12,231 than the contribution expected at $1,000. Therefore, the income will be higher if we retain the $800/hour price. b. Reducing the price to commercial customers to $600 per hour would increase demand by 30%. In March 1997, demand was for 138 hours, so that a 30% increase would give demand of 179 hours (138 hours x 1.30 = 179.4 hours). 179 hours x ($600 - $28.5) = $102,299 Compared to present contribution of $106,467, a price reduction would apparently reduce profit by $4,169 per month. c. An increase in promotion that would increase commercial sales by 30% would increase sales to 179 hours per month. At $800 per hour, the total contribution would be:

179 hours x ($800 - $28.5) = $138,099 An amount up to the difference between this new contribution and the present contribution of $106,467 or $31,632 could be spent without reducing income. d. Reducing hours would reduce demand for commercial revenue hours by 20%, from 138 hours to 110 hours. At that level, the total contribution would be: 110 hours x ($800 - $28.5) = $84,865 or $21,602 less than at present.

V. Selection of alternatives and implementation

In deciding whether to continue, or discontinue the subsidiary company, we should consider the benefits and disadvantages of each option. We gauge the contribution of a subsidiary not only by looking at its profitability but also the advantage it can give to the parent company particularly in reducing its costs. Having a low profitability or even a net loss does not necessarily mean that the decision of retaining the subsidiary is wrong. Separating the relevant costs from the irrelevant costs helps the parent company determine how the subsidiary can be a factor in its overall operation. So continuing the subsidiary could most likely be the best decision.

Preparing the Cost-Volume-Profit (CVP) analysis is very helpful in making sound business decisions for the short term, as well as for long-range planning, particularly in this case for product features and pricing. For a company to avoid operating losses, like in the case of Prestige Data Services, the managers should be looking at the breakeven point of the company. By doing this, they would know the level of output needed for the operating income/loss to be equal to zero; hence, they would be targeting sales volume higher than the breakeven point to be profitable. Also with the use of CVP analysis, companies can make projections on the operating level to succeed in achieving its targeted operating income. In the case of Prestige Data Services, management should be concerned with trying to reach the breakeven point in sales. They would need different strategies to be able to reach their goal of maximizing profit. With the use of CVP analysis, they would be able to predict changes in operation income when there is price change or increase in sales. By employing strategies like sales promotions, additional services, and adjustments in operating hours, the company may be able to attract more sales and increase income. As the result in analyzing the effects of possible changes in demand due to changing price, promotion or operating conditions, except for operations wages (and perhaps materials and supplies) it appears most other expenses would not be affected by this reduction of service and revenue. $21,600 of operating wages are nonvariable, so perhaps onethird of that could be eliminated by going on two-shift operations rather than three shifts. Savings of $7,200 hardly offsets a loss of contribution of $21,602, so the option of giving up a shift appears not very attractive.