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Prestige Telephone Company AIM 4343 02/09/04

Top management of Prestige Telephone Company, is considering alternative courses of action which might be taken to improve the performance of a new subsidiary, Prestige Data Services. It was originally conceived as a mechanism by which high and nonregulated returns could be used to augment the profits of Prestige Telephone Company, while at the same time providing computer services to that company. The subsidiarys performance has not lived up to expectations. Nevertheless, after two years of operation, Prestige Data Services has succeeded in coming on line with services needed by the parent company and is selling excess hours of capacity to outside customers at an increasing rate. The key issues relate to questions are whether the reports presently being prepared provide information necessary to answer the questions which top management is asking, and if they do not, what kind of analysis can help with the decisions being considered. Despite the fact that this case is quite straightforward, it provides ample information and data to analyze three tasks which are critical to effective management accounting. First, to analyze the results of operations as they have been reported, and to understand the origin and nature of receipts, revenues, expenditures and expenses. Second, 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. And third, 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. Incremental Cost Analysis: Shut Down Prestige Data Services Vs. Retain the subsidiary The decision criterion is 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. We need to take into account opportunity costs rather than reported or historical costs to perform this analysis. The first issue is to estimate the decision horizon. Lets take it to be 4 years since the noncancelable leases on computer equipment have four more years to run. Now go down the list of revenues/costs in Exhibit 2 and estimate from the parent companys point of view the opportunity costs or benefits to shutting down the subsidiary relative to keeping it. For example, if Prestige shuts down the subsidiary it needs to outsource data services from an outside vendor. What is an appropriate estimate of the incremental costs associated with this outsourcing? Similarly you estimate lost contribution from commercial sales, incremental benefits or cost savings from laying off people in the subsidiary, proceeds from sale of owned equipment, benefits from possible alternative uses of space currently occupied by Data Services, services currently provided by the parent company to Prestige Data etc.,. Think about these issues and come up with a recommendation as to whether the subsidiary should be shutdown or not.

Cost-volume-profit Analysis
Assume the decision is to keep the subsidiary. Cost-volume-profit analysis of the subsidiary requires a break up 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) Less (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.

Analyzing Options Discussed in Question 3

Each of the sets of assumptions in Question #3 in the case offers the opportunity 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. But what expenses could be saved? 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 one-third 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.