backgraound information

Part C

Sydney Water Services and Melbourne Water Services are two wholly-owned subsidiaries of Midal Water. You are an accountant, and you have recently joined the finance team of Midal Water's headquarters.

The finance director has also provided you with the following background information on the two companies.

Sydney Water Services

The company holds a license issued by the government to be the sole supplier of drinking water to a large town in Victoria. The business requires a considerable investment in infrastructure assets and is therefore highly capital intensive. To comply with the license, the company must demonstrate that it is maintaining the guaranteed service standards to its customers. Sydney Water Services is extensively regulated, requiring detailed annual returns concerning costs, prices, profits, and service delivery standards. The government enforces a price-capping regime and therefore the company has limited freedom in tariff determination - the government will normally only sanction a price increase following a demonstrable rise in costs.

Melbourne Water Services

In contrast to Sydney Water Services, Melbourne Water Services operate in an extremely competitive market offering plumbing services to domestic properties. The business is experiencing the following.

Rapidly changing market conditions

A high rate of new entrants and business failures

Occasional shortages of skilled plumbers

Fluctuating profits

In addition to this background information, you also have the following.

Summarised income statements and statements of financial position (balance sheets) for the last two years for both companies

Service contract costing information from Melbourne water services

Notes from a meeting that you have had with the manager responsible for the profitability of the three service contracts offered by Melbourne water services

Fixed overheads are allocated to the contracts at 150% of total direct costs.

The selling price is arrived at by adding 50% to the total costs.

Notes from the meeting

The manager states that his prime objective is to maximise the total profit that the three service contracts earn.

You discover that there is currently an unavoidable shortage of labour that has resulted in the available hours being limited to 80% of those originally planned in the budget.

The manager responds to the shortfall in labour hours by "concentrating sales on our most profitable service contracts, surely this is the obvious thing to do."

The manager is provided with the fixed overhead figure (150% of direct costs) from the finance department and assumes that it remains "fixed" irrespective of the contract volume and contract mix. This overhead arises only because of operating the service contract business.

The manager would never knowingly "supply a service contract that did not cover the total cost, otherwise, the company's profits would decline."

The manager estimates the volume of contracts for budgetary purposes and provides these figures to the Finance Department of Melbourne Water Services.