Barings Telephone Company

In April 2015, Mark Rowe, president of Barings Telephone Company, a public utility company,

was preparing for a meeting with Susan Bradley, manager of Barings Data Services, a company

subsidiary. Partial deregulation and an agreement with the government had permitted Barings

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 government in 2012 that a profitable computer services subsidiary would

reduce pressure for telephone rate increases. However, by the end of 2014 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.

Barings Data Services had grown out of the needs of Barings Telephone for computer services

to plan, control, and account for its own operations in the region it served. The realization by

Barings that other businesses in the region needed similar services and that centralized service

could be provided over telephone circuits suggested that Barings could sell computer time not

needed by telephone operations. In addition, the government had encouraged all public

utilities under its jurisdiction to seek new sources of revenue and profits as a step toward

deregulation and to reduce the need for rate increases which higher costs would otherwise

bring.

Because it operated as a public utility, the rates charged by Barings Telephone Company for

telephone service could not be changed without the approval of the government. In presenting

the proposal for the new subsidiary, Mr. Rowe had argued for a separate but wholly owned

entity whose prices for service would not be regulated. In this way, Barings could compete with

other computer service organizations in a dynamic field; in addition, revenues for use of

telephone services might also be increased. The government accepted this proposal subject

only to the restriction that the average monthly charge for service by the subsidiary to the

parent not exceed $82,000, the estimated cost of equivalent services used by Barings

Telephone Company in 2012. All accounts of Barings Data Services were separated from those

of Barings Telephone, and each paid the other for services received from the other.

From the start of operations of Barings Data Services in 2013 there had been problems.

Equipment deliveries were delayed. Personnel had commanded higher salaries than expected.

And most important, customers were harder to find than earlier estimates had led the company

to expect. By the end of 2014, when income of Barings Telephone was low enough to

necessitate a report to shareholders revealing the lowest return on investment in seven years,

Rowe felt it was time to reassess Barings Data Services. Susan Bradley had asked for more time,

as she felt the subsidiary would be profitable by March. But when the quarterly reports came

(Tables 1 and 2), Rowe called Bradley to arrange their meeting.

Rowe received two reports on operations of Barings Data Services. The Summary of Computer

Utilization (Table 1) summarized the use of available hours of computer time. Service was

offered to commercial customers 24 hours a day on weekdays and eight hours on Saturdays.

Routine maintenance of the computers was provided by an outside contractor who took the

computer off-line for eight hours each week for testing and upkeep. The reports for the quarter

revealed a persistent problem; available hours, which did not provide revenue, remained high.

Revenue and cost data were summarized in the quarterly report on results of operations (Table

2). Intracompany work was billed at $400 per hour, a rate based on usage estimates for 2015

and the government's restrictions that cost to Barings Telephone should not exceed an average

of $82,000 per month. Commercial sales were billed at $800 per hour.

While most expenses summarized in the report were self-explanatory, Rowe reminded himself

of the characteristics of a few. Space costs were all paid to Barings Telephone. Barings Data

Services rented the ground floor of a central exchange building owned by the company for

$8,000 per month. In addition, a charge for custodial service based on the estimated annual

cost per square foot was paid by Data Services, as Telephone personnel provided these

services.

Computer equipment had been acquired by lease and by purchases; leases had four years to

run and were nto cancelable. Owned equipment was all salable but probably could not bring

more than its book value in the used equipment market.

Wages and salaries were separated in the report to show the expense of four different kinds of

activities. Operating salaries included those of the six persons necessary to run the center

around the clock as well as amounts paid hourly help who were required when the computer

was in operation. Salaries of the programming staff who provided service to clients and

maintained the operating system were reported as system development and maintenance.

Sales personnel, who called upon and serviced present and prospective commercial clients,

were also salaried.

Because of its relationship with Barings Telephone, Barings Data Services was able to avoid

many costs an independent company would have. For example, all payroll, billing, collections,

and accounting were done by telephone company personnel. For those corporate services,

Barings Data Services paid Barings Telephone an amount based on wages and salaries each

month.

Although Rowe was discouraged by results to date, he was reluctant to suggest to Bradley that

Barings Data Services be closed down or sold. The idea behind the subsidiary just seemed too

good to give up easily.

Besides, he was not sure that the accounting report really revealed the contribution that Data

Services was making to Barings Telephone. In other cases, he felt that the procedures used in

accounting for separate activities in the company tended to obscure the costs and benefits they

provided.

After examining the reports briefly, Rowe resolved to study them in preparation for asking

Bradley to estimate the possible effects on profits of increasing the price to customers other

than Barings Telephone, reducing prices, increasing sales efforts and promotion, and of going to

two-shift rather than 24-hour operations.

Questions

1. Appraise the results of operations of Barings Data Services. Is the subsidiary really a problem

to Barings Telephone Company? Consider carefully the differences between reported costs and

costs relevant for decisions that Mark Rowe is considering.

2. Assuming the company demand for service will average 205 hours per month, what level of

commercial sales of computer use would be necessary to break even each month?

3. Estimate the effect on income of each of the options Rowe has suggested if Bradley

estimates as follows:

a. Increasing the price to commercial customers to $1,000 per hour would reduce

demand by 30 percent.

b. Reducing the price to commercial customers to $600 per hour would increase demand

by 30 percent.

c. Increased promotion would increase sales by up to 30 percent. Bradley is unsure how

much promotion this would take. (How much could be spent and still leave Barings Data

Services with no reported loss each month if commercial hours were increased 30

percent?)

d. Reducing operations to 16 hours on weekdays and eight hours on Saturdays would

result in a loss of 20 percent of commercial revenue hours.

4.Can you suggest changes in the accounting and reporting system now used for operations of

Barings Data Services which would result in more useful information for Rowe and Bradley?

Table

1

Barings Data Services Summary of Computer Utilisation First Quarter 2015

Revenue Hours January February March

Intercompany 206 181 223

Commercial 127 135 138

Total revenue hours 333 316 361

Service Hours 32 32 40

Available hours 175 188 167

Total hours 540 536 568

Revenues:

Intercompany sales $82,400 $72,400 $89,200

Commercial sales:

Computer use 98,400 108,000 110,400

Other 9,241 9,184 12,685

Total revenue $190,041 $189,584 $212,285

Expenses

Space costs

Rent $8,000 $8,000 $8,000

Custodial services 1,240 1,240 1,240

9,240 9,240 9,240

Equipment costs:

Computer leases 95,000 95,000 95,000

Maintenance 5,400 5,400 5,400

Depreciation:

Computer equipment 25,500 25,500 25,500

Office equipment and

fixtures 680 680 680

Power 1,633 1,592 1,803

128,213 128,172 128,383

Wages and salaries:

Operations 29,496 29,184 30,264

Systems development and

maintenance 12,000 12,000 12,000

Administration 9,000 9,000 9,000

Sales 11,200 11,200 11,200

61,696 61,384 62,464

Materials 9,031 8,731 10,317

Sales promotions 7,909 7,039 8,083

Corporate services 15,424 15,359 15,236

Total expenses $231,513 $229,925 $233,723

Net income (loss) -$41,472 -$40,341 -$21,438