Case study: Salem Telephone Company

By: WILLIAM J. BRUNS, JR. and JULIE HERTENSTEIN

WILLIAM]. BRUNS,]R. JULIE HERTENSTEIN Salem Telephone Company In April 2004, Peter Flores, president of Salem Telephone Company, was preparing for a meeting with Cynthia Wu, manager of Salem Data Services. An agreement with the state Public Service Commission had permitted Salem Telephone to establish Salem Data Services, a computer data service subsidiary, to perform data processing for the telephone company and to sell computer service to other companies and organizations. It was necessary for these two companies to be separate because Salem Telephone was a regulated utility, and Salem Data Services was an unregulated company. Flores had told the Public Service Commission in 2000 that a profitable computer service subsidiary would reduce pressure for telephone rate increases. However, by the end of 2003 Salem Data Services had yet to experience a profitable month. Wu felt the business was progressing well and only more time was needed until Salem Data Services showed a profit, but Flores felt action was necessary to reduce the drain on Salem Telephone Company resources. Salem Data Services had grown out of the needs of Salem Telephone for computer services to plan, control, and account for its operations in the metropolitan region it served. However, when Salem Telephone management realized that other businesses in the metropolitan region needed similar services and that centralized service could be provided over telephone circuits, they suggested that Salem Telephone could sell computer time not needed by telephone operations. In addition, the state Public Service Commission had encouraged all public utilities under its jurisdiction to seek new sources of revenue and profits to reduce the need for rate increases that higher costs would otherwise bring. Because it operated as a regulated public utility, Salem Telephone Company could not change its rates for telephone service without the approval of the Public Service Commission. In presenting the proposal for the new subsidiary, Flores had argued for a separate but wholly owned company whose prices for service would not be regulated. In this way, Salem Data Services could compete with other computer service organizations in a dynamic field. The commission accepted this proposal subject only to the restriction that the average monthly charges for services provided by Salem Data Services to Salem Telephone not exceed $82,000, the estimated cost of equivalent services used by Salem Telephone Company in 2000. To maintain the separation between Salem Telephone and its unregulated subsidiary, all accounts of Salem Data Services were separated from those of Salem Telephone and each paid the other for services received from the other. Salem Data Services started operations in 2001, and as was typical for most start-ups, there had been some 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 2003, most of these problems had been overcome. In 2003, the income of Salem Telephone was so low that the report to shareholders revealed the lowest return on investment in seven years. At that time, Flores felt it was necessary to reassess Salem Data Services. Wu had asked for more time, as she felt Salem Data Services would be profitable by March. But when the quarterly reports came (Exhibits 1 and 2), Flores called Wu to arrange their meeting. Flores received two reports on the operations of Salem Data Services. The summary of computer utilization in Exhibit 1 shows the hours of computer time that were available and how they were used. Computer service was offered to commercial customers 24 hours a day on weekdays and eight hours on Saturdays. An outside contractor who took the computer off-line for eight hours each week for testing provided routine maintenance of the computers and upkeep during the weekend shifts not used for commercial customers. The reports for the quarter revealed a persistent problem: the hours still available to sell (as shown in Exhibit 1) that did not provide revenue remained high. Revenue and cost data were summarized in the quarterly report on results of operations (Exhibit 2). Intracompany work was billed at $400 per hour, a rate based on usage estimates for 2001 and the Public Service Commission's restrictions that cost to Salem 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, Flores reminded himself of the characteristics of a few. Space costs were all paid to Salem Telephone. Salem Data Services rented the ground oor of a central exchange building owned by Salem Telephone for $8,000 per month. In addition, Salem Data Services paid a charge for custodial service based on Salem Telephone's estimated annual cost per square foot, as telephone personnel provided these services. Computer equipment had been acquired by lease and by purchases; leases had four years to run and were noncancelable. 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 five different kinds of activities. Operations salaries included those of the six people necessary to run the center around the clock; in addition there were operations wages paid hourly workers who were required when the computer was in operation. Salaries of the programming staff that 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, as were the administrators of Salem Data Services. Because of its relationship with Salem Telephone, Salem Data Services was able to avoid many costs an independent company would have. For example, telephone company personnel did all payroll, billing, collections, and accounting. For those items shown in Exhibit 2 as corporate services, Salem Data Services paid Salem Telephone an amount based on factors such as total wages and salaries, total accounts receivable, and the number of past-due accounts. Finally, sales promotion was the amount that the managers chose to spend on advertising and the other promotional activities that they used to inform prospective clients of their services and to support the activities of their sales personnel. This amount was not related to the current level of work but instead depended on how much they estimated they needed to spend to acquire new clients. Salem Data Services managers believed that this expense would remain at least at the level it was in March, although they were evaluating whether higher expenditures were warranted. Although Flores was discouraged by results to date, he was reluctant to suggest to Wu that Salem Data Services be closed down or sold. He thought that the opportunity to have this subsidiary just seemed too good to give up easily. Besides, he was not Sure that the accounting report really revealed the contribution that Salem Data Services was making to Salem Telephone. In other situations he had reviewed in the past, 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 briey, Flores resolved to study them in preparation for asking Wu to estimate the possible effects on profits of increasing the price to customers other than Salem Telephone, reducing prices, and increasing sales efforts. Questions 1. "Revenue hours\" represent the key activity that drives costs at Salem Data Services. Which expenses in Exhibit 2 are variable with respect to revenue hours? Which expenses are fixed with respect to revenue hours? 2. For each expense that is variable with respect to revenue hours, calculate the cost per revenue hour. 3. Create a contribution margin income statement for Salem Data Services. Assume that intra- company usage is 205 hours. Assume commercial usage is at the March level. 4. Assuming the intracompany demand for service will average 205 hours per month, what level of commercial revenue hours of computer use would be necessary to break even each month? Since the intracompany demand is known to be 205 hours, the contribution from these sales is assured to cover a portion of the fixed costs. Thus, to determine the level of commercial revenue hours required to break even, the contribution from commercial sales only needs to cover the fixed costs remaining after subtracting the xed costs already covered by the contribution from intracompany sales. 5. Estimate the effect on income of each of the options Flores has suggested if Wu estimates as follows: o Increasing the price to commercial customers to $1,000 per hour would reduce demand by 30%. 0 Reducing the price to commercial customers to $600 per hour would increase demand by 30%. o Increased promotion would increase revenue hours by up to 30%. Wu is unsure how much promotion this would take. (How much could be spent and still leave Salem Data Services with no reported loss each month if commercial hours were increased 30%?) 6. Based on your analysis above, is Salem Data Services really a problem to Salem Telephone Company? What should Flores do about Salem Data Services? 104-086 Salem Telephone Company Exhibit 1 Salem Data Services Summary of Computer Utilization, First Quarter 2004 January February March Number of weekdays (M-F) 22 20 23 X 24 hours per day 528 480 552 Number of Saturdays 5 4 4 X 8 hours per day 40 32 32 Total hours available for revenue 568 512 584 Revenue hours Intracompany 206 181 223 Commercial 123 135 138 Total revenue hours 329 316 361 Hours available to sell 239 196 223 Source: Casewriter