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 Serive Commission had permitted Salem Telephone to establish Salem Data Serivices, a computer data service subsidiary, to perform data processing for the telephone company and to sell computer seriice to other companies and organizations. It was necessary for these two companies to be separate because Salem Telephone was a a regulated utility, and Salem Data Services was an unregulated company. Flores had told the Public Service Commision 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 Telphone management realized that other businesses in the metropolitan region needed similar services and that centrailized services could be provided over telephone circuits they suggest that Salem Telephone could sell computer time not needed by telephone operations. In addition, the state Public Service Commission had encouraged all public utlities under its jurisdiction to seek new sources of revenue and profits to reduce the need for rate increases that higher cost 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 service would not be regulated. In this way, Salem Data Services could compete with other computer service organizations in a dynamic field. The commision 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 use 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 oter for services received from the other.

Salem Data Services started operations in 2001, and as was typical for most start-us, 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 utlitlization 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.

Computer equipment had been acquired by lease and by purchase; 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 commerical clients, were also salaried, as were the adminstrators 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 facors 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 instend depended on how much they estimated they needed to spend to acquire new clients. Salem Data Serices manager 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 tend to obscure the costs and benefits they provided.

After examining the reports briefly, Flores resolved to study them in preparation for asking Wu to estimate the possible effects on profits of increasing the price to customoers other than Salem Telephone, reducing prices, and increasing sales efforts.

1. What should Flores do?

As you think about your answer to this question, keep the following questions in your mind: 1) Is it feasible to achieve profitability with Commercial usage? What is the evidence that supports your conclusion? 2) What would happen if Flores did not do anything? 3) How much fixed cost does Commercial cover? 4) What were the original reasons that Salem Telephone formed Salem Data services? Have they achieved these goals?

In responding to this final question, which relates your analysis to the strategic implications and management decisions for Salem Telephone, make sure you integrate the thinking from all activities related to this case including data and trends from the case, your calculations and analysis, and what you have learned from ICE's and presentations.

Exhibit 1 Salem Data Services Summary of Computer Utilization, First Quarter 2004 January February March 22 528 20 480 23 552 5 40 4 32 4 32 Total hours available for revenue 568 512 584 Revenue hours Intracompany Commercial Total revenue hours 206 123 329 181 135 316 223 138 361 Hours available to sell 239 196 223 Number of weekdays (M-F) X 24 hours per day Number of Saturdays X 8 hours per day Source: Casewriter. Exhibit 2 Salem Data Services Summary Results of Operations, First Quarter 2004 January Revenues Intracompany sales Commercial sales Total revenue February March $82,400 98,400 $180,800 $72,400 108,000 $180,400 $89,200 110,400 $199,600 $8,000 1,240 9,240 $8,000 1,240 9,240 $8,000 1,240 9,240 95,000 5,400 95,000 5,400 95,000 5,400 25,500 680 1,546 128,126 25,500 680 1,485 128,065 25,500 680 1,697 128,277 21,600 7,896 12,000 9,000 11,200 61,696 21,600 7,584 12,000 9,000 11,200 61,384 21,600 8,664 12,000 9,000 11,200 62,464 Sales promotion Corporate services Total expenses 7,909 15,424 $222,395 7,039 15,359 $221,087 8,083 15,236 $223,300 Net income (loss) ($41,595) ($40,687) ($23,700) Expenses Space costs: Rent Custodial services Equipment costs Computer leases Maintenance Depreciation: Computer equipment Office equipment and fixtures Power Wages and salaries Operations: salaried staff Operations: hourly personnel Systems development and maintenance Administration Sales Source: Casewriter