Prestige Telephone Company (Solutions)

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
e!pectations. "evertheless, after two years of operation, Prestige Data Services has succeeded in
coming on line with services needed by the parent company and is selling e!cess hours of
capacity to outside customers at an increasing rate. The key issues relate to #uestions are
whether the reports presently being prepared provide information necessary to answer the
#uestions 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 #uite straightforward, it provides ample information and
data to analy$e three tasks which are critical to effective management accounting. %irst, to
analy$e the results of operations as they have been reported, and to understand the origin and
nature of receipts, revenues, e!penditures and e!penses. 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.
&nd 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.
Answer to Question 1:
'esult &ppraisal
Subsidiarys performance has not lived up to e!pectations
(owever, Prestige Data Services has succeeded in coming on line with services needed
by the parent company and is selling e!cess hours of capacity to outside customers at an
increasing rate
Shut Down v)s 'etention
'etention
Total *!pense + ,-... /0a!imum amount PData can charge from
PTelephone1
2oss of Subsidy + 3,,4-3 /net loss in 0arch 33,3-3 5 6,-.. /additional
loss7 ,8-..9,-...11
'evenue *arned + -::6; /space costs 8-:. 5 corporate services 3<-4;1
"et Cost + = 6<,,:<
Shutdown
>uying %rom ?utside + =36,:.. /intercompany hours for march --4
@market price ,..1
Sunk Cost + =:,<;.,... /noncancelable contract 8<...)month @ 3-mo.
@:yrs1
Increase in Total *!pense + = :64,:..
So, retaining PDS seems the better option.
Incremental Cost Analysis: Shut Down Prestige Data Services s! "etain the su#si$iary
The decision criterion is to shutdown the subsidiary and outsource the data services from
outside if the incremental cost of shutting down /relative to keeping the subsidiary1 is negative
i.e., incremental benefits are positive. Ae need to take into account opportunity costs rather than
reported or historical costs to perform this analysis. ?ne issue is to estimate the decision
hori$on. 2ets take it to be : years since the noncancelable leases on computer e#uipment have
four more years to run.
Answer to Question %:
Cost&volume&pro'it Analysis
Cost9volume9profit analysis of the subsidiary re#uires a break up of the costs into fi!ed
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 =:.<. per hour and the variable
portion of the operations wages is =-: per hour and the fi!ed portion of the operations wages is
=-3,;... Ae will assume that materials are offset by other revenue and therefore, can be
e!cluded from analysis. Ae will also assume that for the purposes of planning, sales promotion
e!penses are about =,,.,4 per month. %urther we will assume that =3<,-4; 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 fi!ed
costs for the subsidiary are7
8,-:.58<,...5<,:..5-<,<..5;,.5-3,;..53-,...58,...533,-..5,,.,453<,-4;+ -3-,848.
Power /=:.<. per hour1 and part of the operations wages /=-: per hour1 are the only
variable costs. Aith low variable costs /=-,.<. per hour1 to deduct from the commercial
revenues per hour /=,.. per hour1 each commercial hour sold generates a high contribution to
fi!ed costs and profit. In addition, the assumption that Prestige Telephone Company can always
cover =,-,... of the cost under its agreement with the Public Service Commission enables that
amount to be deducted directly from fi!ed cost in determining break9even volume. (ence, from
this analysis, it is easy to calculate a break9even volume as follows7
/Total %i!ed Costs1 2ess /&llowed Costs &fter Bariable Costs of Intercompany ?perations1 +
>reakeven (ours
Contribution per (our /,..9:.<.9-:1
= -3-,848 C D=,-,... C /-.< (ours ! =-,.<. + =<,,:41E + 366.-8(ours
=663.<.
366.-8 hours at =,.. per hour is e#ual to = 3:3,,4- of commercial revenue per month.
Answer to Question (:
*ach of the sets of assumptions in Fuestion G4 in the case offers the opportunity to
analy$e 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. ?nce that
analysis is accepted, each calculation is straightforward. & summary follows7
a. Increasing the price to commercial customers to =3,... per hour would reduce
demand by 4.H. In 0arch 3886, demand was for 34, hours, and a 4.H reduction
would leave demand of 86 hours /34, hours ! .6. + 8;.; hours1.
Demand ! Contribution per hour + Contribution
86 hours ! /=3,... 9 =-,.<.1 + =8:,-4;
Compare to present7
34, hours ! /=,.. 9 =-,.<.1 + =3.;,:;6
The monthly contribution to fi!ed costs and income at =,.. is greater by =3-,-43
than the contribution e!pected at =3,.... Therefore, the income will be higher if we
retain the =,..)hour price.
b. 'educing the price to commercial customers to =;.. per hour would increase demand
by 4.H. In 0arch 3886, demand was for 34, hours, so that a 4.H increase would
give demand of 368 hours /34, hours ! 3.4. + 368.: hours1.
368 hours ! /=;.. 9 =-,.<1 + =3.-,-88
Compared to present contribution of =3.;,:;6, a price reduction would apparently
reduce profit by =:,3;8 per month.
c. &n increase in promotion that would increase commercial sales by 4.H would
increase sales to 368 hours per month. &t =,.. per hour, the total contribution would
be7
368 hours ! /=,.. 9 =-,.<1 + =34,,.88
&n amount up to the difference between this new contribution and the present
contribution of =3.;,:;6 or =43,;4- could be spent without reducing income.
d. 'educing hours would reduce demand for commercial revenue hours by -.H, from
34, hours to 33. hours. &t that level, the total contribution would be7
33. hours ! /=,.. 9 =-,.<1 + =,:,,;< or =-3,;.- less than at present.
>ut what e!penses could be savedI *!cept for operations wages /and perhaps
materials and supplies1 it appears most other e!penses would not be affected by this
reduction of service and revenue. =-3,;.. of operating wages are nonvariable, so
perhaps one9third of that could be eliminated by going on two9shift operations rather
than three shifts. Savings of =6,-.. hardly offsets a loss of contribution of =-3,;.-,
so the option of giving up a shift appears not very attractive.
Answer to Question ):
PDS should show fi!ed and variable costs in its reports
Corporate services costs should be reported