Prestige Telephone Company – AIM 4343 – 02/09/04

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 subsidiary’s performance has not lived up to
expectations. Nevertheless, after two years of operation, Prestige Data Services has succeeded in
coming on line with services needed by the parent company and is selling excess hours of
capacity to outside customers at an increasing rate. The key issues relate to questions are
whether the reports presently being prepared provide information necessary to answer the
questions 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 quite straightforward, it provides ample information and
data to analyze three tasks which are critical to effective management accounting. First, to
analyze the results of operations as they have been reported, and to understand the origin and
nature of receipts, revenues, expenditures and expenses. 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.
And 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.

Incremental Cost Analysis: Shut Down Prestige Data Services Vs. Retain the subsidiary

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 subsidiary) is negative
i.e., incremental benefits are positive. We need to take into account opportunity costs rather than
reported or historical costs to perform this analysis. The first issue is to estimate the decision
horizon. Let’s take it to be 4 years since the noncancelable leases on computer equipment have
four more years to run. Now go down the list of revenues/costs in Exhibit 2 and estimate from
the parent company’s point of view the opportunity costs or benefits to shutting down the
subsidiary relative to keeping it. For example, if Prestige shuts down the subsidiary it needs to
outsource data services from an outside vendor. What is an appropriate estimate of the
incremental costs associated with this outsourcing?
Similarly you estimate lost contribution from commercial sales, incremental benefits or
cost savings from laying off people in the subsidiary, proceeds from sale of owned equipment,
benefits from possible alternative uses of space currently occupied by Data Services, services
currently provided by the parent company to Prestige Data etc.,. Think about these issues and
come up with a recommendation as to whether the subsidiary should be shutdown or not.

Cost-volume-profit Analysis

Assume the decision is to keep the subsidiary. Cost-volume-profit analysis of the

subsidiary requires a break up of the costs into fixed 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 $4.50 per hour and the variable portion of the operations wages is $24 per
hour and the fixed portion of the operations wages is $21,600. We will assume that materials are
offset by other revenue and therefore, can be excluded from analysis. We will also assume that
for the purposes of planning, sales promotion expenses are about $8,000 per month. Further we
will assume that $15,000 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 fixed costs for the subsidiary are:
9,240+95,000+5,400+25,500+680+21,600+12,000+9,000+11,200+8,000+15,000= 212,620.

Power ($4.50 per hour) and part of the operations wages ($24 per hour) are the only
variable costs. With low variable costs ($28.50 per hour) to deduct from the commercial
revenues per hour ($800 per hour) each commercial hour sold generates a high contribution to
fixed costs and profit. In addition, the assumption that Prestige Telephone Company can always
cover $82,000 of the cost under its agreement with the Public Service Commission enables that
amount to be deducted directly from fixed cost in determining break-even volume. Hence, from
this analysis, it is easy to calculate a break-even volume as follows:

(Total Fixed Costs) Less (Allowed Costs After Variable Costs of Intercompany Operations) = Breakeven Hours
Contribution per Hour (800-4.50-24)

$212,620 – [$82,000 – (205 Hours x $28.50 = $5,843)] = 176.88 Hours

$771.50

176.88 hours at $800 per hour is equal to $141,504 of commercial revenue per month.

Analyzing Options Discussed in Question 3

Each of the sets of assumptions in Question #3 in the case offers the opportunity to
analyze 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. Once that
analysis is accepted, each calculation is straightforward. A summary follows:

a. Increasing the price to commercial customers to $1,000 per hour would reduce
demand by 30%. In March 1997, demand was for 138 hours, and a 30% reduction
would leave demand of 97 hours (138 hours x .70 = 96.6 hours).

Demand x Contribution per hour = Contribution

97 hours x ($1,000 - $28.50) = $94,236

Compare to present:

138 hours x ($800 - $28.50) = $106,467

The monthly contribution to fixed costs and income at $800 is greater by $12,231
than the contribution expected at $1,000. Therefore, the income will be higher if we
retain the $800/hour price.

b. Reducing the price to commercial customers to $600 per hour would increase demand
by 30%. In March 1997, demand was for 138 hours, so that a 30% increase would
give demand of 179 hours (138 hours x 1.30 = 179.4 hours).
 179 hours x ($600 - $28.5) = $102,299

Compared to present contribution of $106,467, a price reduction would apparently

reduce profit by $4,169 per month.

c. An increase in promotion that would increase commercial sales by 30% would

increase sales to 179 hours per month. At $800 per hour, the total contribution would
be:

179 hours x ($800 - $28.5) = $138,099

An amount up to the difference between this new contribution and the present
contribution of $106,467 or $31,632 could be spent without reducing income.

d. Reducing hours would reduce demand for commercial revenue hours by 20%, from
138 hours to 110 hours. At that level, the total contribution would be:

110 hours x ($800 - $28.5) = $84,865 or $21,602 less than at present.

But what expenses could be saved? Except for operations wages (and perhaps
materials and supplies) it appears most other expenses would not be affected by this
reduction of service and revenue. $21,600 of operating wages are nonvariable, so
perhaps one-third of that could be eliminated by going on two-shift operations rather
than three shifts. Savings of $7,200 hardly offsets a loss of contribution of $21,602,
so the option of giving up a shift appears not very attractive.