Salem Telephone Company -- Notes

Cost-volume-profit Analysis

The first five questions listed in the Salem Telephone case require a cost-volume-profit
analysis of Salem Data Service based on cost behavior inferred from the first 3 months data. The
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 the operations wages paid to hourly workers. It
can be estimated that power costs are about $4.70 per hour (there is a very, very small fixed
portion to the power costs and I have ignored that) and the variable portion of the operations
wages is $24 per hour.
There is no ambiguity with respect to other cost items, all of which are fixed within the
relevant range of revenue hours, except for sales promotion (which has no obvious relation to
revenue hours because it is a discretionary fixed cost) and corporate services which is an
allocated cost and appears to have no specific relationship to revenue hours. We will assume that
for the purposes of planning, sales promotion expenses are about $8,000 per month. Further we
will assume that $15,400 reimbursement for corporate services provided by Salem to its
subsidiary can be a reasonable estimate of the long run consumption of administrative resources
by Salem Data. The total relevant monthly fixed costs for the subsidiary can be computes as:
9,240+95,000+5,400+25,500+680+21,600+12,000+9,000+11,200+8,000+15,400= 213,020.
With the above break-up of costs, one can estimate total contribution made by data
services for a month with 138 commercial hours (based on March level) and 205 hours of intra-
company demand as (138 x (800-28.70) + 205 x (400-28.70)) = $182,556. Subtracting fixed
costs of $213,020 we get a net income of $(30,464).
Note that with low variable costs ($28.70 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 Salem Telephone Company can always
cover $82,000 (205 x 400) 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 (800-4.70-24)

$213,020 – [$82,000 – (205 Hours x $28.70 = $5,884)] = 177.5 Hours

$771.30

177.5 hours at $800 per hour is equal to $142,000 of commercial revenue per month.

Analyzing Options Discussed in Question 5

Each of the sets of assumptions in Question #5 in the case offers the opportunity to
analyze the effects of possible changes in demand due to changing price and promotion. 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 2004, 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 - $28.70) = $94,216

Compare to present:

138 hours x ($800 - $28.70) = $106,439

The monthly contribution to fixed costs and income at $800 is greater by $12,223
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 - $28.70) = $102,263

Compared to present contribution of $106,439, a price reduction would apparently

reduce profit by $4,176 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 - $28.70) = $138,063

The difference between this new contribution and the present contribution of
$106,439 or $31,624. The current loss based on March 2004 is $23,700. Therefore,
at most, 31,624 – 23,700 = $7,924 can be spent on additional promotion if the idea is
to break-even.

Question 6

Now the question is about the decision to shut-down or keep the subsidiary. For this we need to
understand the total cash flows for the combined Salem Telephone entity (Entity = Salem
Telephone + Salem Data) over a four-year time period starting from April 2004. We will work
with a decision horizon of 4-years because the non-cancelable leases had 4 years to run. Assume
that the remaining life of owned computer equipment and office equipment and fixtures is 4
years as of April 1, 2004 and they are being depreciated on a straight-line basis with no terminal
value at the end of life.

This is not a trivial exercise. Remember that historical costs and revenues are some times not
relevant when projecting future costs and benefits. You will have to think about a variety of
issues when you compute the incremental cash flows since you are dealing with future costs and
benefits that vary across the two alternatives. For instance, the magnitude of outsourcing costs
 and the magnitude of lost contribution from commercial sales when the subsidiary is shut down;
the savings from shutting down the subsidiary (which costs will stay and which will go away?),
resale value of equipment when the subsidiary is shut down, $ value of alternative uses of
company space vacated by Data Services when it is shut down, the magnitude of reduction in
corporate overhead when the subsidiary is shut down and so on.

Obviously, the projections will be dependent on your assumptions, anticipation of certain

managerial decisions and logical extrapolations of past data and expectations of future. That
said, there are reasonable forecasts and unreasonable forecasts. I have provided below an
example of an incremental analysis examining the relevant items. Incremental cash out flows in
brackets. High positive value for the cumulative cash flows will lead to a recommendation of
shutting down subsidiary and a high negative value for a recommendation of keeping it.

Estimating Incremental Cash flows from Shutting down the Subsidiary Relative to Keeping It
over a 4-year (48 month) period

 Outsourcing costs assuming that an average of 205 hours of IT will be outsourced at a rate of $800 per hour
to satisfy Salem Telephone’s needs – (note that the $400 transfer price used currently is way underestimating
the opportunity cost of outsourcing data services from outside)
= 48 x 205 x 800 = $ (7,872,000)
 Loss of commercial sales (conservatively keeping it at March 2004 levels of 138 hours) – if you build a trend
this may be higher
= 48 x 138 x 800 = $(5,299,200)
 Cost savings from the absence of variable costs related to commercial sales
= 48 x 138 x 28.70 = $190,100
 Cost savings from the absence of variable costs related to internal IT needs
= 48 x 205 x 28.70 = $ 282,400
 Cash flows from alternative use of facilities currently used by subsidiary assuming that $8,000 monthly rent
represents the value of this use
= 48 x 8000 = $384,000
 Cash flows from the absence of custodial services assuming parent company can realize these savings
= 48 x 1240 = $59,500
 Cost savings – computer leases
= $0 (assuming non-cancelable leases) – this number is irrelevant because it is the same across both
alternatives.
 Cash flows from the absence of maintenance services
= 48 x 5400 = $259,200
 Cash flows from the sale of owned computer equipment assuming it can be sold for book value.
Unfortunately book value is not known. Book value can be possibly estimated assuming that the equipment
has four years of life remaining with no salvage value and straight line depreciation
= 48 x 25,500 = $1,224,000
 Cash flows from the sale of owned office equipment and fixture assuming it can be sold for book value.
Book value is estimated assuming the equipment has four years of life remaining with no salvage value
= 48 x 680 = $32,600
 Savings from the absence of operations salaries
= 48 x 21,600 = $1,036,800
 Savings from the absence of systems development and maintenance salaries
= 48 x 12,000 = $576,000
 Savings from the absence of administration
= 48 x 9,000 = $432,000
 Savings from the absence of sales administration
= 48 x 11,200 = $537,600
 Savings from the absence of promotions assuming $8,000 of promotional expenses per month
= 48 x 8000 = $384,000
 Savings from the absence of corporate services assuming that expense reduction of $15,400 can be achieved
at corporate offices when subsidiary is shut down
= 48 x 15,400 = $ 739,200

Total incremental cash flows =$(7,033,800). The company will make $7 million less over the next four years
by shutting down the subsidiary when compared to keeping it. If you want to generate a possible range of
solutions, you can change the assumptions and check the sensitivity of the results.