Salem Telephone Co., a computer subsidiary, has been losing profits. Its managers are tasked with determining if it is actually unprofitable. Likewise, they must look into price changes and other promotions which might help increase the profits.
William J. Bruns Jr.; Julie H. Hertenstein
Harvard Business Review (104086-PDF-ENG)
June 07, 2004
Case questions answered:
- Which expenses are variable and fixed with respect to revenue hours?
- Calculate the cost per hour for each variable expense.
- Prepare a contribution margin statement for Salem Data Services, assuming that intra-company usage is 205 hours. Assume commercial usage is at the march level.
- Assuming the inter-company 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?
- Estimate the effect of income of each of the options Flores has suggested if Wu estimates as follows:
Option 1: Increasing the price for commercial customers to $1000 per hour would reduce demand by 30%.
Option 2: Reducing the price for commercial customers to $600 per hour would increase demand by 30%.
Option 3: Increased promotion would increase revenue hours by up to 30%. Wu is unsure how much this promotion would take (How much could be spent and still leave Salem data services with no reported loss each month if commercial hours were increased by 30%). - Based on your analysis above, is Salem Data Service really a problem for Salem Telephone Co.? What should Flores do about Salem Data Service?
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Salem Telephone Co. Case Answers
Q.1: Which expenses are variable and fixed with respect to revenue hours?
Answer:
Variable expenses:
- Power Expense
- Operations: Hourly personnel
Fixed Expenses:
- Rent Expense
- Custodial service
- Computer leases
- Maintenance
- Depreciation:
Computer equipment
Office equipment
- Operations Salaried Staff
- System development and maintenance
- Administration
- Sales
- Sales promotions
- Corporate services
Q.2: Calculate the cost per hour for each variable expense.
Answer:
Q.3 Prepare a Contribution margin statement for Salem Data services, assuming that intracompany usage is 205 hours. Assume commercial usage is at the march level.
Answer:
Income statement for Salem Data Services. From the article, I know that intracompany work was billed at $400 per hour, and commercial sales were billed at $800 per hour.
So, intracompany contribution margin: $400-$28.7= $371.3/hour while Commercial contribution margin: $800-$28.7=$771.3/hour
Salem Data Service
Contribution Margin statement
For the month ended March 2004
Q.4 Assume the intercompany 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?
Answer:
Break-even point = Fixed costs/ CM per unit
Let’s suppose A is the commercial revenue hours to break even
Sales revenue per unit = $82,000/205= $400.00
Variable cost per unit = $9,844.10/343= $28.70
(205 x $400 + A x $800) – 28.70 x (205 + A) – 212,939 = 0
82,000 + 800A – 28.70A – 5883.50 – 212,939 = 0
-136,822.50 + 771.30A = 0
771.30 A = 136,882.50
A = 177.39
Salem Data Services would need 177.39 commercial hours to break even each month.
Q.5 Estimate the effect of income of each of the options Flores has suggested if Wu estimates as follows:
Answer:
Option 1: Increasing the price for the commercial customer to $1000 per hour would reduce demand by 30%.
Original March data
P= Net Income= ($23,700)
For option 1:
Commercial revenue hours 138
A 30% decrease in demand would result in revenue hours of:
138*0.3= 41.4
138-41.4= 96.6 hours
Commercial revenue per hour cost increased to $1000/hour, and for intracompany, cost per hour would be the same as no assumption is given for intracompany.
205+96.6= 301.6 hours in total to calculate Variable cost.
Commercial revenue 96.6(1000) = $96,600
Intra-company revenue 205 (400) =$82,000
Less Variable cost 301.6 (28.7) = ($8655.92)
Less Fixed cost = ($212,939)
Net income= Revenue-Variable cost- fixed cost
Net income= ($42,994.2)
Option 2: Reducing the price for commercial customers to $600 per hour would increase demand by 30%.
Commercial revenue hours 138
With a 30% increase in demand would result in revenue hours of:
138*0.3= 41.4
138+41.4= 179.4 hours
Commercial revenue per hour cost decreased to $600/hour, and for intracompany, cost per hour would be the same as no assumption is given for intracompany.
205+179.4= 384.4 hours in total to calculate Variable cost.
Commercial revenue 179.4(600) = $107640
Intracompany revenue 205 (400) =$82,000
Less Variable cost 384.4(28.7) = ($11032.82)
Less Fixed cost = ($212,939)
Net income= Revenue-Variable cost- fixed cost
Net income= ($34331.28)
Option 3: Increased promotion would increase revenue hours by up to 30%. Wu is unsure how much this promotion would take (How much could be spent and still leave Salem data services with no reported loss each month if commercial hours were increased by 30%).
Commercial revenue hours 138
With a 30% increase in demand would result in revenue hours of:
138*0.3= 41.4
138+41.4= 179.4 hours
Assuming commercial per-hour costs are $800 because there is no price assumption, take the original per-hour cost. The intracompany cost per hour would be the same as no assumption is given for intracompany.
205+179.4= 384.4 hours in total to calculate Variable cost.
Commercial revenue 179.4(800) = $143,520
Intracompany revenue 205 (400) =$82,000
Less Variable cost 384.4(28.7) = ($11032.82)
Less Fixed cost = ($212,939)
Net income= Revenue-Variable cost- fixed cost
Net income= $1548.72
For options 1 and 2, the company would be in a loss, and for option 3, if the company is still spending $1548.72, there would be no loss to the company spending more than $1548.72, which will result in a loss. It could be spent on either sales promotion or corporate services costs.
Q.6: Based on your analysis above, is Salem Data service really a problem for Salem Telephone Co.? What should Flores do about Salem Data Service?
Answer:
Based on my analysis above, I can say that Salem Telephone Co. should keep Salem’s data service. This is a new startup, so every new start-up business faces losses at the beginning because customers are less -aware of the product/service, and awareness takes time.
Slowly and gradually, its loss is decreasing. From Exhibit 2, we can see that from February to March, loss has decreased by almost $17000.
Salem data service has huge fixed costs, and profits are not in the beginning months. Salem Telephone should keep Salem data service. If not, then they could save fixed costs, but they have to pay/spend money for purchasing intracompany revenue hours.
If Salem data service is closed, then the situation would be like this:
Salem company would save the cost of ($86884), but he would purchase intracompany hours of $164,000.
Flores should continue to operate Salem Data Company. They should focus more on marketing strategies to make customers more aware of their service. Also, they should revise their cost strategies to decrease fixed expenses and increase profits.
They should apply the pricing strategy of option 2 in the 5th question to decrease per hour price, so this would increase demand by 30% or more percentage. As the price is reduced, automatically, it will increase sales and will take the company towards profits.
Another thing they can do is to prepare budgets where commercial revenue hours will be forecasted, and the decision could be made that makes the company profitable.
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