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Retention
Total Expense = 82000 (Maximum amount PData can charge from PTelephone)
Loss of Subsidy = 18,321 (net loss in March 11,121 + 7,200 (additional loss: 89200-82000))
Revenue Earned = 24476 (space costs 9240 + corporate services 15236)
Net Cost = $ 75,845
Shutdown
Buying From Outside = $178400 (intercompany hours for march 223 *market price 800)
Sunk Cost = $4,560,000 (noncancelable contract 95000/month * 12mo. *4yrs)
Increase in Total Expense = $ 4738400
So, retaining PDS seems the better option.
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. One issue is to estimate
the decision horizon. Lets 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 fromthe parent companys point of view the opportunity costs or benefits to
shutting down thesubsidiary relative to keeping it. For example, if Prestige shuts down the
subsidiary it needs tooutsource data services from an outside vendor. What is an appropriate
estimate of theincremental 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, servicescurrently provided by
the parent company to Prestige Data etc.,. Think about these issues andcome up with a
recommendation as to whether the subsidiary should be shutdown or not.
Question 2
Cost-volume-profit Analysis
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 $8,083 per month. Further we will assume that
$15,236 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+8,083+15,236= 212,939.
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)
$ 212,939 [$82,000 (205 Hours x $28.50 = $5,843)] = 177.29Hours
$771.50
177.29 hours at $800 per hour is equal to $ 141,832 of commercial revenue per month.
Question 3
The analyses are dependent upon the cost analysis previously completed. Once that analysis
is accepted, each calculation is straightforward.
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.
Question 4
Currently PDS is using a full or absorption costing system which is a historical costing
method. The current method indicates that some cost inefficiencies could be embedded in the
value of the services provided and which is not reflecting the revenue expenses statement.
Moreover, there is an unused or excess capacity which is not yielding any revenue but for
which variable costs are expended. Moreover the resourcing model is a committed model
(because of the fixed capacity).
By using a simple ABC with Capacity measurement and analysis, PDS will get a more
accurate costing system that will provide a more accurate and quantitative data on the cost
allocation, measure how much of computer and resource time is being spent on PTC versus
other commercial usage customers. This will help to decide the final pricing to the
commercial usage customer as well as establish a proper transfer pricing to PTC.