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Salem Telephone Case 
 
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Salem Telephone Company / Salem Data Services

FINANCIAL ANALYSIS

Sunday, February 8, 2009

Presented By:

Steven Brown, Marilynn Homer, Anthony Thesing

BUS 5431 - Managerial Accounting – Spring1 2009

Professor Tim Muth

In 2001, Salem Telephone Company created a subsidiary, Salem Data Services (SDS). The intent of creating SDS was to provide a revenue stream to subsidize the telephone operations and alleviate the need for a rate increase.  Unfortunately, after 3 years, SDS has not met profit expectations. In fact, SDS continued to experience losses at the rate of $40-$45k per month making it necessary to reassess operations. While providing services to both internal and external customers, SDS found that their computer system had surplus capacity to support additional commercial sales.  Based on the amount of unsold monthly computer hours, Salem Data has about $190k of revenue potential from the commercial sales. With increasing pressure from shareholders and record low financial performance, Salem Telephone reexamined the current business model for SDS. However, Salem Data’s ability to reduce costs is limited based on 91% of expenses being fixed presents a challenge to overcome losses. The following analysis is an overview of performance, assessment of costs and estimates for possible effects of increasing profits concluded by a future recommendation for Sales Data Services.

During first quarter operations, Salem Data Services reported 90% of accrued costs were fixed with the remaining being variable.  Fixed costs included rent, custodial services, computer leases, equipment maintenance, depreciation, power, system development/maintenance, employee salaries. Salem Telephone also provides corporate services for processing accounts receivable and past-due accounts which fixes the cost paid out by SDS for an essential function of the company. Variable costs include hourly wages and sales promotion since they depend on the amount of business and can change with business activity.  Since these were the only variable costs, the cost per revenue hour was calculated (Figure 1) for both operations and sales during first quarter.

While January through March remained constant at a level of $24.00 per revenue for hourly operations, sales promotion per revenue hour went down $24.04 in January to $22.39 per revenue hour in March. As a result, expenses went down as revenue hours decreased. March, however, was the highest revenue generating month all quarter. SDS has focused their efforts to increase revenues by selling the available hours that are available to other companies to turn a higher profit.  In order to achieve higher sales and increase profits, Salem needs to focus its efforts on sales promotion. The extra revenue will cover the fixed costs and improve the profit outlook.

To estimate the impact of additional sales generated through promotion, a calculation of variable and fixed cost (Figure 2) was assessed to understand the impact of increasing activity by cost per hour for commercial and intra-company services. Fixed costs include space, equipment, wages and salaries. Variable costs are described as total hourly wages, sales promotion and corporate services divided by 205 estimated available intra-company hours resulting in $156 variable cost per hour. When compared to 138 commercial hours available in March, it is anticipated that SDS will yield better profits through reevaluating fixed cost allocation and promoting commercial services outside the company.  With these estimates in mind, SDS can project future costs to improve their margin.

A measure of the contribution (Figure 3) of all sales dollars generated through internal and external customers to cover fixed cost indicates that as sales increased in March variable costs increased in proportion. While sales have fluctuated with intra-company sales, commercial sales have continued to increase month over month indicating demand for the company’s services externally. However, combined sales demonstrate the company’s ability to generate profit as an estimated contribution margin of 0.17 will increase the total revenue stream by more than 1 million to break-even. (Figure 4) As commercial sales increase, SDS can assess whether their pricing decisions are contributing to profitability. An incremental analysis using the contribution margin has allowed the company to gain better perspective of their pricing model.

As pricing scenarios do not change fixed costs, a limited analysis was performed to test the controls on expenses. For example, charging commercial accounts $1,000/hr with a 30% reduction in demand would lead to the company being further in the red that it was previously. (Figure 5) On average, over a 3 month period, the company would lose about $12,000 more dollars per month. Therefore, $1,000/hr would not be a feasible option.  Another pricing example is charging commercial accounts $600/hr with a 30% uplift in demand. Unfortunately, this scenario would also not sustain the company either and would put SDS further in the red by about $3,000 per month.  The only feasible option is to charge commercial accounts $800/hr with 30% uplift in demand through increased spending on promotion.

Because SDS has a high level of fixed costs they also have a high level of operating leverage. SDS has an extreme situation where fixed costs made up of set space, equipment and salaries. Mr. Flores should reassess such costs as equipment and salaries for expense line items such as salary creep, better maintenance agreements and equipment expenditures. Also, if necessary, replace salaried employees with more automated processes. SDS can operate less equipment with part-time employees that would further reduce salaries/wages and gain slight savings in power.  SDS can control their operating leverage and can control its affects on profits when sales fluctuate through determining the mix of fixed and variable cost levels. For example, by increasing sales by 25%, profit as percent of sales will be a 10.5% go ahead for the company. (Figure 6)

In conclusion, SDS is assessed as a risky new venture for Salem Telephone Company due to fluctuations in profit and, more specifically, with sluggish intra-company sales. SDS should decrease fixed costs and continue to operate concentrating on the market that has the most potential for growth - commercial sales. Allocating more money into effective marketing and promotions, controlling fixed costs and increasing sales revenues will allow SDS to evaluate resource constraints. SDS should evaluate shifts to the contribution margin per hour and focus on commercial sales that will produce the most return on investment while covering costs and ultimately generating profit.

APPENDIX

Figure 1:

      For each expense that is variable with respect to revenue hours, calculate the cost per revenue hour. Numbers are divided by total revenue hours actually completed and used.

      Operations on the hourly level:

          January:        $7,896/329 = $24.00 per revenue hour

          February:        $7,584/316 = $24.00 per revenue hour

          March:        $8,664/361 = $24.00 per revenue hour

      Sales Promotion:

          January:        $7,909/329 = $24.04 per revenue hour

          February:    $7,039/316 = $22.28 per revenue hour

          March:        $8,083/361 = $22.39 per revenue hour

Figure 2:

|Variable Cost Estimate:                               |             |
|  |Hourly Wages                                      |$8,664       |
|  |Sales Promotion                                   |$8,083       |
|  |Corporate Services                                |$15,236      |
|  |                                                  |$31,983      |
|  |Intra-Company Usage Hrs                           |205          |
|  |Intra-Company VC per Hour                         |$156         |
|  |                                                  |             |
|  |Commercial Usage Hrs                              |138          |
|  |Commercial VC per Hour                            |$232         |
|Fixed Cost Estimate:                                  |             |
|  |Space Costs                                       |$9,240       |
|  |Equipment Cost                                    |$128,277     |
|  |Wages & Salaries                                  |$53,800      |
|  |Total Fixed Cost (March)                          |$191,317     |

Figure 3:

|Contribution Margin Income Statement                           |   |             |   |             |   |                 |
|                 |                                                                      |January          |                   |February          |             |
|Scenario 1       |Charge Commercial Accounts $1000/hr with a 30% Reduction in Demand    |($53,895)        |($54,187)          |($37,500)         |             |
|Scenario 2       |Charge Commercial Accounts $600/hr with a 30% Uplift in Demand        |($44,055)        |($43,387)          |($26,460)         |             |
|Scenario 3       |Charge Commercial Accounts $800/hr with a 30% Uplift in Demand through|($12,075)        |($8,287)           |$9,420            |*            |
|                 |increased spending on Promotion                                       |                 |                   |                  |             |
|                 |                                                                      |                 |                   |                  |             |
|* Salem Data could spend an additional $9,420 for Sales promotion and still break even.                                        |                  |             |

$1000hr 30%   |                 |$600/hr, 30% >   |                 |Demand           |
|                              |                 |Demand           |                 |Demand           |                 |                 |
|Number of weekdays (M-F)      |22               |22               |20               |20               |23               |23               |
|X 24 hours/day                |528              |528              |480              |480              |552              |552              |
|                              |                 |                 |                 |                 |                 |                 |
|Number of Saturdays           |5                |5                |4                |4                |4                |4                |
|X 8 hours/day                 |40               |40               |32               |32               |32               |32               |
|                              |                 |                 |                 |                 |                 |                 |
| Hrs avail. for revenue       |568              |568              |512              |512              |584              |584              |
|                              |                 |                 |                 |                 |                 |                 |
|Revenue Hours                 |                 |                 |                 |                 |                 |                 |
|Intra-Company                 |206              |206              |181              |181              |223              |223              |
|Commercial                    |123              |160              |135              |176              |138              |179              |
|Total Revenue Hrs             |329              |366              |316              |357              |361              |402              |
|                              |                 |                 |                 |                 |                 |                 |
|Hrs Avail. to Sell            |239              |202              |196              |156              |223              |182              |
|                              |                 |                 |                 |                 |                 |                 |
|                              |                 |                 |                 |                 |                 |                 |
|                              |                 |                 |                 |                 |                 |                 |
|                              |                 |                 |                 |                 |                 |                 |
|                              |                 |                 |                 |                 |                 |                 |
|                              |                 |                 |                 |                 |                 |                 |
|Revenues                      |                 |                 |                 |                 |                 |                 |
|Intra-Company Sales           |$82,400          |$82,400          |$72,400          |$72,400          |$89,200          |$89,200          |
|Commercial Sales              |$98,400          |$95,940          |$108,000         |$105,300         |$110,400         |$107,640         |
|Total Revenue                 |$180,800         |$178,340         |$180,400         |$177,700         |$199,600         |$196,840         |
|                              |                 |                 |                 |                 |                 |                 |
|Expenses                      |                 |                 |                 |                 |                 |                 |
|Space Costs                   |                 |                 |                 |                 |                 |                 |
|Rent                          |$8,000           |$8,000           |$8,000           |$8,000           |$8,000           |$8,000           |
|Custodial Services            |$1,240           |$1,240           |$1,240           |$1,240           |$1,240           |$1,240           |
|                              |$9,240           |$9,240           |$9,240           |$9,240           |$9,240           |$9,240           |
|                              |                 |                 |                 |                 |                 |                 |
|Equipment Costs               |                 |                 |                 |                 |                 |                 |
|Computer Leases               |$95,000          |$95,000          |$95,000          |$95,000          |$95,000          |$95,000          |
|Maintenance                   |$5,400           |$5,400           |$5,400           |$5,400           |$5,400           |$5,400           |
|Depreciation                  |                 |                 |                 |                 |                 |                 |
|Computer Equipment            |$25,500          |$25,500          |$25,500          |$25,500          |$25,500          |$25,500          |
|Office Equip. / Fixtures      |$680             |$680             |$680             |$680             |$680             |$680             |
|Power                         |$1,546           |$1,546           |$1,485           |$1,485           |$1,697           |$1,697           |
|                              |$128,126         |$128,126         |$128,065         |$128,065         |$128,277         |$128,277         |
|                              |                 |                 |                 |                 |                 |                 |
|Wages and Salaries            |                 |                 |                 |                 |                 |                 |
|Salaried Staff                |$21,600          |$21,600          |$21,600          |$21,600          |$21,600          |$21,600          |
|Hourly Personnel              |$7,896           |$7,896           |$7,584           |$7,584           |$8,664           |$8,664           |
|Sys. Dev.  / Maintenance      |$12,000          |$12,000          |$12,000          |$12,000          |$12,000          |$12,000          |
|Administration                |$9,000           |$9,000           |$9,000           |$9,000           |$9,000           |$9,000           |
|Sales                         |$11,200          |$11,200          |$11,200          |$11,200          |$11,200          |$11,200          |
|                              |$61,696          |$61,696          |$61,384          |$61,384          |$62,464          |$62,464          |
|                              |                 |                 |                 |                 |                 |                 |
|                              |                 |                 |                 |                 |                 |                 |
|Sales Promotion               |$7,909           |$7,909           |$7,039           |$7,039           |$8,083           |$8,083           |
|Corporate Services            |$15,424          |$15,424          |$15,359          |$15,359          |$15,236          |$15,236          |
|Total Expenses                |$222,395         |$222,395         |$221,087         |$221,087         |$223,300         |$223,300         |
|                              |                 |                 |                 |                 |                 |                 |
|Net Income                    |($41,595)        |($44,055)        |($40,687)        |($43,387)        |($23,700)        |($26,460)        |

30% Uplift with SDS Promotion:

|                                         |January             |
|  |Total Profit                         |-$23,700            |
|  |Total Sales                          |$199,600            |
|  |                                     |-11.9%              |
|If sales increase monthly by 25%, profit as a percent of      |
|sales:                                                        |
|  |Total Sales (March)                  |$199,600            |
|  |Increase of Sales                    |25.00%              |
|  |                                     |$49,900             |
|  |Sales  plus 15%                      |$249,500            |
|  |Less Variable Cost                   |$31,983             |
|  |                                     |$217,517            |
|  |Less Fixed Costs                     |$191,317            |
|  |Profit                               |$26,200             |
|  |Profit as Percent of Sales           |10.5%               |
 
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