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 atthe 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 thereports 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, toanalyze 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, tounderstand 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 dataservices 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 equipmenthave 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 costsassociated 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 issuesand come up with a recommendation as to whether the subsidiary should be shutdown or not.
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 estimatedthat 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...