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SUMMARY Salem Telephone Company operates as a regulated public utility. The state Public Service Commission (PSC) permitted Salem to establish a wholly owned subsidiary to provide computer services to other companies for a profit. The reason for the separate entities was so Salem Data Services could sell services unregulated and Salem Telephone could operate without raising rates. In 2000, the initial report to the PSC from the president of Salem Telephone was to convince them that the public entity, Salem Data Services, would become profitable and would end the need to raise telephone rates. By 2003, Salem Data had not turned a profit. Mr. Flores requested a meeting with the manager of Salem Data, Ms. Wu, so some type of action would be taken to reduce the drain on Salem Telephone Company resources (Bruns, Jr. & Hertenstein, 2005). The analysis that follows will show that Salem Data Services will not be a problem to Salem Telephone and eventually make a profit by spending more on promotional activities to increase commercial hours, and by moving fixed costs into variable costs.

ANALYSIS Salem Datas variable expenses with respect to revenue hours are power expense and hourly salary. Their fixed expenses for revenue hours are rent, custodial services, computer

2 leases, maintenance, depreciations of computer and office equipment and fixture, operations salaried staff, system development and maintenance, administration, sales, sales promotion and corporate services (Exhibit 3).

Salem Data Services cost of power per revenue hour is $4.70. The hourly cost of personnel per revenue hour is $24. Therefore, the total variable cost per hour was $28.70 (Exhibit 2). The contribution margin statement (Exhibit 4) is based on the assumption of intracompany usage of 205 hours and commercial usage at the March level (138 hours). The contribution margin was $189,239. With total fixed cost at $212,939, the net income was a loss of -$23,700. Salem Data Services has a break-even point of 177.39 for commercial hours (Exhibit 5) and 205 intracompany hours. Increasing the number of commercial hours will cover the fixed costs. Salem Data Services should increase the number of hours from 138 to 177.39 at a minimum. The following is the effect on income for the three options that Mr. Flores suggested to Ms. Wu (Exhibit 6): Option 1 With the assumption that if the price to commercial customers should increase to $1,000 per hour, demand would be reduced by 30% is validated by the view of net income loss of -$42,606. The contribution margin increases because price per hour has lowered. Option 2 The assumption for this option is that reducing the price to commercial customers to $600 per hour would increase demand by 30%. The contribution margin increased because the price per hour lowered and that increased demand. Salem continues to have a net loss of -

3 $33,989. Option 3 This option has Salem Data increasing their promotion budget with the assumption that revenue hours would be increased by 30%. Salem Data can increase the promotional expense to $40,654 to increase the revenue hours by 30%. This will lead to a positive net income of $2,012. CONCLUSION Salem Data Services has a large amount of fixed costs that reduces the overall profit. Neither increasing the price to $1,000 nor reducing to $600 would prevent a net loss. Salem Data Services should increase their promotional costs by $2,012 (in addition to the $8,083 spent in March) which would help them to get to a net income in positive range. Salem Data Services does not have the potential to become a problem for Salem Telephone. The infrastructure is in place for Salem Data Services to start showing a profit but as more competition enters in the field it will become increasingly difficult. In addition, Salem Telephone should continue to use Salem Data since outsourcing the 205 intracompany hours would amount to $164,000 (based on $800 per hour). In evaluating the fixed expenses that Salem Telephone would save if they closed Salem Data, a savings in $85,644. If this happened, Salem Telephone would still have to pay $78,356 ($164,000 - $85,644) so it makes sense to continue the intracompany relationship with Salem Data Services. In summary, Mr. Flores should increase promotional activities with a budget increase of $2,012 and convert fixed costs into variable costs. These changes with help Salem Data Services become profitable.

4 References Jiambalvo, J. (2010). Managerial accounting. (4 ed.). Hoboken, NJ: John Wiley & Sons, Inc. Bruns, Jr., W., & Hertenstein, J. (2005). Salem telephone company. Harvard Business School

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