Salem Telephone Co Case Solution

1. Which costs of Salem Data Services are fixed and which are variable? Make a list of each.

i. Fixed Costs

Fixed costs are expenses of Salem Data Services that remain constant, and have no relation to revenue hours. Fixed costs of Salem Data Services include:

Space Costs

• Rent

• Custodial services

Equipment Costs

• Computer leases

• Maintenance

• Depreciation

• Computer equipment

• Office equipment and fixtures

Wages and Salaries

• Operations: salaried staff

• Systems development and maintenance

• Administration

• Sales

• Sales promotion

• Corporate services

ii. Variable Costs

Variable costs are the costs that depend on revenue hours i.e., they increase or decrease with respective increase or decrease in revenue hours. Variable Costs of Salem Data Services include:

Equipment costs

• Power

Wages and Salaries

• Operations: hourly personnel

2. For each expense that is variable with respect to revenue hours, calculate the variable cost per revenue hour.

Variable costs of Salem Data Services are i) Power ii) Operations: hourly personnel. Variable cost per revenue hour can be calculated by simply dividing the monthly total variable costs by monthly total revenue hours.

Variable cost per revenue hour comes out to be 28.70.

3. Compute a contribution margin per hour of revenue using 205 hours of intra-company usage plus commercial usage at the March level. Based on this analysis, how many commercial hours does Salem Data need to sell in order to finally break even?

Contribution margin can be calculated by subtracting variable costs from the total revenue.

The contribution margin comes out to be $182,556.

To calculate the commercial hours Salem Data Services need to sell in order to break even, two methods can be used;

1. Using goal seek in excel

2. Using equation and solve for the value of commercial hours

Using Goal Seek

Salem Data Services needs to service 177.39 commercial revenue hours to break even. (Find calculations in the attached excel file).

Using Equation Method

(Intra - company hours x 400 + commercial hours x 800) – Variable cost per revenue hour x (intra - company hours + commercial hours) – total fixed expenses = 0

Let commercial hours = x

(205x400 + xx800) – 28.7x (205 + x) – 212939 = 0

x = (212939 - 82000 + 5884) / (800 - 28.7) = 177.39

Again, the number of commercial hours needed to break even is 177.39.

4. On page 3 of the case, look at question 5 and compute the effect on income of each of the options that Flores is suggesting to Wu as possible strategic alternatives.

Option 1: Increasing the price to commercial customers to $1,000 per hour, reducing the demand by 30%

The net income is further reduced by 12,612 to (42,995).

Option 2: Reducing the price to commercial customers to $600 per hour, increasing the demand by 30%

In this case, the net income is reduced by 3,948 to (34,332).

Option 3: Increasing the sales promotion, increasing the demand by 30%. How much could be spent and still leave Salem Data Services with no reported loss?

The net income comes out to be $1,548. Hence, in addition to the already spent $8,083, Salem Data Services can spend $1,548 additionally and still report no loss. In total, Salem Data Services can spend no more than 8,083 + 1,548 = $9,631 on sales promotion for a 30% increased demand without reporting losses.

5. Is Salem Data Services really a problem to Flores and Salem Telephone Company? Should Flores insist on any of the suggested options or just be more patient for Salem Data Services to get into the black?

To find the real value of Salem Data Services to Salem Telephone Company, it is necessary to find out how much contribution is Salem Data Services making to Salem Telephone Company and the costs Salem Data Services is saving for Salem Telephone Company. Salem Data Services serves 205 intra-company hours for Salem Telephone Company at the rate of $400. In the absence of Salem Data Services, Salem Telephone Company would purchase that from external companies at $800 (assuming Salem Data Services’ own commercial hours’ price as the market price). Hence, the incremental per hour cost to Salem Telephone Company will be $800 - $400= $400, and the incremental cost for 205 hours will be 205 x 400 = $81,600.