Case Scenario:
In April 2008, Galen Williams, president of the Medical Insurance Company, was preparing for a meeting with Robin Lane, manager of MedCo Billing Services. MedCo Billing Services was a subsidiary of the Medical Insurance Company, a completely separate company that was wholly owned by the Medical Insurance Company. An agreement with the state of New Hampshire Insurance Commission had permitted Medical Insurance to establish MedCo Billing Services, a computer invoicing and billing service subsidiary, to perform billing processing for the insurance company and to sell computer billing services to other insurance companies and organizations. It was necessary for these two companies to be separate companies because Medical Insurance was a regulated business, and MedCo Billing Services would be an unregulated company. Mr. Williams had told the Insurance Commission in 2004 that a profitable computer billing services subsidiary would reduce pressure for insurance rate increases. However, by the end of 2007 MedCo Billing Services had yet to experience a profitable month. Ms. Lane felt the business was progressing well, and only more time was needed until MedCo Billing Services showed a profit, but Williams felt action was necessary to reduce the drain on Medical Insurance Company resources.
MedCo Billing Services had grown out of the needs of Medical Insurance Company for computer services to invoice, collect, and account for its own operations in the metropolitan region it served. However, when Medical Insurance management realized that other insurance companies in the metropolitan region needed similar services and that a centralized computer service could be provided over existing internet portal networks, they suggested that MedCo could sell computer time not needed by the insurance operations. In addition, the state Insurance Commission had encouraged all insurance companies under its jurisdiction to seek new sources of revenue and profits to reduce the need for rate increases that higher costs would otherwise bring.
Because it operated as a regulated business, the rates charged by the Medical Insurance Company for insurance could not be changed without the approval of the Insurance Commission. In presenting the proposal for the new subsidiary, Mr. Williams had argued for a separate but wholly owned company whose prices for service would not be regulated. In this way, MedCo Billing Services could compete with other computer billing service organizations in a dynamic field. The commission accepted this proposal subject only to the restriction that the average monthly charges for services provided by MedCo Billing Services to Medical Insurance not exceed $82,000, the estimated cost of equivalent services used by Medical Insurance Company in 2004. To maintain the separation between Medical Insurance and its unregulated subsidiary, all accounts of MedCo Billing Services were separated from those of Medical Insurance and each paid the other for services received from the other.
MedCo Billing Services started operations in 2005, and as was typical for most start-ups, there had been some problems. Equipment deliveries were delayed. Personnel had commanded higher salaries than expected. And most important, customers were harder to find than earlier estimates had led the company to expect. By the end of 2007, most of these problems had been overcome.
In 2007, the income of Medical Insurance was so low that the report to shareholders revealed the lowest return on investment in seven years. At that time, Williams felt it was necessary to reassess MedCo Billing Services. Robin Lane had asked for more time, as she felt MedCo Billing Services would be profitable by March. But when the quarterly reports came out (Exhibits 1 and 2), Williams called Lane to arrange their meeting.
Galen Williams received two reports on operations of MedCo Billing Services. The summary of computer utilization Exhibit 1 showed the hours of computer time that were available and how they were used. Computer service was offered to commercial customers 24 hours a day on weekdays and eight hours on Saturdays. An outside contractor who took the computer off-line for eight hours each week for testing provided routine maintenance of the computers and upkeep during the weekend shifts not used for commercial customers. The reports for the quarter revealed a persistent problem; the hours still available to sell (as shown in Exhibit 1), which did not provide revenue, remained high.
Revenue and expenses were summarized in the quarterly report on results of operations (Exhibit 2). Intracompany work was billed at $400 per hour, a rate based on usage estimates for 2005 and the Insurance Commission’s restrictions that cost to Medical Insurance should not exceed an average of $82,000 per month. Commercial sales were billed at $800 per hour.
While most expenses summarized in the report were self-explanatory, Williams reminded himself of the characteristics of a few. Space costs were all paid to Medical Insurance. MedCo Billing Services rented the ground floor of a central office building owned by Medical Insurance for $8,000 per month. In addition, MedCo Billing Services paid a charge for custodial service based on Medical Insurance’s estimated annual cost per square foot, as Medical Insurance Company personnel provided these services.
Computer equipment had been acquired by lease and by purchases; leases had four years to run and were noncancelable. Owned equipment was all saleable but probably could not bring more than its book value in the used equipment market.
Wages and salaries were separated in the report to show the expense of five different kinds of activities. Operations salaries included those of the six persons necessary to run the center around the clock; in addition there were operations wages paid hourly workers who were required when the computer was in operation. Salaries of the programming staff that provided service to clients and maintained the operating system were reported as system development and maintenance. Sales personnel, who called upon and serviced present and prospective commercial clients, were also salaried, as were the administration of MedCo Billing Services.
Because of its relationship with Medical Insurance, MedCo Billing Services was able to avoid many costs an independent company would have. For example, Insurance Company personnel did all payroll, billing, collections, and accounting. For those items, which are shown in Exhibit 2 as corporate services, MedCo Billing Services paid Medical Insurance an amount based on factors such as total wages and salaries, total accounts receivable, and the number of past due accounts.
Finally, sales promotion was the amount that the managers chose to spend on advertising and the other promotional activities that they used to inform prospective clients of their services, and to support the activities of their sales personnel. This amount was not related to the current level of work, but instead depended on how much they estimated they needed to spend to acquire new clients. MedCo Billing Services managers believed that this expense would remain at least at the level it was in March, although they were evaluating whether higher expenditures were warranted.
Although Williams was discouraged by results to date, he was reluctant to suggest to Lane that MedCo Billing Services be closed down or sold. He thought that the opportunity to have this subsidiary just seemed too good to give up easily. Besides, he was not sure that the accounting report really revealed the contribution that MedCo Billing Services was making to Medical Insurance. In other situations he had reviewed in the past, he felt that the procedures used in accounting for separate activities in the company tended to obscure the costs and benefits they provided.
After examining the reports briefly, Williams resolved to study them in preparation for asking Lane to estimate the possible effects on profits of increasing the price to customers other than Medical Insurance, reducing prices, and increasing sales efforts.
Questions to Guide the Analysis
1. “Revenue hours” is the key activity that drives costs at MedCo Billing Services. Which expenses in Exhibit 2 are variable with respect to revenue hours? Which expenses are fixed with respect to revenue hours? Explain why each expense was chosen as such.
2. For each expense that is variable with respect to revenue hours, calculate the cost per revenue hour.
3. Create a contribution margin income statement for MedCo Billing Services. Assume that intra-company usage is 205 hours. Assume Commercial usage is at the March level. This statement therefore, will not reflect any specific time period but will be used as the company’s basis for future analysis.
4. Assuming the intra-company demand for service will average 205 hours per month, what level of commercial revenue hours of computer use would be necessary to break even each month?
Since the intra-company demand is known to be 205 hours, the contribution from these sales is assured to cover a portion of the fixed costs. Thus, to determine the level of commercial revenue hours required to break even, the contribution from the commercial sales only needs to cover the fixed costs remaining after subtracting the fixed costs already covered by the contribution from intra-company sales.
5. Estimate the effect on net income for MedCo Billing Services for each of the options Williams has suggested if Lane estimates as follows:
• (A) Increasing the price to commercial customers to $1,000 per hour would reduce demand by 30%.
• (B) Reducing the price to commercial customers to $600 per hour would increase demand by 30%.
• (C) Increased promotion would increase revenue hours by up to 30%. Lane is unsure how much promotion this would take. (How much could be spent and still leave MedCo Billing Services with no reported loss each month if commercial hours were increased by 30%?)
Since the intra-company usage is known to be 205 hours (as used in question 3), use this in your analysis and comparison of the options above.
6. Based on your analysis of this case, is MedCo Billing Services really a problem to the Medical Insurance Company?
If you were Galen Williams what would you do about MedCo Billing Services? Further, when answering this question, make sure that you put yourself in Williams’ shoes and think of your response to this question as he would think about it from his point of view. What financially does he know and what does it mean to him as he tries to make his decision?
Support your statements/responses to the above two questions with a quantitative presentation or calculations wherever possible
Exhibit 1 MedCo Billing Services Computer Utilization Summary, First Quarter 2008
|
|
January
|
February
|
March
|
|
Number of weekdays (M-F)
|
22
|
20
|
23
|
|
x 24 hours per day
|
528
|
480
|
552
|
|
Number of Saturdays
|
5
|
4
|
4
|
|
x 8 hours per day
|
40
|
32
|
32
|
|
Total hours available for revenue
|
568
|
512
|
584
|
|
Revenue hours
|
|
|
|
|
Intra-company
|
206
|
181
|
223
|
|
Commercial
|
123
|
135
|
138
|
|
Total revenue hours
|
329
|
316
|
361
|
|
Hours available to sell
|
239
|
196
|
223
|
Exhibit 2 MedCo Billing Services Results of Operations Summary, First Quarter 2008
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|
January
|
February
|
March
|
|
Revenues
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|
|
|
|
Intra-company sales
|
82,400
|
72,400
|
89,200
|
|
Commercial sales
|
98,400
|
108,000
|
110,400
|
|
Total Revenue:
|
$180,800
|
$180,400
|
$199,600
|
|
Expenses
|
|
|
|
|
Space costs:
|
|
|
|
|
Rent
|
8,000
|
8,000
|
8,000
|
|
Custodial services
|
1,240
|
1,240
|
1,240
|
|
|
9,240
|
9,240
|
9,240
|
|
Equipment Costs
|
|
|
|
|
Computer leases
|
95,000
|
95,000
|
95,000
|
|
Maintenance
|
5,400
|
5,400
|
5,400
|
|
Depreciation:
|
|
|
|
|
Computer equipment
|
25,500
|
25,500
|
25,500
|
|
Office equipment and fixtures
|
680
|
680
|
680
|
|
Power
|
1,546
|
1,485
|
1,697
|
|
|
128,126
|
128,065
|
128,277
|
|
Wages and Salaries
|
|
|
|
|
Operations: salaried staff
|
21,600
|
21,600
|
21,600
|
|
Operations: hourly personnel
|
7,896
|
7,584
|
8,664
|
|
Systems development and maintenance
|
12,000
|
12,000
|
12,000
|
|
Administration
|
9,000
|
9,000
|
9,000
|
|
Sales
|
11,200
|
11,200
|
11,200
|
|
|
61,696
|
61,384
|
62,464
|
|
|
|
|
|
|
Sales Promotion
|
7,909
|
7,039
|
8,083
|
|
Corporate Services
|
15,424
|
15,359
|
15,236
|
|
Total Expenses:
|
$222,395
|
$221,087
|
$223,300
|
|
|
|
|
|
|
Net Income (loss)
|
$(41,595)
|
$(40,687)
|
$(23,700)
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