Question

Clearbell Telephone provides slow-dialing (SD) service to customers for a low fee, and fast-dialing (FD) service to other customers who pay a somewhat higher fee. FD technology, however, is so efficient that it costs Clearbell substantially less per average call to provide than does SD. Nonetheless, accountants have calculated that Clearbell’s profits would drop if it provided FD to all its customers at the current low-fee rate.

Assume that installation costs for FD are insignificant if the customer already has SD service. Which of the following, if true about Clearbell, best explains the results of the accountants’ calculation?

Option A
Option B
Option C
Option D
Option E

(This question is from Official Guide. Therefore, because of copyrights, the complete question cannot be copied here. The question can be accessed at GMAT Club)

Solution

The Story

Clearbell Telephone provides slow-dialing (SD) service to customers for a low fee, and fast-dialing (FD) service to other customers who pay a somewhat higher fee.

SD service is cheaper than FD service for customers of the company.

FD technology, however, is so efficient that it costs Clearbell substantially less per average call to provide than does SD.

To the telephone company, an average FD call’s cost is actually lower than an average SD call’s cost

Nonetheless, accountants have calculated that Clearbell’s profits would drop if it provided FD to all its customers at the current low-fee rate.

As per accountants’ calculations, providing FD at the SD prices will reduce the company’s profits. That too despite an average FD call costing less than an average SD call. (We note that the statement is about reducing profits, and not about losses.)

Assume that installation costs for FD are insignificant if the customer already has SD service.

To  move SD customers to FD, the costs are insignificant. So one hurdle – moving customers from SD to FD – would not be too costly for Clearbell.  (While mentioned in the question stem, this statement gives us another piece of information to consider, and is a part of the story.)

Gist: Currently, Clearbell charges a higher fee for FD than for SD. The company’s costs per average call on FD service are lower. Yet, if the company moved its customers to FD and charged them the current SD rates, its profits would drop.

The Goal

How come despite costs being lower, if FD were provided at SD rates, the company’s profits would drop? We need to choose an answer that would resolve this seeming discrepancy.

Profit = Revenue – Cost. So, for lower profits either the revenues would become lower, or the costs would become higher. The per average call cost of FD is lower. So, either there is some other cost that makes the FD service more costly (it’s already mentioned that the installation costs for the switch from SD to FD are insignificant), or the switchover reduces the company’s revenues.  If an option highlights either of these two situations, it’ll get the job done.

The Evaluation

(A) Correct.  If the customers were all moved to FD at the lower fee, the net reduction in costs would be lower than the reduction in revenues, leading to overall lower profits.

Say the extra revenue collected from customers who pay the high fee is $10,000.

And, say the extra cost of providing SD to customers who pay the low fee is $9,000.

Say the current profit is given by: Current Profit = R – C

Then the profit after the shift would be: New profit = (R – 10,000) – (C – 9,000) = R – C – 1,000. New profit = Current Profit – 1,000.

So, although both the revenue and the cost would drop, since the drop in revenue would be higher, the profits would drop if FD were provided at the lower fee.

(B) Incorrect. This option tells us about how the two fees have changed in the last year. It does not explain at all how profits might be impacted by the switchover.

(C) Incorrect. So, a significant majority currently do not use FD. If there were a switch over, for these customers, the average cost per call to Clearbell would be lower. The fee charged to these customers would remain the same (current SD fee). So, if there aren’t any other costs, it appears that the company’s costs would, in fact, significantly decrease. This option is actually making a case for higher profits.

(D) Incorrect. We need to explain the results of the accountants’ calculation. How the company’s competitors offer their services does not help us figure out the basis of the accountants’ calculation at all. This option does not help us understand anything about the impact of the switch on profits.

(E) Incorrect. How customers possibly responded to FD service at the time of launch does not tell us anything about how profits might change if there was a switchover.

Additional Notes

‘Profit and loss’ is quite often used as the subject matter for CR passages. While the questions will not require any pre-existing technical knowledge from you, basic understanding of how revenues and costs impact profits is expected.

SC Notes:

“Nonetheless, accountants have calculated that Clearbell’s profits would drop if it provided FD to all its customers at the current low-fee rate.” – Notice the use of “it” to refer to “Clearbell” although the sentence has only the possessive form of the company’s name (Clearbell’s). This kind of reference is perfectly fine and has been used in an official SC question, even though many people consider it wrong.

This solution was created by Chiranjeev Singh and Anish Passi.