Wednesday, 1 April 2015

Profits have been decreasing for several years at Pegasus Airlines. In an effort to improve the company’s performance, consideration is being given to dropping several flights that appear to be unprofitable.

Profits have been decreasing for several years at Pegasus Airlines. In an effort to improve the company’s performance, consideration is being given to dropping several flights that appear to be unprofitable.
  
     A typical income statement for one round-trip of one such flight (flight 482) is as follows:

         
  Ticket revenue (115 seats × 40%
    occupancy × $60 ticket price)
$ 2,760   100 %
  Variable expenses ($12.00 per person)   552   20  
 



  Contribution margin   2,208   80 %
 







  Flight expenses:        
     Salaries, flight crew $ 380      
     Flight promotion   680      
     Depreciation of aircraft   410      
     Fuel for aircraft   195      
     Liability insurance   300      
     Salaries, flight assistants   710      
     Baggage loading and flight preparation   180      
     Overnight costs for flight crew and      assistants at destination   80      
 

   
  Total flight expenses   2,935      
 

   
  Net operating loss $ (727)      
 



   


The following additional information is available about flight 482:
a.
Members of the flight crew are paid fixed annual salaries, whereas the flight assistants are paid based on the number of round trips they complete.
b.
One-third of the liability insurance is a special charge assessed against flight 482 because in the opinion of the insurance company, the destination of the flight is in a "high-risk" area. The remaining two-thirds would be unaffected by a decision to drop flight 482.
c.
The baggage loading and flight preparation expense is an allocation of ground crews' salaries and depreciation of ground equipment. Dropping flight 482 would have no effect on the company's total baggage loading and flight preparation expenses.
d.
If flight 482 is dropped, Pegasus Airlines has no authorization at present to replace it with another flight.
e.
Aircraft depreciation is due entirely to obsolescence. Depreciation due to wear and tear is negligible.
f.
Dropping flight 482 would not allow Pegasus Airlines to reduce the number of aircraft in its fleet or the number of flight crew on its payroll.
 
Required:
1.
Prepare an analysis showing what impact dropping flight 482 would have on the airline's profits.
 save image

Explanation:
1.
The following costs are not relevant to the decision:

Cost Reason
  Salaries, flight crew   Fixed annual salaries, which will not change.
  Depreciation of aircraft   Sunk cost.
  Liability insurance (two-thirds)   Two-thirds of the liability insurance is unaffected by this decision
  Baggage loading and flight
  preparation
  This is an allocated cost that will continue even if the flight is   discontinued.



Liability insurance (1/3 × $300) = $100

Alternative Solution:

    Keep the Flight   Drop
the
Flight
Difference: Net Operating Income Increase or (Decrease)
  Ticket revenue $ 2,760   $ 0   $ (2,760)   
  Variable expenses   552     0     552   
 











  Contribution margin   2,208     0     (2,208)   
 











  Less flight expenses:            
    Salaries, flight crew   380     380     0   
    Flight promotion   680     0     680   
    Depreciation of aircraft   410     410     0   
    Fuel for aircraft   195     0     195   
    Liability insurance   300     200     100   
    Salaries, flight assistants   710     0     710   
    Baggage loading and flight preparation   180     180     0   
    Overnight costs for flight crew and assistants at destination   80     0     80   
 











  Total flight expenses    2,935     1,170     1,765   
 











  Net operating loss $ (727)   $ (1,170)   $ (443)