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Managerial Accounting

1-4 C ost- Volume-Profit Analysis and Pricing in
the Airline Industry* (Edward Deakin, Adapted)
Trans Western Airlines is considering a proposal to initiate air service between Phoenix, Arizona, and Las Vegas, Nevada. The route would be designed primarily to serve the recreation and tourist travelers who frequently travel between the two cities. By offering low-cost tourist fares, the airline hopes to persuade persons who now travel by
other modes of transportation to switch and fly Trans Western on this route. In addition, the airline expects to attract business travelers during the hours of 7 A.M. to 6 P.M. on Mondays through Fridays. The fare price schedule, or tariff, would be designed to charge a higher fare during business-travel hours so that tourist demand
would be reduced during those hours. The company believes that a business fare of $100 one way during business hours and a fare of $60 for all other hours would equalize the passenger load during business-travel and tourist-travel hours.
To operate the route, the airline would need two 200-passenger jet aircraft. The air¬craft would be leased at an annual cost of $10,000,000 each. Other committed costs for ground service would amount to $5,000,000 per year.
Operation of each aircraft requires a flight crew whose salaries are based primarily on the hours of flying time. The costs of the flight crew are approximately $800 per hour of flying time.
Fuel costs are also a function of flying time. These costs are estimated at $1,000 per hour of flying time. Flying time between Phoenix and Las Vegas is estimated at 45 min¬utes each way.
The flexible costs associated with processing each passenger amount to $5. This amount includes ticket processing, agent commissions, and baggage handling. Food and beverage service cost $10 per passenger and will be offered at no charge on flights during business hours. The airline expects to recover the cost of this service on non-business¬hour flights through charges levied for alcoholic beverages.
(I) If six business flights and four tourist flights are offered each way every weekday, and 12 tourist flights are offered each way every Saturday and Sunday, what is the average
number of passengers that must be carried on each flight to break even?
(2) What is the breakeven load factor (percentage of available seats occupied) on a route? (3) If Trans Western Airlines operates the Phoenix-Las Vegas route, its aircraft on that
route will be idle between midnight and 6 A.M. The airline is considering offering a "Red Die" special, which would leave Phoenix daily at midnight and return by 6 A.M. The marketing division estimates that if the fare were no more than $40, the load factor would be 50% for each Red Die flight. Operating costs would be the same for this flight, but advertising costs of $10,000 per week would be required for promotion of the service. No food or beverage costs would be borne by the company. Management wants to know the minimum fare that would be required to break even on the Red Die special, assuming that the marketing division's passenger estimates are correct.

3-4 Fort Erie Consumer Products
Fort Erie Consumer Products manufactured a wide range of consumer products. To sup¬port all aspects of its acquisition, manufacturing, distribution, and marketing operations, the company maintained a graphics department. This department, ,called the Corporate Graphics Department, employed graphics designers and maintained and operated its own printing equipment.
The company was organized on a responsibility basis. The method of evaluating the various responsibility centers varied. Some of the centers were evaluated as cost centers, others as profit centers, and still others as investment centers.
When the Corporate Graphics Department was first established in 1994, there was relatively little interest in, or demand for, the products of the department. To encourage the use of these graphics capabilities, management decided not to charge the services and products of the graphics department to users. By mid-1995, the Corporate Graphics De¬partment was running at capacity and was issuing requests to buy more sophisticated (and very expensive) printing equipment. There was some concern that the graphics depart¬ment was empire building in the sense that it was acquiring equipment that was techno¬logically elite but had no obvious or legitimate use in the firm.
To provide some control over the Corporate Graphics Department, Maureen Jack¬son, the vice president of finance, decreed in early 1996 that the Corporate Graphics De¬partment would be run as a cost center. That is, Martin Roy, the manager of the Corporate Graphics Department, would be evaluated on the basis of his ability to control the depart¬ment's costs relative to budgeted, or standard, costs for the work done. Moreover, to exer¬cise some control on the empire-building inclinations of the graphics department, she de¬clared that the department would be required to charge out all its costs to users. That is, the graphics department was to become customer-drlven in the sense that it could not incur any costs that would not be reimbursed by customers.
In response to the vice president's decision, Martin developed a charge rate for his department. Martin decided that there were two classes of costs in his department: materi¬als costs and overhead costs (which consisted of all the costs other than materials costs in the Corporate Graphics Department). In 1995, the graphics department had undertaken 12,736 jobs and had incurred materials costs of $6,704,948 and overhead costs of $5,678,346. There were many components of overhead costs, but the primary components of overhead costs were equipment and equipment-related costs of $3,586,239 and salary costs of$1,408,376.
The decision was made that the charge for any job would be the out-of-pocket mate¬rials costs for doing the job, plus an allocation to cover the overhead cost. The materials cost for any job was readily available from the job-cost sheet maintained for each job. The
overhead rate for each job was computed by taking the overhead cost per job in the pre¬
ceding year and adding 10%. Therefore, this rate in 1996 would be $490.44 per job. Mar¬tin provided the following rationale for his decision:
This method is simple and easy to implement. It requires that each job absorb its own materials costs plus bear its fair share of the overhead of the Corporate Graphics Department. The 10% uplift of costs is needed to cover the installation and breaking¬in costs of the new equipment that is not yet operational that we feel we ought to

Chapter 3 Assigning Resource Costs to Production Cost Centers 87

continually acquire in order to provide a full range of printing capabilities. We think of these costs as the research and development costs that we have to incur so that we can educate ourselves and our customers about how to use the state-of-the-art
equipment that we are buying.

In 1996, for the first year since the Corporate Graphics Department had been created, demand for jobs fell off. In an attempt to discover what had happened, Maureen Jack¬son commissioned a special study of users. Although there were many complaints-in¬cluding dissatisfaction with the timeliness of the work done, the quality of the work done, and the willingness of the Corporate Graphics Department to listen to and meet the customers' needs-the major complaint was cost. The following comment from Paul Tremaine, the manager of the Safety Department, summarized many of the criticisms:

I'm tired of dealing with these guys. They spend all their time trying to talk us into using their fancy equipment. They have about twelve pieces of printing equipment in there. most of which are doing things that we will never need. We have specific needs, dictated by employee safety standards and requirements, for graphics materials. I do not need graphics consultants and fancy offset printing. I need visibility and coverage provided economically. We know what we want; we just cannot print it ourselves. And their prices-well, they are way out of line. I have a specific budget for printing safety posters and I am going to take my business outside. I can get the same job done outside for about half the cost that I am expected to pay internally.

On the other hand, the comments of some users were very positive. The director of new promotions in the Marketing Department made the following comments:

I think that their service is great. Their graphics consultants are great-creative and innovative. They take their time and provide outstanding artwork and high-quality graphics. And the cost is next to nothing; ,we would have to pay almost ten times as much for the same service outside.

In response to these comments, in early 1997 Maureen Jackson directed one of her staff consultants to undertake a preliminary analysis of the situation and provide some alterna¬tive approaches to dealing with the problems identified. The gist of the consultant's report was that the cost allocations did not reflect the actual demands and usage of the Corporate Graphics Department. Moreover, the consultant pointed out that conventional cost ac¬counting wisdom required that fixed costs and variable costs be charged and allocated separately. Variable costs should be allocated on the basis of actual usage, and fixed costs on the basis of planned usage. The consultant pointed out ~hat, under the current scheme, materials costs were allocated on the basis of actual cost, wfiereas fixed and variable over¬head costs were allocated on theUbasis of actual usage. That approach, the consultant pointed out, might create problems.

(1) What benefits might accrue from allocating fixed costs on the basis of planned usage
and variable costs on the basis of actual usage?

88 Chapter 3 Assigning Resource Costs to Production Cost Centers

. .

(2) Should standard or actual costs be allocated in a charge-out system such as this?
(3) Explain why the scheme developed by Martin Roy does not fulfill Maureen Jackson's
intention that the cost-charging scheme should control the Corporate Graphic Depart¬ment's empire-building tendencies. What evidence is there of the failure to meet that objective?
(4) What would you recommend to provide the Corporate Graphics Department with a
more effective motivation to operate effectively and efficiently?


Solution Preview

The attached file has the calculations

I) If six business flights and four tourist flights are offered each way every weekday, and 12 tourist flights are offered each way every Saturday and Sunday, what is the average
number of passengers that must be carried on each flight to break even?

Breakeven is when the total revenue is equal to the total cost and is calculated as fixed costs divided by contribution margin per unit. This is because contribution margin is after removing the variable costs and thus all contribution margin must go towards meeting the fixed costs. At beakeven total contribution margin is equal to the total fixed costs.

In the attached file, we first find the total fixed costs. Next we find the revenue per passenger and the variable cost per passenger. The difference between the 2 gives us contribution margin per passenger. Dividing the total fixed cost by the contribution margin per passenger gives us the breakeven number of passengers. It comes to 68 per flight

(2) What is the breakeven load factor (percentage of available seats occupied) on a route?

The load factor is number of occupied seats to total seats. The total seats are 200 and the breakeven passengers are 68. The load factor is 68/200=34%

3. Here we have to find the fare. We first find the total cost of operating the flights. Then we find the total passengers in the flights, given that the load factor is 50% ( there would be 100 passengers per flight). Dividing the total cost by the total ...

Solution Summary

The solution has various mangerial accounting problems relating to breakeven, overhead rate and allocation of overhead costs