Question

Profits have been decreasing for several years at Pegasus Airlines. In an effort to improve the company's performance, the company is thinking about 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: $ 18,000 1,296 16,704 100.0% 7.2 92.8% Ticket revenue (180 seats x 40% occupancy x $250 ticket price) Variable expenses ($18.00 per person) Contribution margin Flight expenses: Salaries, flight crew Flight promotion Depreciation of aircraft Fuel for aircraft Liability insurance Salaries, flight assistants Baggage loading and flight preparation Overnight costs for flight crew and assistants at destination Total flight expenses Net operating loss $ 1,700 790 1,700 5,200 5,100 1,200 2,000 700 18,390 $(1,686) 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. What is the financial advantage (disadvantage) of discontinuing flight 482?

Answer 1

NOTE: If Flight 482 If Flight 482 Effect on net is is operating continued dropped income $18,000 $0 ($18,000) [Revenue is lost fully] $1,296 $0 $1,296 [Variable cost is saved fully] $16,704 $0 ($16,704) (Contribution margin lost] Fixed costs are those costs which would remain the same in total irrespective of level of production or sales. It is a committed cost to be incurred by the firm whether it carries out operations or not. Therefore, avoidable fixed costs are relevant costs for decision making. Tickets revenue Variable expenses Contribution margin Flight expenses: Salaries, flight crew Flight promotion Depreciation of aircraft Fuel for aircraft Liability insurance Salaries, flight assistants Baggage loading & flight preparation Overnight costs for flight crew & assistants at destination Total flight expenses $1,700 $790 $1,700 $5,200 $5,100 $1,200 $2,000 $1,700 $0 $1,700 $0 $3,400 $0 $2,000 $0 [No effect even if dropped] $790 [Relevant cost is saved fully] $0 [No effect even if dropped] $5,200 [Relevant cost is saved fully] $1,700 [1/3rd is saved if dropped] $1,200 [Relevant cost is saved fully] $0 [No effect even if dropped] Variable costs are those costs which would remain the same per unit irrespective of level of production or sales. It is an unit cost to be incurred by the firm only when the firm carries out its business operation. Therefore, variable costs are the relevant costs for any decision making. $700 $18,390 $0 $8,800 $700 [Relevant cost is saved fully] $9,590 Relevant costs are those costs that would be incurred when a particular product or product line is continued only. That is, when a product or product line is dropped, if costs can be avoided, those costs are called as relevant costs and they shall be considered in the evaluation of dropping decision making process. Other costs are called irrelevant costs and so they shall be ignored for evaluating whether to continue or drop a product or product line. Net operating income (loss) ($1,686) ($8,800) ($7,114) So, Financial disadvantage of dropping flight 482 is ($7,114)