(Solution) Profits have been decreasing for several years at Pegasus Airlines

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 (175 = seat capacity × 40% occupancy × $200 ticket price)	14,000	100.0
Variable expenses ($15 per person)	1,050	7.5%
Contribution margin	12,950	92.5%
Flight expenses:
Salaries, flight crew	1,800
Flight promotion	750
Depreciation of aircraft	1,550
Fuel for aircraft	5,800
Liability insurance	4,200
Salaries, flight assistants	1,500
Baggage loading and flight preparation	1,700
Overnight costs for flight crew at destination	300
Total flight expenses	17,600
Operating loss	(4,650

The following additional information is available about the flight:

1. 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.
2. 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.
3. 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.
4. If flight 482 is dropped, Pegasus Airlines has no authorization at present to replace it with another flight.
5. Aircraft depreciation is due entirely to obsolescence. Depreciation due to wear and tear is negligible.
6. 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. (Any losses/ reductions should be indicated by a minus sign.)

Solution

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 × $4,200) = $1,400

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