Question

Assignment 1 CVP Comprehensive Problem Gupta Travel is a charter airline service for corporate clients traveling between Atlanta and Boston. The company leases one jet aircraft and flies an average of 160 one-way trips per year. Gupta’s marketing strategy is to sell a more enjoyable travel experience than its rivals in the commercial airline industry. Gupta arranges ground transportation in Atlanta and Boston for its clients, offers a more spacious cabin with larger seats and more legroom, and serves gourmet meals on its flights. Gupta does not sell its services to individuals; rather its services are marketed directly to corporate clients. Therefore, when Gupta books a flight for a client, it is not merely selling a few seats on its aircraft. Rather, the corporate client is booking the use of the aircraft for its travel needs. Gupta uses a network of commissioned travel agents to sell its services. These agents are not employees of Gupta, and the agents receive a 20 percent commission (no fixed salary) on each flight sold on Gupta Travel. Gupta had the following income statement for the year ending December 31, 2018. Gupta Travel Income Statement For the Year Ending 12/31/2018 Sales Revenue (160 one-way flights _ $50,000 per flight) $8,000,000 Commissions Expense (20 percent of Sales Revenue) $1,600,000 Annual Lease Expense—Airplane $1,200,000 Annual Fee for Airport Ground Crew Services $900,000 Flight Crew Expense (160 one-way flights _ $1,600 per flight) $256,000 Fuel Expense (160 one-way flights _ $1,100 per flight) $176,000 Food Expense (160 one-way flights _ $900 per flight) $144,000 Ground Transportation Expense (160 one-way flights _ $250 per flight) $40,000 Other Fixed General and Administrative Expenses $180,000 Fixed Interest Expense $250,000 Net Income $ 3,254,000 (ignore tax)

(1) Prepare the contribution margin Income Statement (2) What is Gupta’s current breakeven point? (3) At the end of 2015, Gupta’s management learned that its commissioned travel agents are demanding an increase in their commission rate to 30 percent per flight for the upcoming year. As a result, Gupta’s president has decided to investigate the possibility of hiring an in-house sales staff to replace the commissioned travel agents. Gupta’s accounting department compiled the following information to be used to evaluate the cost of establishing an in-house sales department. Costs of Establishing an In-House Sales Department The accounting department estimates that Gupta would need to hire four salespeople at an average payroll cost of $85,000 per employee to cover the workload of the current travel agents. Also, in order to hire highly qualified individuals for these positions, the compensation package must include commissions. To be competitive with the industry-standard commission rate, Gupta must offer a 15 percent commission on each flight sold in addition to the salary. The cost of the in house sales department will also include travel costs and support staff. Travel and entertainment expense is expected to total $600,000 (fixed) for the year, and the annual cost of support staff positions will be fixed at $150,000. Gupta currently relies on the travel agents to sell its services. If Gupta were to replace its commissioned travel agents with an in-house sales department, then it would have to bear more of the cost of advertising its services. In order to maintain the company’s image and manage the transition from established travel agents to an inhouse sales staff, the accounting department recommends spending $550,000 (fixed) annually on advertising. (3) Use the December 31, 2018 Income Statement (with 160 flights sold) to estimate Gupta’s breakeven point in units (flights) if the company hires its own sales force and increases its advertising costs. Based on your answer, what amount of sales revenue would the company generate at this breakeven point? (4) Assume that Gupta decides not to hire its own sales force, but instead consents to give its current commissioned travel agents the raise they are demanding. How many flights must the company sell (with the new commission rate) to generate the same net income that was reported in 2018? (5) Management must choose between: (a) hiring its own sales force and (b) compensating its current network of travel agents with a higher commission rate. (i ) What is the profit formula for alternative (a), hiring an in-house sales force? (ii ) What is the profit formula for alternative (b), increasing the commission rate of the current travel agents? (iii ) At what level of sales volume (in flights) would management be indifferent between these two alternatives? (Indifference means the sales volume [units] that would produce the same profit between the alternatives.)

Answer 1

1.

Gupta Travel Contribution Margin Income Statement
	Per Unit	$	$
Sales Revenue	$ 50,000		8,000,000
Less: Variable Costs
Sales Commission	10,000	1,600,000
Flight Crew Expense	1,600	256,000
Fuel Expense	1,100	176,000
Food Expense	900	144,000
Ground Transportation	250	40,000
Total Variable Costs	13,850		2,216,000
Contribution Margin	36,150		5,784,000
Less: Fixed General and Administrative Costs
Annual Lease Expense		1,200,000
Annual Fee for Airport Ground Crew Services		900,000
Other Fixed General and Administrative Expense		180,000	2,280,000
Operating Income			3,504,000
Less: Fixed Interest Expense			250,000
Net Income			3,254,000

2. Gupta's current break-even point = Total Fixed Cost / Contribution Margin per Unit = $ 2,530,000 / $ 36,150 = 69.99 flights or 70 flights.

3. Computation of Total Fixed Costs:

Additional Advertising Cost	$ 550,000
Payroll Cost of Salespeople ( $ 85,000 x 4)	340,000
Travel and Entertainment Cost	600,000
Annual Cost of Support Staff	150,000
Annual Lease Expense: Airplane	1,200,000
Annual Fee for Airport Ground Crew Services	900,000
Other Fixed General and Administrative Expense	180,000
Fixed Interest Expense	250,000
Total Fixed Cost	$ 4,170,000

Computation of Variable Cost per Flight:

Sales Commission	$ 7,500
Flight Crew Expense	1,600
Fuel Expense	1,100
Food Expense	900
Ground Transportation Expense	250
Total Variable Cost per Flight	$ 11,350

Break-even number of flights = $ 4,170,000 / $ 11,350 = 367.40 flights.

Sales revenue at this point = 368 x $ 50,000 = $ 18,400,000.

4. Variable cost per flight = $ ( 15,000 + 1,600 + 1,100 + 900 + 250) = $ 18,850

Number of flights needed to be sold to earn $ 3,254,000 = $ ( 2,530,000 + 3,254,000 ) / $ 18,850 = 306.84 flights.

5. i.Profit formula for option a : 38,650 q -  4,170,000, where q is the number of flights sold.

ii.Profit formula for option b: 31,150 q - 2,530,000

iii. At indifference,

38,650 q - 4,170,000 = 31,150 q - 2,530,000

7,500 q = 1,640,000

q = 218.67 flights

At a sales volume of 218.67 flights, the management would be indifferent between the two alternatives.