Question

WSM Corporation is considering offering an air shuttle service between Sao Paulo and Rio de Janeiro. It plans to offer four flights every day (excluding certain holidays) for a total of 1,400 flights per year (= 350 days × 4 flights per day). WSM has hired a consultant to determine activity-based costs for this operation. The consultant’s report shows the following.

Activity	Activity Measure (cost driver)	Unit Cost (cost per unit of activity)
Flying and maintaining aircraft	Number of flights	$	1,600	per flight
Serving passengers	Number of passengers	$	4	per passenger
Advertising and marketing	Number of promotions	$	60,000	per promotion

WSM estimates the following annual information. With 20 advertising promotions, it will be able to generate demand for 40 passengers per flight at a fare of $225. The lease of the 60-seat aircraft will cost $4,000,000. Other equipment costs will be $2,000,000. Administrative and other marketing costs will be $1,250,000.

Required:

a. What annual operating income can WSM expect from this new service?

b-1. WSM is considering selling tickets over the Internet to save on commissions and other costs. It is estimated that the cost driver rate for flights would decrease by $100 as a result of Internet sales. Administrative and other marketing costs would increase by $1 million. WSM estimates that the added convenience would generate a 5 percent increase in demand. All other costs and fares would remain the same. What annual operating income can WSM expect from adopting Internet ticket sales?

b-2. Would you recommend that WSM adopt Internet ticket sales?

c. Assume that WSM management decides not to adopt the Internet strategy, regardless of your answer to requirement (b). Instead, it is now considering a plan to sell tickets at two prices. An unrestricted ticket (good for travel at any time on any day) would sell for $250. A discount ticket, good for reservations made in advance, would sell for $150. Management estimates that it can sell 35,000 tickets (25 per flight) at the unrestricted airfare of $250. All other data remain the same.

Ignoring the information in requirement (b), how many discounted tickets would WSM have to sell annually to earn an operating income of $1,700,000? Assume that the annual number of flights remains at 1,400 and that the discounted tickets would be evenly divided across the 1,400 flights.

Answer 1

Answers: -

a.) Operating income = $1,686

b-1.) Operating income = $1,444.80

b-2.) No

c.) Number of discount tickets = 25890

EXPLANATION: -

a.)

Income statement (in thousands)

Sales revenue	(40 passengers × 1,400 flights × $225)	$12,600
Costs:
Flight related	(1,400 × $1,600)	$2,240
Passengers related	(40 passengers × 1,400 flights × $4)	224
Advertising related	(20 promotions × $60,000)	1,200
Fixed costs	($4,000 + $2,000 + $1,250)	7,250	10,914
Operating income		$1,686

b-1.)

Estimated changes:

New Number of passengers = 40 + 5% = 42 passengers

New Administrative and marketing costs = $1,250,000 + $1,000,000 = $2,250,000

New cost per flight = $1,600 - $100 = $1,500

Income statement (in thousands)

Sales revenue	(42 passengers × 1,400 flights × $225)		$13,230
Costs:
Flight related	(1,400 × $1,500)	$2,100
Passengers related	(42 passengers × 1,400 flights × $4)	235.2
Advertising related	(20 promotions × $60,000)	1,200
Fixed costs	($4,000 + $2,000 + $2,250)	8,250	11,785.2
Operating income			1,444.8

b-2.) I would not recommend WSM to adopt internet ticket sales because the operating income after adopting the internet ticket sales ($1,444,800) is less than that of the operating income before adopting the internet ticket sales (1,686,000).

c.)

Number of discount tickets can be calculated using the basic equation: -

Total revenues – Total cost = Operating income

Here,

Let’s assume Number of discount tickets be “X”

operating income =$1,700,000

Total Revenue = (35000 tickets × $250) + (X × $150)

= $8,75,000 + 150X

Total cost = Flight related + Advertising related + Fixed costs + Passengers related

= $2,240,000 +$1,200,000 +$7,250,000 + (35000 + X) × $4

= $10,690,000 + $140,000 + 4X

By substituting the values in the equation, we get

$8,750,000 + 150X - $10,690,000 + $140,000 + 4X = $1,700,000

$8,750,000 + 150X – ($10,830,000 + 4X) = $1,700,000

146X = $1,700,000 + 2,080,000

= $3,780,000/ 146

X = 25890 tickets