Relevant Cost Problems, Case Study Example

The operating income is also called the operating profit. It is the income that a company or any business firm obtains before deducting interest payments and taxes. In the case of Westcost Air Co., the operating income will be calculated by the deduction of operating expenses from the gross income. If the operating income is a positive value then it is referred to as the net operating income but when the value is negative, it is known as the net operating loss.

The Gross Income = seating capacity * average one way fare

Therefore: 175 * 325 = $56, 875

Total number of operating expenses =

Fuel costs + food and beverage cost + commission paid to travel agents + ground services + crew salaries + annual lease costs

Hence: 14,000 + (10/100 * 56, 875) + 7,500 + 7,000 + (4 * 175) + 53, 000 = 14, 000 + 5, 687.5 + 7, 500 + 7, 000 + 700 + 53, 000 = $ 87, 887.5

Thus the company runs at a net operating income loss of

The Gross income- Total operating expenses

That is, 87, 887.5 – 56, 875 = $ 31, 012.5

The operating income (net operating income loss) is $ 31, 012.5

By lowering the average fare, the following will be the gross income;

212 * 280 = $ 59, 360

As shown from this calculation, reducing the average one way fare which will consequently lead to increased number of passengers will have a positive influence on the company’s total income. This is clearly evidenced by an increase in the gross income. However, this gross income will not have any significant effect in altering the net operating income. All in all, I think that it would be in order if the company reduced the average fare to the proposed fee of $280 by the Market Research Department as it will increase the number of passengers and consequently the gross income. However, this reduction in fare would only be applicable if there is a guarantee that the number of passengers will increase from at least 212. Otherwise, this approach would not be favorable to the company as it would only make the company to endure more losses.

If Westcost Air Co. accepts the offer by Travel International Tour Operator then the following will be its operating income:

75, 000 – 53, 000 – 7,000- 7,500 = $ 7,500

Where 75, 000 is the money which will be paid to the Westcost Air Company per flight.

The deductions (53,000, 7,000 & 7,500) are the operating expenses

Therefore it is clear that the Travel International Tour Operator will be a life savior in that the Westcost Air Company will finally encounter a net operating profit of $ 7,500. This is because after deducting the lease costs, ground services costs and crew salaries cost, the balance is $ 7,500. I therefore strongly agree with the idea that Westcost Air Company should accept the offer by the Travel International Tour Operator basing argument on purely financial considerations.

The offer seems enticing but it would be wise if the Company looked at other issues before accepting this offer. These are;

1. Would there be any commissions involved. Like in their usual operations, commissions to travel agents are included as they are the ones who are involved in the booking of the tickets. If there are no commissions on the side of the Travel International Tour Operator, will their typical travel agents still warrant a 10% of the fare?
2. Mode of payment. The Air Company should make sure that the mode of payment used will be convenient so that they do not incur greater losses.
3. The Westcost Company should also consider the days which the Travel International Tour Operator wants to hire the plane. Its operation days are precise and predefined. If not within their usual days of operation, then several factors need to be evaluated before coming up with a decision.
4. Is the renting out long-term or short-term? Such information is very important to enable the Westcost Air Company efficiently and effectively plan for the company.