Custom «Relevant Costing» Essay Paper Sample

Relevant Costing

West Cost Airways is a small Airways company. It owns a single air plane on leasing terms and operates its flights between Son Francisco and Fiji only. The company seems a profitable one; however it is considering two proposals for its decision making. The first proposal considers a reduction in the fare that is being charged to the travelers. On the other hand, the second proposal has been put forward by another tourist company, known as Travel International, which intends to charter West Cost's air plane for its own operations. Although the proposal does not allow for full out sourcing, yet it seems an offer worthy of consideration.

The study focuses upon the pros and cons of the above stated proposal and determines their profit abilities and risk association. Both the proposals seem worthy to commence however, some further information would still be required if a final judgment is to be reached.

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Operating Income Statement

West Cost Airways


Revenue (Average passenger*Average fare) 56 875

Less: Fuel costs (14 000)

Less: Food, beverage, services costs (700)

Less: Commission (5 688)

Less: Finance cost (Lease Payment/average flights) (254)

Less: Ground service costs (7 500)

Less: Crew salaries (7 000)

Operating Income from One way flight 21 733


Revenue 59 360

Less Fuel Costs (14 000)

Less Food, beverage and service costs (848)

Less Commission (5 936)

Less Finance cost (254)

Less Ground service costs (7 500)

Less Crew Salaries (7 000)

23 822

Explanation: West Cost Airways should absolutely go ahead with the plan and offer a fare reduction to its customers. Price elasticity of demand of luxury goods, such as tourist journeys, is always high, and a fare reduction demonstrates mighty increase in profits. (Titley, 2002)

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West Cost is only providing tourist type journeys in its leased sir craft. Hence the service it is offering can be categorized as luxury. Luxury goods always have a high elasticity of demand. A reduction in the revenue has been complemented by the highly elastic increase in number of passengers. This is leading to efficient usage of capacity. The increase in number of passengers would also lead to cost reductions and economies of scale. For example, previously when the average passengers per flight had been 175, the proportion of fixed cost of fuel, borne by each customer had been 14 000/175=$80/ However, now, when the average passenger rises from 175 to 212, the average fixed customer borne by each customer reduces to $66. Previously, West Cost had to pay 25% of fixed costs out of its revenue. Now this proportion reduces to 20%. Cost reduction in a company, so large, can be deemed as a massive one here.(Pride, 2009)

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The fixed finance cost of the leasing of air planes would also fall on an average. Similarly, West Co would also gain discounts when it purchases beverages and food for travelers in a larger quantity. Discounts could be availed and recurring transportation costs could be avoided.

The average cost would also decline because ground services would now be availed for a larger number of consumers paying the same amount of cost. It is a bounty for West Co that most of its costs are fixed, and hence, an increase in number of travelers would immediately lead to a decrease in average total cost. (Pride, 2009)

Increase in number of travelers would also help West Co achieve marketing economies of scale. This would happen when the same amount of advertisement would bring more consumers, again ultimately leading to decrease in average costs. This is highly profitable for the West Cost Airways.

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Forecasted Profits with Chartering Operations

Revenue from Plane charter 1 800 000

Revenue from flights 10 465 000

Total Revenue 12 265 000

Less: Fuel Costs 2 576 000

Less: Commission 1 046 500

Less: Finance Cost 53 000

Less: Ground Service Costs 1 560 000

Less: Crew Salaries 1 456 000 5 281 000

Net Income 6 984 000

Forecasted Profits with Full Operations

Revenue 11 830 000

Less Fuel Costs (2 912 000)

Less Commission (1 183 000)

Less Finance Cost (35 000)

Less Ground Services Costs (1 560 000)

Less: Crew Salaries (1 456 000)

Net Income (4 684 000)

It is worthwhile for West Co to charter its planes to Travel International. Travel International. The tour operator might have more recognition in the market and may lead to increase in market goodwill. Similarly, the deal seems very tempting since TI has agreed to bear all other costs except crew and ground services. The forecasted profits with full operations and chartered operations have been presented above for comparison. West Co would earn a yearly profit of $6 984 000 if it chooses to sign the deal with Travel International. On the other hand if it chooses to operate to its own maximum, profits are expected to fall by a drastic 33%. West Co must go ahead with the deal.

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How ever, it's not only about financial factors when the projects have to be appraised. There can be a lot of non-financial factors too when projects are being appraised. West Co must also consider the present rate of inflation going on in the country. If the prices raise more than they normally do, the seemingly profitable offer from Travel International might convert into a lost opportunity. West Co is a service provider and its income is adaptable to circumstances. It means that it can charge any fare to its customers subject to any increases in costs. How ever, if the inflation rate rises more than expected, the income from Travel International would remain unchangeable and West Co would have to face declined profits from its chartered operations.

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Similarly, it should also consider the market trends in the industry and look for those opportunities that Travel International might have considered while offering the deal to West Co. In this way, West Co might perhaps discover a market niche in tourism industry and exploit it before any other competitors make entry.

West Co should remain careful about the credit rating and gearing of the company too. If the offer from TI is accepted, than West Co would be subject to a risk arising from TI, which would exist due to TI being West Co's debtor. It must be made sure that TI has a good credit rating and does not have a high gearing ratio.

West Co should also draft a budget for its expected course of action. A budget is a detailed and financial plan for a future time period. Planning for the future is important for all organizations. If no plans are made, an organization drifts without real direction and purpose. Managers will not be able to allocate the scarce resources of business effectively without a plan to work towards.

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Without a detailed and co-ordinate set of plans for allocating money and resources of the business, decision making can not take place.

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