A High-Flying Problem Slightly modified version of an example taken from Trivedi (1991). The chairman of the board of Transcontinental Airlines Incorporated has convened an emergency meeting of the board to discuss his airlines’ dismal profits. The main agenda for the meeting is a proposal submitted by a consultant for increasing the firm’s profits. The consultant has argued that the airline is leaving potential profits on the table. She asserts that the airline should fly all routes on which it can earn enough to cover its out-of-pocket expenses. She illustrated her case using the following example. The Question: Should Transcontinental run an extra daily flight from Birmingham to Austin? The Facts: Fully allocated cost of this flight = $155,000 Out-of-pocket expenses of the flight = $130,000 Expected revenue from the flight = $142,000 The Decision: Run the flight. The “fully allocated” cost of the flight differs from the “out-of-pocket expenses” for the flight because, whether the flight is run or not, the airline has to pay for the hangar that it uses to house the plane when it’s not in the air, monthly runway fees owed to the airport, and so forth. These added expenses total $25,000. Fully allocated expenses include these costs plus the out-of-pocket expenses of the flight. The consultant argues that the airline has been foolish not to run flights of this sort, at least until the firm’s long-term costs can be re-structured (e.g., by reducing the size of the airline’s fleet). The chairman of the board thinks that the consultant has a screw loose. “If we run these flights, we’re going to lose money,” he argues. “It’s right there in your numbers – the costs of this flight exceed the revenues that it would produce!” Who is right, the chairman of the board or the consultant? Explain your answer.
A High-Flying Problem
Slightly modified version of an example taken from Trivedi (1991). The chairman of the board of Transcontinental Airlines Incorporated has convened an emergency meeting of the board to discuss his airlines’ dismal profits. The main agenda for the meeting is a proposal submitted by a consultant for increasing the firm’s profits. The consultant has argued that the airline is leaving potential profits on the table. She asserts that the airline should fly all routes on which it can earn enough to cover its out-of-pocket expenses. She illustrated her case using the following example.
The Question:
Should Transcontinental run an extra daily flight from Birmingham to Austin?
The Facts:
Fully allocated cost of this flight = $155,000 Out-of-pocket expenses of the flight = $130,000 Expected revenue from the flight = $142,000
The Decision:
Run the flight. The “fully allocated” cost of the flight differs from the “out-of-pocket expenses” for the flight because, whether the flight is run or not, the airline has to pay for the hangar that it uses to house the plane when it’s not in the air, monthly runway fees owed to the airport, and so forth. These added expenses total $25,000. Fully allocated expenses include these costs plus the out-of-pocket expenses of the flight. The consultant argues that the airline has been foolish not to run flights of this sort, at least until the firm’s long-term costs can be re-structured (e.g., by reducing the size of the airline’s fleet). The chairman of the board thinks that the consultant has a screw loose. “If we run these flights, we’re going to lose money,” he argues. “It’s right there in your numbers – the costs of this flight exceed the revenues that it would produce!” Who is right, the chairman of the board or the consultant? Explain your answer.
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