A Detailed Analysis of the Activities of Luton Airport - Case Study Example

LUTONIAN AIRPORT CASE STUDY Barsands Plc owns and operates Lutonian Airport. AirCraft refuelling, passenger meals, car parking and airport shops are contracted out to other suppliers. Air Traffic Control is carried out by a government agency. All the remaining activities at Lutonian Airport concerned with passenger and aircraft movements are the responsibility of Barsands Plc. Four airlines operate from Lutonian Airport: Alpha Airlines; Broom Flights; FastJet and Mason Airlions. Currently Barsand Plc uses absorption costing to allocate overhead costs based on the number of passenger departures to the four airlines. It charges the airlines £5.75 per passenger departure. It is considering changing to an Activity based costing approach (ABC). Barsands Plc intends to change its pricing policy and charge these airlines £180 per aircraft movement (take off or landing) and £2.75 per passenger departure. The company has gathered the following information: The key activities carried out by Barsands Plc at Lutonian Airport, and their cost drivers are: Activity Cost driver Costs per year (£000) Passenger check in Passenger departures 2,025 Baggage handling Bags handled 3,680 Aircraft cleaning Aircraft movements 846 Security Passenger departures 1,003 Emergency services Aircraft movements 1,921 Airport cleaning Passenger departure 914 Administration Aircraft movements 1,105 Ground handling Aircraft movements 1,603 TOTAL 13,097 Consumption of each of the cost drivers per year by the four airline customers is as follows: Airline Alpha Airlines Broom Flights FastJet Mason Airlions Passenger departures 1,132,000 1,020,000 384,000 92,000 Bags handled 2,625,000 3,870,000 2,465,000 240,000 Aircraft movements 14,000 8,000 3,600 18,200 Barsands Plcs, board of directors are concerned that the Return on Investment at Lutonian Airport is lower than the average of 9% achieved by comparable airports. The capital employed at Lutonian Airport is £36,000,000. You have been assigned to analyse the position and make recommendations. ASSIGNMENT PART B (80 MARKS) SECTION 1 LUTONIAN AIRPORT CASE STUDY CONTINUED REQUIRED: Making use of the results obtained from your excel spreadsheet: (a) Calculate Lutonian Airport’s annual revenues under both Absorption and ABC from each airline and in total. (4 marks) Under the absorption costing, the total revenues for the company is computed by multiplying the rate per passenger departure and the number of passenger departures, since the airport charges its usage based on the number of passenger departures. This results in a total revenue for the company amounting to 15,111,000, or 2,628,000 multiplied by the charge of 5.75 per passenger departure. Under the ABC system however, the revenue is split between the activity drivers passenger departures and aircraft movements. With the revised pricing policy, the company charges 2.75 per passenger departure, and an additional 180 for every aircraft movement. Revenues from passenger departures amount to 7,227,000, while revenues for aircraft movements amount to 7,884,000. This gives a total revenue figure of 15,111,000. (b) Calculate the profitability for each of Lutonian Airports four customer airlines and for Lutonian Airport in total. (6 marks) Under absorption costing, the companys total revenues equal 15,111,000, while its total costs amount to 13,097,000, giving a total profit figure of 2,014,000. Under absorption costing, the cost allocation rate is computed by dividing the total costs by the total number of passenger departures. This rate is then multiplied to the respective quantities of passenger departures per airline, thus providing the costs to the individual airlines. For Alpha Airlines with 1,132,000 passenger departures, the cost to Lutonian is 5,641,477.93. The profits for this airline amounts to 867,522.07—the highest contributor to the total profits of the airport. For Broom Flights with 1,020,000 passenger departures, the cost is 5,083,310.5 which leaves 781,689.5 in profits. For Fast Jet with 384,000 passenger departures, the cost to the company amounts to 1,913,716.89, leaving profits amounting to 294,283.11. For Mason Airlions with 92,000 passenger departures, the cost to the company amounts to 458,494.67, leaving 70,505.33 in profits. Under the ABC system however, the costs are computed according to their corresponding cost drivers. Under the cost allocation schedule, the rate for an individual cost item depending on the total quantity of activities for a certain cost driver is computed. This rate, multiplied to the respective quantity of activities to each company results in the allocation of costs depending on the cost drivers associated with the activities. For Alpha Airlines for example, the total costs change to 4,498,140. This changes the respective profitability from 1,134,860 which is higher than its respective share under the absorption costing. For Broom Flights, the total costs amount to 4,078,080 under the ABC system, with a profit amounting to 166,920—way lower than its respective share under the absorption costing. For Fast Jet, the total costs amount to 2,012,036, and a net loss of 308,036, way lower than its share of profits under absorption costing. The cost to Lutonian from its operations from Mason Airlions amount to 2,509,182, with a profit of 1,019,818—way higher than its share of profits under absorption costing. (c) Comment on the profitability of each airline for the airport and comment on what the analysis reveals about the airports current pricing structure. (10 marks) While the analysis shows no difference in terms of total revenues, total costs and total profits between the absorption costing and the ABC system, the analysis shows huge discrepancies in terms of contribution to revenues, costs and overall profitability among the four individual airlines. While under the absorption costing, the basis of the price and the costs is only the number of passenger departures, by incorporating different activities under the ABC system and making these activities the bases for pricing and costing decisions, the share of profitability for each airline becomes more apparent. For example, under the absorption costing, Mason Airlions seems to be the least profitable among the four customers of the company. This is because, the basis for the profitability is merely the cost driver passenger departures, which is low for Mason Airlines. Under the ABC system however, when the pricing is based on the companys two cost drivers, and significant activities are broken down according to their respective cost drivers, costs are more appropriately allocated. These show that Mason Airlions, in fact is the next most profitable customer to Lutonian, after Alpha Airlines. Under ABC system, Alpha Airlines share in the companys profitability is also higher than its share under absorption costing. What is more significant is that, while the company thinks it is making money from FastJet under the absorption costing, the company is incurring a net loss under the ABC system. This is after determining the significant cost drivers, determining the cause and effect relationships between them to better allocate the costs, according to what causes them. (d) Wider applications of activity based costing “ABC is an improvement on conventional absorption costing in that it enables the organisation to build up a more realistic figure for the costs attributed to each product. However, the provision of more realistic product costs should be a by-product rather than an explicit aim of ABC. The strength of ABC lies not in any inherent improvement in product or service costing but in the way in which it aids budgeting and cost reduction.“ Explain, in addition to providing product/service costs, how an activity based costing system can be used to generate a variety of other useful information for Lutonian Airport. (8 marks) The ABC system breaks down the cost items into activities that serve as the causes for the company to incur such costs. In other words, the cause and effect relationships between the cost items and certain items are identified in order to more accurately allocate the costs (Stratton et al 2009, 39), and the basis for allocation becomes stronger in order to make better decisions (Babad & Bala 1993). Using the ABC system, it is apparent that pricing the service according to value-adding activities to the customer, rather than only one activity reflects the true economic benefit to the customer. In such case, pricing the service not only according to passenger departures, but also according to aircraft movement, which is a significant activity for airlines is a significant decision to the management. With this, the company sees who gets to use its facility the most and should be charged more appropriately. This is true for the case of Mason Airlions, for example. Under the ABC system, the share in terms of profitability from each customer is also assessed based on the cost the company incurs on them by providing them services in terms of the the significant cost activities. Therefore, it can be seen, for example, which customer to prioritize and which one to drop as judged by their share of profitability to the company. If the company loses money on one customer, decisions should be made in order to cut further losses, or on how to improve profitability under such customer. This is the case for Fast Jet. Because the company can determine the rate in terms of allocation per cost item, the company can determine which among the cost items, in relation to the cost driver has the highest rate as well. For example, based on the cost allocations schedule, the cost with the highest allocation for the cost driver aircraft movement is emergency services. The company spends most in emergency services, in line with the aircraft movement cost driver. The company can identify activities that are non-value adding to the customers, and decide on how to minimize such costs in order to increase profitability. (e) Early critics of ABC claimed that the system was ‘nothing new’, ‘simply applied common sense’, and just another version of absorption costing’. Give reasons why this is not true. (8 marks) This is not true. As mentioned earlier, ABC system tries is about defining key activities and their respective cost drivers, for the purposes of allocating costs more accurately (Stratton et al 2009, 39). Under this system, the relationships between the activities and their resource consumption as regards to the cost that a company incurs for them becomes clearer (Stratton et al 2009, 39). With these relationships, a company will have the ability to know where to cut costs without affecting the value it provides to its customers: As the company segregates its cost items according to certain activities, it will have a better picture of what activities are value-adding, as well as those which are non-value adding to customers. These are the key activities where it can minimize the costs without changing the value it provides to its customers, thus harming its relationships to the latter (Stratton et al 2009, 39). CASE STUDY 2 ALPHA PRODUCTS Alpha Products Plc is also owned by Barsands Bank and is considering undertaking a project to produce a new product called Drake. Drake would be produced using a machine costing £100,000. The machine would be used for 4 years and then sold for £20,000. To date, the research and development costs have totalled £150,000. The sales price and costs per unit for product Drake at current prices are as follows: £ Sales price 70 Material 3kg @ £10/kg 30 Labour 1.5hr @ £10/hr 15 Contribution/unit 25 Fixed cost specific to this project is £45,000 per year (including depreciation on the machine). Expected demand is 3,000 product units per year. The company depreciates the machine on a straight-line basis. The company has decided to maintain the sales price at £70/product unit due to increasing competition but its costs are subject to inflation. Inflation rates Material 2%pa Labour 3%pa Fixed costs 4%pa The company uses a target accounting rate of return of 15%pa. A target payback period of 2 years. The company’s cost of capital is 12%pa. The Managing Director of Alpha Products Ltd is concerned on the appropriate methods it should use to carry out investment appraisal of its projects. The Financial director has suggested the following methods could be used: (i) Accounting rate of return (ii) Payback period (iii) Net Present Value Required (a) Calculate the net present value of the project and comment on whether the project should be undertaken. (18 marks) There are three significant cash flow items in this case in order to get the projects NPV. The first one, the initial outlay, then the cash flows from operations, lastly, the terminal cash flows. The initial outlay is comprised of the cost of the machine, which is 100,000. The initial outlay does not include the cost of research and development—because the incremental cash flows are analyzed, this cost of R&D is already considered a sunk cost, therefore, insignificant. Since there are no provisions as to increase of working capital in relation to operating the machine, there is no incremental working capital. As for the terminal cash flow, this should be comprised by the salvage value of the capital asset, as well as redeemable amount of the working capital. Since there is no mention of incremental working capital, the only significant terminal cash flow is the salvage value, which has to be discounted back using the 12% discount rate for four years. For the cash flow from operations, the profits are first determined. After the profits are computed, the depreciation which amounts to 25,000, or 100,000/4 per year is added back. This comprises the companys operating cash flows. From the computation, the net present value of the project amounts to 63,175.57. If the positive NPV is the basis, the project should be taken. (b) Advise Alpha Products Ltd whether they should accept or reject the project. Give reasons for your recommendation. (2 marks) The project should be accepted. First, using the NPV method, the project will yield a positive value to the firm of 63,175.57. As the companys target payback for the project is 2 years, this project has 1 year and 10.58 months, which is less than the target. Even if the denominator used for the accounting rate of return is the original investment, the lowest accounting rate of return among the four years is higher than the firms target of 15%. The highest accounting rate of return for the project is 30%, while the lowest is 18% using the original investment as the denominator. Therefore, the project should be considered and accepted. (c) Discuss the main advantages and disadvantages of each method suggested by the Finance director and give reasons why a company might use each method. (14 marks) The goal of capital budgeting is to choose projects that will contribute and add value to the company. This increase in value is reflected by the time value of money, a principle in finance that states that there is an opportunity cost to holding money, thus companies are obliged as agents to the owners to choose projects that would yield higher returns than the opportunity cost of investing money in other ventures. This is the way the company creates value to its shareholders wealth. In line with this, three appraisal methods are used to evaluate projects—with the net present value as the strongest of the methods as it incorporates the concept of the time value of money in the analysis, and uses the investors required rate of return as the hurdle rate as basis on what projects will be chosen (Watt 2009). Thus, those projects that have positive net present value contribute to maximizing the wealth of the shareholders. The opportunity cost of investing money somewhere else, from the point of view of the investors is assumed, therefore this method reflects the benefit to investors when the project is undertaken (Greenfield, Randall & Woods 1983). However, there is a major drawback to using the net present value. The net present value, in order to be computed requires a hurdle rate. This hurdle rate is the companys weighted average cost of capital. Even though there are some formula that are used in order to determine the components of the cost of capital, it still requires certain degree of judgment on the part of the one which computes for it, if the company is not a public one (Watt 2009). This leaves for margin of error for the company—not a hard and fast measure of value. The traditional use of the payback period is to get the amount of time needed in order to recoup the investment by the cash flow from the companys operations. Corporations use this method because of its simplicity, as well as its ability to predict in terms of the amount of time when the company will be able to get its investment from the venture (Weingartner 1969). However, because the payback method uses the cash flow without regard to the time value of money, this is considered a weak approach. This does not include the economic cost, or opportunity costs of money from the point of view of the investors (Boardman, Reinhart & Celec 1982). Because it does not capture this cost, the payback method does not capture the concept of wealth creation for the shareholders when deciding to undertake a certain capital budgeting decision. The accounting rate of return is computed by dividing the annual average increase in operating income by the average investment. Companies use this in order to predict the rate of returns as measured by operating income from the investment that is undertaken. The major drawback in this method, lies on the numerator—the use of net income, which is an accounting perspective, contrary to the use of cash flows, which is an economic perspective (Salamon 1985). Net income is the benefit from the accounting perspective, which is based on the accrual method. It disregards the timing of the cash flow, which is significant in measuring the benefit of the project against the opportunity cost of the financial capital employed (Salamon 1985). Net income does not consider the timing of the cash flows, and the equation does not consider the effect of time value of money in the analysis (Watt 2009). Thus, in terms of creating shareholder value by accepting certain projects, this is also a weak method for capital budgeting. Evidence of research, bibliography and presentation (10 marks) ( TOTAL 100 MARKS) References Babad, Yair M., and Bala V. Balachandran. 1993. "Cost Driver Optimization in Activity-Based Costing." Accounting Review 68, no. 3: 563-575. Business Source Premier, EBSCOhost (accessed September 13, 2009). Boardman, Calvin M., Walter J. Reinhart, and Stephen E. Celec. 1982. "THE ROLE OF THE PAYBACK PERIOD IN THE THEORY AND APPLICATION OF DURATION TO CAPITAL BUDGETING." Journal of Business Finance & Accounting 9, no. 4: 511-522. Business Source Premier, EBSCOhost (accessed September 13, 2009). Greenfield, Robert L., Maury R. Randall, and John C. Woods. 1983. "Financial Leverage and the Use of the Net Present Value Investment Criterion." Financial Management (1972) 12, no. 3: 40-44. Business Source Premier, EBSCOhost (accessed September 13, 2009). Salamon, Gerald L. 1985. "Accounting Rates of Return." American Economic Review 75, no. 3: 495. Business Source Premier, EBSCOhost (accessed September 13, 2009). STRATTON, WILLIAM O., D.E.N.I.S. DESROCHES, RAEFA . LAWSON, and T.O.B.Y. HATCH. 2009. "Activity-Based Costing: Is It Still Relevant?." Management Accounting Quarterly 10, no. 3: 31-40. Business Source Premier, EBSCOhost (accessed September 13, 2009). Watt, Amanda. 2009. "Understanding payback on investments." NZ Business 23, no. 6: 58-58. Business Source Premier, EBSCOhost (accessed September 13, 2009). Weingartner, H. Martin. 1969. "SOME NEW VIEWS ON THE PAYBACK PERIOD AND CAPITAL BUDGETING DECISIONS." Management Science 15, no. 12: B-594-B-607. Business Source Premier, EBSCOhost (accessed September 13, 2009). Bibliography 12Manage.com. 2008 November 8. Valuing stocks, securities, derivatives, and/or assets by relating risk and expected return: Explanation of Capital Asset Pricing Model of William Sharpe. Available from http://www.12manage.com/methods_capm.html. (accessed September 13, 2009). Horngren, C. T., Harrison Jr., W. T., & Bamber, L. S., 2002. Accounting. 5th edition. New Jersey: Prentice-Hall International, Inc. Horngren, C. T., Sundem, G. L., & Stratton, W. O., 1996. Introduction to Management Accounting. 10th edition. 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