TN Lecture 2 PDF

324223: IMA (2018 -2019) Lecture 2: RegionFly (2)
Teaching Notes – RegionFly

Lecture objectives
By learning this week’s case, students should be able to:
1. Recall the basic costing concepts, including cost classification, cost behavior, cost allocation, and
the cost-volume-profit analysis.
2. Describe why a costing system is necessary for modern organizations
3. Based on the RegionFly case, calculate allocated costs using the volume-based cost allocation
method.
4. Describe the features of the volume-based cost allocation method.
5. Based on the RegionFly case, identify the weaknesses of the volume-based method.
Link to the course goals (CGs)

This lecture is linked to:
CG2: Describe the features of different costing systems (i.e., rate-based cost allocation, ABC, TDABC).
CG3: Calculate cost allocation and profits using different costing systems; compare and analyze the
results of different systems.
CG4: Evaluate the advantages and disadvantages of different costing system and choose the most
appropriate system based on the business context.
Knowledge Structure
1. Basic cost concepts
See teaching notes Lecture 2 (1) for details.
2. Volume-based (also called rate-based) cost allocation method

Feature: Allocating indirect costs to a cost object. A cost object is anything for which cost data are
desired (e.g., products, product line, customers, jobs, subunits for organizations, etc.)
Strengths: Easy to understand and implement. Not expensive.
Weaknesses:
1) It does not recognize that different products may incur indirect costs in different ways. For
example, some products may have low production volume and/or machine hours, but it will
incur similar or even more indirect costs than products that have higher volume and/or machine
hours. In other words, the volume-based cost allocation is not accurate and may lead to biased
decision of the managers.
2) It ignores the fact that some indirect costs are fixed and will not change with the volume of the
products. It may lead managers to wrong perception about the profitability of different products
and undesired decisions about whether to cut a particular product line.
See the examples in teaching notes Lecture 2 (1)
3. Resources Spending versus Resources Consuming

Resources Spending ≠ Resources Consuming
 Resources spending may be independent from volumes produced;
− For example, a firm needs to pay for the rent of its warehouse/factory/office regardless
of the volume it sells.
 Resources consuming is usually directly related to production;
− For example, the direct and/or indirect labor and materials used to produce the
products change proportionally with the volume of the production.
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When saving costs, managers need to reduce both resource spending and resource consumption to
make the saving work. Managers need to think the following question carefully:
Which costs are avoidable and which are unavoidable?
To answer this questions, managers need to be familiar with the cost behaviors, as fixed and variable
costs as approximation of what costs are unavoidable or avoidable:
 Variable costs change proportionally with volume;
 Fixed costs remain fixed throughout.
− This may not always be the case. If a firm increases/decreases its capacity (e.g.,
purchased a new machine or sold a warehouse), its fixed costs will change. But even
when fixed costs change, it does not change proportionally with volume of product.
4. Death spiral
The death spiral can be summarized as follows:
 A product is dropped from the lineup;
 Production and sales volumes decrease;
 Some of the overhead/indirect costs are fixed and do not decrease with the production and sales
volumes;
 Overhead cost allocation rate (=overhead costs/allocation base) increases if the allocation base
(usually volumes or variable costs) decreases significantly more than overhead costs;
 Reported costs of remaining products increase. In some cases, more products will fall under
the minimum profitability criterion;
 More products are dropped from the lineup as their costs are “too high”.
The iterative cycle described above might eventually lead to the elimination of all products from the
lineup, resulting in the death of the firm. More remarks about death spiral:
 There are fixed components to overhead costs. Those fixed components will not go away as a
result of a product drop, which causes the vicious cycle in death spiral;
 In practices, classifying costs as fixed or variable is not always easy;
 In this particular case the death spiral was relatively easy to identify. However, in companies
that produce hundreds of products, such effect might not be as easy to isolate;
 Reducing resource consumption is the only effective way to implement successful cost
reduction initiatives.
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Case synopsis
1. Situation in the competitive market
RegionFly’s business model:
 Focus on a specific niche of the airline industry, i.e., the premium services (high price +
high quality service).
 The quality of the service has been recognized by their customers.
 The firm's culture focused on maintaining the corporate image and identity, even at the
expense of growth and expansion opportunities.
Although this business model helped RegionFly achieved high performance in the previous three
decades. The economic environment and customers’ preference have changed:
 As a result of the Great Recession, travelers have become sensitive to prices. The demand
shifts from ultra-premium first class services to business class or economy class, thus
reducing RegionFly’s revenues and profitability;
 Airlines are merging. The economies of scale reduce costs and increase price competition.
RegionFly used to decline the opportunities to expand. So now it does not have the size to
exploit similar economies of scale, and costs can be reduced only at the expense of quality
of service.
As a result, RegionFly’s financial performance keeps declining, and researched the lowest level in
2012.
2. Current strategy and cost system

As a reaction to the decrease in profitability, RegionFly introduces two important initiatives:
 Aggressive cost cutting measures "across the board”;
 Product profit margin criterion, leading to the elimination of two of the seven routes
historically served by the company.
The management team of RegionFly decides to drop routes based on their profitability. If any route
were to contribute less than 25% of its revenue toward the overall firm profit, this route’s costs are
considered as “too high” and this route will be dropped. To calculate the profitability of each route,
the management team needs to allocate the overhead costs to each route. The current cost system
allocate overhead costs to each route based on variable costs.
Variable direct costs (VDC) are used as cost allocation base. The management team:
1) Divides total overhead (i.e., indirect cost pool) by total VDC to calculate a cost allocation
rate;
2) Use the cost allocation rate to allocate overhead costs to each route;
3) Calculate the contribution of each route based on its revenue, direct costs incurred, and
allocated overhead costs.
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3. Cost behaviors
In 2013, Route 2 and 4 were dropped as they failed the “contribution test”. However, the situation
of RegionFly has not been improved, but become even worse. After the two routes were dropped,
revenue and direct variable costs dropped proportionally with the volume. But overhead costs
dropped less, as some of the overhead costs are fixed or partially fixed. A lot of the overhead costs
are still incurred, even in the situation of declining volumes. Due to a reduction in volumes, the
overhead allocation rate increases from 267% to 302%. Each route is allocated with more overhead
costs, especially the routes that can generate higher revenue, because routes that can generate higher
revenue also tend to incur higher variable direct costs.
The management team is deciding whether they should drop Route 7, as its profitability does not
pass the “contribution test”. To make this decision, it is important to recognize that by dropping a
route, which costs can be reduced and which cannot:
 Variable costs remain constant in proportion to the chosen allocation base.
 Fixed costs incurred are not impacted by the volume of production. However, the amount
of the expense might not be exactly the same over time.
 Fixed and variable costs are an approximation of what costs are avoidable or unavoidable.
For example, the costs that will still be incurred by the firm after a change in service mix
(i.e. dropping Route 7) are unavoidable with respect to that particular decision, whereas
the costs that might disappear due to the change are, instead, avoidable.
 In order to obtain results from a cost cutting initiative, it is imperative that both
consumption of and spending on resources is reduced.
Classifying costs as fixed or variable may not always be an easy task. Many costs in real life are
not clearly fixed or clearly variable. Some grey areas exist for costs that are “mostly fixed” or
“mostly variable”. Classifying these costs might require some degree of subjective judgment. The
description of costs reported in Exhibit 2 might aid in the interpretation of the cost categories and
in their subsequent classification as fixed or variable. Additionally, the behavior of the overhead
costs reported in Exhibit 1 can be analyzed numerically.
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Exhibit 1
Based on these analyses, costs reported in accounts 1000, 3000, and 7000 are completely variable
with respect to direct variable costs, as the rates are constant despite changes in volumes. The other
overheads accounts appear to include costs that are, at least, semi-fixed.
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4. Decision about Route 7

The key point of the case is the decision of dropping vs. keeping Route 7. To make this decision,
the management team needs to estimate and compare financial results for RegionFly in the two
scenarios. If Route 7 were kept, then the financial performance in 2015 would be estimated to be
exactly the same as it was in 2014. However, if Route 7 were dropped, total costs and revenues for
RegionFly would, in general, decrease. Route 7 is a major contributor to the overall revenue;
therefore, dropping Route 7 will negatively impact the top line for RegionFly. The total variable
direct costs will also decrease by the amount accounted for in 2014 with respect to Route 7.
The analysis of the changes in overhead costs is less intuitive. Since there isn't always a direct link
between volume of production and overhead costs incurred, analyzing the effect of a previously
experienced comparable event might inform the prediction of overhead amounts for 2015. As
described in the case, Route 2 and Route 4 were dropped at the beginning of 2013. As a
consequence of having dropped the two routes, variable direct costs decreased by 26.73% between
2012 and 2013. Since dropping Route 7 in 2015 would reduce variable direct costs by 24.92%, the
two events might be considered comparable. Therefore, analyzing the changes in costs between
2012 and 2013 might inform the prediction of RegionFly’s financial results in 2015. Using the
information from 2013 to 2014, estimations about the overhead costs can be prepared (see the
answers for Q4).
Based on these analyses, if Route 7 is dropped:

 Even if overhead costs decrease in total, the overhead allocation rate increases as a result
of the greater reduction in the allocation base (total variable direct costs). Those overhead
costs that are not purely variable and do not decrease proportionally to the variable direct
costs;
 RegionFly's profit decreases, because certain overhead costs do not diminish
proportionally;
 It will future reduce the cost allocation base and the size of the firm, lead more routes to be
dropped and cause death spiral.
 This result is inconsistent with the expectations that senior managers and the consulting
team had formed when the 25% profit margin criterion was introduce.
This case shows that rationalizing the product portfolio can be done successfully only if there is
careful consideration of the effects on fixed and variable costs and, consequently, on the overall
profitability of the firm.
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Answers to the case questions

Q1: Calculate the overhead allocation rate per variable direct cost dollar (VDC) for each of the years
(2011, 2012, 2013, and 2014).
A: Overhead allocation rate = 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡𝑠 ÷ 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒
= 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡𝑠 ÷ VDC
2011 2012 2013 2014

Total overhead $2,697,292 $2,809,015 $2,331,876 $2,179,686
Total VDC $1,013,732 $1,053,342 $771,782 $722,206
Overhead Allocation rate 266% 267% 302% 302%
Q2: Are the route costs reported by the cost system appropriate for use in the current strategic analysis?
Your judgment should be informed by a classification of the costs listed in Exhibit 2 as variable or
fixed.
A: No. The purpose of the current strategic analysis is to cut costs and increase profitability. The costs
reported were not appropriate, as the current cost system ignores that even drop a route, the fixed costs
will not decrease proportionally with the revenue and variable costs. Dropping a route based on the
current cost system will not lead to high profitability as expected by the management team.
Q3: What happened to the costs when Route 2 and Route 4 were dropped? What is likely to happen if Route
7 is dropped as well?
A: After Route 2 and Route 4 were dropped, both revenue and direct costs decreased. Some of the overhead
costs also decreased (i.e., 1000, 3000, 7000). However, the other overhead costs did not decreased
significantly (i.e., 2000, 4000, 5000, 6000). From 2012 to 2013:
 Revenue decreased by ($5,713,233 - $4,416,922)/$5,713,233 = 22.69% VCD $ decreased

by ($1,053,342 - $771,782)/$1,053,342 = 26.73%
 Overhead decreased by ($2,809,015 - $2,331,876)/$2,809,015 = 16.99%
 Operating profits decreased by ($1,850,877 – 1,313,264)/$1,850,877 = 29.05%
Overhead costs didn’t decrease as much as the revenue or the direct variable costs. Dropping route 7
may have similar effect, as some of the overhead costs are fixed or partially fixed and thus will not
decrease significantly if route 7 were dropped.
Q4: Assume that revenues and variable direct costs for each route in 2015 will be the same as they were
in 2014. Also assume that if Route 7 is kept, revenues and variable direct costs will not change either.
With this information:
a) Prepare an estimate of the budget for 2015, with respect to the following scenarios:
i) No additional routes are dropped;
ii) Route 7 is dropped in 2015;
b) What assumptions did you make to prepare this estimation?
c) What will be the overhead rate in each of the above scenarios?
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A: Budget for Revenue and VDC are easy to prepare, as they are assumed to be the same as in 2014:
2015 not drop Route 7 drop Route 7
Revenue
Route 1 $1,273,941 $1,273,941
Route 2 $0 $0
Route 3 $901,845 $901,845
Route 4 $0 $0
Route 5 $608,818 $608,818
Route 6 $539,726 $539,726
Route 7 $840,010 $0
Total $4,164,339 $3,324,329
Variable Direct Costs

Route 1 $205,474 $205,474
Route 2 $0 $0
Route 3 $154,203 $154,203
Route 4 $0 $0
Route 5 $98,196 $98,196
Route 6 $84,332 $84,332
Route 7 $180,000 $0
Total $722,206 $542,206
For overhead costs, we need to estimate how they would change if Route 7 were dropped. We don't
have the actual information about how they change, so the best we can do is to make estimations
based on the information of 2012 and 2013, when Route 2 and Route 4 were dropped:
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Based these rates, we can estimate the overhead costs if dropping Route 7:
Be aware that the budget and allocation rate presented above are just our estimations, which would
be different with the actual costs. But it can inform the management team that the overhead costs
does not decrease proportionally with the volume if Route 7 were dropped.
Assumptions made to prepare these estimations:

 Market conditions will not change in 2015, so revenue and costs will remain similar if not
dropping route 7;
 The company will not make other changes, such as the change of strategies, selling channels,
equipment, etc.;
 Cost behaviors remain the same.
− For example, if the company cut some administrative positions or move their office
to a building with cheaper rent, the fixed costs will change.
Q5: Would you drop Route 7 in 2015? Why or why not? What additional information would you require
before making a final decision?
A: Dropping route 7 may not be a good decision for RegionFly, as it is likely to cause death spiral. If Route
7 were drooped:
 Products were dropped. Production volume would decrease.
 Allocation base would decrease disproportionately more than overhead costs decrease.
 Burden rate for the remaining routes would increase.
 Reported costs of remaining routes increase.
 More routes would be dropped, until no routes were left.
 Death of the firm.
To make decision about whether to drop Route 7 and what the company should do in the next step,
additional information shall be collected, for example:
 Trend in the airline market: Price? Customer preference? Competitors?
 Trend in raw material and personnel market: Price of crude oil? Employee salary?
 Any change in cost behaviors?
 Change in technology? Conditions of current equipment?
 Other changes that may happen in the firm?
Students are encouraged to think of other information that would be relevant.
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324223: IMA (2018 -2019) Lecture 2: RegionFly (2)

Teaching Notes – RegionFly

Link to the course goals (CGs)

2. Volume-based (also called rate-based) cost allocation method

3. Resources Spending versus Resources Consuming

Which costs are avoidable and which are unavoidable?

2. Current strategy and cost system

4. Decision about Route 7

Based on these analyses, if Route 7 is dropped:

Answers to the case questions

2011 2012 2013 2014

 Revenue decreased by ($5,713,233 - $4,416,922)/$5,713,233 = 22.69% VCD $ decreased

Variable Direct Costs

Assumptions made to prepare these estimations:

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