UNIVERSITY OF Hertfordshire

MASTER OF BUSINESS ADMINISTRATION

COURSE CODE: XXXXXX TITLE OF ASSIGNMENT

Management Accounting: A case of Hertfordshire Airways PLC

Author's initials and surname J. Law Students Registration Number XXXXXXXX Month and year of submission
JANUARY 2009

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Table of Contents
1. Executive Summary.............................................................................3 2. Strategic Decision Independent of Forecasting Team..........................4 2.1 Strategic Decision 1: New Fuel Efficient Aircraft (Type A)...............4 2.1.1 Cost Considerations for Aircraft Type A....................................4 2.1.2 Revenue Considerations...........................................................5 2.1.3 Profit Consideration..................................................................5 2.1.4 Analysis.....................................................................................6 2.2 Strategic Decision 2: Improved Design of Current Model................6 2.2.1 Cost Considerations for Aircraft Model Improvement...............7 2.2.2 Revenue Considerations: Optimistic Scenario..........................7 2.2.3 Profit Consideration: Optimistic Scenario..................................8 2.2.4 Analysis.....................................................................................8 2.3 Strategic Decision 3: Previous Aircraft Model.................................9 2.3.1 Cost Considerations for Aircraft Model Improvement...............9 2.3.2 Revenue Considerations: Optimistic Scenario........................10 2.3.3 Profit Consideration: Optimistic Scenario................................10 2.3.4 Analysis...................................................................................11 3. Strategic Decision based on Predictions of Forecasting Team...........12 ...............................................................................................................12 3.1 Analysis.........................................................................................12 3.2 Final Recommendations................................................................13 4. Assumptions & Methodology: Traditional Cost System......................13 4.1 Critique: Traditional Based Cost System.......................................13 4.2 Alternative: Activity Based Costing Approaches...........................13 4.3 ABC: Overcoming Limitations & Improving Decision Making........14 4.3.1 Price Allocation.......................................................................14 4.3.2 Revenue Generation vs Resource Consumption.....................14 4.3.3 Different Views........................................................................14 5. Strategy Option: Short Haul Flights....................................................15 6. Bibliography & Reference...................................................................15

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Assignment Overview

1. Executive Summary
Hertfordshire Airways is currently in the process of repositioning itself as market leader after long years of market domination, but with an ageing fleet and dip in profits, Hertfordshire Airways seeks recommendations on the best strategy to implement amongst three options as it responds with a commitment to long haul routes which requires renewal of its fleet of aircrafts. In this report, utilizing the traditional cost methodology which involves identifying and calculating the key cost drivers such as variable cost, fixed cost and projected profitability, I have outlined for top management the viability of three different strategies and a final recommendation on the best option based on sample evidence as the company pursues its drive to renew its fleet for long haul flights. For the first strategy which is the purchase of 35 new fuel-efficient aircrafts of type (A), which is a radically new aircraft model, with a projection of no delivery delays and a realistic scenario, the company would incur a total cost of 837,600,000, a total revenue of 1,940,400,000 and a projected profitability of 1,102,800,000. For the second strategy which is embarking on the purchase of 15 new aircrafts of type (A) and 25 new aircrafts of type (B) which are both improved designs of the current model, the company would incur a total cost of 362,400,000, a total revenue of 831,600,000 and a projected profitability of 469,200,000 for the 15 new aircrafts of type (A). In addition, the company would incur a total cost of 298,000,000, a total revenue of 588,000,000 and a projected profitability of 290,000,000 if it purchases 25 new aircrafts of type (B). With regards the final strategy, if the company embarks on purchasing 25 aircrafts of type (B) and 25 new aircrafts of type (C), which are previous designs of the current model, it would incur a total cost of 298,000,000, a total revenue of 588,000,000 and a projected profitability of 290,000,000 for aircrafts type (B) and incur a total cost of 156,625,000, a total revenue of 306,250,000 and a projected profitability of 149,625,000 for aircrafts type (C). Based on the sample evidence, I would therefore recommend the third strategy because based on delivery delays of 3 years for aircraft type (A) and 18 months for aircraft type (B), the company would run at a loss of 18,000,000 fixed cost for the first 3 years if it decides to go ahead with the first strategy and would only break even in year 3, while the company would run at a loss of -8,000,000 fixed cost for the first two years if it decides to go ahead with the second strategy and would only break even at the end of year 2. But with the third strategy, there are no delivery delays and the company would be better positioned to overcome the disruptions, risks, teething issues which are synonymous with the
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introduction of major new models of aircraft. In addition, based on the fact that a ten year profitability projection is desired starting from 2007, profitability of 290,000,000 for aircraft type (B) and 149,625,000 for aircrafts type (C) is most viable considering the other options.

2. Strategic Decision Independent of Forecasting Team

2.1 Strategic Decision 1: New Fuel Efficient Aircraft (Type A) Number of aircrafts = 35 Aircraft capacity for Type A = 550 Total Capacity = 550 * 35 = 19250 Average number of flights per routes for Type A = 90 Total Number of flights / routes for Type A = 90 * 4 = 360 Average ticket price of Type A = 280 Cost per flight for Type (A) - 280 * 19250 = 5,390,000 AFC of Type A = 6,000,000 AVC per passenger for Type A = 120 * 19250 = 2,310,000 2.1.1 Cost Considerations for Aircraft Type A Routes: Cost of Tickets / Flights Total Variable Cost = Variable cost multiplied by the quantity (VCq)
Total Aircraft Capacity 19250 0 AVC per Flight 2,310,0 00 0 Total No of Flights / Routes 360 0

Aircraf t Type A B

Variable Cost for Routes 2,310,000 * 360 = 831,600,000 0

Total Variable Cost for Aircraft Type A = 831,600,000 Fixed Cost

Aircraft Type Total Aircraft Capacity Fixed Cost

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19250

6,000,000

Fixed Cost for Aircraft Type A = 6,000,000 Total Cost for Aircraft Type A = (Fixed Cost) + (Total Variable Cost) TC=FC + VCq Total Cost = 6,000,000 + 831,600,000 Total Cost = 837,600,000

Total cost

6,000,000 + 831,600,000

837,600,0 00

2.1.2 Revenue Considerations Total Revenue = (Selling Price / Unit) Multiplied by (Quantity Sold) TR=pq Total Revenue = 5,390,000 * 360 Total Revenue = 1,940,400,000
Total Aircraft Capacity Average Price / Passenger Total Ticket Cost / Flight Total No of Flights / Routes

Aircraft Type

Total Cost of Tickets / Routes 5,390,000 * 360 = 1,940,400,000

19250

280

5,390,000

360

2.1.3 Profit Consideration Profit = Total Revenue Total Cost Profit = 1,940,400,000 - 837,600,000

Total cost Total

6,000,000 + 831,600,000 5,390,000 * 360

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= =

837,600,00 0 1,940,400,0

revenue Pre-tax profit 2.1.4 Analysis From the calculated analysis, with a projection of no delivery delays and a realistic scenario, it can be observed that if the company decided to buy 35 new fuel-efficient aircraft of type (A), which is a radically new aircraft model, it would incur a total cost of 837,600,000, a total revenue of 1,940,400,000 and a projected profitability of 1,102,800,000. 2.2 Strategic Decision 2: Improved Design of Current Model 15 of aircraft A = 15A 25 of aircraft B = 25B Type C = 0 Aircraft Type A Aircraft capacity for Type A = 550 Average number of flights per routes for Type A = 90 Total Capacity = 550 * 15 = 8250 Total Number of flights / routes for Type A = 90 * 4 = 360 Average ticket price of Type A = 280 Cost per flight for Type (A) - 280 * 8250 = 2,310,000 AFC of Type A = 6,000,000 AVC per passenger for Type A = 120 * 8250 = 990,000 Aircraft Type B Aircraft capacity for Type B = 420 Average number of flights per routes for Type B = 140 Total Capacity = 420 * 25 = 10500 Total Number of flights / routes for Type B = 140 * 2 = 280

00 1,102,800,0 00

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Average ticket price of Type B = 200 Cost per flight for Type (B) - 200 * 10500 = 2,100,000 AFC of Type B = 4,000,000 AVC per passenger for Type B = 100 * 10500 = 1,050,000 2.2.1 Cost Considerations for Aircraft Model Improvement Routes: Cost of Tickets / Flights Total Variable Cost = Variable cost multiplied by the quantity (VCq)
Aircraft Type Total Aircraft Capacity AVC per Flight Total No of Flights / Routes

Variable Cost for Routes 990,000 * 560 = 356,400,000 1,050,000 * 280 = 294,000,000

A B

550 420

990,000 1,050,000

360 280

Total Variable Cost for Aircraft Type A = 356,400,000 Total Variable Cost for Aircraft Type B = 294,000,000 Fixed Cost
Aircraft Type A B Total Aircraft Capacity 8250 10500 Fixed Cost 6,000,000 4,000,000

Total Cost = (Fixed Cost) + (Total Variable Cost) TC=FC + VCq

Total Cost Type A Total Cost Type B

6,000,000 + 356,400,000 4,000,000 + 294,000,000

362,400,0 00 298,000,0 00

2.2.2 Revenue Considerations: Optimistic Scenario Total Revenue = (Selling Price / Unit) Multiplied by (Quantity Sold)
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TR=pq

Aircraft Type

Total Aircraft Capacity

Average Price / Passenger

Total Ticket Cost / Flight

Total No of Flights / Routes

Total Cost of Tickets / Routes 2,310,000 * 360 = 831,600,000 2,100,000 * 280 = 588,000,000

A B

550 420

280 200

2,310,000 2,100,000

360 280

2.2.3 Profit Consideration: Optimistic Scenario Profit = Total Revenue Total Cost Profit = 47,040,000 - 27,520,000 Total Cost Type A Total Cost Type B Total Revenue Type A Total Revenue Type B Pre-tax profit (Type A) Pre-tax profit (Type B) 362,400,00 0 298,000,00 0 831,600,00 0 588,000,00 0 469,200,00 0 290,000,00 0

6,000,000 + 356,400,000 4,000,000 + 294,000,000 2,310,000 * 360 2,100,000 * 280 831,600,000 - 362,400,000 588,000,000 - 298,000,000

= =

= = = =

2.2.4 Analysis From the calculated analysis, if the company embarks on purchasing 15 new aircraft of type (A) which is an improved design of the current model, it would incur a total cost of 362,400,000, a total revenue of 831,600,000 and a projected profitability of 469,200,000. In addition, if the company embarks on purchasing 25 new aircraft of type (B) which is an improved design of the current model, it would incur a total cost of 298,000,000, a total revenue of 588,000,000 and a projected profitability of 290,000,000.

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2.3 Strategic Decision 3: Previous Aircraft Model 25 of aircraft B = 25B 25 of aircraft C = 25C Aircraft Type B Aircraft capacity for Type B = 420 Average number of flights per routes for Type B = 140 Total Capacity - 420 * 25 = 10500 Total Number of flights / routes for Type B = 140 * 2 = 280 Average ticket price of Type B = 200 Cost per flight for Type (B) - 200 * 10500 = 2,100,000 AFC of Type A = 4,000,000 AVC per passenger for Type B = 100 * 10500 = 1,050,000 Aircraft Type C Aircraft capacity for Type C = 350 Average number of flights per routes for Type C = 250 Total Capacity - 350 * 25 = 8750 Total Number of flights / routes for Type C = 250 * 1 = 250 Average ticket price of Type C = 140 Cost per flight for Type (A) - 140 * 8750 = 1,225,000 AFC of Type A = 3,500,000 AVC per passenger for Type A = 70 * 8750 = 612,500 2.3.1 Cost Considerations for Aircraft Model Improvement Routes: Cost of Tickets / Flights Total Variable Cost = Variable cost multiplied by the quantity (VCq)
Aircraft Total AVC per Total No Variable Cost for Routes

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Type

Aircraft Capacity

Flight

of Flights / Routes 1,050,000 * 280 = 294,000,000 612,500 * 250 = 153,125,000

B C

420 350

1,050,000 612,500

280 250

Total Variable Cost for Aircraft Type B = 294,000,000 Total Variable Cost for Aircraft Type C = 153,125,000 Fixed Cost
Aircraft Type B C Total Aircraft Capacity 10500 8750 Fixed Cost 4,000,000 3,500,000

Total Cost = (Fixed Cost) + (Total Variable Cost) TC=FC + VCq

Total Cost Type B Total Cost Type C

4,000,000 + 294,000,000 3,500,000 + 153,125,000

298,000,0 00 156,625,0 00

2.3.2 Revenue Considerations: Optimistic Scenario Total Revenue = (Selling Price / Unit) Multiplied by (Quantity Sold) TR=pq
Total Aircraft Capacity Average Price / Passenger Total Ticket Cost / Flight Total No of Flights / Routes

Aircraft Type

Total Cost of Tickets / Routes 2,100,000 * 280 = 588,000,000 1,225,000 * 250 = 306,250,000

B C

420 350

200 140

2,100,000 1,225,000

280 1000

2.3.3 Profit Consideration: Optimistic Scenario Profit = Total Revenue Total Cost

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Total Cost Type B Total Cost Type C Total Revenue Type B Total Revenue Type C Pre-tax profit (Type B) Pre-tax profit (Type C)

4,000,000 + 294,000,000 3,500,000 + 153,125,000 2,100,000 * 280 1,225,000 * 250 588,000,000 - 298,000,000 306,250,000 - 156,625,000

298,000,000 156,625,000 588,000,000 306,250,000 290,000,000 149,625,000

= = = = =

2.3.4 Analysis From the calculated analysis, if the company embarks on purchasing 25 aircrafts of type (B) which is a previous design of the current model, it would incur a total cost of 298,000,000, a total revenue of 588,000,000 and a projected profitability of 290,000,000. In addition, if the company embarks on purchasing 25 new aircraft of type (C) which is a previous design of the current model, it would incur a total cost of 156,625,000, a total revenue of 306,250,000 and a projected profitability of 149,625,000.

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3. Strategic Decision based on Predictions of Forecasting Team

Figure 1 Profitability projections of type (A) aircraft based on 3 year delay

Figure 2 Profitability projections of type (B) aircraft based on 18 month delay 3.1 Analysis

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Based on delivery delays of 3 years for aircraft type (A) and 18 months for aircraft type (B) as shown in figure 1 and 2 above, the company would run at a loss of -18,000,000 fixed cost for the first 3 years if it decides to go ahead with the first strategy and would only break even in year 3, while the company would run at a loss of -8,000,000 fixed cost for the first two years if it decides to go ahead with the second strategy and would only break even at the end of year 2. 3.2 Final Recommendations Based on the sample evidence, I would therefore recommend the third strategy, as with the third strategy, there are no delivery delays and the company would be better positioned overcome the disruptions, risks, teething issues which are synonymous with the introduction major new models of aircraft. In addition, based on the fact that a ten year profitability projection is desired starting from 2007, profitability of 290,000,000 for aircraft type (B) and 149,625,000 for aircrafts type (C) is most suitable.

4. Assumptions & Methodology: Traditional Cost System

4.1 Critique: Traditional Based Cost System The traditional cost systems assign costs directly to the products or services, so there is no information about the activities. The traditional costing system utilizes different cost structures, (e.g. fixed cost) to distribute the indirect costs to all products and services. This method of allocating indirect costs commonly results in erroneous cost data. Often products which have high volume (and high labour cost) are over costed, and likewise, the cost of lower volume products are often understated, and many of the indirect costs of these products are overlooked. Consequently, traditional cost systems can actually hide problems and fail to identify improvement opportunities. 4.2 Alternative: Activity Based Costing Approaches In contrast, ABC provides more accurate cost information by assigning costs to the activities that generate the costs, and then assigning the costs from the activities to the products or services, this is unlike the traditional-based costing where all overhead costs including unused, or idle capacity costs are applied to the products. By moving away from traditional cost allocation methods and using improved ABC methods of tracing and assignment, ABC provides managers with a clearer picture of cost of processes and the profitability of customers and products. Unlike

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traditional cost systems, ABC assumes that activities cause cost, not products or services (i.e., products and services merely create demand for activities). By knowing what activities cost, organizations can identify activities that have the greatest potential for cost reduction. This more accurate cost information allows organizations to make improvements such as eliminating waste from overhead activities that are inefficient or nonessential. 4.3 ABC: Overcoming Limitations & Improving Decision Making 4.3.1 Price Allocation Activity Based Costing is a management tool to assist decisions. It can be used as a basis to allocate fixed costs or indirect costs across products or services with a view to justifying prices. This stems from the existence of costs in an organisation which are not directly related to Products. These may be service departments (finance, personnel etc.) or fixed overheads (factory rent, office heating etc.). If unchecked, these costs can build up sizeable portions of the total revenue and unless management takes care to control them they can outweigh the Contribution from products sold, thereby causing a loss. 4.3.2 Revenue Generation vs Resource Consumption ABC can be a guide to management action that can translate directly into higher profits reveals the links between performing particular activities and the demands those activities make on the organizations resources, it can give managers a clear picture of how products, brands, customers, facilities, regions, or distribution channels both generate revenues and consume resources. The profitability picture that emerges from the ABC analysis helps managers focus their attention and energy on improving activities that will have the biggest impact on the bottom line. 4.3.3 Different Views ABC analysis enables managers to have varied views into the business many different ways, either by product or group of similar products, by individual customer or client group, or by distribution channel, thus giving them a close-up view of whatever aspect of the business they are considering. ABC analysis also illuminates exactly what activities are associated with that part of the business and how those activities are linked to the generation of revenues and the consumption of resources. By highlighting those relationships, ABC helps managers understand precisely where to take actions that will drive profits.

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5. Strategy Option: Short Haul Flights 6. Bibliography & Reference

Anderson, S. 1995. A framework for assessing cost management system changes: The case of activity based costing implementation at General Motors, 1986-1993. Journal of Management Accounting Research (7): 151. Anthony, R. N. 2003. Management accounting: A personal history. Journal of Management Accounting Research (15): 249-253. Balakishnan, R. and K. Sivaramakrishnan. 2002. A critical overview of the use of full-cost data for planning and pricing. Journal of Management Accounting Research (14): 3-31. Banker, R. D. and G. Potter. 1993. Economic implications of single cost driver systems. Journal of Management Accounting Research (5): 15-32. Banker, R. D. and S. C. Hansen. 2002. The adequacy of full-cost-based pricing heuristics. Journal of Management Accounting Research (14): 3358. Birnberg, J. G. 2003. Introductory note to "Management accounting: A personal history". Journal of Management Accounting Research (15): 247. Covaleski, M. A, J. H. Evans III, J. L. Luft and M. D. Shields. 2003. Budgeting research: Three theoretical perspectives and criteria for selective integration. Journal of Management Accounting Research (15): 3-49. Dearman, D. T. and M. D. Shields. 2001. Cost knowledge and cost-based judgment performance. Journal of Management Accounting Research (13): 1-18. Dhavale, D. G. 2007. Product costing for decision making in certain variable-proportion technologies. Journal of Management Accounting Research (19): 51-70. Foster, G. and D. W. Swenson. 1997 Measuring the success of activitybased cost management and its determinants. Journal of Management Accounting Research (9): 109-141. Hilton, Ronal W. (1994) Managerial Accounting, Second Edition, McGrawHill, Inc., New York. Horngren, C. T. 2004. Management accounting: Some comments. Journal of Management Accounting Research (16): 207-211.

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Leitch, R. A., P. R. Philipoom and T. D. Fry. 2005. Opportunity costing decision heuristics for product acceptance decisions. Journal of Management Accounting Research (17): 95-117.

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