Examining Southwest Airlines Strategic Execution

Examining Southwest
Airlines Strategic
Execution: A Strategic
Variance Analysis
B Y PA U L A . M U D D E , P H . D . ,
HERE
AND
PA RV E Z R . S O PA R I WA L A , P H . D .
IS AN ANALYSIS OF HOW ONE AIRLINE COMPANY MADE SOME STRATEGIC

CHANGES AND IMPROVED ITS FINANCIAL PERFORMANCE.
EXECUTIVE SUMMARY Using a strategic variance analysis, Southwest Airlines increase in 2005 operating income of
$266 million can be explained as a $70 million increase from a rise in domestic air traffic, a $126 million increase from
Southwests greater market share, a $22 million decrease because Southwest was unable to offset higher costs by
increasing its airfares, a $135 million increase from efficiencies, and, finally, a $42 million decrease because of low
capacity utilization.
RPMs (a composite of the number of passengers and

miles flown) by 4.5%, but they increased available seat
miles, or ASMs (a composite of the number of available
seats, empty or occupied, flown and number of miles
flown) by only 0.9%. This resulted in an increase in the
domestic industry passenger-load factor (the number of
passengers as a percentage of available seats) from
74.5% in 2004 to 77.2% in 2005. Hence, although
domestic airlines increased their traffic and used their
capacity more efficiently, higher fuel prices adversely
affected their progress toward more sustained
profitability.
he domestic U.S. airline industry revealed

improved performance metrics in 2005 compared to 2004. For example, 2005 operating
losses were about $2.1 billion on operating
revenues of $111 billion, compared to 2004
operating losses of $3.5 billion on operating revenues of
$101 billion.1
Consistent with the increase in 2005 operating revenues, the Bureau of Transportation Statistics reported
increased domestic traffic during that year.2 For example, U.S. domestic airlines carried 4.1% more passengers. The carriers increased revenue passenger miles, or
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
20
SUMMER 2008, VOL. 9, NO. 4
influence the domestic commercial aviation market by

itself.
Second, SWA was reasonably successful in recovering
almost all increases in costs from its customers. For
example, its fuel and passenger-related costs (providing
services to passengers while on land) increased by
$277 million and $19 million, respectively, whereas its
flight-related costs (relating to the actual flying operations) declined by $52 million, leading to a net increase
of $244 million during 2005. In contrast, SWAs airfares
increased by $222 million that year, resulting in a shortfall of only $22 million.
More importantly, SWA was able to increase its 2005
operating income by $261 million. First, it earned an
additional $135 million from:
Efficiencies in fuel usage due to longer flights
($46 million),
Efficiencies in fuel usage due to an increase in
the passenger load factor ($23 million), and
Reduction in passenger-related costs due to an
increase in average miles per passenger
($66 million).
In addition, by aggressively expanding its offerings,
the airline earned an additional $126 million because it
increased its market share of the 2005 domestic air traffic market (the market share effect). Finally, SWAs
operating income declined by $42 million, despite an
improvement in its passenger load factor, because the
increase in its cost of acquiring capacity during 2005
exceeded the increase in its cost of capacity used.
As a result, the carrier known traditionally for its lowcost strategy was very successful in executing its costleadership strategy. SWAs operating income grew by
$70 million as a result of the overall growth in industry
demand. It earned an additional $135 million as a result
of its cost reduction and productivity efforts and another $126 million by aggressively expanding its market
share; i.e., it earned an additional $261 million primarily
as a classic cost leader. On the other hand, SWA did
increase its prices and incur higher costs for some
inputsstrategic changes associated with a product differentiation strategy. Its inability to create a positive
price-recovery variance by increasing its prices is consistent with its traditional strength as a cost leader,
although its ability to transfer all but $22 million of its
In terms of individual U.S. major domestic airlines,

the 2005 operating profit of Southwest Airlines (SWA)
was $820 million on operating revenues of $7.6 billion.3
In addition, SWAs 2005 revenues increased by
$1.054 billion, and its 2005 expenses increased by
$788 million, leading to an increased 2005 operating
income of $266 million.4 Finally, SWA carried 9% more
passengers and increased RPMs by 12.75% and ASMs
by 10.8% during 2005 compared to 2004.5
It is not evident, however, either from the Bureau of
Transportation Statistics TranStats Aviation Database or
from SWAs Annual Report or 10-K statements how the
airline managed to improve its performance and how
such performance affected the success of its cost leadership strategy. In order to determine the extent of such
success, it is necessary to determine how much of this
$266 million increase in 2005 operating income was
attributable to:
The airline keeping up with the increase in the
domestic air traffic market.
Its increased market share in the domestic air
traffic market.
Increased average air fares.
Increased cost of resources acquired.
Improvement in operating efficiencies.
Utilization of its existing human and aircraft
capacities.
Utilizing publicly available information, we apply the
strategic analysis of income formulation developed by
Charles T. Horngren, George Foster, and Srikant M.
Datar, as amended by Parvez Sopariwala, to SWAs operating and financial results for 2004 and 2005.6 We chose
2004-2005 because it was a significant period for
changes in operating performance in the airline industry
since it provided unique threats and opportunities to
SWA. It was the first period with industry growth post
9-11, but SWA also had to respond to increased price
competition from strengthening competitors and higher
fuel prices. Applying strategic variance analysis (SVA) to
this period of SWAs strategy provides a basis to better
understand the impact of each of its strategic changes.
First, SWA earned an additional $70 million in 2005
that resulted from a 4.55% increase in 2005 domestic
traffic (the market size effect), a factor that Horngren,
Foster, and Datar isolate because of SWAs inability to
21
The third component, productivity, measures the

change in operating income caused by variations in the
input-output relationships: a companys operational efficiencies, holding sales units, sales prices, and unit input
costs constant. Horngren, Foster, and Datar argue that
this component determines whether a companys lowcost strategy is successful because a favorable productivity variance indicates profitability through efficiency
gains.9
The fourth component, capacity underutilization,
measures the change in operating income caused by a
variation in the cost of unused capacity between the
years (for example, whether the cost of capacity underutilization increased or decreased during the year).
cost increases to its customers indicates some degree of

customer loyaltyquite rare for a cost leader. Finally,
SWAs operating income declined by $42 million as a
result of its investments in additional capacity.
T H E S T R AT E G I C V A R I A N C E A N A LY S I S
This analysis has its genesis in the strategic analysis of

operating income first formulated by Horngren, Foster,
and Datar and later amended by Sopariwala. The
amended analysis attempts to explain the difference in
operating income between two years as a combination
of the following components: growth, price recovery,
productivity, and capacity underutilization.
The growth component essentially measures the
change in operating income caused by a change in sales
units while keeping sales prices, input costs, and inputoutput relationships constant. This growth component,
which is similar to the sales volume variance, is made
up of two subcomponents: the market size variance (the
change in the companys operating income because the
industry size changed) and market share variance (the
change in operating income because its market share
changed). As it is unlikely that any one company can
influence the market sufficiently, the market size variance is usually considered uncontrollable and hence
treated separately. On the other hand, the market share
variance is controllable and hence added to the pricerecovery or productivity components, depending on
whether the company is a product differentiator or a
low-cost provider.
The price-recovery component measures the change
in operating income caused by variations in sales prices
and unit input costs holding sales units and inputoutput relationships constant. This price-recovery component includes a revenue effect that, holding sales
units constant, measures the impact of changing prices.
This revenue effect is set off against the cost effect,
which measures the impact of changing input costs,
again holding sales units and input-output relationships
constant.7 According to Horngren, Foster, and Datar,
this component evaluates a companys product differentiation strategy.8 A favorable price-recovery component
suggests that the companys pricing power induced its
customers to reimburse the company for more than the
cost increases it experienced.
T H E D ATA U S E D
IN
S WA S S T R AT E G I C
V A R I A N C E A N A LY S I S
The data is extracted from the U. S. Department of

Transportations Bureau of Transportation Statistics
TranStats Aviation Database. In Table 1, Panel A provides SWAs operational data, Panel B details its domestic operating revenues and expenses, and Panel C
provides information related to its fuel usage and
costs.10
To be consistent with the cost drivers developed in
the next section, however, Panel D reclassifies the total
SWA domestic operating expenses of $6.76 billion and
$5.98 billion (relating to 2005 and 2004, respectively)
into three groups: fuel costs, flight-related costs (including flying operations without fuel costs, maintenance,
passenger service expense, general and administrative
expense, depreciation and amortization, and transportrelated expense), and passenger-related costs (including
aircraft and traffic servicing expenses and promotion
and sales expenses). Finally, Panel E provides the total
domestic market size for 2005 and 2004, which will be
used to determine how much of the growth component
represents market size and how much represents market share.
S WA S S T R AT E G I C V A R I A N C E A N A LY S I S
While the revenue and cost categories used by Horngren, Foster, and Datar and by Sopariwala are applicable to a manufacturing environment, the airline
industry provides a different challenge. Rajiv Banker
22
Table 1:
Southwest Airlines Corporation Data Used in the

Strategic Variance Analysis
PANEL A: Selected Operational Data
Difference
2005
Domestic revenue passenger enplanements (Note A)
2004
Amount
88,379,900
81,066,038
7,313,862
9.02%
Domestic revenue passenger miles (RPMs) (Note A)
60,223,283,800
53,414,514,494
6,808,769,306
12.75%
Domestic available seat miles (ASMs) (Note A)
85,189,413,714
76,863,374,223
8,326,039,491
10.83%
2005
2004
Amount
$7,583,837,000
$6,529,620,000
$1,054,217,000
16.15%
$2,605,499,000
$2,127,995,000
$477,504,000
22.44%
$708,338,000
$701,955,000
$6,383,000
0.91%
PANEL B: Selected Financial Data

Total domestic operating revenues (Note B)
Difference
Domestic operating expenses:

Domestic flying operations (Note B)
Domestic maintenance (Note B)
Domestic passenger service (Note B)
$583,581,000
$521,964,000
$61,617,000
11.80%
$1,346,023,000
$1,187,483,000
$158,540,000
13.35%
Domestic promotion and sales (Note B)
$597,704,000
$578,909,000
$18,795,000
3.25%
Domestic general and administrative (Note B)
$440,097,000
$405,619,000
$34,478,000
8.50%
Domestic depreciation and amortization (Note B)
$469,019,000
$438,835,000
$30,184,000
6.88%
$13,496,000
$13,279,000
$217,000
1.63%
$6,763,757,000
$5,976,039,000
$787,718,000
13.18%
$820,080,000
$553,581,000
$266,499,000
48.14%
Domestic aircraft and traffic servicing (Note B)
Domestic transport related expenses (Note B)

Total domestic operating expenses
Domestic operating profit
PANEL C: Selected Fuel Data
Difference
2005
2004
1,287,355,108
1,200,566,952
86,788,156
7.23%
$1,333,043,851
$997,391,463
$335,652,388
33.65%
$1.04
$0.83
$0.20
24.64%
Total scheduled domestic gallons used (Note C)

Total scheduled domestic fuel cost (Note C)
Average system fuel cost per gallon
Amount
PANEL D: Reclassified Financial Data
Difference
2005
2004
Amount
$7,583,837,000
$6,529,620,000
$1,054,217,000
16.15%
Domestic fuel costs (Panel C)
$1,333,043,851
$997,391,463
$(335,652,388)
-33.65%
Domestic flight-related costs (Note D)
$3,486,986,149
$3,212,255,537
$(274,730,612)
-8.55%
Domestic passenger-related costs (Note E)
$1,943,727,000
$1,766,392,000
$(177,335,000)
-10.04%
$6,763,757,000
$5,976,039,000
$(787,718,000)
-13.18%
$820,080,000
$553,581,000
$266,499,000
48.14%
Total domestic operating revenues (Panel B)

Less: Total domestic operating expenses
Total domestic operating expenses

Domestic operating income/(loss)
continues on next page
23
Table 1:
continued
PANEL E: Selected Industry Data
Difference
2004
2005
Scheduled domestic traffic (RPMs) (Note F)
572,885,732,000 547,958,502,000
Amount
24,927,230,000
4.55%
Notes
A. Bureau of Transportation Statistics, TranStats Aviation Database, Schedule T-1, Scheduled Service
www.transtats.bts.gov/Fields.asp?Table_ID=264
B. Bureau of Transportation Statistics, TranStats Aviation Database, Schedule P-12
C. Bureau of Transportation Statistics, TranStats Aviation Database, Schedule P-12A, Scheduled Service
Difference
2005
2004
Amount
D. Flying operations (Panel B)
$2,605,499,000
$2,127,995,000
$477,504,000
22.44%
Less: Fuel cost (Panel C)
$1,333,043,851
$997,391,463
$335,652,388
33.65%
Flying operations (excluding fuel cost)
$1,272,455,149
$1,130,603,537
$141,851,612
12.55%
Maintenance (Panel B)
$708,338,000
$701,955,000
$6,383,000
0.91%
Passenger service (Panel B)
$583,581,000
$521,964,000
$61,617,000
11.80%
General and administrative (Panel B)
$440,097,000
$405,619,000
$34,478,000
8.50%
Depreciation and amortization (Panel B)
$469,019,000
$438,835,000
$30,184,000
6.88%
Transport related (Panel B)

Total flight-related costs
E. Aircraft and traffic servicing (Panel B)
$13,496,000
$13,279,000
$217,000
1.63%
$3,486,986,149
$3,212,255,537
$274,730,612
8.55%
$1,346,023,000
$1,187,483,000
$158,540,000
13.35%
Promotion and sales (Panel B)
$597,704,000
$578,909,000
$ 18,795,000
3.25%
Total passenger-related costs
$1,943,727,000
$1,766,392,000
$177,335,000
10.04%
F. Bureau of Transportation Statistics (2006)

www.bts.gov/press_releases/2006/bts013_06/html/bts013_06.html
lines flying different types and sizes of aircraft can be

differentiated. Even though SWA flies only Boeing
737s, we have retained ASMs as the cost driver.
Third, for flight-related costs that relate directly to a
flight, we again follow Banker and Johnston and choose
available seat miles (ASMs), often regarded as a measure of airline capacity, as the cost driver. Finally, for
passenger-related costs, which essentially represent
expenses for serving passengers while on land, we follow Banker and Johnston and choose the number of
passengers enplaned as the cost driver.
Using these cost/revenue drivers, we reveal the
and Holly Hanson Johnston conducted a comprehensive analysis of the airline industry and developed several volume-based (e.g., ASMs) and nonvolume-based
cost drivers (e.g., hub concentration) for airline costs.11
First, for operating revenues, we choose revenue passenger miles. Contrary to using revenue passengers
enplaned, which merely measures the number of passengers, RPMs measure passenger intensity. A passenger flying 500 miles is more likely to buy a more
expensive ticket than one traveling only 100 miles. Second, for fuel costs, we follow Banker and Johnston and
choose available seat miles as the cost driver so that air-
24
Southwest Airlines Corporation

Why did Southwest Airlines Corporations domestic operations earn
$266 million more in 2005?
Table 2:
THE GROWTH COMPONENT

1.
Revenue effect of the Growth Component

(i.e., higher expected revenue due to
higher RPMs)
2004 revenue/
RPM
(Note A)
Airline revenues
2.
$0.1222
Fuel cost effect of the Growth Component

(i.e., higher expected fuel costs
due to higher RPMs)
Fuel costs
3.
Flight-related cost effect of the Growth

Component (i.e., higher expected flightrelated costs due to higher RPMs)
Flight-related costs
4.
2004 fuel
cost/gallon
2005
RPMs
60,223,283,800
0.0156
2004 cost/
ASM
(Note E)
2004 passenger
load factor
(Note B)
}{
Passenger-related costs
$832,333,246
86,661,178,961
Variance
$(127,137,885)
2004 actual 2005 budgeted

ASMs
ASMs
(Note B)
}{
76,863,374,223
86,661,178,961
Variance
$(284,550,439)
2004 revenue 2005 budgeted

passengers revenue passengers
(Note C)
2004 cost/
passenger
(Note F)
Variance
76,863,374,223
69.49%
Passenger-related cost effect of the Growth

Component (i.e., higher expected
passenger-related costs due to higher RPMs)
53,414,514,494
}{
$0.83
$0.0418
2004
RPMs
2004 actual 2005 budgeted

ASMs
ASMs
(Note B)
2004 gallons
used per ASM
(Note D)
}{
$21.79
81,066,038
91,399,558
Variance
$(225,162,687)
THE PRICE-RECOVERY COMPONENT

5.
Revenue effect of the Price-Recovery

Component (i.e., higher revenue due to
increase in airfares)
2005
RPMs
60,223,283,800
Airline revenues
6.
Fuel cost effect of the Price-Recovery

Component (i.e., higher costs due to
increase in fuel prices)
Flight-related cost effect of the Price-Recovery

Component (i.e., lower costs due to decrease
in flight-related costs per ASM)
2004 gallons
used per mile
(Note D)
86,661,178,961
0.0156
$0.83
2005 passenger
load factor
(Note B)
2005
ASMs
}{ } {
2004 cost/
ASM
(Note E)
70.69%
85,189,413,714
$0.042
}{
8.
$0.126
2005 budgeted
ASMs
(Note B)
Fuel costs
7.
2005 revenue/ 2004 revenue/

RPM (Note A) RPM (Note A)
Passenger-related cost effect of the Price-Recovery

Component (i.e., higher costs due to increase
in cost to serve a passenger)
91,399,558
$21.79
25
$1.04
Variance
$(277,114,281)
2005 cost/
ASM
(Note E)
$0.041
Variance
$51,768,215
2005 cost/
passenger
(Note F)
Variance
$21.99
$(18,583,235)
Variance
$221,883,754
}{
$0.122
2004 fuel 2005 fuel

cost/gallon
cost/gallon
2005 budgeted
2004 cost/
revenue passengers passenger
(Note C)
(Note F)
Table 2:
continued
THE PRODUCTIVITY COMPONENT

9.
Fuel cost effect of the Productivity

Component (i.e., lower costs due to decrease
in fuel usage per gallon)
2005
2004 gallons 2005 gallons
budgeted ASMs used per ASM used per ASM
(Note B)
(Note D)
(Note D)
}{
2005 fuel
cost/gallon
Fuel costs
$1.04
10. Fuel (ASM) cost effect of the Productivity

Component (i.e., lower costs due to
increase in passenger load factor)
Fuel costs
}{
86,661,178,961
}{
}{
2005 fuel
cost/gallon
2005 gallons
used per ASM
(Note D)
$1.04
0.0151
11. Passenger-related cost effect of the Productivity

Component (i.e., lower costs due to increase
in miles per passenger)
0.0151
$45,569,596
2005 budgeted 2005 actual

ASMs
ASMs
(Note B)
86,661,178,961
85,189,413,714
}{
2005 cost/
passenger
(Note F)
0.0156
2005 budgeted 2005 revenue

revenue passengers passengers
(Note C)
$21.99
91,399,558
Variance
88,379,900
Variance
$23,030,181
Variance
$66,410,923
THE CAPACITY UNDERUTILIZATION COMPONENT

12. Changes in flight-related costs relating to
unused capacities (i.e., lower costs to
acquire capacity that is unused)
2005 actual
ASMs
85,189,413,714
13. Changes in flight-related costs of available

capacities (i.e., higher underutilization due to
increase in capacity acquired)
2004 cost/
ASM
(Note E)
60,223,283,800
$0.042
2004 cost/ASM
(Note E)
14. Changes in flight-related costs of used
capacities (i.e., lower underutilization due to
increase in capacity used)
} {
2005
RPMs
$0.042
2004 cost/ASM
(Note E)
$0.042
2005 cost/
ASM
(Note E)
$0.041
$21,461,001
2004 actual 2005 actual

ASMs
ASMs
76,863,374,223
2005
RPMs
60,223,283,800
85,189,413,714
2004
RPMs
Variance
53,414,514,494
Variance
$(347,959,828)
Variance
$284,550,439
which is made up primarily of the following two major

ingredients:12
1. Increase in SWAs revenues due to the increase in 2005
RPMs. The first major ingredient of the growth
component represents the change in revenue
resulting from a change in SWAs 2005 output.
Because SWA is a not a manufacturing company,
we adopt RPMs (one passenger flying one mile)
details of the $266 million increase in SWAs 2005

domestic operating income in terms of the growth, price
recovery, productivity, and capacity underutilization
components as follows (see Table 2).
The Growth Component. Items 14 of Table 2
determine the revenue and cost effects of the growth
component. Table 3, summarizing these effects,
reveals a favorable growth component of $196 million,
26
Table 2:
continued
NOTES
2004
2005
Difference
Amount
%
A. Total domestic operating revenues (Panel B, Table 1)

Domestic revenue passenger miles (RPMs) (Panel A, Table 1)
Average domestic revenue per RPM
$7,583,837,000
60,223,283,800
$0.126
$6,529,620,000
53,414,514,494
$0.122
$1,054,217,000
6,808,769,306
$0.004
16.15%
12.75%
3.01%
B. Domestic revenue passenger miles (RPMs) (Panel A, Table 1)

Domestic available seat miles (ASMs) (Panel A, Table 1)
Domestic passenger load factor (%)
Hence, budgeted domestic available seat miles
60,223,283,800
85,189,413,714
70.69%
86,661,178,961
53,414,514,494
76,863,374,223
69.49%
6,808,769,306
8,326,039,491
1.20%
12.75%
10.83%
1.73%
C. Domestic revenue passenger miles (RPMs) (Panel A, Table 1)

Domestic revenue passenger enplanements (Panel A, Table 1)
Average domestic revenue passenger miles per passenger
Hence, budgeted revenue passenger enplanements
60,223,283,800
88,379,900
681.41
91,399,558
53,414,514,494
81,066,038
658.90
6,808,769,306
7,313,862
22.51
12.75%
9.02%
3.42%
D. Number of gallons used domestically (Panel C, Table 1)

Average number of gallons used per domestic ASM
1,287,355,108
85,189,413,714
0.0151
1,200,566,952
76,863,374,223
0.0156
86,788,156
8,326,039,491
(0.0005)
7.23%
10.83%
-3.25%
E. Total domestic flight-related costs (Note D, Table 1)

Average domestic flight-related cost per ASM
$3,486,986,149
85,189,413,714
$0.041
$3,212,255,537
76,863,374,223
$0.042
274,730,612
8,326,039,491
$(0.001)
8.55%
10.83%
-2.06%
F. Total domestic passenger-related costs (Note E, Table 1)

Domestic revenue passenger enplanements (Panel A, Table 1)
Average domestic cost per revenue passenger
$1,943,727,000
88,379,900
$21.99
$1,766,392,000
81,066,038
$21.79
177,335,000
7,313,862
$0.20
10.04%
9.02%
0.93%
output is reflected in RPMs, we use the passenger load

factor (RPMs/ASMs) as the bridge from ASMs to
RPMs. Note B to Table 2 reveals the 2004 passengerload factor to be 69.49% (on average, SWAs planes flew
69.49% full during 2004). Hence, keeping the 2004
passenger-load factor constant, the budgeted 2005
ASMs (the ASMs that should have been incurred to
support the 2005 RPMs of 60,223,283,800) were
86,661,178,961 (60,223,283,800/69.49%), whereas the
actual 2004 ASMs were 76,863,374,223. In effect, we
are comparing the 2004 RPMs to the 2005 RPMs.13 As
a result, the additional fuel costs needed to support the
increased 2005 RPMs are determined by comparing the
actual 2004 ASMs against the budgeted 2005 ASMs,
revealing that fuel costs should have increased by $127
million (Item 2, Table 2).
Next, we determine the expected increase in flightrelated costs that would have been incurred to support
the 12.75% increase in SWAs RPMs. Again, because
our chosen cost driver for flight-related costs is ASMs,
and SWAs output is reflected in RPMs, we use the
passenger-load factor as the bridge from ASMs to
as our surrogate for its output. Because SWAs

domestic output increased by 6.81 billion RPMs
(60.22 billion in 2005 vs. 53.41 billion in 2004), or
an increase of 12.75%, SWAs 2005 operating
income increased by $832 million (Item 1,
Table 2).
2. Expected increase in SWAs costs due to the increase in
SWAs 2005 RPMs. Considering that SWAs output
is measured in RPMs, the question now is What
costs would have been necessary if SWAs RPMs
had increased by 12.75% during 2004? Hence,
the second major part reveals that additional budgeted costs of $637 million would have been necessary to accomplish this 12.75% increase in
SWAs RPMs. These additional costs, representing fuel costs ($127 million), flight-related costs
($285 million) and passenger-related costs ($225
million), are now discussed in greater detail.
First, we determine the expected increase in fuel
costs that would have been incurred to support the
12.75% increase in SWAs RPMs. Considering that our
chosen cost driver for fuel costs is ASMs, and SWAs
27
effect, was earned by SWA for keeping up with the

4.55% increase in the 2005 domestic market and is
reflected separately. On the other hand, the remaining
$126 million, representing the market share effect,
was earned because SWA increased its share of the
domestic market by 0.76% (9.75% in 2004 vs. 10.51% in
2005) and is subsequently added to the productivity
component because SWAs increased market share was
no doubt a result of its successful cost-leadership
strategy.
The Price-Recovery Component. Items 58 of Table 2
determine the effects of the price-recovery component.
Table 3 summarizes these effects and reveals an unfavorable price-recovery component of $22 million made
up of the following elements:
1. Increase in SWAs 2005 average airfares. The first
element of the price-recovery component represents an increase in SWAs average air ticket
prices during 2005. For example, SWAs average
revenue per RPM increased by 3.01% during
2005 (Note A, Table 2). Hence, despite being a
cost leader, SWA was able to increase its average
fares during 2005, possibly to recover a major portion of its increased fuel costs, resulting in an
increase in SWAs 2005 operating income by
$222 million (Item 5, Table 2).
2. Net increase in fuel costs. Despite SWAs successful
fuel hedging program, its cost per gallon
increased from $0.83 a gallon in 2004 to $1.04 per
gallon in 2005, or a 24.64% increase in 2005 average fuel cost per gallon (Panel C, Table 1). As a
result, SWAs fuel costs increased by $277 million
(Item 6, Table 2). Imagine what these costs
would be today!
3. Net decrease in flight-related costs. Note E of Table 2
reveals that SWAs 2005 flight-related costs per
ASM decreased by 2.06% because while SWAs
ASMs increased by 10.83% during 2005, SWAs
flight-related costs increased by only 8.55% during 2005. As a result, SWAs 2005 flight-related
costs declined by $52 million (Item 7, Table 2).
4. Net increase in passenger-related costs. Note F of
Table 2 reveals that SWAs 2005 passenger-related
costs per revenue passenger enplaned increased
by 0.93%; i.e., its average cost per revenue pas-
RPMs. Similar to fuel costs, we determine the budgeted 2005 ASMs (86,661,178,961) and compare them to
the actual 2004 ASMs (76,863,374,223). As a result, the
flight-related costs needed to support the increased
2005 RPMs should have increased by $284 million
(Item 3, Table 2).
Finally, we determine the expected increase in
passenger-related costs that would have been incurred
to support the 12.75% increase in SWAs RPMs. Considering that our chosen cost driver for passenger-related
costs is revenue passenger enplanements and that
SWAs output is reflected in RPMs, we create average
passenger miles per passenger (RPMs/revenue passenger enplanements) as the bridge from passenger
enplanements to RPMs. Note C to Table 2 reveals the
2004 average miles per passenger to be 658.9 (on average, each passenger flew 658.9 miles during 2004).
Keeping the 2004 average miles per passenger constant,
the budgeted 2005 revenue passengers (the revenue
passengers that should have been served to support the
2005 RPMs of 60,223,283,800) were 91,399,558
(60,223,283,800/658.90) (Note C, Table 2), whereas the
actual 2004 revenue passengers enplaned were
81,066,038; i.e., like fuel costs earlier, we are, for all
practical purposes, comparing the 2004 RPMs to the
2005 RPMs. As a result, the passenger-related costs
needed to support the increased 2005 RPMs should
have increased by $225 million (Item 4, Table 2).
We now separate the market size and market share
components that are currently included in the growth
component. Scheduled domestic airline traffic increased
by 4.55% during 2005 (see Table 1, Panel E). On the
other hand, SWAs domestic traffic increased by 12.75%
during 2005 (see Table 1, Panel A). One could argue
that 35.69% (4.55%/12.75%) of SWAs traffic increase
was due to an expansion in the domestic airline market
(the market size component), and the remaining
64.31% [(12.75% 4.55%)/12.75%] of its traffic increase
represented the market share component. This would
be an expansion in SWAs market share from 9.75% (i.e.,
SWAs 2004 RPMs of 53,414,514,494/2004 domestic
market RPMs of 547,958,502,000) in 2004 to 10.51%
(SWAs 2005 RPMs of 60,223,283,800/2005 domestic
market RPMs of 572,885,732,000) in 2005 (see Table 3).
Hence, $70 million, representing the market size
28
Table 3:
Explanations for the $266 million increase in SWAs

2005 operating income
Impact of increased market size during 2005 due to

1. Increase in operating revenues due to increase in RPMs (Item 1, Table 2)
2. Increase in expected fuel costs due to increase in RPMs (Item 2, Table 2)
3. Increase in expected flight-related costs due to increase in RPMs (Item 3, Table 2)
4. Increase in expected passenger-related costs due to increase in RPMs (Item 4, Table 2)
Net increase in the Growth Component during 2005
Impact of market size increase [4.55%/12.75%]($195,482,235)
Impact of loss of market share [(12.75% 4.55%)/(12.75%)]($195,482,235)
Impact of price recoveries during 2005 due to
5. Increase in revenue due to increase in airfares (Item 5, Table 2)
6. Increase in costs due to increase in price per gallon (Item 6, Table 2)
7. Decrease in costs due to a decrease in flight-related costs (Item 7., Table 2)
8. Increase in costs due to an increase in passenger-related costs (Item 8, Table 2)
$832,333,246
$(127,137,885)
$(284,550,439)
$(225,162,687)
$69,762,866
$125,719,369
$221,883,754
$(277,114,281)
$51,768,215
$(18,583,235)
Impact of cost efficiencies and market share increase during 2005 due to
9. Decrease in costs due to decrease in fuel usage per gallon (Item 9, Table 2)
10. Decrease in costs due to increase in passenger load factor (Item 10, Table 2)
11. Decrease in costs due to increase in miles per passenger (Item 11, Table 2)
Impact of loss of market share [(12.75% 4.55%)/(12.75%)]($195,482,235)
Change in the capacity underutilization during 2005 due to
Flight-related capacity underutilization during 2005
$1,021,917,459
Flight-related capacity underutilization during 2004
$979,969,072
Net increase in the Capacity Underutilization Component during 2005
$(41,948,387)
Represented by:
12. Decrease in cost of acquired but unused flight-related capacity (Item 12, Table 2)
13. Increase in cost due to an increase in flight-related capacity acquisitions (Item 13, Table 2)
14. Decrease in cost due to increase in flight-related capacity usage (Item 14, Table 2)
Increase/(decrease) in operating income
$(243,929,301)
$(22,045,547)
$45,569,596
$23,030,181
$66,410,923
$135,010,700
$125,719,369
$260,730,069
$21,461,001
$(347,959,828)
$284,550,439
$(41,948,387)
$266,499,000
tomers. Hence, SWA was able to recover all but

$22 million of its cost increasespossibly a sign that
the flying public viewed SWA as being, the nations
low-fare, high Customer Satisfaction airline.14
The Productivity Component. Items 911 of Table 2
determine the effects of the productivity component,
and Table 3 summarizes these effects and reveals a
favorable cost component of $261 million representing
the following factors:
1. Decrease in fuel usage per gallon due to fuel efficiencies.
SWA was successful in reducing its fuel-related
costs by using fewer gallons per ASM. For example, the average gallons used per ASM reduced
by 3.25% during 2005 (Note D, Table 2), suggest-
senger increased from $21.79 during 2004 to

$21.99 during 2005. As a result, SWAs passengerrelated costs increased by $19 million during 2005
(Item 8, Table 2).
Table 3 summarizes the impact of the changes in airfares, fuel costs, flight-related costs, and passengerrelated costs and reveals an unfavorable price-recovery
component of $22 million. For a product differentiator,
the price-recovery component determines the degree to
which a company is able to alter its level of product differentiation between two periods. For SWA, traditionally identified with a cost-leadership strategy, the
price-recovery component represents the extent to
which increases in costs were recovered from its cus-
$(636,851,011)
$195,482,235
29
strengths as a cost leader and indicates that SWA

improved its low-cost position further between 2004
and 2005. One might consider this aspect to be the real
highlight for SWA; it was able to improve its efficiencies
and grow its market share while striving for improved
quality and service.
The Capacity Underutilization Component. The capacity underutilization component represents the change in
SWAs cost of unused capacity during 2005. As SWAs
cost of unused capacity during 2005 was $1,021,917,459
and was $979,969,072 for 2004,20 the increase in the
cost of capacity underutilization during 2005 was
approximately $42 million (Table 3), which is explained
below.
1. Net decrease in costs of acquiring capacity that was
unused. This effect examines how much more
expensive or less expensive it was to acquire the
flight-related capacity that was available but
unused during 2005. Note E of Table 2 reveals
that SWAs 2005 average flight-related cost per
ASM decreased by 2.06%, and, because about
25 billion ASM capacity was unused during
2005, the cost of maintaining capacity available
but unused during 2005 was $21 million less
(Item 12, Table 2).21
2. Increase in costs of acquired capacity. Panel A of
Table 1 reveals that SWAs ASMs increased by
10.8% during 2005. This suggests that additional
flight-related capacity was acquired during 2005
and that the cost of acquiring this additional
flight-related capacity was $348 million (Item 13,
Table 2). Such an increase represents an unfavorable variance because it increases the cost of
capacity underutilization during 2005.
3. Increase in cost of used capacity. Panel A of Table 1
reveals that SWAs RPMs increased by 12.75%
during 2005. This suggests that additional flightrelated capacity was used during 2005 and that
the cost of using this additional flight-related
capacity was $285 million (Item 14, Table 2).22
Such decrease in the usage of existing flightrelated capacity represents a favorable variance
because it decreases the cost of capacity underutilization during 2005.23
Table 3 summarizes the three elements that affect
ing that SWA obtained better gas mileage during

2005. Banker and Johnston point out that
economies in fuel consumption are achieved as
average stage length (i.e., average length of a
flight in miles) increases because fuel consumption is greatest during takeoffs and landings.15
SWA reports that its average stage length
increased by 5.4% (607 miles in 2005 vs. 576
miles in 2004), which probably explains part or all
of the fuel cost savings of $46 million (Item 9,
Table 2).16
2. Decrease in fuel usage due to a larger passenger load
factor. Note B of Table 2 reveals that SWAs
passenger-load factor increased from 69.49% in
2004 to 70.69% in 2005. That is, to achieve 2005
RPMs, SWA flew fewer ASMs, which resulted in
a decrease in fuel usage. Hence, we compare the
actual 85,189,413,714 ASMs flown during 2005
against the budgeted ASMs of 86,661,178,961
(Note b, Table 2).17 Therefore, SWA achieved its
2005 RPMs by flying 1,471,765,247 fewer ASMs,
thereby using less fuel and saving $23 million
(Item 10, Table 2).
3. Decrease in passenger-related costs due to increase in
miles per passenger. Note C of Table 2 reveals that
SWAs miles per passenger increased from 658.90
in 2004 to 681.41 in 2005. To achieve 2005 RPMs,
SWA flew fewer passengers, resulting in a reduction in the passengers served on the ground.
Hence, we compare the actual 88,379,900 passengers served during 2005 against 91,399,558 budgeted passengers who should have been served in
2005 (Note C, Table 2).18 Therefore, SWA
achieved its 2005 RPMs by serving 3,019,658
fewer passengers, thereby saving $66 million
(Item 11, Table 2).
Table 3 determines the cost efficiencies to be a favorable $135 million by emphasizing longer flights,
improving its passenger load factor, and improving its
average miles per passenger. Table 3 also adds the
market-share component (extracted from the growth
component above) of $126 million to the productivity
component. As a result, SWAs productivity component
represented an increase in operating income of
$261 million.19 This is consistent with SWAs traditional
30
the capacity underutilization component and reveals

that SWAs operating income declined by $42 million
despite the fact that SWAs capacity utilization (its
RPMs) increased by 12.75% in 2005 but its capacity
acquisition (its ASMs) increased by only 10.8% during
2005. SWAs investment in capacity is consistent with its
actions related to growth, price recovery, and productivity. Building on its continued success as a cost leader,
SWA invested in additional aircraft to be able to
increase its 2005 market share.
Paul A. Mudde, Ph.D., is an associate professor in the Management Department of Grand Valley State University in
Grand Rapids, Mich. He can be reached at (616) 331-7443
or muddep@gvsu.edu.
Parvez R. Sopariwala, Ph.D., is a professor in Grand Valley State Universitys Accounting and Taxation Department.
He can be reached at (616) 331-7406 or
sopariwp@gvsu.edu.
E N D N OT E S
1 Bureau of Transportation Statistics TranStats Aviation Database,
U.S. Department of Transportation, Schedule P-12,
www.transtats.bts.gov/Fields.asp?Table_ID=295.
2 Bureau of Transportation Statistics, 2005 Domestic Airline
Passenger Traffic Up 4.1 Percent From 2004, U.S. Department
of Transportation press release dated March 16, 2006,
www.bts.gov/press_releases/2006/bts013_06/html/bts
013_06.html.
3 Southwest Airlines Corporation, 10-K Report for 2005, p. 11.
4 TranStats Aviation Database, Schedule P-12.
5 TranStats Aviation Database, Schedule T-1, Scheduled Service,
www.transtats.bts.gov/Fields.asp?Table_ID=264.
6 Charles T. Horngren, George Foster, and Srikant M. Datar,
Cost Accounting, Tenth Edition, Prentice-Hall, Upper Saddle
River, N.J., 2000, pp. 470-477; Parvez R. Sopariwala, Strategic
Analysis of Operating Income: An Extension to Horngren,
Foster and Datar, Journal of Accounting Education, Vol. 21,
2003, pp. 25-42.
7 Units produced are assumed to be equal to units sold in this
formulation.
8 Horngren, Foster, and Datar, 2000, p. 472.
9 Ibid.
10 For definitions of terms used in Panels A, B, and C, please
refer to Bureau of Transportation Statistics, TranStats Aviation
Database, Data Library: Aviation, www.transtats.bts.gov/data
bases.asp?Mode_ID=1&Mode_Desc=Aviation&Subject_
ID2=0.
11 Rajiv Banker and Holly Hanson Johnston, An Empirical
Study of Cost Drivers in the U.S. Airline Industry, The
Accounting Review, July 1993, pp. 576-601. Banker and Johnston
considered nonvolume-based cost drivers because they wanted
to distinguish between airline companies in terms of density of
flights over ones network, hub concentration, etc. Because we
are merely comparing SWAs 2004 operations to its 2005 operations and not comparing across airlines, these nonvolumebased cost drivers are ignored.
12 That is, this $196 million represents what SWA would have
earned during 2004 if its RPMs had increased by a similar
amount during 2004. Hence, the growth component uses 2004
air ticket prices and input costs. In other words, the average
revenue earned per RPM during 2005, or the average gallons
used per aircraft revenue mile during 2005, or the average fuel
cost per gallon during 2005, or the average flight-related cost
per ASM during 2005, or, finally, the average cost per passenger enplaned during 2005, did not affect the growth component because all of these factors are included in Items 14 at
2004 levels.
13 The budgeted 2005 ASMs of 86,661,178,961 represent the
TA K E A W AY S
The strategic analysis of operating income first formulated by Horngren, Foster, and Datar and later amended by Sopariwala attempts to determine success in a
companys chosen strategy by evaluating the difference
in operating incomes between two years as a combination of the growth, price-recovery, productivity, and
capacity underutilization components. As applied to
SWA, this analysis reveals that the airline continued to
build on its successful cost-leader position in 2005 for
several reasons. First, SWA benefited from the overall
growth of the airline industry during 2005, achieving a
$70 million improvement in operating income. Following an aggressive growth strategy, SWA increased its
market share in 2005, which led to an increase in
operating income of $126 million. In addition, SWA
was able to wring out additional efficiencies worth
$135 million representing longer flights, improving its
passenger load factor and its average miles per passenger. Although it was not a product differentiator, SWA
still had a substantial degree of pricing power in that it
was able to recover all but $22 million of its input cost
increases. Finally, despite improvement in capacity
utilization during 2005, SWA increased its passenger
capacity in 2005, resulting in a net reduction in operating income of $42 million. Thus, the strategic variance
analysis shows the impact of the following specific
strategic changes made by SWA: (1) improved profits
from gains in market size and share, (2) improved
financial performance from efficiencies, (3) reduced
operating profits from rising costs that were not completely offset by increases in pricing, and (4) reduced
operating profits due to the increased cost of investments in capacity.
31
14
15
16
17
18
19
2005 RPMs of 60,223,283,800 divided by the 2004 passenger

load factor of 69.49%. In contrast, the actual 2004 ASMs of
76,863,374,223 represent the 2004 RPMs of 53,414,514,494
divided, once again, by the 2004 passenger load factor of
69.49%. Hence, if we ignore the 2004 passenger load factor, we
are, in reality, comparing 2004 RPMs against 2005 RPMs.
Southwest Airlines Corporation, Annual Report for 2005, front
page.
Banker and Johnston, July 1993, p. 582.
Southwest Airlines Corporation, 10-K Report for 2005, p. 11.
The budgeted 2005 ASMs of 86,661,178,961 represent the
2005 RPMs of 60,223,283,800 divided by the 2004 passenger
load factor of 69.49%. In contrast, the actual 2005 ASMs of
85,189,413,714 represent the 2005 RPMs of 60,223,283,800
divided by the 2005 passenger load factor of 70.69% (Note B,
Table 2). Hence, if we ignore the 2005 RPMs, we are, for all
practical purposes, comparing the 2004 passenger load factor
against the 2005 passenger load factor.
The budgeted 2005 revenue passengers of 91,399,558 represent the 2005 RPMs of 60,223,283,800 divided by the 2004
average miles per passenger of 658.90. In contrast, the actual
2005 revenue passengers of 88,379,900 represent the 2005
RPMs of 60,223,283,800 divided by the 2005 average miles per
passenger of 681.41 (Note C, Table 2). Hence, if we ignore the
2005 RPMs, we are, for all practical purposes, comparing the
2004 average miles per passenger against the 2005 average
miles per passenger.
The productivity component includes elements of efficiencies
for fuel costs because fuel costs are a variable cost. In contrast,
flight-related costs, being fixed capacity-related costs, are
excluded from the productivity component but included in the
capacity underutilization component. Similarly, passengerrelated costs, again being fixed capacity-related costs, should
have been included in the capacity underutilization component. Capacity-related information, however, is not available
for passenger-related costs, so while SWA served 88 million
passengers during 2005 at a passenger-related cost of $1.9 billion (Note F, Table 2), we do not know how many passengers
SWA could have served during 2005 while spending $1.9 billion. As a result, the remaining impact of the passenger-related
cost is included in the productivity component.
20 Note B of Table 2 determines SWAs 2005 passenger load factor or capacity utilization to be 70.69%, whereas Note E determines SWAs 2005 average flight-related cost per ASM to be
$0.041. Hence, SWAs 2005 cost of unused capacity is
$1,021,917,459 [(100% 70.69%)(2005 ASMs of
85,189,413,714)($0.041)].
Note B of Table 2 determines SWAs 2004 passenger load
factor or capacity utilization to be 69.49%, whereas Note E
determines SWAs 2004 average flight-related cost per ASM to
be $0.042. Hence, SWAs 2004 cost of unused capacity is
$979,969,072 [(100% 69.49%)(2004 ASMs of
76,863,374,223)($0.042)].
21 In contrast, the flight-related cost effect of the price-recovery
component (Item 7, Table 2) of $52 million represents the
decrease in flight-related input costs of capacity used during
2005.
22 Interestingly, this amount of $285 million is the contra (the
opposite) to the unfavorable variance of $285 million representing the flight-related cost effect of the growth component
(Item 3, Table 2). This amount reflected the cost of using
additional capacity to support increased demand during 2005.
23 Items 1314 could have been combined to reflect the net
changes in capacity acquisition and capacity use between 2004
and 2005, but keeping the impact of changes in capacity acquisition (Item 13) separate from the impact of changes in capacity usage (Item 14) is certainly more informative than the
aggregate amount.
32
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Examining Southwest

IS AN ANALYSIS OF HOW ONE AIRLINE COMPANY MADE SOME STRATEGIC

RPMs (a composite of the number of passengers and

he domestic U.S. airline industry revealed

SUMMER 2008, VOL. 9, NO. 4

influence the domestic commercial aviation market by

In terms of individual U.S. major domestic airlines,

SUMMER 2008, VOL. 9, NO. 4

The third component, productivity, measures the

cost increases to its customers indicates some degree of

This analysis has its genesis in the strategic analysis of

The data is extracted from the U. S. Department of

SUMMER 2008, VOL. 9, NO. 4

Southwest Airlines Corporation Data Used in the

PANEL A: Selected Operational Data

Domestic revenue passenger enplanements (Note A)

Domestic revenue passenger miles (RPMs) (Note A)

Domestic available seat miles (ASMs) (Note A)

PANEL B: Selected Financial Data

Domestic operating expenses:

Domestic promotion and sales (Note B)

Domestic general and administrative (Note B)

Domestic depreciation and amortization (Note B)

Domestic aircraft and traffic servicing (Note B)

Domestic transport related expenses (Note B)

Total scheduled domestic gallons used (Note C)

PANEL D: Reclassified Financial Data

Domestic fuel costs (Panel C)

Domestic flight-related costs (Note D)

Domestic passenger-related costs (Note E)

Total domestic operating revenues (Panel B)

Total domestic operating expenses

SUMMER 2008, VOL. 9, NO. 4

PANEL E: Selected Industry Data

D. Flying operations (Panel B)

Less: Fuel cost (Panel C)

Flying operations (excluding fuel cost)

Passenger service (Panel B)

General and administrative (Panel B)

Depreciation and amortization (Panel B)

Transport related (Panel B)

Promotion and sales (Panel B)

Total passenger-related costs

F. Bureau of Transportation Statistics (2006)

lines flying different types and sizes of aircraft can be

SUMMER 2008, VOL. 9, NO. 4

Southwest Airlines Corporation

THE GROWTH COMPONENT

Revenue effect of the Growth Component

Fuel cost effect of the Growth Component

Flight-related cost effect of the Growth

2004 actual 2005 budgeted

2004 revenue 2005 budgeted

Passenger-related cost effect of the Growth

2004 actual 2005 budgeted

THE PRICE-RECOVERY COMPONENT

Revenue effect of the Price-Recovery

Fuel cost effect of the Price-Recovery

Flight-related cost effect of the Price-Recovery

2005 revenue/ 2004 revenue/

Passenger-related cost effect of the Price-Recovery

continues on next page

2004 fuel 2005 fuel

SUMMER 2008, VOL. 9, NO. 4