Examining Southwest Airlines Strategic Execution: A Strategic Variance Analysis

B Y PA U L A . M U D D E , P H . D . ,
AND

PA RV E Z R . S O PA R I WA L A , P H . D .

HERE

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.

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

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.

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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: x The airline keeping up with the increase in the domestic air traffic market. x Its increased market share in the domestic air traffic market. x Increased average air fares. x Increased cost of resources acquired. x Improvement in operating efficiencies. x 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

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: x Efficiencies in fuel usage due to longer flights ($46 million), x Efficiencies in fuel usage due to an increase in the passenger load factor ($23 million), and x 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

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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.

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).
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

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Table 1:

Southwest Airlines Corporation Data Used in the Strategic Variance Analysis

Difference 2005 2004 81,066,038 53,414,514,494 76,863,374,223 Amount 7,313,862 6,808,769,306 8,326,039,491 % 9.02% 12.75% 10.83% 88,379,900 60,223,283,800 85,189,413,714

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 2005 Total domestic operating revenues (Note B) Domestic operating expenses: Domestic flying operations (Note B) Domestic maintenance (Note B) Domestic passenger service (Note B) Domestic aircraft and traffic servicing (Note B) Domestic promotion and sales (Note B) Domestic general and administrative (Note B) Domestic depreciation and amortization (Note B) Domestic transport related expenses (Note B) Total domestic operating expenses Domestic operating profit PANEL C: Selected Fuel Data 2005 Total scheduled domestic gallons used (Note C) Total scheduled domestic fuel cost (Note C) Average system fuel cost per gallon PANEL D: Reclassified Financial Data 2005 Total domestic operating revenues (Panel B) Less: Total domestic operating expenses Domestic fuel costs (Panel C) Domestic flight-related costs (Note D) Domestic passenger-related costs (Note E) Total domestic operating expenses Domestic operating income/(loss) continues on next page $1,333,043,851 $3,486,986,149 $1,943,727,000 $6,763,757,000 $820,080,000 $997,391,463 $3,212,255,537 $1,766,392,000 $5,976,039,000 $553,581,000 $7,583,837,000 2004 $6,529,620,000 1,287,355,108 $1,333,043,851 $1.04 2004 1,200,566,952 $997,391,463 $0.83 $2,605,499,000 $708,338,000 $583,581,000 $1,346,023,000 $597,704,000 $440,097,000 $469,019,000 $13,496,000 $6,763,757,000 $820,080,000 $2,127,995,000 $701,955,000 $521,964,000 $1,187,483,000 $578,909,000 $405,619,000 $438,835,000 $13,279,000 $5,976,039,000 $553,581,000 $7,583,837,000 2004 $6,529,620,000

Difference Amount $1,054,217,000 $477,504,000 $6,383,000 $61,617,000 $158,540,000 $18,795,000 $34,478,000 $30,184,000 $217,000 $787,718,000 $266,499,000 % 16.15% 22.44% 0.91% 11.80% 13.35% 3.25% 8.50% 6.88% 1.63% 13.18% 48.14%

Difference Amount 86,788,156 $335,652,388 $0.20 % 7.23% 33.65% 24.64%

Difference Amount $1,054,217,000 $(335,652,388) $(274,730,612) $(177,335,000) $(787,718,000) $266,499,000 % 16.15% -33.65% -8.55% -10.04% -13.18% 48.14%

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Table 1:
PANEL E: Selected Industry Data

continued
Difference 2005 2004 Amount 24,927,230,000 % 4.55% 572,885,732,000 547,958,502,000

Scheduled domestic traffic (RPMs) (Note F) 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 www.transtats.bts.gov/Fields.asp?Table_ID=295 C. Bureau of Transportation Statistics, TranStats Aviation Database, Schedule P-12A, Scheduled Service www.transtats.bts.gov/Fields.asp?Table_ID=294 Difference 2005 D. Flying operations (Panel B) Less: Fuel cost (Panel C) Flying operations (excluding fuel cost) Maintenance (Panel B) Passenger service (Panel B) General and administrative (Panel B) Depreciation and amortization (Panel B) Transport related (Panel B) Total flight-related costs E. Aircraft and traffic servicing (Panel B) Promotion and sales (Panel B) Total passenger-related costs F. Bureau of Transportation Statistics (2006) www.bts.gov/press_releases/2006/bts013_06/html/bts013_06.html $2,605,499,000 $1,333,043,851 $1,272,455,149 $708,338,000 $583,581,000 $440,097,000 $469,019,000 $13,496,000 $3,486,986,149 $1,346,023,000 $597,704,000 $1,943,727,000 2004 $2,127,995,000 $997,391,463 $1,130,603,537 $701,955,000 $521,964,000 $405,619,000 $438,835,000 $13,279,000 $3,212,255,537 $1,187,483,000 $578,909,000 $1,766,392,000 Amount $477,504,000 $335,652,388 $141,851,612 $6,383,000 $61,617,000 $34,478,000 $30,184,000 $217,000 $274,730,612 $158,540,000 $ 18,795,000 $177,335,000 % 22.44% 33.65% 12.55% 0.91% 11.80% 8.50% 6.88% 1.63% 8.55% 13.35% 3.25% 10.04%

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-

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

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

2005 RPMs

2004 RPMs

} } } }

Variance

60,223,283,800

53,414,514,494

$832,333,246

{ {

2004 fuel cost/gallon

}{ }{

2004 gallons used per ASM (Note D) 0.0156 2004 passenger load factor (Note B) 69.49% 2004 cost/ passenger (Note F) $21.79

}{ }{ { {

2004 actual 2005 budgeted ASMs ASMs (Note B) 86,661,178,961

Variance

$0.83 2004 cost/ ASM (Note E) $0.0418

76,863,374,223

$(127,137,885)

2004 actual 2005 budgeted ASMs ASMs (Note B) 86,661,178,961

Variance

76,863,374,223

$(284,550,439)

2004 revenue 2005 budgeted passengers revenue passengers (Note C) 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) Airline revenues 6. Fuel cost effect of the Price-Recovery Component (i.e., higher costs due to increase in fuel prices) Fuel costs 7. Flight-related cost effect of the Price-Recovery Component (i.e., lower costs due to decrease in flight-related costs per ASM) Flight-related costs 8. Passenger-related cost effect of the Price-Recovery Component (i.e., higher costs due to increase in cost to serve a passenger) Passenger-related costs continues on next page 2005 RPMs 2005 revenue/ 2004 revenue/ RPM (Note A) RPM (Note A)

Variance

60,223,283,800

$0.126

$0.122

$221,883,754

{ {

2005 budgeted ASMs (Note B) 86,661,178,961

}{

2004 gallons used per mile (Note D) 0.0156

}{

2004 fuel 2005 fuel cost/gallon cost/gallon

} }

Variance

$0.83 2004 cost/ ASM (Note E) $0.042

$1.04

$(277,114,281)

2005 passenger load factor (Note B) 70.69%

}{ } {
85,189,413,714 91,399,558

2005 ASMs

2005 cost/
ASM (Note E) $0.041

Variance

$51,768,215

2005 budgeted 2004 cost/ revenue passengers passenger (Note C) (Note F)

2005 cost/

passenger (Note F) $21.99

Variance

$21.79

$(18,583,235)

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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) Fuel costs 10. Fuel (ASM) cost effect of the Productivity Component (i.e., lower costs due to increase in passenger load factor) Fuel costs 11. Passenger-related cost effect of the Productivity Component (i.e., lower costs due to increase in miles per passenger) Passenger-related costs

{ {

2005 fuel cost/gallon

}{

2005 2004 gallons 2005 gallons budgeted ASMs used per ASM used per ASM (Note B) (Note D) (Note D)

}{

Variance

$1.04 2005 fuel cost/gallon

86,661,178,961

0.0156

0.0151

$45,569,596

}{

2005 gallons used per ASM (Note D) 0.0151

}{

2005 budgeted 2005 actual ASMs ASMs (Note B)

} }

Variance

$1.04

86,661,178,961

85,189,413,714

$23,030,181

{ {
2005 actual ASMs

2005 cost/ passenger (Note F) $21.99

}{

2005 budgeted 2005 revenue revenue passengers passengers (Note C) 91,399,558 88,379,900

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) Flight-related costs 13. Changes in flight-related costs of available capacities (i.e., higher underutilization due to increase in capacity acquired) Flight-related costs 14. Changes in flight-related costs of used capacities (i.e., lower underutilization due to increase in capacity used) Flight-related costs continues on next page

2005 RPMs

} { {

2004 cost/ ASM (Note E) $0.042

2005 cost/
ASM (Note E) $0.041

} }

Variance

85,189,413,714

60,223,283,800 2004 cost/ASM (Note E)

$21,461,001

2004 actual 2005 actual ASMs ASMs

Variance

$0.042 2004 cost/ASM (Note E)

76,863,374,223

85,189,413,714

$(347,959,828)

2005 RPMs

2004 RPMs

Variance

$0.042

60,223,283,800

53,414,514,494

$284,550,439

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,

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)

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Table 2:
NOTES

continued
2005 2004
$6,529,620,000 53,414,514,494 $0.122 53,414,514,494 76,863,374,223 69.49%

Difference Amount %
$1,054,217,000 6,808,769,306 $0.004 6,808,769,306 8,326,039,491 1.20% 16.15% 12.75% 3.01% 12.75% 10.83% 1.73%

A. Total domestic operating revenues (Panel B, Table 1) Domestic revenue passenger miles (RPMs) (Panel A, Table 1) Average domestic revenue per RPM 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 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 D. Number of gallons used domestically (Panel C, Table 1) Domestic available seat miles (ASMs) (Panel A, Table 1) Average number of gallons used per domestic ASM E. Total domestic flight-related costs (Note D, Table 1) Domestic available seat miles (ASMs) (Panel A, Table 1) Average domestic flight-related cost per ASM F. Total domestic passenger-related costs (Note E, Table 1) Domestic revenue passenger enplanements (Panel A, Table 1) Average domestic cost per revenue passenger

$7,583,837,000 60,223,283,800 $0.126 60,223,283,800 85,189,413,714 70.69% 86,661,178,961 60,223,283,800 88,379,900 681.41 91,399,558 1,287,355,108 85,189,413,714 0.0151 $3,486,986,149 85,189,413,714 $0.041 $1,943,727,000 88,379,900 $21.99

53,414,514,494 81,066,038 658.90

6,808,769,306 7,313,862 22.51

12.75% 9.02% 3.42%

1,200,566,952 76,863,374,223 0.0156 $3,212,255,537 76,863,374,223 $0.042 $1,766,392,000 81,066,038 $21.79

86,788,156 8,326,039,491 (0.0005) 274,730,612 8,326,039,491 $(0.001) 177,335,000 7,313,862 $0.20

7.23% 10.83% -3.25% 8.55% 10.83% -2.06% 10.04% 9.02% 0.93%

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

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

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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

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-

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Table 3:

Explanations for the $266 million increase in SWAs 2005 operating income
$832,333,246 $(127,137,885) $(284,550,439) $(225,162,687)

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) 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)

$(636,851,011) $195,482,235 $69,762,866

$125,719,369

$221,883,754 $(277,114,281) $51,768,215 $(18,583,235)

$(243,929,301)

$(22,045,547)

$45,569,596 $23,030,181 $66,410,923 $135,010,700 $125,719,369

$260,730,069

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

$21,461,001 $(347,959,828) $284,550,439

$(41,948,387) $266,499,000

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-

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-

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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

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

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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.
TA K E A W AY S

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

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. s

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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.

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Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.