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Article Excerpt
The 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.
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, SWA's 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 SWA's 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 SWA's 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 SWA's 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 SWA's 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, SWA's 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, SWA's 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 low-cost strategy was very successful in executing its cost-leadership strategy. SWA's 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 inputs--strategic 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 cost increases to its customers indicates some degree of customer loyalty--quite rare for a cost leader. Finally, SWA's operating income declined by $42 million as a result of its investments in additional capacity.
THE STRATEGIC VARIANCE ANALYSIS
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 input-output 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 company's operating income because the industry size changed)...
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