Profitability Analysis of Components of Operating Income An Application of the Horngren, Datar and Foster (2006) Methodology ACCT 5301 May 26, 2012

Decomposing Changes in Operating Earnings Horngren et al. (2006) argue that changes in operating earnings reflect the strategic considerations of managers’ decisions. Why should we analyze changes in earnings? Managers need to measure whether a strategic initiative is successful by evaluating its impact on changes in operating earnings.

Firm Strategy Choices Product differentiation. A firm competes on the basis of product characteristics. Low cost leadership. A firm competes on the basis of low output prices.

Southwest Airlines How does Southwest compete? Low costs! “. . . . One of Southwest’s primary competitive strengths is its low operating costs. Southwest has the lowest costs, adjusted for stage length, on a seat mile basis, of all the major airlines. Among the factors that contribute to its low cost structure are a single aircraft type, an efficient, high-utilization, point-to-point route structure, and hardworking, innovative, and highly productive Employees . . .” (Southwest Airlines 10-K, February 17, 2007, page 1). This has implications for what drives Southwest’s changes in operating income.

Southwest Revenue and Expense Data 2003 2004 Revenues $5,937,000,000 $6,530,000,000 Expenses: Personnel-related $2,224,000,000 $2,443,000,000 Trip-related $1,250,000,000 $1,410,000,000 Aircraft-related $ 997,000,000 $1,068,000,000 Other $ 983,000,000 $1,055,000,000 Operating income $ 483,000,000 $ 554,000,000 Difference $ 71,000,000 increase

The Horngren, Datar and Foster (2006) Strategic Analysis of Operating Income Allows the comparison of one period operating results to those of any future period. Components: Growth. Price-Recovery. Productivity. These components relate to cost leadership, product differentiation and growth aspects of a firm’s strategy.

Growth Component Growth component – the impact on operating income attributable solely to changes in the quantities of outputs sold between periods. Growth affects both revenues and costs; hence, we have a growth metric for revenues and a growth metric for expenses. Measures are computed for each input and each output. The net growth component measures the change in operating income as the difference between the change in revenues due to growth and the growth-related changes in expenses.

Price-Recovery Component Price-Recovery component – the impact on operating income attributable solely to changes in the prices charged for outputs and prices paid for inputs. Price-recovery affects both revenues and costs; hence, we have a price-recovery metric for revenues and a price-recovery metric for expenses. Measures are computed for each input and each output. The net price-recovery component measures the change in operating income as the difference between the change in revenues due to changes in prices and the changes in expenses due to changes in unit costs.

Productivity Component Productivity component – the impact on operating income attributable to changes in the use of inputs (either different levels of inputs, a different mix of inputs, and/or changes in capacity) relative to the inputs used in prior periods. Productivity affects only inputs; hence, we have a productivity metric only for expenses. Measures are computed for each input. The net productivity component measures the change in operating income as the sum of the productivity components for each input.

Predictions Southwest’s stated strategy is to operate as a low-cost air carrier. As a low-cost carrier, Southwest would be expected to: Keep its fares relatively low, even in the face of input price increases. Focus on improving the productivity of its workforce and aircraft. With low fares and aggressive expansion of its route structure, Southwest should grow its revenue passenger-miles. Southwest should report: a favorable aggregate growth component, A possibly unfavorable aggregate price-recovery component, and a favorable productivity component.

Southwest’s Revenue and Expense Categories Total operating revenues. Expense categories: Salaries, wages and benefits (personnel-related). Fuel and oil (trip-related). Maintenance materials and repairs (aircraft-related). Agency commissions (trip-related). Aircraft rentals (aircraft-related). Landing fees and other rentals (trip-related). Depreciation (aircraft-related). Other operating expenses.

Selected Output and Input Measures Revenues ― Revenue passenger-miles (output). Personnel-related expenses ― Number of employees (input). Trip-related expenses ― Number of trips (input). Fuel and oil. Agency commissions. Landing fees and other rentals. Aircraft-related expenses ― Number of seats of capacity (input). Maintenance materials and repairs. Aircraft rentals. Depreciation. Other operating expenses ― Number of seats of capacity (input).

Southwest Output and Input Data 2003 2004 Revenue passenger miles* 47,943,066,000 53,418,353,000 Available seat miles** 71,790,425,000 76,861,296,000 Number of employees 32,847 31,011 Number of passengers 65,673,945 70,902,773 Number of trips flown 949,882 981,591 Aircraft seats 52,436*** 56,679**** *  Number of seat-miles flown by revenue-paying passengers. **  Available seat mile = One seat flown one mile, whether occupied or not. ***  Based on (48) 122-seat aircraft and (340) 137-seat aircraft. ****  Based on (30) 122-seat aircraft and (387) 137-seat aircraft.

Relevant Measures OUTPUT MEASURES: ACTOUTPUT2003 = 47,943,066,000 RPMs ACTOUTPUT2004 = 53,418,353,000 RPMs OUTPUTPRICE2003 = $0.1238 / RPM OUTPUTPRICE2004 = $0.1222 / RPM INPUT MEASURES  Variable/Discretionary Expenses: Personnel-related expenses (number of employees): ACTINPUT2003,EEs = 32,847 EEs ACTINPUT2004,EEs = 31,011 EEs INPUTPRICE2003,EEs = $67,707.86 / EE INPUTPRICE2004,EEs = $78,778.50 / EE EXPINPUT = (53,418,353,000 RPM / 47,943,066,000 RPM) × 32,847 EEs ≈ 36,598 EEs. Trip-related expenses (number of trips flown): ACTINPUT2003,trips = 949,882 trips flown ACTINPUT2004,trips = 981,591 trips flown INPUTPRICE2003,trips = $1,315.95 / trip INPUTPRICE2004,trips = $1,436.44 / trip EXPINPUT = (53,418,353,000 RPM / 47,943,066,000 RPM) × 949,882 trips ≈ 1,058,363 trips.

Relevant Measures (continued) INPUT MEASURES  Fixed/Capacity Expenses: Aircraft-related expenses: ACTINPUT2003,seats = 52,436 seats ACTINPUT2004,seats = 56,679 seats INPUTPRICE2003,seat = $19,013.65/seat INPUTPRICE2004,seat = $18,842.96/seat EXPINPUT = (53,418,353,000 RPM/47,943,066,000 RPM) × 52,436 seats ≈ 58,424 seats. Other expenses: ACTINPUT2003,=seats = 52,436 seats ACTINPUT2004,seats = 56,679 seats INPUTPRICE2003,seat = $18,746.66/seat INPUTPRICE2004,seat = $18,613.60/seat EXPINPUT = (53,418,353,000 RPM/47,943,066,000 RPM) × 52,436 Seats ≈ 58,424 seats.

Growth Components2003-2004 REVEFFGROW = (ACTOUTPUT2004– ACTOUTPUT2003) × OUTPUTPRICE2003 = (53,418,353,000 RPM – 47,943,066,000 RPM) × $0.1238/RPM = $678,028,788 F INTERPRETATION OF REVEFFGROW: Operating revenues increased by $678,028,788, or approximately $678 million, because of the 11.4 percent growth in Southwest’s output market.

Growth Components2003-2004 (continued) COSTEFFGROW = (EXPINPUT2004,2003 – ACTINPUT2003) × INPUTPRICE2003 Personnel-related expenses: COSTEFFGROW = (36,598 EEs – 32,847 EEs) × $67,707.86/EE = $253,989,561 U Trip-related expenses: COSTEFFGROW = (1,058,363 trips – 949,882 trips) × $1,315.95/trip = $142,754,924 U Aircraft-related expenses: COSTEFFGROW = (58,424 seats – 52,436 seats) × $19,013.65/seat = $113,861,327 U Other expenses: COSTEFFGROW = (58,424 seats – 52,436 seats) × $18,746.66/seat = $112,262,472 U

Growth Components2003-2004 (continued) INTERPRETATION OF COSTEFFGROW COMPONENTS: Operating expenses increased by approximately $623 million because of the 11.4 percent growth in Southwest’s output market. Disaggregated, this amount was: Personnel-related expenses: $253,989,561 U Trip-related expenses: $142,754,924 U Aircraft-related expenses: $113,861,327 U Other expenses: $112,262,472 U Total $622,868,284 U INTERPRETATION OF THE AGGREGATED GROWTH EFFECT: The net growth effect on operating income was $678,028,788 F + $622,868,284 U = $55,160,504 F. The aggregate effect of growth was to increase Southwest’s operating income by approximately $55 million.

Price-Recovery Components2003-2004 REVEFFP-R = (OUTPUTPRICE2004– OUTPUTPRICE2003) × ACTOUTPUT2004 = ($0.1222/RPM – $0.1238/RPM) × 53,418,353,000 RPM = $(85,028,788) U INTERPRETATION OF REVEFFP-R: Operating revenues decreased by $85,028,788, or approximately $85 million, because of lower revenues per revenue passenger-mile.

Price-Recovery Components2003-2004 (continued) COSTEFFP-R = (INPUTPRICE2004 – INPUTPRICE2003) × EXPINPUT2004,2003 Personnel-related expenses: COSTEFFP-R = ($78,778.50/EE – $67,707.86/EE) × 36,598 EEs = $405,166,137 U Trip-related expenses: COSTEFFP-R = ($1,436.44/trip – $1,315.95/trip) × 1,058,363 trips = $127,522,661 U Aircraft-related expenses: COSTEFFP-R = ($18,842.96/seat – $19,013.65/seat) × 58,424 seats = $(9,972,871) F Other expenses: COSTEFFP-R = ($18,613.60/seat – $18,746.66/seat) × 58,424 seats = $(7,774,344) F

Price-Recovery Components2003-2004 (continued) INTERPRETATION OF COSTEFFP-R COMPONENTS: Operating expenses increased by approximately $515 million because of unit cost increases in three out of four categories. Disaggregated, this amount was: Personnel-related expense: $405,166,137 U Trip-related expenses: $127,522,661 U Aircraft-related expenses: $ 9,972,871 F Other expenses: $ 7,774,344 F Total $514,941,583 U INTERPRETATION OF THE AGGREGATED PRICE-RECOVERY EFFECT: The net price-recovery effect on operating income was $85,028,788 U + $514,941,583 U = $599,970,371 U. The aggregate effect of price-recovery was to decrease Southwest’s operating income by approximately $600 million.

Productivity Components2003-2004 COSTEFFPROD = (ACTINPUT2004 – EXPINPUT2004,2003) × INPUTPRICE2004 Personnel-related expenses: COSTEFFPROD = (31,011 EEs – 36,598 EEs) × $78,778.50/EE = $(440,155,698) F Trip-related expenses: COSTEFFPROD = (981,591 trips – 1,058,363 trips) × $1,436.44/trip = $(110,277,586) F Aircraft-related expenses: COSTEFFPROD = (56,679 seats – 58,424 seats) × $18,842.96/seat = $(32,888,456) F Other expenses: COSTEFFPROD = (56,679 seats – 58,424 seats) × $18,613.60/seat = $(32,488,129) F

Productivity Components2003-2004 (continued) INTERPRETATION OF COSTEFFPROD COMPONENTS: Operating expenses decreased by approximately $616 million because of increased productivity for all four inputs. Disaggregated, this amount was: Personnel-related expense: $440,155,698 F Trip-related expenses: $110,277,586 F Aircraft-related expenses: $ 32,888,456 F Other expenses: $ 32,488,129 F Total $615,809,869 F INTERPRETATION OF THE AGGREGATED PRODUCTIVITY EFFECT: The net productivity effect on operating income was $615,809,869 F. Therefore, the aggregate effect of productivity was to increase Southwest’s operating income by approximately $616 million.

Reconciliation of Operating Income 2003-2004 2003 Operating Income $ 483,000,000 Aggregate Growth Component $ 55,160,504 Aggregate Price-Recovery Component $ (599,970,371) Aggregate Productivity Component $ 615,809,869 2004 Operating Income $ 554,000,000