MANAGEMENT ACCOUNTING

CONTENTS

SOUTHWEST AIRLINES BUSINESS STRATEGY/MODEL

SPIRIT AIRLINES BUSINESS STRATEGY/MODEL

COMPARISON OF SOUTHWEST AND SPIRIT AIRLINES MODELS

PART I - ANALYSIS OF COSTS AS FIXED COST/VARIABLE COST

PART II- CALCULATIONS OF PARAMETERS AND THEIR SIGNIFICANCE

PART III- CONCLUSION….

This document discusses the Fixed and Variable costs in an airline with specific reference to Southwest Airlines and Spirit Airlines. The document is logically divided in to three parts. The first part outlines the major expenses of the airlines (extracted from their annual reports ending Dec 2014) and discusses which cost is being attributed as FC/VC and the rationale behind it. The second part highlights the calculation of Contribution Margin, Break Even Point, Margin of Safety, CVP Index and Degree of Operating Leverage, and comments on the significance of these numbers. The third part is presented as a conclusion and compares the two airlines on these parameters for a better understanding of the commonalities of airline business, and at the same time brings out the differences between the two differently managed brands.

Rashmi Rau (GMAE0143)Rohit Beri (GMAE0144)

Vimal Yadav (GMAE0170)Anurag Sharma (GMAE0107)

SOUTHWEST AIRLINES BUSINESS STRATEGY/MODEL

Southwest Airlines Co. operates Southwest Airlines (“Southwest”), a major passenger airline that provides scheduled air transportation in the U.S. and near-international markets. During 2014, the company also operated AirTran Airways (“AirTran”). AirTran’s final passenger service occurred on December 28, 2014, and the company reached a major milestone by effectively completing the integration of AirTran into Southwest. Southwest commenced service on June 18, 1971, with three Boeing 737 aircraft serving three Texas cities and ended in 2014 serving 93 destinations in 40 states and five near-international countries. The company has been profitable for the 42nd consecutive year earning 1136 million USD in net income in 2014. On December 31, 2014, Southwest operated a total of 665 Boeing 737 aircraft of which it owns 553 aircraft and has leased the rest (112 aircraft). It is one of the largest operators in the U.S. with an approximately 20 percent market share. Southwest primarily provides “point-to-point” service, as opposed to the “hub-and-spoke” service provided by most major U.S. airlines. By not concentrating their operations through one or more central transfer points, Southwest’s point-to-point route structure has allowed for more direct non-stop routing than the hub-and-spoke service. It has also enabled them to provide the market with frequent, conveniently timed flights, and low fares. A key component of the company’s business strategy has historically been its low-cost structure which was designed to allow them to profitably charge low fares. Flying to less congested airports (as compared to hub airports) has contributed to Southwest’s ability to achieve high asset utilization because aircraft can be scheduled to minimize the amount of time they are on the ground.

SPIRIT AIRLINES BUSINESS STRATEGY/MODEL

Spirit Airlines is an ultra-low-cost, low-fare airline based in Miramar, Florida that offers affordable travel to price-conscious customers. It has an all-Airbus fleet currently operating more than 300 daily flights to 56 destinations in the U.S., Caribbean and Latin America. The company was founded in 1964 as Clippert Trucking Company, a Michigan corporation. They began air charter operations in 1990 and renamed themselves as Spirit Airlines, Inc. in 1992.The Ultra-Low-Cost Carrier (ULCC) business model allows the airline to compete primarily by offering low fares to the customers. The airline aggressively uses low fares to stimulate air travel demand in order to increase passenger volume, load factors, and non-ticket revenue on the flights they operate. Higher passenger volumes and load factors helps them sell more ancillary products and services, which in turn allows them to further reduce the base fare, stimulating additional demand. They strive to be recognized by customers as the low-fare leader in markets. The company earned 225 million USD in net income in 2014. As of December 31 2014, the airline had a fleet of 65 Airbus single-aisle aircraft of which they own only 4 aircraft and 61 are leased. Spirit Airlines is a small but growing player with a 2-3% market share.

COMPARISON OF SOUTHWEST AND SPIRIT AIRLINES MODELSSouthwest Airlines is one of the largest airlines in the U.S. (industry bellwether) while Spirit is a smaller, more nimble player. Southwest operates 665 Boeing 737 aircraft of which it owns 553 and has leased 112 aircraft whereas Spirit Airlines operates 65 A320 family aircraft of which it owns only 04 and leases 61. Both position themselves as low fare airlines. However, within this model, Southwest offers three type of airfares with each airfare signifying different customer privileges (all three include free baggage), whereas Spirit offers only a single basic airfare and customers purchase any additional amenities including baggage, meals, seat allocation, and so on (unbundling concept). It is interesting to note that while Southwest positions itself as low cost, its yield per revenue passenger per mile is one of the highest in the industry.Both airlines fly a single aircraft type leading to higher efficiency. In addition, both airlines operate the point-to-point model as opposed to the hub-and-spoke.Both airlines generate maximum revenue from domestic operations and are in direct competition on the domestic routes. Both airlines are slowly expanding into nearby international destinations, but revenue generation from international operations is marginal as of now.While they have similar models, the two companies vary in their size and scale of operations.

PART I - ANALYSIS OF COSTS AS FIXED COST/VARIABLE COST The size of an airline is typically quantified by the number of aircraft it owns or the market share it has. The operating cost of airlines however may not strictly depend upon the number of aircraft and would rather depend on the number of flights which it undertakes. Once again, the number of flights is inadequate information as the flight duration may last from 30 minutes to 3 hours, and the cost of major expense such as fuel, maintenance etc. is directly dependent upon the duration. To overcome this dichotomy and to keep a standard base for comparison, the concept of Available Seat Miles (ASM) has been used to quantify the costs. This is simply the Number of seats (occupied or vacant) x Number of miles flown by all the aircraft of airlines in one year. This concept is particularly useful in the two chosen airlines as both the airlines operate only one type of aircraft, and hence there are no variations in cost due to the varying expenses of operating different aircraft types.Some costs on the other hand would not be dependent upon ASM such as hangar parking costs, advertisement costs etc. The rationale for classifying these costs has been dealt on case to case basis. The major operating costs of an airline and the rationale of classifying them as Fixed Cost or Variable Cost are enumerated in succeeding paragraphs.

FUEL AND OILFuel and Oil expense is the largest expense in any airline. It stands to logic that the amount of fuel consumed would directly depend upon the number of ASM. The more the number of flights and longer the duration, higher would be the ASM and this would directly translate in to

increased consumption of fuel and oil. The cost of fuel per ASM might change due to the changes in the price of fuel but this does not change the nature of the cost. Another factor which needs to be considered is whether the load factor makes a significant difference to the fuel consumption. For eg; would the fuel consumption of a 100 seat aircraft change when flying with 80 passengers (Load Factor-80%) as compared to when it is flying with 100 passengers (Load Factor 100%)? The answer is yes, but the change would not be significant. It can be safely said that once a flight has been scheduled, the fuel consumption would be majorly dependent upon the ASM and would not be affected by the number of onboard passengers. Fuel cost is therefore classified as Variable Cost; directly dependent upon the number of ASM.

SALARIES, WAGES AND BENEFITSSalaries, wages and benefits expense includes the salaries, hourly wages, bonuses and equity compensation paid to employees for their services, as well as the related expenses associated with employee benefit plans and employer payroll taxes. As can be seen, some part of this expense (salary) is fixed which is paid irrespective of the ASM, and the other part i.e hourly wages would depend upon the ASM. The bonus/equity compensation would also not depend on the ASM but would rather depend on the profit made by the company that year and management’s decision in this regard. Taking these factors in to consideration, and taking cognizance of the existing proportions of the fixed/variable part in the industry today, 80% of this expense is designated as Fixed Cost and 20 % as Variable Cost.

AIRCRAFT RENTAircraft rent expense consists of monthly lease rents for aircraft and spare engines under the terms of the related operating leases and is recognized on a straight-line basis. Aircraft rent expense also includes supplemental rent. Supplemental rent is made up of maintenance reserves paid or to be paid to aircraft lessors in advance of the performance of major maintenance activities that are not probable of being reimbursed and lease return condition obligations which are accrued when they are probable. Examination of the above text clearly shows that the cost is not dependent upon ASM or the flight hours. Aircraft rent is hence designated as Fixed Cost.

LANDING FEES AND OTHER RENTSLanding fees and other rents include both fixed and variable facilities expenses, such as the fees charged by airports for the use or lease of airport facilities, overfly fees paid to other countries and the monthly rent paid for the headquarters facility. Further perusal of the annual report showed that the majority of this expense is fixed, as the slots for landing and overfly fees is paid at the start of a designated period when the flight schedule is fixed (bi-annually). The variable part is extremely small. The Landing Fees is designated as 90% Fixed Cost and 10% Variable Cost.

MAINTENANCE, MATIERALS AND REPAIRS“The cost of scheduled inspections and repairs and routine maintenance costs for all aircraft and engines are charged to Maintenance materials and repairs expense as incurred. The Company also has “power-by-the-hour” agreements related to certain of its aircraft engines with external service providers. Under these agreements, which the Company has determined effectively transfers the risk and creates an obligation associated with the maintenance on such engines to the counterparty, expense is recorded commensurate with each hour flown on an engine. In situations where the payments to the counterparty do not sufficiently match the level of services received during the period, expense is recorded on a straight-line basis over the term of the agreement based on our best estimate of expected future aircraft utilization. For its engine maintenance contracts that do not transfer risk to the service provider, the Company records expense on a time and materials basis when an engine repair event takes place.” Further analysis of the annual report shows that 65% of the expense depends on the ASM and is hence Variable Cost, while 35 % is independent and is Fixed Cost.

DEPRECIATION AND AMORTIZATION“Depreciation is provided by the straight-line method to estimated residual values over periods generally ranging from 23 to 25 years for flight equipment and 5 to 30 years for ground property and equipment once the asset is placed in service. Residual values estimated for aircraft generally range from 2 to 20 percent and for ground property and equipment generally range from 0 to 10 percent”. It is clear that this expense is independent of the hours flown (ASM), and is therefore classified as Fixed Cost.

OTHER OPERATING EXPENSESOther operating expenses consist of distribution costs, advertising expenses, personnel expenses, professional fees, and other operating costs, none of which individually exceed 10 percent of Operating expenses. It also includes the maintenance agreement contract rate, and consulting fees. Distribution fees also forms a part of this expense in SW income statement, though it has been specified separately in Spirit statement as the proportion exceeds 10% of operating costs. The entire expense is independent of ASM, and is classified as Fixed Expense.

MISCELLANEOUS EXPENSESLosses on disposal of assets, special charges, and acquisition costs have not been considered in this analysis as they constitute extraordinary items. These costs are ignored.

INTEREST EXPENSE/ INCOME, CAPITALIZED INTEREST AND OTHER EXPENSEThe Company’s policy for recording interest and penalties associated with uncertain tax positions is to record such items as a component of income before income taxes. Penalties are recorded in Other (gains) losses, net, and interest paid or received is recorded in Interest expense or Interest income, respectively, in the Consolidated Statement of Income. Interest expense/income and other expense is hence classified as Fixed Cost.

Capitalizing interest for expenses on capital acquisition is simply an accounting practice, and this item is ignored in the analysis.

PART II- CALCULATIONS OF PARAMETERS AND THEIR SIGNIFICANCE This section aims to provide the development of key metrics viz. Contribution Margin (CM), Break Even Point (BEP), Margin of Safety (MOS), CVP Index and Degree of Operating Leverage (DOL). For this exercise, the published financials have been considered (Table 1), for FY2014, as the basis for these calculations.

Attributes (FY 2014)

SOUTHWEST AIRLINES

ALL FIGURES IN MILLION (USD) EXCEPT SHARE

PRICES/EPS

SPIRIT AIRLINESALL FIGURES IN MILLION

(USD) EXCEPT SHARE PRICES/EPS

COMMON SIZING

SWAIRLINES

SPIRIT AIRLINES

OPERATING REVENUES

Passenger 17658 1144.97 100.00 100.00

Non Ticket 947 786.61 94.91 59.28

Total Operating Revenues 18605 1931.58 5.09 40.72

OPERATING EXPENSES

Aircraft Fuel (&oil) 5293 612.91 28.45 31.73

Salaries, wages & benefits 5434 313.99 29.21 16.26

Aircraft rent 295 195.83 1.59 10.14

Landing fees and other rents 1111 105.12 5.97 5.44

Distribution 74.82 3.87Maintenance, Material, and Repairs 978 73.96 5.26 3.83

Depreciation and amortization 938 46.97 5.04 2.43

Other operating expenses 2205 149.68 11.85 7.75

Loss on disposal of Assets 3.01 0.16

Special Charges (credits) 0.05 0.00

Acquisition and integration 126 0.68

Total operating expenses 16380 1576.32 88.04 81.61

OPERATING INCOME 2225 355.26 11.96 18.39

Other (income) expense:

Interest expense 130 2.75 0.70 0.14

Capitalised interest -21 -2.75 -0.11 -0.14

Interest income -7 -0.34 -0.04 -0.02

Other expense 309 2.61 1.66 0.13

Total other (income) expenses 409 2.27 2.20 0.12

INCOME BEFORE INCOME TAXES 1816 352.99 9.76 18.27

PROVISION FOR INCOME TAXES 680 127.53 3.65 6.60

NET INCOME 1136 225.46 6.11 11.67

EPS, BASIC 1.65 3.1

EPS, DILUTED 1.64 3.08

Table 1.

Based on the segregation of the Fixed cost (FC) and Variable cost (VC) in Part I above, Table 2 summarizes the spread of the FC and VC contributions of each operating costs associated with Southwest and Spirit airlines.

Table 2.

Table 3 summarize the values of the FC and VC against each operating costs (FY 2014) associated with Southwest and Spirit airlines.

OPERATING EXPENSES CATEGORIZATIONTYPE Fixed Cost Variable Cost

Aircraft Fuel (&oil) 0% 100%Salaries, wages & benefits 80% 20%Aircraft rent 100% 0%Landing fees and other rents 90% 10%Distribution 100% 0%Maintenance, Material, and Repairs 35% 65%Depreciation and amortization 100% 0%Other operating expenses 100% 0%Loss on disposal of Assets 0% 0%Special Charges (credits) 0% 0%Acquisition and integration 0% 0%

TYPE

SOUTHWEST AIRLINESMILLION (USD)

SPIRIT AIRLINESMILLION (USD)

Fixed Cost Variable Cost Fixed Cost Variable

CostAircraft Fuel (&oil) 0 5293 0 613Salaries, wages & benefits 4347 1087 251 63Aircraft rent 295 0 196 0Landing fees and other rents 1000 111 95 11Distribution 0 0 75 0Maintenance, Material, and Repairs 342 636 26 48

Depreciation and amortization 938 0 47 0Other operating expenses 2205 0 150 0Loss on disposal of Assets 0 0 0 0Special Charges (credits) 0 0 0 0Acquisition and integration 0 0 0 0Total 9127 7127 839 734

Table 3.The key metrics of BEP, MOS, CVP Index and DOL description as well as their significance has been elaborated in the paragraphs below. In addition Table 4 contains the quantitative comparison of BEP, MOS, CVP and DOL for Southwest and Spirit Airlines.

Key Metrics Comparative Data (ALL FIGURES IN MILLION (USD) EXCEPT CM)

Metric SOUTHWEST SPIRITVariable Cost (VC) 7127 734Contribution (Revenue - Variable Cost) 11478 1197Contribution Margin (CM = Contribution/Revenue) 61.70% 61.99%Fixed Cost (FC) 9127 839Break Even Point (BEP = FC/CM) 14794 1354BEP as % of Revenue 79.51% 70.1%Margin of Safety (MOS = Revenue-BEP) 3811 578CVP Index (CM*MOS/BEP) 0.16 0.26Degree of Operating Leverage (DOL = Cont./PBT) 6.32 3.39

Table 4.

CONTRIBUTION MARGINThe Contribution Margin for both the airlines is nearly the same; which implies that both the airlines have similar variable costs. The highest contribution to VC is from fuel (100%), followed by maintenance (35%), salaries (20%) and finally landing fees (10%). Closer inspection of the common sizing in Table 1 shows that Southwest has lower outgo in fuel expenses, but this is offset by higher outgo in salaries and maintenance which balances the advantage it gains

from lower fuel cost. The source of lower fuel cost is the difference in the aircraft fleet (Boeing 737 vs A320 of Spirit).. The source of higher maintenance costs arise from two fundamental differences. The first difference is that Spirit has a younger fleet and therefore the maintenance expenses are lower. The second difference is that Spirit leases most of its fleet, and follows the policy of returning the aircraft before the very costly first major servicing which comes up at around 6 years of aircraft life.Southwest also has higher outgo in terms of salaries; both due to more number of employees per aircraft (70 employees per aircraft as compared to Spirit’s 65) and also due to a higher compensation.

BREAK EVEN POINT (BEP)The BEP is the point (expressed in terms of the number of units sold or revenue) wherein all the costs of generating the revenue have been recovered. It analyses the cost, both fixed as well as variable. We have already seen however that the variable costs are roughly the same for both airlines; so any difference in BEP would be due to a difference in Fixed Costs. The BEP for Southwest and Spirit are 14794 mil$ and 1354 mil$ respectively. To get a common platform, we have expressed this as a percentage of revenues and the figures for SW and Spirit are (14794/18605 ) ~ 80% and (1354/1932) ~ 70% of the revenues respectively. This implies that Spirit has been able to better manage and control its Fixed Costs. Closer inspection of the common sizing in Table 1 shows that:(a) The biggest advantage in fixed costs for Spirit is due to the difference in salaries where in Spirit spends 16% of revenue in salaries as compared to 29 % of revenue being spent by SW.(b) Spirit has a higher outgo in rent as most of the aircraft are leased. But at the same time leasing aircraft keeps Spirit’s fleet younger, and the increased outgo on rent is being compensated by lower maintenance and depreciation expenses.(c) On the face of it, the Other Expenses of SW appear to be higher. But this is not correct as SW includes distribution expenses in the Other Expenses. After including distribution expenses for Spirit, the percentage outgo is 7.75+3.87= 11.62 % is similar as the figure of 11.85 % for SW.(d) SW has a higher outgo on interest as it has higher borrowings required to buy and own the aircraft as compared to the leasing model of Spirit which is less capital intensive.(e) The other expenses are also higher for SW Airlines and is increasing its fixed costs; which is primarily due to poor management of fuel hedging contracts.

MARGIN OF SAFETY (MOS)The MOS (expressed in terms of the number of units sold or revenue) is the delta between the actual or projected sales and BEP sales. It is a measure of the “fluctuation of sale” that a business can withstand. In case the negative “fluctuation of sale” is more than the MOS, the business incurs a net loss for that period. The BEP and MOS have been illustrated in Figure 1. Spirit MOS is higher than Southwest, and it has a wider cushion (~30% of revenues) to absorb the fluctuation in sales.

Figure 1.

CVP Index The CVP analysis establishes a relationship between Cost, Volume (which in this case is the number of seats sold) and Profit. Since the CM is almost the same, Spirit enjoys a better number (0.26 vs 0.16 of SW) due to higher MOS and lower BEP. This implies that since Spirit has a lower overall cost, increase in volume would generate a comparatively higher profit for Spirit.

DEGREE of OPERATING LEVERAGE (DOL)The Degree of Operating leverage (DOL) is a ratio that summarizes the volatility of EBIT based on the operating leverage. This is hugely based on the contribution of fixed cost versus variable cost in overall expenses. Higher the fixed cost, more volatile the EBIT. Since SW has a higher fixed cost as discussed earlier, the EBIT would also be more volatile in case of any change in sales. DOL for Southwest is 6.32 as compared to 3.39 in Spirit. This means that any delta (positive or negative) 1% of sales in Southwest will respectively increase/decrease the EBIT by 6.32%. Whereas, in case of Spirit, the change noted will be 3.39%.

PART III- CONCLUSION….

COMMONALITIES OF AIRLINE BUSINESS

1. Although SW and Spirit vary hugely in the number of aircraft being operated and market share, both had near same Contribution Margin and hence the same proportion of VC to revenue. The biggest determinant of VC (and also overall cost) in an airline is the fuel expense and would depend on the no. of flights being operated. It may be appreciated that flight schedules are fixed upto 6 months in advance due to limited availability/auctioning of landing slots. Once fixed, an airline does not have much opportunity to cancel the flight even if the load factor is low and it would incur the fuel cost irrespective of the revenue being generated. This is the reason why planning of flight times and sector is one of the most crucial factor in the airline business. Many budding and even established airlines have gone bankrupt when they have tried to expand by increasing the number of flights or by adding sectors without having done a proper market study of demand.

2. Since fuel expense forms a high part of overall cost; fuel-efficient aircraft, lower fuel prices and better management of fuel hedging contracts are extremely beneficial for the health of the company.

3. The sale and lease back model is proving to be extremely beneficial for budding airlines. The higher outgo in terms of aircraft rental is offset by lower outgo in maintenance, depreciation and interest expense. This model has an added advantage of the company having a lower Debt/ Equity ratio.

4. Fixed cost in both the airlines was higher than the variable costs. This is a general trend in the industry, and therefore there is a high degree of operating leverage in the industry. Any slump in sales due to economic recession/ terror attacks (9/11) or travel advisories (SARS outbreak) can quickly bring even a well-established airline to bankruptcy.

DIFFERENCES IN SOUTHWEST AND SPIRIT AIRLINES

1. It has been famously said that, “Airlines don’t have revenue problems. They have cost problems”. This has been amply demonstrated in this case where Spirt has managed its costs and especially the fixed costs better, and scores much better on all considered parameters.

2. The major difference in fixed cost has been due to the difference in salary outgo. SW employs 70 employees per aircraft which is 7.7 % higher than that employed by Spirit airlines. SW should review its employee strength. It should also consider increasing the VC of salary (hourly wages), so as to bring the fixed costs down. This would have a positive effect on its DOL.

3. The other sources of higher fixed costs were seen to be maintenance, depreciation and higher interest outgo mainly because of higher ownership rather than lease model. SW should consider gradually selling the older aircraft on its inventory, and replace it with younger leased aircraft. Since leased aircraft come with maintenance contracts, the outgo in terms of salaries for technicians would also be reduced.