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, pointto-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
Revenues
Expenses:
Personnel-related
Trip-related
Aircraft-related
Other
Operating income
Difference
2003
$5,937,000,000
2004
$6,530,000,000
$2,224,000,000
$1,250,000,000
$ 997,000,000
$ 983,000,000
$ 483,000,000
$2,443,000,000
$1,410,000,000
$1,068,000,000
$1,055,000,000
$ 554,000,000
$ 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
Revenue passenger miles* 47,943,066,000
Available seat miles**
71,790,425,000
Number of employees
32,847
Number of passengers
65,673,945
Number of trips flown
949,882
Aircraft seats
52,436***
2004
53,418,353,000
76,861,296,000
31,011
70,902,773
981,591
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
OUTPUTPRICE2003 = $0.1238 / RPM
ACTOUTPUT2004 = 53,418,353,000 RPMs
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
Aggregate Price-Recovery Component
Aggregate Productivity Component
$ 55,160,504
$ (599,970,371)
$ 615,809,869
2004 Operating Income
$ 554,000,000