Accounting 5075
Case 1
Southwest Airlines (SWA)
By
Gulver Karamemis
Joshua Morse
Manuel Hurtado
Puneet Kankaria
(Section 4993)
Introduction
We are choosing Southwest Airlines, a very well known company in the air transportation
industry for its innovative practices and for its long standing history of being profitable for 34 years
in a row. This makes our target interesting for everyone.
Southwest Airlines currently provides low-fare service to 63 airports in 32 states
throughout the United States. According to the International Air Transport Association (IATA), in
2006 Southwest Airlines had the largest number of domestic scheduled passengers carried and the
second largest total (international & domestic) scheduled passengers carried in the world.
Contents
Strategic Mission & Goal………………………………………………………….2
SWA’s Inventory…………………………………………………………………..2
List of Companies Expenses……………………………………………………….2
Value Chain………………………………………………………………………..3
Regression Analysis………………………………………………………………..4
Competitive Business Environment………………………………………………..4
Break Even Analysis……………………………………………………………….4
Macroeconomic Analysis…………………………………………………………..5
Acquisition Decision……………………………………………………………….6
Appendix…………………………………………………………………………...7
1
Strategic Mission & Goal:
“To get passengers to their destinations when they want to get there, on time, at the lowest possible
fares and making sure they have a good time doing it”. SWA provides air-transport service.
SWA’s Inventory:
Company’s Inventory Items: The Inventory items listed in SWA’s Balance Sheet are
Inventories of parts and supplies, PPE at cost, Flight Equipment, Ground property and equipment.
Inventory Expensed on Income Statement:
Depreciation & amortization, Maintenance materials and repairs. Fuel and Oil is expensed
separately as SWA does not store Fuel and Oil as Inventory.
List of Companies Expenses (Cost Analysis and Estimation):
1)
Salaries, Wages and benefits.
2)
Fuel and Oil ( Includes the Fuel hedging expenses)
3)
Maintenance, Materials and Repairs.
4)
Aircraft Rentals.
5)
Landing Fees and other rentals.
6)
Depreciation and Amortization.
7)
Other Operating Expense.
Salary Expense: (Mixed form regression analysis) SWA avoided layoffs after 9/11, a trend common
for other airlines. This includes the sharp change in number of passengers due to 9/11 and therefore a
regression may not be correct way to calculate salary expense relationship with Sales. SW has
fulltime as well as part time flexible workers. Thus it is better able to manage its salary costs.
Recently the company offered voluntary retirement to some of its employees and 600 accepted the
offer. This shows a sudden spike in employee expense.
2
Fuel and Oil: (Mixed form regression analysis) Fuel and Oil costs have been varying a lot for the
past 3 years. The prices have also gone up and today form the 2nd biggest cost for SWA. The sharp
rise in Fuel costs makes it difficult to have a good co-relation with sales, though ticket prices have
gone up but not as much compared to the rise in price of Fuel Oil. SWA has an effective hedging
strategy to help itself avoid this increase n fuel oil by some part for the next couple of years. Can be
considered as direct material for the service SW is providing.
Maintenance, Materials and repairs: (Mixed form regression analysis) SW has the youngest fleet
among competitor airlines as it has consistently bought new airplanes of the same model for the past
5 years and is going to continue the same in near future. A younger fleet age results into lower
service and repairs required. Also newer technology in these planes helps in increasing efficiency.
Aircraft Rentals: (Mixed form regression analysis) this is expected to be proportional to the
aircrafts leased.
Landing Fees and other rentals: (Mixed form regression analysis) Landing fees are expected to go
up as SW is now expanding its network to new unexplored cities and new destinations require new
setup cost.
Depreciation and amortization: Have increased due to younger age of fleet.
Value Chain:
Strategic Cost Management (Cost Leadership): SWA’s quick turns are still a key to its amazing
productivity. Inline maintenance during regular operation, requiring quick service is carried in house
and major servicing outsourced.
Fewer Models of Airplanes: SWA operates with fewer models of the same aircraft. Similar aircraft
models in the fleet has advantages of lower inventory level, lesser training of employees, more
reliability and placing systematic cost effective orders of new planes of the same model with Boeing.
3
Better maintenance and services are carried out in a scheduled manner as substitute aircraft available
is of the same type.
Use of less congested airports: SWA can have less turnaround times in gates and serve more
customers. An additional advantage of using secondary airports is the low cost they generally have
in comparison with major airports at the same destination. SWA also aims at higher frequency at
these airports which gives it economies of scale for a particular location.
Fuel Cost Hedging: An increasing fuel cost is restricted by SW with effective use of Fuel hedges.
With the claims in their 10 K they have a large portion of expected requirement hedged at a low
price compared to current market price of fuel.
Regression Analysis:
The regression of each expense with Sales shows that all expenses are mixed. (Refer App.Pg10, 20).
Competitive Business Environment:
A look at comparative statistics (Refer App.Pg22-23) tells us how SWA has been doing for the past
2 years. It shows that SWA has performed really well with number of passengers enplaned
increasing at a very good rate compared to addition to new aircrafts. This shows better utilization of
resources.
Another comparative Chart shows that revenues and expenses per passenger mile have remained
more or so constant. This shows stable financial position and performance.
Break Even Analysis: (Refer regression analysis App.Pg18)
Break even point is the point that total revenues equal total costs. Given that break even in sales $
equals total fixed cost divided by contribution margin ratio;
Break Even in Sales$ = a / CMR
= 136.3915 / .119357
= 1142.7189 sales $(million) per quarter to break even.
4
Until 1142.71 $ of sales are reached, SWA operates at a loss but after sales become bigger than
1142.71$, company’s profit starts to increase.
Value for Customer: Online features provide additional convenience to Customers by allowing
them to proceed to their departure gate without stopping at the ticket counter, Skycap, or self-service
kiosk. SWA pioneered Senior Fares, a same-day air freight delivery service, and Ticket-less Travel
and the first airline corporate blog, Nuts about Southwest. DING! ; The first-ever direct link to
Customer’s computer desktops that delivers live updates on the hottest deals and southwest-giftcard™. Southwest.com extends online check-in to 24 hours prior to departure. "SWABIZ," a tool
that assists company travel managers in booking and tracking trips made through southwest.com.
Point –to –point service is of importance in SWA’s strategy as customers do not mind paying more
for a direct flight compared to a change over. Thus 79% of SW’s customers fly directly to their
destination. Southwest has consistently led the entire airline industry with the lowest ratio of
complaints per passengers boarded.
Macroeconomic Analysis
Pros about the future: With over 500 aircraft, SWA has one of the youngest fleets in the nation,
with an average age of approximately nine years. SWA’s Balance Sheets for 2006 and 2005 show
that it has invested a lot of capital in new aircrafts and is going to continue the same for the next five
years with similar order numbers. Therefore we believe Southwest will have to venture into
currently unexplored markets by the company and go for more profitable longer routes. The Cash
Flow statement also shows higher depreciation on this account. The company also plans to lease
aircrafts in the near future along with buying new ones. It also recognizes its future capital
requirements for these activities and has so prudently reduced its current debt, which makes its
Debt/Equity ratio low for a capital intensive industry and shows significant improvement over year
5
on year basis. Hence in future it will be easy for SWA to attract more debt. We expect SWA’s
average cost per passenger mile flown to drop a little as it is expanding and will now fly longer
routes than earlier. This will definitely help increase productivity. Longer routes also mean increased
revenue and customer base.
A sudden economic downturn will definitely affect net income but SWA is very safe from
bankruptcy. Higher fuel cost will not affect SWA in the next couple of years due to Fuel Hedging.
These are crucial years where we are seeing large capacity addition by International Airlines and on
the other hand Airlines trying to survive the Fuel Cost Bump along with increased competition.
Cons: With the current market scenario looking very promising, we are skeptic about future
performance as most airlines are introducing new flights and so profit margins may drop due to
excess capacity. A threat of collective bargaining exits as most employee union amendments are due
in mid of 2008. Airlines like Delta have started focusing more on more profitable international
routes than domestic. Southwest stands at a disadvantage of not flying global.
Acquisition Decision:
Yes, we recommend buying SWA in the current market scenario. Good Brand value is due to
performance. SWA has bagged leading awards and maintained high customer satisfaction.
From 2002 to 2005, we saw the airline industry recovering to profitability. During this time
Southwest did more than remaining profitable. It invested in technology, equipment and is therefore
better prepared compared to the competition for the future. No layoff during the downturn resulted
into a better relationship of the management and the employees. This will help during the union
amendments scheduled in 2008.
SWA has entered into a contract with Boeing to upgrade its planes to new technology.
A Finance Check - The last 10Q states 752,000,000 shares outstanding. With current stock price of
13.25 $ (As on 11/8/07), the market cap of SWA is 9,964,000,000 $.
P/E ratio is = Price of Stock / 4 *EPS for the last quarter= 13.25/4*0.22 = 15.04
6
We expect EPS to go up as SWA has yet to reap profits due to investment in new airplanes.
Appendix
Numerical Analysis
Sales:
Sales in million $
2007 3rd q
2007 2nd q
2007 1st q
2006 4th q
2006 3rd q
2006 2nd q
2006 1st q
2005 4th q
2005 3rd q
2005 2nd q
2005 1st q
2004 4th q
2004 3rd q
2004 2nd q
2004 1st q
2003 4th q
2003 3rd q
2003 2nd q
2003 1st q
2002 4th q
2002 3rd q
2002 2nd q
2002 1st q
Passenger
2482
2475
2112
2192
2258
2362
1938
1907
1912
1868
1592
1586
1612
1654
1428
1467
1503
1465
1306
1357
1344
1425
1215
Freight
32
33
30
31
30
38
35
34
32
33
34
36
28
28
25
24
23
25
22
22
20
22
21
7
Expenses:
Expenses
Quarter
2007 3rd q
2007 2nd q
2007 1st q
2006 4th q
2006 3rd q
2006 2nd q
2006 1st q
2005 4th q
2005 3rd q
2005 2nd q
2005 1st q
2004 4th q
2004 3rd q
2004 2nd q
2004 1st q
2003 4th q
2003 3rd q
2003 2nd q
2003 1st q
2002 4th q
2002 3rd q
2002 2nd q
2002 1st q
Salaries,
wages &
benefits
832
814
767
779
771
786
716
782
693
667
640
755
612
622
589
567
554
587
516
520
510
501
462
Fuel & oil
660
607
564
556
563
518
501
395
337
330
279
277
247
246
230
214
214
194
208
200
203
189
170
Maintenance
materials &
repairs
160
154
136
128
117
119
104
128
110
107
101
121
113
124
114
109
111
104
106
93
99
101
97
Aircraft
rentals
38
40
39
40
39
39
40
42
36
42
43
45
45
44
45
46
46
46
45
47
46
47
47
Landing fees
& other
rentals
145
140
136
121
128
126
120
109
118
114
113
102
104
99
103
96
95
91
90
87
87
88
83
Depreciation
&
amortization
140
137
135
133
131
127
124
120
121
116
112
113
108
107
103
99
97
95
93
93
92
86
85
Other
362
363
337
346
332
332
316
343
301
291
269
273
254
277
254
227
251
258
247
217
264
272
264
8
Basic Regression:
2007-3
2
1
2006-4
3
2
1
2005-4
3
2
1
2004-4
3
2
1
2003-4
3
2
1
2002-4
Expenses
2337
2255
2114
2102
2081
2047
1921
1847
1716
1688
1557
1535
1483
1519
1438
1406
1368
1375
1305
1313
Sales
2588
2583
2198
2276
2342
2449
2019
1987
1989
1944
1663
1655
1674
1716
1484
1517
1553
1515
1351
1401
9
Salaries
10
Fuel Expense:
11
Maintenance Expense:
12
Rental Expenses:
13
Landing Fees:
14
Regression for Total Expenses for Passengers Sales:
15
Regression for Total Expenses for Freight Sales:
16
Multiple Regression
Adjusted R2 Values for Each Regression
17
Regression Analysis:
Regression analysis is the examination of the relationship of independent variables with a dependent
variable. The aim of our analysis is to determine the relationship between expenses and sales.
Therefore, we used basic regression, regression for each expense, regression for each sales segments
and multiple regression analysis’s. According to the analyzed regression output, basic
regression(page 9) has the adjusted R² value of .9580199 which means that basic regression’s
explanatory power for the relation of total expenses and total sales is .9580199%. When the total
expense is decomposed, and relation of each expense is examined, the R2 value of salaries vs. sales
is .96, salaries are 96% related with sales which shows a high relation between salaries and sales.
The R2 value of fuel expense vs. sales(page 11) is .919483; and maintenance vs. sales(page 12) is
.5525 which is a very small regression value that presents a very low explanatory power for relation
between maintenance and sales. The R2 value of rental expense vs. sales(page 13) is .728476 which
executes again a low explanatory power for relation between rental expenses and; and R 2 value of
landing expense vs. sales(page 14) is .885185524. The average adjusted R² value of every sub
expense is .8091289 which is relatively very smaller than the basic regression’s output. In addition,
according to the data from 10-Q’s sales are presented as segments of passenger sales and freight
sales. The R2 value of total expenses vs. passenger sales(page 15) is .9556215 whereas it is
.438257 for total expenses vs. freight sales(page 16). The R2 value is very low to express the
relation between total expenses and freight sales so we’d better decided to analyze multiple
regression for two types of sales. As a result, we analyzed multiple regression(page 17) has the
adjusted R² value of 0.953011. Multiple-regression has approximately same R² value with the basic
regression and the result is: bigger R2 value explains the relationship between sales and expenses
better. Since multiple regression analysis using segment data can be used for forecasting future costs
18
by segment, we decided to choose multiple regression outputs for our company. The total cost
equation for multiple regression analysis is: Y  a   bi * X i
Y= 136.3915 + (.868317*X1 +.012326* X2 )
All numbers are in million dollars.
Total fixed cost of Southwest Airlines for a quarter is:
 a = 136.3915
Variable cost per unit of X is:  b = (.868317+.012326) = .880643
Computing Variable Cost Ratio and Contribution Margin Ratio:
VCR =
 b = .880643
CMR = 1 – VCR = .119357
19
P-Values Explained:
Salaries: The p-value of intercept “a” which presents the fixed cost is 3,49682E-08 and of slope
coefficient “b” which presents the variable cost is 2,79682E-14. These values are very close to 0 and
salaries is a mixed cost because both of the p-values are <.05.
Fuel Expense: The p-value of intercept “a” is 1,0124E-06 and of slope coefficient “b” is 1,68037E11. “a” is not equal to 0 so it is not a variable cost and “b” is not equal to 0 too; so it is not a fixed
cost either. Since both of the p-values are <.05 fuel expense is a mixed cost.
Maintenance Expense: The p-value of intercept “a” is 0,000306514 and of slope coefficient “b” is
0,000104388. These values are very close to 0 and maintenance expense is mixed cost for the
company because both of the p-values are <.05.
Rental Expense: According to the analyzed regression output, rental expense equation has a
negative slope and fixed cost “a” equals 1,02358E-16 and variable cost “b” equals 1,04363E-06.
Since the p-values are both <.05 the type of expense is mixed.
Landing Fees: The p-value of intercept “a” which presents the fixed cost is 4,54835E-05 and of
slope coefficient “b” which presents the variable cost is 4,16203E-10. These values are very close to
0 and landing fee is a mixed cost because both of the p-values are <.05.
20
CVP Chart
Profit
Value
Break-Even Point=
1142.71
In order to plot our CVP graph we determined our hypothetical sales value as 2000 million sales
dollars according to the data points we have collected from our 10-Q’s. We can conclude from the
graph that if SW airlines sell a volume of 2000 million sales dollars (hypothetical sales value), the
total cost will be 1897.6775 million dollars. The break-even point is 1142.71 million sales dollars
per quarter. Until the break-even point our company is in a loss but after the BE point company
starts to gain profit.
Furthermore, variable costs and total revenues lines are parallel to each other and the difference
presents the value of our company’s fixed costs. Since 136.3915 is our fixed cost, the difference of
total costs and fixed costs gives us the value of variable cost which is 1761.286 million dollars. In
addition, the difference between total revenues and total costs gives the profit for that volume sale
which is 102.3225 million dollars. We can conclude that our company will have a profit of 102.3225
million dollars in the case that produces 2000 million dollars of sales.
21
Comparative Anaylsis:
Revenue
passengers
carried
Enplaned
passengers
Revenue
passenger miles
(RPMs) (000s)
Available seat
miles (ASMs)
(000s)
Load factor
Avg length of
passenger haul
(miles)
Avg aircraft
stage length
(miles)
Trips flown
Avg passenger
fare
Passenger
revenue yield /
RPM (cents)
Operating
revenue yield /
ASM (cents)
Operating
expenses / ASM
(cents)
Operating
expenses per
ASM, excluding
fuel (cents)
Fuel
costs/gallon,
excluding fuel
tax
Fuel consumed,
in
gallon(millions)
Full-time
equivalent
Employees at
period-end
Size of fleet at
period-end
2007-3
2007-2
2007-1
2006-4
2006-3
2006-2
2006-1
2005-4
23,553,366
23,442,019
19,960,933
21,057,102
21558982
21999251
19199488
19485000
27,242,613
26,889,424
22,903,073
24,073,919
24880646
25306858
22015484
22225000
19,685,690
19,018,769
16,109,071
16,799,816
17767128
17843848
15280497
15139000
25715957
24982675
23678376
23914966
23784615
22883984
22079458
21748000
76.6
72.20%
68.00%
73.10%
74.7
0.737
0.692
0.707
836
809
807
808
824
804
796
775
633
628
627
622
625
618
617
607
297,782
290,647
276,900
279,903
279032
270947
262449
259377
$105.37
$105.68
$105.79
$104.40
104.75
104.38
100.94
93.68
12.61
13.06
13.11
12.93
12.71
12.98
12.68
12.09
10.06
9.82
9.28
9.81
9.85
9.94
9.15
8.9
9.09
9.01
8.93
8.8
8.75
8.73
8.7
8.05
6.52
6.57
6.54
6.49
6.38
6.56
6.43
6.48
$1.69
$1.61
$1.59
$1.53
1.56
1.51
1.51
1.03
388
726
354
1,389
359
673
329
1287
33,787
33,261
33,195
32,664
32144
31734
31396
31729
511
500
489
481
475
462
451
445
22
Comparative Analysis 1
30,000,000
25,000,000
Revenue passengers
carried
20,000,000
Enplaned passengers
15,000,000
Revenue passenger
miles (RPMs) (000s)
10,000,000
Available seat miles
(ASMs) (000s)
5,000,000
0
200
7-3
200
7-2
200
7-1
200
6-4
200
6-3
200
6-2
200
6-1
200
5-4
Comaparative Analysis 2
14
12
10
Passenger revenue yield per
RPM (cents)
8
Operating revenue yield per
ASM (cents)
6
Operating expenses per
ASM (cents)
4
Operating expenses per
ASM, excluding fuel (cents)
2
0
2007- 2007- 2007- 2006- 2006- 2006- 2006- 20053
2
1
4
3
2
1
4
23