Please help with #5 question & add to it: (i) How do-airlines make money?, (ii) What is the airline cost structure, and (iii) In which cost area do you see greatest potential to achieve cost reductions?

Continental Airlines Case Study

THE DECISION CONTEXT

In 2008, the senior management team at Continental Airlines, commanded by Lawrence Kellner,

the Chairman and Chief Executive Officer, convened a special meeting to discuss the firm's

latest quarterly financial results. A bleak situation lay before them. Continental had incurred an

operating loss of $71 million dollarsits second consecutive quarterly earnings decline that

year. Likewise, passenger volume was significantly down, dropping by nearly 5 percent from the

prior year's quarter. Continental's senior management needed to act swiftly to reverse this trend

and return to profitability.

Being the fourth largest airline in the U.S. and eighth largest in the world, Continental was

perceived as one of the most efficiently run companies in the airline industry. Nonetheless, 2008

brought unprecedented challenges for Continental and the entire industry as the United States

and much of the world was heading into a severe economic recession. Companies cutting deeply

into their budgets for business travel, the highest yielding component of Continental's total

revenue, together with a similar downward trend from the leisure and casual sector, combined to

sharply reduce total revenue.

Concurrent with this revenue decline, the price of jet fuel soared to record levels during 2008.1

Thus, while revenue was decreasing, Continental was paying almost twice as much in fuel costs.

Interestingly, fuel costs surpassed the firm's salaries and wages as the highest cost in

Continental's cost structure. This obviously had a negative impact on the bottom line, squeezing

even further the already strained profit margins.

The outlook for a quick recovery in the U.S. economy and, consequently, an upturn in the

demand for air travel in the short term did not seem likely. Continental's internal forecasts

indicated that a further decline in passenger volume should be anticipated throughout 2009, with

a recovery in travel possibly occurring by the middle of 2010.

To summarize, adverse economic conditions in the U.S., coupled with the rise in fuel costs, were

dragging down Continental's profits and relief was unlikely through the foreseeable future.

Given the situation described above, management needed to act swiftly to restore profitability.

Several strategic options were evaluated. Since the U.S. and much of the world was facing

asevere recession, the prospect for growing revenues by either raising airfares or passenger

volume seemed futile. Contrary to raising revenue, Continental's managers believed that raising

fares could potentially erode future revenues beyond the present level. Discounting fares did not

seem a plausible solution either, because given the severity of the economic situation a fare cut

could fall short in stimulating additional passenger demand and lead to lowering revenues.

1 To illustrate, jet fuel is tied to the price of oil and, over the past year, oil prices surged from about $70 to

$135 per barrel. Consequently, the price of jet fuel increased markedly, from an average of $1.77 per

gallon to $4.20 by the mid-summer of 2008.

Thus, because management anticipated that revenues would remain flat for most of the year,the

only viable short-term solution to restoring profits was a substantial and swift reduction

inoperating costs. This could most effectively be accomplished in two ways. First, through a

reductionin flying capacity adjusted to match projected passenger demand. With this in mind,

Continental'smanagement agreed to reduce flying capacity by 11 percent on domestic and

internationalroutes.2 As a result of this action, Continental would eliminate the least profitable

(or unprofitable)flights and, accordingly, would ground several planes in the fleet. Management

anticipated that thisdecision would reduce several of the firm's operating costs.

Apart from this, Continental could achieve further reductions in costs by implementing

severalcost-cutting initiatives and through operational efficiencies. For example, management

projected that it could achieve reductions in Passenger Services expenses by consolidating

several tasks during passenger check-in and by reducing food and beverage waste served during

flights. Additionally, the firm could reduce various miscellaneous expenses through targeted cuts

in discretionary spending.

In sum, to close the gap in profitability, Continental's strategy was geared toward slashing

operating costs by cutting capacity and through aggressive identification and implementation of

cost-cutting initiatives.

The next step would be for management to know precisely how their decision to downsize

capacity would impact the firm's future operating costs, and also identify specific areas in which

the firm could achieve additional cost reductions. Additionally, the cost analysis would help

forecast the firm's operating costs and projected profits (or losses) for the upcoming fiscal year.

However, before we can proceed with such analysis, an examination of how the various

categories of Continental's costs behave is in order.

Before we begin, let us prepare with an overview of the airline industry and its competitive

landscape, and an understanding of why cost behavior bears particular relevance in this case.

Relative to other industries, airlines are a very difficult business to manage. In particular, they

are exposed to tremendous risks brought by volatility inherent in their business model, as they

deal with high fixed costs, labor unions, instability in fuel prices, weather and natural disasters,

passenger safety, and security regulations. These aspects bring a large burden to airlines' cost

structures. Moreover, competition within the industry is fierce; the proliferation of discount

carriers, such as Southwest Airlines and, most recently, Jet Blue, and the end of fare regulation in

1978, has hindered airlines' pricing power and their ability to spur revenues. For these reasons,

cost containment is a critically important aspect of profitability in this industry.

In order for Continental to restore profitability in this harsh environment of weak demand for air

travel, it must be able to contain its operating costs, especially its massive fixed costs, which are

visible in several ways. For example, salaries for pilots, flight attendants, and mechanics, as well

as aircraft leasing costs, are typically fixed, varying little with shifts in passenger volume.

Because fixed costs typically embody the amount of operating capacity of a firm, they are

2 Specifically, on June 13, 2008, Continental Airlines announced that it planned to reduce its flight

capacity by 11 percent.By shrinking capacity, Continental expected to reduce the number of domestic and

international flights from its threemajor hubs in Houston, Cleveland, and Newark (Maynard 2008).

commonly referred as "capacity" costs. Since fixed costs do not self-adjust to fluctuations in

passengervolume, the only way in which they can be decreased (or increased) is if management

adjusts them in accordance to the level of operating capacity. In contrast, other costs, such as

passenger services and reservation and distribution costs, behave as variable and would selfadjust

with variations in volume or operating activity.

Hence, to assess the impact of this strategic decision to alter Continental's cost structure, and

identify the areas that could achieve the greatest reduction in costs, we must resolve how

Continental's operating costs behave and what drives them. In what follows, we learn how to

apply regression analyses to examine cost behavior and forecast future costs, and then use that

knowledge to assess how the reduction in flying capacity would affect Continental's operating

costs and profitability in the near term.

ESTIMATING COSTS USING REGRESSION ANALYSES

The previous discussion highlighted the importance of examining the behavior of Continental's

operating costs to pave the way for a cost and profitability analysis using regression

analysis.Regression analysis is a powerful statistical tool that is frequently used by firms to

examine costbehavior and predict future costs. The idea behind regression analysis is

straightforward: historicaldata for costs, and the various activities that could potentially drive

operating costs, are insertedinto a mathematical calculation which yields the average amount of

change in that particular costthat has occurred over time. Average values provided by regression

calculations may then beapplied to estimate future change that will occur in that cost given a

one-unit change in one or more of the business activities which drive that cost.3

More precisely,

in a regression model, cost is a function of one or more business activities (or factors)underlying

a business operation. Simply put, the business activities are the drivers of operating costs.

Therefore, since activities drive costs, our first step in the estimation of a cost function is to

identify the underlying activities or other potential factors that drive the cost in questionthe

cost drivers. This requires extensive knowledge of the business operation. In the case of

Continental Airlines, the potential drivers of operating costs vary greatly. For instance, as

previously noted, the number of passengers that Continental flies may drive the costs related to

Passenger Services. Likewise, Aircraft Maintenance and Repairs costs could be driven by the

number of aircraft in the fleet and by the level of flying capacity set by Continental (i.e.,

available seat miles).

In synthesis, to predict how Continental's operating costs would be affected by the decision to

reduce capacity, and to identify those areas in which additional room is available for cost cutting,

we need to identify which costs in this firm's cost structure behave as variable, fixed, or mixed

(in which elements of both variable and fixed are observable). Equally important, we should also

identify the specific drivers (if any)of each cost.

Your job is to assist management in their quest to restore profitability at Continental Airlines.

Specifically, you must conduct regression analyses to examine cost behavior and then use this

information to forecast operating costs and profitability for the upcoming year. As part of your

3

For ease in exposition, cost functions and regression analyses are discussed briefly here. For further

insight on cost functions and the mechanics of regression analyses, refer to the Appendix.

cost analysis, you should investigate how the decision to cut flying capacity would impact the

firm's future operating costs and, equally important, identify those specific expense categories

(or operating areas)in which this firm could attain additional cost saving by implementing costcutting

initiatives. Your conclusions should be outlined in a memorandum directed to

Continental's ExecutiveManagement team.

You are provided next with a description of Continental's operating costs and the potential

drivers of costs so you can conduct regression analysis to estimate the corresponding cost

functions. To help you in estimating the regressions, a comprehensive set of instructions for

performing regression analysis using Microsoft Excel is provided in the Appendix. Immediately

following the description of costs, a series of questions is provided that should help guide your

analysis. Additionally, to help you estimate your regressions, the Excel Spreadsheet

accompanying this casepresents past quarterly data for all of the above expenditures for the

period of January 2000 through December 2008, and also quarterly operations data over the

same period.

CONTINENTAL'S OPERATING COSTS AND POTENTIAL COST DRIVERS

The spreadsheet provides ten categories of operating costs, including salaries and wages, aircraft

fuel and related taxes, aircraft rentals, airport fees, aircraft maintenance and repairs, depreciation

and amortization, distribution costs, passenger services, regional capacity purchases, and other

expenses. Of these, some represent a single expense item. For example, the cost of aircraft

rentals and airport fees together comprise a single cost item. Other costs represent cost pools

comprising several cost items. Such is the case of passenger services and other expenses.

The following provides a detailed description of each cost, along with the potential cost drivers.

Salaries and wages

This account represents costs related to salaries and wages, as well as fringe benefits, of

Continental's workers. These include salaries for pilots and wages for flight attendants and

ground crew, as well as wages for Continental's mechanics. Additionally, a significant portion of

this salary pool represents wages of reservation specialists, customer service representatives at

airports, and the salaries for administrative and support personnel (e.g., flight schedulers,

technologypersonnel, accountants, and division managers. A possible cost driver of salaries is

the available seat miles.

4

Aircraft fuel and related taxes

This represents the cost of jet fuel and related fuel taxes. Jet fuel cost tends to be driven by the

current price of jet fuel and gallons of jet fuel consumed.

Aircraft rentals

These are expenses for capital leases of aircraft. The main driver is the number of leased planesin

Continental's fleet, including regional jets operated on behalf of Continental by four regional

airlines under various capacity purchase agreements.

4 Available seat miles is calculated as the number of seats available for passengers multiplied by the

number of scheduled miles those seats are flown.

Airport fees

Represents landing fees and passenger security fees paid to the various domestic and

international airports where Continental flies. Landing fees are driven by the number of

passengers.

Aircraft maintenance and repairs

These are expenses associated with the service and maintenance of planes. These include

expenses related to scheduled maintenance, spare parts and materials, and airframe and engine

overhauls. The main drivers of these costs are the number of planes in the fleet and the number

of miles flown.

Depreciation and amortization

This represents depreciation and amortization expenses of aircraft, ground equipment, buildings,

and other property. It must be emphasized that the largest portion of depreciation expense relates

to the depreciation of aircraft. Although depreciation expenses are driven by the acquisition cost

of Continental's capital assets, depreciation is greatly influenced by both company policy and

accounting principles, such as the depreciation method, that a firm adopts.

Distribution costs

These expenses represent credit card discount fees, booking fees, and travel agency

commissions, all of which are affected by passenger revenue. Therefore, the driver of these costs

is total revenue.

Passenger services

This is also a cost pool that includes expenses related to processing and servicing passengers

prior to take-off, during flight, and after arrival at their destination. A significant portion of these

costs is generated by Continental's Field Services Division, the main function of which is to

provide service to planes prior to take-off. Some of these expenses relate to checking in

passengers, handling luggage on and off planes, cleaning planes, stocking planes with beverage

and food, and refueling the aircraft prior to take-off. The potential cost driver of these costs is the

number of passengers.

Regional capacity purchases

These are costs related to the purchase of regional routes served by several regional airlines on

behalf of Continental (ExpressJet, Chautauqua, CommutAir, and Cogan). These costs are driven

by the combined flying capacity of the four airlines: available regional seat miles.

Other expenses

This is a cost pool that comprises many ancillary and discretionary expenditures, including

technology expenses, security and outside services, general supplies, and advertising and

promotional expenses. Further, this cost pool contains various special charges for gains and

losses from the sale of retired aircraft and costs of future leases. Given the large variety of

miscellaneous items, there is no clear driver of these expenses; however, a large portion of them,

such as advertising and promotional expenses, are driven by total revenue.

CASE QUESTIONS

1. Using the quarterly data for operating costs and the various cost drivers of costs provided in the spreadsheet, estimate regressions for each of the ten cost categories listed above. Then, write the appropriate cost function for each category of cost and interpret your regression results. For example, your first regression would have "salaries and wages" as your dependent variable and "available seat miles" as independent variable.

2. Based on your regression results and your interpretation of those results, where do you see the largest reductions in costs if flying capacity is lowered by 11 percent? Also, in which areas do you see opportunities to achieve further cost reductions? Why?

3. The table below provides a quarterly forecast of revenues, jet fuel prices,5 and the projected operating activity for 2009. Using the information from your regressions and the forecast information provided, estimate Continental's operating costs and expected profit for the upcoming fiscal year.

4. Based on the results of your profitability analysis, what can you say about the firm's financial outlook? Would Continental be earning an operating profit in 2009? If not, what should Continental's management do to restore profitability in 2009?

5. Summarize your conclusions in a memorandum addressed to Continental's CEO. In the memo, you must clearly communicate your main findings, emphasizing specific areas in which you see the greatest potential to achieve further reductions in costs and, based on your profitability analysis, sum up the financial outlook for 2009.