A Case Study on Cost Estimation and Profitability Analysis

Issues in Accounting Education

Abstract:

This case exposes students to the application of regression analyses to be used as a tool pursuant to understanding cost behavior and forecasting future costs using publicly available data from Continental Airlines. Speci cally, the case focuses on the harsh  nancial situation faced by Continental as a result of the recent  ancial crisis and the challenges it faces to remain pro table. It then highlights the importance of reducing and controlling costs as a viable strategy to restore pro tability and how regression analysis can assist in this pursuit. Students are next presented with quarterly data for various categories of costs and several potential cost drivers, which they must use to perform regressions on operating costs using a variety of cost drivers. They must then use their regression results to forecast operating costs and conduct a pro tability analysis to project quarterly pro ts for the upcoming  scal year.

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Finally, students must summarize the main results of their analysis in a memorandum addressed to Continental’s management, providing recommendations to restore pro ts. In particular, the concept of mixed cost functions is reinforced, as is the understanding of the steps required to perform regression analysis in Excel, interpreting the regression output, and the underlying standard assumptions in regression analysis. The case has been tested and well received in an intermediate cost accounting course and it is suitable for both undergraduate and graduate students. Keywords: cost estimation; pro ability analysis; cost behavior; regression analyses; cost functions. Data Availability: All data are from public sources and are available in hard copy inside the case. Data are also available in electronic form by the author upon request.

Introduction

2008, the senior management team at Continental Airlines, commanded by Lawrence Kellner, the Chairman and Chief Executive Of cer, convened a special meeting to discuss the  rm’s latest quarterly  nancial results. A bleak situation lay before them. Continental had incurred an operating loss of $71 million dollars—its second consecutive quarterly earnings de-I Francisco J. Roman is an Assistant Professor at Texas Tech University. I thank Kent St. Pierre editor , Michael Costa, and two anonymous referees for their suggestions on previous versions of the case. Editor’s note: Accepted by Kent St. Pierre Published Online: February 2011 181 182 Roman cline that year. Likewise, passenger volume was signi cantly 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 pro tability. Being the fourth largest airline in the U.

S. and eighth largest in the world, Continental was perceived as one of the most ef ciently 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  rm’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 pro t 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 pro ts and relief was unlikely through the foreseeable future.

The Decision to Reduce Flying Capacity and the Impact on Operating Costs

Given the situation described above, management needed to act swiftly to restore pro tability. Several strategic options were evaluated. Since the U. S. and much of the world was facing a severe 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.

Thus, because management anticipated that revenues would remain  t for most of the year, the only viable short-term solution to restoring pro ts was a substantial and swift reduction in operating costs. This could most effectively be accomplished in two ways. First, through a reduction in  ying capacity adjusted to match projected passenger demand. With this in mind, Continental’s management agreed to reduce ying capacity by 11 percent on domestic and international routes. 2 As a result of this action, Continental would eliminate the least pro table or unpro table  ights and, accordingly, would ground several planes in the  eet.

Management anticipated that this decision would reduce several of the  rm’s operating costs. Apart from this, Continental could achieve further reductions in costs by implementing several cost-cutting initiatives and through operational ef ciencies. For example, management pro- 1 2 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. Speci cally, on June 13, 2008, Continental Airlines announced that it planned to reduce its  ght capacity by 11 percent. By shrinking capacity, Continental expected to reduce the number of domestic and international  ights from its three major hubs in Houston, Cleveland, and Newark Maynard 2008 .

Issues in Accounting Education American Accounting Association Volume 26, No. 1, 2011 A Case Study on Cost Estimation and Pro tability Analysis at Continental Airlines 183 jected 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  ights. Additionally, the  m could reduce various miscellaneous expenses through targeted cuts in discretionary spending. In sum, to close the gap in pro tability, Continental’s strategy was geared toward slashing operating costs by cutting capacity and through aggressive ident cation 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  rm’s future operating costs, and also identify specic areas in which the  rm could achieve additional cost reductions. Additionally, the cost analysis would help forecast the m’s operating costs and projected pro ts or losses for the upcoming  scal 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 dif cult business to manage.

In particular, they are exposed to tremendous risks brought by volatility inherent in their business model, as they deal with high  ed 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 erce; 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 protability in this industry.

In order for Continental to restore pro tability in this harsh environment of weak demand for air travel, it must be able to contain its operating costs, especially its massive  xed costs, which are visible in several ways. For example, salaries for pilots,  ight attendants, and mechanics, as well as aircraft leasing costs, are typically  xed, varying little with shifts in passenger volume. Because xed costs typically embody the amount of operating capacity of a  rm, they are commonly referred as “capacity” costs. Since  xed costs do not self-adjust to  ctuations in passenger volume, 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 self-adjust 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  ying capacity would affect Continental’s operating costs and pr tability 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 pro tability analysis using regression analysis. Regression analysis is a powerful statistical tool that is frequently used byms to examine cost behavior and predict future costs. The idea behind regression analysis is straightforward: historical data for costs, and the various activities that could potentially drive operating costs, are inserted into a mathematical calculation which yields the average amount of change in that particular cost that has occurred over time. Average values provided by regression calculations may then be applied to estimate future change that will occur in that cost given a one-unit change in one or Issues in Accounting Education Volume 26, No. 1, 2011 American Accounting Association 184 Roman ore 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  rst step in the estimation of a cost function is to identify the underlying activities or other potential factors that drive the cost in question — the 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  ies may drive the costs related to Passenger Services. Likewise, Aircraft Maintenance and Repairs costs could be driven by the number of aircraft in the  eet and by the level of  ying 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  rm’s cost structure behave as variable,  ed, or mixed in which elements of both variable and  xed are observable . Equally important, we should also identify the speci c drivers if any of each cost.

Your job is to assist management in their quest to restore protability at Continental Airlines. Specically, you must conduct regression analyses to examine cost behavior and then use this information to forecast operating costs and pro tability for the upcoming year. As part of your cost analysis, you should investigate how the decision to cut  ying capacity would impact the  rm’s future operating costs and, equally important, identify those speci expense categories or operating areas in which this  rm could attain additional costs saving by implementing cost-cutting initiatives. Your conclusions should be outlined in a memorandum directed to Continental’s Executive management 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, Exhibit 1 presents past quarterly data for all of the above expenditures for the period of January 2000 through December 2008, while Exhibit 2 provides quarterly operations data for the same period of time.

Continental’s Operating Costs and Potential Cost Drivers

As shown in Exhibit 1, there are ten categories of operating costs.These include 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. 3 4 For ease in exposition, cost functions and regression analyses are discussed briey here. For further insight on cost functions and on the mechanics of regression analyses, I refer the reader to the Appendix. A cost driver represents a particular business activity, which usually tends to have a cause-and-effect relationship with a given cost. For example, for airlines, a typical cost driver for landing fees is the number of daily  ights carried by the airline, as well as the number of passengers  own. An increase decrease in the number of  ights or passengers  own would increase decrease landing fees.

Issues in Accounting Education

Volume 26, No. 1, 2011 American Accounting Association 188 Roman Period 23 24 25 26 27 28 29 30 31 32 33 34 35 36 Passenger Miles Flown Employees Fuel Price Fuel Consumed 3Q-2005 4Q-2005 1Q-2006 2Q-2006 3Q-2006 4Q-2006 1Q-2007 2Q-2007 3Q-2007 4Q-2007 1Q-2008 2Q-2008 3Q-2008 4Q-2008 Obs. 21,762,000,000 20,033,000,000 20,336,000,000 23,367,000,000 24,042,000,000 21,772,000,000 21,450,000,000 24,623,000,000 25,422,000,000 22,670,000,000 22,280,000,000 24,836,000,000 24,746,000,000 20,825,000,000 50,018 42,200 42,600 43,450 41,500 38,033 41,800 43,300 41,400 39,640 43,000 40,100 43,500 42,490 $1. 880 $1. 776 $1. 904 $2. 10 $2. 215 $2. 064 $1. 895 $2. 079 $2. 206 $2. 499 $2. 797 $3. 856 $3. 450 $2. 925 364,000,000 344,000,000 347,000,000 375,000,000 387,000,000 362,000,000 361,000,000 395,000,000 406,000,000 380,000,000 375,000,000 389,000,000 395,000,000 339,000,000

Exhibit

Projections of Revenues and Operating Activity for Year

2009 Variable Revenues Available seat miles Available regional seat miles Number of passengers Number of planes Number leased planes Price of fuel per gallon Gallons of fuel consumed Quarter 1 Quarter 2 Quarter 3 Quarter 4 $2,962,000,000 26,323,000,000 2,971,000,000 14,408,000 634 398 $1. 82 403,000,000 2,767,000,000 28,007,000,000 3,044,000,000 16,348,000 617 394 $2. 07 430,000,000 $2,947,000,000 28,933,000,000 3,130,000,000 16,795,000 604 380 $1. 99 369,000,000 $2,462,000,000 26,291,000,000 3,002,000,000 15,258,000 601 379 $1. 98 479,000,000 All  nancial and operational data represent quarterly data for the quarter beginning January 2000 Observation 1 through December 2008.

Data have been compiled from Continental’s 8-K and10-K reports, submitted to the Securities and Exchange Commission. De nitions of Operations Variables: Available seat miles the number of seats available multiplied by the number of miles  wn; Available regional seat miles available seat miles on regional routes; Number of passengers number of paying passengers  own; Number of planes number of planes in the  eet, including regional routes aircraft; Number of leased planes number of leased planes; Price of jet fuel average price per gallon of jet fuel in the respective quarter; and Gallons of fuel consumed number of gallons of fuel consumed in the respective quarter. Salaries and Wages This account represents costs related to salaries and wages, as well as fringe bene ts, of Continental’s workers. These include salaries for pilots and wages for  ght attendants and ground crew, as well as wages for Continental’s mechanics. Additionally, a signi cant 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. ,  ight schedulers, technology Issues in Accounting Education American Accounting Association Volume 26, No. 1, 2011

A Case Study on Cost Estimation and Protability Analysis at Continental Airlines 189 personnel, accountants, and division managers . A possible cost driver of salaries is the available seat miles. 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 planes in Continental’s  eet, including regional jets operated on behalf of Continental by four regional airlines under various capacity purchase agreements. Airport Fees Represents landing fees and passenger security fees paid to the various domestic and international airports where Continental  ies.

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  eet and the number of miles  own. 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 in uenced by both company policy and accounting principles, such as the depreciation method, that a  rm 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  ight, and after arrival at their destination.

A signi cant 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 5 Available seat miles is calculated as the number of seats available for passengers multiplied by the number of scheduled miles those seats are  own. Issues in Accounting Education Volume 26, No. 1, 2011 American Accounting Association 190 Roman driven by the combined  ying 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. DISCUSSION QUESTIONS 1. 2. 3. 4. 5. 6 Using the quarterly data for operating costs and the various cost drivers of costs provided by Exhibits 1 and 2, estimate regression for cost category of costs.

Then, write the appropriate cost function for each category of cost and then interpret your regression results. Based on your regression results, where do you see the largest reductions in costs if  ying capacity is lowered by 11 percent Also, in which areas do you see opportunities to achieve further cost reductions and why Exhibit 2 provides a quarterly forecast of revenues, jet fuel prices,6 and the projected operating activity for 2009. Using the information from your regressions and the forecast information provided in Exhibit 2, estimate Continental’s operating costs and expected pro for the upcoming  scal year. Based on the results of your protability analysis, what can you say about the  rm’s  nancial outlook Would Continental be earning an operating prot in 2009 If not, what should Continental’s management do to restore pro ability in 2009 Summarize your conclusions in a memorandum addressed to Continental’s CEO. In the memo, you must clearly communicate your main ndings, emphasizing speci c areas in which you see the greatest potential to achieve further reductions in costs and, based on your pr tability analysis, sum up the  nancial outlook for 2009.

You should note that Continental has entered into several future contracts to hedge the exposed risks of rising fuel prices. The projected costs for jet fuel on exhibit reects the value of the various future contracts which guarantee Continental a  xed price for jet fuel at various maturity dates in 2009, as well the estimated gallons of fuel that Continental plans to use during the year. Issues in Accounting Education American Accounting Association Volume 26, No. 1, 2011 A Case Study on Cost Estimation and Protability Analysis at Continental Airlines 191

Case Learning Objectives and Implementation Guidance

Cost estimation is a fundamental aspect of managerial/cost accounting Datar et al. 2008; Eldenburg and Wolcott 2005 . For example, cost estimation is critical for developing budgets, setting up cost standards, inventory valuation, product costing, and many other applications. Ultimately,  rms’ ability to accurately predict production and operating costs has a profound impact on decision-making. Additionally, given the frequency with which  rms downsize or expand their operations in response to economic or market-wide conditions, knowing how this strategic decision of scaling output impacts  ms’ future operating costs, and which tools can facilitate this task, has become increasingly relevant for  rms. Nonetheless, despite its importance, cost estimation is a topic that merits further discussion in accounting textbooks.

Although several managerial/cost accounting textbooks provide rich theoretical discussions of cost estimation, including cost behavior, cost functions, and, to some extent, regression analyses, the examples that are typically used to illustrate such an important concept often lack a sense of realism. Either  titious data are commonly used in cost estimation, or the examples covered fail to capture realistic situations faced by  rms in a “real world” context. Accordingly, this case aims to close this gap. The objective is to support students in learning how to apply regression analyses to understand cost behavior and forecast future costs using real data frorms. The case focuses on the harsh  nancial situation faced by Continental Airlines as a result of the recent  nancial crisis and the challenges it faces to remain proable.

It then highlights the importance of reducing and controlling costs as a viable strategy to restore protability, and how regression analysis can assist in this pursuit. Students are next presented with quarterly data for various categories of costs and several potential cost drivers, which they must analyze and then perform regressions on operating costs using a variety of cost drivers. Based on these results, students have to examine how costs behave and then use the regression output to forecast the  rm’s operating costs for year 2009. As part of the cost analysis, students must also identify speci areas in which Continental could achieve the largest cost savings as a result of cutting capacity and implementing other cost-cutting measures.

Apart from this, they must conduct a protability analysis to project quarterly pro ts for the upcoming  scal year. The learning objectives of the case are as follows: Students learn to conduct regression analysis in Excel and use this technique to study cost behavior and forecast future costs. Students also learn how to use actual rm-level data from public sources for estimating costs, and apply cost estimation in a “real world” context that involves a widespread decision among  ms: downsizing capacity. Moreover, learning to use public  nancial information in cost estimation could have implications that reach beyond accounting; learning to access public  nancial information exposes students to the possibilities of applying regression analysis for business analysis in general, including cost and protability analyses. The case requires students to synthesize their ndings in a memorandum addressed to Continental’s CEO; thus, students are also exposed to rening their writing skills in a business setting. Implementation Guidance

This case is primarily designed for use in an intermediate managerial/cost accounting undergraduate class; however, it could also work well in a graduate-level managerial accounting course, at either the master’s level or M. B. A. Issues in Accounting Education Volume 26, No. 1, 2011 American Accounting Association 192 Roman The realistic nature of the setting everyone can easily identify with the business model of airlines makes a particularly appealing environment for students to learn how regression analyses can be applied in cost estimation in a real-world context.

The questions presented in the case include both practical and theoretical questions. As an augmentation of the principles contained in the application of this case, instructors could enhance the student experience by devoting time to reviewing the concepts of cost functions and cost estimation, as well as discussing the fundamentals of regression analyses, so students can be exposed to these concepts prior to receiving the case. Alternatively, students can review these concepts on their own.

Conclusion

The Appendix provides a detailed explanation of cost functions and regression analysis and describes the steps to perform regression analysis in Excel. Additionally, it provides students with broad guidelines to write an effective memorandum. Student Feedback The case was administered to two sections of an upper-level intermediate undergraduate cost accounting class at a major U. S. university. Seventy-seven students responded to an evaluation survey to assess whether they improved their understanding of the concepts illustrated in the case, as well as to whether the case illustrated a “real world” application in predicting operating costs.

As shown in Table 1, students agreed that the case enhanced their understanding of the use of regression analyses in predicting future costs mean of 4. 17, based on a ve-point scale , the case encouraged them to think critically about the behavior of operating costs in a “real world” context mean of 4. 03, based on a ve-point scale ; plus, they found the case interesting and recommended it for use in teaching cost estimation via regression analyses mean of 4. 07, based on a  ve-point scale; s

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