A Case Study on Cost Estimation and Profitability Analysis at Continental Airlines

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A Case Study on Cost Estimation and
Profitability Analysis at Continental Airlines

Francisco J. Román

Introduction

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 dollars—its 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.

THE DECISION TO REDUCE FLYING CAPACITY AND THE IMPACT ON OPERATING COSTS 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 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 flat for most of the year, the only viable short-term solution to restoring profits was a substantial and swift reduction in operating costs. This could most effectively be accomplished in two ways. First, through a reduction in flying capacity adjusted to match projected passenger demand. With this in mind, Continental’s management agreed to reduce flying capacity by 11 percent on domestic and international routes.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 this decision would reduce several of the firm’s operating costs. Apart from this, Continental could achieve further reductions in costs by implementing several cost-cutting initiatives and through operational efficiencies. For example, management projected that it could achieve reductions in...
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