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ABSTRACT: This case provides the opportunity to use various empirical techniques (i.e., high-low method, simple regression, and multiple regression) in the estimation of cost functions. The case uses the airline industry as the setting for this analysis and, in particular, focuses on the efforts of Delta Airlines to plan for salaries, the cost category that dominates its income statement. The case provides the data and the opportunity to learn the details of cost function estimation, but more importantly, it provides a rich setting in which issues related to the interpretation of these cost functions can be discussed. Finally, the entry of Delta into the low-cost carrier segment with its formation of Song provides a unique opportunity to think about how the cost function of an established full-service airline compares to that of a low-fare startup. Data from successful newcomer JetBlue is used to illustrate these differences. More generally, the case shows how the use of historical costs and cost estimation techniques can facilitate decision making about entry into new product markets.
INTRODUCTION
Founded in 1924, Delta Airlines is the third largest U.S. airline in operating revenues and revenue passenger miles flown.1 Traditionally, Delta's primary competition came from the other full-service airlines, including United Airlines and American Airlines. However, in recent years, the major airlines have increasingly been forced to compete with low-cost, no-frill airlines pioneered by "fly for peanuts" Southwest Airlines. The significant downturn in passenger volume in the third quarter of 2001 (following the September 11 attacks) served only to increase the head-to-head competition between the majors and the low-cost competitors.
AIRLINE LABOR COSTS
Industry Challenges
Airlines must operate within a low-margin, high-fixed-cost environment, making profitability particularly sensitive to decreases in volume, either from environmental factors (e.g., the September 11,2001 attacks) or from competition. Moreover, the airline business is labor-intensive. Labor costs as a percentage of revenues ranges from a low of about 25 percent for the low-fare airlines to almost 50 percent for the large, full-service airlines such as United (see Exhibit 1).
For many airlines labor unions at various levels of the organization are strong, presenting an additional challenge in the management of costs. Labor union (re)negotiations were on the rise during 2003, as airlines tried to pass along an increasing...