Case Report: Deltas New Song

Background
The entire US airline business is facing the challenge of operating within a low-margin, high-fixed-cost
environment. Its profitability is particularly sensitive to decreases in volume, either from environmental
factors 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. Furthermore, for many airlines, labor unions
are strong, presenting an additional challenge in the management of cost. Salaries are largely fixed in
the short term for unionized employees. In recent years, some major airlines have won concessions
from labor unions about reducing the staff and cutting down salaries.
Delta Airline is the third largest U.S. airline in operating revenues and revenue passenger miles flown.
Traditionally, the competition came from the other full-service airlines such as United Airlines and
American Airlines. However, in recent years, the major airlines have been forced to compete with low-
cost, no-frill airlines pioneered by Southwest Airlines. Salaries are a significant component of Deltas cost
structure. Delta pilots are the highest paid in the industry. Meanwhile, it is the least unionized of the
major airlines. Delta pilots are the only unionized employee group. Its flight attendant and ticket agents
are not under union contract. Consequently, their salaries present flexibility and variability in nature.
In November 2002, despite its previous failure in entry into the low-fare market, Delta decided to form a
new low-cost carrier, Song, which is targeted to compete with successful newcomer JetBlue.
Main Issue
How can Delta create a different cost structure and business model in order to succeed in the low-cost
carrier market?
Problems
Delta is in a position of evaluating entry into the low-cost carrier market. The success of Deltas Song
depends on the following issues:
Can Delta create a very different cost structure and a new business model to compete with JetBlue?
How to predict future salaries of Delta and JetBlue?
How to deal with the strong work union?
Analysis
1. High-low method
Firstly, we identify some possible cost drivers to estimate Deltas salaries: available seat miles;
available ton miles; number of departures; revenue passenger miles; revenue ton miles. After
applying simple regression using each of the possible drivers and comparing R
2
and residual errors of
each driver, we choose two most reasonable cost drivers: revenue passenger miles and available
ton miles.
The salaries consist of payments to pilots, flight attendants and ticket agents. They are determined
not only by the number of passengers and cargoes but also the miles or hours flown. In fact, miles
and hours are correlated. So we choose revenue passenger miles and available ton miles as cost
drivers. Revenue passenger miles is a major indicator in the airline industry, so its reasonable to be
a driver. Available ton miles, however, seems not so good. But after calculation we find that R
2
of
the former is 0.1764, and R
2
of the latter is 0.5577. For more obvious comparison, we draw the
following scatter plots.

The scatter plot between revenue passenger miles and salary

The scatter plot between available ton miles and salary
We can see that the latter scatter plot shows a more linear relationship between the two variables.
From the perspective of either numerical analysis or visual judgment, available ton miles is more
accurate for estimation. So we choose available ton miles as the cost driver.
Low point (3132, 1145), high point (4029, 1514)
Salary=0.4114available ton miles-143.50
This technique has advantages: only two data is needed, so its quite convenient. Its easy to apply
and illustrate mathematically how a change in a cost driver can change total cost.
However, not all the information is used, which is regarded as inefficient. Because it bases cost
function on only two periods cost experience, regardless of how many relevant data points have
been allocated. In a word, its less accurate.
2. Simple Regression
We use simple regression to estimate the salary cost with available ton miles as the cost driver.
Results are as follows:

Salary = 0.5517 available ton miles - 682.64
R
2
= 0.5577, and standard deviations are much smaller than coefficients, so its statistically valid and
significant.
Regression analysis measures cost behavior more reliably than other cost measurement methods,
since this technique uses statistics to fit a cost function to all the historical data. Compared with the
high-low method which only contains two groups of data, its an improvement. Whats more,
regression analysis yields important statistical information about the reliability of the cost estimates,
which allows analyst to assess confidence in the cost measures and select best cost driver. But we
should notice that only one cost driver is considered, so it cant explain the variation of salaries
completely.
3. Multiple Regression
Because of the reasons mentioned in Question 1, we choose revenue passenger miles and available
ton miles as cost drivers and use multiple regression to estimate the salary cost. Results are as
follows:

Salary = -1144.55 + 1.05 available ton miles - 72.30 revenue passenger miles
R
2
= 0.5577, and standard deviations are much smaller than coefficients, so its statistically valid and
significant.
This technique takes more cost drivers into consideration, and the results calculated are more close
to the data given, so its an improvement over the model estimated in Question 2. The accuracy of
estimation thus serves as its top advantage. However, it might be more costly, time-consuming and
complicated to be implemented than other techniques.
4. The usefulness of analysis in Question 1-3
The cost functions estimated in Question 1-3 are based on the assumption that the wages per hour
remain the same and there is no additional labor needed, so its useful only under certain
conditions. Taking the background of the industry and the companys circumstance into
consideration, we think these are important:
The first one is that the present equilibrium between Delta and the labor unions is not
interfered. That is, endeavors concerning lowering pilots salaries to industry level will not be
obstructed by union forces, and employees other than pilots will not join labor unions to require
higher payments. If not, adjustments on cost structure will be futile and Song will only turn out
to be another Delta Express.
Secondly, no harsh regulations regarding reducing staffs or cutting salaries are to be formulated.
Restrictions about layoffs will directly lead to weak control over budgets, and in turn creates
similar problems as high salaries do. Nevertheless, regulations of this kind are almost inevitable.
According to precedents, large scale furloughs have already been blocked once by ALPA, thus we
have no reason to remain optimistic as long as the recession of the general economics stay as a
fact.
The last point we come up with is the new fixed cost caused by new security directives after the
September 11 terrorist attacks. However, since security costs can be expected amid the whole
industry, it shall not become a major concern for Song, although our prediction model may
overall shift upwards.
If the conditions are not met, the cost functions will be less useful.

5. Estimate the salary cost for JetBlue
According to Question 1, available ton miles should be used to estimate the salary cost. However,
available ton miles of 2002Q3 is eccentrically low. So we draw a scatter plot:

In this situation, available ton miles and salaries are not linear. The scatter plot of revenue
passenger miles and salaries is as follows:

Revenue passenger miles and salaries are quite linear. We use the high-low technique to estimate
the salary cost with revenue passenger miles as cost driver.
Low point (599.4, 16000), high point (2016.2, 49000)
Salary = 23.29 revenue passenger miles + 2038.83


6. Estimate the salaries cost for Song in its first year
To estimate the salaries cost of Song is quite difficult because there is no historical data for
reference. Because JetBlue is a successful example in the low-cost market, we use its historical
salaries cost to predict Songs salary. For simplicity, we make some assumptions:
Song can achieve the same revenue passenger miles as JetBlue in every quarter
JetBlues salaries are linear with time series
Though the first assumption is very strong, the second one can be easily verified. We number each
quarter in 2001 and 2002 from 1 to 8, and make simple regression between the time series and
salary.

Simple regression between the time series and salary:

JetBlues salary = $ 4761.91 number of time series + $ 9571.43
The scatter plot of number of time series and salary is as follows:

R
2
= 0.9900 and standard deviations are much smaller than coefficients, so the estimation is
statistically valid and significant. The scatter plot also supports this predication.
With the formula above, JetBlues salary of each quarter in 2003 can be calculated.

To determine Songs salary, three deviations must be taken into consideration:
1) Song pilots per hour wage rates are $100 more than those of JetBlue on average.
From the material, we know that a Boeing 757 captain is paid $254 per hour in Song, so a pilot is
paid $154 per hour in JetBlue. Since Song is supported by a single-airliner fleet of 36 Boeing
757s, the additional salary to pilots can be calculated easily. But before that, we need to know
how much is paid to pilots in JetBlue.
As the material indicates, pilots are paid for hours flown. The question is how to predict revenue
hours for JetBlue.
As is done before, we number each quarter in 2001 and 2002 from 1 to 8, and make simple
regression between the time series and revenue air hours.

Simple regression between the time series and revenue air hours:

Revenue air hours = 6.2821 number of time series + 3.3095
The scatter plot of number of time series and salary is as follows:

R
2
= 0.9936 and standard deviations are much smaller than coefficients, so the estimation is
statistically valid and significant. The scatter plot also supports this predication.
With the formula above, revenue air hours and additional salary to pilots of each quarter in
2003 can be calculated.

2) Songs salaries paid to flight attendants, ticket agents and other workers might be higher, too.
Considering Songs poor performance in controlling the salaries, its reasonable to assume that
Songs salaries of other workers is also higher. However, there is no enough evidence in
material, so we use a compromising method. Firstly, we assume the other workers salaries are
the same and calculate a floor. Then we assume the other workers salaries are also higher
and calculate a ceiling.
A. Floor
The additional salary cost of Song is just the additional salary paid to pilots.

B. Ceiling
The additional salary coast of Song includes additional salary paid to pilots and other
workers. To get the maxim, we assume that Songs salary exceeds JetBlues by the same
percentage. That is to say,

= 1.6494

3) Song began service on April 15, 2003
Salary cost before April 15, 2003 should be deducted, which includes salary of the first quarter
and the first 14 days in the second quarter. Number of days in the second
quarter=30+31+30+31=122. The adjusted salary is as follows.
A. Floor

B. Ceiling

In conclusion, Songs salary for 2003 lies between $191649 and $292636, taking the higher wage
rates and the date of beginning service into consideration.
Solutions to problems & suggestions
1) Cutting Salaries
The restructure of cost will primarily lie in the reduction of salaries. As implied in the background, its
main competitor in low-cost market, JetBlue, enjoys the lowest labor fraction of 25.5%. Thus, Delta
should no longer persist in its previous strategy on salaries.
Delta has the superiority of being the least unionized one in the industry, which makes a
substantial competitive advantage. Since un-unionized employees are not restricted to fixed
working hours, salaries cost can be largely eliminated through condensing working time, since
all of the personnel are paid by hours. (1). Effective training programs are expected to enhance
efficiency and accordingly reduce time needed per hourly personnel to get work finished. (2).
Flexible working hours should be launched especially for the women personnel like flight
attendants and ticket agents. As women are more inclined to family and personal life, an unpaid
leave program should be launched for them to better achieve a balance between life and work.
Furthermore, the humanistic vacation plan will nurture employee loyalty and thus enhance
productivity in the long term.
Delta provides the highest salary for pilots, combined with the block from furlough.
Consequently, pilots salaries take up a majority of their cost. Since pilots are unionized with
fixed working time, salary reduction will be the only way. As JetBlues cost function might be
impractical for Delta, Southwest Airlines figures might be an appropriate goal. (1). Attain
concession from the labor union as other companies. (2) Since Deltas salary level is currently
above the industry average and, moreover, contracted maintenance work creates additional
flexibility in salaries cost, there is no need to worry about brain drain.
2) Omit traditional service frills
Apart from lowering salaries, Song needs to omit traditional service frills so as to adjust to the low-
cost business mode. Concrete measures can be simplifying aircraft services, cancelling flight meals
for short-term flights, refusing to return airfares for late passengers and so on. To compensate for
the relatively inferior service, it becomes an essence for Song flights to enhance in-flight
entertainment. Approaches such as introducing satellite televisions, which has become a favorite for
JetBlues customers, ought to be on the agenda of Songs operation.
3) About its business model
Delta plans to base its new business model on the low-cost model of Southwest Airlines.
Southwest Airlines retain a leading role in the low-cost airline industry by innovation in business
model. The condensed flight schedule and a good reputation of punctuation allow it to generate
revenue from business men. More importantly, its planes are all Boeing 737s, which enormously
decreases the maintenance cost. Southwest Airlines choose the landing airport in secondary
cities to further cut the operating expenses, meanwhile enables the business customers to reach
the destination by expressway in time. All the features can be copied by Song to reach its cost
controlling goals. Since Song is facing the challenge of insufficient investment, the strategy of
Southwest Airlines simply meets its current need.
In addition, Southwest Airlines key to success is its highly-centripetal culture. The financing
policy provides dividends to every employee, creating an efficient team with a high sense of
company loyalty. The dividend institution acts as an effective incentive which motivates the
personnel to contribute more efforts to the company especially in difficult times after the 911
incident. Nevertheless, company culture cannot be nurtured in one day. Delta might need to
develop its own culture which better matches its own history and enterprise background.

Reference: http://wenku.baidu.com/view/885cb61ea300a6c30c229f32.html