In pricing and yield management, airlines continually seek to estimate the varia
ID: 2568570 • Letter: I
Question
In pricing and yield management, airlines continually seek to estimate the variable costs of additional passengers. In doing so, United Air Lines (UAL) analysts specified the regression model by regressing the change in total costs each period against changes in revenue passenger miles and system wide takeoffs. The analysts concluded that about 70 percent of UAL’s costs varied with passenger traffic and takeoffs; that is, about 70 percent of UAL’s costs were variable. This result surprised other analysts, who thought the UAL’s cost must be mostly fixed. These skeptics observed that UAL averages about 35 percent empty seats on its flights. They thought that when UAL carried a few extra passengers, these passengers would sit in the otherwise empty seats. Then, the only incremental costs would be about 25 percent of revenue for extra credit card fees, commissions, fuel, food, check-in agents, and baggage handling. The skeptics assumed UAL would not buy new airplanes and other major assets to handle the incremental passenger traffic. The analysts at UAL who developed the regression estimates showed that the airline responded to an increase in demand for seats by expanding its total airline capacity, not only by putting the extra passengers in otherwise empty seats. Required: 1. Present a discussion of the differences between variable and fixed cost. 2. As a manager at UAL, how would you use the information in the passage for decision making? 3. Based on your experience or the materials covered in this module, do you agree with their conclusions? Why or why not?
Explanation / Answer
1. Variable and fixed costs;
Variable costs are those costs which changes as per an increase in sales’ revenue and we can say that costs which can be change as per the level of operations. Whenever airline will increase its operations then variable costs will also increase in same proportion.
Thus those costs which change as per change in the sales revenue are known as variable costs.
Now come to fixed costs, those costs which remain fixed upto a certain level are known as fixed costs. In other words we can say that those costs which do not change as per change in sales revenue or as per change in operations are known as fixed costs.
But we should keep in mind that per unit fixed cost will decrease with an increase in sales revenue or with an increase in operations because total quantum of fixed costs remain constant upto a limit.
(2.)
As a manager at UAL, I will see the pattern of costs and try to maintain the operations to use the fixed and variable costs as well. As per the information of the question it is clear that some costs are fixed for the available seats that is why I will try to use these available free seats for fulfill an increased demand. By doing so I will be in position to minimize the costs of the operation and as a result overall profitability will be improved.
As we know that there are always two types of costs, fixed and variable. Thus we should carefully catch the pattern of these costs because by utilising fixed costs properly we can minimize overall costs of the operations and it will improve the profitability.
(3.)
I am agree with the conclusion upto a limit because there are two type of information is given in the question, one is that 70% costs are variable and other point is that 25% costs are incremental that means only 25% costs are variable.
So when we analysis both points then we reach at point that cost of a available seat consisted of fixed & variable costs, that is why experts of UAL must separate fixed and variable cost so that maximum benefits can be taken from the available free space.
So I am not agree with this statement that “the airline responded to an increase in demand for seats by expanding its total airline capacity, not only by putting the extra passengers in otherwise empty seats.”
Because in practical life every airline will first of all use its empty seats for meeting an increased demand then go for exapanding its capacity. As we know that for expanding the capacity airline will have to bear many major costs that is why airline first of all must use empty seats to minimize its overall costs.