Variance Analysis: Whom To Blame At Southwest?

What a difference a half-year makes! As recently as July 2008, the mass market uber-tabloid USA Today was praising Southwest Airlines for achieving its 69th consecutive quarter of operating profit. That’s a remarkable continuing achievement, one that the USA Today attributed to Southwest’s foresight in using hedging contracts to lock in low fuel prices during an era of skyrocketing energy costs.

Today, though, the direction of fuel price trends has shifted dramatically. What seemed to be prescient foresight on the part of Southwest now appears, with 20/20 hindsight, to have been a strategic error. By hedging at a price level that is now well above the market cost of fuel, Southwest incurred financial costs that currently exceed its total operating profits. Their CFO recently, and perhaps somewhat ruefully, confirmed to analysts “We do not believe it is the time to be long on energy.

So what was considered a brilliant fiscal strategy last July is now perceived as a costly and unnecessary expenditure. How should Southwest determine whether any one should be blamed for its current difficulties?

Two Variables … Umm, Make That Three

The first important point to recognize in answering this question is that there are at least two variables that must be considered when managing fuel costs. One is the price spent on each barrel on fuel; the other is the quantity of fuel used.

That may be an obvious fact, but its implications are fairly subtle because decisions about price and quantity are intertwined in complex ways. For instance, let’s assume that holiday season congestion at major airports is expected to drive up the volume of fuel consumed on airplane taxiways. Well, if the members of an airline’s management team are certain that the consumption quantity of fuel will spike up next month, they might be willing to take more aggressive risks to keep the price per barrel low. Conversely, in times of declining fuel usage, the airline’s willingness to engage in aggressive price hedging activities might wane.

Furthermore, these two variables – price and quantity – often evolve into three variables when companies lock in guaranteed energy prices well in advance. Let’s assume, for instance, that an airline originally budgets $10 billion to buy 200 million barrels @ $50 per barrel. Let’s also assume that three different individuals, working independently of each other, make three different decisions: (a) the CFO hedges all oil purchases to lock in a rate of $45 per barrel, (b) the COO believes that fuel usage will likely spike upwards and authorizes the purchase of 250 million barrels, and (c) the Engineering Department finds a way to run jet engines at a highly fuel-efficient level during peak times, thereby holding fuel usage to 220 million barrels.

So what happens? Assuming the market price of fuel remains above $45 per barrel, the actual cost of purchasing 250 million barrels @ $45 will be $11.25 billion. Thus, the airline will overspend its $10 billion fuel budget by $1.25 billion, and three people – the CFO, COO, and Engineering Department Director – will share responsibility for this unfavorable variance.

So … Who’s To Blame?

An impatient Board of Directors might rush to judgment and hold all three individuals jointly responsible for overspending the cost budget by $1.25 billion. However, a “back of the envelope” set of variance calculations would caution them to take a more nuanced approach:

Based on this analysis, the CFO should actually be praised and not blamed for slashing a potential $2.5 billion budget shortfall in half by saving the firm $1.25 billion through effective hedging mechanisms. And what about the COO? (S)he should indeed be blamed for ordering 30 million barrels in excess of what was actually used, but not blamed for the full 50 million barrel difference between the volume originally budgeted and the volume eventually used.

So who gets the blame for the remaining 20 million barrel difference between the 200 million barrels in the original purchase budget and the 220 million barrels actually used? That’s hard to say; only an in-depth review of internal company records would be able to answer that question. Perhaps the COO’s analysts who prepared the original budget failed to reach out to the Engineering Department for a realistic estimate. Or perhaps the engineers neglected to provide the analysts with accurate information. Either way, it would be terribly misleading to rely on the overall $1.25 billion variance to make management decisions without considering its three core components separately.

A Failure To Communicate

Without knowing the situation that existed within Southwest during the past year, it would be unfair to blame the sudden and unexpected ineffectiveness of Southwest’s fuel cost management strategy on any single party. You can be sure, though, that any organization facing volatile price and volume factors will use variance analysis to track performance and address such issues.

To paraphrase Paul Newman’s nemesis in the 1967 film Cool Hand Luke, organizations that face huge budget variances often find that “what we have here is (a) failure to communicate.” Look again at the preceding hypothetical example. Had the COO and Engineering Department simply communicated with each other, the COO might have ordered 220 million barrels instead of 250 million barrels, and his $1.5 billion unfavorable variance might have shrunk to zero. Heck, the firm would thus have paid $9.9 billion for 220 million barrels @ $45, and therefore would have underspent its original budget of $10 billion!

That’s the power of variance analysis; in addition to identifying the sources of budget problems, it also suggests ways to fix ’em. Sometimes, sadly enough, we learn that multi-billion dollar variances could have been prevented by simple intra-firm communication techniques.