Harvard Case - Accounting for Frequent Fliers
"Accounting for Frequent Fliers" Harvard business case study is written by William J. Bruns Jr., Susan S. Harmeling. It deals with the challenges in the field of Accounting. The case study is 7 page(s) long and it was first published on : Nov 14, 1991
At Fern Fort University, we recommend that American Airlines implement a comprehensive activity-based costing (ABC) system to accurately allocate costs to its frequent flyer program, "AAdvantage." This will involve a thorough cost analysis, development of new accounting procedures and policies, and a shift in the company's focus from traditional accounting methods to a more sophisticated, activity-based approach. This shift will enable the airline to gain a clearer understanding of the true cost of its frequent flyer program, leading to more informed decision-making regarding pricing, program design, and overall profitability.
2. Background
American Airlines, a major player in the airline industry, faces a critical challenge in accurately accounting for its frequent flyer program, 'AAdvantage.' The program, while a valuable tool for customer loyalty and revenue generation, has become increasingly expensive to operate. The current accounting system, based on traditional cost allocation methods, fails to capture the true cost of the program, leading to potential miscalculations in profitability and strategic decision-making.
The case study focuses on the challenges faced by American Airlines in understanding the true cost of its frequent flyer program. The main protagonist is the airline's management team, tasked with finding a solution to the accounting dilemma and ensuring the long-term viability of the AAdvantage program.
3. Analysis of the Case Study
To analyze the situation, we can utilize the following frameworks:
Strategic Framework:
- Porter's Five Forces: The airline industry is characterized by intense competition, high fixed costs, and low switching costs for consumers. The AAdvantage program is a key differentiator for American Airlines, providing a competitive edge in attracting and retaining customers. However, the program's rising costs can erode this advantage.
- Value Chain Analysis: The AAdvantage program is a critical part of American Airlines' value chain, contributing to customer loyalty, revenue generation, and brand building. However, the program's cost structure needs to be aligned with its strategic importance.
Financial Framework:
- Cost-Volume-Profit Analysis: The case highlights the need for a more accurate understanding of the cost structure of the AAdvantage program. This analysis will help determine the break-even point for the program and identify potential cost optimization opportunities.
- Financial Statement Analysis: The current accounting system fails to provide a clear picture of the program's true profitability. Analyzing the balance sheet, income statement, and cash flow statement using activity-based costing will reveal a more accurate financial picture.
Operational Framework:
- Activity-Based Costing (ABC): ABC is a superior method for cost allocation, as it identifies and assigns costs based on specific activities. This approach will provide a more accurate picture of the cost drivers for the AAdvantage program, such as redemption miles, customer service calls, and marketing expenses.
- Process Mapping: Mapping the AAdvantage program's processes will help identify areas for cost reduction and efficiency improvements.
4. Recommendations
To address the challenges faced by American Airlines, we recommend the following steps:
- Implement an Activity-Based Costing (ABC) System: This involves identifying all activities related to the AAdvantage program, assigning costs to those activities, and then allocating costs to specific customers or segments based on their usage of the program.
- Develop New Accounting Procedures and Policies: This will involve establishing new accounting policies and procedures specifically tailored to the AAdvantage program, ensuring that costs are accurately tracked and allocated.
- Conduct a Comprehensive Cost Analysis: This analysis will identify and quantify all costs associated with the AAdvantage program, including direct costs, indirect costs, and overhead costs.
- Develop a Pricing Strategy for the AAdvantage Program: The new cost information obtained through ABC will enable American Airlines to develop a more informed pricing strategy for the program, ensuring that it remains profitable.
- Re-evaluate the AAdvantage Program Design: Based on the cost analysis and pricing strategy, American Airlines can re-evaluate the design of the AAdvantage program, potentially making adjustments to improve profitability and customer satisfaction.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The AAdvantage program is a core competency of American Airlines, contributing to its mission of providing superior customer service and building brand loyalty. Implementing ABC will ensure that the program remains aligned with these core values.
- External Customers and Internal Clients: The ABC system will provide a more accurate understanding of the cost of the AAdvantage program, allowing American Airlines to better serve its external customers (frequent flyers) and internal clients (departments responsible for the program).
- Competitors: By implementing ABC, American Airlines can gain a competitive advantage by better understanding the cost structure of its frequent flyer program compared to its competitors.
- Attractiveness - Quantitative Measures: The ABC system will provide more accurate financial data, leading to improved profitability, higher return on investment (ROI), and a more favorable break-even analysis.
6. Conclusion
By implementing an activity-based costing system, American Airlines can gain a more accurate understanding of the true cost of its AAdvantage program, leading to improved financial performance, strategic decision-making, and a more sustainable future for the program. This approach will ensure that the AAdvantage program continues to be a valuable asset for the airline, contributing to customer loyalty, revenue generation, and competitive advantage.
7. Discussion
Alternative approaches to addressing the accounting challenges include:
- Maintaining the current accounting system: This would be a less costly option in the short term, but it would continue to provide inaccurate cost information, leading to potential miscalculations and poor decision-making.
- Outsourcing the AAdvantage program: This option would transfer the cost and responsibility of managing the program to a third-party provider, but it could lead to a loss of control over the program and potential conflicts of interest.
The key risks associated with our recommended approach include:
- Implementation costs: Implementing ABC can be expensive and time-consuming.
- Resistance to change: Employees may resist the adoption of a new accounting system.
- Accuracy of cost allocation: Ensuring the accuracy of cost allocation under ABC is crucial for the system's effectiveness.
8. Next Steps
To implement the recommended approach, American Airlines should follow these steps:
- Form a cross-functional team: This team should include representatives from accounting, finance, marketing, and operations to ensure a comprehensive approach.
- Develop a detailed implementation plan: This plan should outline the steps involved, timelines, and resources required for implementation.
- Pilot the ABC system: Implementing the ABC system on a pilot basis before full-scale deployment will allow for testing and refinement.
- Communicate the changes: Open communication with employees about the rationale for the change and the benefits of ABC is essential.
By following these steps, American Airlines can successfully implement an activity-based costing system, enabling the airline to gain a more accurate understanding of the cost of its AAdvantage program and make informed decisions about its future.
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Case Description
Airline frequent flier programs offer members the opportunity to earn free flights by accumulating mileage. Accounting and reporting the obligations of airlines and the cost of frequent flier programs raises difficult measurement issues. In 1991, the U.S. Securities and Exchange Commission began to require airlines to disclose the number of free flights program members took. The case allows estimates of the cost and obligations of the United Air Lines program.
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