AN EFFICIENCY MEASURE AND ITS IMPORTANCE

University of Portland

University of Portland, Oregon

The operating ratio (OPR) is a measure of operating efficiency in many industries, and it is a key statistic in several modes of transportation. . Historically it had been used to set rates for motor carriers and to judge railroad performance. Defined as the ratio of operating expenses to operating revenues, it was an alternative to that standard set in the several past fare investigations when the airlines were heavily regulated. As a basic measure of carrier operating profitability, it was useful in the past air transportation as a measure of airline efficiency and as a compliment to the so-called ―fair rate of return‖ or cost of capital standard used by the now defunct Civil Aeronautics Board (CAB), which sunset in 1985.

The purpose of this paper is to explore the use of the operating ratio for a different purpose. It can be used as an indicator of air carrier risk at the operating level as it can be input into an equation that will gauge the operating volatility of a carrier or the industry. It is an alternative measure to the concept of the degree of operating leverage discussed in many financial management textbooks. This paper will examine the operating ratio for the US airline industry, and its major carriers, over the past several years. The level and stability of the air carrier ratios will then be compared to that a large sample of other industrial and transportation firms. It will be shown that the airline industry is very high in what financial theory defines as business risk. As such, the OPR can be useful in making decisions on optimal and operating financial strategies to be followed by the carriers.

INTRODUCTION

The operating ratio (OPR) is a useful measure of efficiency for any industry. It is defined as the ratio of operating expenses (OE) to operating revenues (OR). It determines the operating profit margin since that ratio is simply (1- OPR). Obviously, lower ratios indicate greater firm efficiency of

Gritta and Seal

producing revenues with lower costs. Higher ratios signal lower margins and thus less firm efficiency. They may also be an indication of higher fixed costs in the operating structure of the firm which, by nature, can and does affect the stability of operating profits over time.

The operating ratio has a long history of application in the transportation sector of the economy. The OPR has historically been used to set rates for motor carriers and to judge financial railroad performance. As a basic measure of carrier profitability, the OPR was useful in the past air transportation as a measure of airline efficiency and as a compliment to the so-called ―fair rate of return‖ or cost of capital standard used by the now defunct Civil Aeronautics Board (CAB), which sunset in 1985. It was an alternative to that standard set in the Domestic Passenger Fare Investigation (U.S. Civil Aeronautics Board) in 1969.¹ The sunset of the CAB marked the end of the regulatory era of the U.S. airline industry, and ushered in the increased competitive nature of the industry where carrier efficiency would now become far more critical to survival.

The purpose of this paper is to explore the use of the operating ratio for a different purpose. It can be used as an indicator of air carrier risk at the operating level as it can be input into an equation that will gauge the operating profit volatility of a carrier or the industry. The paper will examine the operating ratio for the U.S. airline industry and compare its volatility to that a large sample of other industrial and transportation firms selected from the Value Line Investment Survey. It will be shown that the airline industry is very high in what financial theory defines as business risk.

The motivation of the study is to present a basic measure useful in aiding
carrier financial management decision making. The OPR can be useful in making
decisions on optimal financial and operational strategies to be followed by the
carriers. Section II of the paper briefly outlines the calculation and significance
of the OPR and presents the data for both the major carriers and a large sample of
other industries including other transport modes including motor carriers,
railroads and maritime firms. Section III addresses the significance of the OPR
for air carrier financial management. Finally, Section IV offers some

conclusions.

The OPR provides an indication of the volatility of operating profits (often called EBIT or earnings before interest and taxes) given changes in operating revenues. In financial theory this is known as business risk. In comparisons, firms with more unstable operating profits and pre-tax returns on assets are considered to be higher in business risk than firms with more stable profits. The following equation directly measures the potential volatility of operating profit given a change in revenues:

68

Journal of Business and Behavioral Sciences

where e is defined as the percentage change in operating profit given a 1% change in operating revenues. It is an alternative measure to the concept of the degree of operating leverage discussed in many financial management textbooks (Moyer et. al., 344-345). Appendix A shows the derivation of the equation.

Higher operating ratios are an indication of greater instability in operating profits, while low ratios indicate the reverse. Ratios in excess of 90.0% can be considered high (Gritta, 1975).² Ratios could be very high in air transportation for most of the airlines for several reasons. The airline industry is highly cyclical and is therefore very vulnerable to economic declines, as the price elasticity of demand is high. In addition, the industry faces some fixed costs and a high level of what economists (Frederick, 1961) call ―constant or sticky costs.‖³ Some carrier cost elements are fixed (such as depreciation on airframes and ground equipment, general and administrative) and these are significant. But other costs (such as fuel which normally accounts for about 15%-20% of total operating costs), while not classic fixed costs, do not behave as normal variable costs. Fuel is supposed to be a variable cost of business and it normally is so. In air transport, however, it really is relatively ―sticky.‖ As traffic declines, load factors decline, but it takes management time to react to cut flight frequencies in response to decreased demand for travel. This was especially true in 2008 because of the run up in the price of aviation fuel due to the increase price of a barrel of oil which topped at over $140 per bbl in mid-2008. Some carriers found that fuel costs accounted for over 35% of total operating costs. Difficulty in forecasting traffic and capacity needs further add to the problem.

Table I presents the OPRs for the Value Line passenger air carriers for the years, 2004-2007.

Gritta and Seal