Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

During 2018, we produced strong revenue growth across all three segments. We realized improvements in revenue per piece as pricing and growth initiatives drove an increase in yields in all of our major products.

We achieved solid operating profit growth in both our International Package and Supply Chain & Freight segments. Operating profit in our U.S. Domestic segment operation was negatively impacted primarily by planned costs related to our transformation strategy, higher pension expenses, one less operating day and the impact of bringing new facility and technology projects on-line. The benefits of our efficiency and growth initiatives in the U.S. will not be fully realized until future periods.

Consolidated revenue increased 7.9% to $71.861 billion, up from $66.585 billion in 2017. Operating profit for 2018 decreased 6.7% to $7.024 billion, which includes the impact of $360 million pre-tax transformation strategy costs.

Consolidated average daily package volume increased 3.2% in 2018. We reported 2018 net income of $4.791 billion and diluted earnings per share of $5.51, compared to 2017 net income of $4.905 billion and diluted earnings per share of $5.61. Adjusting for the after-tax impacts of transformation costs of $273 million and an increase in pension expense due to a mark-to-market loss recognized outside of the 10% corridor of $1.237 billion ($1.627 billion before tax), net income was $6.301 billion.

Our consolidated results are presented in the table below:

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Revenue (in millions)$71,861$66,585$61,6107.9%8.1%
Operating Expenses (in millions)64,83759,05653,9229.8%9.5%
Operating Profit (in millions)$7,024$7,529$7,688(6.7)%(2.1)%
Operating Margin9.8%11.3%12.5%
Average Daily Package Volume (in thousands)20,67720,03019,0833.2%5.0%
Average Revenue Per Piece$10.98$10.53$10.294.3%2.3%
Net Income (in millions)$4,791$4,905$3,422(2.3)%43.3%
Basic Earnings Per Share$5.53$5.63$3.88(1.8)%45.1%
Diluted Earnings Per Share$5.51$5.61$3.86(1.8)%45.3%

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Items Affecting Comparability

The results and discussions that follow are reflective of how our executive management monitors the performance of our reporting segments. We supplement the reporting of our financial information determined under generally accepted accounting principles (“GAAP”) with certain non-GAAP financial measures, including, as applicable, "adjusted" compensation and benefits, operating expenses, operating profit, operating margin, other income (expense), pre-tax income, net income and earnings per share. These adjustments reflect the non-comparable items discussed below. We believe that these adjusted financial measures provide meaningful information to assist investors and analysts in understanding our financial results and assessing our prospects for future performance. We believe these adjusted financial measures are important indicators of our recurring results of operations because they exclude items that may not be indicative of, or are unrelated to, our underlying operating results and provide a useful baseline for analyzing trends in our underlying businesses. Additionally, these adjusted financial measures are used internally by management for the determination of incentive compensation awards, business unit operating performance analysis and business unit resource allocation.

Non-GAAP financial measures should be considered in addition to, and not as an alternative for, our reported results prepared in accordance with GAAP. Our non-GAAP financial information does not represent a comprehensive basis of accounting. Therefore, our non-GAAP financial information may not be comparable to similarly titled measures reported by other companies.

The year-over-year comparisons of our financial results are affected by the following items (in millions):

Year Ended December 31,
Non-GAAP Adjustments201820172016
Operating Expenses:
Transformation Strategy Costs$360$—$—
Total Adjustments to Operating Expenses360——
Other Income and (Expense):——
Defined Benefit Plans Mark-to-Market Charges$1,627$800$2,651
Total Adjustments to Other Income and (Expense)1,6278002,651
Total Adjustments to Income Before Income Taxes1,9878002,651
Income Tax Benefit from the Mark-to-Market Charges(390)(193)(978)
Income Tax Benefit from Transformation Strategy Costs(87)——
Income Tax Benefit from the Tax Cuts and Jobs Act and Other Non-U.S. Tax Law Changes—(258)—
Total Adjustments to Income Tax Expense$(477)$(451)$(978)
Total Adjustments to Net Income$1,510$349$1,673

These items have been excluded from comparisons of "adjusted" Compensation and benefits, Operating Expenses, Operating Profit, Operating Margin, Other Income and (Expense), Income Tax Expense and effective tax rate in the discussion that follows. The income tax effects of the transformation strategy costs and the mark-to-market charges are calculated by multiplying the statutory tax rates applicable in each tax jurisdiction, including the U.S. federal jurisdiction and various U.S. state and non-U.S. jurisdictions, by the adjustments. The blended average of the applicable statutory tax rates in 2018, 2017 and 2016 were 24.0%, 24.1% and 36.9%, respectively. We believe this adjusted information provides useful comparison of year-to-year ongoing operating performance without considering the short-term impact of transformation strategy costs. We evaluate the performance of our businesses on an adjusted basis.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Impact of Changes in Foreign Currency Exchange Rates

We supplement the reporting of our revenue, revenue per piece, and operating profit, along with other income and expense, with similar non-GAAP measures that exclude the period-over-period impact of foreign currency exchange rate changes and hedging activities. We believe currency-neutral revenue, revenue per piece and operating profit information allows users of our financial statements to understand growth trends in our products and results. We evaluate the performance of our International Package and Supply Chain & Freight businesses on a currency-neutral basis.

Currency-neutral revenue, revenue per piece and operating profit are calculated by dividing current period reported U.S. dollar revenue, revenue per piece and operating profit by the current period average exchange rates to derive current period local currency revenue, revenue per piece and operating profit. The derived current period local currency revenue, revenue per piece and operating profit are then multiplied by the average foreign exchange rates used to translate the comparable results for each month in the prior year period (including the period over period impact of foreign currency revenue hedging activities). The difference between the current period reported U.S. dollar revenue, revenue per piece and operating profit and the derived current period U.S. dollar revenue, revenue per piece and operating profit is the period over period impact of currency fluctuations.

Transformation Strategy Costs

Transformation strategy costs described in note 16 to the audited consolidated financial statements have been excluded from comparisons of "adjusted" Compensation and benefits, Other Operating Expenses, Operating Profit, Operating Margin, Income Tax Expense and effective tax rate. The pre-tax transformation strategy costs totaled $360 million ($273 million after-tax) in 2018, and reflects costs and other benefits of $262 million included within Compensation and benefits on the statements of consolidated income, and other costs of $98 million recorded to total other expenses. We believe this adjusted information provides useful comparison of year-to-year ongoing operating performance without considering the short-term impact of transformation strategy costs.

Income Tax Benefit from the Tax Cuts and Jobs Act

We supplement the presentation of our income tax expense and effective tax rate with "adjusted" measures that exclude the impact of the income tax benefit from the Tax Cuts and Jobs Act (the "Tax Act") described in the "Income Tax Expense" section of Management's Discussion and Analysis and note 13 to the audited consolidated financial statements. We believe income tax expense and the effective tax rate excluding the tax benefit is useful in evaluating our ongoing operating performance for the current period to that of other periods presented.

Defined Benefit Plans Mark-to-Market Charges

We recognize changes in the fair value of plan assets and net actuarial gains and losses in excess of a 10% corridor for our pension and postretirement defined benefit plans immediately as part of net periodic benefit cost other than service cost. We supplement the presentation of our Other Income and (Expense) with "adjusted" measures that exclude the impact of the portion of net periodic benefit cost other than service cost represented by the gains and losses recognized in excess of the 10% corridor and the related income tax effects.

This adjusted net periodic benefit cost ($615 million in 2018, $843 million in 2017 and $1.074 billion in 2016) utilizes the expected return on plan assets (7.68% in 2018 and 8.65% in 2017 and 2016). The non-adjusted net periodic benefit cost reflects the actual return on plan assets (-2.38% in 2018, 14.25% in 2017 and 6.06% in 2016) and the discount rate used to measure the projected benefit obligation at the December 31 measurement date (4.45% in 2018, 3.81% in 2017 and 4.34% in 2016). We believe excluding these mark-to-market charges from our adjusted results provides important supplemental information that reflects the anticipated long-term cost of our defined benefit plans and provides a benchmark for historical defined benefit cost trends that may provide a useful comparison of year-to-year financial performance without considering the short-term impact of changes in market interest rates, equity prices and similar factors.

We recognized pre-tax mark-to-market losses in "Other Income and (Expense)" of $1.627 billion, $800 million and $2.651 billion on our pension and postretirement defined benefit plans related to the remeasurement of plan assets and liabilities recognized outside of a 10% corridor, for 2018, 2017 and 2016, respectively.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The table below indicates the amounts associated with each component of the pre-tax mark-to-market losses, as well as the weighted-average actuarial assumptions used to determine our net periodic benefit costs, for each year:

Year Ended December 31,
Components of mark-to-market gain (loss) (in millions):201820172016
Discount rates$845$(2,288)$(1,953)
Return on assets(1,057)1,525(732)
Demographic and assumption changes(22)(37)34
Coordinating benefits attributable to the Central States Pension Fund(1,393)——
Total mark-to-market gain (loss)$(1,627)$(800)$(2,651)
Year Ended December 31,
Weighted-average actuarial assumptions used to determine net periodic benefit cost:201820172016
Expected rate of return on plan assets7.68%8.65%8.65%
Actual rate of return on plan assets(2.38)%14.25%6.06%
Discount rate used for net periodic benefit cost3.81%4.34%4.81%
Discount rate at measurement date4.45%3.81%4.34%

The $1.627 billion, $800 million and $2.651 billion pre-tax mark-to-market losses for the years ended December 31, 2018, 2017 and 2016, respectively, were comprised of the following components:

2018 - $1.627 billion pre-tax mark-to-market loss:

•Return on Assets ($1.057 billion pre-tax loss): In 2018, the actual (2.38)% rate of return on plan assets was lower than our expected rate of return of 7.68%, primarily due to weak global equity markets.
•Coordinating benefits attributable to the Central States Pension Fund ($1.393 billion pre-tax loss): This represents our current best estimate of potential coordinating benefits that may be required to be paid related to the Central States Pension Fund.
•Discount Rates ($845 million pre-tax gain): The weighted-average discount rate for our pension and postretirement medical plans increased from 3.81% at December 31, 2017 to 4.45% at December 31, 2018, primarily due to both an increase in U.S. treasury yields and an increase in credit spreads on AA-rated corporate bonds in 2018.
•Demographic and Assumption Changes ($22 million pre-tax loss): This represents the difference between actual and estimated participant data and demographic factors, including items such as healthcare cost trends, compensation rate increases and rates of termination, retirement and mortality.

2017 - $800 million pre-tax mark-to-market loss:

•Discount Rates ($2.288 billion pre-tax loss): The weighted-average discount rate for our pension and postretirement medical plans decreased from 4.34% at December 31, 2016 to 3.81% at December 31, 2017, primarily due to both a decline in U.S. treasury yields and a decrease in credit spreads on AA-rated corporate bonds in 2017.
•Return on Assets ($1.525 billion pre-tax gain): In 2017, the actual 14.25% rate of return on plan assets exceeded our expected rate of return of 8.65%, primarily due to strong global equity and U.S. bond markets.
•Demographic and Assumption Changes ($37 million pre-tax loss): This represents the difference between actual and estimated participant data and demographic factors, including items such as healthcare cost trends, compensation rate increases and rates of termination, retirement and mortality.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

2016 - $2.651 billion pre-tax mark-to-market loss:

•Discount Rates ($1.953 billion pre-tax loss): The weighted-average discount rate for our pension and postretirement medical plans decreased from 4.81% at December 31, 2015 to 4.34% at December 31 2016, primarily due to a decrease in credit spreads on AA-rated corporate bonds in 2016.
•Return on Assets ($732 million pre-tax loss): In 2016, the actual 6.06% rate of return on plan assets fell short of our expected rate of return of 8.65%, primarily due to weak bond markets.
•Demographic and Assumption Changes ($34 million pre-tax gain): This represents the difference between actual and estimated participant data and demographic factors, including items such as healthcare cost trends, compensation rate increases and rates of termination, retirement and mortality.

Expense Allocations

Certain operating expenses are allocated between our reporting segments using activity-based costing methods. These activity-based costing methods require us to make estimates that impact the amount of each expense category that is attributed to each segment. Changes in these estimates will directly impact the amount of expense allocated to each segment, and therefore the operating profit of each reporting segment. Our allocation methodologies are refined periodically, as necessary, to reflect changes in our businesses. There were no significant changes in our expense allocation methodologies during 2018, 2017 or 2016.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

U.S. Domestic Package Operations

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Average Daily Package Volume (in thousands):
Next Day Air1,5421,4601,3795.6%5.9%
Deferred1,4321,4001,3502.3%3.7%
Ground14,49814,06013,5083.1%4.1%
Total Avg. Daily Package Volume17,47216,92016,2373.3%4.2%
Average Revenue Per Piece:
Next Day Air$19.53$19.11$19.202.2%(0.5)%
Deferred13.1212.4411.855.5%5.0%
Ground8.518.197.973.9%2.8%
Total Avg. Revenue Per Piece$9.86$9.48$9.254.0%2.5%
Operating Days in Period253254255
Revenue (in millions):
Next Day Air$7,618$7,088$6,7527.5%5.0%
Deferred4,7524,4224,0807.5%8.4%
Ground31,22329,25127,4526.7%6.6%
Total Revenue$43,593$40,761$38,2846.9%6.5%
Operating Expenses (in millions):
Operating Expenses$39,950$36,458$33,6569.6%8.3%
Transformation Strategy Costs(235)——
Adjusted Operating Expenses$39,715$36,458$33,6568.9%8.3%
Operating Profit (in millions) and Operating Margin:
Operating Profit$3,643$4,303$4,628(15.3)%(7.0)%
Adjusted Operating Profit$3,878$4,303$4,628(9.9)%(7.0)%
Operating Margin8.4%10.6%12.1%
Adjusted Operating Margin8.9%10.6%12.1%

Revenue

The change in overall revenue was impacted by the following factors for the years ended December 31, 2018 and 2017, compared with the corresponding prior year periods:

VolumeRates / Product MixFuel SurchargeTotal Revenue Change
Revenue Change Drivers:
2018/ 20172.9%2.5%1.5%6.9%
2017/ 20163.8%1.8%0.9%6.5%

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Volume

2018 compared to 2017

Our overall volume increased across all products in 2018 despite one less operating day, largely due to continued growth in overall retail sales, of which e-commerce continues to represent a larger percentage of the total growth. Growth was focused within the retail, healthcare and manufacturing industries.

Business-to-consumer shipments, which represented more than 50% of total U.S. Domestic Package volume, grew 6.2% for the year and drove overall increases in both air and ground shipments. While business-to-business shipments were relatively flat in 2018 compared to 2017, volume grew 3% in the fourth quarter of 2018 compared to 2017.

Among our air products, volume increased in 2018 for our Next Day Air and Deferred services. Solid air volume growth continued for those products most aligned with business-to-consumer shipping, including our residential Next Day Air, Next Day Air Saver and Second Day package products, as consumers continue to demand faster and more economical delivery options. This growth was slightly offset by declines in residential Next Day Air letter, Next Day Air Saver letter and Second Day letter volume.

The increase in ground volume in 2018 was driven by growth in residential ground and SurePost volume, which benefited from continued e-commerce demand. Business-to-business ground shipments were relatively flat in 2018 compared to 2017, however they grew approximately 3% in the fourth quarter of 2018 compared to 2017.

2017 compared to 2016

Our overall volume increased across all products in 2017, largely due to continued growth in overall retail sales, of which e-commerce continues to represent a larger percentage of the total growth. Business-to-consumer shipments, which represented just over 50% of total U.S. Domestic Package volume, grew 9.4% for the year, which drove increases in both air and ground shipments. Business-to-business shipments decreased slightly in 2017 compared to 2016 largely due to declines in volume in professional services as a result of increased digitization, and high tech industries.

Among our air products, volume increased in 2017 for our Next Day Air and Deferred services. Solid air volume growth continued for those products most aligned with business-to-consumer shipping, including our residential Next Day Air, Next Day Air Saver and Three Day Select package products, as consumers continue to demand faster options. This growth was slightly offset by a decline in Next Day Air letter volume, largely due to declines in the professional services industry as a result of continued growth in digitization.

The increase in ground volume in 2017 was driven by growth in residential ground and SurePost volume, which benefited from continued e-commerce demand. Business-to-business shipments decreased slightly due to adverse weather conditions in third quarter 2017, however this decrease was partially offset by an increase in our return shipping services.

Rates and Product Mix

2018 compared to 2017

Overall revenue per piece increased 4.0% in 2018, and was impacted by changes in base rates, the implementation of new surcharges for oversized packages and other fees, customer and product mix and fuel surcharge rates.

Revenue per piece for ground and air products was positively impacted by a base rate increase on December 24, 2017. UPS Ground rates and UPS Air services rates increased an average net 4.9%. Effective June 4, 2018, we increased the surcharge for Over Maximum Limits, Oversize Pallet Handling, and added a shipping correction audit fee. Effective July 8, 2018, we implemented a U.S. Residential Large Package surcharge and an additional handling surcharge for packages exceeding 70 pounds. Additionally peak surcharges were in effect from October 1, 2018 through December 22, 2018 for U.S. Residential, Large Packages and packages Over Maximum Limits. The charge was designed to enable UPS to continue to offset some of the additional expenses incurred during significant volume surges. Additionally on December 5, 2018, we announced an average 4.9% base rate increase effective December 26, 2018 for UPS Ground and UPS Air services.

In the first quarter of 2017, we began our expanded Saturday ground operations to several metropolitan areas in the United States. As of December 31, 2018, Saturday service is available in approximately 6,100 cities and towns in the U.S. covering approximately 60% of the population.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Revenue per piece for all products was positively impacted by higher fuel surcharge rates in 2018 due to escalating fuel prices and increases in rates.

Revenue per piece for our Next Day Air services increased in 2018 compared with 2017. The increase in Next Day Air revenue per piece was primarily due to an increase in base rates driven by pricing initiatives and an increase in average billable weight per piece which more than offset an unfavorable shift in product mix.

Revenue per piece for our Deferred air services increased in 2018 compared with 2017 due to an increase in base rate pricing driven by pricing initiatives and average billable weight per piece offset slightly by an unfavorable shift in product mix.

Ground revenue per piece increased in 2018 compared with 2017, primarily due to base rate increases driven by our pricing initiatives. These factors were partially offset by changes in product mix, as we experienced faster volume growth in our SurePost product.

2017 compared to 2016

Overall revenue per piece increased 2.5% in 2017, and was impacted by changes in base rates, customer and product mix and fuel surcharge rates.

Revenue per piece for ground and air products was positively impacted by a base rate increase on December 26, 2016. UPS Ground rates and UPS Air services rates increased an average net 4.9%. Effective January 8, 2017, we changed the dimensional weight calculation for packages subject to UPS daily rates. On June 19, 2017, we announced a new peak charge applicable during selected weeks in November and December 2017 for U.S. Residential, Large Packages and packages Over Maximum Limits. The new charge is designed to enable UPS to continue to offset some of the additional expenses incurred during significant volume surges. Additionally on October 25, 2017, we announced an average 4.9% base rate increase effective December 24, 2017 for UPS Ground and UPS Air services.

In the first quarter of 2017, we began our expanded Saturday ground operations to several metropolitan areas in the United States. As of December 2017, Saturday service was available in approximately 4,700 cities and towns in the U.S. covering approximately 50% of the population. A Saturday pickup stop charge went into effect on May 1, 2017 and varies depending on the pickup service selected.

Revenue per piece for all products was positively impacted by higher fuel surcharge rates for 2017.

Revenue per piece for our Next Day Air services decreased in 2017 compared with 2016. The decrease in Next Day Air revenue per piece was primarily driven by a shift in product mix, as our lower yielding products experienced much larger volume growth than our higher yielding products. This shift was offset slightly by an increase in the average billable weight per piece.

Revenue per piece of our Deferred air services increased in 2017 compared with 2016. Deferred revenue per piece increased primarily due to an increase in average billable weight per piece, but was partially offset by an unfavorable shift in product mix.

Ground revenue per piece increased in 2017, primarily due to base rate increases, higher fuel surcharge rates and an increase in average billable weight per piece. These factors were partially offset by changes in product mix, as we experienced faster volume growth in our SurePost product.

Fuel Surcharges

UPS applies a fuel surcharge on our domestic air and ground services. The air fuel surcharge is based on the U.S. Department of Energy’s (“DOE”) Gulf Coast spot price for a gallon of kerosene-type jet fuel, while the ground fuel surcharge is based on the DOE’s On-Highway Diesel Fuel Price. Based on published rates, the average fuel surcharge rates for domestic air and ground products were as follows:

Year Ended December 31,% Point Change
2018201720162018/ 20172017/ 2016
Next Day Air / Deferred7.7%5.1%3.6%2.6%1.5%
Ground7.0%5.6%4.9%1.4%0.7%

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Effective February 6, 2017, the U.S. fuel surcharge rates are reset weekly instead of monthly. In addition, the price indices have moved from a two month to a two week lag in order to more closely align fuel surcharge revenues with fuel expenses. In June and October 2018, ground fuel surcharge rates were raised by 0.50% and 0.25%, respectively, for all thresholds. In October 2018, Domestic air fuel surcharge rates were increased by 0.25% for all thresholds.

While fluctuations in fuel surcharge percentages can be significant from period to period, fuel surcharges represent one of the many individual components of our pricing structure that impact our overall revenue and yield. Additional components include the mix of services sold, the base price and extra service charges we obtain for these services and the level of pricing discounts offered.

Total domestic fuel surcharge revenue increased by $632 million in 2018 as a result of higher fuel surcharge rates caused by an increase in jet and diesel fuel prices, as well as an overall increase in package volume which drove increased delivery miles driven and aircraft block hours.

Operating Expenses

2018 compared to 2017

Operating expenses for the segment increased $3.492 billion in 2018 compared with 2017, which included $235 million of transformation strategy costs. Excluding the impact of transformation strategy costs, operating expenses for the segment increased $3.257 billion in 2018, primarily due to pickup and delivery costs (up $1.305 billion), the costs of operating our domestic integrated air and ground network (up $1.649 billion) and the costs of package sorting (up $639 million), offset by a reduction in indirect operating costs (down $336 million) for the year. These expenses were primarily due to higher volume, increased employee compensation costs, higher pension expense, higher fuel prices, a 6.2% increase in average daily block hours and expansion of our technology-enabled network.

The growth in pickup and delivery and network costs was impacted by several factors:

•We incurred higher employee compensation and benefit costs largely resulting from volume growth, which impacted an increase in average daily union labor hours (up 5.2%), scheduled union pay rate and benefit increases and growth in the overall size of the workforce due to facility expansions. Labor hour increases were also related to the continued expansion in Saturday operations. In addition, pension expense increased due to lower year-end discount rates used to measure the pension benefit obligation, driving higher service costs.
•We incurred higher fuel expense in 2018 primarily due to higher fuel prices and increased volume which resulted in higher fuel usage (increase in aircraft block hours of 6.2% and package delivery miles driven of 4.4%), partially offset by alternative fuel tax credits. The manner in which we purchase fuel also influences the net impact of fuel on our results. The majority of our contracts for fuel purchases utilize index-based pricing formulas plus or minus a fixed locational/supplier differential. While many of the indices are aligned, each index may fluctuate at a different pace, driving variability in the prices paid for fuel. Because of this, our operating results may be affected should the market price of fuel suddenly change by a significant amount or change by amounts that do not result in an adjustment in our fuel surcharges, which can significantly affect our earnings either positively or negatively in the short-term.
•We incurred higher costs associated with outside contract carriers, primarily due to volume growth (including SurePost), higher fuel surcharges passed to us by carriers and general rate increases.
•In order to contain costs, we continually adjust our air and ground networks to better match higher volume levels. In addition, we continue to deploy and utilize technology to increase package sorting and delivery productivity.

Total cost per piece increased 6.6% in 2018 compared with 2017, which includes transformation strategy costs of $235 million. The cost per piece increase was primarily impacted by the cost increases described previously. The increased expenses in 2018 were also driven by costs related to the improvement of our smart global logistics network, including additional aircraft leases to improve our air service reliability; costs related to the implementation of Saturday operations in additional markets, depreciation costs due to new facilities placed in service and higher pension expense. Costs were also negatively impacted by rising fuel prices offset by net changes in depreciation, primarily driven by changes in the useful lives of vehicles, plant equipment and building improvements.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

2017 compared to 2016

Operating expenses for the period increased $2.802 billion in 2017, primarily due to pickup and delivery costs (up $1.312 billion), the cost of operating our domestic integrated air and ground network (up $810 million), the costs of package sorting (up $746 million), offset by a reduction in indirect operating costs (down $66 million). These increases were driven primarily by overall volume growth in 2017. Adjusted operating expenses were impacted by several factors:

•We incurred higher employee compensation, largely resulting from volume growth, an increase in average daily union labor hours (up 6.5%), growth in the overall size of the workforce and an increase in wage rates.
•Employee benefit costs increased, largely due to increased employee healthcare, partially offset by a decrease in pension expense and workers' compensation expense.
•We incurred higher fuel expense in 2017 primarily due to higher fuel prices and increased volume, which resulted in higher fuel usage (increase in aircraft block hours of 7.0% and package delivery miles driven of 4.1%).
•We incurred higher costs associated with outside contract carriers, primarily due to volume growth (including SurePost), higher fuel surcharges passed to us by carriers and general rate increases.

Total cost per piece increased 4.3% in 2017 compared to 2016 and was primarily impacted by the cost increases described previously. The increased expenses in 2017 were also driven by capacity constraints due to volume surges in the fourth quarter of 2017, start-up costs of several investments underway to further expand and modernize our air and ground networks, and the costs of implementing Saturday operations. Costs were further impacted by rising fuel prices.

Operating Profit and Margin

2018 compared to 2017

Operating profit was negatively impacted primarily by planned costs related to our transformation strategy, higher pension expenses, one less operating day and the impact of bringing new facility and technology projects on-line. Operating profit decreased $660 million in 2018 compared with 2017 with operating margins decreasing 220 basis points to 8.4%. Excluding the impact of transformation strategy costs, operating profit decreased $425 million in 2018 compared to 2017 with operating margins decreasing 170 basis points. While benefits from fuel (fuel surcharge revenue increased at a faster pace than expense) and lower net depreciation expense had a positive impact on operating profit, higher purchased transportation costs due to volume growth, one less operating day and an increase in pension costs driven by lower discount rates weighed on profits. Additionally, operating profit was negatively impacted by costs related to continued investments in our smart global logistics network, including implementation of Saturday operations in additional markets. The benefits of these projects will not be fully realized until future periods.

2017 compared to 2016

Operating profit decreased $325 million in 2017 compared with 2016. Operating margin decreased 150 basis points to 10.6%. Operating profit was negatively impacted by an increase in continued investments in new buildings and new strategic investments, including deployment of Saturday operations. There was an adverse impact from higher purchased transportation costs due to volume surges in the fourth quarter of 2017 and from fuel as expense increased at a faster pace than fuel surcharge revenue.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

International Package Operations

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Average Daily Package Volume (in thousands):
Domestic1,7231,7151,6350.5%4.9%
Export1,4821,3951,2116.2%15.2%
Total Avg. Daily Package Volume3,2053,1102,8463.1%9.3%
Average Revenue Per Piece:
Domestic$6.59$6.07$5.858.6%3.8%
Export29.2728.7030.342.0%(5.4)%
Total Avg. Revenue Per Piece$17.08$16.22$16.275.3%(0.3)%
Operating Days in Period253254255
Revenue (in millions):
Domestic$2,874$2,646$2,4418.6%8.4%
Export10,97310,1709,3697.9%8.5%
Cargo & Other59552653613.1%(1.9)%
Total Revenue$14,442$13,342$12,3468.2%8.1%
Operating Expenses (in millions):
Operating Expenses$11,913$10,913$9,9299.2%9.9%
Transformation Strategy Costs(76)——
Adjusted Operating Expenses$11,837$10,913$9,9298.5%9.9%
Operating Profit (in millions) and Operating Margin:
Operating Profit$2,529$2,429$2,4174.1%0.5%
Adjusted Operating Profit$2,605$2,429$2,4177.2%0.5%
Operating Margin17.5%18.2%19.6%
Adjusted Operating Margin18.0%18.2%19.6%
Currency Translation Benefit / (Cost)—(in millions)*:
Revenue$147$(325)
Operating Expenses(157)(50)
Operating Profit$(10)$(375)
*Net of currency hedging; amount represents the change compared to the prior year.

Revenue

The change in overall revenue was impacted by the following factors for the years ended December 31, 2018 and 2017, compared with the corresponding prior year periods:

VolumeRates / Product MixFuel SurchargeCurrencyTotal Revenue Change
Revenue Change Drivers:
2018/ 20172.6%1.8%2.7%1.1%8.2%
2017/ 20168.8%(0.7)%2.6%(2.6)%8.1%

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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Volume

2018 compared to 2017

Our overall average daily volume increased in 2018 largely due to strong demand from several sectors including retail, industrial manufacturing, high-tech and healthcare. Business-to-consumer shipments remained relatively flat for the year.

We continued to experience export volume growth in 2018. The growth was mainly driven by our European, U.S. and Asian operations, which experienced increases in volume on almost all major trade lanes. European export volume showed growth in the Europe-to-U.S. and intra-Europe trade lanes. Export volume into the U.S. grew in most major trade lanes, led by Europe and the Americas. Asia export volume growth was the most significant in the Asia-to- Americas and intra-Asia trade lanes. Export volume growth was strong across most major products, with a continued shift towards our premium express products, such as Worldwide Express and Transborder Express services.

Domestic volume increased slightly, primarily due to growth in Mexico, Canada and Netherlands, while domestic products in the Euro zone declined slightly.

2017 compared to 2016

Our overall average daily volume increased in 2017, largely due to continued strength in business-to-consumer volume, as well as strong demand from several sectors including retail, industrial manufacturing, high-tech and healthcare.

We continued to experience export volume growth in 2017. The growth was mainly driven by our European, Asian and U.S. operations, which experienced increases in volume to major trade lanes of the world. European export volume increased in 2017, with growth in all trade lanes. Asia export volume also increased in 2017, with particular strength in Asia-to-U.S., Asia-to-Americas and intra-Asia trade lanes. Export volume into the U.S. grew in all trade lanes, led by Europe and the Americas. Export volume growth was strong across all major products, with a continued shift towards our premium express products, such as Worldwide Express and Transborder Express services.

The increase in domestic volume in 2017 was primarily due to growth in Turkey, Germany, France, Italy and U.K.

Rates and Product Mix

2018 compared to 2017

Total average revenue per piece increased 5.3% in 2018, impacted by a 110 basis point increase from currency. Additionally, total revenue per piece was impacted by an increase in fuel surcharge revenue, as well as a shift in product mix, as the growth in higher yielding premium products continued to exceed overall growth.

On December 24, 2017, we implemented an average 4.9% net increase in base and accessorial rates for international shipments originating in the United States. Rate changes for shipments originating outside the U.S. are made throughout the year and vary by geographic market. On October 15, 2018, we implemented a 0.50% increase in International Air-Import fuel surcharge. Additionally, on December 5, 2018, we announced an average 4.9% net increase in base and accessorial rates for international shipping originating in the United States, which became effective on December 26, 2018.

Export revenue per piece increased 2.0% in 2018, impacted by a 60 basis point increase from currency, shift in product mix and higher fuel surcharge revenue.

Domestic revenue per piece increased 8.6% in 2018, impacted by a 320 basis point increase from currency and higher fuel surcharges.

2017 compared to 2016

Total average revenue per piece decreased 0.3% in 2017, impacted by a 250 basis point reduction from currency and a shift in product mix. These factors were partially offset by an increase in fuel surcharge rates as well as an increase in base rates.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

On December 26, 2016, we implemented an average 4.9% net increase in base and accessorial rates for international shipments originating in the United States. Rate changes for shipments originating outside the U.S. are made throughout the year and vary by geographic markets. Effective September 17, 2017, a peak surcharge was applied to any shipment originating from China or Hong Kong to the United States for certain service levels during the peak period. The surcharge was applied as a rate per pound based upon the billable weight of the shipment. Additionally, on October 25, 2017, we announced an average 4.9% net increase in base and accessorial rates for international shipping originating in the United States; changes became effective on December 24, 2017.

Export revenue per piece decreased 5.4% in 2017, impacted by a 320 basis point reduction from currency and product mix. This was partially offset by an increase in fuel surcharges, an increase in base rates and strong volume growth in premium products.

Domestic revenue per piece increased 3.8% in 2017, impacted by a 50 basis point increase from currency, increases in base rates and higher fuel surcharges.

Fuel Surcharges

We maintain fuel surcharges on our international air and ground services. The fuel surcharges for international air products originating inside or outside the United States are largely indexed to the DOE's Gulf Coast spot price for a gallon of kerosene-type jet fuel, while the fuel surcharges for ground products originating outside the United States are indexed to fuel prices in the international region or country where the shipment takes place.

While fluctuations in fuel surcharge percentages can be significant from period to period, fuel surcharges represent one of the many individual components of our pricing structure that impact our overall revenue and yield. Additional components include the mix of services sold, the base price and extra service charges we obtain for these services and the level of pricing discounts offered.

Total international fuel surcharge revenue increased by $382 million in 2018, primarily due to volume increases and higher fuel prices. Total international fuel surcharge revenue increased by $325 million in 2017, primarily due to volume increase, higher fuel prices and pricing changes made to base freight rates and to the fuel surcharge indices from a two month lag to a two week lag.

Operating Expenses

2018 compared to 2017

Overall operating expenses increased by $1.0 billion, which included a $76 million increase from transformation strategy costs. Excluding the impact of the transformation strategy costs, adjusted operating expenses for the segment increased $924 million in 2018 primarily due to increased volumes, currency fluctuations and higher fuel costs driven by increased usage and higher prices.

In addition to variability in usage and fuel prices, the manner in which we purchase fuel also influences the net impact of fuel on our results. The majority of our contracts for fuel purchases utilize index-based pricing formulas plus or minus a fixed locational/supplier differential. While many of the indices are aligned, each index may fluctuate at a different pace, driving variability in the prices paid for fuel. Because of this, our operating results may be affected should the market price of fuel suddenly change by a significant amount or change by amounts that do not result in an adjustment in our fuel surcharges, which can affect our earnings either positively or negatively in the short-term.

Operating expenses were impacted by changes in the cost of operating our international integrated air and ground network, which increased $546 million, as well as pickup and delivery costs, which increased $287 million. The increase in network costs was largely driven by volume growth in the majority of our products and higher fuel costs due to increased prices and usage. Additionally, the increase in pickup and delivery costs is due to increased volume. Operating expenses were also impacted by a $91 million increase in indirect overhead and package sorting costs and other costs.

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RESULTS OF OPERATIONS

2017 compared to 2016

Overall operating expenses increased by $984 million, primarily due to increased volumes, higher fuel usage and currency fluctuations.

Operating expenses were impacted by changes in the cost of operating our international integrated air and ground network, which increased $424 million, as well as pickup and delivery costs, which increased $287 million. The increase in network costs was largely driven by volume growth in our Express products, which drove a 3.0% increase in aircraft block hours and higher fuel usage. Additionally, the increase in pickup and delivery costs is due to increased volume. Operating expenses were also impacted in 2017 by a $273 million increase in indirect overhead and package sorting costs and other costs.

Operating Profit and Margin

2018 compared to 2017

Operating profit increased $100 million (4.1%) in 2018 compared with 2017, including $76 million in transformation strategy costs. Operating margin decreased 70 basis points to 17.5%. Adjusted operating profit without transformation strategy costs increased by $176 million (7.2%) in 2018, while the adjusted operating margin decreased 20 basis points to 18.0%. Included in adjusted operating profit is a $10 million decrease due to currency. Currency adjusted margin was 18.3% up from 18.2% in the prior year.

2017 compared to 2016

Operating profit increased $12 million in 2017 compared with 2016. Operating margin increased 140 basis points to 18.2%. Operating margin was affected by negative currency exchange movements due to volatility of both hedged and unhedged currencies. Included in adjusted operating profit is a $375 million decrease due to currency.

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RESULTS OF OPERATIONS

Supply Chain & Freight Operations

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Freight LTL Statistics:
Revenue (in millions)$2,706$2,598$2,3854.2%8.9%
Revenue Per Hundredweight$25.52$24.08$23.446.0%2.7%
Shipments (in thousands)9,72010,2109,961(4.8)%2.5%
Shipments Per Day (in thousands)38.440.539.4(5.2)%2.8%
Gross Weight Hauled (in millions of lbs)10,60510,78810,174(1.7)%6.0%
Weight Per Shipment (in lbs)1,0911,0571,0213.2%3.5%
Operating Days in Period253252253
Revenue (in millions):
Forwarding6,5805,6744,87316.0%16.4%
Logistics3,2343,0172,6447.2%14.1%
Freight3,2183,0002,7377.3%9.6%
Other7947917260.4%9.0%
Total Revenue$13,826$12,482$10,98010.8%13.7%
Operating Expenses (in millions):
Operating Expenses$12,974$11,685$10,33711.0%13.0%
Transformation Strategy Costs(49)——
Adjusted Operating Expenses$12,925$11,685$10,33710.6%13.0%
Operating Profit (in millions) and Operating Margins:
Operating Profit$852$797$6436.9%24.0%
Adjusted Operating Profit$901$797$64313.0%24.0%
Operating Margin6.2%6.4%5.9%
Adjusted Operating Margin6.5%6.4%5.9%
Currency Translation Benefit / (Cost)—(in millions)*:
Revenue$39$10
Operating Expenses(44)(12)
Operating Profit$(5)$(2)
*Amount represents the change compared to the prior year.

In December 2016, we acquired Marken, a global provider of supply chain solutions to the life sciences industry and leader in clinical trials, material storage and distribution. Marken's financial results are included in the above table within the Logistics unit from the date of the acquisition and have impacted the year-over-year comparability of revenue, operating expenses and operating profit for the years ended December 31, 2017 and 2016.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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Revenue

2018 compared to 2017

Total revenue for the Supply Chain & Freight segment increased $1.344 billion in 2018 compared to 2017.

Forwarding revenue increased $906 million in 2018 compared with 2017, primarily due to increased truckload brokerage volume as well as tonnage increases in our international air freight and ocean freight forwarding businesses. Sell price improvements in our international air freight forwarding business also contributed to the increase in revenue. Revenue in our truckload brokerage business was driven by robust demand and tight capacity.

Logistics revenue increased by $217 million in 2018 compared with 2017, as we experienced growth in the healthcare, aerospace, retail and manufacturing sectors.

UPS Freight revenue increased $218 million in 2018 compared with 2017, despite fourth-quarter volume declines as a result of the contract ratification process wherein we took actions to clear our LTL network. Revenue was driven by increases in average weight per shipment from improved customer mix due to middle market growth. LTL revenue per hundredweight increased 6.0% as LTL base rate increases for certain shipments in the U.S., Canada and Mexico, averaging 5.9%, took effect March 26, 2018. Fuel surcharge revenue also increased $75 million due to changes in diesel fuel prices.

2017 compared to 2016

Total revenue for the Supply Chain & Freight segment increased $1.502 billion in 2017 compared to 2016.

Forwarding revenue increased $801 million in 2017 compared with 2016, primarily due to increased truckload brokerage volume movement and tonnage increases in our international air freight and North American air freight forwarding businesses. The volume and tonnage increases were driven by improving overall market demand.

Logistics revenue increased $373 million in 2017 due to growth in mail services, healthcare, retail and aerospace solutions, offset by declines among our high tech customers. Additionally, the Marken acquisition on December 21, 2016 contributed to the increase in revenue. Revenue was positively impacted by currency exchange rate movements.

UPS Freight revenue increased $263 million in 2017 compared to 2016, driven by increases in shipments and weight per shipment. These increases were impacted by an overall improvement in market demand and customer mix. LTL revenue per hundredweight increased slightly as LTL base rate increases, averaging 4.9%, took effect September 19, 2016. Additionally, effective June 26, 2017, LTL base rates increased by an additional 4.9% for certain shipments in the U.S., Canada and Mexico. Fuel surcharge revenue also increased $70 million due to changes in overall LTL shipment volume and diesel fuel prices.

Revenue for the other businesses within Supply Chain & Freight increased $65 million in 2017 due to revenue growth at UPS Capital and UPS Customer Solutions, as well as service contracts with the U.S. Postal Service.

Operating Expenses

2018 compared to 2017

Total operating expenses for the Supply Chain & Freight segment increased $1.289 billion in 2018 compared to 2017, which includes $49 million of costs related to our transformation strategy.

Forwarding operating expenses increased $845 million in 2018 compared with 2017, largely due to increased purchased transportation expenses, transformation strategy costs, and a $20 million favorable legal settlement in 2017. Excluding $16 million in costs related to our transformation strategy, Forwarding operating expenses increased $829 million. Purchased transportation expense increased $720 million compared to 2017 primarily due to increased truckload brokerage volume and higher tonnage in our international air freight forwarding business as well as the resulting costs passed to us from outside contract carriers.

Logistics operating expenses increased $205 million in 2018 compared with 2017. Excluding $22 million in costs related to our transformation strategy, Logistics operating expenses increased $183 million. The increases were driven by costs associated with retail facility expansions, increased rates for mail services and strategic information technology investments.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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UPS Freight operating expenses increased $258 million in 2018 compared with 2017. Excluding $6 million in costs related to our transformation strategy, UPS Freight operating expenses increased $252 million. Total cost per LTL shipment increased 11.4% in 2018 compared to 2017. The operating expenses increased largely due to costs associated with operating our linehaul network ($85 million) and increases in pickup and delivery costs ($60 million). The linehaul network and pickup and delivery costs were driven by higher fuel prices and expense for outside transportation carriers, including fuel surcharges passed on to us by these outside carriers.

2017 compared to 2016

Total operating expenses for the Supply Chain & Freight segment increased $1.348 billion in 2017 compared to 2016.

Forwarding operating expenses increased $752 million, largely due to increased purchased transportation expenses. This was offset by operating efficiencies and the receipt of a $20 million favorable legal settlement in the second quarter of 2017. Purchased transportation expense increased by $770 million compared to 2016 due to increased truckload brokerage movements and the resulting increased fuel surcharges passed to us from outside transportation providers. Increased tonnage and third-party air carrier procurement rates in our North American and international air freight forwarding businesses, also contributed to increased purchased transportation expenses.

Logistics operating expenses increased $308 million in 2017, primarily due to the acquisition of Marken in 2016 and increased purchased transportation costs driven by increased volume and rates for mail services.

UPS Freight operating expenses increased $256 million in 2017 compared with 2016. The increase in operating expense was largely due to costs associated with operating our linehaul network ($126 million) and increases in pickup and delivery costs ($99 million). The network costs and pickup and delivery expenses were driven by higher fuel cost and higher expense for outside transportation carriers, largely due to LTL volume growth and fuel surcharges passed to us by outside carriers. Total cost per LTL shipment increased 5.7% in 2017 compared to 2016. Operating expenses related to our casualty self-insurance reserves also increased in 2017 compared with 2016.

Other expenses for the other businesses within Supply Chain & Freight increased $32 million in 2017 compared with 2016 primarily due to UPS Capital, UPS Customer Solutions and service contracts with the U.S. Postal Service, slightly offset by decreases in The UPS Store.

Operating Profit and Margin

2018 compared to 2017

Total operating profit for the Supply Chain & Freight segment increased $55 million in 2018 compared to 2017, which includes a $49 million impact related to transformation strategy costs. Excluding transformation strategy costs, operating profit increased $104 million. Operating margin decreased 20 basis points to 6.2%, while the adjusted operating margin increased 10 basis points to 6.5%.

Operating profit for the Forwarding unit increased $61 million in 2018 compared with 2017. Excluding the $16 million impact related to transformation strategy costs, operating profit increased $77 million. Operating profit and margins increased mainly due to tonnage increases in our international air freight and ocean freight forwarding business as well as pricing improvements. Additionally, our truckload brokerage business grew due to robust demand and tight capacity.

Operating profit for the Logistics unit increased $12 million in 2018 compared with 2017. Excluding the $22 million impact related to transformation strategy costs, operating profit increased $34 million. Operating profit and margins increased due to higher demand in the healthcare, aerospace, retail and manufacturing sectors.

UPS Freight operating profit decreased $40 million in 2018 compared with 2017. Excluding the $6 million impact related to transformation strategy costs, operating profit decreased $34 million. Operating profit and margins decreased as volume declined due to labor uncertainties around the Teamsters contract ratification, partially offsetting the increased LTL revenue per hundredweight realized during the year. Actions to clear our LTL network as a result of the contract ratification process reduced operating profit by approximately $60 million.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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The combined operating profit for all of our other businesses within Supply Chain & Freight increased $22 million in 2018, primarily due to higher operating profit at UPS Capital, UPS Customer Solutions and The UPS Store, as well as service contracts with the U.S. Postal Service. Excluding the $5 million impact related to transformation strategy costs, operating profit increased $27 million.

2017 compared to 2016

Total operating profit for the Supply Chain & Freight segment increased $154 million in 2017 compared with 2016.

Operating profit for the Forwarding unit increased $49 million in 2017 compared with 2016. Operating profit and margins for the North American air freight business increased in 2017 due to an increase in volume, slightly offset by higher transportation expenses. Operating profit and margins in our international air freight forwarding business increased due to volume increases and higher revenue per kilo, slightly offset by higher rates at which we procure capacity from third-party air carriers.

Operating profit for the Logistics unit increased $65 million in 2017 compared to 2016 due to strong performance in the U.S. as well as within our mail services. Additionally, the Marken acquisition in 2016 contributed to the increase in operating profit.

UPS Freight operating profit increased $7 million in 2017 compared with 2016, as increased volume and prices were partially offset by increased purchased transportation costs.

The combined operating profit for all of our other businesses in this segment increased $33 million in 2017, primarily due to higher operating profit at UPS Capital, UPS Customer Solutions and The UPS Store, as well as service contracts with the U.S. Postal Service.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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Consolidated Operating Expenses

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Operating Expenses (in millions):
Compensation and Benefits:$37,235$34,577$32,5347.7%6.3%
Transformation Strategy Costs(262)——
Adjusted Compensation and Benefits36,97334,57732,5346.9%6.3%
Repairs and Maintenance1,7321,6011,5428.2%3.8%
Depreciation and Amortization2,2072,2822,224(3.3)%2.6%
Purchased Transportation13,40911,6969,84814.6%18.8%
Fuel3,4272,6902,11827.4%27.0%
Other Occupancy1,3621,1551,03717.9%11.4%
Other Expenses5,4655,0554,6198.1%9.4%
Total Other Expenses27,60224,47921,38812.8%14.5%
Other Transformation Strategy Costs(98)——
Adjusted Total Other Expenses$27,504$24,479$21,38812.4%14.5%
Total Operating Expenses$64,837$59,056$53,9229.8%9.5%
Adjusted Total Operating Expenses$64,477$59,056$53,9229.2%9.5%
Currency Translation Cost / (Benefit)*$201$62
*Amount represents the change compared to the prior year.

Compensation and Benefits

2018 compared to 2017

Total compensation and benefits increased $2.658 billion in 2018 compared to 2017. Excluding the impact of transformation strategy costs of $262 million discussed in note 16 to the audited consolidated financial statements, adjusted compensation and benefits expense increased $2.396 billion in 2018.

Employee payroll costs increased $1.459 billion in 2018 compared with 2017, largely due to higher U.S. domestic hourly and management compensation costs. Total compensation costs increased 6.9%, while consolidated average daily volume growth was 3.2%. U.S. domestic compensation costs for hourly employees increased largely due to higher volume growth, contractual union wage increases, headcount increases, wage rate adjustments for part time workers and a 5.2% increase in average daily union labor hours. Compensation costs for management employees increased primarily due to merit salary increases and growth in the overall size of the workforce.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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Benefits expense increased $1.199 billion in 2018 compared to 2017. Excluding the impact of transformation strategy costs of $262 million, benefits costs increased $937 million in 2018 compared to 2017, primarily due to the following factors:

•Health and welfare costs increased $341 million in 2018 compared to 2017, largely due to increased contributions to multiemployer plans resulting from contractual contribution rate increases and an overall increase in the size of the workforce.
•Pension and retirement benefits expense increased $312 million in 2018 compared to 2017 primarily due to increased expense in UPS sponsored pension plans due to lower discount rates and additional expenses related to multiemployer plan contributions, which were impacted by contractual contribution rate increases and an overall increase in the size of the workforce. These increases were partially offset by lower Pension Benefit Guaranty Corporation premiums due to prior voluntary pension contributions, as well as the amendment of the UPS Retirement Plan in the prior year.
•Vacation, holiday, excused absence, payroll tax and other expenses increased $244 million in 2018 due to salary increases and growth in the overall size of the workforce.
•Workers' compensation expense increased $40 million in 2018 compared to 2017 as we experienced less favorable actuarial adjustments.

2017 compared to 2016

Total compensation and benefits increased $2.043 billion in 2017 compared to 2016.

Employee payroll costs increased $1.273 billion in 2017 compared with 2016, largely due to higher U.S. domestic hourly and management compensation costs. Total compensation costs increased 6.4%, while consolidated average daily volume growth was 5.0%. U.S. domestic compensation costs for hourly employees increased largely due to fourth quarter 2017 seasonal staffing increases resulting from 5.4% volume growth, contractual union wage increases, headcount increases, wage rate adjustments for part time workers and a 6.5% increase in average daily union labor hours. Compensation costs for management employees increased primarily due to merit salary increases and growth in the overall size of the workforce.

Benefits expense increased $770 million in 2017 compared to 2016, primarily due to the following factors:

•Pension costs increased $342 million in 2017 compared to 2016, primarily due to increased expense in UPS sponsored pension plans due to lower discount rates and additional expenses related to multiemployer plan contributions, which were impacted by contractual contribution rate increases and an overall increase in the size of the workforce.
•Health and welfare costs increased $240 million in 2017, largely due to increased contributions to multiemployer plans resulting from contractual contribution rate increases and an overall increase in the size of the workforce.
•Vacation, holiday, excused absence, payroll tax and other expenses increased $251 million in 2017 due to salary increases and growth in the overall size of the workforce.
•Workers' compensation expense decreased $63 million in 2017 as we experienced more favorable actuarial adjustments. This decrease was partially offset by increases in work hours, medical trends and wage increases. Insurance reserves are established for estimates of the loss that we will ultimately incur on reported workers' compensation claims, as well as estimates of claims that have been incurred but not reported, and take into account a number of factors, including our history of claim losses, payroll growth and the impact of safety improvement initiatives.

Repairs and Maintenance

2018 compared to 2017

The $131 million increase in repairs and maintenance expense in 2018 was primarily due to maintenance of our transportation equipment and aircraft and routine repairs to buildings and facilities. Building expansions and additions throughout 2018 also contributed to increases in expense.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

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2017 compared to 2016

The $59 million increase in repairs and maintenance expense in 2017 was primarily due to repairs and maintenance of our transportation equipment resulting from growth in the size of our vehicle fleet and routine repairs to buildings and facilities.

Depreciation and Amortization

2018 compared to 2017

We evaluate the useful lives of all our property, plant and equipment based on our usage, maintenance and replacement policies, and taking into account physical and economic factors that may affect the useful lives of the assets. Refer to note 1 in our consolidated financial statements for further description of our policy.

Total depreciation and amortization expense decreased $75 million in 2018 compared with 2017. The principal components of this change included:

•An increase in expense of $257 million arising from capital investments in several large facilities and other new projects coming into service. This had the effect of decreasing net income by $205 million or $0.24 per share on a basic and diluted basis in 2018; and
•A decrease in expense of $286 million resulting from prospective revisions to our estimates of useful lives for building improvements, vehicles and plant equipment as part of our ongoing investment in transformation. This had the effect of increasing net income by $228 million or $0.26 per share on a basic and diluted basis.

Combining the impact of the revisions to the estimated useful lives with the impact of the increased capital investments noted above resulted in a net decrease of $29 million to depreciation expense and an increase to net income of $23 million or $0.03 per share on both a basic and diluted basis in 2018.

The changes to the estimated useful lives described above are expected to decrease 2019 depreciation and amortization expense by approximately $335 million as compared to 2018. However, this will be largely offset by approximately $330 million of additional depreciation expense related to the addition of numerous facility automation and capacity expansion projects, which are part of our multi-year transformation strategy.

2017 compared to 2016

Depreciation and amortization expense increased $58 million in 2017 compared with 2016, primarily due to the following factors: (1) depreciation expense on vehicles increased due to an overall increase in the size of our vehicle fleet in our U.S. Domestic Package and UPS Freight operations, (2) depreciation expense for buildings and facilities increased due to the opening of new facilities and facility automation and capacity expansion projects and (3) amortization expense of intangible assets increased in conjunction with the Marken acquisition. These factors were largely offset by a decrease in amortization expense related to longer lived internally developed capitalized software.

Purchased Transportation

2018 compared to 2017

The $1.713 billion increase in purchased transportation expense charged to us by third-party air, rail, ocean and truck carriers in 2018 compared with 2017 was primarily driven by the following factors:

•Expense for our Forwarding and Logistics business increased $824 million in 2018, primarily due to increased truckload brokerage freight loads per day; increased tonnage in our international air freight forwarding business, and increased volume and rates for mail services. Additionally, expenses increased due to additional fuel surcharges passed onto us from outside contract carriers.
•U.S. Domestic Package expense increased $326 million in 2018, primarily due to increased volume, general rate increases and higher fuel surcharges passed to us from outside contract carriers.
•International Package expense increased $180 million in 2018, primarily due to the increased usage of third-party carriers to handle higher transborder volume and an unfavorable impact from currency exchange rate movements.

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•UPS Freight expense increased $153 million in 2018, due to an increase in our ground freight pricing product, LTL tonnage and higher fuel surcharges passed to us from outside transportation providers, partially offset by declines in our LTL shipments due to fourth quarter labor uncertainties around the Teamsters contract ratification.
•We incurred additional purchased transportation expense of $230 million in 2018 compared to 2017, which was primarily due to leasing additional aircraft to handle increases in air volume and higher jet fuel surcharges associated with aircraft charters.

2017 compared to 2016

The $1.848 billion increase in purchased transportation expense charged to us by third-party air, rail, ocean and truck carriers in 2017 compared with 2016 was primarily driven by the following factors:

•Expense for our Forwarding and Logistics business increased $937 million in 2017, primarily due to increased truckload brokerage freight loads per day and the resulting increased fuel surcharges passed to us from outside transportation providers; increased volume and rates for mail services; and increased tonnage in our North American and international air freight forwarding businesses. Additionally, purchased transportation expense increased due to the acquisition of Marken in December 2016.
•U.S. Domestic Package expense increased $421 million in 2017, primarily due to increased volume (including SurePost), higher rates and higher fuel surcharges passed to us from outside contract carriers.
•International Package expense increased $270 million in 2017, primarily due to the increased usage of third-party carriers (due to higher volume); higher fuel surcharges passed to us from outside transportation providers and an unfavorable impact of currency exchange rate movements.
•UPS Freight expense increased $163 million in 2017, due to an increase in LTL shipments and higher fuel surcharges passed to us from outside transportation providers.

Fuel

2018 compared to 2017

Fuel expense increased $737 million in 2018 as compared to 2017. The increase in fuel expense in 2018 was primarily due to higher jet fuel, diesel and unleaded gasoline prices and higher consumption due to higher total aircraft block hours and increased Domestic Package delivery miles driven as a result of overall higher volume. These increases were partially offset by the benefit of alternative fuel costs.

The manner in which we purchase fuel also influences the net impact of fuel on our results. The majority of our contracts for fuel purchases utilize index-based pricing formulas plus or minus a fixed locational/supplier differential. While many of the indices are aligned, each index may fluctuate at a different pace, driving variability in the prices paid for fuel. Because of this, our operating results may be affected should the market price of fuel suddenly change by a significant amount or change by amounts that do not result in an adjustment in our fuel surcharges, which can significantly affect our earnings either positively or negatively in the short-term.

2017 compared to 2016

The $572 million increase in fuel expense in 2017 as compared to 2016 was primarily due to higher jet fuel, diesel and unleaded gasoline prices, which increased fuel expense by $419 million. Additionally, increased alternative fuel costs and fuel consumption increased expense by $170 million primarily due to volume increases, which resulted in higher total aircraft block hours and Domestic Package delivery miles driven. These increases were partially offset by increased fuel efficiency.

Other Occupancy

2018 compared to 2017

The $207 million increase in other occupancy expense in 2018 compared to 2017 was largely due to higher facility rent expense, property tax expense and utility expenses. These increases were primarily driven by an increase in the number of operating facilities compared to 2017.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

2017 compared to 2016

The $118 million increase in other occupancy expense in 2017 compared to 2016 was largely due to higher facility rent expense driven by new facilities, as well as higher utilities and property taxes at our operating facilities.

Other Expenses

2018 compared to 2017

The $410 million increase in other expenses in 2018 compared to 2017 was primarily attributable to increases in transportation equipment rental, outside professional service costs, security protection, non-income based state and local taxes, and data processing costs. Additionally, costs of $86 million related to our transformation strategy contributed to the increase in 2018 when compared to 2017.

2017 compared to 2016

The $436 million increase in other expenses in 2017 compared to 2016 was caused by (1) an auto liability insurance expense increase of $75 million due to miles driven, medical trend rates and severity experience trends and (2) transportation equipment rental increase of $60 million driven by growth in package volume.

The remaining $280 million increase is comprised of increases in several other expense categories, including outside professional services, security protection, computer and plant supplies and air cargo handling, partially offset by a decrease in advertising expense.

Other Income and (Expense)

The following table sets forth investment income (expense) and other and interest expense for the years ended December 31, 2018, 2017 and 2016 (in millions):

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Investment Income (Expense) and Other$(400)61(2,186)NA(102.8)%
Defined Benefit Plans Mark-to-Market Charges1,6278002,651103.4%(69.8)%
Adjusted Investment Income (Expense) and Other1,22786146542.5%85.2%
Interest Expense(605)(453)(381)33.6%18.9%
Total Other Income and (Expense)$(1,005)$(392)$(2,567)156.4%(84.7)%
Adjusted Other Income and (Expense)$622$408$8452.5%NA

Investment Income (Expense) and Other

2018 compared to 2017

Investment income (expense) and other for the period decreased $461 million, which included a $827 million increase in mark-to-market pension charges. Excluding the impact of the defined benefit plan mark-to-market charges, adjusted investment income (expense) and other for the period increased $366 million, which was comprised of expected investment returns on pension assets, net of interest cost on projected benefit obligations and prior service cost. Expected returns on plan assets increased as a result of both higher discretionary contributions and higher actual returns on plan assets in 2017. Interest cost on projected benefit obligations decreased as a result of lower discount rates. Investment income increased as a result of higher yields on invested assets, partially offset by foreign currency exchange rate movements.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

2017 compared to 2016

Investment income (expense) and other for the period increased $2.247 billion, which included a $1.851 billion decrease in mark-to-market pension charges. Excluding the impact of the defined benefit plan mark-to-market charges, adjusted investment income (expense) and other for the period increased $396 million, which was comprised of expected investment returns on pension assets, net of interest cost on projected benefit obligations and prior service cost. Expected returns on plan assets increased as a result of higher discretionary contributions in 2017 and 2016. Investment income also increased as a result of higher invested assets and the ongoing reduction in losses from fair value adjustments on real estate partnerships, partially offset by foreign currency exchange rate movements.

Interest Expense

2018 compared to 2017

Interest expense increased in 2018 as compared to 2017, primarily due to higher average outstanding debt balances and higher effective interest rates, partially offset by higher capitalized interest related to several large construction projects.

2017 compared to 2016

Interest expense increased in 2017 as compared to 2016, primarily due to the issuance of long-term Canadian Dollar Senior Notes, Euro Senior Notes and U.S. Dollar Senior Notes and higher effective interest rates on senior notes.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Income Tax Expense

The following table sets forth income tax expense and our effective tax rate for the years ended December 31, 2018, 2017 and 2016 (in millions):

Year Ended December 31,% Change
2018201720162018/ 20172017/ 2016
Income Tax Expense:$1,228$2,232$1,699(45.0)%31.4%
Income Tax Impact of:
Defined Benefit Plans Mark-to-Market Charge390193978
Transformation Strategy Costs87——
Income Tax Benefit from the Tax Cuts and Jobs Act and Other Non-U.S. Tax Law Changes—258—
Adjusted Income Tax Expense$1,705$2,683$2,677(36.5)%0.2%
Effective Tax Rate20.4%31.3%33.2%
Adjusted Effective Tax Rate21.3%33.8%34.4%

Our effective tax rate is affected by recurring factors such as statutory tax rates in the jurisdictions in which we operate and the relative amounts of taxable income we earn in those jurisdictions. It is also affected by discrete items that may occur in any given year but may not be consistent from year to year.

Our effective tax rate decreased to 20.4% in 2018, compared with 31.3% in 2017 and 33.2% in 2016, primarily due to the effects of the aforementioned recurring factors and the following discrete tax items.

Tax Cuts and Jobs Act

On December 22, 2017, the United States enacted into law the Tax Act. The Tax Act made broad and complex changes to the U.S. tax code, including a permanent corporate rate reduction to 21% and a transition to a territorial international system effective in 2018. The Tax Act includes provisions that affected 2017, including: (1) requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries (“Transition Tax”) that is payable over eight years; (2) requiring a remeasurement of all U.S. deferred tax assets and liabilities to the newly enacted corporate tax rate of 21% and (3) providing for additional first-year depreciation that allows full expensing of qualified property placed into service after September 27, 2017.

In late December 2017, the SEC staff issued Staff Accounting Bulletin ("SAB") 118, which provided guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the related accounting under U.S. GAAP. We recorded a $272 million provisional benefit inclusive of our Transition Tax liability, the change in our indefinite reinvestment assertion for certain foreign subsidiaries and the remeasurement of our U.S. net deferred tax liabilities for the year ended December 31, 2017. During the fourth quarter of 2018, we completed our accounting for the Tax Act based on the current regulatory guidance available at the end of the SAB 118 measurement period and recorded no net adjustment to our provisional estimate.

The Tax Act also enacted provisions that took effect in 2018 including but not limited to: (1) a provision that imposes U.S. tax on certain foreign subsidiary income known as Global Intangible Low-Taxed Income ("GILTI"); (2) a new deduction for Foreign-Derived Intangible Income ("FDII"); (3) additional limitations on tax deductions for expenses such as interest and executive compensation, and (4) a new minimum tax based on certain payments from a U.S. company to foreign related parties known as the Base Erosion and Anti-Abuse Tax ("BEAT").

We included the impact of each of the newly effective Tax Act provisions in our computation of the 2018 income tax expense. Throughout 2018, the U.S. Department of the Treasury and Internal Revenue Service issued preliminary regulatory guidance clarifying certain provisions of the Tax Act. We anticipate additional regulatory guidance and technical clarifications that could change our future income tax expense. When additional guidance is issued, we will recognize the related tax impact in the quarter of enactment.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

2018 Discrete Items

The decrease in our effective tax rate was primarily due to the impact of the Tax Act which reduced the U.S. federal corporate income tax rate from 35% to 21% effective January 1, 2018.

In the fourth quarter of 2018, we recognized an income tax benefit of $390 million related to pre-tax mark-to-market losses of $1.627 billion on our pension and postretirement defined benefit plans. This income tax benefit was generated at a higher average tax rate than the 2018 U.S. federal statutory tax rate because it included the effect of U.S. state and local and foreign taxes.

We recorded pre-tax transformation strategy costs of $360 million during the year ended December 31, 2018. As a result, we recorded an additional income tax benefit of $87 million. This income tax benefit was generated at a higher average tax rate than the 2018 U.S. federal statutory tax rate due to the effect of U.S. state and local and foreign taxes.

The recognition of excess tax benefits and deficiencies related to share-based compensation in income tax expense resulted in a net tax benefit of $38 million and reduced our effective tax rate by 0.6% during the year ended December 31, 2018.

Other factors that impacted our 2018 effective tax rate include favorable resolutions of uncertain tax positions, favorable U.S. state and local tax law changes, favorable tax provisions enacted in the Bipartisan Budget Act of 2018 and discrete tax credits associated with the filing of our 2017 U.S. federal income tax return.

2017 Discrete Items

In addition to the impact of the Tax Act described above, the following discrete items were recorded during the year ended December 31, 2017.

In the fourth quarter of 2017, we recognized an income tax benefit of $193 million related to pre-tax mark-to-market losses of $800 million on our pension and postretirement defined benefit plans. This income tax benefit was generated at a lower average tax rate than the 2017 U.S. federal statutory tax rate due to future tax rate changes enacted by the Tax Act and differences between U.S. and foreign statutory rates, which was partially offset by the effect of U.S. state and local taxes.

In the fourth quarter of 2017, tax law changes were enacted in certain non-U.S. jurisdictions in which we operate. As a result, we recorded a decrease to our foreign net deferred tax assets of $14 million with a corresponding net increase to deferred tax expense of $14 million for the year ended December 31, 2017.

In the first quarter of 2017, we adopted a new accounting standard that requires the recognition of excess tax benefits related to share-based compensation in income tax expense, which resulted in tax benefits for the year ended December 31, 2017 of $71 million and reduced our effective tax rate by 1.0%.

2016 Discrete Items

In the fourth quarter of 2016, we recognized an income tax benefit of $978 million related to pre-tax mark-to-market losses of $2.651 billion on our pension and postretirement defined benefit plans. This income tax benefit was generated at a higher average tax rate than the U.S. federal statutory tax rate because it included the effect of U.S. state and local taxes.

As described in the Items Affecting Comparability section, certain items have been excluded from comparisons of "adjusted" income taxes in the discussion that follows.

Our adjusted effective tax rate decreased to 21.3% in 2018 from 33.8% in 2017 primarily due to the impact of the Tax Act which reduced the U.S. federal corporate income tax rate from 35% to 21% effective January 1, 2018.

Our adjusted effective tax rate decreased to 33.8% in 2017 from 34.4% in 2016 primarily due to favorable discrete tax adjustments related to recognition of excess tax benefits related to share-based compensation in income tax expense.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Liquidity and Capital Resources

As of December 31, 2018, we had $5.035 billion in cash, cash equivalents and marketable securities. We believe that our current cash position, access to the commercial paper programs and long-term debt capital markets and cash flow generated from operations should be adequate not only for operating requirements but also to enable us to complete our capital expenditure programs, transformation strategy and to fund dividend payments, share repurchases and long-term debt payments through the next several years. We regularly evaluate opportunities to optimize our capital structure, including through issuances of debt to refinance existing debt and to fund ongoing cash needs.

Cash Flows From Operating Activities

The following is a summary of the significant sources (uses) of cash from operating activities (amounts in millions):

201820172016
Net Income$4,791$4,905$3,422
Non-cash operating activities(1)6,0485,7706,438
Pension and postretirement plan contributions (UPS sponsored plans)(186)(7,794)(2,668)
Hedge margin receivables and payables482(732)(142)
Income tax receivables and payables469(550)(505)
Changes in working capital and other non-current assets and liabilities1,091(168)(47)
Other operating activities1648(25)
Net cash from operating activities$12,711$1,479$6,473
(1)Represents depreciation and amortization, gains and losses on derivative transactions and foreign exchange, deferred income taxes, provisions for uncollectible accounts, pension and postretirement benefit expense, stock compensation expense and other non-cash items.

Cash from operating activities remained strong throughout 2016 to 2018. Most of the variability in operating cash flows during the 2016 to 2018 time period relates to the funding of our company-sponsored pension and postretirement benefit plans (and related cash tax deductions). Except for discretionary or accelerated fundings of our plans, contributions to our company-sponsored pension plans have largely varied based on whether any minimum funding requirements are present for individual pension plans. We made no discretionary contributions to our three primary company-sponsored U.S. pension plans in 2018, however we made contributions of $7.291 and $2.461 billion in 2017 and 2016, respectively. The remaining contributions from 2016 to 2018 were due to contributions to our international pension plans and U.S. postretirement medical benefit plans.

Apart from the transactions described above, operating cash flow was impacted by changes in our hedge margin receivables and payables, timing of income tax receipts and payments and improvements in our working capital position. The net hedge margin collateral received (paid) from our derivative counterparties was $482, $(732) and $(142) million during 2018, 2017 and 2016, respectively, due to settlements and changes in the fair value of the derivative contracts used in our currency and interest rate hedging programs. Cash payments for income taxes were $2 million, $1.559 billion and $2.064 billion for 2018, 2017 and 2016, respectively, primarily impacted by the timing of a $5.0 billion pension contribution made in December 2017 which resulted in a tax refund in 2018, and the timing of current tax deductions.

As of December 31, 2018, the total of our worldwide holdings of cash, cash equivalents and marketable securities were $5.035 billion, of which approximately $2.853 billion was held by foreign subsidiaries. The amount of cash, cash equivalents and marketable securities held by our U.S. and foreign subsidiaries fluctuates throughout the year due to a variety of factors, including the timing of cash receipts and disbursements in the normal course of business. Cash provided by operating activities in the U.S. continues to be our primary source of funds to finance domestic operating needs, capital expenditures, share repurchases and dividend payments to shareowners. All cash, cash equivalents and marketable securities held by foreign subsidiaries are generally available for distribution to the U.S. without any U.S. federal income taxes. Any such distributions may be subject to foreign withholding and U.S. state taxes. When amounts earned by foreign subsidiaries are expected to be indefinitely reinvested, no accrual for taxes is provided.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Cash Flows From Investing Activities

Our primary sources (uses) of cash for investing activities were as follows (amounts in millions):

201820172016
Net cash used in investing activities$(6,330)$(4,971)$(2,563)
Capital Expenditures:
Buildings, facilities and plant equipment$(3,147)$(2,954)$(1,316)
Aircraft and parts(1,496)(789)(350)
Vehicles(931)(924)(864)
Information technology(709)(560)(435)
Total Capital Expenditures :(1)$(6,283)$(5,227)$(2,965)
Capital Expenditures as a % of Revenue8.7%7.9%4.9%
Other Investing Activities:
Proceeds from disposals of property, plant and equipment$37$24$88
Net decrease in finance receivables$4$5$9
Net (purchases), sales of marketable securities$(87)$360$911
Cash paid for business acquisitions$(2)$(134)$(547)
Other investing activities$1$1$(59)

(1) In addition to capital expenditures of $6.283 billion in 2018, there were capital expenditures relating to the principal repayments of capital lease obligations of $340 million. These are included in cash flows from financing activities.

We have commitments for the purchase of aircraft, vehicles, equipment and real estate to provide for the replacement of existing capacity and anticipated future growth. We generally fund our capital expenditures with our cash from operations. Future capital spending for anticipated growth and replacement assets will depend on a variety of factors, including economic and industry conditions. In 2017 we began a multi-year investment program in our smart logistics network which impacts all asset categories, with the largest investments in buildings, facilities and plant equipment. This investment program will continue in 2019, whereby we anticipate that our capital expenditures will be approximately $7.0 billion.

As such, capital expenditures on buildings, facilities and plant equipment increased in 2018 compared to prior periods in our U.S. and international package businesses, largely due to several facility automation and capacity expansion projects. Capital spending on aircraft also increased in 2018 compared to prior periods due to increased contract deposits on open aircraft orders and final payments associated with the delivery of aircraft. Capital spending on information technology increased in 2018 compared to the prior periods due to further development of technology enabled enhancements and capitalized software projects.

The proceeds from the disposal of property, plant and equipment were largely due to the disposal of equipment in 2018, vehicle retirements in 2017 and insurance recoveries in 2016. The purchases and sales of marketable securities are largely determined by liquidity needs and the periodic rebalancing of investment types and will fluctuate from period to period.

Cash paid for business acquisitions was related to our acquisition of area franchise rights for The UPS Store in 2018, Freightex, Nightline and STTAS in 2017 and Marken in 2016.

Other investing activities are impacted by changes in our non-current investments, capital contributions into certain investment partnerships and various other items.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Cash Flows From Financing Activities

Our primary sources (uses) of cash for financing activities were as follows (amounts in millions, except per share data):

201820172016
Net cash used in financing activities$(5,692)$3,287$(3,140)
Share Repurchases:
Cash expended for shares repurchased$(1,011)$(1,813)$(2,678)
Number of shares repurchased(8.9)(16.1)(25.4)
Shares outstanding at year-end858859868
Percent reduction in shares outstanding(0.1)%(1.0)%(2.0)%
Dividends:
Dividends declared per share$3.64$3.32$3.12
Cash expended for dividend payments$(3,011)$(2,771)$(2,643)
Borrowings:
Net borrowings (repayments) of debt principal$(1,622)$7,827$2,034
Other Financing Activities:
Cash received for common stock issuances$240$247$245
Other financing activities$(288)$(203)$(98)
Capitalization:
Total debt outstanding at year-end$22,736$24,289$16,075
Total shareowners’ equity at year-end3,0371,024430
Total capitalization$25,773$25,313$16,505

For the years ended December 31, 2018, 2017 and 2016, we repurchased a total of 8.9, 16.1 and 25.2 million shares of class A and class B common stock for $1.000, $1.816 and $2.680 billion, respectively ($1.011, $1.813 and $2.678 billion in repurchases for 2018, 2017 and 2016, respectively, are reported on the cash flow statement due to the timing of settlements).

In May 2016, the Board of Directors approved a share repurchase authorization of $8.0 billion, which replaced an authorization previously announced in 2013. The share repurchase authorization has no expiration date. As of December 31, 2018, we had $3.339 billion of this share repurchase authorization remaining.

Share repurchases may take the form of accelerated share repurchases, open market purchases, or other such methods as we deem appropriate. The timing of our share repurchases will depend upon market conditions. We anticipate repurchasing approximately $1.0 billion of shares in 2019.

The declaration of dividends is subject to the discretion of the Board of Directors and will depend on various factors, including our net income, financial condition, cash requirements, future prospects and other relevant factors. We expect to continue the practice of paying regular cash dividends. In February 2019, we increased our quarterly dividend payment from $0.91 to $0.96 per share, a 5.5% increase.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Issuances of debt in 2018 consisted primarily of commercial paper. In 2017 and 2016 we completed senior rate note offerings of $8.355 and $1.775 billion, respectively. The following is a summary of debt issuances in 2017 and 2016 (in millions):

Principal Amount in USD
2017
Fixed-rate senior notes:
2.050% senior notes$700
2.350% senior notes600
2.500% senior notes1,000
2.800% senior notes500
3.050% senior notes1,000
3.750% senior notes1,150
Floating-rate senior notes (multiple issuances)1,461
Euro senior notes:
0.375% senior notes (€700)815
1.500% senior notes (€500)582
Canadian senior notes:
2.125% senior notes (C$750)547
Total$8,355
Principal Amount in USD
2016
Fixed-rate senior notes:
2.400% senior notes$500
3.400% senior notes500
Floating-rate senior notes (multiple issuances)226
Euro senior notes:
1.000% senior notes (€500)549
$1,775

The remaining debt issuances for 2017 and 2016 consisted primarily of commercial paper.

Repayment of debt in 2018 and 2017 consisted primarily of the maturity of our $750 million 5.50% fixed-rate senior notes that matured in January 2018 and $375 million 1.125% fixed-rate senior notes that matured in October 2017. In 2016, there were no repayments of fixed-rate senior notes or floating-rate senior notes. The remaining repayments of debt during the 2016 through 2018 time period included paydowns of commercial paper and scheduled principal payments on our capitalized lease obligations. We consider the overall fixed and floating interest rate mix of our portfolio and the related overall cost of borrowing when planning for future issuances and non-scheduled repayments of debt.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The amount of commercial paper outstanding fluctuates throughout the year based on daily liquidity needs. The following is a summary of our commercial paper program (amount in millions):

Functional currency outstanding balance at year-endOutstanding balance at year-end ($)Average balance outstandingAverage balance outstanding ($)Average interest rate
2018
USD$1,968$1,968$2,137$2,1371.81%
EUR€606$694€360$425(0.38)%
Total$2,662
Functional currency outstanding balance at year-endOutstanding balance at year-end ($)Average balance outstandingAverage balance outstanding ($)Average interest rate
2017
USD$2,458$2,458$2,163$2,1630.88%
EUR€622$745€941$1,062(0.39)%
Total$3,203
Functional currency outstanding balance at year-endOutstanding balance at year-end ($)Average balance outstandingAverage balance outstanding ($)Average interest rate
2016
USD$2,406$2,406$1,838$1,8380.44%
EUR€801$844€776$817(0.28)%
GBP£—$—£94$1160.50%
Total$3,250

The variation in cash received from common stock issuances was primarily due to the level of stock option exercises by employees in the 2016 through 2018 period.

The cash outflows in other financing activities were impacted by several factors, primarily the repurchase of shares to satisfy tax withholding obligations on vested employee stock awards of $259, $247 and $167 million for 2018, 2017 and 2016, respectively. Net cash inflows from premium received on capped call options for the purchase of UPS class B shares were $34 million in 2018, and $54 million in both 2017 and 2016.

Sources of Credit

See note 8 to the audited consolidated financial statements for a discussion of our available credit and debt covenants.

Guarantees and Other Off-Balance Sheet Arrangements

We do not have guarantees or other off-balance sheet financing arrangements, including variable interest entities, which we believe could have a material impact on financial condition or liquidity.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Contractual Commitments

We have contractual obligations and commitments in the form of capital leases, operating leases, debt obligations, purchase commitments and certain other liabilities. We intend to satisfy these obligations through the use of cash flow from operations. The following table summarizes the expected cash outflow to satisfy our contractual obligations and commitments as of December 31, 2018 (in millions):

Commitment Type20192020202120222023After 2023Total
Capital Leases$158$95$42$39$36$293$663
Operating Leases5784773993252629262,967
Debt Principal3,6679982,5512,0002,30310,83022,349
Debt Interest6245825254613895,6268,207
Purchase Commitments (1)3,6861,7321,1503832286,981
Tax Act Repatriation Liability—————9696
Pension Funding2,192—————2,192
Total$10,905$3,884$4,667$3,208$3,012$17,779$43,455

(1) Purchase commitments include aircraft leases that we entered into in 2019.

Our capital lease obligations relate primarily to leases on aircraft and real estate. Capital leases, operating leases and purchase commitments, as well as our debt principal obligations, are discussed further in note 8 to our consolidated financial statements. The amount of interest on our debt was calculated as the contractual interest payments due on our fixed-rate debt, in addition to interest on variable rate debt that was calculated based on interest rates as of December 31, 2018. The calculations of debt interest take into account the effect of interest rate swap agreements. For debt denominated in a foreign currency, the U.S. Dollar equivalent principal amount of the debt at the end of the year was used as the basis to calculate future interest payments.

Purchase commitments represent contractual agreements to purchase assets, goods or services that are legally binding, including contracts for aircraft, construction of new or expanded facilities and orders for technology equipment and vehicles. As of December 31, 2018, we had firm commitments to purchase 19 new Boeing 747-8F cargo aircraft to be delivered between 2019 and 2022 and nine Boeing 767 aircraft to be delivered between 2019 and 2020.

On December 22, 2017, the United States enacted into law the Tax Act requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries. Companies may elect to pay the tax over eight years based on an installment schedule outlined in the Tax Act but are required under current IRS guidance to offset certain overpayments of tax against the liability. We intend to make this election and have reflected our remaining transition tax due by year as a contractual obligation.

There are no anticipated required minimum cash contributions to our qualified U.S. pension plans in 2019 (these plans are discussed further in note 5 to the audited consolidated financial statements). The amount of any minimum funding requirement, as applicable, for these plans could change significantly in future periods, depending on many factors, including future plan asset returns, discount rates and changes to pension plan funding regulations. A decline in discount rates or a sustained significant decline in the world equity or bond markets could result in our domestic pension plans being subject to significantly higher minimum funding requirements. Actual contributions made in future years could materially differ and consequently required minimum contributions beyond 2019 cannot be reasonably estimated.

As discussed in note 6 to the audited consolidated financial statements, we are not currently subject to any minimum contributions or surcharges with respect to the multiemployer pension and health and welfare plans in which we participate. Contribution rates to these multiemployer pension and health and welfare plans are established through the collective bargaining process. As we are not subject to any minimum contribution levels, we have not included any amounts in the contractual commitments table with respect to these multiemployer plans.

The table above does not include approximately $216 million of liabilities for uncertain tax positions because we are uncertain if or when such amounts will ultimately be settled in cash. Uncertain tax positions are further discussed in note 13 to the consolidated financial statements.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

As of December 31, 2018, we had outstanding letters of credit totaling approximately $1.256 billion issued in connection with our self-insurance reserves and other routine business requirements. We also issue surety bonds as an alternative to letters of credit in certain instances, and as of December 31, 2018, we had $1.031 million of surety bonds written. As of December 31, 2018, we had unfunded loan commitments totaling $164 million associated with UPS Capital.

We believe that funds from operations and borrowing programs will provide adequate sources of liquidity and capital resources to meet our expected long-term needs for the operation of our business, including anticipated capital expenditures, for the foreseeable future.

Contingencies

See note 5 to the audited consolidated financial statements for a discussion of pension related matters and note 9 for a discussion of judicial proceedings and other matters arising from the conduct of our business activities.

Collective Bargaining Agreements

Status of Collective Bargaining Agreements

As of December 31, 2018, we had approximately 283,000 employees employed under a national master agreement and various supplemental agreements with local unions affiliated with the Teamsters. These agreements expired on July 31, 2018. On October 5, 2018, the Teamsters declared that the tentative national master agreement for the U.S. Domestic Package business unit was considered ratified, and will be implemented as soon as five remaining local and supplemental agreements are negotiated and ratified. We remain in the process of negotiating and ratifying four of these local and supplemental agreements which, when ratified, will be retroactive to August 1, 2018. The UPS Freight business unit national master agreement was ratified on November 11, 2018.

We have approximately 2,800 pilots who are employed under a collective bargaining agreement with the Independent Pilots Association ("IPA"), which becomes amendable on September 1, 2021.

Our airline mechanics are covered by a collective bargaining agreement with Teamsters Local 2727. On February 8, 2019, the airline mechanics who are covered by this agreement voted to ratify a new contract which will become amendable November 1, 2023. In addition, approximately 3,100 of our auto and maintenance mechanics who are not employed under agreements with the Teamsters are employed under collective bargaining agreements with the International Association of Machinists and Aerospace Workers (“IAM”) that will expire on July 31, 2019.

Multiemployer Benefit Plans

We contribute to a number of multiemployer defined benefit and health and welfare plans under terms of collective bargaining agreements that cover our union represented employees. Our current collective bargaining agreements set forth the annual contribution increases allotted to the plans that we participate in, and we are in compliance with these contribution rates. These limitations will remain in effect throughout the terms of the existing collective bargaining agreements.

New Accounting Pronouncements

Recently Adopted Accounting Standards

See note 1 to the audited consolidated financial statements for a discussion of recently adopted accounting standards.

Accounting Standards Issued But Not Yet Effective

See note 1 to the audited consolidated financial statements for a discussion of accounting standards issued, but not yet effective.

Rate Adjustments

Effective February 18, 2019, general UPS Freight rates will increase by 5.9%. This rate adjustment applies to non-contractual less-than-truckload (LTL) shipments. The impact of this general rate increase may vary by specific lane or shipment characteristics such as weight or class.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America. As indicated in note 1 to our consolidated financial statements, the amounts of assets, liabilities, revenue and expenses reported in our financial statements are affected by estimates and judgments that are necessary to comply with generally accepted accounting principles. We base our estimates on prior experience and other assumptions that we consider reasonable to our circumstances. Actual results could differ from our estimates, which would affect the related amounts reported in our consolidated financial statements. While estimates and judgments are applied in arriving at many reported amounts, we believe that the following matters may involve a higher degree of judgment and complexity.

Contingencies

As discussed in note 9 to the audited consolidated financial statements, we are involved in various legal proceedings and contingencies. The events that may impact our contingent liabilities are often unique and generally are not predictable. At the time a contingency is identified, we consider all relevant facts as part of our evaluation. We record a liability for a loss when the loss is probable of occurring and reasonably estimable. Events may arise that were not anticipated and the outcome of a contingency may result in a loss to us that differs from our previously estimated liability. These factors could result in a material difference between estimated and actual operating results. Contingent losses that are probable and estimable, excluding those related to income taxes and self-insurance which are discussed further below, were not material to our financial position or results of operations as of, and for the year ended, December 31, 2018. In addition, we have certain contingent liabilities that have not been recognized as of December 31, 2018, because a loss is not reasonably estimable.

Goodwill and Intangible Impairment

We perform impairment testing of goodwill for each of our reporting units on an annual basis. In our U.S. Domestic Package and International Package reporting segments, we have the following reporting units: Europe, Asia, Americas and ISMEA (Indian Subcontinent, Middle East and Africa). In our Supply Chain & Freight segment we have the following reporting units: Forwarding, Logistics, UPS Mail Innovations, UPS Freight, The UPS Store, UPS Capital, Marken and Coyote Logistics. Our annual goodwill impairment testing date is July 1st for each reporting unit owned at the testing date. In assessing goodwill for impairment, we initially evaluate qualitative factors to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the qualitative assessment is not conclusive and it is necessary to calculate the fair value of a reporting unit, then we utilize a two-step process to test goodwill for impairment. First, a comparison of the fair value of the applicable reporting unit with the aggregate carrying value, including goodwill, is performed. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the goodwill impairment test to determine the amount of impairment loss. The second step includes comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

We primarily determine the fair value of our reporting units using a discounted cash flow model (“DCF model”) and supplement this with observable valuation multiples for comparable companies, as appropriate. The completion of the DCF model requires that we make a number of significant assumptions to produce an estimate of future cash flows. These assumptions include projections of future revenue, costs, capital expenditures and working capital changes. In addition, we make assumptions about the estimated cost of capital and other relevant variables, as required, in estimating the fair value of our reporting units. The projections that we use in our DCF model are updated annually and will change over time based on the historical performance and changing business conditions for each of our reporting units. The determination of whether goodwill is impaired involves a significant level of judgment in these assumptions, and changes in our business strategy, government regulations, or economic or market conditions could significantly impact these judgments. We routinely monitor market conditions and other factors to determine if interim impairment tests are necessary. If impairment indicators are present in future periods, the resulting impairment charges could have a material impact on our results of operations.

None of the reporting units incurred any goodwill impairment charges in 2018, 2017 or 2016. Changes in our forecasts could cause carrying values of our reporting units to exceed their fair values in future periods, potentially resulting in a goodwill impairment charge. During the year, management monitored the actual performance of the business relative to the fair value assumptions used during our annual goodwill impairment test. For the periods presented, no triggering events were identified that required an interim impairment test. Based on most recent tests, the fair value of all our reporting units substantially exceed their carrying value.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

A trade name with a carrying value of $200 million and licenses with a carrying value of $5 million as of December 31, 2018 are considered to be indefinite-lived intangibles, and therefore are not amortized. Impairment tests for indefinite-lived intangibles are performed on an annual basis. We determined that the income approach, specifically the relief from royalty method, is the most appropriate valuation method for the trade name. The estimated fair value of the trade name is compared to the carrying value of the asset. If the carrying value of the trade name exceeds its estimated fair value, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds its fair value. This valuation approach requires that we make a number of assumptions to estimate fair value. These assumptions include projections of future revenues, market royalty rates, tax rates, discount rates and other relevant variables. The projections we use in the model are updated annually and will change over time based on the historical performance and changing business conditions.

All of our remaining recorded intangible assets are deemed to be finite-lived intangibles, and are amortized over their estimated useful lives. Impairment tests for these intangible assets are only performed when a triggering event occurs that indicates that the carrying value of the intangible may not be recoverable based on the undiscounted future cash flows of the intangible. If the carrying amount of the intangible is determined not to be recoverable, a write-down to fair value is recorded. Fair values are determined based on a DCF model. If impairment indicators are present in future periods, the resulting impairment charges could have a material impact on our results of operations. There was a $12 and $7 impairment of finite-lived intangible assets in 2018 and 2017, respectively and no impairment of finite-lived intangible assets in 2016. There was no impairment of indefinite-lived intangible assets in 2018, 2017 or 2016.

Self-Insurance Accruals

We self-insure costs associated with workers’ compensation claims, automobile liability, health and welfare and general business liabilities, up to certain limits. Insurance reserves are established for estimates of the loss that we will ultimately incur on reported claims, as well as estimates of claims that have been incurred but not yet reported. Recorded balances are based on reserve levels, which incorporate historical loss experience and judgments about the present and expected levels of cost per claim. Trends in actual experience are a significant factor in the determination of such reserves. We believe our estimated reserves for such claims are adequate, but actual experience in claim frequency and/or severity could materially differ from our estimates and affect our results of operations.

Workers’ compensation, automobile liability and general liability insurance claims may take several years to completely settle. Consequently, actuarial estimates are required to project the ultimate cost that will be incurred to fully resolve the claims. A number of factors can affect the actual cost of a claim, including the length of time the claim remains open, trends in healthcare costs and the results of related litigation. Furthermore, claims may emerge in future years for events that occurred in a prior year at a rate that differs from previous actuarial projections. Changes in state legislation with respect to workers' compensation can affect the adequacy of our self-insurance accruals. All of these factors can result in revisions to prior actuarial projections and produce a material difference between estimated and actual operating results. Prior to 2017, outside actuarial studies were performed semi-annually and we used the studies to estimate the liability in intervening quarters. Beginning in 2017, outside actuarial studies are now performed quarterly as we believe this provides us with better quarterly estimates of our outstanding workers' compensation liability.

We sponsor a number of health and welfare insurance plans for our employees. These liabilities and related expenses are based on estimates of the number of employees and eligible dependents covered under the plans, anticipated medical usage by participants and overall trends in medical costs and inflation. Actual experience may differ from these estimates and, therefore, produce a material difference between estimated and actual operating results.

Pension and Postretirement Medical Benefits

Our pension and other postretirement benefit costs are calculated using various actuarial assumptions and methodologies. These assumptions include discount rates, healthcare cost trend rates, inflation, compensation increase rates, expected returns on plan assets, mortality rates and other factors. The assumptions utilized in recording the obligations under our plans represent our best estimates, and we believe that they are reasonable, based on information as to historical experience and performance as well as other factors that might cause future expectations to differ from past trends.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Differences in actual experience or changes in assumptions may affect our pension and other postretirement obligations and future expense. The primary factors contributing to actuarial gains and losses each year are (1) changes in the discount rate used to value pension and postretirement benefit obligations as of the measurement date, (2) differences between the expected and the actual return on plan assets, (3) changes in demographic assumptions including mortality, (4) participant experience different from demographic assumptions and (5) changes in coordinating benefits with plans not sponsored by UPS.

We recognize changes in the fair value of plan assets and net actuarial gains or losses in excess of a corridor (defined as 10% of the greater of the fair value of plan assets or the plans' projected benefit obligations) in pension expense annually at December 31st each year. The remaining components of pension expense (herein referred to as "ongoing net periodic benefit cost"), primarily service and interest costs and the expected return on plan assets, are reported on a quarterly basis.

The following sensitivity analysis shows the impact of a 25 basis point change in the assumed discount rate and return on assets for our pension and postretirement benefit plans, and the resulting increase/(decrease) on our obligations and expense as of, and for the year ended, December 31, 2018 (in millions).

Pension Plans25 Basis Point Increase25 Basis Point Decrease
Discount Rate:
Effect on ongoing net periodic benefit cost$(48)$50
Effect on net periodic benefit cost for amounts recognized outside the 10% corridor(360)1,065
Effect on projected benefit obligation(1,717)1,823
Return on Assets:
Effect on ongoing net periodic benefit cost(1)(106)106
Effect on net periodic benefit cost for amounts recognized outside the 10% corridor(2)(24)24
Postretirement Medical Plans
Discount Rate:
Effect on ongoing net periodic benefit cost3(3)
Effect on net periodic benefit cost for amounts recognized outside the 10% corridor(10)11
Effect on accumulated postretirement benefit obligation(53)62
Healthcare Cost Trend Rate:
Effect on ongoing net periodic benefit cost1(1)
Effect on net periodic benefit cost for amounts recognized outside the 10% corridor9(9)
Effect on accumulated postretirement benefit obligation15(16)
(1)Amount calculated based on 25 basis point increase / decrease in the expected return on assets.
(2)Amount calculated based on 25 basis point increase / decrease in the actual return on assets.

Pension Backstop

UPS was a contributing employer to the Central States Pension Fund (“CSPF”) until 2007 when we withdrew from the CSPF and fully funded our allocable share of unfunded vested benefits by paying a $6.1 billion withdrawal liability. Under a collective bargaining agreement with the International Brotherhood of Teamsters (“IBT”), UPS agreed to provide coordinating benefits in the UPS/IBT Full Time Employee Pension Plan (“UPS/IBT Plan”) for UPS participants whose last employer was UPS and who had not retired as of January 1, 2008 (“the UPS Transfer Group”) in the event that benefits are lawfully reduced by the CSPF in the future consistent with the terms of our withdrawal agreement with the CSPF. Under our withdrawal agreement with the CSPF, benefits to the UPS Transfer Group cannot be reduced without our consent and can only be reduced in accordance with applicable law.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

In December 2014, Congress passed the Multiemployer Pension Reform Act (“MPRA”). This change in law for the first time permitted multiemployer pension plans to reduce benefit payments to retirees, subject to specific guidelines in the statute and government approval. In September 2015, the CSPF submitted a proposed pension benefit reduction plan to the U.S. Department of the Treasury (“Treasury”). In May 2016, Treasury rejected the proposed plan submitted by the CSPF. In the first quarter of 2018, Congress established a Joint Select Committee to develop a recommendation to improve the solvency of multiemployer plans and the Pension Benefit Guaranty Corporation (“PBGC”) before a November 30, 2018 deadline. While the Committee’s efforts failed to meet its deadline, the Committee made significant progress towards finding solutions that will address the long term solvency of multiemployer pension plans. UPS will continue to work with all stakeholders, including legislators and regulators, to implement an acceptable solution.

The CSPF has said that it believes a legislative solution to its funded status is necessary or that it will become insolvent in 2025, and we expect that the CSPF will continue to explore options to avoid insolvency. Numerous factors could affect the CSPF’s funded status and UPS’s potential obligation to pay coordinating benefits under the UPS/IBT Plan. Any obligation to pay coordinating benefits will be subject to a number of significant uncertainties, including whether the CSPF submits a revised MPRA filing and the terms thereof, or whether it otherwise seeks federal government assistance, as well as the terms of any applicable legislation, the extent to which benefits are paid by the PBGC and our ability to successfully defend legal positions we may take in the future under the MPRA, including the suspension ordering provisions, our withdrawal agreement and other applicable law.

We account for the potential obligation to pay coordinating benefits to the UPS Transfer Group under Accounting Standards Codification Topic 715- Compensation- Retirement Benefits (“ASC 715”), which requires us to provide a best estimate of various actuarial assumptions, including the eventual outcome of this matter, in measuring our pension benefit obligation at the December 31st measurement date. While we currently believe the most likely outcome to this matter and the broader systemic problems facing multiemployer pension plans is intervention by the federal government, ASC 715 does not permit anticipation of changes in law in making a best estimate of pension liabilities.

As such, our best estimate of the next most likely outcome at the measurement date is that the CSPF submits and implements another benefit reduction plan under the MPRA during 2019. We believe any MPRA filing would be designed to forestall insolvency by reducing benefits to participants other than the UPS Transfer Group to the maximum extent permitted, and then reducing benefits to the UPS Transfer Group by a lesser amount.

We have evaluated this outcome using a deterministic cash flow projection, reflecting updated estimated CSPF cash flows and investment earnings, the lack of legislative action and the absence of a MPRA filing by the CSPF in 2018. As a result, at the December 31, 2018 measurement date, the best estimate of our projected benefit obligation increased by $1.6 billion for coordinating benefits that may be required to be directly provided by the UPS/IBT Plan to the UPS Transfer Group.

The future value of this estimate will be influenced by the terms and timing of any MPRA filing, changes in our discount rate, rate of return on assets and other actuarial assumptions, presumed solvency of the PBGC, as well as potential solutions resulting from federal government intervention. Any such event may result in a decrease or an increase in the best estimate of our projected benefit obligation. If the uncertainties are not resolved, it is reasonably possible that our projected benefit obligation could increase by approximately $2.4 billion, resulting in a total obligation for coordinating benefits of approximately $4.0 billion as previously disclosed. If a future change in law occurs, it may be a significant event requiring an interim remeasurement of the UPS/IBT Plan at the date the law is enacted. We will continue to assess the impact of these uncertainties on our projected benefit obligation in accordance with ASC 715.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Depreciation, Residual Value and Impairment of Fixed Assets

As of December 31, 2018, we had $26.576 billion of net fixed assets, the most significant category of which is aircraft. In accounting for fixed assets, we make estimates about the expected useful lives and the expected residual values of the assets, and the potential for impairment based on the fair values of the assets and the cash flows generated by these assets.

We evaluate the useful lives of our property, plant and equipment based on our usage, maintenance and replacement policies, and taking into account physical and economic factors that may affect the useful lives of the assets. As part of our ongoing investment in transformation in 2018, we revised our estimates of useful lives for building improvements, vehicles and plant equipment based on our current assessment of these factors. In general, these changes in estimate had the effect of lengthening the useful lives of vehicles, building improvements and plant equipment. The change in estimates for building improvements, vehicles and plant equipment was applied prospectively beginning in 2018 through depreciation expense. See "Consolidated Operating Expense" of Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for the discussion of the impacts to "Depreciation and amortization." See note 1 to the audited consolidated financial statements for a discussion of our accounting policies. See note 4 to the audited consolidated financial statements for a discussion of the change in estimated useful lives.

In estimating the lives and expected residual values of aircraft, we have relied upon actual experience with the same or similar aircraft types. Subsequent revisions to these estimates could be caused by changes to our maintenance program, changes in the utilization of the aircraft, governmental regulations on aging aircraft and changing market prices of new and used aircraft of the same or similar types. We periodically evaluate these estimates and assumptions, and adjust the estimates and assumptions as necessary. Adjustments to the expected lives and residual values are accounted for on a prospective basis through depreciation expense. In estimating cash flows, we project future volume levels for our different air express products in all geographic regions in which we do business. Adverse changes in these volume forecasts, or a shortfall of our actual volume compared with our projections, could result in our current aircraft capacity exceeding current or projected demand. This situation could lead to an excess of a particular aircraft, resulting in an aircraft impairment charge or a reduction of the expected life of an aircraft (thus resulting in increased depreciation expense).

We review long-lived assets for impairment when circumstances indicate the carrying amount of an asset may not be recoverable based on the undiscounted future cash flows of the asset. If the carrying amount of the asset is determined not to be recoverable, a write-down to fair value is recorded. Fair values are determined based on quoted market values, discounted cash flows or external appraisals, as appropriate. We review long-lived assets for impairment at the individual asset or the asset group level for which the lowest level of independent cash flows can be identified. The circumstances that would indicate potential impairment may include, but are not limited to, a significant change in the extent to which an asset is utilized and operating or cash flow losses associated with the use of the asset.

There were no impairment charges on our property, plant and equipment during 2018, 2017 and 2016.

Fair Value Measurements

In the normal course of business, we hold and issue financial instruments that contain elements of market risk, including derivatives, marketable securities, finance receivables, pension assets, other investments and debt. Certain of these financial instruments are required to be recorded at fair value, principally derivatives, marketable securities, pension assets and certain other investments. Fair values are based on listed market prices, when such prices are available. To the extent that listed market prices are not available, fair value is determined based on other relevant factors, including dealer price quotations. If listed market prices and other relevant facts are not available, inputs are developed from unobservable data reflecting our own assumptions and include situations where there is little or no market activity for the asset or liability. Certain financial instruments, including over-the-counter derivative instruments, are valued using pricing models that consider, among other factors, contractual and market prices, correlations, time value, credit spreads and yield curve volatility factors. Changes in the fixed income, foreign exchange and commodity markets will impact our estimates of fair value in the future, potentially affecting our results of operations. A quantitative sensitivity analysis of our exposure to changes in commodity prices, foreign currency exchange rates and interest rates is presented in the “Quantitative and Qualitative Disclosures about Market Risk” section of this report.

Certain non-financial assets and liabilities are measured at fair value on a nonrecurring basis, including property, plant, and equipment, goodwill and intangible assets. These assets are not measured at fair value on a recurring basis; however, they are subject to fair value adjustments in certain circumstances, such as when there is evidence of an impairment.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. Such valuations require management to make significant estimates and assumptions, especially with respect to intangible assets. Significant estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from acquired customers, technology and trade names from a market participant perspective, useful lives and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, which is one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.

Income Taxes

We make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of income by legal entity and jurisdiction, tax credits, benefits, and deductions, and in the calculation of deferred tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes, as well as tax, interest and penalties related to uncertain tax positions. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period.

We assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. We believe that we will ultimately recover a substantial majority of the deferred tax assets recorded on our consolidated balance sheets. However, should there be a change in our ability to recover our deferred tax assets, our tax provision would increase in the period in which we determined that the recovery was not likely.

The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. Once it is determined that the position meets the recognition threshold, the second step requires us to estimate and measure the largest amount of tax benefit that is more likely than not to be realized upon ultimate settlement. The difference between the amount of recognizable tax benefit and the total amount of tax benefit from positions filed or to be filed with the tax authorities is recorded as a liability for uncertain tax benefits. It is inherently difficult and subjective to estimate such amounts, as we have to determine the probability of various possible outcomes. We reevaluate uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement could result in the recognition of a tax benefit or an additional charge to the tax provision.

See note 13 to the audited consolidated financial statements for a discussion of impacts of the Tax Act.

UNITED PARCEL SERVICE, INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

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