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Airline Economics

Airline Economics

Because of all of the equipment and facilities involved in air transportation, it is easy to lose sight of the fact that this is, fundamentally, a service industry. Airlines perform a service for their customers - transporting them and their belongings (or their products, in the case of cargo customers) from one point to another for an agreed price. In that sense, the airline business is similar to other service businesses like banks, insurance companies or even barbershops. There is no physical product given in return for the money paid by the customer, nor inventory created and stored for sale at some later date.

Airline Economics

Because of all of the equipment and facilities involved in air transportation, it is easy to lose sight of the fact that this is, fundamentally, a service industry. Airlines perform a service for their customers - transporting them and their belongings (or their products, in the case of cargo customers) from one point to another for an agreed price. In that sense, the airline business is similar to other service businesses like banks, insurance companies or even barbershops. There is no physical product given in return for the money paid by the customer, nor inventory created and stored for sale at some later date.

Airline Economics

Chief Characteristics of the Airline Business

Service Industry

Capital Intensive

Unlike many service businesses, airlines need more than storefronts and telephones to get started. They need an enormous range of expensive equipment and facilities, from airplanes to flight simulators to maintenance hangars. As a result, the airline industry is a capital-intensive business, requiring large sums of money to operate effectively. Most equipment is financed through loans or the issuance of stock. Increasingly, airlines are also leasing equipment, including equipment they owned previously but sold to someone else and leased back. Whatever arrangements an airline chooses to pursue, its capital needs require consistent profitability.

High Cash Flow

Because airlines own large fleets of expensive aircraft which depreciate in value over time, they typically generate a substantial positive cash flow (profits plus depreciation). Most airlines use their cash flow to repay debt or acquire new aircraft. When profits and cash flow decline, an airline's ability to repay debt and acquire new aircraft is jeopardized.

Labor Intensive

Airlines also are labor intensive. Each major airline employs a virtual army of pilots, flight attendants, mechanics, baggage handlers, reservation agents, gate agents, security personnel, cooks, cleaners, managers, accountants, lawyers, etc. Computers have enabled airlines to automate many tasks, but there is no changing the fact that they are a service business, where customers require personal attention. More than one-third of the revenue generated each day by the airlines goes to pay its workforce. Labor costs per employee are among the highest of any industry.

Highly Unionized

In part because of its long history as a regulated industry, the airline industry is highly unionized.

Thin Profit Margins

The bottom line result of all of this is thin profit margins, even in the best of times. Airlines, through the years, have earned a net profit between one and two percent, compared to an average of above five percent for U.S. industry as a whole.

Seasonal

The airline business historically has been very seasonal. The summer months were extremely busy, as many people took vacations at that time of the year. Winter, on the other hand, was slower, with the exception of the holidays. The result of such peaks and valleys in travel patterns was that airline revenues also rose and fell significantly through the course of the year. This pattern continues today, although it is less pronounced than in the past. The growth in the demand for air transportation since deregulation has substantially lessened the valleys.

Airline Revenue - Where the Money Comes From

About 75 percent of the U.S. airline industry's revenue comes from passengers; about 15 percent from cargo shippers, the largest of which is the U.S. Postal Service. The remaining 10 percent comes from other transport-related services. For the all-cargo carriers, of course, cargo is the sole source of transportation revenue. For the major passenger airlines which also carry cargo in the bellies of their planes, less than 10 percent of revenue comes from cargo (in many cases far less).

Most of the passenger revenue (nearly 80 percent) comes from domestic travel, while 20 percent comes from travel to and from destinations in other countries. More than 90 percent of the tickets sold by U.S. airlines are discounted, with discounts averaging two-thirds off full fare. Fewer than 10 percent pay full fare, most of them last-minute business travelers. The majority of business travelers, however, receive discounts when they travel. A relatively small group of travelers (the frequent flyers who take more than 10 trips a year) account for a significant portion of air travel. While these flyers represent only eight percent of the total number of passengers flying in a given year, they make about 40 percent of the trips.

Travel agencies play an important role in airline ticket sales. Eighty percent of the industry's tickets are sold by agents, most of whom use airline-owned computer reservation systems to keep track of schedules and fares, to book reservations, and to print tickets for customers. Airlines pay travel agents a commission for each ticket sold. There are more than 40,000 travel agents in the United States, providing a vast network of retail outlets for air transportation.

Similarly, freight forwarders book the majority of air-cargo space. Like travel agents, freight forwarders are an independent sales force for airline services, in their case working for shippers.

Airline Costs - Where the Money Goes

According to reports filed with the Department of Transportation in 1999, airline costs were as follows:

Flying Operations - essentially any cost associated with the operation of aircraft, such as fuel and pilot salaries - 27 percent;
Maintenance - both parts and labor - 13 percent;
Aircraft and Traffic Service - basically the cost of handling passengers, cargo and aircraft on the ground and including such things as the salaries of baggage handlers, dispatchers and airline gate agents - 16 percent;
Promotion/Sales - including advertising, reservations and travel agent commissions - 13 percent;
Passenger Service - mostly in-flight service and including such things as food and flight attendant salaries - 9 percent;
Transport Related - delivery trucks and in-flight sales - 10 percent;
Administrative - 6 percent;
Depreciation/Amortization - equipment and plants - 6 percent.
Labor costs are common to nearly all of those categories. When looked at as a whole, labor accounts for 35 percent of the airlines' operating expenses and 75 percent of controllable costs. Fuel is the airlines' second largest cost (about 10 to 12 percent of total expenses), and travel-agent commissions is third (about 6 percent). Commission costs, as a percent of total costs, have recently been declining, as more sales are now made directly to the customer through electronic commerce. Another rapidly rising cost has been airport landing fees and terminal rents.

Break-Even Load Factors

Every airline has what is called a break-even load factor. That is the percentage of the seats the airline has in service that it must sell at a given yield, or price level, to cover its costs.

Since revenue and costs vary from one airline to another, so does the break-even load factor. Escalating costs push up the break-even load factor, while increasing prices for airline services have just the opposite effect, pushing it lower. Overall, the break-even load factor for the industry in recent years has been approximately 66 percent.

Airlines typically operate very close to their break-even load factor. The sale of just one or two more seats on each flight can mean the difference between profit and loss for an airline.

Seat Configurations

Adding seats to an aircraft increases its revenue-generating power, without adding proportionately to its costs. However, the total number of seats aboard an aircraft depend on the operator's marketing strategy. If low prices are what an airline's customers favor, it will seek to maximize the number of seats to keep prices as low as possible. On the other hand, a carrier with a strong following in the business community may opt for a large business-class section, with fewer, larger seats, because it knows that its business customers are willing to pay premium prices for the added comfort and workspace. The key for most airlines is to strike the right balance to satisfy its mix of customers and thereby maintain profitability.

Overbooking

Airlines occasionally overbook flights, meaning that they book more passengers for a flight than they have seats on the same flight.

The practice is rooted in careful analysis of historic demand for a flight, economics and human behavior. Historically, many travelers, especially business travelers buying unrestricted, full-fare tickets, have not traveled on the flights for which they have a reservation. Changes in their own schedules may have made it necessary for them to take a different flight, maybe with a different airline, or to cancel their travel plans altogether, often with little or no notice to the airline. Some travelers, unfortunately, reserve seats on more than one flight.

Both airlines and customers are advantaged when airlines sell all the seats for which they have received reservations. An airline's inventory is comprised of the seats that it has on each flight. If a customer does not fly on the flight which he or she has a reservation, his or her seat is unused and cannot be returned to inventory for future use as in other industries. This undermines the productivity of an airline's operations; it is increasing productivity, of course, that contributes to lower airfares and expanded service. Consequently, airlines sometimes overbook flights.

Importantly for travelers, airlines do not overbook haphazardly. They examine the history of particular flights, in the process determining how many no-shows typically occur, and then decide how much to overbook that particular flight. The goal is to have the overbooking match the number of no-shows.

In most cases the practice works effectively. Occasionally, however, when more people show up for a flight than there are seats available, airlines offer incentives to get people to give up their seats. Free tickets are the usual incentive; those volunteering are booked on another flight.

Normally, there are more volunteers than the airlines need, but when there are not enough volunteers, airlines must bump passengers involuntarily. In the rare cases where this occurs, federal regulations require the airlines to compensate passengers for their trouble and help them make alternative travel arrangements. The amount of compensation is determined by government regulation.

Pricing

Since deregulation, airlines have had the same pricing freedom as companies in other industries. They set fares and freight rates in response to both customer demand and the prices of competitors. As a result, fares change much more rapidly than they used to, and passengers sitting in the same section on the same flight often are paying different prices for their seats.

Although this may be difficult to understand for some travelers, it makes perfect sense, considering that a seat on a particular flight is of different value to different people. It is far more valuable, for instance, to a salesperson who suddenly has an opportunity to visit an important client than it is to someone contemplating a visit to a friend. The pleasure traveler likely will make the trip only if the fare is relatively low. The salesperson, on the other hand, likely will pay a higher premium in order to make the appointment.

For the airlines, the chief objective in setting fares is to maximize the revenue from each flight, by offering the right mix of full-fare tickets and various discounted tickets. Too little discounting in the face of weak demand for the flight, and the plane will leave the ground with a large number of empty seats, and revenue-generating opportunities will be lost forever. On the other hand, too much discounting can sell out a flight far in advance and preclude the airline from booking last-minute passengers that might be willing to pay higher fares (another lost-revenue opportunity).

The process of finding the right mix of fares for each flight is called yield, inventory or revenue management. It is a complex process, requiring sophisticated computer software that helps an airline estimate the demand for seats on a particular flight, so it can price the seats accordingly. And, it is an ongoing process, requiring continual adjustments as market conditions change. Unexpected discounting in a particular market by a competitor, for instance, can leave an airline with too many unsold seats if they do not match the discounts.

Scheduling

Since deregulation, airlines have been free to serve whatever domestic markets they feel warrant their service, and they adjust their schedules often, in response to market opportunities and competitive pressures. Along with price, schedule is an important consideration for air travelers. For business travelers, schedule is often more important than price. Business travelers like to see alternative flights they may take on the same airline if, for instance, a meeting runs longer or shorter than they anticipate. A carrier that has several flights a day between two cities has a competitive advantage over carriers that serve the market less frequently, or less directly.

Airlines establish their schedules in accordance with demand for their services and their marketing objectives. Scheduling, however, can be extraordinarily complex and must take into account aircraft and crew availability, maintenance needs and airport operating restrictions.

Contrary to popular myth, airlines do not cancel flights because they have too few passengers for the flight. The nature of scheduled service is such that aircraft move throughout an airline's system during the course of each day. A flight cancellation at one airport, therefore, means the airline will be short an aircraft someplace else later in the day, and another flight will have to be canceled. If an airline must cancel a flight because of a mechanical problem, it may choose to cancel the flight with the fewest number of passengers and utilize that aircraft for a flight with more passengers. While it may appear to be a cancellation for economic reasons, it is not. The substitution was made in order to inconvenience the fewest number of passengers.

Fleet Planning

Selecting the right aircraft for the markets an airline wants to serve is vitally important to its financial success. As a result, the selection and purchase of new aircraft is usually directed by an airline's top officials, although it involves personnel from many other divisions such as maintenance and engineering, finance, marketing and flight operations.

There are numerous factors to consider when planning new aircraft purchases, beginning with the composition of an airline's existing fleet. Do existing aircraft need to be replaced, what plans does the airline have to expand service, how much fuel do they burn per mile, how much are maintenance costs, and how many people are needed to fly them. These are the type of questions that must be answered.

In general, newer aircraft are more efficient and cost less to operate than older aircraft. A Boeing 727, for example, is less fuel efficient than the 757 that Boeing designed to replace it. In addition, the larger 757 requires only a two-person flight crew, versus three for the 727. As planes get older, maintenance costs can also rise appreciably.

However, such productivity gains must be weighed against the cost of acquiring a new aircraft. Can the airline afford to take on more debt? What does that do to profits? What is the company's credit rating, and what must it pay to borrow money? What are investors willing to pay for stock in the company if additional shares are floated? A company's finances, like those of an individual considering the purchase of a house or new car, play a key role in the aircraft acquisition process.

Marketing strategies are important, too. An airline considering expansion into international markets, for example, typically cannot pursue that goal without long-range, wide-body aircraft. If it has been largely a domestic carrier, it may not have that type of aircraft in its fleet. What's more, changes in markets already served may require an airline to reconfigure its fleet. Having the right-sized aircraft for the market is vitally important. Too large an aircraft can mean that a large number of unsold seats will be moved back and forth within a market each day. Too small an aircraft can mean lost revenue opportunities.

Since aircraft purchases take time (often two or three years, if there is a production backlog), airlines also must do some economic forecasting before placing new aircraft orders. This is perhaps the most difficult part of the planning process, because no one knows for certain what economic conditions will be like many months, or even years, into the future. An economic downturn coinciding with the delivery of a large number of expensive new aircraft can cause major financial losses. Conversely, an unanticipated boom in the travel market can mean lost market share for an airline that held back on aircraft purchases while competitors were moving ahead.

Sometimes, airline planners determine their company needs an aircraft that does not yet exist. In such cases, they approach the aircraft manufacturers about developing a new model, if the manufacturers have not already anticipated their needs. Typically, new aircraft reflect the needs of several major airlines, because start-up costs for the production of a new aircraft are enormous, manufacturers must sell substantial numbers of a new model just to break even. They usually will not proceed with a new aircraft unless they have a launch customer, meaning an airline willing to step forward with a large order for the plane, plus smaller purchase commitments from several other airlines.

There have been several important trends in aircraft acquisition since deregulation. One is the increased popularity of leasing versus ownership. Leasing reduces some of the risks involved in purchasing new technology. It also can be a less expensive way to acquire aircraft, since high-income leasing companies can take advantage of tax credits. In such cases, the tax savings to a lessor can be reflected in the lessor's price. Some carriers also use the leasing option to safeguard against hostile takeovers. Leasing leaves a carrier with fewer tangible assets that a corporate raider can sell to reduce debt incurred in the takeover.

A second trend, since 1978, relates to the size of the aircraft ordered. The development of hub-and-spoke networks, as described in Chapter 2, resulted in airlines adding flights to small cities around their hubs. In addition, deregulation has enabled airlines to respond more effectively to consumer demand. In larger markets, this often means more frequent service. These considerations, in turn, increased the demand for small- and medium-sized aircraft to feed the hubs. Larger aircraft remain important for the more heavily traveled routes, but the ordering trend is toward smaller aircraft.

The third trend is toward increased fuel efficiency. As the price of fuel rose rapidly in the 1970s and early 1980s, the airlines gave top priority to increasing the fuel efficiency of their fleets. That led to numerous design innovations on the part of the manufacturers. Airlines, today, average about 40 passenger miles per gallon - a statistic that compares favorably with even the most efficient autos.

Similarly, the fourth trend has been in response to airline and public concerns about aircraft noise and engine emissions. Technological developments have produced quieter and cleaner-burning jets, and Congress has produced timetables for the airlines to retire or update their older jets. A ban on the operation of Stage 1 jets, such as the Boeing 707 and DC-8, has been in effect since January 1, 1985. In 1989, Congress dictated that all Stage 2 jets, such as 727s and DC-9s, were to be phased out by the year 2000. Today, Stage 3 jets, taking their place, include the Boeing 757 and the MD-80. Hush kits are also available for older engines, and some airlines have chosen to pursue this option rather than make the much greater financial commitment necessary to buy new airplanes. Others have chosen to re-engine, or replace their older, noisier engines with new ones that meet Stage 3 standards. While more expensive than hush kits, new engines have operating-cost advantages that make them the preferred option for some carriers.

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Airline Economics

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