Airline Industry Analysis

Basic Characteristics of the Airline Business

Service Industry
Fundamentally airline is a service industry. Airlines perform a service for their customers –
transporting them and their belongings from one point to another at a price. No physical product no
inventory created and stored for sale at some later date. It is also highly perishable in nature.

Airline Market Segments

 Revenues are generated by sale of tickets to Passengers and Cargo, majority being passenger.
 Typically, three-fourths of airline passenger revenue is generated from Domestic service rest
from International flights.
 Customers are broadly classified into Business traveller, Personal or tourism travel and Cargo.
 Each of the above tends to use Full Service Carriers, Low Cost Carriers and Cargo Carriers
respectively. A small portion of the business comes from Chartered Airlines.
 Demand for personal transportation is highly cyclical (depends on economic growth) as well
as Seasonal – the summer months are extremely busy.
 Majority of tickets for international travel are processed by travel agents, while most of
domestic are done by direct airline web or through indirect web.

Cost Structure: Capital-Intensive

In contrast with many service businesses, airlines industry is a capital-intensive business to finance an
enormous range of expensive equipment and facilities, from airplanes to flight simulators to
maintenance hangars, aircraft tugs, airport counter space and gates. Most equipment is financed
through loans or the issuance of stock and increasingly through leases these days. Airline needs to
earn consistent profitability to service the huge Capital. Because of the high depreciation, they
historically have generated a substantial positive cash flow which uses to repay debt, acquire new
aircraft, and pay dividends to shareholders.

Labor-Intensive
Airline industry employs several hundred thousand pilots, flight attendants, mechanics, baggage
handlers, reservation & customer service representatives, cleaners, analysts, salespersons, accountants,
lawyers, engineers, schedulers, computer programmers and other professional worker. Inspite of
automation, the industry remains labor-intensive, with a substantial share of airline revenue set aside
to pay the wages, benefits and payroll taxes of its workforce and professional fees.
Airline Profitability
Airlines, are a Perishable, Competitive low margin business with 80% of its cost per flight being fixed
in nature. They have earned a net profit margin consistently below the average for other industry as a
whole and in recent years due to a host of economic and governmental factors they have typically lost
money and, failed to generate a return to covers their cost of capital – For example, cost of debt and
equity.

Profitability highly depends on the load factor per flight (The occupancy rate or ratio of revenue
passenger miles to available seat miles). In the early years of deregulation, the industry experienced
an average break-even load factor of 65 percent, but rising fuel, labor and security costs over time, as
well as decreasing real yields have driven that number closer to 80 percent. Even in a profitable year,
airlines typically operate very close to their break-even load factor.

Airline expenses include flying operations (For example, fuel, flight crew compensation, aircraft
ownership), maintenance (For example, parts, labor), aircraft and traffic service (For example, ground
service equipment, cargo handling, baggage, dispatch, gate agents), promotion and sales (For example,
advertising, reservations agents, travel agency commissions), passenger service (For example, food
and beverage, in-flight crew compensation), transport-related (For example, outsourced regional
flying, cost of generating in-flight sales) and administration.

When looked at as a whole, labor and fuel combined consistently account for approximately 50% of
passenger airline operating expenses. Costs have increased steeply in the recent years due to high oil
costs and labor costs.

Adding seats to an aircraft increases its ability to generate revenue at a low marginal cost. However,
an aircraft’s optimal seat configuration depends on the operator’s marketing strategy. If an airline is
targeting price-sensitive consumers, maximize the number of seats to keep prices as low as possible
and if targeting service-oriented business clientele may opt for a less dense seat configuration with
either a larger premium cabin and/or an economy cabin with greater seat pitch. In reality, the key for
most airlines is to strike the right balance as most serve a broad mix of both business and leisure
customers.

To maximize revenue, airlines sometimes overbook flights, meaning they book more passengers than
they have seats on a given flight. This is done to account for passenger “no-shows” usually by
Business Travellers and to avoid having to raise fares for those who do show for their flights. Most of
this is regulated. Because an airline seat is a perishable product, No-shows that result in unsold seats
undermine airline productivity; consequently, airlines have found overbooking to be an economic
necessity.

Pricing
Since deregulation, airlines have generally 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 offered
by competitors. As a result, fares change much more rapidly, and passengers sitting in the same
section on the same flight often pay different prices for their seats. Although this may be difficult to
understand for some travellers, 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 that
suddenly has an opportunity to visit an important client than it is to someone contemplating a visit to a
friend.

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, unrestricted tickets and various discounted tickets with restrictions.
Too little discounting in the face of weak demand will result in a flight departing with many empty
seats, a lost revenue opportunity. On the other hand, too much discounting can sell out a flight far in
advance and preclude the airline from booking last-minute passengers who might be willing to pay
higher fares.

The process of finding the right mix of fares for each flight is called 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 that it can price the seats accordingly. And it is an ongoing process,
requiring continual adjustments as market conditions change.

Since deregulation, airlines have been free to enter and exit any domestic market at their own
discretion, and have adjusted their Schedules often in response to market opportunities and
competitive pressures. For business travellers, who typically are time-sensitive and value convenience,
schedule is often more important than price. A carrier that operates several flights a day between two
cities (Point to Point) has a competitive advantage over carriers that serve the market less frequently
or less directly. Contrary to popular myth, airlines do not cancel flights because they have too few
passengers for the flight. A flight cancellation at one airport, therefore, means the airline will be short
an aircraft someplace else, rippling costs and foregone revenue across the network.

Selecting the right aircraft for the markets that an airline wants to serve is vitally important to its
financial success. There are numerous factors to consider when planning new aircraft purchases, Are
any potential aircraft purchases related to replacement of existing aircraft or are they intended to drive
service growth? In general, newer aircraft are more efficient and cost less to operate than older aircraft,
as a result of new airframe and engine technologies. As planes get older, maintenance costs can also
rise appreciably. Can the airline afford to take on more debt? What does that do to profits?

An airline considering expansion into international markets, for example, typically cannot pursue that
goal without long-range, wide-body aircraft. Having the right-size 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 to four 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 lead to deep financial losses. Conversely, an
unanticipated boom in the travel market can mean lost market share.

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 and also less expensive way to acquire aircraft, since high-income leasing
companies can take advantage of tax credits. Some carriers also use the leasing option to safeguard
against hostile takeovers.

The development of hub-and-spoke networks resulted in airlines adding flights to small cities around
their hubs. These considerations increased the demand for small and medium-sized aircraft to feed the
hubs.

Demand and Supply

There are few determinants that will cause a change in the supply demand curve in the airline industry.

Determinants on demand curve.

The first determinant is income. When a country experiences a growth in the economy, the average
income of citizens will increase. In this case, air ticket plays a role as a normal good, this is because
an increase in the income will lead to an increase in the demand of air ticket purchased, and one
example is families might travel more often as they are in good economic condition.

The second determinant is prices of related goods, where a change in price of a good might affect the
demand of the other good. In the airline industry, the price of fuel has a direct influence to the demand
of air ticket. When the price of fuel increases, airline industry has to increase the price of air ticket to
maintain its revenue. Therefore, the fuel price and the demand of air ticket have a relationship of
complements, where increase in the fuel price leads to a decrease in the demand for air ticket.
However, in some special cases especially during a decline in the economy, the airline industry will
not raise the price of air tickets because the customers would scare away. Therefore, the demand of air
tickets is also quite dependent to the condition of economy.

The third determinant is number of buyers. The more the buyers in the airline industry, the demand of
air ticket will be higher. When a promotion is held by the industry airlines, there will be more buyers
on the purchase of air ticket. This is because the air tickets normally sell at a lower price to attract
more customers especially during a not-so-peak season. Thus, the demand or air tickets will increase
and the airline industry will gain more profits even though the air tickets are selling at a lower price.

The last determinant is expectation on future income and future price, which means the prediction of
consumers on how much they will earn and the value of a good in the future. For example, if the
economy has a positive development, where people expect a higher income in the future, they might
go for a vacation and shift the demand curve of air ticket to the right. However, if they realize there
will be an increase in price of air ticket in the future probably due to peak season, they will choose to
purchase now then later and cause the demand curve to shift to the right.

Determinants on supply curve.

The first determinant is input prices. When the cost of producing goods increases, the supply will
decrease. In airline industry, one of the main input prices is the fuel price. As other variables are
constant, when the price of fuel increases, the number of flight per day will decrease to reduce the
cost of airline industry.

The second determinant is technology. A better technology can shift the supply curve to the right.
Technology advancement plays a very important role in airline industry. Airline industry is trying
their best to seek for better technology in fuel conservation. Besides, they also work with airframe and
engine manufacturer in designing the components of aircraft to reduce the fuel consumption of each
flight. Thus, with the improvement of technology, airlines can provide more flight then before using
the same amount of fuel.

The third determinant is weather. As this is air transportation, weather often becomes a big issue to
the airline industry. A heavy snow during winter, or a bad pollution, often disrupts the take-off and
landing of aircraft. Unfortunately, weather is not control by humans, the airline industry only can do
their best in providing complete and safety facilities to protect their users. Although bad weather does
not last very long, it does bring some effect on flight for short periods.
The last determinant is expectation on future price. When a firm expects there is a raise of price in
future, they will supply less today until the price of the product increase. In the airline industry, when
they expect the price of air ticket to rise in the coming peak season that brings higher profits, they will
reduce or maintain the number of flights now. Thus, when comparing the number of flights for two
periods, the supply for now can said to be less compare to future.
TITLE: MICROECONOMIC ANALYSIS ON AIRLINE INDUSTRY

NAME: RAYMOND JAYASURYA A/L JAYASEELAN

MATRIC NO: 18030388

PROGRAMME NAME: CORPORATE MASTER IN BUSINESS ADMINISTRATION

COURSE NAME: ECONOMIC THEORY

COURSE CODE: EBB6023

LECTURER NAME: PROF DATO’ DR SHAZALI ABU MANSOR