Airline Economics Is there a formula for success?

By

Ken Cubbin

Without a doubt airlines have never been through more troubling times. The economic hardships inflicted upon them in the last couple of years by 9/11, the war on Iraq, SARS, and escalating fuel prices, are forcing managers to cut costs to the bone. Despite best efforts US airlines lost $6.2 billion in 2001, $7.4 billion in 2002, and an estimated $5 billion in 2003 even with passenger traffic returning to pre-9/11 levels many airlines are still bleeding. In what appears to be an industry-wide dichotomy traditional airlines struggle to stay in business while low-cost airlines are not only prospering but expanding. Low-cost airline share of the domestic market has almost quadrupled since 1990. This year, 2004, low-cost airline sector growth is expected to be around 11% as compared to traditional airline market growth of 7 percent. To comprehend this phenomenon it is necessary to analyze the intrinsic differences between these two airline genres.

The nature of costs...

Total costs can be broken down into two broad categories: fixed and variable. The best way of determining which category a particular cost falls under is to assess whether the cost would exist if the airline were not operating because of strike action. Under these circumstances fixed costs would include items such as rent for buildings, lease payments, maintenance of property, utilities, insurance, interest on loans, etc. Examples of variable costs would include aircrew salaries, fuel, landing fees, and passenger refreshments.

Airlines, as compared to manufacturing and other transport industries such as railways, require relatively low capital expenditure. Manufacturing companies generally need to make massive capital investments in factories, while railways have to expend capital in infrastructure such as tracks. Airlines can lease airplanes, airport gates and other property. The capital investment in airways and airport infrastructure is borne by governments. As a consequence airlines have lower fixed costs, but higher variable costs than the two examples mentioned. The cost of operating a flight will be the same whether the flight is full of passengers or empty, but the income from that flight is proportional to seats sold. The seats are a perishable commodity -that is they have no value at the end of a flight. Therefore, airlines have to sell as many seats as possible on each flight. Because new airlines can be started on a budget many niche-market, low-cost airlines came into being after the industry was deregulated in 1978. These have been the bane of traditional airlines.

Energy costs soar...

Behind labor the second highest expenditure for airlines is fuel which is now hovering at nearrecord prices. According to the Air Transport Association (ATA) each 1 cent rise in fuel costs US airlines an extra $180 million annually. Average airline fuel price at time of writing was more than $1 per gallon as opposed to 60 cents a gallon two years ago. As an example of how increased fuel prices affect the bottom line Delta Airlines reported that its fuel bill for 2003 was $255 -- million more than 15% higher than the year before. As a result, Delta expects to lose $400 million in the first quarter of 2004, up from its previous forecast of $300 to $350 million. Northwest Airlines says that it consumes just short of 2 billion gallons of fuel a year and that each 1 cent increase in the price of fuel adds $19 million to costs. As a consequence of rising costs the airline has asked employees for another $950 million in wage concessions in order to remain competitive.

Airlines typically try to hedge fuel prices by buying futures; however, these contracts are expensive and only tend to dampen swings in fuel costs. The best option is for airlines to add a fuel surcharge to each ticket sold, but numerous attempts by various airlines to initiate this industry move to date have failed. Even if airlines are eventually successful in adding a fuel surcharge the resultant higher ticket prices might prove counterproductive because demand for seats may fall in sympathy. Representing airline managers lament, Gordon Bethune, CEO of Continental Airlines, remarked to journalists that it would be a struggle to break even this year with persistently high fuel prices. To make matters worse many pundits think that increased oil demand from China and India, coupled with OPECs cohesive ability to place limits on production, oil prices may continue on an upward trend.

Taxing times...

On any US airline ticket there are four separate government imposed taxes or fees:

Federal excise tax adds 7.5% to the basic ticket price and is used to pay for air traffic control (ATC). A federal security fee adds $2.50 for each emplanement, up to $10 per round-trip, and is used to pay for federally-controlled security measures. (Airlines also pay separate taxes to help defray the cost of the war on terrorism). The third charge is a $3.10 fee added for each segment on a ticket that goes to fund the FAA and airport activities. Lastly, local airports add passenger facility charges of up to $4.50 that is used to airport projects. According to the ATA, security expenditure alone cost airlines $3 billion annually. The combined costs of taxes, fees, and security charges can amount to 25% of a $200 round-trip ticket.

Many airline managers have called for a reduction of taxes and fees on airline tickets and for the federal government to bear the cost of all mandated security measures. However, aviation infrastructure, regulatory oversight, and security have to be funded by the public in some form. Rather than the government increasing income taxes, economically speaking, it is more equitable that airline users pay for these costs. The downside, of course, is that higher ticket prices result in lower demand.

Revenue generation...

Airline revenue comes from carriage of passengers, cargo, mail, and contracting services. To maximize the number of passengers on each flight airlines utilize complex computer programs that try to forecast discount versus full-fare ticket demand. This process is called revenue management and is more complex for traditional airlines than it is for low-cost airlines.

For any airline there is a break-even load factor where revenue generated covers total costs of operation. In an industry that is known for price sensitivity (lower ticket prices = higher demand) passengers have become even more price conscious. At one time in recent history businessclass passengers, who were willing to pay high fares for last-minute ticket purchases, accounted for only 35% of total passengers but provided airlines with 65% of total revenue. With the downturn in the economy, coupled with the rise of Internet sites offering low-cost, last-minute travel options, business-class travel has dropped dramatically. For example, one report stated that, in order to reduce the cost of business travel, over 2,500 businesses now use Expedia.com, Travelocity.com, or Orbitz.com for their corporate accounts. As a result airlines with low-cost structures that do not rely disproportionately on business-class travelers have managed to weather this demand shift better than traditional carriers.

Network carriers versus low-cost carriers...

As defined by the Department of Transport (DOT), network carriers are those which use huband-spoke systems, while low-cost carriers are those that the industry recognizes as operating with a low-cost business model. A hub-and-spoke system is one in which airlines strategically establish major airport operations in centralized locations. The airlines then schedule banks of flights to arrive within a given time period so cross-connections facilitate more cities to be served. While the hub-and-spoke system broadens the reach of airlines it also increases costs. For example, transit times are longer (around 45 minutes), staffing needs are higher and workers less efficient. Low-cost airlines workers are far more efficient and innovative worker functions have evolved that reduce costs. For example, AirTrans gate agents also work the ramp, JetBlues pilots help clean the cabin between flights, and JetBlues reservation agents work from home rather than high-overhead call centers. Hubs also require that network airlines utilize multiple aircraft types. Multi-type fleet operation increases cost of operation due to pilot training, equipment use, spare parts, maintenance, etc. Hub-and-spoke systems can also cause system-wide disruption in bad weather.

Low-cost business model...

Typically low-cost airlines utilize linear route structures with one aircraft type. They usually operate between secondary airports serving major traffic routes, where high-density, highfrequency operations enable high load factors. No systematic alliances, and turn-around times of 20 minutes, simplify operations and allow better usage of airplanes. According to the Bureau of Transportation Statistics (BTS), low-cost airlines cost per available seat mile (ASM) for the 3rd quarter of 2003 averaged 7.3 cents as opposed to network carriers domestic unit costs per ASM

of 11.7 cents. This equates to network carriers costs being almost 38% higher than low-cost airlines.

Average low-cost airlines revenue for the same period above was 8.3 cents per ASM versus 11.5 cents per ASM (38% higher) for network carriers domestic operations. While low-cost carriers revenue generation per ASM is markedly lower than network carriers they at least enjoy a positive differential between revenue and costs. If network carriers can reduce costs per ASM, while maintaining revenue per ASM at near current levels, they would begin to be profitable again. This has been the main impetus behind the frenzied attempts by network airlines to reduce costs.

The cost cutting begins...

It is somewhat difficult, but not impossible, for airlines to reduce fixed costs. Assets can be divested and leased back, loan payments can be renegotiated and capacity reduced, but in real terms this may limit the airlines ability to generate revenue and may create poor marketing messages to the traveling public. The largest fixed cost differences between low-cost and network carriers occur because of the added expense of maintaining hubs and mixed fleets.

Variable costs are more flexible. As the accompanying pie chart shows the biggest cost to airlines is labor. Furloughing workers, reducing remuneration, and outsourcing have been the order of the day for network airlines desperately trying to reduce costs, but this practice is damaging to employee morale and, as I will articulate later in this article, may even threaten

future success of the airline. From the airlines perspective they are only taking back previously awarded pay increases, but from airline workers' perspective they are being targeted as derivatives of cost rather than facilitators of revenue generation.

Other, more imaginative, ways of reducing costs come from airlines, such as Southwest, where a focus on encouraging passengers to book on-line has resulted in the airline being able to shutdown three call centers. Southwest is also retrofitting its Boeing 737 fleet with winglets to reduce fuel consumption. Travel agents' commissions have been all but eliminated by many airlines.

But some measures airlines are taking are coming at passengers expense. In the US, for example, most network airlines have tried to reduce variable costs by making passengers pay for in-flight food on domestic legs. While these airlines laud revenue generation and price savings passengers grumble about having to pay high prices for pre-packaged food.

Discount carriers, especially in Europe, have more flexibility when reducing passenger amenities. For example, Ryannair, a low-cost European airline, has decided to dispense with aircraft blinds, reclining seats, headrest covers, and seat pockets. Emergency procedure notices will be stitched to the back of seats. According to a comment to the Associated Press by Paul Fitzsimmon, a spokesperson for Ryannair, this will save hundreds of thousands of dollars per plane in purchase price and maintenance which can then be passed on to passengers. Ryannair is also considering making passengers pay for checked-in luggage, but this may only exacerbate the already crowded overhead bin problem. EasyJet, another European low-cost airline, has removed one of its toilets and installed another row of revenue-generating seats. One airline consultant commented that this should not create a problem on short-haul flights. Other airlines reduce seat pitch to jam in more passengers. With obesity levels reaching record levels throughout the world reducing seat comfort, on-board amenities, and space available will only serve to further alienate passengers.

Therefore the question of the day is: how far can airlines reduce passenger comforts before a backlash occurs?

Lifetime customers...

According to marketing service experts, Zeithaml and Bitner, there are proven links between customer retention, profitability, and reduced employee turnover. Frederick Reichheld, another marketing expert, says that when a company consistently delivers superior value and wins customer loyalty, market share and revenues go up, and the cost of acquiring and serving customers goes down.

British Airways estimates that an airline passengers life value what that passenger can be expected to spend on airline tickets over his or her life is estimated to be around $160,000. Relationship marketing, or loyalty-based management, is the practice of focusing on profitable customers by finding out what they want and then building processes to fulfill their needs. Customers must be satisfied with the service quality to remain loyal to an airline, but their perception of quality is only as good as their last experience. Every airline is going to have problems occasionally; therefore, superior recovery processes are critical to passenger retention. Mark Lee, president of Singapore Airlines, conducted an exhaustive study in the early 90s and concluded that there were four essential elements to service excellence: consistency, attentiveness, recoverability and continuous evaluation.

However, because passengers are so sensitive to price it is hard for airlines to achieve loyalty. Frequent flyer programs achieve some measure of loyalty, but these are stereotyped among all airlines. According to Reichheld, the key to customer retention is employee retention. Longterm employees, who are satisfied with their positions, relate better to customers and provide higher quality service.

For an airline to differentiate itself from the pack it needs to have a sustainable competitive advantage -- that is something other airlines dont have. Price is easily copied and passengers feel captive if given only one choice of airline for certain routes. Could it be that in the end an airlines success depends on how well it treats its employees?

Proof in the pudding...

Southwest Airlines, the premier low-cost airline in the US, attracts customers with low fares, frequent service and on-time reliability, however, its real competitive advantage comes from having a highly motivated and productive workforce. The organizational culture at Southwest was established and nurtured by one of its original founders, Jack Kelleher. From the airlines inception he insisted that employees hired must have a positive attitude and a sense of fun. He also insisted on company credos of keeping it simple and running a loose-tight operation. In Southwest employees are empowered to make critical customer service decisions without fear of punishment for mistakes, and all employees can access top management at any time. As a result employees exude confidence and have fun on the job -- this helps passengers enjoy their travel experience. Surly indifference seems pervasive throughout the rest of the airline industry so passengers really appreciate respect and good humor when shown. In almost thirty years of operation Southwest has made a profit each year, even in the tumultuous last few years.

Act first, think later...

In the deregulated, manic dynamics of the airline industry airlines do not have the luxury of quiet contemplation. Traditional airlines have been forced to initiate a myriad of ad hoc changes that they hope will return them to profitability. These include everything from renegotiated pay scales for employees to making passengers pay for food on domestic flights. Full-service, network airlines have seen their high revenue segments eaten away by low-cost competitors, such as Southwest Airlines, JetBlue, AirTran and others. For example, UAL claims that it has lowcost competition on 70% of its domestic routes structure.

Confirming the old adage, If you cant beat them, join them, network airlines are, once again, forming discount operations themselves. Ted, by UAL, and Song, by Delta, are two discount derivatives formed in a desperate attempt to compete with low-cost airlines. However, network carriers have tried and failed at this strategy in the past. Shuttle by United and Continental Lite are two cases that come to mind. Largely this was because the parent airlines failed to recognize the intrinsic recipe for success satisfied workers. So what makes network carriers think they can successfully reinvent themselves this time?

As shown above a critical element in the long-term success of Southwest Airlines is its internal marketing philosophy. Make employees happy first and they will put in extra effort to make passengers happy. In a reflection of how United employees morale stands, after so many of their peers have been furloughed, they snidely remark that Ted means United without U'n'I. There are plenty of research data that show that job satisfaction is negatively related to turnover. The more people who are laid off the more dissatisfied the remaining workers become. However, this is usually the first action many airlines take when times get tough. Of course this action is taken because labor is an airlines biggest expense. However, such action is probably counterproductive in the long-term.

Labor debacle...

In the industry boom of the late 90s unions negotiated huge wage and benefit increases. One pilot union representative at the time remarked that they [the union] did not want to kill the golden goose, just get every last egg out of it. According to a retired ATA economist, average airline remuneration grew from $63,000 in 1999 to $76,000 in 2003. According to the BTS, industry-wide labor costs per ASM rose 12% in 2003 while revenue per ASM declined 10%.

Following 9/11 United and US Airways filed chapter 11 bankruptcy. Even now, as the industry recovers in terms of travel, Delta cant rule out filing, and American narrowly avoided filing bankruptcy early 2004. US Airways later emerged from bankruptcy by gaining $1 billion in wage concessions, terminating it pilots pension plan and furloughing staff. Faced with more low-cost competition from Southwest in one of its main hubs, David Siegal, CEO of US Airways, warned that if the airline cannot gain more concessions from workers he will be forced to divest assets and layoff more workers. Siegal has also said that he is adopting a strategy that will enable US Airways to be an attractive acquisition for another airline.

Because of draconian measures taken to reduce costs every network airline is facing labor unrest. Airlines see no other course of action than to slash labor costs and airline workers morale is at its nadir. Are there no other options for airlines?

The right course to take...

Maybe so, but it will take managers with vision and charisma to articulate what changes need to occur and then convince employees, and their unions, to face the challenge. No business can succeed by mistreating employees and alienating customers, yet that is exactly the course network airlines have taken.

The future belongs to niche market, low-cost carriers that can offer passengers low price, high volume flights between major cities. In a speech to the Potomac Officers Club earlier this year Siegal reportedly said, "I see a world with there are three strong hub-and-spoke carriers providing international service and broad networks that connect small, medium and large markets, and then a swarm of low-cost carriers battling it out in high-density markets."

But I disagree with his sentiments.

Just consolidating existing network carriers, without rectifying fundamental flaws, will only exacerbate industry problems. Disgruntled employees would be even more upset by the prospect of losing their job or having to meld seniority lists and job functions. Success will not occur unless employees are satisfied with their lot in life. Therefore, organizational cultures must change to be employee focused. Some employees can be shed through voluntary retrenchment and natural attrition, but mass furloughs and dramatic pay reductions must be abandoned in future cost cutting measures. Managers must delineate their airlines strategy to employees and elicit their help in restructuring.

The era for network carriers using a one-size-fits-all business model is over. The hub-and-spoke system should be devolved. This can be done by network carriers splitting their operations into strategic business units (SBU) with each being responsible for setting prices and containing

costs. For example, Northwest could split into four SBUs: cargo, international, domestic, and feeder airlines. A low-cost operation could also be established, if deemed necessary, using appropriate criteria. For each unit, fleet commonality and simplification would ensue, alliances would be more flexible, and linear route structures adopted. Corporate offices would control functions common to each unit, such as reservations and ticketing. Maintenance might also be operated as a separate SBU or alternatively outsourced. Each unit would have the autonomy to react quickly to competitive forces in their respective market. With the decline of the hub-andspoke system, service to small communities might suffer. Service may decrease and fares increase, but if the business is there, and airlines remain deregulated, some carrier will fill the need.

Employees would be subject to their respective SBU's wage structure, but their ownership and feeling of belonging is likely to increase. Labor costs could be contained by linking remuneration to success of the SBU profit sharing. This would be a great incentive for workers to be more productive. Given autonomy they would be more likely to initiate change from the bottom up so market adaptations could occur more quickly. Increased job satisfaction would improve employee retention, passenger satisfaction, increase customer loyalty, and revenue. In the end, costs would be lower and revenues higher.

It sounds pretty easy doesnt it?

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