Chief Characteristics of the Airline Business
Service Industry
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 shippers) from one point to another at a published or negotiated rate. 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.
Capital-Intensive
In contrast with many service businesses, airlines today 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, aircraft tugs, airport counter space and gates. Consequently, 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 assets they owned previously but sold to someone else and leased back. Whatever arrangements an airline chooses to pursue, its capital needs require consistent profitability. Because airlines own large fleets of expensive aircraft that depreciate in value over time, they historically have generated a substantial positive cash flow (profits plus depreciation). Most airlines use their cash flow to repay debt, acquire new aircraft or upgrade facilities. When cash flow is significant, airlines may also issue dividends to shareholders.
Labor-Intensive
Airlines employ a virtual army of pilots, flight attendants, mechanics, baggage handlers, reservation and customer service representatives, cleaners, analysts, sales staff, accountants, lawyers, engineers, schedulers, auditors and others. New technologies have enabled airlines to automate many tasks and operate more efficiently but, because airlines are a service provider where customers require personal attention, human capital will retain a prominent role within any airline’s operations. More than one-third of the revenue generated each day by the airlines goes to pay the wages, benefits and payroll taxes of its workforce, and labor costs per employee are above average compared to other service industries.
Airline employees have extensive contact with the customer, particularly in passenger transportation. Many airline employees belong to unions, making it one of the most unionized industries in the country. In 2004, according to the U.S. Bureau of Labor Statistics, about 50 percent of all workers in the air transportation industry were union members or were covered by union contracts, compared with 14 percent of workers throughout the economy.
Airlines, through the years, have earned a net profit margin consistently below the average for U.S. industry as a whole. Also, customer demand is highly seasonal. The summer months are extremely busy, as students are out of school and many individuals and families take vacations. Winter, on the other hand, tends to be slow, with the exception of the Thanksgiving and Winter holidays. Accordingly, passenger traffic and revenue rise and fall throughout the course of any given year. Airlines have responded in kind by adjusting their schedules periodically to realign their scheduled capacity to better fit this ebb and flow.
Airline Revenue - Where the Money Comes From
On average, 80 percent of a U.S. passenger airline’s revenue comes from passengers purchasing tickets. Of the balance, the majority comes from cargo and other transport-related services. For the all-cargo sector, of course, freight, express and mail is the sole source of transport carriage revenue.
Approximately three-fourths of all U.S. airline passenger revenue is generated from domestic service while a fifth comes from international passengers. The majority of tickets are processed by travel agents, most of whom rely on global distribution systems to keep track of schedules and fares, to book reservations and to print tickets for customers.
Similarly, freight forwarders book the majority of air-cargo space. Like travel agents, freight forwarders are independent intermediaries that match shippers with cargo suppliers.
Airline Costs - Where the Money Goes
According to reports filed with the Department of Transportation in 2005, airline costs were as follows:
- Flying Operations – essentially any cost associated with the operation of aircraft, such as fuel and pilot salaries – 37 percent
- Maintenance – both parts and labor – 10 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 representatives – 14 percent
- Promotion/Sales – including advertising, reservations and travel agent commissions – 6 percent
- Passenger Service – in-flight service, including such things as food and flight attendant salaries – 6 percent
- Transport Related – outsourced regional capacity providers, in-flight sales – 17 percent
- Administrative – 6 percent Depreciation/Amortization – equipment and plants – 5 percent
Labor costs are common to nearly all of these categories. When looked at as a whole, labor accounts for a fourth of the airlines’ operating expenses and three fourths of controllable costs. Fuel recently overtook labor as the airlines’ largest cost (about 25 to 30 percent of total expenses), and transport-related costs are third (about 17 percent). Transport-related costs, in particular, have grown sharply in recent years, and many airlines have outsourced a substantial portion of their flying needs to smaller regional carriers to align supply and costs more closely with demand.
Every airline – indeed every flight – 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. Higher costs raise the break-even load factor, while higher fares have just the opposite effect. On average, the break-even load factor for the industry in recent years has surpassed 80 percent, thanks principally to higher fuel prices and lower fares.
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.
Seat Configurations
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, such as leisure travelers, an airline will seek to maximize the number of seats to keep prices as low as possible. On the other hand, a carrier that is 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.
Overbooking
In seeking to maximize revenue across their networks and serve as many passengers as possible, airlines sometimes overbook flights, meaning they book more passengers than they have seats on a given flight. This in part is done to account for passenger “no-shows.”
The practice is rooted in careful analysis of historic demand for a flight, economics and human behavior. Historically, some travelers, especially business travelers buying unrestricted, full-fare tickets, are no-shows and have not flown 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. At other times, they may simply be caught in traffic or perhaps in lengthy airport security lines. Some travelers, unfortunately, reserve seats on more than one flight.
Both airlines and customers benefit when airlines sell all the seats for which they have received reservations. An airline seat is a perishable product and if a customer fails to show up for a booked reservation, that seat cannot be returned for future use as in other industries. This undermines airline productivity, which otherwise contributes to lower airfares and expanded service. Consequently, some airlines overbook flights. Importantly for travelers, however, airlines do not do so haphazardly. Rather, they examine the history of particular flights to determining how many no-shows typically occur, and subsequently decide how many seats to authorize for sale. The goal is to align the overbooking with the eventual 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 passengers to relinquish their seats. Travel vouchers are the most common incentive, with volunteers getting re-booked on another flight.
Normally there are more than enough volunteers, but when there are not enough, 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 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 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 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 and therefore generate incremental revenue.
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.
Scheduling
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. Along with price, schedule is an important consideration for air travelers. For business travelers, who typically are time sensitive and value convenience, schedule is often more important than price. 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 local 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, rippling costs and foregone revenue across the network. 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. Are any potential aircraft purchases related to replacement of existing aircraft or are they intended to drive service growth? What are the potential cost impacts on a carrier’s fuel and maintenance programs, its crew resources and its training requirements? These are some of the issues that must be examined. In general, newer aircraft are more efficient and cost less to operate than older aircraft, as a result of new airframe and engine technologies. A Boeing 737-200, for example, is less fuel efficient than the 737-700 that Boeing designed to replace it. 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 equity in the company if additional shares of stock 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 principally been 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 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 or operating-cost disadvantages for an airline that held back on aircraft purchases while competitors were moving ahead.
Sometimes airline planners may determine that their company needs an aircraft that is not yet in production or even in design. 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 airlines because start-up costs for the production of a new aircraft are enormous and, consequently, 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 in fleet planning, 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 enabled airlines to respond more effectively to consumer demand. In larger markets, this often means more frequent service. These considerations increased the demand for small- and medium-sized aircraft to feed the hubs. Larger aircraft remain important for the more heavily traveled and capacity-constrained routes, but the ordering trend is toward smaller jet 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. The most recent run-up in fuel prices in the 21st century has renewed focus on this issue by both airlines and airplane manufacturers, leading to numerous design innovations on the part of manufacturers. Today, airline fuel efficiency compares, on a per passenger basis, 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 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 Jan. 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, and many were replaced by Stage 3 jets, such as the Boeing 757 and the MD-80. Hush kits were also available for older engines, and some airlines chose to pursue this option rather than make the much greater financial commitment necessary to buy new airplanes. Others chose to re-engine, or replace their older, noisier engines with new ones that met Stage 3 standards. While more expensive than hush kits, new engines have operating-cost advantages that make them the preferred option for some carriers.
Chapter 3
Chapter 5