Micro Economics Assignment: EGMP4

Santhosh Tholpady

Airline Industry Analysis

Basic Characteristics of the Airline Business

Service Industry
Fundamentally airlines 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.
• Customer are broadly classified into Business traveler, Personal or tourism travel and
Cargo.
• Each of the above tend 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. Airlines 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 use to repay debt, acquire new
aircraft, 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 ….... 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, Competative 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 – iecost of
debt and equity.

Profitability highly depends on the load factor per flight (ie 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 (e.g., fuel, flight crew compensation, aircraft ownership),
maintenance (e.g., parts, labor), aircraft and traffic service (e.g., ground service equipment, cargo
handling, baggage, dispatch, gate agents), promotion and sales (e.g., advertising, reservations agents,
travel agency commissions), passenger service (e.g., food and beverage, in-flight crew
compensation), transport-related (e.g., 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 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.

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 travelers, 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.
Source: Various and also from Air Transport Association (http://www.airlines.org)