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Airline Economics
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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.

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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
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ability to repay debt and acquire new aircraft is jeopardized.

Labor Intensive

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goes to pay its workforce. Labor costs per employee are among the highest of any industry.
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Highly Unionized

In part because of its long history as a regulated industry, the airline industry is highly unionized.
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Thin Profit Margins
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About 75 percent of the U.S. airline industry's revenue comes from passengers; about 15 percent
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Travel agencies play an important role in airline ticket sales. Eighty percent of the industry's tickets
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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 Learn more
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.

History | Deregulation | Structure | Economics | How they Fly | Safety | Airports | ATC | Environment | Glossary

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