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Briefing Memo The purpose of the briefing memo is to give you an opportunity to apply tools of economic analysis in thinking

about interesting problems or situations you identify. Doing this will increase your understanding of key concepts of managerial economics and how they can be applied analyzing realworld situations. In effect, the memo will be a relatively brief case study. Periodicals providing high-quality coverage of business and economic topics represent sources of material for memos. Specific sources include The Wall Street Journal, The Economist, Forbes, Business Week, and Fortune. The memo should focus on the contribution economic analysis can make for managers who are seeking to understand a problem or reach a decision. Either situations where decisions have been made or those where decisions are still in play would be appropriate. Although no specific format is required, the following items should be treated: 1. Description of the background setting. 2. Identification and statement of the problem what is to be explained, understood, decided, evaluated, etc. 3. Discussion of the economic dimension of the problem. 4. Analysis of the problem or decision, including a description of the economic concepts or tools being utilized, a discussion of key linkages or cause and effect relationships, and an identification of the information used or required to resolve the issues. 5. Evaluation, based on (a) either a discussion of the outcome and its performance impacts where a decision or conclusion has been reached, or (b) an indication of possible decision alternatives, their ramifications, and a recommendation, if appropriate, where no resolution has occurred. The memo should not exceed 3 pages, exclusive of tables, graphs, etc. Please include detailed citations for sources of case situations and any other references.

Recently, there has been much news of weird airline charges for the passengers. I recently read that COMTEL, Austrian airline made passengers to pay for the fuel of the aircraft1. I have chosen this topic to analyze in micro-economic way from purely cost perspective. Through this analysis I will try to analyze viability of the low cost carriers in aviation market, in short run and long term run. Airline industry has undergone significant ups and downs since its inception but times have never been so challenging. Market before 90 s was dominated by premium carriers. Onset of 21st century brought a new business model of low cost carriers came into existence. Early in the decade many low cost airlines came into existence and ate into market share of established carriers. The business model was to keep the ticket prices low by reducing operating cost and lower capital investments. The luxuries which were assumed with air travel before 20th century now started coming at premium. After advent of low cost airlines, a collapse in pricing power and a fundamental shift in the buying behavior of business travelers, coupled with fierce competition from low-cost airlines, forced U.S. major carriers to restructure their operations or face the prospect of eventually going out of business. However, recently many low costcarriers are also having trouble and are looking for refuge with their bigger and premium siblings for survival. First we will briefly touch upon at what are airline cost drivers, we will then analyze new cost structure of low cost carriers that made them successful and transformed the industry. Lastly we will discuss the current state of the low cost carrier industry and try to explain the charges we see and link them to status of the industry, if possible. Cost Structure of Airlines: Airlines costs are measured by Cost for any airlines are defined by operating expenses for the airline divided by Available seat miles (ASM or CASM). ASM is a way to measure cost per unit of output for airline industry. The typical expenses for airline are divided into operating costs and non-operating costs. The operating costs include Fuel costs (Jet Fuels and other oils), Labor costs (Flying, Passenger Service, ATC, Marketing, maintenance etc.) and Maintenance Costs excluding overheads. The non-operating costs include overheads for Aircrafts and Facilities. The operating costs could be considered as variable costs and nonoperating costs could be considered as fixed cost. The output produced by any airline industry is number of passengers carried (or Cargo which we are not analyzing). On close observation it can be seen that most costs are driven by available output capacity and not the actual output. Meaning capacity of the airline if not used carefully may lead to significant cost inefficiencies. Airlines use Load Factor as a parameter to measure occupancy rate of aircraft. The graph in FIGURE 1 indicates pattern of CASM for US airlines in particular setup. (Yellow are Major US carriers and Blue are low cost) Airlines typically have high proportions of non-operating costs or fixed costs. The operating costs are comparatively smaller. In some cases this proportion is 60 to 80%. While there is loads of data to support this here is how Warren Buffet summed it up, There's no worse business of size that I can think of than the airline business. You're selling a commodity product with no variable costs. Huge fixed costs. It's a terrible business. REF TABLE 1 If we draw our avg total cost curve (ATC) and avg variable cost curve AVC the distance between then will be significant for any airline. This implies that decision to operate any airline will be complex one since in short term, it will be easy for airline to make up for its variable expenses but making up for fixed costs will be an uphill task. Essentially this means that operating decisions in airline industry need to consider fixed costs in its decision making.

Low Cost Carrier Business Model: Low cost airlines worked on reducing the fixed costs significantly. They worked on reducing the operating costs by making them proportional to the volume carried and converting their staff expense as mostly variable. They only operated in high volume routes. Here are some examples of what low cost carriers did to reduce the costs10 y y y y y y y y Low cost carriers generally serve cities of 1.3 million or greater. Southwest has 84.6 employees per aircraft, United has 116. JetBlue sells 2 percent of its tickets through agents, US Airways sells 61 percent. Low-cost carriers generally avoid costly foreign flights. A Delta captain earns $215,000 a year vs AirTran captain $135,000 with cheaper pension. Southwest, JetBlue, and AirTran have no downtown ticket offices. US Airways has 13. US Airways pays its telephone reservation agents $21 an hour. JetBlue pays them $8.25 JetBlue flies one kind of plane, Delta flies 16 different kinds of aircraft.

This data indicates that operating costs of low cost airlines are low mainly due to low fixed costs. Study of CASM for airline industry reveals that major US carriers have significantly higher CASM than low cost carriers make them cost efficient. (REF FIGURE 2) This made significant changes in the industry. Low cost carriers have changed the Airline industry in a very profound way. This pushed major carriers towards either losses or consolidation to achieve some sort of scale economies and scope economies. Currently there is only one major carrier (US) which has not undergone mergers, rest of the industry managers have either opted for mergers or have gone bankrupt. All surviving low cost carriers have been reporting operating profits till recently. Current Status for low cost carriers9, 11: Long run cost adjustments are starting to show on the operating model of low cost carriers. The demand for air travel has been steady or falling last few years6. Due to economic recession the fall of demand in airline travel has been continued5. Major component of CASM, fuel costs have gone up significantly. Major US carriers have changed their operating structure to adopt some of budget airlines concepts like reducing capacity and reducing non-essential costs by downsizing etc. Most of the low carrier industry expansion has come through four or five carriers while rest of them perished. Growths for these carriers have been restricted by slowing demand and recession. Interestingly all network carriers now have opened their low cost operations under different name or acquired a low cost airline. As low cost carriers are growing in business their service costs are growing eating into their profit margins. Hubs which were increased costs for network carriers have started to build into low cost carriers as well. JetBlue, a low cost carrier have placed orders for 100 higher capacity aircrafts thereby creating more capacity which was the reason for cost inefficiency for network carriers. In short despite of a different cost structure low cost carriers are maturing into somewhat similar shape of network carriers as part of long run adjustments in the industry. With obvious disadvantages coming into these carriers the profit margins have become harder to maintain REF TABLE 2. Budget Airlines like COMTEL are finding it hard to operate on low margins and fuel costs are being taken from passengers. Some other airlines are charging for pillows and use of toilets1, 2, 3, 4. While such charges sound very ridiculous at its face they are coming from very business model of these low cost carriers. Since fuel costs are rising, bigger airlines are trying to remain afloat and mimic models of low cost carriers the operating costs we will have more of fixed costs transferred to variable costs and charged to customers as part of revenue model to have net operating profits in short and long runs. We should expect more such charges coming in and prices of the tickets going down.



TABLE 1 - This data is sourced from a book Airline (2005) TC VC FC United Airlines 28.84 19.07% 80.93% Delta 16.05 36.32% 63.68% Continental 16.34 36.47% 63.53% Northwest 18.26 37.51% 62.49% US 14.89 41.37% 58.63% AA 12.3 48.46% 51.54% America West 11.88 48.99% 51.01% Southwest 7.86 54.71% 45.29% JetBlue 7.27 54.75% 45.25%

AS AirTran TABLE 2 Airline

10.56 9.42

57.95% 42.05% 66.77% 33.23%

Southwest Airlines Air Berlin Ryanair EasyJet JetBlue Airways Gol AirTran Airways WestJet Airways Virgin Blue Airways Aer Lingus

2009 Revenues $10.4bn $4.6bn $4.1bn $4.1bn $3.3bn $3.1bn $2.3bn $2.0bn $1.9bn $1.7bn

Change in Revenue % -6.10% -9.20% 6.90% -11.80% -3.00% -12.90% -8.30% -15.80% -10.20% -15.70%

Articles used for the memo, 1. COMTEL Plane Passengers Pony Up For Fuel As Airline Goes Broke http://www.huffingtonpost.com/2011/11/16/plane-passengers-pony-up-_n_1098073.html 2. -

Yet another new charge for RYANAIR customers http://www.thesun.co.uk/sol/homepage/travel/3961763/Yet-another-new-charge-for-Ryanaircustomers.html

3. Spirit Airline Raises online booking fees- http://www.huffingtonpost.com/2011/11/14/spiritairlines-raises-on_0_n_1093430.html 4. Others - http://www.airlinetickets.org/blog/5-ridiculous-airline-charges/ 5. The demand falls for Thanksgiving - http://www.businessweek.com/news/2011-1103/thanksgiving-air-travel-may-drop-2-as-slow-economy-saps-demand.html

6. The airline data http://www.faa.gov/airports/planning_capacity/passenger_allcargo_stats/passenger/index.cfm ?year=2010 7. The airline data comparison for http://www.airlinefinancials.com/uploads/2009_mainline_summary.pdf 2009 -

8. Cost Drivers for Airlines http://astro.temple.edu/~banker/Accounting/17%20An%20Empirical%20Study%20of%20Cost% 20Drivers.pdf

9. http://www.economist.com/node/2897525 10. http://marginalrevolution.com/marginalrevolution/2004/03/the_economics_o.html 11. http://www.flightglobal.com/news/articles/special-report-low-cost-carriers-coming-of-age340853/ 12. Airline Economics Book http://books.google.com/books?id=ZzPekWiS9I0C&pg=PA86&lpg=PA86&dq=average+total+cost +curve+for+Airlines&source=bl&ots=Aas-Q4InAo&sig=ULLfGkwH7X-grOEzGTB7t7TCmQ&hl=en&ei=EhvTTuSxFeLb0QHHhNlE&sa=X&oi=book_result&ct=result&resnum= 3&ved=0CDgQ6AEwAg#v=onepage&q=average%20total%20cost%20curve%20for%20Airlines&f =false