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Airline Economics

Becauseofalloftheequipmentandfacilitiesinvolvedinairtransportation,itiseasytolosesightofthefactthat
thisis,fundamentally,aserviceindustry.Airlinesperformaservicefortheircustomerstransportingthemand
theirbelongings(ortheirproducts,inthecaseofcargocustomers)fromonepointtoanotherforanagreedprice.In
thatsense,theairlinebusinessissimilartootherservicebusinesseslikebanks,insurancecompaniesoreven
barbershops.Thereisnophysicalproductgiveninreturnforthemoneypaidbythecustomer,norinventory
createdandstoredforsaleatsomelaterdate.

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Becauseofalloftheequipmentandfacilitiesinvolvedinairtransportation,itiseasytolosesight
ofthefactthatthisis,fundamentally,aserviceindustry.Airlinesperformaservicefortheir
customerstransportingthemandtheirbelongings(ortheirproducts,inthecaseofcargo
customers)fromonepointtoanotherforanagreedprice.Inthatsense,theairlinebusinessis
similartootherservicebusinesseslikebanks,insurancecompaniesorevenbarbershops.Thereis
nophysicalproductgiveninreturnforthemoneypaidbythecustomer,norinventorycreatedand
storedforsaleatsomelaterdate.
Airline Economics

ChiefCharacteristicsoftheAirlineBusiness
ServiceIndustry
CapitalIntensive
Unlikemanyservicebusinesses,airlinesneedmorethanstorefrontsandtelephonestoget
started.Theyneedanenormousrangeofexpensiveequipmentandfacilities,fromairplanesto
flightsimulatorstomaintenancehangars.Asaresult,theairlineindustryisacapitalintensive
business,requiringlargesumsofmoneytooperateeffectively.Mostequipmentisfinanced
throughloansortheissuanceofstock.Increasingly,airlinesarealsoleasingequipment,including
equipmenttheyownedpreviouslybutsoldtosomeoneelseandleasedback.Whatever
arrangementsanairlinechoosestopursue,itscapitalneedsrequireconsistentprofitability.
HighCashFlow
Becauseairlinesownlargefleetsofexpensiveaircraftwhichdepreciateinvalueovertime,they
typicallygenerateasubstantialpositivecashflow(profitsplusdepreciation).Mostairlinesuse
theircashflowtorepaydebtoracquirenewaircraft.Whenprofitsandcashflowdecline,an
airline'sabilitytorepaydebtandacquirenewaircraftisjeopardized.
LaborIntensive
Airlinesalsoarelaborintensive.Eachmajorairlineemploysavirtualarmyofpilots,flight
attendants,mechanics,baggagehandlers,reservationagents,gateagents,securitypersonnel,
cooks,cleaners,managers,accountants,lawyers,etc.Computershaveenabledairlinesto
automatemanytasks,butthereisnochangingthefactthattheyareaservicebusiness,where
customersrequirepersonalattention.Morethanonethirdoftherevenuegeneratedeachdayby
theairlinesgoestopayitsworkforce.Laborcostsperemployeeareamongthehighestofany
industry.
HighlyUnionized
Inpartbecauseofitslonghistoryasaregulatedindustry,theairlineindustryishighlyunionized.

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ThinProfitMargins
Thebottomlineresultofallofthisisthinprofitmargins,eveninthebestoftimes.Airlines,
throughtheyears,haveearnedanetprofitbetweenoneandtwopercent,comparedtoan
averageofabovefivepercentforU.S.industryasawhole.
Seasonal
Theairlinebusinesshistoricallyhasbeenveryseasonal.Thesummermonthswereextremely
busy,asmanypeopletookvacationsatthattimeoftheyear.Winter,ontheotherhand,was
slower,withtheexceptionoftheholidays.Theresultofsuchpeaksandvalleysintravelpatterns

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wasthatairlinerevenuesalsoroseandfellsignificantlythroughthecourseoftheyear.This
patterncontinuestoday,althoughitislesspronouncedthaninthepast.Thegrowthinthedemand
forairtransportationsincederegulationhassubstantiallylessenedthevalleys.
AirlineRevenueWheretheMoneyComesFrom
About75percentoftheU.S.airlineindustry'srevenuecomesfrompassengersabout15percent
fromcargoshippers,thelargestofwhichistheU.S.PostalService.Theremaining10percent
comesfromothertransportrelatedservices.Fortheallcargocarriers,ofcourse,cargoisthesole
sourceoftransportationrevenue.Forthemajorpassengerairlineswhichalsocarrycargointhe
belliesoftheirplanes,lessthan10percentofrevenuecomesfromcargo(inmanycasesfarless).
Mostofthepassengerrevenue(nearly80percent)comesfromdomestictravel,while20percent
comesfromtraveltoandfromdestinationsinothercountries.Morethan90percentofthetickets
soldbyU.S.airlinesarediscounted,withdiscountsaveragingtwothirdsofffullfare.Fewerthan10
percentpayfullfare,mostofthemlastminutebusinesstravelers.Themajorityofbusiness
travelers,however,receivediscountswhentheytravel.Arelativelysmallgroupoftravelers(the
frequentflyerswhotakemorethan10tripsayear)accountforasignificantportionofairtravel.
Whiletheseflyersrepresentonlyeightpercentofthetotalnumberofpassengersflyinginagiven
year,theymakeabout40percentofthetrips.
Travelagenciesplayanimportantroleinairlineticketsales.Eightypercentoftheindustry's
ticketsaresoldbyagents,mostofwhomuseairlineownedcomputerreservationsystemstokeep
trackofschedulesandfares,tobookreservations,andtoprintticketsforcustomers.Airlinespay
travelagentsacommissionforeachticketsold.Therearemorethan40,000travelagentsinthe
UnitedStates,providingavastnetworkofretailoutletsforairtransportation.
Similarly,freightforwardersbookthemajorityofaircargospace.Liketravelagents,freight
forwardersareanindependentsalesforceforairlineservices,intheircaseworkingforshippers.
AirlineCostsWheretheMoneyGoes

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AccordingtoreportsfiledwiththeDepartmentofTransportationin1999,airlinecostswereas
follows:
FlyingOperationsessentiallyanycostassociatedwiththeoperationofaircraft,suchasfueland
pilotsalaries27percent
Maintenancebothpartsandlabor13percent
AircraftandTrafficServicebasicallythecostofhandlingpassengers,cargoandaircraftonthe
groundandincludingsuchthingsasthesalariesofbaggagehandlers,dispatchersandairlinegate
agents16percent
Promotion/Salesincludingadvertising,reservationsandtravelagentcommissions13percent
PassengerServicemostlyinflightserviceandincludingsuchthingsasfoodandflightattendant
salaries9percent
TransportRelateddeliverytrucksandinflightsales10percent
Administrative6percent
Depreciation/Amortizationequipmentandplants6percent.
Laborcostsarecommontonearlyallofthosecategories.Whenlookedatasawhole,labor
accountsfor35percentoftheairlines'operatingexpensesand75percentofcontrollablecosts.
Fuelistheairlines'secondlargestcost(about10to12percentoftotalexpenses),andtravel
agentcommissionsisthird(about6percent).Commissioncosts,asapercentoftotalcosts,have
recentlybeendeclining,asmoresalesarenowmadedirectlytothecustomerthroughelectronic
commerce.Anotherrapidlyrisingcosthasbeenairportlandingfeesandterminalrents.
BreakEvenLoadFactors
Everyairlinehaswhatiscalledabreakevenloadfactor.Thatisthepercentageoftheseatsthe
airlinehasinservicethatitmustsellatagivenyield,orpricelevel,tocoveritscosts.
Sincerevenueandcostsvaryfromoneairlinetoanother,sodoesthebreakevenloadfactor.
Escalatingcostspushupthebreakevenloadfactor,whileincreasingpricesforairlineservices
havejusttheoppositeeffect,pushingitlower.Overall,thebreakevenloadfactorfortheindustry
inrecentyearshasbeenapproximately66percent.
Airlinestypicallyoperateveryclosetotheirbreakevenloadfactor.Thesaleofjustoneortwo
moreseatsoneachflightcanmeanthedifferencebetweenprofitandlossforanairline.
SeatConfigurations
Addingseatstoanaircraftincreasesitsrevenuegeneratingpower,withoutaddingproportionately
toitscosts.However,thetotalnumberofseatsaboardanaircraftdependontheoperator's
marketingstrategy.Iflowpricesarewhatanairline'scustomersfavor,itwillseektomaximizethe
numberofseatstokeeppricesaslowaspossible.Ontheotherhand,acarrierwithastrong
followinginthebusinesscommunitymayoptforalargebusinessclasssection,withfewer,larger
seats,becauseitknowsthatitsbusinesscustomersarewillingtopaypremiumpricesforthe
addedcomfortandworkspace.Thekeyformostairlinesistostriketherightbalancetosatisfyits
mixofcustomersandtherebymaintainprofitability.
Overbooking
Airlinesoccasionallyoverbookflights,meaningthattheybookmorepassengersforaflightthan
theyhaveseatsonthesameflight.
Thepracticeisrootedincarefulanalysisofhistoricdemandforaflight,economicsandhuman
behavior.Historically,manytravelers,especiallybusinesstravelersbuyingunrestricted,fullfare
tickets,havenottraveledontheflightsforwhichtheyhaveareservation.Changesintheirown
schedulesmayhavemadeitnecessaryforthemtotakeadifferentflight,maybewithadifferent
airline,ortocanceltheirtravelplansaltogether,oftenwithlittleornonoticetotheairline.Some
travelers,unfortunately,reserveseatsonmorethanoneflight.
Bothairlinesandcustomersareadvantagedwhenairlinessellalltheseatsforwhichtheyhave
receivedreservations.Anairline'sinventoryiscomprisedoftheseatsthatithasoneachflight.If
acustomerdoesnotflyontheflightwhichheorshehasareservation,hisorherseatisunused

Learnmore

andcannotbereturnedtoinventoryforfutureuseasinotherindustries.Thisunderminesthe
productivityofanairline'soperationsitisincreasingproductivity,ofcourse,thatcontributesto
lowerairfaresandexpandedservice.Consequently,airlinessometimesoverbookflights.
Importantlyfortravelers,airlinesdonotoverbookhaphazardly.Theyexaminethehistoryof
particularflights,intheprocessdetermininghowmanynoshowstypicallyoccur,andthendecide
howmuchtooverbookthatparticularflight.Thegoalistohavetheoverbookingmatchthe
numberofnoshows.
Inmostcasesthepracticeworkseffectively.Occasionally,however,whenmorepeopleshowup
foraflightthanthereareseatsavailable,airlinesofferincentivestogetpeopletogiveuptheir
seats.Freeticketsaretheusualincentivethosevolunteeringarebookedonanotherflight.
Normally,therearemorevolunteersthantheairlinesneed,butwhentherearenotenough
volunteers,airlinesmustbumppassengersinvoluntarily.Intherarecaseswherethisoccurs,
federalregulationsrequiretheairlinestocompensatepassengersfortheirtroubleandhelpthem
makealternativetravelarrangements.Theamountofcompensationisdeterminedbygovernment
regulation.
Pricing
Sincederegulation,airlineshavehadthesamepricingfreedomascompaniesinotherindustries.
Theysetfaresandfreightratesinresponsetobothcustomerdemandandthepricesof
competitors.Asaresult,fareschangemuchmorerapidlythantheyusedto,andpassengers
sittinginthesamesectiononthesameflightoftenarepayingdifferentpricesfortheirseats.
Althoughthismaybedifficulttounderstandforsometravelers,itmakesperfectsense,
consideringthataseatonaparticularflightisofdifferentvaluetodifferentpeople.Itisfarmore
valuable,forinstance,toasalespersonwhosuddenlyhasanopportunitytovisitanimportant
clientthanitistosomeonecontemplatingavisittoafriend.Thepleasuretravelerlikelywillmake
thetriponlyifthefareisrelativelylow.Thesalesperson,ontheotherhand,likelywillpayahigher
premiuminordertomaketheappointment.
Fortheairlines,thechiefobjectiveinsettingfaresistomaximizetherevenuefromeachflight,by
offeringtherightmixoffullfareticketsandvariousdiscountedtickets.Toolittlediscountinginthe
faceofweakdemandfortheflight,andtheplanewillleavethegroundwithalargenumberof
emptyseats,andrevenuegeneratingopportunitieswillbelostforever.Ontheotherhand,too
muchdiscountingcanselloutaflightfarinadvanceandprecludetheairlinefrombookinglast
minutepassengersthatmightbewillingtopayhigherfares(anotherlostrevenueopportunity).
Theprocessoffindingtherightmixoffaresforeachflightiscalledyield,inventoryorrevenue
management.Itisacomplexprocess,requiringsophisticatedcomputersoftwarethathelpsan
airlineestimatethedemandforseatsonaparticularflight,soitcanpricetheseatsaccordingly.
And,itisanongoingprocess,requiringcontinualadjustmentsasmarketconditionschange.
Unexpecteddiscountinginaparticularmarketbyacompetitor,forinstance,canleaveanairline
withtoomanyunsoldseatsiftheydonotmatchthediscounts.
Scheduling
Sincederegulation,airlineshavebeenfreetoservewhateverdomesticmarketstheyfeelwarrant
theirservice,andtheyadjusttheirschedulesoften,inresponsetomarketopportunitiesand
competitivepressures.Alongwithprice,scheduleisanimportantconsiderationforairtravelers.
Forbusinesstravelers,scheduleisoftenmoreimportantthanprice.Businesstravelersliketosee
alternativeflightstheymaytakeonthesameairlineif,forinstance,ameetingrunslongeror
shorterthantheyanticipate.Acarrierthathasseveralflightsadaybetweentwocitieshasa
competitiveadvantageovercarriersthatservethemarketlessfrequently,orlessdirectly.
Airlinesestablishtheirschedulesinaccordancewithdemandfortheirservicesandtheirmarketing
objectives.Scheduling,however,canbeextraordinarilycomplexandmusttakeintoaccount
aircraftandcrewavailability,maintenanceneedsandairportoperatingrestrictions.
Contrarytopopularmyth,airlinesdonotcancelflightsbecausetheyhavetoofewpassengersfor
theflight.Thenatureofscheduledserviceissuchthataircraftmovethroughoutanairline's
systemduringthecourseofeachday.Aflightcancellationatoneairport,therefore,meansthe
airlinewillbeshortanaircraftsomeplaceelselaterintheday,andanotherflightwillhavetobe
canceled.Ifanairlinemustcancelaflightbecauseofamechanicalproblem,itmaychooseto
canceltheflightwiththefewestnumberofpassengersandutilizethataircraftforaflightwith
morepassengers.Whileitmayappeartobeacancellationforeconomicreasons,itisnot.The
substitutionwasmadeinordertoinconveniencethefewestnumberofpassengers.
FleetPlanning
Selectingtherightaircraftforthemarketsanairlinewantstoserveisvitallyimportanttoits
financialsuccess.Asaresult,theselectionandpurchaseofnewaircraftisusuallydirectedbyan
airline'stopofficials,althoughitinvolvespersonnelfrommanyotherdivisionssuchas
maintenanceandengineering,finance,marketingandflightoperations.
Therearenumerousfactorstoconsiderwhenplanningnewaircraftpurchases,beginningwiththe
compositionofanairline'sexistingfleet.Doexistingaircraftneedtobereplaced,whatplansdoes
theairlinehavetoexpandservice,howmuchfueldotheyburnpermile,howmuchare
maintenancecosts,andhowmanypeopleareneededtoflythem.Thesearethetypeofquestions
thatmustbeanswered.
Ingeneral,neweraircraftaremoreefficientandcostlesstooperatethanolderaircraft.ABoeing
727,forexample,islessfuelefficientthanthe757thatBoeingdesignedtoreplaceit.Inaddition,
thelarger757requiresonlyatwopersonflightcrew,versusthreeforthe727.Asplanesgetolder,
maintenancecostscanalsoriseappreciably.
However,suchproductivitygainsmustbeweighedagainstthecostofacquiringanewaircraft.
Cantheairlineaffordtotakeonmoredebt?Whatdoesthatdotoprofits?Whatisthecompany's
creditrating,andwhatmustitpaytoborrowmoney?Whatareinvestorswillingtopayforstockin
thecompanyifadditionalsharesarefloated?Acompany'sfinances,likethoseofanindividual
consideringthepurchaseofahouseornewcar,playakeyroleintheaircraftacquisitionprocess.

Marketingstrategiesareimportant,too.Anairlineconsideringexpansionintointernational
markets,forexample,typicallycannotpursuethatgoalwithoutlongrange,widebodyaircraft.If
ithasbeenlargelyadomesticcarrier,itmaynothavethattypeofaircraftinitsfleet.What's
more,changesinmarketsalreadyservedmayrequireanairlinetoreconfigureitsfleet.Havingthe
rightsizedaircraftforthemarketisvitallyimportant.Toolargeanaircraftcanmeanthatalarge
numberofunsoldseatswillbemovedbackandforthwithinamarketeachday.Toosmallan
aircraftcanmeanlostrevenueopportunities.
Sinceaircraftpurchasestaketime(oftentwoorthreeyears,ifthereisaproductionbacklog),
airlinesalsomustdosomeeconomicforecastingbeforeplacingnewaircraftorders.Thisisperhaps
themostdifficultpartoftheplanningprocess,becausenooneknowsforcertainwhateconomic
conditionswillbelikemanymonths,orevenyears,intothefuture.Aneconomicdownturn
coincidingwiththedeliveryofalargenumberofexpensivenewaircraftcancausemajorfinancial
losses.Conversely,anunanticipatedboominthetravelmarketcanmeanlostmarketshareforan
airlinethatheldbackonaircraftpurchaseswhilecompetitorsweremovingahead.
Sometimes,airlineplannersdeterminetheircompanyneedsanaircraftthatdoesnotyetexist.In
suchcases,theyapproachtheaircraftmanufacturersaboutdevelopinganewmodel,ifthe
manufacturershavenotalreadyanticipatedtheirneeds.Typically,newaircraftreflecttheneedsof
severalmajorairlines,becausestartupcostsfortheproductionofanewaircraftareenormous,
manufacturersmustsellsubstantialnumbersofanewmodeljusttobreakeven.Theyusuallywill
notproceedwithanewaircraftunlesstheyhavealaunchcustomer,meaninganairlinewillingto
stepforwardwithalargeorderfortheplane,plussmallerpurchasecommitmentsfromseveral
otherairlines.
Therehavebeenseveralimportanttrendsinaircraftacquisitionsincederegulation.Oneisthe
increasedpopularityofleasingversusownership.Leasingreducessomeoftherisksinvolvedin
purchasingnewtechnology.Italsocanbealessexpensivewaytoacquireaircraft,sincehigh
incomeleasingcompaniescantakeadvantageoftaxcredits.Insuchcases,thetaxsavingstoa
lessorcanbereflectedinthelessor'sprice.Somecarriersalsousetheleasingoptiontosafeguard
againsthostiletakeovers.Leasingleavesacarrierwithfewertangibleassetsthatacorporate
raidercanselltoreducedebtincurredinthetakeover.
Asecondtrend,since1978,relatestothesizeoftheaircraftordered.Thedevelopmentofhub
andspokenetworks,asdescribedinChapter2,resultedinairlinesaddingflightstosmallcities
aroundtheirhubs.Inaddition,deregulationhasenabledairlinestorespondmoreeffectivelyto
consumerdemand.Inlargermarkets,thisoftenmeansmorefrequentservice.These
considerations,inturn,increasedthedemandforsmallandmediumsizedaircrafttofeedthe
hubs.Largeraircraftremainimportantforthemoreheavilytraveledroutes,buttheorderingtrend
istowardsmalleraircraft.
Thethirdtrendistowardincreasedfuelefficiency.Asthepriceoffuelroserapidlyinthe1970sand
early1980s,theairlinesgavetopprioritytoincreasingthefuelefficiencyoftheirfleets.Thatledto
numerousdesigninnovationsonthepartofthemanufacturers.Airlines,today,averageabout40
passengermilespergallonastatisticthatcomparesfavorablywitheventhemostefficient
autos.
Similarly,thefourthtrendhasbeeninresponsetoairlineandpublicconcernsaboutaircraftnoise
andengineemissions.Technologicaldevelopmentshaveproducedquieterandcleanerburning
jets,andCongresshasproducedtimetablesfortheairlinestoretireorupdatetheirolderjets.A
banontheoperationofStage1jets,suchastheBoeing707andDC8,hasbeenineffectsince
January1,1985.In1989,CongressdictatedthatallStage2jets,suchas727sandDC9s,wereto
bephasedoutbytheyear2000.Today,Stage3jets,takingtheirplace,includetheBoeing757
andtheMD80.Hushkitsarealsoavailableforolderengines,andsomeairlineshavechosento
pursuethisoptionratherthanmakethemuchgreaterfinancialcommitmentnecessarytobuynew
airplanes.Othershavechosentoreengine,orreplacetheirolder,noisierengineswithnewones
thatmeetStage3standards.Whilemoreexpensivethanhushkits,newengineshaveoperating
costadvantagesthatmakethemthepreferredoptionforsomecarriers.

History | Deregulation | Structure | Economics | HowtheyFly | Safety | Airports | ATC | Environment | Glossary

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