The Airline Industry
Historically, air travel has survived largely through state support, whether in the form of equity or subsidies. The airline industry as a whole has made a cumulative loss during its strenuous history, the costs include subsidies for aircraft development and airport construction. Because of increasing fuel prices and new industry standards the airlines have raised ticket prices as a compensation for the high cost of operating. Going hand-in-hand with these increasing prices, the effects of 9/11 have added more strain to the already existing problem of debt that the airline industry faces.
Airline Business Models
Hub-and-Spoke vs. Low-Cost
The traditional operating model for large U.S. and European airlines has been the hub-and-spoke approach. This model enables airlines to virtually take anyone from any place to any desired destination. However, many industry analysts consider this model as no longer competitvely substainable in its present form due to industry changes and exterior economic effects.Within the traditional airline business model, costs quickly build up as a result of the complex system that is used to operate. The business model is based on offering consumers a larger number of destinations with significant flexibility such as last-minute seat reassignments, upgrades, and “frills” like meals, private lounges, and entertainment. Thus the model is troubled by the included cost penalties of synchronized hub operations, with long aircraft turnaround times and slack built into schedules to increase connectivity by ensuring there is time for passengers and baggage to make connections. (14) In addition, the hub-and-spoke business model relies on highly sophisticated information systems and infrastructure to optimize its complex operations. (14) Essentially the traditional model supports a system that inherently accepts a slower pace of business to accommodate incessant change.
The low-cost model is a simple, focused, and highly productive business model founded on nonstop air travel to and from medium to high density markets at significantly lower prices. Low-cost carriers pay lower salaries, use cheaper airports, and leverage resources much more effectively than hub-and-spoke carriers. (14) The cost disparity between the hub-and-spoke carriers and low-cost carriers is 2 to 1 for the same stage length and aircraft, even after adjustments for differences in pay scales, fuel prices, and seat density are made. (14) Many hub-and-spoke carriers are attempting to reproduce the low-cost model through subsidiaries such as United Airlines Ted because they realize that their survival depends on overhauling their archaic model.
Considering the respective models in relation to productivity, carriers that maintain operations based on the traditional model are struggling to stay afloat in the present economy, where as carriers that were either founded on the low-cost model or have adopted it, are actually turning profits. In further comparison of the two models it is interesting to note that the biggest difference in terms of their success are their production models. The production model for traditional carriers, which effects scheduling, processing, pace, and distribution, makes up 65% of the disparity in costs compared to low-cost carries, and surprisingly on 5% of the difference is because of "frills." (14) Another 15% applies to compensation and other labor issues, and 12% to financial structure. (14) The overall difference between the average hub-and-spoke carrier and low-cost carrier is 7.2 cents per seat mile. (14) It is quite clear that the issue with hub-and-spoke carriers is the complexity of their operations model and not "frills." Thus because the traditional operating model of major U.S. and European airlines is flawed and unproductive, consumers and the governments absorb the cost of their failure.
Boeing vs. Airbus
The airplane manufacturing industry is dominated by two companies: The Boeing Company and Airbus S.A.S. Boeing is the world's leading aerospace company and the largest manufacturer of commercial jetliners and military aircraft combined. Airbus began as a consortium between France and Germany which was later joined by Spain and Britain. Their fight for market share is the clearest example of global competition going on in the world today (15,16).
Airbus and Boeing is in tight competition with every year for aircraft orders. Airbus has managed to win over 50% of aircraft orders in recent years. However, once again Boeing surpassed Airbus in 2005 and 2006 as a result of their success in the market for wide body aircraft (17).
The impact of the weak dollar
Much controversy surrounds this international competition. The economic impact of the weak dollar has give Boeing a tremendous advantage in the global airplane markets. In, addition, both companies are accused of violating world-trade agreements relating to restricting government subsidies (18,19).
Both companies sell their airplanes in US Dollars; however Boeing’s manufacturing is primarily done in the United States while Airbus manufactures in Europe. This means that Airbus pays its cost in euros while Boeing spends dollars. The falling dollar means Airbus earns fewer euros causing a squeeze on profits. The weak dollar and the costly delays in the introduction of the jumbo A380 has cost the company billions of euros. Just two weeks ago Airbus’s chief executive, Tom Enders, proclaimed that the weak dollar is “life threatening” to the European airplane manufacturer. While there is much debate as to whether Airbus’s life is truly in danger, there are definitely indications of pain. Early this year Airbus devised a plan to turn things around; the plan calls for the closing of six factories and terminating 10,000 employees.
Boeing has been on the receiving end of the weak dollar situation. Revenue from their commercial airplane business is up 18% for the nine-months ended September 30, 2007 from the same period in 2006. The value of Boeing stock is almost double where it was at the end of 2004. The manufacturing delays at Airbus has also helped fuel orders of Boeing planes (20,21).
The Subsidy War
Boeing’s recent success not stopped the company from crying foul over Airbus’s receipt of unfair government subsidies. U.S. Trade Representatives decided to file a formal complaint with the World Trade Organization claiming that the European Union has provided Airbus with billions of dollars of unfair subsidies. The subsidies received by Airbus are referred to as “launch aid” and provides money for the development of new commercial airplanes. The Europeans claim that launch aid is no more than a loan to the company to be paid back from sales of the planes. However, launch aid transfers the risk of manufacturing from Airbus to the European governments because the loan does not need to be repaid if the aircraft program is unsuccessful. For example, if Airbus’s A380 fails to sell the company will not have to repay the $3 billion in loans it has already received. Boeing claims that these subsidies provide Airbus an unfair economic advantage that is strictly forbidden in the 1992 bilateral aircraft-development agreement.
Airbus and the European Union argue that launch aid is nothing more than repayable loans which are acceptable according to the agreement. They go on to accuse Boeing of receiving illegal subsidies for its midsize 7E7 “Dreamliner” program. However, the subsidies that the EU mostly refer to is the $3.2 in tax breaks Boeing secured from the stat of Washington for the 7E7 program. This benefit to Boeing comes over a twenty year period as reduced sales tax on airplane sales. The big difference is that Boeing only benefits if the plane is successful and only after they have made a substantial investment in the development of the aircraft. Airbus, on the other hand does not need to repay the $3 billion loan if the A380 fails to sell. Also, the tax break provided to Boeing is available to anyone in the aerospace industry including Airbus.
The subsidy war continues to wage on through mostly rhetoric. How it plays out in the international governing bodies such as the World Trade Organization is yet uncertain (22,23,24,25).
In attempts to fully maximize profits the airlines focus on the price of tickets. Since everything in the last couple of years, especially since 9/11, has changed, the price of tickets has become a very confusing aspect of the airline industry and has changed rapidly.
Most airlines use differentiated pricing, a form of price discrimination, in order to sell air services at different prices and in different time segments to coop with the losses that would normally occur. There are many factors that contribute to determining the price of tickets. These factors include the days remaining until departure, the current booked load factor, the projected public demand and variations by the day of the week the departure is and the time of day. This price distribution is obviously done mostly by seating classes.
The beginning of advanced computerized reservations systems in the late 1970s allowed competing airline industries to easily perform cost-benefit analyses on different pricing techniques, which lead to almost perfect price discrimination by filling each seat on an aircraft at the highest price possible without driving the consumer elsewhere. This crazy aspect of the industry has caused airlines to compete for lower prices on same routes and because of this competition aspect, most airlines experience major losses as a result.
These ticket prices end up having the greatest impact in the industry because due to operating costs, the income that is distributed amongst providers, even at its highest, is only a small portion of the overall income. Basically in the end, if the ticket prices are too low, the revenue won't cover the operating costs and competing airlines would see decreased profits and won't be able to keep up with the market. United Airlines, US Airways (twice), Delta Air Lines, and Northwest Airlines have all declared Chapter 11 bankruptcy, and American has barely avoided doing so, just proving the effects of ticket sales.
Oil Prices, the Direct Effect on Ticket Prices
Over the past few fiscal quarters oil prices have steadily increased due to scarcity and high demand. In 2003 a barrel of crude oil was under $25 on the NYMEX; in August 2005 the market saw prices rise to $60 per barrel, and currently (October 2007) the prices have been floating around $92 per barrel. At the same time the value of the US dollar has been in a steady decline, which could be seen, as one of the reasons oil prices have peaked. “Oil is almost always bought and sold in US dollars, even when this is not the currency of either vendor or buyer, it is easy to be confused by the movement of the dollar relative to other currencies.” Higher oil prices have constrained airline budgets, pushing them into debt; as a result airlines have raised ticket prices to subsidize the increased cost of operations. In today’s global society, travelers search the Internet to find cheap tickets, and last minute deals but as operation costs rise, these deals will disappear.(11)
Summary of the Problem:
Due to the rise in oil prices the International Airline Industry is set to lose six billion dollars. According to the International Air Transport Association (IATA) the airlines industries fuel bill accounts for approximately 22 percent of its total operations cost. Subsequently, it has raised $39 billion over the past two years. Between 2001-2005 the global airline industry has calculated $42 billion in net losses alone, with $ 9.1 billion in net losses coming from the US air industry. The IATA has estimated that airlines would struggle to break even if the oil prices settled around $35 a barrel. Unfortunately, jet fuel prices have held solid at above $70 for more than a year now. As both international and domestic airline providers search for a way to balance their budget, increase ticket prices are the short-term solution for a long-term problem.(10)
The effect of rising oil prices has minimized the margin between operating costs and revenues for the entire Airline Industry. As a direct result ticket prices have begun to rise to cushion financial positions of most airline companies. Consumers are now experiencing the impact of oil prices on fares, and the availability of those “cheap tickets”. Such companies as American Airlines, Continental Airlines, and Southwest Airlines have financially felt the pinch :
American Airlines: Annual fuel costs rose $80 million for every dollar increase in a barrel of oil, said Thomas W. Horton, the chief financial officer of AA. He has stated that the difference between January’s low and today’s price would translate to an increase of $3 billion a year. One JP Morgan analyst, Jamie Baker,suggested that American and others needed to raise fares in order to offset the fuel price hike. American has already implemented transatlantic and domestic fuel charges.
Continental Airlines: It's financial position is deteriorating, as a result they have canceled new aircraft orders, as well as, selling 24 Boeing 737-500 jetliners. Continental has stated that they will be cutting $800 million in labor costs as opposed to the $500 million they had originally projected.(9)
Southwest Airlines: Owns long-term contracts to buy most of its fuel through 2009 for what it would cost if oil were $51 a barrel. The value of those hedges soared as oil raced above $90 a barrel, and they are now worth more than $2 billion. Those gains will mostly be realized over the next two years.(6)(7)
Internationally, rising oil costs have lead airlines to implement the same oil surcharges on tickets. India’s Jet Airways announced its seventh hike in fuel surcharge within a 12-month period of $7.60 or 300 rupees. As much as the US consumer and airlines are fiscally strained by the rise of oil prices; the Indian aviation fuel prices are among the highest in the world and account for 40% of the operating costs for domestic airlines. Japanese airline, Singapore Air announced that it would increase fuel surcharges on its ticket prices in many of their long haul international flights. According to Bloomberg, the cost of a barrel of refined Singapore Jet fuel hit a record high of US$116.80 on Monday. It is now hovering around US$113 a barrel. S.A to Australia will increase from $67 to $75, as well as, a $36 surcharge on flights to and from Europe.(5)
What is Deregulation?:
• The process of removing government regulatory controls from an industry.
• The reduction or elimination of government power in industry, usually done to create more competition within the industry. (8)
History of Deregulation:
• From 1938-1978; the Civil Aeronautics Board (CAB) all domestic air transport, setting fares, routes, and schedules.
• CAB manipulated fares (long- haul, and short- haul) to ensure that airlines would have a good rate of return.
• In the 1970’s the CAB fell under new economic pressures due to the 1973 energy crisis and national stagflation.
• New technology innovations introduced the jumbo jet to Airline carriers. They favored the CAB because of gurenteed rates of return; however, passanger fares kept climbing.
• Economist feared that consumers would choose cheaper methods of travel and that regulation had lead the Airline industry to be "innefficant" and "pricey".
• Congress believes that the CAB was stunting the Airline Industries growth through subsides and shielding from market forces.
• In 1977, Jimmy Carter/ Congressional Democrats wanted to shift air transportation system to rely more on competitive market forces.
• The Act removed CAB regulation. (12)
• Lower fares
• Increase competition between airlines
• Exposes the Industry to free market forces
• Airlines have the ability to choose profitable routes
• Increased air safety standards
• Increased quality of service
Ted Sirvaitis (Sirvaitr)
Michael Outwin (Outwinm)
Alex Baranick (Baranica)
Kaitlin Van Wagner (Vanwagnk)
Cost Benefit Analysis