The New Drivers of Airline ProfitabilityInfluence Service Decisions

Airline strategies to maximize profitability will continue to affect service decisions.

FINDING THE OPPORTUNITY IN CHANGE

The prolonged recovery from the financial and economic crises of the last few years has prompted new thinking

about airport planning. New challenges created by volatile oil prices, an aging infrastructure, scarce funding sources, and ongoing restructuring in the airline industry suggest that airport planning will need to be responsive to a constantly changing environment. This focus piece is the third in a series addressing challenges airport operators face in finding the opportunity in change.

l November 2011

Airline service decisions are increasingly infl uenced by the new drivers of profi tability. Th ese new drivers include charging passengers baggage and other fees, limiting

capacity to reduce costs and drive airfares higher, discontinuing the operation of uneconomical aircraft types, and eliminating “unprofi table fl ying” from their route networks. A better understanding of the factors that infl uence airline service decisions will allow airport operators to consider overall industry trends and airline specifi c strategies, and communicate the rationale for changes in airline service at their airports.

The Crude Awakening

The volatility of crude oil prices forced airlines to

develop new strategies to increase revenues and

reduce costs.

When fuel costs approached nearly 40% of airline operating costs in 2008, the U.S. airlines had already initiated strategies to charge baggage and other fees to off set the eff ects of rising fuel costs. Although fuel prices decreased in the last quarter of 2008 and in 2009, the airlines continued to charge ancillary fees to off set the eff ects of depressed demand related to the fi nancial crisis and economic recession. Between 2008 and 2010, the

FINDING THE OPPORTUNITY IN CHANGE

U.S. airlines collected more than $20 billion in ancillary revenues, including baggage, reservation cancellation, priority seating, and frequent fl yer fees.

A second strategy implemented by the airlines in response to increasing fuel prices was the retirement of fuel-ineffi cient aircraft and the discontinuation of “unprofi table fl ying” in city-pair markets where fuel costs made the routes uneconomical. Between 2007 and 2010, the airlines decreased seating capacity at U.S. airports by approximately 10%.

Ancillary fees provide a bridge to airline

profitability

“Our changes at Memphis are designed to improve the

performance of the hub by trimming unprofitable flying on

small, regional routes with little local demand and focusing

our service on flights to the top destinations that matter

most to Memphis customers.”

Bob Cortelyou, Senior Vice President, Network Planning, Delta Air Lines,

The Commercial Appeal, Memphis, Tennessee, March 22, 2011.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4$1.6

Bil

lio

ns

Baggage fees Reservation cancellation fees

12007 2008 2009 2010 20112 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1

Includes six network airlines (Alaska, American, Continental, Delta, United, and US Airways), seven low-cost carriers (AirTran, Allegiant, Frontier, JetBlue, Southwest, Spirit, and Virgin America), and seven regional and other airlines (Colgan, Hawaiian, Horizon, Mesa, Republic, Sun Country, and USA 3000).U.S. Department of Transportation, Form 41, Schedule P 1.2, as reported by the Bureau of Transportation Statistics, www.bts.gov.

Note:

U.S. DeSource:

l2

The New Drivers of Airline Profitability Influence Service Decisions

What is “Unprofitable Flying”?

The interpretation of “unprofitable flying” varies,

depending on how airlines evaluate the contribution

of a route to their overall profitability.

Th e phrase “unprofi table fl ying” often appears in press releases announcing reductions in airline service and has a meaning that is both clear and unclear at the same time. While it is clear that the airlines will reduce service on such routes, the reasons leading to that decision are less clear. Th e challenge in understanding “unprofi table fl ying” is that airlines make decisions in diff erent ways. Airlines with diverse aircraft fl eets, consisting of narrowbody and regional aircraft, and extensive hub networks can manage route costs by substituting smaller-capacity aircraft, adjusting frequencies, or rescheduling a route through an alternate hub airport. In contrast, airlines with one aircraft type that fl y point-to-point often discontinue service on a route that does not generate enough revenue to cover costs.

In addition to aircraft fl eets and route networks, airline service decisions are also infl uenced by external events. Since 2007, airline service in nearly 400 U.S. city-pair markets has been discontinued in response to increasing fuel costs, the fi nancial crisis, and the national economic recession. Th e eff ects of these events on airline service decisions depend, in part, on the aircraft operating costs of the airline fl eets.

“Flying Costs” Drive Airline Expenses

Flying costs are the largest component of airline

expenses.

Flying costs accounted for 73% of total airline operating costs in 2010, including expenses for fuel, labor, and ground handling and landing fees.

Flying costs are mostly variable and are incurred as a direct result of operating a fl ight. In contrast, aircraft ownership costs are fi xed and are incurred whether or not a specifi c fl ight is operated. Aircraft ownership costs accounted for 14% of total airline costs in 2010, including expenses for aircraft rental, maintenance, and depreciation. Overhead costs accounted for the remaining 13% of total airline costs in 2010, including administrative, marketing, and sales expenses.

Ancillary Fees Bolster Airline Revenues

Without ancillary fees, ticket revenues alone would

fall short of total airline costs.

It is diffi cult to know precisely how much the airlines collect in ancillary fees. Ancillary fees are included in various categories of airline revenues and, with the exception of baggage and reservation cancellation fees, cannot be identifi ed separately. In addition, ancillary fees are not reported by all airlines. In July

2011, the U.S. Department of Transportation (DOT) proposed a stand-alone reporting form to capture ancillary revenues, which met with considerable opposition from the airlines. At this time, the proposed reporting form has not been approved. According to the DOT’s Bureau of Transportation Statistics, ancillary fees totaled $8.14 billion in 2010, although no detail is available on the airlines reporting such fees or on the types of fees. What is known with some certainty is that baggage and reservation cancellation fees totaled $5.4 billion in airline revenue in 2010.

Airline cost and revenue strategies achieved profitability in 2010

Flyingcosts

$89.70 billion

Overheadcosts

$15.48 billion

Aircraft ownership

costs $16.96 billion

Total expenses in 2010 = $122.14 billion

Ticket revenues

$95.75 billion

Other revenues $2.36 billion

Reservation cancellation fees $2.30 billion Belly cargo and mail

$3.10 billion Baggage fees $3.40 billion

Transport related

revenues $22.86 billion

Total revenues in 2010 = $129.77 billion

Includes data for airlines noted in the graph on page 1.U.S. Department of Transportation, Form 41, Schedule P 1.2, online database, accessed October 2011.

Note:Source:

“As we continue to strengthen our business,

Delta is retiring the Saab turboprops and some

50-seat jet aircraft, which will hinder the financial

viability of serving these smaller markets.”

Delta Air Lines press release, July 15, 2011.

l3

The New Drivers of Airline Profitability Influence Service Decisions

Airline Fleets Matter

Differences in aircraft operating costs by equipment

type affect the contribution of a route to overall

airline profitability.

In an environment of fuel price volatility, it is no secret that small-capacity aircraft consume more fuel per seat than larger-capacity aircraft and have higher unit costs. Th e total cost per available seat mile (CASM) of small-capacity aircraft, such as the Embraer 135 and Canadair regional jet, ranks the highest of selected regional jet and narrowbody aircraft. However, other costs also aff ect the relative performance of certain equipment types. For example, aircraft ownership costs are 75% higher for the Canadair regional jet than for the Embraer 145, even though each aircraft has 50 seats. Similarly, ownership costs

are 51% higher for an Airbus 319 than for a Boeing 737-700, even though both aircraft have comparable seat capacity.

Prior to the increase in fuel prices, small-capacity aircraft were typically preferred on routes with low demand because it was more profi table to operate such aircraft than larger aircraft with low load factors. When fuel costs account for a larger share of total operating costs, the economic balance shifts. A route operated using a small-capacity aircraft is no longer more profi table than a route operated using a large aircraft and, if fuel costs keep increasing, the contribution of certain routes to profi ts could be negative.

To illustrate this shift in aircraft economics, consider a 400-mile route with demand of 120 passengers daily each way and an average one-way fare of $125, as shown in the table below.

Using the CASM by equipment type presented in the bar graph, a route operated with Canadair regional jets contributes less to airline profi ts than if a B-737-700 aircraft with a 44% load factor were operated on the same route. However, in an environment of scarce resources, there is an opportunity cost of underutilizing a large aircraft in a small market. Th e opportunity cost is in potential lost revenue if the aircraft were operated on a route where an 80% load factor could be achieved.

When Fuel Prices Increase

All bets are off.

In recent years, fuel price increases have been one of the most signifi cant external shocks confronting the airline industry. Th e fuel price spike in 2008 resulted in a 50% increase in airline fuel costs. If fuel costs were to increase 50% today, the contribution of a route to overall profi tability would decrease if the airlines are not able to pass on that increase to passengers through higher airfares

Flying and ownership costs vary by equipment type

Co

st p

er a

vail

able

sea

t m

ile

(cen

ts)

Flying costs include expenses for fuel, labor, and other costs.Aircraft ownership costs include expenses for aircraft rent, maintenance, and depreciation.

ESG Aviation Services, The Airline Monitor, August 2011.

Notes:

Source:

EMB-135

EMB-145

CRJ700

MD-80 EMB-190

A319 B-737-700

A320CRJ 100-200

Fuel Labor and other Aircraft ownership costs

0

5

10

15

20

25

9.54

5.58

5.223.89

3.47

6.80

2.24

5.963.41

1.49 1.42

3.17

4.58

1.61

2.19

4.03

1.63

2.68

3.56

1.26

2.75

3.30

1.491.82

3.090.982.04

“This new fleet will dramatically improve

our fuel and operating costs, while

enhancing our financial flexibility.”

Gerard Arpey, CEO, American Airlines,

CNNMoney, July 20, 2011.

Equipment types affect a route’s contribution to airline profits

Assumptions for this table include a demand level of 120 passengers daily each way, a one-way airfare of $125 (for daily fare revenue of $15,000), and a 400-mile flight segment. It is also assumed that the total demand and revenue on the route is not affected by flight frequency.Route contribution equals fare revenue (excluding ancillary fees) less operating costs and does not include an assessment of overhead costs or “beyond” revenue and costs. Opportunity cost equals the additional revenue obtained with an 80% load factor.

CASM—ESG Aviation Services, The Airline Monitor, August 2011. Estimated route contribution and opportunity cost—LeighFisher, October 2011.

Notes:

Sources:

SeatsEquipment Dailydepartures

Loadfactor

Totaloperating

costs

Availableseat

miles

Routecontribution

to profits

Opportunitycost (potential lost revenue)

$ 000

5,4004,960

10,46012,06013,22014,600

$ 3,2778,9286,7288,0788,3447,2907,8375,5397,766

$ 11,7236,0728,2726,9226,6567,7107,1639,4617,234

59,20060,00060,00081,60079,840

101,840108,240112,880118,400

81%80%80%59%60%47%44%43%41%

433322222

37505068

100127135141148

EMB135EMB145CRJ 100-200CRJ 700EMB190A319B-737-700MD-80A320

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555 Airport BoulevardSuite 300Burlingame, California 94010 U.S.A.Tel: +1 650.579.7722www.leighfi sher.com

Copyright © 2011 LeighFisher—All Rights Reserved.

Prepared by Linda Perry, with contributions from

Mark Taylor.

For further information, please contact:Linda Perry—linda.perry@leighfi sher.com

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The New Drivers of Airline Profitability Influence Service Decisions

or fees. Th e graph to the right is based on the 400-mile route with a demand of 120 passengers daily each way discussed earlier and does not incorporate an increase in airfares to off set increased fuel prices. It is important to note that the route contribution of similarly sized aircraft varies considerably when fuel prices increase. For example, the route contribution of the Canadair regional jet is considerably lower than that of the Embraer 145, its 50-seat counterpart. Similarly, the route contribution of the MD-80 is considerably lower than that of the similarly sized B-737-700 and A320 aircraft. American Airlines, with more than 200 MD-80 aircraft in its fl eet, recently placed an order for 460 Airbus and Boeing aircraft as a hedge against increases in future fuel prices.

Unlocking the Black Box

One of the keys to unlocking the black

box of airline service decisions is a better

understanding of aircraft operating costs and the

fleet options of specific airlines in matching capacity

to demand.

All airlines do not make decisions in the same way. An airline with a diverse aircraft fl eet and an extensive hub network may decide to serve a particular route using a mix of large- and small-capacity aircraft during diff erent times of the day and scheduling fl ights through alternate hub airports. In contrast, another airline with one aircraft type may serve the same route with fewer fl ights. Th e challenge, or perhaps the

“We just have a lot of flights that aren’t profit-

able and with these fuel prices, there’s obviously

no way to change these economics.”

Gary Kelly, CEO, Southwest Airlines, The Atlanta

Journal-Constitution, July 12, 2011.

In route profitability analysis, a point-to-point network is assumed to exist

and a route’s contribution to profits is determined independently from any

connecting flights within the network.

In network profitability analysis, a route is considered part of a larger system of

passenger itineraries consisting of multiple flight legs. The objective is to show

the contribution of a route to overall or network profitability. Consequently,

network profitability analysis also includes costs and revenues from connecting

passengers into the calculation of a route’s contribution.1

It is important to note that many routes in a network are operated to feed the

hub and fill larger aircraft. Thus, while an airline will always want to realize

revenue such that an individual route can be called “profitable,” an airline may

still operate routes that do not appear profitable for other network or strategic

reasons.

Route vs. Network Profitability Analysis

1 Niehaus, T., Reuhle, J. and Knigge, A. (2009). Relevance of route and network profitability analysis for the network management process of network carriers. Journal of Air Transport Management, vol 15, 175-183.

opportunity, for airport operators is to cultivate an analytical approach to understanding airline service decisions at their airports considering their particular mix of airlines. With this understanding, airport operators can consider overall industry trends and airline specifi c strategies, and can communicate the rationale for changes in airline service at their airports.

A route’s contribution to profits varies by equipment type

when fuel prices increase

(10,000)

(2,000)

(4,000)

(6,000)

(8,000)

0

2,000

4,000

8,000

6,000

$10,000

2010 fuel costs

Route contribution equals fare revenue (excluding ancillary fees) less operating costs and does notinclude an assessment of overhead costs or connecting passenger revenue and costs.CASM—ESG Aviation Services, The Airline Monitor, August 2011.

Note:

Source:

Ro

ute

co

ntr

ibu

tio

n t

o p

rofi

ts

50% Increase in fuel costs: 100% 200%

EMB-135

EMB-145

CRJ700

MD-80EMB-190

A319B-737-700

A320 CRJ 100-200