Air Carriers. Competitive Indicators and Drivers of the German Domestic Aviation Market

Table of Content

List of Abbreviations

List of Tables, Figures and Equations

1. Executive Summary

2 Introduction
2.1 Current Profitability of Airlines
2.2 The Significance of Costing in the Airline Industry

3 The General Spreading of Costs

4 Classification of Expenses
4.1 Non-Operating and Operating Costs
4.1.1 Non-Operating Cost
4.1.2 Operating Cost
4.2 Concept of Cost Escapability

5 Determinants of Costs
5.1 Controllability of Costs
5.2 Break-Even Load Factor
5.3 Total Operating Cost and Unit Cost
5.4 Influence of Demand
5.5 Externally Determined Input Costs
5.5.1 Fuel Prices
5.5.2 Airport and En-Route Charges
5.6 Cost of Labour
5.7 Aircraft Type and Attributes
5.8. Network Characteristics
5.9 Economies of Scale, Density and Scope

6 Conclusions

List of References

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

List of Tables, Figures and Equations

Equation 1: Break-Even Load Factor

Figure 1: General Distriubtion of Expenses

Figure 2: Fuel Consumption and Sector Distance

Table 1: Operational Cost Shares of Air Carriers ICAO Members States

Table 2: Degree of Management Control regarding different cost items

1. Executive Summary

This paper deals with cost drivers in the airline industry. A theoretical approach including examples is used. The objective is to gain a clear understanding of what problems airlines are facing within the industry and about the challenges they have to master concerning cost related topics. What are the key determinants behind cost related figures? This paper consists of five major parts. The first part explains the necessity of costing. Why should this topic be taken into account with regard to the airline industry? Therefore, a presentation of profitability within the industry and the significance of costing is presented. The second part demonstrates an overview of the general spreading of expenses, while the third part displays the categorization of costs. This is crucial for a clear understanding of the business; therefore, non-operating aspects have to be excluded. The last section deals with cost topics from different perspectives, such as e.g. total cost, unit cost or external cost factors. Essential matters such as the controllability of costs or BELF are additionally taken into account.

2 Introduction

Despite recent years in which many airlines could improve their profitability, costing is still a very important matter, and a challenge airlines have to address. Since ticket prices are mostly set by market forces, managers can try to expand margins by reducing costs. Many low-cost carriers have carefully monitored their costs, one reason why their profits are among the highest.

The industry is facing severe issues such as climate change, fuel prices, pilot shortages, technology changes (Industry 4.0) and congestions. But also, full service carriers such as Lufthansa have proved that profitability is possible, despite a difficult environment.

2.1 Current Profitability of Airlines

“If you want to be a Millionaire, start with a billion dollars and launch a new airline Sir Richard Branson in October 2001

The answer of Richard Branson to how one becomes a millionaire stresses out the difficulty of airlines to make money, although it is anything else than impossible as the current market situation in the airline sector proves.

At the beginning of December 2017, IATA has published a press release commenting on the overall shape of the airline industry in 2017. In matters of profitability of air carriers worldwide, it included an outlook for 2018. Accordingly, profitability of airlines continues to be strong in 2018, with a slight reduction in operation margins (8,3% in 2017 to 8,1 %) and a small improvement considering net margins, precisely an increment of 0,1 % to 4,7 % in the year ahead. The average net profit per departing passenger at 8,90 USD, with a slight increase of 0,45 USD compared to 2017.

Despite a profitable year for the industry in 2017, the biggest challenge for 2018 is to deal with rising costs. The major cost drivers to be fuel prices and labour costs. Moreover, unit costs were expected to grow by 4,3 %.1

Doganis clarifies that profits seem to be closely connected and thus influenced by the world economic climate. In the event of an economic downturn or stagnancy, the¹ growth in demand reacts correspondingly, no matter if passenger or cargo related. The same applies to economic recoveries.

The airline business is very cyclical due to several factors. Determinants affecting financial performance highly differ between the region or market the airline operates in.²

The airline business is quite dynamic and consistently subject to hasty and unforeseen variations in the costs of many of its inputs. This demonstrates why a proper understanding of costs is essential in order to make favourable decisions within an air transport service organization. In general, there are four main cost information elements, which have to be categorized according to the following key requirements:

- General breakdown of total expenditures and categorization of different cost items: This may be used for general management issues and is valuable in terms of accounting themes. The breakdown of costs is beneficial for displaying certain trends over time and to provide a tool of measurement regarding cost efficiency of areas such as flight operations.
- Accurate cost information and knowledge: In order to master operational challenges, well thought-out decisions have to be made, considering e.g. the determination of whether to add or reduce frequencies on an existing route.
- The identification of specific cost objects: This is pivotal looking at pricing policies and pricing decisions.
- Evaluation of expenses: This is crucial regarding any type of investment decision, no matter if new aircrafts have to be purchased or it is thought about launching a new route.

None of these requirements is adequate of satisfying all managerial needs at the same time. Every airline needs to figure out the purpose and nature of a decision, taking into account the necessary cost information it needs to produce a fruitful result. The categorization of cost is mainly influenced by accounting standards of each home country as well as by the ICAO.³

In Europe, LCC’s such as Ryanair offer ticket prices far lower than they used to be in former years. Ryanair does have this capability of offering such low fares because of its persistent monitoring of cost related issues such as e.g. crew productivity, aircraft utilisation, state of the art aircraft or less ground handling fees.⁴

A look at Lufthansa’s annual report shows an astonishing number of 418 cost-related words including words such as unit cost, cost reduction or cost structure, just to name a very small fraction. This shows the significant efforts and focus the management puts on cost issues to satisfy and convince investors with crucial information.⁵

3 The General Spreading of Costs

A general distribution of costs is necessary to get an overview of major expenses. The following graph presents dominant cost items of European Airlines.

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: General Distribution of Expenses6

Huge cost components are both fuel and employees with a total share of 30 - 40 % of total expenses. Especially employee expenses cover an immense proportion. Fuel costs show a smaller but still abundant variation, in any of the airline operators responsible for 10 - 15 % of total costs. Selling costs show considerable variation between airlines, this may imply a substantial degree of management control. The same applies for materials, with differences of up to 25 % between air carriers.

In 2017, the German full-service carrier Lufthansa had a cost distribution of 15 % in fuel costs, 23,5 % in labour costs as well as fees and charges of around 18 %.^{6 7} The American low-cost carrier Southwest announced a share of 22 % in fuel costs and 40% was related to issues concerning labour. They had to spend a proportion of roughly 7 % in fees and charges.⁸

4 Classification of Expenses

4.1 Non-Operating and Operating Costs

With the intention of comparing expenses and income within an industry, non-operating costs have to be excluded. It should be noted that the categorization of costs is not always standardised, different perspectives and purposes of use lead to distinctive ways of displaying cost structures. Accounting principles of nations must be taken into account, too. The good news is: Most airlines have adopted the ICAO recommendations of how to categorize and visualize a mutual framework of expenses.

4.1.1 Non-Operating Cost

Non-operating expenses are not directly related to the business. The consecutive five elements represent the categorization of non-operating costs:

1. Gains or losses resulting from retirement of property or equipment, no matter if aeronautical or not. These concerns appear if there is an inequality between a depreciated book value and the value at the end of a period, when the good is retired or sold off.
2. Interest paid on credits and interest received from banks. Some carriers categorize interest paid on A/C-related loans as operating costs.
3. Gains or losses resulting from affiliated companies. Few of them are directly operating in the airline sector.
4. A variety of cost elements which are not classifiable in the categories 1 - 3. (e.g. losses or gains from currency exchange, sale of shares)
5. The last category is all about expenses related to taxes and governmental subsidies. Years ago, governmental subsidies played a significant role.

For some air carriers, non-operating elements played a crucial role in the overall strategy and performance.⁹

[...]

¹ Cf. IATA Press Release (2017): Outlook for 2018, Online

² Cf. Doganis (2005), pp. 4-6: It can be debated if GDP affects Air Services or vice versa.

³ Cf. Doganis (2010), p. 64

⁴ Cf. Zuidberg (2014), Online, p. 86.

⁵ Lufthansa Group Annual Report (2017), Online

⁶ Figure 1: Heitmann, (2005), Online, p. 116

⁷ Lufthansa Group Annual Report (2017), Online, p. 33

⁸ Southwest Airlines Annual Report, (2017), Online, p. 84

⁹ Cf. Doganis (2010), p. 65