The Traditional Airline Industry - Essay Example

Table of Contents Low-Cost Airlines 2 Business Models That Define the Airline Industry 2 Economics Of the Airline Flight Industry 3 The reasons for the success Of Low-Cost Airlines 5 Lessons for Traditional Airlines 9 Conclusion 12 References 14 Low-Cost Airlines Introduction “In 2001, while most traditional players reported losses and some succumbed to the competition, Europe's leading low-cost carriers were more than merely profitable: Ryanair and easy Jet boasted operating margins of 26 and 9.5 percent, respectively--results that traditional airlines only dream about” (Binggeli & Pompeo, 2002) Low-cost airlines have achieved a high degree of success in the airline industry. They have gained a significant market share in short-haul domestic flights and have even begun to penetrate into the long-haul markets. They have achieved this success in an industry that traditionally has operated on relatively small margins in a highly cyclical pattern. By examining the ways in which the low-cost air industry has succeeded in an otherwise fickle market will offer insight on sound management principles and efficient cost accounting. This paper will review those areas and suggest how perhaps to use these principles so that they can be applied to the financially under performing traditional airline. Business Models That Define the Airline Industry Placing low cost airlines within their context in the airline industry is necessary before proceeding to examining them. There are centrally three models in the airline industry. The first is the traditional model or the conventional airlines. They are characterized by scheduled flights offered in a network which is connected by airport hubs. They serve passenger and freight and operate on the basis of high fares. The other two models are based on lower costs, offering cheaper flights to customers. Within the context of low-cost flights there is the older model of charter flights and the more recent advent of low frills and low cost flights. Charter flights originally began as almost a rental of flights by special event organizers who were interested in taking groups of individuals willing to pay the cost to special events, like for example sporting events. The decreased regulation that these types of flights faced allowed them to operate at lower costs. From these origins the concept of low frills and low cost budget flights emerged. Low-cost flights market share were initially small but today they have 13% of the international flight market in Europe which is the biggest low-cost flight market in the world. Economics Of the Airline Flight Industry A brief excursion into the economics of costs in the airline industry is necessary at this point before elaborating on the success the low-cost industry has achieved. The traditional airline industry has been marked by traditionally thin profit margins. This appears counterintuitive considering the scale of the operations in question but it has been a function of decreasing operating costs at the expense of rising capital costs. Since its early beginnings in the 1950s the airline industry initially saw a steep curve in technological advancement. Technology advances progressed into the early 70s. These advances resulted in much increased fuel efficiency reductions while also seeing increases in carrying capacity. These to changes would appear to translate into increased profit margins since the costs were exponentially decreased. The problem however was the steep cost of this technological advancement. The problem however was the prices of planes increased markedly. The capital investment required to finance airlines went beyond the capacity of individual carriers. There then emerged larger financing organizations which took on these financial burdens and leased the planes out to individual carriers. Considering the financial investment by the financial conglomerates they continued to lease out planes to carriers even when the financial records of these carriers were subpart. This scenario could not continue indefinitely and eventually some measure of financial discipline was imposed, nevertheless the overall pattern of the airline industry was not one of strict accountability and careful management. In some ways the industry was sustained by the low cost of fuel during his time in the 70s. Relying on the fluctuations of this commodity however was to take its toll on the industry as prices increased. Airlines were famously going bankrupt as fuel costs rose. It is into this undisciplined market that the potential charter flight industry grew: "Some low-cost carriers seem to have found the key to success. Having slashed fares by as much as 70 percent, low-cost airlines now hold 15 percent of total traffic" (Barkin, Hertzell & Young, 1995, p. 86) Today low cost flights dominate up to two thirds of the international flight industry in the European Union. The reasons for the success Of Low-Cost Airlines “Charter airlines present an enigma. They fly passenger aircraft similar to those of their scheduled counterparts, often on the same routes. Most of their input costs, such as those for fuel or maintenance, are similar too. Yet, when they compete head-on with scheduled airlines they can sell their seats at one-third of the latter's average fares and still make a profit. How do they do it? This is the enigma.” (Doganis, 2002, p. 151) Rigas Doganis uses the principles of managerial accounting to analyze the relative cost advantages that the low-cost air industry achieve compared to traditional airlines. This is a most effective method since the principles of managerial accounting precisely allocate costs, both direct costs and indirect costs in the running of a business enterprise. These principles allow one to systematically analyze all of the costs of the enterprise and seek methods in which to reduce them. Also, these principles allow comparison between industries to demonstrate the relative advantages and disadvantages. In the area of direct costs Doganis suggests that flight operations account for the majority of the expenditures. In this area he suggests with the traditional airlines enjoy a marginal advantage over low-cost airlines because of their larger size and their established relationships with suppliers. Taking them one at a time it is possible to see the patterns. Fuel costs would appear to be uniform for both types of industries, however the transport of fuel to these areas depends in large part on established patterns of use. Here the traditional airlines will have an advantage since their routes are firmly established and less influenced by patterns of demand which is the case in low-cost airlines. In the area of navigation route costs low-cost airlines have an advantage since they are willing to use cheaper off route airports, but when they use the larger hubs then they perform at a relative disadvantage from the established patterns of the traditional airlines. Maintenance costs tend to be uniform across all of the different airline models. The requirement for high uniform standard by safety regulating bodies ensures that quality is not sacrificed for price in this vital safety dimension. Insurance costs would appear to be an outside observer of high premium in the airline industry but typically this is a low-cost area no doubt because of the high safety record of the airline industry at large. In this area traditional airlines have a distinct advantage but still not a significantly large advantage in regard to cost. Capital depreciation costs are measured, in part, by utilizing the per hour utilization principles. In this regard low-cost airlines which are more demand driven tend to use more frequent rotations and especially during peak periods . Scheduled flights, on the other hand, operated by traditional airlines do not achieve the same utilization since they have lower rotations and therefore do not extract the same amount of premium for their capital depreciation and therefore their costs are higher. But this is not as significant an advantage as it appears. Overall this is not the area in which low-cost flights achieve their advantages. In direct costs there appear to be advantages and disadvantages in both the traditional model and the low cost model but overall the traditional model enjoys a marginal edge in costs. The real value in this analysis comes from an inspection of indirect costs which is the bedrock of managerial accounting principles. An examination of these indirect costs reveals the true picture. In the area of indirect costs low cost airlines achieve their initial advantage by their practice of subcontracting all of their baggage handling passenger management and smaller duties to independent companies. This figures to be more expensive on a per flight basis but when it is taken on a year-long basis it allows adjustments for reduced demand and also reduces many of the costs of keeping permanent staff in these areas. Adjustments in passenger management are interesting to observe. For flight attendants low-cost airlines employ on a seasonal basis and the continual rotation of staff that are not far removed from their home base to reduce overnight accommodation costs in this area. Other personnel are also paid at a lower scale including pilots, but this is offset by increasing current command for pilot services. The service costs become more apparent when one factors in the mule like nature of charter flights. They tend to operate on longer distances always for the underlying principle of maximizing distance in passenger load with each flight. When these considerations are taken into account low cost airlines achieve a dramatic advantage over traditional airlines in this area alone. But this is not the greatest area of their cost advantage. Low-cost airlines achieve their greatest in direct cost advantage in the area of ticket sales, promotions and sales. Low cost airlines to not require large infrastructures to sell their tickets or promote their products. Most of their business is conducted over the Internet. Indeed printing costs are completely supplanted by requiring customers to print out their own ticket from Internet-based booking. Furthermore they achieve indirect cost cuts having no need for sales agents and their commission costs since sales are made directly to the public. The spartan principles also apply to financial management as low-cost airlines try to minimize these areas as well. It is in the area of indirect costs and low cost airlines achieve the greatest advantage. Some of this is in direct cost advantages achieved in passenger services but the lion's share is achieved in the sales division which can account for up to 15% of cost for traditional airlines and is largely minimal for low-cost airlines. Allied to these savings is also the underlying egalitarian nature of the seating arrangements of low cost airlines. Operating at low cost principles obviates the need for business class. Therefore our low-cost airlines passenger seating becomes far more dense allowing a much larger passenger load. Lessons for Traditional Airlines Low-cost airlines achieve a significant part of their cost advantage over traditional airlines in the area of indirect costs. There are aspects of this business model that could be used in traditional airlines. The outsourcing of work to independent contractors based on competitive tenders would cut a great deal of cost from keeping on permanent staff, staff there often promised health benefits and pension benefits. These costs had considerably to traditional airlines but then there is a level of quality and traditional airlines would like to keep secure a certain niches over low-cost airlines. Reducing staffing incentives too much would result in the loss of quality personnel. Considerable cost reductions can be achieved by downsizing at the very least the ticket sales aspect of the operation in traditional airlines. Using the platform of the Internet would decrease the distance between customers and product and therefore reduce the cost of hiring middlemen with their associated commission costs. Increasing carrying capacity and airlines would be a conflict with the quality of the overall product. Since the designation of first-class seating requires use of space that is minimized in the egalitarian structure of low-cost airlines. This good be handled on a cost benefit analysis bases to see whether the extra revenue from offering premium class seating would offset the loss in carrying capacity. Indeed, the area in which the low cost airlines further readily succeed in which the traditional airlines could readily adopt are in the straightforward collection of accounts receivable. Low-cost airlines are known for quickly collecting funds owed to them. In large part this is due to the direct purchasing pattern of their business model which does not leave much in the area of accounts accrued. They further add to this by adopting the pattern of paying fuel costs in arrears so that there are large reserves of cash available in company accounts which are then kept in banking accounts at the appropriate time in the business cycle when maximum yields can be gained. In many ways low-cost airlines treat the whole service encounter as an opportunity to do business and therefore are in the practice of selling large volumes of on board cigarettes and alcohol and other gift purchases. Significant income is generated from the practice. Perhaps the most important lesson that traditional airlines can take away from low cost airline business models is the element of pre-planning which is underrepresented in the traditional airline model. Low cost airlines devote considerable time and resources to planning out and being responsive to customer demand. In this way they are able to adapt the product to when it is most in need and scale back in times of lower demand. The simple element of planning would cut considerable costs to the sometimes disorganized pattern of traditional airlines. Conclusion Low-cost airlines have made gradual inroads on the market share of traditional airlines. They achieve this by operating at lower costs which they in turn transfer to customers in terms of low-cost tickets. In terms of direct costs there's not much to distinguish the two business models. Using managerial accounting and taking into consideration indirect costs low-cost airlines achieve considerable cost reductions compared to traditional airlines. They do this in large part by outsourcing their passenger service on small term contracts where they are able to pay lower costs and wages. They further add to this cost advantage considerably by making sales directly to customers without the use of large-scale ticketing agencies and costly middlemen. The egalitarian nature of the seating arrangements allows a greater carrying capacity on the airlines. Some of these practices can be adopted by traditional airlines but at their own risk considering that customers may play a premium for better service. The reduction of the infrastructure of the ticket sales is definitely a lesson that traditional airlines should take away consider as a reasonable alternative to their tremendous costs in this area. There are three ways in particular though that deserve the most attention by traditional airlines. There is the elements of fore planning which should be considered in regard to the demand for their product. This would do much to counter the waste of over surplus of flights or missing opportunities by not offering flights were there is demand. In essence it means being responsive to the true demand patterns of the consumer public. The other area of major concern is better accounting so that accounts receivable are not too long delayed and prevented from earning their appropriate returns in investment. Finally there needs to be instilled in traditional airlines the philosophy that it is after all a business. Using the opportunities to sell retail products in the way that low cost airlines do would offer new ways to increase revenue without adding to cost. References Barkin, T. I., Hertzell, O. S., & Young, S. J. (1995). Facing Low-Cost Competitors: Lessons from US Airlines. The McKinsey Quarterly, (4), 86. Retrieved September 2, 2006, from Questia database: http://www.questia.com/PM.qst?a=o&d=5000392482 Binggeli, U., & Pompeo, L. (2002). Hyped Hopes for Europe's Low-Cost Airlines: Europe's Most Successful No-Frills Carriers Are Making a Lot of Money. but as They Mature, They Will Have Problems Expanding. 87+. Retrieved September 2, 2006, from Questia database: http://www.questia.com/PM.qst?a=o&d=5000843886 Doganis, R. (2002). Flying off Course: The Economics of International Airlines. London: Routledge. Retrieved September 2, 2006, from Questia database: http://www.questia.com/PM.qst?a=o&d=108443671 Ford, N. (2004, March). Low Cost Airlines Enter Gulf Market; Low Cost Airlines Have Revolutionised Travel in Europe, with Some Fares-Between London and Ireland or the South of France-As Low as 1 [pounds Sterling]. Now the Revolution Has Reached the Middle East. The Middle East 40+. Retrieved September 2, 2006, from Questia database: http://www.questia.com/PM.qst?a=o&d=5006550463 Macavoy, P. W. & Snow, J. W. (Eds.). (1977). Regulation of Passenger Fares and Competition among the Airlines. Washington, DC: American Enterprise Institute. Retrieved September 2, 2006, from Questia database: http://www.questia.com/PM.qst?a=o&d=99978741 Read More