airline management- critical review of lcc vs legacy carrier atm-ii

Airline Management- Critical review of LCC Vs Legacy Carrier


By

P.S.ASHWIN KUMAR

Email Id: [email protected]

Cell no: 09885326003

Center: Hyderabad (Executive PGDALATM)

ABSTRACT:

The airline industry is a young industry. It has been well

regulated and protected, and this was probably necessary during the

establishment of operations at a satisfactory level of safety. However, like

in any protected industry, the protection resulted in the airlines becoming

fat and lazy, and the cost and effectiveness left a lot to be desired. World

over, the airline industry is seeing turbulent times with increasing

operational costs ,rising oil prices, decreasing passenger capacity and

other significant factors. Recently, a number of airlines filed for

bankruptcy. In an attempt to survive, airlines embarked on rapid cost

cutting initiatives. But there is one airline model that defies all this and

manages to bring in profit to the industry and the air travel within the

reach of common people, a business practice that is turning heads towards

it and forcing the conventional carriers to rethink their strategy and their

pricing, a model that is now being taken up as a case study in major b-

schools around the world. This is the world of the Low Cost Carriers. For

the past five years, low-cost airlines have been growing at more than 40

per cent a year, while the full-service airlines are yet to recover from the

crisis that hit them post 9/11. Many of these low-cost airlines, be it

Southwest Airlines, EasyJet, RyanAir or even AirAsia, have had such a

great run that they are taught as case studies at leading business schools

P.S.ASHWIN KUMAR (M.Tech, Aerospace), PGDALATM, HYDERBAD, EXECUTIVE BRANCH


across the world. And the CEOs of these low-cost airlines now see

themselves as a tightly-bound community of evangelists who have an

avowed mission: to make air travel accessible to more and more people.

THE LOW COST AIRLINE: WHAT IS IT?

Let us begin our analysis by taking up a traditional airline. It

has all the luxuries that money can afford viz. hot meals, frequent flyer

programmes, decent legroom, and a full complement of air-hostesses.

Now delete all this, and what you get, to say brusquely and simply, is the

low cost carrier. The low cost carriers do not offer any extra luxury like

those mentioned above, but it all comes down to making air travel more

affordable. They do not issue flashy tickets, do not have a transfer

connections, but operate on a point to point basis, do not have onboard

meals giving additional space for more passengers, spend more time on

the air than conventional carriers, have quick turnaround times in airports,

do not use busy and major airports but use secondary airports with lower

landing and parking charges. They maintain a uniform fleet to reduce

operational and maintenance costs. The merits of low cost carriers are

endless and the above mentioned features are some of the few. Let us go

ahead and see how these changes represent a paradigm shift in the ailing

airline and aircraft industries.

WHY A LOW COST AIRLINE?

Low cost carriers (LCC) satisfy a basic need of humans, the

need for man to travel, to explore, to push his boundaries and to connect

with people and places he had never dreamt of reaching. The rich man

travels by jet; the poor man by rail, bus or foot. But these means of

transportation are limited. Jet aircraft land only at big airports - what



happens to the urban man with rural roots who wants to visit his native

small town? What happens to the working woman who wants to visit her

family living far away from the big cities? LCC bridge the gap and fill the

need of the common man - they connect people in all walks of life to

different and previously untouched sectors in the country.

The low cost carrier industry is a nascent industry in India and so

this paper cites examples from global carriers that include Southwest and

JetBlue from the United States, RyanAir and EasyJet from Europe and

other regional carriers from Australia and South East Asia

NO FRILL SERVICE:

The fundamental and obvious principle of a low cost

carrier is that they operate a no frill service. That is to say, they do not

provide onboard meals, no complementary drinks, and provide nothing

more than the bare essentials. Instead of providing a menu of product

choices priced within a range, these carriers offer a single type of product,

coach system .This results in cutting the costs by upto 3.2%. No meals on

board mean you don't need the extra space for storage. Instead, you can

add seats. In the typical Jet and Indian Airlines layouts, one could

increase the seat factor by as much as 20 per cent by pulling out the

business class, reducing the seat pitch (how far the seat can incline), and

throwing out a couple of galleys. Now, if you can put in three extra rows,

then you get (6x3) 18 seats more. In a 120-seater aircraft, if you get 18

seats more, you are up by 15 per cent. Also, these airlines lack elaborate

loyalty programs, which necessitate extra employees, to provide more

personalized service, and expensive facilities, like airport clubs. Low-cost

airlines do not provide costly services, which are only profits enhancing

for a hub-and-spoke carrier able to extract a high level of rents from



customers with a high willingness to pay, business travelers. The main

advantage of the low-cost carrier is that it can compete on price, with the

high-cost traditional carriers.

POINT TO POINT CONNECTIVITY:

The next major feature of the low cost carrier is that

they operate on a point to point basis. That is, they do not offer

connecting flights like the traditional hub-and-spoke system. In this

system followed by most major carriers, the aircrafts have to wait at an

airport till all the connecting flights have come in. This, added with the

baggage transfer from one aircraft to another often leads to flights being

delayed. The system provides customers a high level of convenience but

creates operating inefficiencies In a point to point service, a passenger

traveling on two different aircrafts isn’t issued a single ticket. Instead, he

is given two tickets for the corresponding destinations. The passenger has

to carry his baggage from one aircraft to another and check in once again.

The airline doesn’t owe the passenger an explanation when the first flight

gets delayed and he is forced to miss the second flight. The contract is to

take the passenger from point A to B and if the airline doesn’t do it, it

returns the money.

THE DISTRIBUTION FACTOR:

Another factor on which the airlines cut costs is on

distribution, which can be 11-15 per cent in a conventional airline. They

do this by not going through the travel agents and the existing central

reservation systems like Amadeus and Galileo. Instead, they sell through

the Internet and call centers - EasyJet in Europe even has its website

address painted on its plane. These airlines don't issue a ticket, as it costs



to print mail and process tickets. What the passenger gets instead is a

booking number when he makes a reservation. Passengers have to quote

this number at airport check-ins, and present their photograph ID to

collect their boarding pass. Air Deccan, has developed its own online

booking system, which has helped it reduce the distribution cost by a

major margin.

LABOUR COSTS:

One of the major factors in reducing the airline operation

cost is in labour costs. The higher number of personal required per flight

to effectively operate a traditional hub may be an important factor in the

different cost structures of traditional and low-cost carriers. The two most

prominent low-cost carriers, JetBlue and Southwest, both have lower

labor costs than the large incumbent carriers. Analysts estimate that Low-

cost carriers such as Southwest and JetBlue have labor costs 30% to 40%

lower than the mainline carriers. For example, United Airlines, American

Airlines, Northwest Airlines, and Continental Airlines all have costs at

least 40% higher than Southwest. Although, Delta Air Lines and Alaska

Airlines have the lowest costs of the majors, each of them has unit costs

30% higher than Southwest’s. While labor costs are the largest single cost

item for airlines, there are many other costs. The cost differential between

the low-cost and major carriers is not only attributable to the wage

differential. Although, the primary cost for any carrier is labor related.

Controlling labor costs can improve the bottom line. The operating cost

distribution suggests that lowering labor costs by 10% can lower the

average airline’s total cost by 36.8%.

LONGER FLYING HOURS



The low cost carriers manage to bring in more revenue

by being on air for a longer time than conventional carriers. This enables

them to cut the fare further. While most full-service airlines like Jet take

at least an hour to leave an airport after landing there, Deccan can do it in

15-20 minutes for ATRs (and about 30 minutes for its new A320 service.)

So, if Deccan does six sectors a day, it can fly one additional sector a day.

This allows it to fly 20-30 per cent more than a full-service airline. On an

average, the conventional airlines fly their aircraft for 8-9 hours a day,

while a low-cost carrier is able to keep its planes airborne for 11 hours a

day. It is only by more hours of flying that you can give a lower price,. In

fact, it is able to make the same revenue with fewer aircraft.

DIFFERENTIAL PRICING SYSTEM

One of the remarkable features of Air Deccan, the low cost

pioneer, is a differential pricing system. This was introduced previously

as Apex fares by the major players, which allowed the passengers to buy

tickets at a price that was as low as 40 percent of the original fare. In the

Deccan system, the price of a ticket is as low as Rs.500 for those who

book there tickets 3 months prior to their journey. And it increases as the

days decrease. Even then, the last day fare comes only to about 60-75%

of other carriers. This is done to generate a good passenger capacity,

known as the Passenger Loading Factor (PLF). Air Deccan at present has

a PLF of around 75% while other carriers have only around 40-50%. This

not only generates the required revenue, but reduces the operating costs

too.

UNIFORM FLEET:



The low cost airlines usually maintain a uniform fleet of aircraft.

This reduces the costs involved in training personnel, maintaining the

fleet and allows the airline to shift its pilots and workmen between

aircrafts easily. It also won't have to worry about carrying spares for three

different kinds of aircraft. That generates economies of scale.

USAGE OF SECONDARY AIRPORTS:

A major factor involved in the cost reduction, not followed

in India though, is the usage of secondary airports. For every major

metropolitan airport there are often two to three secondary airports. Low-

cost carriers can achieve fast turnarounds and pay less for leasing airport

facilities at secondary airports Low airport lease rates and gate costs also

contribute to the lower cost structure of low-cost carriers. Under utilized

secondary airports often levy lower charges for the use of their facilities.

In comparison, hubs require a large number of gates and personnel per

flight, due to the banks of flights that are used at hubs. The banks of

flights result in the majority of flights arriving and departing within 20-30

minutes of each other. These peak periods result in a high demand for

facilities and personnel for short periods of time. For example, at its

Dallas Fort Worth hub, American operates banks of flights to make

connections convenient. While at neighboring Dallas Love Field

Southwest spaces its flights out due to the lower emphasis it places on

connecting traffic. Like other hub-and-spoke carriers, American Airlines

has peak times when a considerable number of planes land at its hubs and

passengers rush off to get on their next flight. The system provides

customers a high level of convenience but creates operating

inefficiencies. Employees stand around between peaks. Planes sit on the

ground longer and get caught in line waiting to take off. The hub-and-

spoke structure raises an airline’s costs at a hub compared to operating P.S.ASHWIN KUMAR (M.Tech, Aerospace), PGDALATM, HYDERBAD, EXECUTIVE BRANCH


that same hub with a de-peaked structure. In particular, the higher number

of personal required per flight to effectively operate a traditional hub may

be an important factor in the different cost structures of traditional and

low-cost carriers.

THE IMPACTS:

INCREASE IN PASSENGER DENSITY:

The entry of these low-cost carriers will have several far-reaching

implications for the aviation sector in India and, to a wider extent, on the

mass transportation industry and domestic tourism. In a country of a

billion people, the Indian aviation industry is puny. We have 12 million

people who travel by air every year against 3 million passengers who fly

everyday in the US, even though its population is one-fourth that of India.

The number of daily flights in India averages just about 400 a day, as

against 40,000 flights a day in the US. RyanAir, among the low-cost

pioneers in Europe, flies 25 million people in a year and still has less than

5 per cent market share. Closer home, in Malaysia, there are 12 million

people who travel by air yearly. Look at it another way: India's 200-

million middle-class population is equal to that of the whole of Europe.

Even if we assumed that only one-fourth of that large middle-class could

afford and would be willing to travel by air, it would call for at least a 5-

6-fold increase in capacity.

DEMAND FOR AIRCRAFT:

The increased demand for air transportation triggered by the entry of the

low cost airlines will in turn generate a demand for newer aircrafts to

meet the demand. The aircraft industry which had been facing a declining



trend after the September 11 attacks is now facing brighter times with the

order for aircrafts. In the year 2002, RyanAir’s order accounted for 54%

of Boeing's 184 aircraft orders year to date while EasyJet order accounted

for 44% of that years order at Airbus - so the terms are likely to favour

the airlines. In India, the present aircraft strength of 174 of all the

aircrafts put together is set to touch 307 in the next 5 years. Air Deccan

has ordered 32 new aircrafts worth around 2 billion USD to expand its

fleet. Another low cost carrier in the offering has ordered 30 aircrafts

worth around Rs.8000 crores. All this leads to an increase in the demand

and development of new aircrafts with an eye on reducing maintenance

costs and increased efficiency.

GROWTH DRIVERS:

The growth drivers for the low cost carriers are stipulated below

State of the economy

Market stimulation from low-cost carriers

Price cuts

Increasing customer acceptance for flying

THE CHALLENGES:

A study by the Mercer Management consulting company finds

that the yield of the low cost business model is expected to decline due to

Surplus capacity

Struggle for survival among carriers in poor financial straits

Competition from low-cost carriers

Further market entrances from new competitors

The report finds the challenges faced by the LCC include:



Rapid occupation of new markets (first mover advantage)

Build up and safeguard dominant market position

Strict cost management and retention of pure low-cost business

design

A recent study by the McKinsey & company finds that

world over the low cost aircraft industry will grow at a tremendous pace

till the year 2007 after which it shows a decline which is attributed to

three reasons :

Increasing competition among low cost carriers in international

traffic

Strong position of national airlines on important domestic routes

Dominance of the tour operators in the package tour segment for

pure tourist destinations

THE FUTURE:

So, what are the possible future scenarios? Over the next few years, one

can expect to see a complex system of low-cost airlines. Depending on

the amount of capital they are able to raise and the business plan they

formulate, some will ply on the trunk routes, others on the Class A and B

towns and then, some will operate purely as air taxis. In India, for the

moment though, Deccan remains a small player, flying just about 1,600-

1,700 passengers a day and expects to achieve a turnover of Rs 450 crores

by end of March 2005. Jet, on the other hand, had operating revenue of

Rs 2,876 crores in 2002-03 with a fleet size of 41. So the critical question

is: do the LCC have the deep pockets needed to withstand a price war?

Much will depend on how traditional carriers react. One possibility is that

they could begin offering more seats under the apex scheme fares than the



current level of 5-10 per cent. Fortunately, a low-cost airline has the

advantage of being a model that throws up cash much faster than its full-

service counterparts. So, if Deccan can survive the price war for the first

year or so and scale up, it will soon reach a size where Jet and the rest

cannot undercut without losing massively in the bargain. It is always

simpler to drop prices if you are trying to take on a company with just

three planes. If, Air Deccan, however, scales up fast to 100 planes or so,

the others cannot undercut it without maiming themselves. Even if it does

scale up, there's another possibility: success will soon attract imitators. In

Europe, the original pioneers, RyanAir and EasyJet, are suddenly faced

with too many new competitors in the same low-price segment, sparking

off an intense price war. To attract customers, they are cutting prices to

unreasonable levels, impacting the profitability of the entire sector, say

analysts. Some low-cost airlines also lose their bearing and begin adding

frills like assigned seating, hot meals and in-flight entertainment to attract

some of the more comfort-seeking customers. But that leaves them

exposed to being undercut by a new competitor who focuses exclusively

on price. Anything (like frills) that adds costs and reduces price

competitiveness is a bad trade-off. After all, if you get them on price, you

could lose them on price too. In the low-price sector, only those with the

lowest costs survive in the long run, and scale does matter in delivering

the lower costs. After all, it comes down to good business management in

the end.

CONCLUSION:

World over, low-cost airlines have begun to radically change

the rules of the business. In market after market - be it in the US,

Europe and, now, Australia and South-east Asia - the low-cost model



has expanded the market, and gained significant share. Full-service

airlines have responded in one of three ways: restructure their

operations, launch their own low-cost airline. Or simply get crippled

whatever is the outcome, the customer is the winner.

SOURCES:

o The New Low Cost Warriors – Business World, July 5,2004

o Low-Cost Carriers and Low Fares- Charles Najda,Department of Economics ,Stanford University

o Flights of Fancy – The Industrial Economisto Impact of Low Cost Airlines :Summary of Mercer Study –

Mercer Management Consultingo The Emerging Airline Industry – A joint study by A T

Kearney ad the Society of British Aerospace Companieso Budget airlines in Europe – McKinsey & Companyo Low Cost Airlines, A revolution in Asian Airline Industry-

Derek Sadubin, ALAANZ conference, Sydney
