Unisys R2A ScorecardAirline Industry Cost Measurement

A thought leadership publication by Unisys R2A Transportation Management Consultants

Volume 5 • Issue 11 • August 2007

Editor-in-Chief

Ron Kuhlmann

Editorial Board

Olivier HouriJohn L. Strain

Managing Editor

Susan Hunter

Graphic Design

Creative Media Services

Publisher

Unisys Corporation

The Unisys R2A Scorecard is published monthly by Unisys

Corporation. This report may be copied, in whole or in part,

provided all legends, copyright, proprietary and other notices

which appear herein are reproduced, and the following,

prominent acknowledgement is added: “Reprinted with

permission of Unisys Corporation.” This document is also

available on the Unisys Global Transportation Web site,

http://www.unisys.com/transportation

Address reader inquiries to Ronald Kuhlmann, Unisys

Transportation Management Consultants, Unisys Corporation,

Suite E1-107, Township Line Road, Blue Bell, Pennsylvania,

19424-0001, USA. mailto:ronald.kuhlmann@unisys.com

Unisys is a registered trademark of Unisys Corporation.

Other trademarks referenced in the Unisys R2A Scorecard

are the property of their respective owners. Unisys makes

no warranty as to the accuracy of and shall not be liable

for damages incurred as a result of reliance on information

in this document.

Unisys R2A Scorecard: Airline Industry Cost Measurement

Copyright © 2007 Unisys Corporation. All rights reserved.

Airline Industry Cost MeasurementVolume 5 • Issue 11 • August 2007

Unisys R2A Scorecard

2

Editor’s NoteOne of the stock words used for describing our world is

change. The constant invocation of the word can become

quite tiresome, as can be the constant realignments

that underlie its frequent use. Human history has never

been static but what distinguishes our time is the pace

with which new stuff, ideas, processes and goods appear

on our radar. The new iPhone, acknowledged by many

to be breakthrough technology has a large cadre of folks

waiting for the next release, which is assumed will be

even more advanced.

Aviation, an industry still in constant turmoil, must

anticipate new challenges even as the carriers operate

in the present. Is it possible to plot a course while

chasing moving markers? See if this helps.

Coming Up• 2007, The First Half

• Revenue Management, A Different Game

3

How Did That Happen?

We learn it early on – to be ready. In every household

there is the perennial question, “Are you ready yet?” Boy scouts

and girl scouts learn to “Be Prepared.” Living in California, every earth

tremor is followed by news articles and broadcasts which once again remind

us to stock up on the requisite items in case the “Big One” should occur.

We all know, and often learn the hard way, that preparedness is a good strategy.

Many times the consequences of inaction are simply inconvenient but at other times,

the repercussions can be substantial.

This month we will look at the “preparedness factor” in aviation, where it has been

anticipated and worked, where surprises have occurred and where the potential

traps lie. Change brings new opportunities and threats and it is a word that has been

virtually synonymous with this industry for almost a decade. As we were reminded at

the Travel and Transportation conference by Dr. Gohde from Lufthansa Systems, it is

not the presence of change but the accelerated pace of change that has dashed many

previous planning systems, reducing time for adaptation and adjustment. The question

then becomes one of how to cope with new situations and technology – some of which

are anticipated but essentially unknown.

But this blurring has also meant profound changes for

the new generation carriers as well. Sensing that a price-

focused race to the bottom was not a good strategy for

them either, the “low-cost” model has been fashioned in

many different variations, making the definition hard to

specify, even among those airlines that make up this

group. Some have opted for two-class offers, some have

included in-flight entertainment options, some offer minimal

amenities for free while others charge for everything but the

air that you breathe – and doubtless ways of charging for

that might still be under study at some carriers.

The latest iteration is evident in the appearance of all-premium

carriers that offer products similar to the first /business

cabins available on traditional carriers but at starkly different

price points. In the U.S., the most mature new generation

market, SkyBus and Virgin America, both new entrants, are

further bending the rules and definitions as to what, exactly,

is encapsulated in the definition of an airline and its prod-

ucts. One (Skybus) has opted for a bare bones operation

a la Ryanair and the other (Virgin America) is attempting to

close the gap between classy and costly. It would appear

that, more and more, the only common denominator among

airlines is transportation between two points, which, of

course, is their core responsibility.

One final observation on this business model topic: not only

is a new hybrid model challenging the incumbents, but there

are also direct challenges from the growing carriers of the

Middle East that are posing a new threat even though the

model is very familiar. Comfortable solutions that worked

for decades are no longer adequate to ensure viability.

Second, the cost components and cost factors are

realigning. For virtually the entire history of the industry,

the most costly expenditure component was labor.

The see-saw relations between labor and management,

as well as the contracts and conditions that were imbedded

with traditional carrier models are cited as the primary

cause of cost differentials between the business models

in 2001 when things really began to unravel.

The ChallengesFinding ways in which the baselines have moved is quite

an easy task. The challenge is in separating those that

have been paradigm shifts from those that are just normal

business evolution.

We would like to suggest three fundamental shifts that

we consider to be of paramount importance.

First, the standard airline business model has been

challenged, expanded, remade – choose your own word.

Up until about six years ago, the vast majority of the

world’s airlines used the same playbook. There were,

of course, some variations and innovations but most of

the carriers looked to their peers (other network carriers)

for benchmarks. In the U.S., Southwest was becoming a

major player but it was a lone dissenter in the aviation

world and was seen as a fluke, limited to the American

marketplace. In 2000, Ryanair carried over 9 million

passengers. In 2007, the forecast is 52 million. Air Asia

has gone from a startup in 2001 to being a group based

in three countries and carrying over 9 million passengers

in fiscal 2006. Meanwhile, the woes encountered by most

network carriers are well known.

The result, some years later, has been a blurring of the

lines between traditional and new generation carriers. The

network players have become serious about cost control,

not as just an initiative, but as a business fundamental.

Aircraft that formerly were used in ways that accommodated

hub connections have now been employed in ways that

maximize utilization. Amenities that once characterized

the divide between traditional carriers and their new

competitors have been eliminated, making price the

primary differentiator for many consumers. In much of the

world, shorthaul flying by the majors has been noticeably

reduced, acknowledging that unbreachable cost gaps

may exist in that market segment. The world’s most

famous airline brands are all seeking profitability in longer,

international services.

4

As the price of crude oil has risen to record

levels in recent months, some airlines have

seen fuel costs eclipse even personnel costs –

traditionally the biggest expense they face.

Pittsburgh Business Times, July 8, 2005

U.S. airlines are increasingly shifting flights

from highly competitive domestic routes to

international destinations.Reuters, October 21, 2005

5

The piper, or in this case the pumper, must be paid.

While creative solutions for short-term savings abound,

these are limited in both scope and application. Further -

more, fuel surcharges appear to be far less palatable to

the consumer than is the grudging acceptance of paying

more at the pump for automobile fuel. Escalating fares

will, if economic principles remain in effect, eventually

flatten the demand which has its own unfortunate

outcome of diminishing demand.

Most importantly, any final resolution of the problem is

ultimately dependent on money and technology. Replacing

older aircraft with newer, more fuel-efficient models is a

costly proposition, made more complex by the fact that

order books are full so that even carriers with the cash

to spend are finding delivery positions hard to come by.

And the long-term solution, radical design change for both

airframes and engines, is surely still over the time horizon.

Incremental change and improvement are coming but the

bill at the pump will remain a problem.

Finally, unless hedging is involved, fuel costs will remain

not only a huge, but also a volatile cost (see Chart 2) to

be managed. Unlike other business expenses, contracts

and negotiations are far less likely to ameliorate the effects

of higher oil prices. So now we have an emerging new

business model intersecting with unpredictable prices for

a primary input.

Much of the newfound cost competitiveness has been

extracted from carriers’ labor forces. Tens of thousands

were cut and the remaining employees almost all work

longer for less pay and fewer benefits. The merits or

demerits of this course of action can be debated for years

to come but the reality of that approach cannot be denied.

Furthermore, despite all this activity, many traditional carri-

ers still operate with a labor cost disadvantage – certainly

vis-à-vis those carriers just emerging with new, entry-level

staff onboard.

But just as the labor gulf was being bridged, fuel cost began

to rise and now, for most carriers, has become the number

one cost. Chart 1 shows that fuel cost has increased by

88% while labor cost is only 82% of the 2001 amount –

down 18%. While there is the cold comfort of knowing that

everyone (except for those able to hedge) is in the same

predicament, the solutions are far more complex and

expensive. First, unlike labor, fuel is an external cost.

Bankruptcy in the U.S. does not allow carriers to abrogate

payments to fuel suppliers in the same way that pension

liabilities could be diminished by congressional fiat.

Chart 2. Fuel Impact on Operating Costs.

Year % of Operating Costs Average Price per Barrel of Crude Total fuel cost

2003 14% US$28.8 US$44 billion

2004 16% US$38.3 US$61 billion

2005 22% US$54.5 US$90 billion

2006 26% US$65.1 US$111 billion

2007 F 26% US$63.0 US$119 billion

Source: IATA

Chart 1. Labor/Fuel as Percentage of Total Expense.

Fuel vs. Labor All Major Airlines

2001 2006 Change

Labor 28.3 23.3 82%

Fuel 13.6 25.5 188%

Source: IATA

The third and final piece is regulation. Globally, for most

traditional airlines, strict regulation has been synonymous

with operations. Though deregulation was “officially” begun

in the U.S. in 1978, that concept is still in process in

the American marketplace. One need only look at the

convoluted regulatory approval meted out to Virgin America

to see that full deregulation is far from complete.

Nonetheless, few would argue that the stringent barriers

that characterized the industry even ten years ago have

been markedly dismantled. Much of the growth and

expansion that we are seeing is the direct result of a

freer environment. From Aalborg to Zurich, one can see

the effects of these changes as air transport becomes

accessible to ever more travelers.

The planning challenge comes in the unevenness and

sometimes seemingly arbitrary ways in which regulation

still exists, as well as the lack of standardization across

borders. This complex jumble of regulations is a problem

in many endeavors but few experience it with the same

immediacy as airlines which, in a matter of hours, move

from one regulatory environment to another.

Certainly security is a prime example where varying standards

and policies create confusion, annoyance and inefficiencies.

As we noted in an earlier issue of Scorecard, the policies

related to taxation and fees are anything but standardized

and can create differences in fares between the same two

points depending on which city is the origin.

And then there are complex infrastructure issues that are

outside airline control. Air traffic management and control

are problematic in every geography and have disparate

oversight and funding mechanisms. Chart 3 reveals that

the single greatest source of delays in the U.S. in 2007

6

thus far has been the aviation system. The second largest

category is rotation – or late arrivals resulting in late

departures – a direct consequence of the initial event.

Airports are essentially local businesses catering to local

markets and concerns such as noise and facility limitations.

As we have seen in locations from Los Angeles to London to

Tokyo, the needs of the aviation community usually do not

trump the will of the local population. The result? Limited or

no expansion, night curfews, high costs, and myriad other

restrictions that can inhibit growth and even change with

sudden and drastic consequences.

Surging domestic traffic growth in China

is creating headaches for the government,

as airport and ATM (air traffic management)

infrastructure fails to keep pace with

airline expansion.Air Transport News, July 18, 2007

“40% of fuel usage in Europe is due to

air traffic control”Peter Lindsay, July 7, 2007

Australian Broadcasting

Chart 3. Delays by Source: January - May 2007.

Source: U.S. Bureau of Transportation Statistics

7

Regulations can also have effects far beyond the area in

which they are in force. Most carriers operating outside the

U.S. find American bankruptcy laws a regulatory loophole

that skews global competition. Additionally, there are

countries in which slot allocations are used as competitive

barriers, especially in limiting new entrants.

Like fuel, regulatory control often remains beyond the

airline sphere of influence and therefore has the ability

to create arbitrary disruption when changes occur. While

IATA, ICAO and others work to synchronize standards, few

nations seem willing to dilute their “sovereign powers” for

the sake of easing complexity. Thus, regulatory challenges

are likely to continue.

Notwithstanding all of these observations, it remains true

that there has never been a time when aviation, or any

industry, has not been faced with uncertainty – nor is there

ever likely to be such a time. However, I will again reference

the opening comments that highlight the increased speed

at which change comes upon us and speculate that the

challenges of that fact alone are quite daunting. I would like

to finish by referencing two specific circumstances where

“new” also contributes to the mix.

New TechnologyLast month Scorecard referenced the introduction of the

A380 and the 787. Specifically in the case of the 787,

carbon fiber technology is being utilized in ways that are

both evolutionary and revolutionary. It is evolutionary in

that the material already is widely used in current aircraft –

but it is revolutionary in that this aircraft has been built

using far more of the material and in ways that go far

beyond simply substituting a lighter material for previously

metal parts. While the material is immune to some metal-

specific problems such as corrosion and improves efficiency

by reducing weight, the next few years will be a learning

curve. As new materials and procedures replace existing

technology, people long accustomed to metal aircraft must

learn to adjust both thinking and behavior that they have

applied for all of their careers.

After more than 60 years, working on metal airframes

provides few surprises. Doubtless, however, new tech -

nologies will find some unsuspected wrinkles lurking in

the future as they are assimilated.1

New Business Model

The age of do-it-yourself travel has arrived. Increasing

numbers of global travelers have become used to the

idea that they are in charge of their bookings, check-in

and other services that used to be supplied by others.

Consumers have generally embraced this and many

actually prefer the reduction in touch points with airline

staff. On the carrier side, these technologies have created

huge cost benefits and created different work patterns and

processes. But jetBlue and others have found that this

move away from staffing can have mighty consequences

when things go awry.

With ever fewer agents deployed across all aspects of

the organization, there are fewer troops to mobilize in

extraordinary circumstances. While jetBlue’s problems last

winter were a magnified vision of this problem, the effects

of reduced staffing and reliance on passenger-generated

solutions can be observed almost anywhere, on any day.

We have clearly perfected the automation of ordinary

operations, but systems capable of cleaning up during

a recovery stage without human intervention remain few

and far between.

The ability to handle increasing numbers of customers with

fewer staff – in all situations – is a challenge yet to be met.

In ConclusionThere will always be irregularities. Some of them will be

messy and prove to be formidable challenges even in cases

that are known and anticipated. For instance, weather will

continue to present operational and service problems and

passengers in 2010 will be just as stranded by snowstorms

as were passengers in 1960.

But the upheaval in the industry is creating new opportuni-

ties for both success and failure, and it is those unknown

and as yet unanticipated circumstances that will add

additional complexity to the aviation matrix. We can hope

that preparation and learning will help to solve them as they

arise, rather than allowing them to become yet another

aspect of travel to be endured.

1 Those who were in the industry at the introduction of the 747 will have memories of theunexpected and costly problems that plagued the new engine technology on that aircraft.

8

Around the Industry: Open Skies, Chapter 1.5While not the same splash created a few months ago, the pending U.S.- EU Open Skies

agreement continues to drive change. New service patterns are beginning to emerge and

thus far, most of the news is coming from the UK – and there is quite a bit of it.

First, Heathrow. As expected, the American members of Skyteam have announced that

they will begin to serve Heathrow as from next spring. The Air France/KLM group has

agreed to share slots with their partners: therefore Delta, Northwest, and Continental

all plan to have some frequencies to Heathrow in their summer 2008 schedules.

British Airways has hinted that all-premium services to the U.S. are being considered

to supplement the existing multi-class aircraft, as has Virgin.

It appears that Gatwick will retain some services from the U.S. as an alternative for

those wishing to avoid Heathrow. Whether or not pricing differentials will exist is unclear.

However, if slots at LHR continue to have extraordinary value, it is conceivable that

alternative price points would be used to differentiate the value of those slots.

American has announced that it will begin services to Stanstead, apparently acknowledging

that a growing number of travelers is attracted by the extensive offering provided by new

generation carriers that are operating from that airport. The announcement also confirms

that the airport, gateway for Eos and Maxjet, is gaining ground as an option to the two

aforementioned established airports.

Furthermore, the appearance of both Zoom and FlyGlobespan, has created even more

alternatives for those looking to travel either at very low cost or to enhance their comfort.

For minimal extra expenditure, travelers can book upgraded seats on these carriers.

Demand is strong and in 2007 it appears that any effects on the incumbents are

negligible. Nonetheless, these developments offer some hint as to what may become

a more formidable challenge over time.

Meanwhile, in the U.S., the Congress and other groups have wasted no time in declaring

their staunch opposition to any change in the current ownership regulations as applied

to U.S. carriers. As resolution of this issue is key to full implementation of the treaty,

uncertainty as to the final outcome will persist.

The story is just beginning.

9

New at Unisys

Much has been made, both in this publication and elsewhere, of the disconnect

between passenger needs and available staff in the case of disrupted operations.

With all carriers more dependent on electronic interface, the number of agents

available for disservice recovery has significantly diminished. This inability

to provide acceptable service amidst difficulties has eroded consumer trust

and made for numerous “horror” stories. Service disruptions are predictable

unpredictables – we know they will happen, just not when or where.

In light of these fundamental changes, Unisys has developed REACT as one

module of its AirCore solution set. As with all of AirCore, the key element is

customer knowledge. REACT allows airlines to establish rules, parameters, and

reference data that the system then uses to electronically rebook passengers

based on the importance and value they represent to the airline.

Since the system is automatically facilitating solutions based on the rules

that have been established, valuable and scarce human resources can be

employed in roles that enhance service delivery – rather than be tied to

machines, keyboards and screens.

Service disruptions are never pleasant but using state-of-the-art tools can

make them palatable and create customer recognition of the carrier’s ability

to cope well with difficult situations. Operating well on a good day is expected.

Operating well in a mess is what creates trust and loyalty.

For more information on how your carrier can cope with unforeseen events,

visit our website,

http://www.unisys.com/transportation/solutions/passenger__services/

airline__core__systems__solutions/index.htm

10

About The Unisys R2A Scorecard

The Unisys R2A Scorecard is a monthly publication authored

by Unisys Transportation Management Consultants and other

contributing experts. Each issue is available on our web site at

http://www.unisys.com/transportation. This web site includes

back issues for your reference, but most importantly it provides

an easy means of communicating with our readers. We crave

feedback. Let us know what you think, argue with us, provide

us with additional information and data, but above all let us

hear from you!

During these challenging times, our focus is on providing solutions

to reduce costs, improve operations and help organizations

expedite the implementation of new solutions.

At Unisys, we help you secure your enterprise by giving you

the visibility to see your business more clearly – ahead of

decision points, investments and risk. We can help you achieve

lower costs and improve processes through our expertise in

Air Transport:

• Consulting

• Systems Integration

• Outsourcing

• Infrastructure

• Server Technology

• Open Source Technology

• Key solutions for Passenger Services, Logistics and Airports

Learn how Unisys can build visibility into your enterprise.

Contact us today at: mailto:Transportationsolutions@Unisys.com

About Unisys

Unisys is a worldwide information technology services and

solutions company. We provide high-level services in consulting,

systems integration, outsourcing, and infrastructure services,

combined with powerful enterprise server technology. We

specialize in helping organizations use information to create

efficient, secure business operations that allow our clients to

grow and achieve their business goals. Our consultants and

industry experts work with clients to understand their business

challenges and create greater visibility into critical linkages

throughout their operations. For more information, visit

http://www.unisys.com.

11

*barcode*Form Number

For more information about Unisys Transportation Solutions,

visit our website at http://www.unisys.com/transportation

or contact us today at mailto:Transportationsolutions@Unisys.com

Specifications are subject to change without notice.

Copyright © 2007 Unisys Corporation. All rights reserved.

Unisys, the Unisys logo, and AirCore are registered trademarks of Unisys Corporation. All other brands and products

referenced herein are acknowledged to be the trademarks or registered trademarks of their respective holders.

Printed in the United States of America 8/07

Are your business operations secure?