The Cyclical Nature of Airline Industry

Profits

Kawika Pierson
MIT System Dynamics Group 3nd Year PhD
Fall 2008 Albany-MIT PhD Colloquium
Outline
Relevant Literature
Reference Mode for Airline Profits
Digging Deeper
The Model
 Demand
Price
Capacity
Costs
Profit
Results
 Relevant Literature
 “Cycles in the sky: understanding and managing business cycles in the
airline market” M Liehr, A Groessler, M Klein, PM Milling - System
Dynamics Review, 2001
Made for Lufthansa as a guide for strategy
Very limited scope (only one feedback loop)
Relevant Literature
 “System dynamics for market forecasting and structural analysis”
James Lyneis - System Dynamics Review, 2000
Commercial jet aircraft industry
Focused on use of SD models as forecasts for Jet Orders
Proprietary, but potentially similar to our work
 "Analysis of Profit Cycles in the Airline Industry" 2004 Helen Jiang,
R. John Hansman
Very simple model, two stocks one feedback loop
Control theory perspective
 Reference Mode
 The data for US airline industry profits shows some cyclicality
since before deregulation

Taken from a presentation by Prof. R. John Hansman and Helen Jiang Nov. 2004
Digging Deeper
Profit = Revenue – Costs
Revenue = Price * sales in units
Costs = unit cost * production
Sales is Revenue Passenger Miles
Price is the Price of Tickets
Production is Available Seat Miles
This gives us Profit
How does financial reporting effect our modeling?
Capacity – Causal Loop Diagram

Demand
+
Forecasted
Capacity Demand
+

- +
B Capacity
Shortfall + Desired
Capacity Capacity
Control
+
Investment
 Capacity - Model Structure
<Airplane
Planned Retirements>
Replacement
Orders
Desired
+ Capacity
Desired Capacity +
Acquisition Rate Adjustment Time to Adjust
For Capacity - - Capacity
<Time Required to
+ Manufacture an
Desired Aircraft Airplane>
Supply Line

Indicated
Capacity Supply Line
Adjustment Adjustment Time

+ -
Order Approval Adjustment for the Weight on Supply
Delay Time Supply Line - Line Adjustment

+
Indicated Orders Mothballed Capacity
<Return to
for Capacity
Service>
<Cancelled
Orders>
Mothballing Off Mothballing
Cancellation
<Into
Storage>

Airline Capacity
Orders of Airplane Airline Capacity
Supply Line Airplane
Airplanes Manufacturing
Completion Retirements
Initial Airline
<Return to Initial Capacity Capacity <Retired>
Service> on Order
 Third Order Stocks –Cancellation
and Mothballing
<Indicated Orders
for Capacity>
Time Required to
Time to Cancel Manufacture an
Airplane
+
<Orders of Cancelled
Airplanes> Orders

Capacity on Capacity on Capacity on

Order 1 Order 2 Order 3
Ordering 1 to 2 2 to 3 Completion

Average
<Airplane Service Life
Manufacturing
Completion>

Capacity 1 Capacity 2 Capacity 3

New Capacity Cap 1 to 2 Cap 2 to 3 Retired

<Operating
<Operating Margin>
Margin> Into Storage Margin Threshold to
Return to
<Time to Service Initiate Mothballing
Mothball>
Time to
Mothball
<Indicated Orders
Capacity on Mothball <Indicated Orders
for Capacity> for Capacity>
 Forecasting Demand
Time Horizion for
Reference Demand

<Time Horizion for

Reference
Reference Demand> Demand
Change in
Reference Demand

Time to Percieve
Indicated
Changes in Demand
Growth Rate
Time to Percieve
Trend in Demand

Perceived
Initial Expected Demand
Expected Growth Change in
Growth Rate in
Rate for Demand Demand
Demand
Change in Perception
Expected Growth
Rate
Gap in Demand
Perception

<Historical <Switch for

Historical
Airline Demand> <Actual Demand Variables>
For Seat Miles>
 Correction For Growth <Perceived
<Expected Growth
Rate for Demand>
Demand>
<Airline Desired Load
Capacity> Factor
<Airplane Expected Demand Forecast
Planned Retirements> Desired Seat Demand Horizion
Capacity Adjustment Replacement <Number of Miles Miles
Weight on Demand for Growth in Demand Orders Flown per Seat>
<Time to Percieve
Forecast Orders Desired Changes in Demand>
+ Capacity
Desired Capacity +
<Expected Growth
Acquisition Rate Adjustment
Rate for Demand>
For Capacity - - Time to Adjust
<Airline Capacity <Time Required to Capacity
+ Manufacture an
Supply Line>
Desired Aircraft Airplane>
+ Supply Line Supply Line
Adjustment for
Growth in Demand Indicated
Capacity Supply Line
Adjustment Adjustment Time

+
-
Order Approval Adjustment for the Weight on Supply
Delay Time Supply Line - Line Adjustment

+
Indicated Orders Mothballed Capacity
<Return to
for Capacity
Service>
<Cancelled
Orders>
Mothballing Off Mothballing
Cancellation
<Into
Storage>

Airline Capacity
Orders of Airplane Airline Capacity
Supply Line Airplane
Airplanes Manufacturing
Completion Retirements
Initial Airline
<Return to Initial Capacity Capacity <Retired>
Service> on Order
Fitting to Data
Get historical data on important stocks
Airlines are great for this
Airlines.org, MIT Airline Data Project, BTS
Set up summary statistics
John Sterman’s Book plus MAE, RMSE, %E, Thiel,
SSE/M^2
Drive each model sector with historical variables
Use Vensim’s model fitting functions
Lets walk through this
 Summary Statistics
Payoff Element <r>
dif cov
Um <dif mean>
Sum of Error
<Sy> <Sx>
Squared over Mean
MSE Us <dif var>
Error over Mean Sum AE MAE over dif var
<dt>
Squared Mean <M Y>
<Yi>
<Yi> <Xi> <dt> <Count> <M X> RMSE Uc <dif cov>
Residuals dif mean
<M X>
<Xi> <M X>
Sum APE MAPE RMSE over
Mean
<Xi> <Yi> <Xi>
<Available Seat
Miles>
SumX2 <dt>
Simulated
<dt> SumXY
<Count>
Y MX2
<Count>
<Historical> Sum Yi
Yi <M X>
Start Time <Time> Mxy
Sx
Percent Error <M Y>
MY
End Time Count Sy
pick <Count>
<Simulated> Interval <TIME STEP> dt
MX r MY2
<dt>
SumY2
Sum Xi
<Yi>
X Xi R^2
<Historical Historical
Available Seat
Miles>
Example of Fitting the Model
1. Open Simulation Control

2.
Create a Payoff
Example of Fitting the Model
3. Run
“Policy”

Negative
Example of Fitting the Model
4.
Set Parameters
Example of Fitting the Model
5.
 Capacity Fit – Historical Inputs
Historical and Simulated Airline Capacity
1e+012

750 B
Seat*miles/Year

500 B

250 B

0
1970 1974 1978 1982 1986 1990 1994 1998
Time (Year)
Historical Available Seat Miles : Match All
Available Seat Miles : Match All

“R^2” MAE/Mean RMSE/Mean Um Uc Us

0.995 0.0224 0.0309 0.0043 0.7475 0.2480
Demand – Causal Loop Diagram
Ticket Price
+
R

Price War
+
Load Factor Congestion

- +
B
Delivery Delay - -
GDP
+ Demand +
+
Forecasted
Capacity R Demand
+ Route
Networks
- +
B Capacity
Shortfall + Desired
Capacity Capacity
Control
+
Investment
 Demand – Model Structure
Historical Population
Data and Projections

Initial <Time>
Population Historical GDP Data
and Projections
Miles per Person per
Population
Dollar of GDP
Actual Demand
GDP per
For Seat Miles Capita
Seat Miles Desired
from GDP per Capita
<Time>
Sensitivity of Constant
Demand to Congestion Demand
Congestion Perception Time Demand for Seat Adjustment
Miles per Capita
Indicated Effect of Effect of
Congestion on <Ticket Price>
Congestion on
Demand Demand
Effect of New Elasticity of Demand
Effect of Price
Capacity on with Respect to Price
<Indicated Load on Demand
Demand
Factor> <Comfortable
Industry Load
Factor> Strength of New
Capacity Effect on Reference
Demand Ticket Price
One Year Percent
Change in Capacity <Initial Ticket
Price>
<Lag for
<Available Seat Measuring
Miles> Changes>
 Demand Fit – Historical Inputs
Historical and Simulated Revenue Passanger Miles
800 B

600 B
Seat*miles/Year

400 B

200 B

0
1970 1974 1978 1982 1986 1990 1994 1998
Time (Year)
Historical Airline Demand : Match All
Actual Demand For Seat Miles : Match All

“R^2” MAE/Mean RMSE/Mean Um Uc Us

0.99 0.0273 0.0356 0.0033 0.9595 0.0371
 Price – Model Structure
<Cost per
Target Margin Available Seat
Sensitivity of <Ticket Price> Mile>
Price to Margin
Target
Effect of Margin Percentage Sensitivity of
on Price Above Cost Price to Costs
<Operating
Margin> Effect of Costs
on Price

Indicated Ticket Minimum

+ <Cost per
<Load Factor> Price per Seat Mile Ticket Price
Effect of Demand Available Seat
Supply Balance Indicated Price Mile>
- on Price
<Desired Load +
Factor>
Sensitivity of Price
to Demand Supply Ticket Price
Balance Change in
Ticket Price
Initial Ticket
Price Time to Adjust
Ticket Prices
 Price Fit – Historical Inputs
Historical and Simulated Ticet Price
0.2

0.15
dollars/(Seat*mile)

0.1

0.05

0
1970 1974 1978 1982 1986 1990 1994 1998
Time (Year)
Historical Airline Ticket Prices : Match Price
Ticket Price : Match Price

“R^2” MAE/Mean RMSE/Mean Um Uc Us

0.98 0.0583 0.0710 0.0004 0.2980 0.7015
Costs – Causal Loop Diagram
Costs
+
+
Ticket Price
B +
R
Costs
Price War
+ B
Load Factor Congestion
Competition +
- + Revenue
B
Delivery Delay - -
GDP
+ Demand +
+
Forecasted
Capacity R Demand
+ Route
Networks
- +
B Capacity
Shortfall + Desired
Capacity Capacity
Control
R + -
+
Profit
Investment+ Investment
 Costs - Model Structure
Table for <Time>
Producer Price Initial Other
Index
Variable Costs
Producer Price
Index Historical Jet Fuel
1982 Other Gallons per Cost per Gallon
Variable Costs Projected Fuel
Other Variable Seat Mile
Cost
Costs
Fuel Cost per
Variable Costs Gallon
Variable Costs from Jet Fuel
<Available Seat <Time>
Miles> per Seat Mile

Variable Cost
Cost per Available
from Operations
Seat Mile

<Average Worker
Compensation> Workers Per Seat
Operating Costs
from Passengers of Capacity

Costs from + Total Worker +

Wages Salary by Type + Total Workers <Airline
Total Operating Operating Costs by Type + Capacity>
Costs From Freight

Freight as a
Percentage of
Passenger Operations
 Cost Fit – Historical Inputs
Historical and Simulated Operating Costs
200 B

150 B
dollars/Year

100 B

50 B

0
1970 1974 1978 1982 1986 1990 1994 1998
Time (Year)
Historical Airline Operating Costs : Match Cost
Total Operating Costs : Match Cost

“R^2” MAE/Mean RMSE/Mean Um Uc Us

0.99 0.055 0.0719 0.0603 0.6697 0.2698
 National Average
Wage Data
Wages – Model Structure
Time to Change
Wage Premium Worker
for Skill Compensation
Initial Worker
National Compensation
Average Wage
Average
<Time>
Worker Change in Worker
Wage Relative to
Compensation Compensation
Average
Strength of Inflation
Strength of Outside on Worker
<Number of Miles Effect of Outside Compensation
Opportunities on Worker Gap For Worker
Flown per Seat> Opportunities on Worker
Compensation Compensation
Compensation
Effect of Inflation in
Historical Airline Worker Compensation
Capacity
Indicated
<Airline
Effect of New Hires Compensation CPI Percentage
Capacity> One Year Change in <Time>
on Worker Change
New Hires
Compensation
CPI Data CPI
Recent Airline Effect of Operating
Strength of New Hire
<Lag for Capacity Margin on Worker
Effect on Worker
Measuring Compensation Compensation
Changes>
Effect of Normal Margin
Unemployment on Strength of Margin on
Worker Compensation Worker Compensation
Recent Margin
Strength of Margin
Unemployment Effect Perception Delay
on Wages
Normal
Historical Unemployment <Operating
Unemployment Margin>

Historical
Unemployment <Time>
Data
 Profits – Model Structure
<Load Factor>

<Ticket Price> Revenue Seat

Miles
Freight as a
Percentage of Passenger <Available Seat
Passenger Operations Revenue Miles>

Freight
Revenue

Operating Operating
Revenue Margin

<Time>

Operating
Profit check year

<Total Operating
Costs>
Accumulated
Operating
New Operating Drain Operating
Profit
Profit Profit

<TIME STEP>
Reported
Operating Profit
 Wages Fit – Historical Inputs
Historical and Simulated Average Wages
80,000

dollars/(Year*worker)
60,000

40,000

20,000

0
1970 1974 1978 1982 1986 1990 1994 1998
Time (Year)
Historical Airline Salaries : Match All
Average Worker Compensation : Match All

“R^2” MAE/Mean RMSE/Mean Um Uc Us

0.99 0.0278 0.0398 0.0294 0.9426 0.0278
 Real Wages Fit – Historical Inputs
Real Wages sim vs actual
20,000
dollars/(Year*worker)

17,500

15,000

12,500

10,000
1970 1974 1978 1982 1986 1990 1994 1998
Time (Year)
Simulated Real Wage : Match All
Historical Real Wage : Match All

“R^2” MAE/Mean RMSE/Mean Um Uc Us

0.68 0.0262 0.0339 0.0290 0.9370 0.0339
 Full model Optimization
Move from partial model tests to full model
parameterization
Historical and Simulated Ticet Price
Fits are slightly worse, parameters more believable
Historical and Simulated Airline Capacity
0.2
2e+012

0.15

dollars/(Seat*mile)
1.5e+012
Seat*miles/Year

0.1
1e+012

0.05
500 B

0
0
1971 1975 1979 1983 1987 1991 1995 1999
1971 1975 1979 1983 1987 1991 1995 1999
Time (Year)
Time (Year)
Historical Airline Ticket Prices : Match All
Historical Available Seat Miles : Match All
Ticket Price : Match All
Available Seat Miles : Match All

MAE/Mean RMSE/Mean MAE/Mean RMSE/Mean

0.0459 0.0564 0.0508 0.0595
 Full model Optimization
Historical and Simulated Revenue Passanger Miles Historical and Simulated Operating Costs
800 B 200 B

600 B 150 B
Seat*miles/Year

dollars/Year
400 B 100 B

200 B 50 B

0 0
1971 1975 1979 1983 1987 1991 1995 1999 1971 1975 1979 1983 1987 1991 1995 1999
Time (Year) Time (Year)
Historical Airline Demand : Match All Historical Airline Operating Costs : Match All
Actual Demand For Seat Miles : Match All Total Operating Costs : Match All

MAE/Mean RMSE/Mean MAE/Mean RMSE/Mean

0.0345 0.0434 0.0372 0.0465
Parameters More Believable
In Partial Model Test SLAT = 0.05 TAC = 1
Theoretically should be very similar
In Full Model Parameterization SLAT = 0.18 TAC
= 0.19

Time to Adjust Prices Partial = 0.05 Full =0.64

Sensitivity of Price to Cost Partial = 3 Full = 0

Profits Still Questionable
Historical and Simulated Profit
10 B

5B
dollars/Year

-5 B

-10 B
1971 1975 1979 1983 1987 1991 1995 1999
Time (Year)
Historical Airline Operating Profit : Match All
Reported Operating Profit : Match All
Conclusions
Growth Correction
Partial Model Tests with Historical Inputs
Cyclical Nature not alleviated by Cancellations or
Mothballing
Standard SD Structures fit the industry reasonably well
More dynamics exist in the real system

Comments? Questions?