AERO 2057_ Airline Finance

Week 2: Airline Costs and Revenues

Repetition

What do you remember from the last lecture?

Airline Costs and Revenues

I. Airline Costs
II. Airline Revenues
Profitability

How can airlines increase profitability?

Airline Costs and Revenues

I. Airline Costs
II. Airline Revenues
Airline Costs
• Costs: costs are an important part of any business,
especially in the airline industry

• Cost is defined as the amount of financial or physical

resource that has to be given up in order to get
something.
Airline costs
• Fixed and variable costs for airlines (cost factors: size &
type of aircraft, fuel efficiency, and distance traveled)

• Operating costs: costs are incurred in the process of

providing air transport service to Pax and freight handlers
- Direct operating costs: greatest portion
- Indirect operating costs: administration costs

• Non-operating costs
• Taxation (carbon offset)
Airline Costs
• Non-operating Costs:
– Costs not associated with providing air service
Airline Costs
• Taxation:
– Different taxes

– Depending on country
Airline Costs
• Fixed Costs:
– costs of production that do not change with the rate of output (not
directly related to flying an additional unit or passenger)

– a large part of the total cost of operation in the short-term

– For example: aircraft / airport gate use agreements/ airport

terminal leases/ buildings/ equipment/ lease contract
Source: Vasigh, Rowe, 2020, p. 42ff.
Airline Costs
• Variable Costs:
– costs that directly vary with changes in production (no of
passengers/ no. of departures/ volume of cargo carried)

– For example: aircraft fuel/ (labour expenses)/ supplies/

replacement parts
Airline Costs
• Total costs
Airline Costs
• Marginal costs
- the cost for a business to produce one additional unit
- for example: incremental fuel burn/ catering costs/
luggage processing expenses
Airline Costs
• What are the marginal costs for one more passenger?
– Cost on the ground:
» Luggage handling
» Airline transaction cost including making reservation,
checking the passenger in, and boarding
» Airport service fees
– Cost on the plane:
» Higher fuel cost
» Higher consumables such as food and beverages
Source:
Vasigh,
Rowe,
2020, p.
56f.
Airline Costs
• Lowering costs through:
– Higher productivity (Employees per available seat mile)

– High aircraft utilization

– Faster aircraft-turnaround time

– Higher load factors

Airline Costs
• Opportunity Costs:
– Costs for making an alternative choice
Airline Costs
• Sunk Costs:
– are any expenses that have already been incurred and

therefore cannot be recovered

– is not a relevant cost for decision-making

Airline Costs: Sunk Costs
Airline Costs
• Start-up Costs:
• Start-up costs are the expense that investors incur from
inception until the business become functional.
- Necessary permits: Air operator’s certificate (AOC)
- Set up costs: procure aircraft, secure landing rights and
gate at airports, find office space, create
a robust IT infrastructure, hire/ train
employees(licenses)
Airline Costs and Revenues

I. Airline Costs
II. Airline Revenues
Airline Revenues

• Revenues are coming mainly from ticket sales

• Pricing practices and policies in the transportation
industry denote how a transport company determines its
prices based on competition, cost, and demand.
Airline Revenues

• Pricing policy effectively changes the price based on

customer profile
• A ticket price should never be less than such variable
costs
• Charging at variable costs does not ensure profitability
Airline Revenues
• Goal:
– Highest possible prices

– Full aircrafts
Airline Revenue Management

• the application of microeconomics that predicts passengers’

economic behaviour by balancing the supply of aircraft seats and
passenger demand to maximize aircraft revenue
• the application of probability theory and pricing practices with the
goal of extracting the largest amount of revenue passengers are
willing to pay
Airline Revenues
• An effective revenue management system requires:
• The establishment of a differential fare structure
• A system of constraints (or fences) on the use of lower fare seats to limit their
availability to passengers who might otherwise be willing to a pay a higher fare
• A system of seat allocation which maximizes expected revenue in the face of
stochastic demand
• A reliable forecast of demand, no-shows, cancelations, go-shows, overbooking, and
inventory limit
Airline Revenues
• Ramsey Pricing
– essentially charging each segment of demand what the market
will bear

– the price margins should be inversely proportional to the demand

elasticity for the various products

– Selling the same product for a different price to different

customers
Airline Revenues

– Dynamic pricing

» the fare a customer pays is based on variables subject to

change over time

» generally, ticket prices get more expensive when a passenger

books a trip closer to the day of departure
Airline Revenues

– Price discrimination

» different prices are charged to different customers for the

same product or service

» prices charged are based on the different price elasticities of

demand between consumers

Discussion: fair or unfair?

Airline revenue management_ Price discrimination

• Price discrimination can increase profit, since the airlines

may charge a higher price to those passengers with less-
elastic demand, and a lower price to those passengers
with more elastic demand
Airline revenue management_ Price discrimination

• For price discrimination to be successful, three

necessary conditions need to exist in the market:
1. market segmentation
2. market separation
3. different elasticities in different sub-markets
Airline revenue management_ Price discrimination

• First-degree (perfect) price discrimination

– charge the maximum price (where consumer surplus does not
exist) that the consumer is willing to pay for that specific unit

– is very difficult to implement

Airline revenue management_ Price discrimination

• Second-degree (quantity discounts) price discrimination

– large quantities of a product are purchased at once

– charter fights, corporate travel deals, large proportion of seats on

a flight
Airline revenue management_ Price discrimination

• Third-degree (multi-market) price discrimination

– most typically practiced by the airline industry

– dividing consumers into different groups based on a set of

characteristics and estimating their respective demand curves
Airline revenue management_ Revenue management

• Revenue management “fences”

– Advance purchase requirements (restrictions)

– Passenger loyalty program

– Ticket refundability

– Change fees

– Schedule-driven fences

– Saturday night rule

Airline Revenues
• Revenue management in practice:
– Distinct control: fixed number of seats for each fare class
– Nested control: Nested control schemes can be customized to suit the individual
characteristics of the flight, but the basic principle is that lower fare classes are embedded in
the booking limits of high fare classes
» serial nesting
» parallel nesting
» virtual nesting
Airline revenue management_ Spoilage and spillage

• Spoilage:
– Spoilage represents the number of empty seats on a flight caused by prices
higher than market expectations

– Spoilage is a result of prices that are too high for the market for the given fare
class
Airline revenue management_ Spoilage and spillage

• Spillage:
– Spillage means that airlines have sold their seats too fast and are forced to stop

– sales way before the time of departure

– Spillage is the result of average fares that are too low for the flight, which leads to
a booking rate that lies above the normal booking curve
Airline revenue management_ Spoilage and spillage
Airline revenue management_ Overbooking

• Airlines overbook flights because they know from the

historical bookings that a fraction of passengers who
make reservations do not always show up or may miss
connections
Airline revenue management_ Overbooking

• Airlines are able to predict, with a relatively high degree

of accuracy, the “no-show” level, or the percentage of
passengers who will fail to show for a particular flight,
based on past experience
Airline revenue management_ Overbooking

• While the benefits of overbooking for the airline are

reduced spoilage and increased potential revenue, the
trade-off is that overbooking can also be costly for the
airline
Airline revenue management_ Overbooking

• the costs associated with overbooking include meal and

hotel vouchers, flight coupons for future flights, potential
departure delays as seats are reallocated, and loss of
passenger goodwill
Key Take-Aways
• Airlines have a lot of different costs
• Fixed costs are usually high for airlines
• To increase revenues airlines use price discrimination
• Important tools are ramsey prices, overbooking and fences
Questions? Comments?