WHY ARE HUB-AND-SPOKE NETWORKS MORE

VULNERABLE TO DEMAND SHOCKS THAN OTHER

NETWORK STRUCTURES?
Hub and Spoke (HS) structures operated by legacy airlines incurred multi-billon losses after 9/11 and seemed less apt
to cope with external shocks, compared to low costs' point-to-point operations. In order to absorb the excess capacity
that is created through demand shocks, airlines can modify several levers that determine capacity that is allocated on
given routes within the network. However, the irreversibility of such choices due to the HS structure presents a
formidable obstacle to the network when trying to cut down on this unforeseen excess capacity. Decentralized airline
networks appear more robust and flexible when confronted with unforeseen volatility in the environment; a finding
that airport financing will need to take into account.

 One of the striking features following 9/11 was the continued growth among low cost carriers, servicing either trans-
European or US domestic networks. This stood in stark contrast with the legacy carriers that held on to Hub and Spoke
(HS) systems, with mostly domestic routes (also in Europe) feeding into intercontinental links. These structures
operated by legacy airlines incurred multi-billon losses after 9/11 and required either direct subsidies (in the US) or
extended slot privileges at hub airports (Europe). The financial results (Figure 1) suggest that legacy carrier's networks
were more risky and less apt to cope with external shocks, compared to low costs' point-to-point operations.

Figure 1: Financial performance of US airlines before and after 9/11

It is reasonable to assume that psychological factors (fear, terror, etc.) would not affect demand on point to point any
differently than demand on HS routes. The argument that lower costs (and thus lower prices) would attract less risk
adverse holiday travellers to low cost airlines is flawed: competition in 2001 and 2002 (both in the US and Europe)
shows that legacy carriers in most cases had to align their prices to low cost operators on common routes. Again, this
implies that asymmetries in demand, if observable at all, cannot be causal for the increased vulnerability (risk) of HS
structures.
Figure 2: Unit costs of US airlines before and after 9/11

In order to understand the different performances of networks to absorb external shocks (such as in demand), one has
to look at their cost structure. Figure 2, for example, shows that low cost airlines in the US managed to reduce costs
after 9/11, whereas legacy carriers were unable to react by lowering theirs. Several elements suggest that HS networks
indeed are less flexible to adapt to such unforeseen changes in the environment:

• Labour cost and productivity advantages are not any longer obvious inside HS systems: Although some studies
suggest economies of density affecting some labour inputs when concentrating flights through hubs (Banker and
Johnston, p.580), the increasing complexity due to airport congestion today easily outweighs such advantages.
Recurring strikes from personnel, air controllers, etc. at concentrated hubs are other intuitive examples for such HS
disadvantages.

• Asset related costs within HS networks: The feeder system of HS is a finely tuned and complex logistical system
involving a diversified and specialized fleet of aircraft. Current airport congestion at major hubs presents serious
constraints to the efficient utilization of the aircraft involved. By comparison, the uniform aircraft types used by low
cost airlines allow for transparent planning and most efficient usage of assets. For example, the aircraft can be
employed for many more hours due to fast turn-around at secondary airports, etc.

From cost analysis to network planning: What can we learn from point-to-point ?

We suggest considering the network as a multi-dimensional system, involving various choices for capacity allocation
on routes: capacity inside a network can be modified by adding/dropping routes, changing aircraft size, changing flight
frequency or transferring more (less) flights via the hub . For HS networks this planning/ allocation process becomes
more complex due to transfer, hubbing and feeder operations. We shall note that adding or dropping certain routes
does not necessarily make a network more vulnerable (or exposed to shocks) as such: point to point services operate
very robustly serving smaller numbers of destinations. Also, even if a HS network may stop servicing certain
destinations, it may in the same time increase the frequency on the remaining ones. This is to say that the number of
destinations served (within a certain range) is not very likely to be determinant for managing risks successfully inside
a network.

Other elements are more specific to the type of network structure, that is, the logic of choosing the optimal frequency,
the optimal aircraft size or redirecting flights via hubs are fundamentally different from the ones made on point-to-
point routes. Whenever a network is faced with demand shocks, it can react by modifying one or more of these levers
to manage its risk exposure. The objective would be to absorb the incremental excess capacity caused by the demand
shock: if the network adapts well, it will present less excess capacity following the demand shock. It is noteworthy that
such choices are greatly simplified and more uniform for point-to-point operations: the size of the aircraft remains
unchanged and the frequency on given routes are in general below those of legacy carriers that involve a hub airport.

Another problem is that the different levers for capacity choices made within the HS networks can also present sunk
costs, that is, irreversible investment. The irreversibility of such choices, a priori, will present a formidable obstacle to
the network when trying to cut down on its excess capacity. With unexpected demand shocks turning marketable
assets into sunk costs, the entire network risks to suffer from a paralysis to adapt: although planes, in general, do not
present irreversible investment, HS operations may render them less usage flexible: feeder and long distance services
require highly specific assets (the introduction of the future A380 is a case in point). During an economic slump, it
may become very difficult to find other usage for such planes, with salvage values being extremely low and few
profitable routes available to serve instead. Under such circumstances, the investment in planes serving HS has
become de facto irreversible, that is, sunk.

To conclude, decentralized airline networks appear more robust and flexible when confronted with unforeseen
volatility in the environment, largely due to their capability to adapt better and more quickly. The capacity choices
involved in operating such routes do not present sunk costs, that is, they can more easily be redeployed elsewhere. On
the contrary, centralization at major and mostly congested hub airports implies increased risk in cases of external
shocks. Financing such HS structures, be it through private or public sources, should therefore increasingly take into
account a risk premium.

References

Banker, R.D. & Johnston, H.H. 1993, An empirical study of cost divers in the US airline industry, The Accounting
Review 68(3), pp.576-601

GAO report, GAO-04-837T, “Despite industry turmoil, low cost airlines are growing and profitable”, June 4, 2004

Huber, H.J., The impact of demand shocks on excess capacity in networks: The case of the European airline industry
after September 11, 2001, Strategic Management Society conference, Paris (September 2002)

 Dr. Hans Huber, Assistant Professor, Audencia, France

COST ACCOUNTING IN THE AVIATION INDUSTRY P Schuster

Hub-and-Spoke Networks and the Full-Service Strategy

The hub-and-spoke strategy is based on broad service in product and geography. It offers customers many destinations
with flexibility and available capacity to accommodate routings, no-shows and flight changes. It requires aircraft with
different capacities and performance characteristics. Hubs require large fixed costs due to large commitments made to
cover scheduled service. They require large fleet and ground infrastructure that is not easily escapable during economic
downturns. All of these increase capital, labor, operating costs, and complexity which are expensive and not easily
avoided (Gillen 2006).

On the positive side, hubs can increase economies of scale in maintaining fleets, using ground property, equipment, and
labor. By funneling in passengers to hubs, airlines can take advantage of economies of density. This is when unit costs
are reduced by increasing output on an unchanged network such as flying the same frequencies with larger aircraft.
Finally, hubs increase economies of scope. These arise when it is less costly per unit of output for two or more products
to be produced and marketed within a single airline than for them to be produced by separate carriers. Hubs increase
economies of scope by combining first class and economy class, local and connecting passengers all traveling on the
same aircraft. All of this works toward reducing average costs.

Point-to-Point Networks and the Low-Cost Strategy

This strategy trades off service, capacity and frequency for low fares. The vast majority of the cost difference relates to
product and process complexity. This is directly tied to the design of their network structure. (Gillen 2006).
While a full service airline relies on a hub-and-spoke network to create catchments, low-cost carriers create the
incentive for each customer to create their own spoke to the point of departure. A common fleet is used to keep
maintenance cost low. Frequency is lower and passengers give up convenience due to lower frequencies. Items like
meal service and passenger lounges are not available. It total, this results in lower costs for the point-to-point network.

Point-to-Point vs. Hub-and-Spoke

Clearly, there are limits to economies of scale, scope and density. At some point, complexity and congestion detract
from the increase productivity. Kanafani and Hansen investigated the connection between hubbing and airline cost in
1985. The question asked was, 'Do airlines that hub more incur lower cost?'

They used data from 13 airlines over a six year period to develop cost functions relating output to factor prices
including the degree of hubbing. An attempt was made to control other factors and let the degree of hubbing vary.
Given that airlines all moved toward increased hubbing after deregulation, Kanafani and Hansen's findings were
surprising. They found that when stage length, capacity, and load factor are controlled for, the degree of hubbing does
not affect airline costs. The authors point out that there are also ways in which hubbing detracts from productivity. The
increased circuitry means that airlines must supply more passenger miles for a given city pair movement. Additionally,
hubs have to 'bank' flights to shorten connection times. This adds to congestion during the peak periods and can lead to
complete network breakdowns when severe weather interrupts operations.

The empirical results from Banker and Johnston found output volumes to be important cost drivers. For all cost
categories, the estimates of the coefficients of the volume base drivers are positive and have t-statistics that are highly
significant. In addition, the coefficients of the operations-based drivers were in the expected directions and have t-
statistics that were fairly high. In some contrast to the Kanafani and Hansen study, Banker and Johnson found that
carriers who dominate their hubs can achieve greater economies from hub concentration than carriers with competitive
hubs. This seems to suggest that carriers that can dominate hubs may be able to schedule, market and operate flights in
a manner that enables them to control the flow of traffic and thereby use their resources more efficiently (Banker and
Johnson 1993). Overall, their results showed that that the effects of operations-based cost driver are statistically
significant.

Approaches to Cost Classification Based on Behaviour. Costs follow three basic behaviours;

'   Fixed- not varying with output.

'   Semi-fixed ' fixed over a range but vary beyond

'   Variable ' (fuel, landing fees)

Airlines generally have a high percentage of fixed cost. As a result, any downturn in traffic or yield possible during a
recession can rapidly take an airline's revenue below the level required to meet fixed cost. On the flip side, since
variable costs are small in relation to fixed costs, once breakeven levels are reached at the existing capacity, profits
increase at a faster rate than revenue. If an airline has a shrinking revenue base it means more seats must be full to hit
the breakeven. As an illustration: Yield among most major U.S. carriers isn't terribly different - United's was 11.1 cents
in mid-2002, while Southwest's was 11.67 cents. A recent Southwest breakeven was 59.3 percent (and its planes were
69.8 percent full) while United's breakeven was a staggering 90.3 percent (MSNBC 2003). To turn a profit, ASM and
RPM need to be as close as possible - at least enough for the passenger load factor to rise above a breakeven point.

One other unique characteristic of airline breakeven analysis is that it must cover the fixed and variable cost of not only
the sold output, but also the portion that is unsold (empty seats and cargo space) Break-even analysis can be used to
check profitability at different volumes of output given the airlines cost and yield structures. Revenue per available seat
mile (RASM) is more comprehensive than yield as it takes into account all revenue not just passengers, but that is not
the reason airlines have adopted it. Their reason relates to the fact that when the load factor is rising, RASM grows
faster than yield because it is a function of both load factor and yield. Thus, during these times, RASM presents a more
favourable picture of company operations than would a yield to unit cost comparison. (A declining load factor produces
the opposite effect) As this suggests, RASM is not an independent variable in airline economics, so using it without
looking at trends in the two underlying components can lead to erroneous conclusions, particularly about the trend of
passenger air fares.

Drawbacks From Break-Even Analysis (Holloway 2003)

1.   Only good for the short run because prices, costs, and their behaviour change over time.
2.   May be inaccurate for a particular product if the entire airline as a whole is being considered.
3.   Any changes to capacity will change the breakeven point.

Comparison of Variable, Average, and Marginal Costs

Marginal costs are somewhat avoidable but do contain some fixed cost depending on the incremental change in output.
For example, if we delete a single flight, the costs are mostly variable but if we delete an entire destination and all the
flights to that station, there are some fixed costs associated with that decision.
Marginal cost is likely to vary over a large range of output and is very different from average cost (Holloway 2003).
With marginal costs below average costs, fierce competition to fill highly perishable seats can drive fairs to below
average cost. If a carrier has empty seats which have already been 'produced' the marginal cost is not significantly more
than the additional ticketing, commissions, and handling to put a passenger into that seat. Average costs must be
covered to maintain a break even result.

Conclusion

Management accounting's function is to assist mangers in planning, controlling, and decision making. All these are
required to synchronize output, unit cost, traffic, and yield management. This information also allows managers to focus
on value, quality management, and strategic position. One of two positions has developed in the airline industry, cost
leadership (low cost carriers) based on the point-to-point model or product differentiation (full-service airlines) based
on the hub-and-spoke model.
Two points are clear from this discussion. First, no one accounting system will work for all airlines. Second, airlines
should constantly look at modifying their cost accounting systems to better fit the evolving competitive industry and
their needs.

Individual airlines must design systems that allocate cost accurately and be useable. Since the purpose is to provide
information to management, the goal should be to limit assigning cost in an arbitrary manner.

References

Banker, R. D., Johnston, H. H. (1993). An Empirical Study of Cost Drivers in the U.S. Airline Industry. The
Accounting Review, Vol. 68, No. 3
Gillen, D. (2006). Airline Business Models and Networks: Regulation, Competition and Evolution in Aviation Markets.
Review of Network Economics, Vol.5, Issue 4, Dec 2006.
Holloway, S. (2003). Straight and Level: Practical Airline Economics. Ashgate Publishing, Ltd.
International Air Transport Association, Distribution of Operating Costs. Retrieved April 23, 2007, from
http://www.iata.org/economics/
International Civil Aviation Organization, Civil Aviation Statistics of the World. Retrieved April 12, 2007, from
http://www.icao.int/icao/en/atb/sea/yearbk.htm
Judd, F. (1949). Development of Cost Accounting Concepts of Scheduled Commercial Airlines. The Accounting
Review, Vol. 24, No. 1.
Hansen, M. (1989). Hubbing and Airline Cost. Journal of Transportation Engineering, Vol115, No. 6, Nov/Dec
Tirovolis, N. L., Serghides, V.C. (2005). Unit Cost Estimation Methodology for Commercial Aircraft. Journal of
Aircraft, Vol. 42, No.6, Nov-Dec 2005.