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Supply and Demand in Airline Economics
  
The key to optimising business activity of an airline is to satisfy the demand by application of supply as capacity. Correct management of both sides of this equation will lead to maximum passengers being able to fly on their chosen flight, and minimum unsold seats which represent lower load factors and less revenue per aircraft.

Demand for air travel is determined primarily by the growth in business activity world-wide. It is expecting to maintain a long-term growth of 5% per year. Revenue Passenger Kilometres (RPK)are expected to grow strongly in the Asia Pacific routes, and the low-cost carriers experiencing similar growth. (1) Analysing this growing demand and how it can be satisfied is a key strategy for profitability.

Price will be the main driver in market growth especially as many passengers now choose their own tickets and airlines have been forced to reassess market strategies which can no longer expect demand to be driven simply by providing capacity and convenience.
 
Demand represented as a willingness to travel is a function not only of business growth and activity, but also of the disposable income of the leisure traveller. Other factors driving demand are the number of potential customers available to buy the airline product; the price of the offering and the price outlook; the competition for the product and the substitution potential. ‘Attraction Factors’ also affect demand : timing of service offered on competing services; location of the airport and scheduling.

When considering a specific route, it is not just the willingness of the passenger to fly, but to fly on that particular route with that particular carrier. A macro model examines the route network and environment as a whole making decisions based on overall situation. A Micro Analysis examines traffic on a route-by-route or city-pair basis using historical data to extrapolate or model scenarios to establish the demand distributions which can be combined into the overall demand curves of the model.

Expected Traffic Growth and projections for RPK and can then be developed. The expected Load Factors will be estimated. From these figures the required capacity ASKs can be established against the predicted demand.

Pricing is at the heart of managing demand and good Yield management is essential to optimise financial returns. Yield is how much revenue is generated by flying one passenger over one km. Yield Management ensures that the revenue price must exceed the average costs of carrying a passenger. (4)

As a result of competitive pressures, market fares are getting lower. Low-Cost Carriers carry out dramatic discounting strategies. To achieve this level of discounting, the airline must have a very low cost base. 

Business travellers are more demanding in terms of flexibility and flight availability and Price-Inelastic. They are higher yielding than leisure travellers for whom price is a major issue, but can be more flexible about travel arrangements.

 Traditional full-service airlines compete by using differential pricing which uses Revenue and Yield Management to try to manipulate demand and gain maximum profitability from each class of service operated on each route. They also have the ability to stimulate demand and gain market penetration by the use of short-term price offers, without having to resort to long-term price reductions. Premium products such as First and Business Class are a major asset for yield generation. 

 Demand for an airlines product can be stimulated by increasing frequencies as high-yielding business travellers in particular will use an airline which provide a more frequent service (this is called the S-curve effect) (2) . 

 An airline must take into account the potential actions of its competitors before making changes. Alternatively, alliances between airlines can control market feed and increase demand for their products where they are unable to buy airlines. 

Capacity is generally represented in a standard form Available Seat Kilometres (ASK) which represents the available airline capacity across its fleet, able to fly one passenger for one kilometre.  If insufficient capacity is available on a given route then passengers will be unable to travel and represent lost revenue to the airline. This is called “Spill”. If the capacity provided by the airline on a route is too large, such that many seats are unfilled, the costs of flying each customer will therefore be higher and route profitability reduced.

The ability of an airline to supply the capacity starts with the existence of a suitable Air Service Agreement. An airline seeks maximum flexibility in adjusting capacity and frequencies in rapidly changing market conditions. Increasing capacity may require increasing freq   uency of service, utilisation, redeploying aircraft, or procuring more or larger aircraft to provide the ASKs that are required to match forecast demand in anticipated markets. Conversely when passenger demand falls, the cost base of the fixed overheads and indirect costs of aircraft ownership remain, and so profits will fall unless changes are made either through redeployment or disposals.(3)

 Balancing Supply and Demand is a ongoing management task which should aim for optimum solution by ensuring capacity is available to match predicted demand. Reaching this goal with appropriate pricing through Yield Management is a major step to maximising the profits from operating the service.

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 © Aerointegrity Gmbh 2007

 
Bibliography

Airbus Global Market Forecast Dec 2005
Air Transport Economics Philip Shearman
Buying The Big Jets, Ashgate Publishing, Paul Clark
Straight and Level – Practical Airline Economics Stephen Holloway
Airline Marketing and Management, Ashgate Publishing, Stephen Shaw

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Factors determining Change in Aircraft 

When faced with the opportunity to make use of additional timeslots, an Airline has to consider very carefully the impact on his business of operating these new frequencies and the impact on current services. It is clear that airlines main aim should be to maximize profitability and the change in aircraft type for existing aircraft or procurement of new aircraft should always be a strategy to improve profitability.

The trend in demand is a key element of the analysis. This should be generally upwards and the timescales should be carefully considered as part of the Business Case for this. Demand Analysis and estimates should be available on a macro level (complete network top-down view) as well from the micro level (route specific bottom-up view).

The macro analysis in this case will give an overall picture of future demand across the network by predicting the Expect Traffic Growth and Future Traffic Kilometres (RFKs). If the conclusion of this demand study that additional capacity is required on the routes under consideration,  then the macro analysis will provide some evidence that an increase in total future capacity is required over the network. This creates a contingency that capacity increased could be used to satisfy demand elsewhere in the network when a decision is made whether to change aircraft type.

It should be noted that macro planning cannot differentiate between aircraft numbers or types and so is useful to establish the overall demand and the effects of the on the available capacity it is of limited use in establishing the makeup of the fleet.

Therefore micro analysis will provide more detail about the planned routes which feed the main routes and can provide more detail about the precise needs on the routes we are considering.

An analysis must be carried out of predicted demand on each of the potential routes under consideration. If the demand is outstripping supply, there will be spill: this is the level of unsatisfied demand, and represents lost custom. This will not happen on all flights obviously, and the modelling of demand assumes a normal distribution. The mean variance of this distribution represents the probability distribution of demand.

The limits of the capacity, the maximum of passengers on that route effectively limit the upper part of the distribution and reduce the mean number of passengers that can be carried and hence the average load factor. The expected demand distribution will determine the effect of  capacity limits on the average demand. A wide distribution will mean more potential demand will be lost with a given capacity limit than if the demand was less varied.

If the route under consideration for new frequencies has low variance relative to its mean value , then it is more predictable and actual demand can be more easily matched by capacity for greater load factors and ultimately profitability.

If new frequencies are envisaged then the viability of the operating the new schedule must be considered and also the impact on the loading of the existing flights. This will indicate whether an additional aircraft of similar type should be employed to fill the available slots, or whether either smaller or larger aircraft would be suitable. The optimum solution is to match the capacity with demand.

 Model to show level and trend of demand are derived primarily from historical passenger data. The Airline has been flying the route already, and will have historical data concerning its own share of demand, but no details on other airlines operating the route. Therefore details of the complete demand on the routes being considered are required to model the total demand that exists and ensure that additional frequencies can be profitable.

 The Marketing Information Data Tapes (MIDT) supply information from a variety of reservation systems. Other agencies can be employed to provide management data and trend analysis on this data. For example the five-year historical data for the LHR-JFK route for example will be available and the marketing agencies can provide estimates of the demand growth to feed into the fleet Plan Analysis. SABRE, the other GDS companies and external agencies such as TravelScan can support this activity.

The additional of extra frequencies on a route already operated, will have the effect of  reducing profits as the cost of operating the second aircraft must be considered. If demand grows as predicted, then profitability should increase until such time as you are making more profit that with the single frequency.

The Fleet Planner will have to make a judgment based on the timescales of the demand growth and the effect that will have on profitability over time.


Aircraft capacity is the main input to the capacity-planning model. The choice of classes must also be established and be fed into the appropriate models to establish the yield.

 If new aircraft type are envisaged on this route, then a complete study is required which encompass the following:

-       The Direct Operating Costs of the new aircraft in comparison with the existing model.

        The Economics of Owning or Leasing the new aircraft compared with current situation (Investment Appraisal). To be study by Airlines Commercial and financial department together with the banks or leasing companies as appropriate.

·        The plan for the new aircraft to meet the Operational Requirements of the new proposed route frequencies, and deployment on other routes in the Airline’s network. Aircraft performance data is available from Manufacturer. Route data and analysis from the Airlines Micro Models.

·        Aircraft Evaluation in terms including Range/Payload, cargo capacity, route and airport compatibility.

·        The effects on the revenue model and likely Yields and profitability following of the introduction of the new aircraft. Fleet Planning Profit Profiling and Models should provide this data.

·        The effects on the benefits of Fleet Commonality and Interoperability. Commonality can results in large savings in Crew Training, Logistic Support and maintenance, spares and Operator experience of the family. The success of the Airbus 3xx series illustrates this very well. Fleet Planning Models should be able to evaluate the data for this. The Manufacturer will also provide data or benefits of commonality (of its models).
A key consideration for the decision to modify the capacity proposed by this airline is to ensure that the demand and capacity side of the equation are optimally matched.

This means that the capacity available matches demand with an acceptable level of load factor and spill and helps ensure the profitability of the frequencies on the routes are maximised.

Risk and Sensitivity

The Sensitivities of the Input Factors affecting the Aircraft Economics are shown in the table below. The Sensitivity shows the extent of the change in the output NPV cash values of the operation when the input factor is varied. This gives an indication of which factors have the largest impact and therefore should be closely managed where this is possible.  A number of the factors are related, for example increasing the Number of Seats by 5%with the same load factor will be the same as increasing the load factor by the amount.

Sorted Factor List   Sensitivity
Passenger Revenue   34.25
Pax load factor   27.40
Number of seats   27.40
Number of sectors per year   7.85
 Other operating costs   6.60
Cargo Revenue   2.94
Cargo load factor   2.94
Fuel price $ per USG - default is $0.80   2.90
Block fuel consumption (t) per trip   2.90
 Pax services   2.86
 Maintenance : mature cost   2.42
 Cabin crew   1.76
 Handling fees   1.76
Revenue and cost escalation rate   1.72
 Cockpit crew   1.54
 Navigation fees   1.54
 Landing fees   1.10

This sensitivity information identifies those elements in the model which should be most closely studied to maximum incoming Cash flow. Where these are external factors such as fuel costs the future volatility of the price should be considered as this indicates the potential volatility of the NPV results.

A number of assumptions must be made about the environment not influenced by the above inputs. Examples of these are given below:

·        Foreign Exchange and interests rates remain constant.
·        Demand for air travel in the markets being considered increases.
·        Regulatory and tax regime stays the same.
·        Ownership conditions and leases (where applicable) remain in force.
·        Political, Environmental factors stay constant.
·        Competition response is envisaged and is not totally unexpected. 

The additional frequencies that are proposed in the previous question will have the effect of supplying additional capacity in the market on these routes at these times. The growing demand should obviously be established before considering adding frequencies, but revenue management can be used to manipulate the demand, to encourage passengers to take advantage of the new flights available. The existence of these new frequencies may also in themselves stimulate demand.

Capacity can be increased in terms of additional seats in aircraft, which is very difficult to retrofit, or by providing larger or additional aircraft. This has a very large sensitivity, and adding capacity while maintaining the load factor by matching demand will have a very dramatic effect on the incoming cashflows. Greater utilisation of existing aircraft may be possible within practical limits. 

The Cargo revenue and loading also is significant, although in this case it has only a 10% effect of that of passenger loading on the cashflows.

The fuel price is an external factor that is very difficult to predict and the risk of future volatility can be hedged by buying purchase options at a price fixed today. This allows planning to be simplified.


Passenger services can be rationalized, and in the case of the low cost carriers has been completely stripped down to bare essentials. Food must be paid for, checking and inflight amenities are minimal. It is a competitive business question how far the airline must go in this rationalization.

Maintenance costs can be managed by operating aircraft that have good commonality and are well represented in the marketplace. This allows for competition among maintenance organizations and hopefully better value for money. The use of Operating Leases and fixed maintenance payments rather than owning the aircraft is a way of managing these costs.

Cabin Crews are a significant cost and there is enormous variance in their remuneration across airlines. The costs are being kept down and managed by multi-skilling, running minimum crew, and in the case of pilots, recruiting only pilots that already have the appropriate type rating for the fleet.

Navigation and Landing Fees are generally fixed, and there is limited scope for negotiation. However airport fees can be minimized by the commercial leverage used by the low-cost carriers at out of town airports.

It is clear from the above that the airline must expend a lot of effort in maximizing load factors and using its revenue model to ensure optimal matching of supply and demand. The aircraft size and frequency should be optimized. Dynamic Aircraft Allocation is a way of doing this that allocates the aircraft to the route depending on prevalent conditions. This allows optimisation of capacity and maximising flexibility to meet demand.

Lease vs Buy Decision

The airline must examine the differences between buying aircraft to meet its capacity need and leasing, either as a financial lease, or more likely, as an Operating Lease. Although traditionally they have owned and maintained their fleet, the trend is toward outsourcing of services, or at least operating these as separate businesses or divisions. The objective of concentrating on Core activities means that many airlines welcome the opportunity to manage the risk associated with operating aircraft. This can be achieved through an Operating Lease.

The single most important aspect of such a lease is the cashflow. For a fixed regular payment the customer obtains exclusive rights to operate the aircraft. The cashflow is constant and represents a mix of Principal and interest. A loan structure requires much higher outgoing cashflows, particularly in the early stages if the normal structure of constant Principal and declining interest is to be followed.

The residual value of an aircraft is a vital part of lease pricing and this means the airline should wherever possible adopt a well-established aircraft type, which demonstrates strong residuals.

Lease payments are considered by most tax authorities to be wholly consumed by the business and therefore totally deductible for tax purposes and remain off-balance sheet..

Purchasing an aircraft fleet means that the airline is exposed to the future volatility in the value of the aircraft which can be illiquid in times of economic downturn.

Flexibility of capacity planning can be exercised by the airline by entering short-term leases. The Operating lease is therefore a useful tool not just for cash flow purposes, but also as part of a long-term capacity strategy or tactically to cover short-term demand fluctuation.

In the case of the airline considering adding frequencies to its schedule the method of adding this capacity depends on the window being considered. This requires input from the Business Case, the financial health of the company and its tax position. The mix of the fleet and interoperability between routes will also be an important consideration.

 The lead-time before the new frequencies are being added. Aircraft supply lead-times can be less than one year, and the opportunity may exist for further options to lease or buy. It may even be possible to convert between aircraft types before delivery. These options may provide additional risk management and flexibility.

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 © Aerointegrity Gmbh 2007