Air Transport System and Airline Operations

∂ST C(Q)

SM C(Q) = =

∂Q ∂Q

• Average variable cost: Total variable cost per unit of output.

39

• Average fixed cost: Total fixed cost per unit of output.

Therefore, the STC(Q) is just the upward translation, of the quantity TFC, of the

TVC(Q). It means that it has the same properties of the long run cost function and

the curvature of all the curves shown in figure 35, are consistence with the curvature

of the cost function.

Figura 35: Short-Run Marginal and Average Cost Curves

2.6.2 Shut-Down Condition

It is important to understand how cost structure affects managerial decision-making.

In this regard the cost function provides the following information for managerial

decision making:

• Marginal Cost tells us where (how much) to produce;

• Average variable cost tells us whether we should cease production in the short

run (Shut-down condition)

Since MC is the cost for extra units of output, then it is obvious that as long as

the revenue from the extra unit exceeds its cost then we will want to produce more.

Conversely, if the cost for that unit exceeds the revenue, then we will not want to

produce that unit. Hence, we will continue production up to the point where MC and

marginal revenue (MR) are equal but not beyond. So, we continue to produce as long

as M R > M C. What tells us whether to cease production?

• Long Run: We still haven’t made a decision, so we are not in the business.

Therefore, fixed cost are non sunk. If we produce we get:

− − −

P r = pQ T C(Q) = pQ V C(Q) F ns

if we do not produce, we get zero profits due to the fact that Q is zero. Then we

produce as long as: − −

pQ V C(Q) F > 0

ns

40

That is as long as: F F

V C(Q) ns ns

+ = AV C(Q) +

p> Q Q Q

• Short run: I’ve already taken the decision to produce (inputs). The worst

decision i could have made is where those inputs have not a secondary market.

So, if i stop the production, at worst, i will have a loss equal to fixed sunk costs.

If we produce we get: − −

P r = pQ V C(Q) F sunk

If we do not produce, we get negative profits, so a loss equal to sunk costs:

−F

P r = sunk

Then, we produce as long as:

− − −F

pQ V C(Q) F >

sunk sunk

That is as long as: V C(Q) = AV C(Q)

p> Q

This result is due to the fact that sunk costs do not enter the decision.

In the end, the general situation is described in figure 36.

Figura 36: Shutdown conditions

2.6.3 Breakeven Analysis - Manufacturing

An important measurement of any company’s cost structure is its breakeven analysis:

the number of units or revenue required in order for the firm’s costs to be recovered.

Therefore, the minimum amount of output in order to not have a loss. In manufacturing,

the breakeven point is represented in product units. For example, the revised breakeven

forecast for the Airbus A380 program is 420 aircraft. In other words, Airbus will have

to sell 420 aircraft to simply recoup the FCs related directly to the A380 program.

Analytically, the breakeven condition correspond to:

pQ = AV C(Q) + T F C

Therefore: TFC

Q =

BE −

p AV C(Q)

41

This is the minimum level of output that i must to produce and sell in order to

breakeven my profit. Let’s consider the previous example of the Airbus A380 program.

Assume that the average list price of an A380 is about US$ 350 million, the variable

$314

cost structure is linear (AV C(Q) = c),with c being equal million, and the total

$15

development cost is about billion (fixed costs). If we calculate, we obtain Q

BE

equal to 416 aircrafts. To date, Airbus only sold 251 A380 units, therefore, it’s obvious

that they are in a loss situation. They only sold the 60% of the programme breakeven

point. As shown in figure 37, the breakeven point (Q ) can be visualized as the

BE

intersection point between two lines: the total cost function, which starts from TFC,

and the revenue function. Before Q costs hare higher than revenues, so the profit

BE

is negative. In the other hand, after Q , the revenue is higher than total costs,

BE

therefore, the profit is positive. This is due to the fact that in the no-profit region,

fixed costs are more influential than the higher slope of the revenue curve. Conversely,

in the profit region, the higher slope of the revenue curve is more important than fixed

costs. Figura 37: Manufacturing Breakeven Point

2.7 Cost Specificities in the Airline Industry

The most common metric used to standardize airline costs are CASMs. We know that

an available seat mile (ASM) is one aircraft seat, flown one mile, regardless of whether

it is carrying a revenue passenger. Therefore, Costs per ASM, or CASM, are the cost

of flying one aircraft seat for one mile. Figure 38, provides a breakdown of various

CASMs for eight major US airlines in 2011 with the TC per ASM representing the

direct operating costs (DOCs) of fuel, labor, maintenance, and other operating and

non-operating costs.The four DOCs can be considered VCs while the nonoperating

costs can be considered FCs. 42

Figura 38: US airlines cost structure, 2011)

For an airline fixed costs could be:

• Fixed salaries, benefits and training costs for flight crews which do not vary

according to aircraft usage.

• Maintenance costs regarding labor and contracts for maintenance scheduled on

an annual basis.

• Lease costs based on a length of time.

• Self-insurance costs

• Operations and Administrative overhead.

On the other hand, variable costs could be:

• Crew costs such as travel expenses, overtime charges.

• Maintenance costs regarding labor, parts and contracts scheduled on the basis

of flying time ore flying cycles.

• Engine overhaul, aircraft refurbishment and major component repairs.

• Landing fees and airport and en-route charges.

2.7.1 DOCs - Fuel costs

Lets define first of all a block hour. A block hour corresponds with the time from

the moment the aircraft door closes at departure of a revenue flight until the moment

the aircraft door opens at the arrival gate following its landing. So, fuel costs con be

analytically expressed by the following equation:

F cg

F = ASM

c ASM/B h

g/h

Where F are fuel costs, F is the fuel price per gallon and b is a block hour. While

c cg h

the price of fuel is generally out of the airline’s control, airlines can lessen the impact

of this cost by: 43

• Using more complex investment strategies such as contracts that grant the

contract holder an option to execute a purchase at a later date at a predetermined

price.

• Increasing fuel efficiency by:

– Operating new fuel-efficient aircraft over older, less fuel-efficient aircraft.

– Technological advances, e.g., example, the installation of blended winglets.

– Fuel management strategies. For instance it’s possible to shut down an

engine during normal taxiing procedures, to plan the flight in such a way

to minimize the fuel-burn, altering the location where fuel is purchased or

by increasing the stage length.

Stage length is also important since longer flights burn less fuel per ASM. The reason

for this is the fact that the takeoff and landing phases of flight use the most fuel per

ASM. Therefore, the longer the flight, the more fuel-efficient ASMs there are to dilute

the less efficient takeoff and landing phase. For example, as shown in figure 39 and in

figure 40, American Airline (AA), in 2011, was the one with the lowest ASM/gallon

and with an higher Average Stage Length (ASL).

Figura 39: US Airlines Fuel Efficiency, 2011

Figura 40: US Airlines Average Stage Length, 2011

In fact, in general, as shown in figure 41, there’s a strong negative correlation

between the ASM/gallon and the ASL. 44

Figura 41: Correlation between Fuel Efficiency and Average Stage Length, 2011

2.7.2 DOCs - Flight/Cabin Crew Expenses

Flight personnel costs can be analytically expressed by the following equation:

L /b

r h

F P = ASM

c ASM/b h

Where L is the labor rate. Since most airlines deal with a heavily unionized labor

r

force, it can be difficult for airlines to adjust labor input to output. That is, contractual

agreements with labor groups make it difficult for the airline to furlough employees.

Productivity gains in labour may also be limited by unions and government regulations

concerning work rules. For example, Southwest is effective through a more efficient

use of its employees. That is, employees are expected to perform many different tasks

in addition to their primary duties. These productivity gains help Southwest offset

its higher pay rate. Instead, JetBlue benefits from being a relatively young company;

therefore, they have a relatively younger workforce with a lower pay rate. Airlines such

as American, Delta, and Continental have been around long enough that many crew

members are quite senior and command a higher pay rate than junior crew members.

This factor is enhanced when pension and Medicare issues are included in the crew

cost calculations.

2.7.3 DOCs - Maintenance Expenses

Maintenance costs can be analytically expressed by the following equation:

M /b

lm h

M = ASM

c ASM/b h

Where M are maintenance labour and material. A major innovation in the maintenance

lm

area has been the outsourcing of maintenance activities to third-party vendors. Maintenance

costs are usually standardized per flight hour since flight hours are the primary driver

of an aircraft’s maintenance cycle. There is some relation between maintenance costs

and the airline’s average aircraft age, maintenance checks which are more expensive

for large aircraft and aircraft commonality, in fact, airlines with diverse aircraft fleets

45

usually must have spare parts on hand for each aircraft type thereby requiring a

large inventory of parts. As figure 42 states, Continental and United had the highest

maintenance costs while the LCCs, Southwest, JetBlue, and Frontier had the lowest

maintenance costs in 2011. One possible explanation for the great differences in

maintenance costs is that the LCC fleets are relatively new.

Figura 42: US Airline Maintenance Costs per Flight Hour for 2011

2.8 Breakeven Analysis - Airline Industry

Breakeven in the airline industry is usually expressed as a percentage of total ASMs.

This provides a breakeven load factor (BLF), or a load factor which the airline must

meet to recover all FCs. BLF is the percentage of seats that must be sold on an

average flight at current average fares for the airline’s passenger revenue to breakeven

with the airline’s expenses. As already treated with the breakeven analysis in the

manufacturing sector, the breakeven condition is when total operating revenues are

equal to total operating costs. Therefore:

∗ ∗

RP