Productivity Trends in the US Passenger Airline Industry

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1 Productivity Trends in the US Passenger Airline Industry Peter Belobaba, Kari Hernandez, Joe Jenkins, Robert Powell, William Swelbar August,

2 Foreword A Nation s economic prosperity depends heavily on the efficiency and effectiveness of its transportation infrastructure. Thirty years have passed since the deregulation of the United States transportation industries, which have made notable changes in their operations. The purpose of s US Transportation Productivity Study is to analyze the productivity trends and data for the transportation industries to understand what improvements have occurred in the past thirty years and why. In the academic year, our team completed two studies, one on freight transported by rail and the other on passengers transported by air. Additional modes of transportation, including air freight, trucking and passenger rail, will be added to the study in Beyond these industry studies, we plan to develop recommendations for government policy and investments, and for industry operations, on how to continue these productivity improvements and enhance our economic growth. This study was made possible by the generous funding from The Speedwell Foundation and The Shelter Hill Foundation. We would like to acknowledge Michael Messner and Paul Shiverick for their insightful feedback and support during our research and their engagement with faculty, research staff and students from the School of Engineering, the MIT Sloan School of Management and the School of Architecture and Planning. Stephen C. Graves Abraham J. Siegel Professor of Management Science Professor of Mechanical Engineering and Engineering Systems Rebecca Cassler Fearing Executive Director of the Initiative 2

3 Contents EXECUTIVE SUMMARY Introduction US Airline Industry Overview Evolution of the US Airline Industry Trends in Traffic, Output, Fares and Profitability Growth in Passenger Traffic and Airline Output Growth of Low Cost Carriers Average Fares and Total Revenues Industry Profit Volatility Airline Operating Cost Categories Unit Operating Costs per Available Seat Mile (CASM) Convergence of NLC and LCC Operating Costs Distribution Cost Reductions Trends in US Airline Productivity Airline Inputs and Outputs Aggregate Measures of Productivity Aircraft Productivity Fuel Efficiency Measures Labor Productivity Multi- Factor Productivity Evolution of Airline Networks and Airport Connectivity Hub- and- Spoke versus Point- to- Point Networks US Airport Connectivity: A Passenger Perspective Since US Airline Domestic Network Development Since Summary Looking Ahead: US Airline Industry Challenges APPENDIX A.1 Hub- and- Spoke Analysis Notes (Hernández et al, 2011) A.2 Airport Connectivity Study Notes (Jenkins, 2011)

4 List of Figures and Tables Figure 2.1 : Annual US Domestic Revenue Passenger Miles Figure 2.2: US Airline Output Figure 2.3: Traffic (RPMs), Output (ASMs), and Average Load Factor Figure 2.4: Domestic ASMs by Carrier Type Table 2.1: Comparison of LCC Business Models (Adapted from Belobaba et al, 2009) Figure 2.6: Inflation Adjusted Total Passenger Revenues by Region Figure 2.7: Inflation Adjusted US Airline Industry Net Profits Figure 3.1: Inflation Adjusted Total US Airline Operating Expenses Figure 3.2: Major Components of Unit Costs (Tsoukalas et al. 2008) Figure 3.3: Inflation Adjusted Unit Costs Figure 3.4: Inflation Adjusted Unit Costs by Category Figure 3.5: Inflation Adjusted Unit Costs (excl Transport Related Expenses) for Domestic Operations, NLC v. LCC Figure 3.6: Inflation Adjusted Fuel Unit Cost for Domestic Operations, NLC v. LCC Figure 3.7: Inflation Adjusted Non- Labor Unit Costs for Domestic Operations, NLC v. LCC Figure 3.8: Inflation Adjusted Labor Unit Cost for Domestic Operations, NLC v. LCC Figure 3.9: Inflation Adjusted Labor Unit Cost for Domestic Operations, NLC v. LCC v. Southwest Figure 3.11: US Airline Commission and Sales Costs as a Percentage of Passenger Revenue Figure 4.2: Aircraft Utilization, NLC v. LCC Figure 4.3: Aircraft Productivity by Carrier Type for Domestic Operations Figure 4.6: Labor Force Productivity and Total Labor Force Figure 4.7: Year- by- Year Change in Total MFP Since Figure 4.8: Cumulative Growth of MFP Since Figure 5.1: Example of Hub Network (Source: Belobaba et al, 2009) Figure 5.2: Passenger Weighted Path Quality Figure 5.3: Destinations Flown Figure 5.4: Passenger Weighted Circuity Table 5.1: Average Excess Miles Flown Figure 5.5: Inflation Adjusted Average Passenger Fares Figure 5.6: Mainline Domestic Flight Volumes by Carrier Table 5.2: US Airline Domestic Hub Operations: LCC v. NLC (Weighted Average) Figure 5.7: Domestic Mainline Percentage by Carrier Figure 5.8: PHL Key Carriers Figure 5.9: PHL Hub Carriers Figure 5.10: US Airways, America West Domestic Mainland Flight VolumesFiFigure Figure 5.11: Delta, Northwest Domestic Mainline Flight Volumes Figure 5.12: United, Continental Domestic Mainline Flight Volumes

5 EXECUTIVE SUMMARY The Airline Deregulation Act of 1978 started a process of transformation for the US passenger airline industry that has accelerated in recent years. Over the past 30 years, air travelers have seen dramatically lower airfares as well as changes to route networks and service quality. At the same time, airlines experienced greater profit volatility and, in some cases, bankruptcy and liquidation. The airlines that survived this transition have also become significantly more cost efficient and productive. This report summarizes the findings of several studies of cost and productivity trends in the US passenger airline industry, undertaken at MIT during the past year. Productivity improvements during the first 50 years of airline industry development were driven primarily by innovations in aircraft technology. Until 1978, the ability of US airlines to achieve greater levels of productivity was constrained by economic regulation. It has only been in the period since deregulation that airlines have focused on cost efficiency and productivity improvement in the face of increasing competition. Traffic, Output, Fares, Revenues US domestic passenger air traffic, measured in revenue passenger miles (RPMs), has almost tripled since deregulation. The output of US passenger airlines, measured in available seat miles (ASMs), increased by 186% between 1978 and its peak output level of The mix of international versus domestic capacity has also changed in 1978, only 19% of US passenger airline output was flown on international routes, whereas this proportion has increased to almost 30%. With RPMs increasing at a faster rate than ASMs, the average system load factor (percentage of available seats sold) has increased steadily since By 2009, average load factors for US airlines surpassed 80%, more than 20 percentage points higher than in the early 80s, with a large portion of the increase realized in the last decade. Higher load factors reflect improvements in productivity attributable to improved scheduling and fleet assignment practices and the development of differential pricing and revenue management techniques. While US domestic air travel has grown at rates significantly greater than prior to deregulation, average real fares have declined significantly and in 2009 remained at less than 50% of 1978 levels. Total industry passenger revenues have risen over much of the period as a result of increased output, traffic, and load factors, but have stagnated in the last decade total 2009 passenger revenues were in real terms equal to 1988 levels, reversing 20 years of revenue growth. Increased competition led to an increase in the volatility of US airline profitability, as the total net profits of US airlines have been both cyclical and increasingly variable over the past 30 years. After the industry posted five consecutive years of losses from 1990 to 1994, it returned to record profitability in the late 1990s, before once again plunging into financial crisis and record operating losses between 2000 and

6 These aggregate measures illustrate the stark contrasts of US airline industry performance since deregulation. Traffic has tripled, while total output has increased by a slightly smaller amount, contributing to higher average load factors. Average real fares have decreased by about 50%, more so in US domestic markets. Total industry passenger revenues have grown more slowly due to lower fares, and recent competitive and economic impacts have reduced passenger revenues to 1988 levels in real terms. Overall, the US airlines have experienced stretches of record profitability since 1978, followed by stretches of even greater record losses, and they remain in a financially fragile condition. Operating Costs Total operating expenses in real terms (2010 dollars) have increased from $67 billion in 1978 to $108 billion in 2010, or by 61%. Compared to the 186% overall growth in ASM capacity over the same period, this relatively modest increase in real operating expenses suggests that significant improvements in cost efficiency have been achieved. Historically, fuel has accounted for a smaller portion of total operating expenses than in the most recent decade, peaking at over 36% of total airline operating expenses in Labor costs, on the other hand, have decreased substantially, especially since the re-structuring by Network Legacy Carriers (NLCs) in the early 2000s. The share of total operating expenses related to labor decreased from 42% in 1978 to 29% in Unit cost is the ratio of airline total operating expenses to ASMs produced, also known as CASM (cost per ASM). The average unit cost of US passenger airlines in real terms has declined almost 40% since deregulation. The largest portion of this decrease in unit operating costs has occurred in the labor cost category. Labor unit costs fell quickly in the early 1980s and then remained relatively stable until the early 2000s, when NLC re-structuring led to a more dramatic drop in labor costs. In real terms, labor unit costs have decreased by 55% since deregulation. The most volatile component of airline unit costs is fuel. Very high fuel costs in the early 1980s exceeded the recent peak in 2008, but much of the period from the late 1980s through the early 2000s was characterized by fairly low and stable real fuel unit costs. Low Cost Carriers (LCCs) have driven significant change in the US airline industry, with lower cost structures and higher productivity levels that allow them to offer lower fares and operate profitably. Although LCCs have historically reported unit costs about 2 per ASM lower than NLCs, unit costs have been converging for the two groups, particularly in recent years. LCC unit costs relative to NLCs were about 20% lower in 2009 compared to 30% lower in 2001, with this convergence explained largely by decreased labor unit costs of the NLC group. Productivity Trends Productivity is typically measured as the amount of output created per unit of input. In the airline industry, output is measured primarily as the capacity produced, or ASMs. RPMs are also used in productivity metrics as it can be argued that the ability of an airline to fill its ASMs with traffic (RPMs) captures additional facets of efficiency and productivity. 6

7 At the most aggregate level for the US passenger airline industry, total ASMs per real dollar of operating expense has increased by over 50% since In the early 1980s, US airlines produced just over 5 ASMs for each dollar (in real 2010 terms) of operating expense. In the most recent decade, productivity has increased to nearly 9 ASMs per dollar. Airline productivity can then be broken down according to key inputs: capital (aircraft), fuel, and labor. Aircraft utilization has increased dramatically since deregulation, peaking in LCCs have historically posted utilization about 1.5 block hours per day higher than NLCs. NLC aircraft utilization increased by about 10%, while LCC aircraft utilization increased by over 30% through Fuel productivity has increased dramatically since 1978: by 73% for produced output (ASMs) per gallon of fuel and by 128% for consumed output (RPMs) per gallon of fuel. By 2010, US airlines delivered 64 ASMs per gallon of fuel (and 52 RPMs), meaning the industry s fuel efficiency exceeds that of the average automobile. The total number of employees in the US airline industry grew along with increasing capacity and traffic through the 1980s and 1990s, with temporary declines during economic downturns. After peaking at almost 550,000 in 2000, total US airline employment has plummeted by over 30%, due largely to the NLC labor force cuts in the early to mid-2000s. Overall, labor productivity has grown in waves since deregulation, and has reached historically high levels. ASMs per employee have more than doubled, increasing 108% since 1978, with more than half of that gain achieved since Preliminary estimates of the overall increase in multi-factor productivity (MFP) for the US passenger airline industry also show tremendous productivity improvement over the past 30 years. Use of the growth accounting methodology for the period since deregulation indicates that, on the basis of ASMs as output, aggregate airline MFP has increased by about 80%. Use of the RPM measure as output increases the estimate of MFP growth since 1980 to 160%, that is, the aggregate MFP of the US passenger airlines has grown by over 2.5 times when increases in average load factor are included. Airport Connectivity and Recent Network Evolution Hub-and-spoke networks allow airlines to provide joint supply of seats to multiple origindestination (O-D) markets with fewer flight departures and fewer aircraft, with lower total operating costs than in a point-to-point route network. Despite repeated forecasts of more pointto-point operations, the trend toward development of bigger and stronger hubs has continued. The economic advantages of hub network operations increased revenues from more frequent (connecting) flight departures combined with the clear unit operating cost savings from operating fewer (and larger) aircraft than in a complete point-to-point network far exceed their disadvantages. The US airline industry s dependence on the hub-and-spoke model has continued to increase, with all NLCs reaching unprecedented levels of hub flights well over 90% of their total operations. Even most LCCs, incorrectly thought to be point-to-point carriers, utilize a designated hub for over 90% of all flight segments. Only Southwest shows relatively low levels 7

8 of hub dependence, but even its use of hubbing has grown significantly, with over 50% of its flights arriving or departing a designated hub. The effect of these changes in network structure on passengers has been lower average path quality and slightly higher circuity both suggesting increased inconvenience of travel for nearly all airport categories studied. However, the apparent declines in these aggregate measures are due in part to the fact that far more passengers are choosing to select a connecting itinerary based on a lower fare. Improved airline efficiency from hubbing has lowered unit operating costs, and increased competition has forced the airlines to pass some of that cost savings to consumers in the form of lower fares. US Airline Industry Challenges The US passenger airline industry has undergone tremendous change since deregulation, with many of the most important changes to business practices, cost efficiency and productivity summarized in this report. Consumers have benefited from increased competition, lower fares, new entry and innovative service options, but airlines have not been able to retain the financial benefits from the many cost and productivity efficiencies they achieved. Despite all of the efforts of US carriers to restructure themselves in recent years, the industry remains in a vulnerable financial position. Moreover, the remnants of 60 years of regulation continue to affect the evolution of the US airline industry. Looking ahead for US airlines, global rather than domestic competition will shape of the future industry. The historical leadership of US airlines has been eroded, particularly during the most recent decade. While the US industry stagnated as it focused on the restructuring of costs and productivity, airlines in other regions of the world have continued to grow and have remained profitable. In the US industry, the NLC and LCC operating models have been converging, and with recent consolidation the two types of carrier will continue to co-exist. Airport and airspace infrastructure capacity constraints, along with the costs of expanding this infrastructure, are critical problems for the future of the airline industry. Although the FAA has been working toward increasing the capacity of the en route airspace, increasing congestion and delays indicate that the US air traffic infrastructure has not kept pace with air travel demand. Without major investments in new technologies and even additional airport infrastructure, it will be extremely difficult to accommodate the expected growth in air traffic. This study of US passenger airline productivity makes it clear that the airline business is both capital-intensive and labor-intensive, and is subject to a tremendous cyclicality driven primarily by economic forces and volatile fuel prices. Repeated cycles of record profitability followed by huge losses have left many US airlines in a weakened financial situation. Given that many elements of this cyclicality are not likely to change, the greatest challenge to the airline industry is to achieve sustained profitability and greater stability. 8

9 1.0 Introduction The passage of the Airline Deregulation Act of 1978 started a dramatic transformation of the US passenger airline industry that is not yet complete. With increased competition, air travelers have seen dramatically lower airfares as well as changes to route networks and service quality. At the same time, airlines have experienced increased profit volatility and, in some cases, bankruptcy and liquidation. Those that survived this transition have also become significantly more cost efficient and productive. The focus of this study is on the changes in operating efficiency and overall productivity of the US passenger airlines over the past three decades. This report summarizes the findings of several studies of cost and productivity trends in the US passenger airline industry, undertaken at MIT during the past year. A brief overview of the industry is provided in the remainder of this first section. Section 2 reviews changes in passenger traffic, average fares, industry output and profitability since In Section 3, the evolution of airline operating costs fuel, labor, and non-labor components is presented, with a focus on differences between established Network Legacy Carriers (NLCs) and new entrant Low Cost Carriers (LCCs). Section 4 examines aircraft and labor productivity measures in more detail, and presents the preliminary results of a Multi-Factor Productivity (MFP) study of the industry in aggregate. Section 5 summarizes the findings of two related studies one looking at the changes in airport connectivity and accessibility from the passengers perspective, the other focusing on the recent evolution of US domestic airline networks. Finally, Section 6 looks ahead to the challenges that continue to face US airlines after more than 30 years of deregulation. 1.1 US Airline Industry Overview In the US airline industry, approximately 100 certificated passenger airlines operate close to 10 million flight departures per year, and carry about one-third of the world s total air passengers. US airlines enplaned 720 million passengers in 2010, 630 million of whom flew domestically. In 2010, US airlines (both cargo and passenger) generated $1.225 trillion in total US economic activity, contributing $731 billion or 5.2% of the US GDP, and provided 10.9 million jobs (ATA, 2011). 9

10 The US airline industry contributes significantly to both the US and global economies. Its economic impacts include direct effects like airline employment and many indirect effects on related activities that include aircraft manufacturers, airports, and tourism. The economic importance of the airline industry and its impacts on so many other major industries makes the volatility of airline profits and the financial sustainability of airlines a national concern. Yes, despite being critical to the nation s economic activity, the US airline industry remains a target of regulation and taxation. Today, the US airline industry, its passengers and cargo are subject to 17 different federal taxes totaling nearly $17 billion per year (Calio, 2011), compared to an inflation-adjusted total of $6.2 billion twenty years ago. Thus, while average fares have decreased and total US airline passenger revenues have grown by only 7% in real terms, total taxes collected have increased by 174%. Based on the average price of a one-way domestic ticket, approximately $50 or more than 16 percent of the passenger fare is some form of tax (Karlsson, 2010). Continued taxation and emerging regulations being promoted in the name of consumer protection are imposing costs on the industry that could lead to unintended consequences a smaller industry contributing less in economic activity than it does today. 1.2 Evolution of the US Airline Industry Productivity improvements during the first 50 years of the US passenger airline industry were driven primarily by innovations in aircraft technology related to speed and capacity the introduction of jet airplanes in the 1960s, followed by wide-body jumbo jets in the 1970s. Yet, until 1978, the ability of US airlines to achieve greater levels of productivity was constrained by economic regulation management decisions as to which routes to serve, how often and at what price were subject to government controls. It has only been since deregulation that airlines have been able to focus on cost efficiency and productivity improvement in the face of increasing competition. Airline deregulation has benefited the vast majority of air travelers in the United States. Domestic air travel in the past 30 years has grown at rates significantly greater than prior to deregulation, while average real fares have dropped dramatically and in 2010 are still about onehalf of 1978 levels. New entry by innovative Low Cost Carriers (LCCs) contributed to increased fare competition, forcing the more established Network Legacy Carriers (NLCs) to reduce costs 10

11 and improve productivity, and changing the traveling public s expectations with respect to lowpriced air travel. On the other hand, deregulation of US airlines also had some negative impacts. Cost cutting, increased profit volatility, mergers and bankruptcies of several large airlines, led to job losses and reduced wages for many airline employees. Residents of some small cities saw changes to their air services, as deregulated airlines were no longer obligated to serve less profitable routes with as much capacity or frequency. And, the development of large connecting hub networks by the NLCs also raised concerns about the pricing power of dominant airlines at hub airports (GAO, 1993). Deregulation removed barriers to entry into the US airline industry, spawning new entrant airlines with lower cost structures that allowed them to offer consumers new options for air travel at lower fares. Their pricing strategies, combined with the additional capacity offered in affected markets, reduced average fares for consumers and, in turn, the revenues of NLCs as they matched the lower prices to protect market share. The significantly lower cost structures of the LCCs allowed them to generate operating profits even at low fares, while the NLCs had little choice but to re-structure their operating models in the hopes of maintaining profitability. The significantly lower cost structures of the LCCs can be attributed primarily to higher levels of productivity of both aircraft and employees. LCCs initially operated point-to-point networks with simplified passenger processing and lower aircraft ground times, in contrast to the hub-andspoke networks of the NLCs. Shorter ground times enabled LCCs to achieve higher aircraft utilization rates than NLCs, contributing to lower unit aircraft operating costs. LCCs were also able to achieve significantly higher labor productivity than NLCs, due to more flexible work rules that allow cross-utilization of employees, which also contributed to lower unit labor costs (Belobaba et al, 2009). Although deregulation legislation was passed in 1978, it has taken several decades for its full impacts to be felt in the industry. In the years immediately following deregulation, a fuel crisis and economic recession clouded any assessment of its initial effects. While some new entrant LCCs began to emerge in the mid-1980s, existing NLCs were able to fend off the competitive 11

12 attacks through aggressive price matching. Barriers to entry had been removed, but there remained a variety of barriers to exit that allowed some inefficient legacy airlines to survive. The early 1990s brought the first Gulf War, a fuel crisis and economic recession that plunged the US airlines into another period of operating losses. Iconic names like Braniff, Eastern and Pan Am disappeared from the industry. By the mid 1990s, the remaining legacy airlines were able to return to profitability by reinforcing their hub and spoke networks, protecting their market share and keeping LCCs at bay. The Big 6 NLCs were able to co-exist and generate record profits during the late 1990s, the last period of extended profitability for US airlines as a group. The financial problems of the US airlines that began with the economic downturn at the beginning of 2001 reached crisis levels between 2001 and The combination of the terror attacks of September 11, 2001, the subsequent economic downturn, several military actions, along with international health concerns drove the US airline industry into uncharted financial territory. Four out of the six US NLCs (US Airways, United, Delta and Northwest) filed Chapter 11 bankruptcy between 2001 and Under bankruptcy protection, these carriers focused on down-sizing, cutting operating costs and improving productivity as part of their re-structuring efforts. NLC airline employment dropped by 30% in just five years, representing over 100,000 jobs lost, while average wage rates were also cut by 7% (US DOT, 2011). Despite these restructuring efforts, US airlines posted cumulative net losses of over $60 billion from 2001 to In response to the challenges since 2000, the US airline industry achieved productivity gains that exceed the gains made during the first two decades of deregulation. Recent productivity gains have come from the introduction of new technologies (e.g., internet ticket distribution, web check-in) and by re-allocating capacity (e.g., moving aircraft from domestic to international routes in an effort to improve both aircraft and employee utilization). The NLCs have also attempted to replicate some of the cost efficiencies of the LCCs, for example, by eliminating free meals and pillows on domestic flights to reduce costs and by reducing aircraft turn-around times to improve aircraft productivity. Yet, three decades after deregulation, the industry remains fragile, with airlines struggling to find a business model that can ensure sustained profitability. Although fragile, the industry is 12

13 nonetheless much stronger today than it has been since Over the first 25 years of deregulation, the industry paid the equivalent of $30 per barrel for jet fuel (cost of crude oil plus the refining margin or crack spread ). Today airlines are paying nearly $100 more per barrel for jet fuel and most of the airline companies are reporting profits, albeit modest profits. Without the restructuring that took place during the lost decade of the 2000s, it is doubtful that many of the iconic names would have survived as standalone companies after the most recent financial crisis. The business model that has been adopted by nearly every US airline following the schedule reductions between 2008 and 2010 is one of capacity discipline and focusing on profits instead of incremental revenue and/or market share. With this capacity discipline comes the capability to increase yields and revenues. Without it, airlines would not be able to pass through increasing proportions of the rising cost of jet fuel to the consumer. The increasing cost of oil has also encouraged consolidation as another approach to capacity discipline, and this recent consolidation has not been limited to only the NLCs but has affected the LCCs and regional sector as well. 13

14 2.0 Trends in Traffic, Output, Fares and Profitability The evolution of the US passenger airline industry described in Section 1 is illustrated in this section with aggregate industry data for the period since deregulation. Changes in passenger traffic and industry output are presented, along with overall trends in load factors (percentage of seats filled), average fares and industry revenues. The growth of LCCs in the US domestic market is discussed, along with the increasing volatility of airline profitability. 2.1 Growth in Passenger Traffic and Airline Output US domestic passenger air traffic, measured in revenue passenger miles (RPM), has almost tripled during the period , as shown in Figure 2.1. The annual growth of domestic passenger air traffic has been consistently positive, with only a few exceptions traffic declined in due to a recession, in 1991 due to the first Gulf War, the subsequent fuel crisis and economic recession, again in after the 9/11 terror attacks; and most recently with the economic recession that followed the 2008 financial crisis. 700 Figure 2.1 : Annual US Domestic Revenue Passenger Miles Figure 2.1: Annual US Domestic Revenue Passenger Miles 600 Revenue Passenger Miles (Billions)

15 The output of US passenger airlines, measured in available seat miles (ASMs), has also almost tripled over the same 30-year period. Figure 2.2 shows that total US passenger airline output, domestic and international combined, increased by 186% between 1978 and the peak output level of The increase in domestic ASMs is somewhat smaller, at 159%, reflecting the shift of capacity by most NLCs from domestic markets with high levels of LCC competition to international markets offering more favorable competitive conditions and operating cost economics. In 1978, only 19% of US passenger airline output was flown on international routes, whereas this proportion increased to almost 30% by ,200 Figure 2.2: US Airline Output Figure 2.2: US Airline Output 1,000 Available Seat Miles (Billions) Domestic Atlantic Latin Pacific The combination of traffic (RPMs) and output (ASMs) determines the average system load factor, defined as RPMs divided by ASMs or, more simply, the proportion of airline output that is actually consumed. Figure 2.3 shows the overall growth in total system RPMs and ASMs for US passenger airlines, along with the resulting average load factors. With RPMs increasing at a faster rate than ASMs over much of the period, the average system load factor has increased steadily since 1980, with particularly dramatic increases since By 2009, average load 15

16 factors for US airlines surpassed 80%, more than 20 percentage points higher than in the early 80s, with a large portion of the increase realized in the last decade. This dramatic increase in average load factors, while perceived negatively by consumers hoping to sit next to an empty seat, represents a major improvement in airline productivity. The greater the proportion of airline output that is actually sold and generates revenues, the greater the potential for higher productivity and profitability. The increase in average load factors can be attributed to factors affecting both capacity (ASMs) and traffic (RPMs). On the capacity side, airlines have improved their scheduling and fleet assignment practices with more sophisticated techniques designed to allocate the right size of aircraft to individual routes during specific seasons, days of the week and times of the day. On the traffic side, the development of differential pricing schemes and revenue management techniques has allowed airlines to fill each flight departure with more revenue (and passengers). 85% Figure 2.3: Traffic (RPMs), Output (ASMs), and Average Load Factor Figure 2.3: Traffic (RPMs), Output (ASMs), and Average Load Factor 1,200 80% 1,000 Load Factor 75% 70% 65% 60% RPMs/ASMs (Billions) 55% % Load Factor ASMs RPMs - 16

17 2.2 Growth of Low Cost Carriers Although several new entrant airlines emerged soon after deregulation, most failed during the 1980s and 1990s. The surviving low-fare airlines (also known as low-cost carriers or LCCs ) grew during the 1980s, but still accounted for less than 7% of US domestic airline capacity (ASMs) in Their slow but steady growth continued until 2000, when the LCC sector began to grow more rapidly and to capture significant market share as the NLCs faced a financial crisis and cut domestic capacity. As shown in Figure 2.4, LCCs provided nearly 27% of domestic ASM capacity in In terms of total US airline output (including international ASMs), the LCC sector accounted for about 20% in 2009, as most LCCs have not expanded to many international markets. Also shown in Figure 2.4 is the growing proportion of domestic ASMs being provided by the Express Carrier (EC) section, namely regional airlines operating feeder services for the NLCs. 100% Figure 2.4: Domestic ASMs by Carrier Type Figure 2.4: Domestic ASMs by Carrier Type 90% 80% Share of Domestic Output 70% 60% 50% 40% 30% 20% 10% 0% NLCs LCCs ECs. 17

18 There are many characteristics and operating strategies commonly assumed to be shared by LCCs. These characteristics include use of a single aircraft type or interchangeable family of aircraft, point-to-point operations instead of connecting hub networks, no labor unions and lower wage rates for employees, single cabin service with no premium classes, no seat assignments, reduced on-board frills and seating space, no frequent flyer loyalty programs, and an avoidance of traditional distribution channels all in pursuit of greater productivity and lower unit operating costs. However, many of these characteristics do not accurately represent the actual strategies employed by the largest and most successful low-cost carriers in the US. Table 2.1 presents a comparison of the three largest LCCs in the US, showing the extent to which each airline meets the above typical LCC characteristics: Table 2.1: Comparison of LCC Business Models (Adapted from Belobaba et al, 2009) Southwest JetBlue AirTran Single aircraft type or single family of aircraft Y N N Point-to-point ticketing, no connecting hubs N N N No labor unions, lower wage rates N Y N Single cabin service, no premium class Y Y N No seat assignments Y N N Reduced frills for on-board service (vs. legacy) N N N No frequent-flyer loyalty program N N N Avoid global distribution service (GDS)? N N Southwest Airlines is the oldest LCC, yet it does not adhere to the strict LCC recipe. While the airline s network is not a classical hub structure, it has many focus cities at which a large proportion of its passengers make connections. And, Southwest is the most heavily unionized airline in the US (Gittell, 2003). JetBlue, launched in 2000, has even fewer of the typical LCC characteristics than Southwest. It operates two different aircraft types and it offers advance seat assignments and on-board service that is perceived by consumers to be superior to that of legacy 18

19 airlines. AirTran, the third largest US LCC, has none of the typical characteristics of LCCs listed in Table 2.1, yet is a successful low-cost operator. 2.3 Average Fares and Total Revenues While US domestic air traffic has almost tripled since deregulation, average real fares have declined significantly and in 2009 remained at less than 50% of 1978 levels. Figure 2.5 shows the dramatic decreases in yield (average fare paid per passenger-mile), inflation adjusted to 2010 dollars, for both domestic and international travel on US carriers. The decrease in real fares has been greater in the US domestic market: international average fares dropped 49% between 1977 and 2009, and domestic average fares decreased at an even higher rate of 56% during the same time period. Figure 2.5: US Airline Inflation Adjusted Average Yield $0.35 Figure 2.5: US Airline Inflation Adjusted Average Yield $0.30 Passenger Fare per RPM $0.25 $0.20 $0.15 $0.10 $0.05 $ Domestic System International 19

20 Despite the significant decline in real fares since deregulation, total industry passenger revenues have continued to rise over most of the period as a result of increased output, passenger traffic, and load factors. Figure 2.6 shows the total passenger revenues for the industry in 2010 dollars. Whereas both output and traffic almost tripled, traffic, total industry passenger revenues in real terms have not even doubled, given the significantly lower average fares. And, of greater concern to industry performance, total passenger revenues have stagnated during the last decade, with dramatic revenue losses during the re-structuring period , and again after the financial crisis of Total passenger revenues in 2009 for the US airline industry were equal in real terms to the industry total back in 1988, effectively wiping out 20 years of revenue growth. $120 Figure 2.6: Inflation Adjusted Total Passenger Revenues by Region Figure 2.6: Inflation Adjusted Total Passenger Revenues by Region $100 Total Passenger Revenue (Billions) $80 $60 $40 $20 $ Domestic Atlantic Latin Pacific 20

21 2.4 Industry Profit Volatility The increased competition of deregulation led to an increase in the volatility of US airline profitability. As shown in Figure 2.7, the total net profits of US airlines have been both cyclical and increasing variable over the past 30 years. After the US airline industry posted five consecutive years of losses totaling over $13 billion from 1990 to 1994, it returned to record profitability in the late 1990s, with total net profits in excess of $34 billion between 1995 and Then, the industry once again plunged into financial crisis and record operating losses between 2000 and 2005, returning to profitability in The losses in 2008 were once again record-setting, with another return to profitability in $20 Figure 2.7: Inflation Adjusted US Airline Industry Net Profits Figure 2.7: Inflation Adjusted US Airline Industry Net Profits $10 Pre- Tax Profit (Billions) $0 ($10) ($20) ($30) ($40) These aggregate industry measures traffic, output, fares, revenues and profitability illustrate vividly the contrasts of US airline industry performance since deregulation. Traffic has tripled, while total output has increased by a slightly smaller amount, contributing to higher average load factors. Average real fares have decreased by about 50%, more so in US domestic markets. At 21

22 the same time, total industry passenger revenues have grown more slowly due to these lower fares, and recent competitive and economic impacts have reduced total industry passenger revenues to 1988 levels in real terms. Overall, the US airlines have experienced cyclical stretches of record profitability almost inevitably followed by stretches of even greater record losses. 22

23 3.0 Trends in US Airline Operating Costs The competition made possible by deregulation focused the attention of airlines on cost containment, particularly given competition from new entrant LCCs with lower cost structures. In this section, we examine the trends in US airline operating costs since 1978, with a focus on unit operating costs in three major categories fuel, labor and non-labor costs. While the industry has made tremendous progress in terms of unit cost efficiencies in the labor and nonlabor categories, the instability of fuel costs has proven to be a driver of the profitability cycles discussed above. A comparison of trends in NLC and LCC unit costs is also presented here, highlighting the extent to which there has been cost convergence between the two groups of airlines, particularly in the past 10 years. 3.1 Airline Operating Cost Categories An airline s operating costs can be divided into three major categories: fuel, labor, and nonlabor expenses. Fuel expenses are the most straightforward to categorize, and changing fuel prices have historically been assumed to affect all airlines equally. However, differences in the fuel efficiency of airline fleets as well as the use of financial hedging instruments by some airlines can result in variations in reported fuel costs, among airlines as well as over time. Labor costs include total salaries, benefits and other costs paid by airlines to employees, providing an indication of the use and cost efficiency of labor inputs. Non-labor costs include all other operating expenses not included in the fuel or labor-related cost categories. This last category includes cost items that represent the structural costs of the airline over which management can exert influence and are therefore a good gauge of how management strategies affect controllable costs not related to fuel or labor inputs. Figure 3.1 shows the evolution of total airline operating expenses broken down into these cost components on an inflation-adjusted basis since 1978, with all other detailed expense items shown as non-labor costs. For the US airline industry overall, total operating expenses in real terms (2010 dollars) have increased from $67 billion in 1978 to $108 billion in 2010, or by 61%. Compared to the 186% overall growth in ASM capacity over the same period, this relatively modest increase in real operating expenses suggests that significant improvements in cost efficiency have been achieved. 23

24 Historically, fuel has accounted for a smaller portion of total operating expenses than in the most recent decade. Fuel costs reached a peak of over 36% of total airline operating expenses in 2008, compared to about 30% during the first fuel crisis after deregulation in The proportion of total operating expenses attributable to fuel returned to 29% in 2010, still greater than that observed during most of the 1980s and 1990s. Labor costs, on the other hand, have declined in terms of both their absolute and relative contribution to total operating expenses, especially since the NLC re-structuring of the early 2000s. The share of total operating expenses related to labor decreased from 42% in 1978 to 29% in Non-labor costs have fluctuated as a proportion of total expenses, as the contributions of many of the smaller components of non-labor costs have changed: Outside Maintenance, Non Aircraft Ownership, and Aircraft Rental costs have increased, while the once significant Commissions (travel agency payments) category has all but disappeared. Figure 3.1: Inflation Adjusted Total US Airline Operating Expenses Figure 3.1: Inflation Adjusted Total US Airline Operating Expenses $140 $120 $100 Total Expense (Billions) $80 $60 $40 $20 $ Fuel Labor Non- Labor 24

25 3.2 Unit Operating Costs per Available Seat Mile (CASM) Total operating expenses have increased since 1978, even on an inflation-adjusted basis, because US airlines have increased output and are carrying more traffic. Unit cost is the ratio of airline total operating expenses to ASMs produced. For passenger airlines, unit cost is also known as CASM, meaning Cost per ASM. Unlike total operating costs, the relationship between unit costs on the one hand and volume of airline output is expected to be negatively correlated. That is, larger airlines expect to see some economies of scale (reduction in unit costs with increased output), as fixed costs are spread over a larger output of ASMs. All else equal, larger capacity aircraft should show some economies of aircraft size, as fixed costs are spread over more seats for any given flight, resulting in lower unit costs. And, longer stage lengths mean that the relatively fixed costs ground servicing, for example, can be spread over more ASMs produced. Total unit costs as reported by US airlines to the DOT Form 41 include a category called transport related expenses which consists largely of payments made by large airlines to regional carriers to provide connecting services on their behalf. These connecting services provide the paying airline (usually a NLC) with incremental connecting traffic and revenue. However, because these payments are not actual operating expenses incurred in the production of the ASM output of the mainline carrier, they should not be included for the purposes of unit cost comparisons across time or among airlines (Tsoukalas et al, 2008). This adjustment is especially important when comparing the unit costs of NLCs and LCCs, given that LCCs do not typically rely on regional partners for connecting traffic feed. Figure 3.2 illustrates the four reported components of unit costs. Transport-related expenses are excluded from all of the comparisons presented here. The remaining three cost components of interest are fuel expenses, labor costs and non-labor costs. 25

26 Figure 3.2: Major Components of Unit Costs (Tsoukalas et al. 2008) $0.20 Figure 3.3: Inflation Adjusted Unit Costs Figure 3.3: Inflation Adjusted Unit Costs $0.15 Cost per ASM $0.10 $0.05 $ Fuel Labor Non- Labor 26

27 Using these cost categories and excluding Transport Related expenses, Figure 3.3 shows the aggregate industry unit cost of providing capacity, expressed in 2010 dollar terms. The average unit cost of US passenger airlines has declined almost 40% since deregulation. In 1979, it cost the average US airline an inflation adjusted 18.3 to produce one ASM; that unit cost dropped to 11.2 in $0.09 Figure 3.4: Inflation Adjusted Unit Costs by Category Figure 3.4: Inflation Adjusted Unit Costs by Category $0.08 Inflation Adjusted Unit Costs by Category $0.07 $0.06 $0.05 $0.04 $0.03 $0.02 $0.01 $ Fuel Labor Non- Labor Figure 3.4 shows the inflation adjusted unit costs for the fuel, labor, and non-labor categories. Non-labor unit costs increased through the late 1980s and peaked in Since then, non-labor costs have fallen gradually, with the exceptions of 2001 and 2008, years in which output had to be reduced quickly in a response to reduced demand. Such rapid reductions in capacity cannot be matched with equally rapid reductions in the fixed costs that contribute to the non-labor cost category. A substantial part of the reduction in real non-labor unit costs since the mid-1990s can be attributed to substantial cuts in airline distribution costs first with the elimination of travel agency commissions in the late 1990s, followed by the use of internet and related technologies 27

28 for ticket distribution since Overall, non-labor costs have decreased by 25% in real terms since Labor unit costs fell quickly in the early 1980s and then remained relatively stable until the turn of the century. A dramatic drop in labor unit costs occurred between 2002 and 2006, with NLC bankruptcies, layoffs and restructuring of labor contracts. In cumulative terms, the average real labor unit cost for US airlines has decreased by an astounding 55% since deregulation. Together, the labor and non-labor operating cost categories combined (excluding fuel) have seen a 40% decrease in real unit costs since Fuel unit costs expressed in inflation adjusted terms, on the other hand, have exhibited much greater volatility than the other two cost categories. Very high fuel unit costs in the early 1980s exceeded the recent peak in 2008 in real terms, but much of the period from the late 1980s through the early 2000s was characterized by fairly low and stable real fuel unit costs. Fuel unit costs began to surge in 2005, peaking in 2008 and leading to the US airline industry s most recent profitability challenge. 3.3 Convergence of NLC and LCC Operating Costs Figure 3.5 compares inflation adjusted NLC and LCC airline unit costs since The NLC group has reported total unit costs (excluding transport-related expenses) that have consistently been approximately two cents (USD) per ASM higher than the LCC aggregate. In percentage terms, the unit costs of the two airline groups appear to be converging. LCCs still had a clear unit cost advantage in 2009, but their unit costs relative to NLCs were about 20% lower in 2009 compared to 30% lower in Figure 3.5: Inflation Adjusted Unit Costs (excl Transport Related Expenses) for Domestic Operations, NLC v. LCC 28

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