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Cost Structure - Irreconcilable Differences?

Charles Tyler compares the cost structures of network airlines and low-cost carriers. They may not be as different as they once were

Once, low-cost carriers (LCCs) looked set to become the dominant force in aviation. Many still believe that to be true. But the response of legacy airlines is no longer as muted as it was—and LCCs are not as low cost as they were.

The business model of LCCs—typically using a new-generation single aircraft type on point-to-point routes—has allowed them to achieve short turnaround times, fuel efficiency and high aircraft utilization. Being start-ups, they have also managed to avoid the labor regulations and unionization that have affected bigger airlines.

Research shows that the cost gap between LCCs and network carriers in 2004 ranged from 36% per available seat kilometer (ASK) in the US market to as much as 70% in parts of Asia and Latin America.
But the figures don’t tell the whole story. Costs are only part of the equation. Keeping them low is always beneficial, but higher costs can also be a precursor to higher yields. For example, network carriers generate significantly higher yields from their investment in business and first class services.

“It is like comparing apples with pears,” says Brian Pearce, IATA’s Chief Economist. “The business models are different and we are always going to see a cost gap between LCCs and network carriers.” 
Even so, it is clear that the gap is closing. Take IATA’s Simplifying the Business (StB) program, which has been so succesful in making the network carrier’s business model more competitive. StB will eventually take out some $16.8 billiom in costs on an annual basis.

Pearce notes that StB has even been effective in reducing the number of staff required for the passenger relationship on the ground, but says network airlines still tend to have more back office and head office staff than LCCs. “There is a lot more paperwork that can be cut from the system,” says Pearce. “We are continuing to work with airlines to improve efficiency in areas that can yield further cost cuts.”

Alan Joyce, CEO at Qantas, says that is exactly what his airline has been tackling. “During the past 18 months, our management headcount has been reduced by 20%. We are also working to improve the efficiency of the way in which we work with our suppliers. We have some 30,000 suppliers, and we want to streamline this. We want to use our purchasing power more efficiently, while also reducing administration costs.”

The LCCS grow up

Network airlines’ costs are coming down, while the costs of LCCs are rising. “As LCCs mature they tend to lose their cost competitiveness,” says Fred Lazar, a professor at the Schulich School of Business, York University in Toronto, Canada. “New entrants always have an advantage but this is eliminated over time.” 
That is certainly the case in the mature North American markets. There, the labor and fuel costs per ASK are now comparable between LCCs and the network carriers, although productivity per employee tends to be higher at LCCs.

But perhaps the bigger concern for LCCs is fuel price, which represents a greater proportion of their overall costs compared with network carriers. During the fuel price spike in 2008, when crude oil rose to more than $140 a barrel, it was LCCs that really felt the pinch. Meanwhile, in 2009, IATA Green Teams helped airlines achieve fuel savings averaging 3% of their annual fuel budget.

And with yields turning the corner and business confidence returning, the role of full-service network carriers is being reinforced. “The advantage of the legacy carriers is their networks,” points out Lazar. “With their hub-and-spoke route structures and global alliances, they can provide connectivity to almost anywhere in the world. LCCs, thus far, only really offer point-to-point connections within a particular region.”

Diverse responses

Some network carriers, however, have chosen to compete head-on with LCCs on domestic and short-haul routes. Air Canada was a leader in this area, gearing up its website and unbundling the product for its lowest economy fares to provide for a basic seat plus add-ons such as check-in baggage, meals and other services.

Lazar sees this spreading into the US and European markets. “Many other carriers are now following in Air Canada’s footsteps, though I think that they have a lot to learn,” he says.

While some airlines have decided to fill up at least part of their economy cabin with price-sensitive passengers, others refuse to toy with customer service. They view the passenger relationship as an integral part of their brand.

“Cost-cutting initiatives have been taking place across the company but nothing that touches the customer has been affected,” says Nicholas Ionides, Vice President Public Affairs at Singapore Airlines. “We are a premium full-service carrier and this is the market niche that we retain. We don’t play in the budget end of the market. Some people have asked whether we should have adapted our business model, but our premium positioning is now being rewarded with renewed growth and improving yields.”
Interestingly, Singapore Airlines also has an equity stake in Tiger Airways, as it is clear that there is major scope for LCC growth in the burgeoning Southeast Asian travel market. Ionides is quick to point out that Tiger Airways operates completely independently of Singapore Airlines, but the approach shows a marked evolution from the days of fully owned subsidiaries. British Airways’ Go, Delta’s Song and the like never really took off.

Even in this respect, big airlines are learning to adapt. Qantas owns Jetstar, a highly successful LCC operation. “We saw the establishment of our own LCC as an imperative,” says Joyce. “After the collapse of Ansett, we saw Virgin Blue looking to take 50% of the market. We knew that there had been many failures in the past where full service carriers wanted to establish their own LCC, and we were aware that we were walking a tightrope.”

In short, if the LCC has too much independence, there is the risk of cannibalizing the major carrier’s routes; if the two airlines are too closely linked the cost base becomes too high.

“We gave Jetstar Asia complete independence, with a different head office in a different city (Melbourne) and set up all the management functions independently,” Joyce informs. “However, we developed a flying committee, which decided which routes Jetstar would operate on to avoid excessive competition.”
Initially, Jetstar and Qantas barely overlapped on domestic routes but, as the brands have developed, the market has segmented. Jetstar now operates in parallel with Qantas on some 26 domestic routes, albeit at different fare levels. “The lowest fare on the Melbourne-Sydney route is $93 (AUD100) with Qantas and $36 (AUD39) with Jetstar, but we are extracting profits from both brands,” says Joyce.

Jetstar has pushed into the booming Southeast Asia region, operating out of Singapore, and is also operating medium-haul flights, with seven A330s on international services out of Australia. It flies to Japan and is looking to take over Qantas’ marginal routes to Athens and Rome. Qantas recently pulled out of the domestic New Zealand market to allow Jetstar more scope to build traffic there.

With Jetstar’s growth running at about 20-30% a year in ASK terms, Joyce says it is easy to keep unit costs down. But he is aware of the threat of increasing fuel prices to Jetstar’s profitability. “Fuel prices could go anywhere, and the ability of LCCs to pass on fuel price increases is limited in this price-sensitive market,” he admits. “We believe, having both a full-service carrier and an LCC, we are well placed to cope, whatever happens.”

Where next for the LCCS?

As Joyce points out, LCCs are under pressure to grow to keep unit costs down. But in the mature markets, the US and most of Europe, the number of route opportunities is beginning to run thin.
Lazar thinks there are three main options for them. Continuing to concentrate on short-haul markets offers limited growth while expansion means a significant shift in strategy and costs to serve long-haul routes. “The third option is to change the business model altogether and try to compete with the majors, which is probably the kiss of death for an LCC,” Lazar suggests.

There is evidence that option two is the preferred choice of LCCs. The AirAsia regional network feeding into the long-haul AirAsia X could mark the beginning of a new trend. AirAsia X and Jetstar recently formed an alliance in an attempt to bring down costs on long-haul services, and Lazar expects to see North American and European LCCs following suit. Ryanair and Westjet are already looking at the possibility of starting transatlantic operations. Lazar can envisage low-cost transpacific operations coming in the future.

Long-haul low cost may challenge the network carriers again. But the short-haul competition from LCCs has ultimately served to build a stronger industry and more efficient airlines.

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