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Making sense of the airline business

The logic of airline industry economics can at times elude common sense; it is, for example, understood that 80 percent of all routes served by major carriers like United or Delta will lose money or break even. So why would anybody be in this business? By Jon Bonne.
Airline stewardesses pose in front of a United Air Lines' Boeing transport in San Francisco in this May 15, 1930 file photo.
Airline stewardesses pose in front of a United Air Lines' Boeing transport in San Francisco in this May 15, 1930 file photo.
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The new sales notion, to market a “Tourate” or “Conditional Passage,” faced more than a bit of skepticism: Sell cheaper airline tickets to passengers who wouldn’t pay for a full-fare, full-service ticket. There was, of course, one big caveat: It had to be made clear to these passengers that they were getting a second-class ride. The year was 1939. Sixty-four years later, airlines and their customers have rediscovered a crucial if obvious notion: Value is in the eye of the beholder.

Cutting air service down to its fundamentals isn’t necessarily a bad thing. But it’s a hard sell to many executives in an industry that doesn’t usually operate the way others do.

The logic of industry economics can at times elude common sense; it is, for example, understood that 80 percent of all routes on a major “network” carrier like United or Delta will lose money or break even — and must be subsidized by the remaining routes that turn a healthy profit.

In part, this was the built-in cost of a system designed to take travelers to and from almost anywhere in the country — a system predicated on the absolute value of its brands.

That brand obsession worked so long as customers were happy. But with major airports crowded to capacity, systemic delays and a drive by the majors to trim every cent possible, the definition of fundamentals have changed: You get in a flying machine, you go somewhere, you land safely and, hopefully, you’re not too uncomfortable while you do it.

To complicate matters, even as that model finally sinks in with the flying public, upstarts like JetBlue have raised the ante by offering extra perks — leather seats, satellite TV — while hewing to a low-fare mandate.

“It’s one of those situations where for a lower price you get a better product, which is really hard to compete with,” says Alex Wilcox, who runs JetBlue’s western operations out of Long Beach, Calif.

Back to basics
The recent rise of low-cost carriers and the point-to-point model have driven a focus back on fundamental economic realities, a simple assessment of profit and loss on any given route.

Basic statistics govern much of the airline business. Available seat miles (ASM) — the total of all the seats available on every airline route, multiplied by the length of the route — are the benchmark of an airline’s total capacity. Revenue passenger miles (RPM) show the number of seat-miles for which the airline is actually filling a seat and making money. Revenue, or yield, per RPM shows how much an airline will make on each filled seat on each mile it flies. 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.

So why would Southwest turn a healthy profit each quarter while United headed to the bankruptcy judge?

To turn a profit, ASM and RPM need to be as close as possible; in English, that means the airlines want their seats filled — at least enough for the so-called passenger load factor (how many revenue tushes end up in available seats) to rise above a breakeven point. And that’s precisely why your center seat on a packed 737 you’re flying to Grandma’s house makes the airline far happier than you are.

In the weakening travel market over the past year, ASM has shrunk 6 percent and RPM is down 3 percent — meaning fewer flights and slightly fewer passengers, a trend that reflects industry efforts to fill seats. But then, the average yield a year ago was 12.42 cents, nearly a penny more for every passenger for each mile they flew.

The shrinking revenue base means more seats must be full to hit the breakeven, which brings us back to the United-Southwest comparison: 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; though UAL filled nearly three of every four seats on every flight, its bar for profit was set unrealistically high.

Industry executives like to cite former American Airlines chief Bob Crandall, who once apocryphally offered that the best way to make a small fortune in flying was to start out with a big one. Indeed, economic realities provide razor-thin operating margins even in good times.

Airlines’ internal financial workings are as mysterious as their meal recipes, but based on recent expense data and passenger loads, an average cost to fly a 1,000-mile route on a 737-700 might hover around $14,000 for the major carriers — or about $120 for each paying passenger. (For ever-thrifty Southwest, the cost was around $10,000 per flight, or $102 per passenger.) The average 1,000-mile airfare this month was $118.46, according to the Air Transport Association.

The expectations game
The key to survival, then, is an economic limbo dance that allows the carriers to keep seats as full as possible while driving costs as low as they’ll go — while knowing too much pressure on either end brings the risk of losing customers and scuttling your business. At this point, travelers are discovering that real, qualitative differences in service are ever harder to find on the shorter-haul flights that make up most domestic air traffic.

“When you start looking at the comparison ... what’s the difference between Southwest and USAir? Well, it’s a reserved seat, mainly,” says Clinton Oster, an Indiana University economist who has studied airline pricing for the Department of Transportation. “If I’m only on the airplane for an hour, hour-and-a-half, how much difference can it make?”

That sort of reality check is spreading across the traveling public. If anything, the major carriers may have disadvantaged themselves over the years by offering full-service flights while at the same time driving down their prices in a searingly competitive market. The net result was a customer base of pleasure flyers who thought they might get something for nothing.

“When you have a first-class cabin and when you have perks for people who pay higher fares for that,” says one airline pricing analyst, “even the people who pay $99 say, ‘I want that.’”

The majors now could take a page from that 1939 business plan: the need to educate customers on what to expect. That will be crucial for a major carrier like United as it resurrects its West Coast shuttle service in a low-fare format.

If anything will help, it’s that even premium travelers have begun to flirt with low-cost options, and low-cost airlines have won at the expectations game, educating customers beforehand so they’re happy when they deplane.

“We haven’t heard a squawk,” says Stephen Smith, president of Air Canada’s low-fare Zip subsidiary. “They understand that when you pay those fares you get that kind of service.”

But in looking for that great deal, it’s worth noting that air travel now is more of a bargain than ever.

“We used to joke around that if you could save people five dollars, you could strap them to the wing,” says Jonathan Ornstein, CEO of regional operator Mesa Air. “I have these old timetables from United from the ’30s. What could you pay less for today than you could 70 years ago?”