Adding Up the Drop
(Originally Published in Barcelona Metropolitan, May 2008)
In 1992, there was an explosion of low-cost carriers (LCCs), sparked by the European Open-Skies Treaty, which essentially de-nationalized European airspace. Prior to that, national governments had restricted their airspace to “flag carriers,” such as British Airways and Air France. Suddenly, small local airlines like Ireland’s Ryanair were free to fly anywhere in the EU without government approval. The result was a freefall in airfares as more competitive market practices sprouted within the industry.
LCCs now account for about a quarter of the more than half-million monthly commercial flights in Europe. Yet, on the surface, their airfares don’t appear to indicate viable business practices. In fact, the fares seem downright counterintuitive. Barcelona to Amsterdam, 10€, for example. The ticket sales, even at full-capacity, would cover just over half of the 2000€ necessary to fuel the plane. Then there are all the other costs incurred for that 1246 km flight: training, benefits, and salaries for cabin and ground crews as well as office personnel; insurance, parts, and maintenance on the €30 million craft; airport charges for runway and airplane parking as well as passenger service charges for the use of its facilities; hotel and food for the cabin crew; government taxes such as the passenger service duty; and there are IT services and networks, among other ancillary costs.
So, how do they do it? How can Ryanair and other LCCs like easyJet and Vueling manage to grow by 25% or more per year –which is well above the industry average of 8%—when often their ticket sales don’t even equal the enormous costs of maintaining an airline?
The answer in general is that these LCCs gain through other revenues while at the same time cutting their costs immensely.
The answer in more specific terms involves a far more elaborate equation. As Airline Consultant, Robert Ditchey, told Metropolitan, “Airline economics is a very complicated subject, and arguably one of the most complex problems in the business world. Exactly how one successfully assembles a true low-cost airline is very detailed.”
Other Revenues
When LCCs sell a ticket for other European destinations, there are often hidden charges. The ticket price doesn’t include baggage, for example, and the novice LCC traveler may be surprised to find at check-in that they have to pay extra for their suitcase. There may also be charges for use of the check-in desk and credit card fees. For sheer cost and variety in imaginative charges, Ryanair has been identified as “the worst offender” by the British magazine Holiday Which?
Further revenue is gained through the sale of in-flight meals and drinks, which –in order to cut the price of the ticket—are not necessarily provided automatically to every passenger. Then there are the mini vendor carts that flight attendants roll up and down the aisle selling perfume and chocolates. Car rental and hotel bookings can equal up to 10% of ancillary revenue, as well as other internet-related sales and commissions.
Also, not all the seats on the plane were sold at the advertised discount price. Ticket sales are usually higher when purchased close to the date of departure. And though LCCs generally have better on-time records than flag carriers like Lufthansa, they occasionally run late. And when they do, they won’t always guarantee a seat on a later flight. Passengers with connecting flights often have to purchase another ticket at a last-minute price.
Cutting Costs
Ryanair, like Southwest, focused on expanding into secondary airports and opening up the market for regions somewhat off the beaten path for traditional air travelers. The benefits are that secondary airports, according to a SWOT analysis by the business-intelligence database, Datamonitor, “are generally less congested than major airports and can be expected to provide higher rates of on-time departures. By choosing secondary airports, the company can thus achieve faster turnaround times and fewer terminal delays and gain competitive handling costs.” Other airlines have followed Ryanair into a reliance on secondary airports. But some, like easyJet, will also fly in and out of major airports.
Other benefits of using secondary airports include subsidies by the local government. In 2004, when Ryanair consolidated its southern Europe base of operations in Girona, it was as a result of €6.2 million in discounts and fee-waivers provided by the Generalitat of Girona. The purpose of these subsidies was to stimulate tourism and the economy of the region, as well as boosting profits for the airport in parking charges and increased retail sales. According to El Pais, the Girona airport accommodated 30% more passengers and flights in 2007 than in 2006.
LCCs often use derivative financial instruments to help them cut costs. One example is the practice of fuel hedging, which is the advanced purchase of fuel at a fixed price for future delivery. Another derivative financial instrument often used is a call option. Call options are similar to hedging, but no physical or financial asset is actually bought or sold. Rather, the airline purchases through a premium the right, but not the obligation, to buy future fuel at a set rate. The benefit of a call option is that the airline may buy fuel more cheaply should fuel costs actually drop, which happened periodically in 2007, forcing Ryanair –because they had hedged rather than buy a call option—to purchase fuel at $73 a barrel rather than the market price of $60.
Other means of cutting costs include the elimination of cleaning between flights. Also, having one single type of aircraft in the fleet reduces training and maintenance costs. Subcontracting maintenance and ground crews at competitive prices has resulted in a substantial reduction in costs for LCCs.
One surprising means which is used to cut costs is the fairly common practice of charging pilots for their training, though Robert Ditchey calls the pilot portion of the airline equation “a mere drop in the proverbial bucket.” Konrad R., a Swedish pilot, who prefers that his surname not be used, is based in Barcelona. He described how the practice works. “Before you start in the company you pay for your own Type Rating, which is the initial training for a specific aircraft type. Depending on how desperate pilots are to join the company, they will charge them more than it actually costs and require you to get your rating from a specific Training Center that they are working with. Then because you don't have much flying experience you also buy hours in the airplane, flying as a First Officer. Most pilots really look down upon this practice. We all have to sacrifice a bit to get that important first job, but when you are actually paying to work, rather than getting paid to work it has gone too far.”
Despite variations in the recipe, the ingredients to all LCC models are essentially the same. For simplicity, this article has focused on Ryanair, the pioneer of European LCCs and currently the largest in Europe. They –as well as other LCCs—first based their business model on that of the U.S. carrier, Southwest Airlines, though “The Southwest Airlines model is ancient history,” said Robert Ditchey, adding, “The new model doesn't really exist. . . . There is no singular model in the world that can be deemed The Model."