Is it wise to maintain the same profit margin year after year for my service business?

Moral considerations apart, the true purpose of all businesses is to maximize profits, which may not be stated in the mission statements of most of the firms.

In my opinion choosing profit margin is not a matter of choice, but function of competition in the market. In a monopolistic situation, however, one can leverage his position to maximize profits from captive clientele by increasing the price without value addition. This would generally be termed as immoral by the consumers and, therefore, consumer protection department of the government might come into action.

In a competitive market, on the other hand, the only way to enhance your profit margin is by adopting creative and innovative methods to cut the cost of production without compromising on quality of a product. Value addition without increasing price is yet another way of increasing sales, therefore, total profits. Additionally target clientele does pay the premium for value addition and differentiation.

But the question remains whether it would be morally correct to increase profit margins in case one has the choice to do so, or not? The answer is yes, but no more than the profit percentage originally calculated considering market risk factors specific to the type of business involved.

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Why do all airlines have “current ratio” less than 1?

If you can do business with other people’s money, that would save you cost of borrowing money from banks for short term use to pay your bills. In airline business you can keep the cash and inventory at bare minimum level as you have sufficient cash flow from advance booking of tickets including government taxes and airports charges. This cash remains with you for quite a few days and you can use it to meet your day to day requirements, instead of borrowing it from the bank. Current liabilities side is accordingly high because you are holding other people’s money.

Besides accounts payable in the form of interest on long term debt and cost of aircraft lease etc results in higher current liabilities. Hence with low current assets and higher current liabilities; current ratio ought to be less than 1.

In airline business ‘equity to assets’ ratio is also very low as airlines leverage assets upto 80% to 90% of their total assets because of very high cost of capital. Hence most of the airlines would have equity to assets ratio in the range of 0.1 to 0.2.

Would an airline ever partner with a startup to increase their load capacity and what cost structure would they expect?

Airlines operate in an oligopolistic (3 to 5 competitors) market. A new entrant in the market only adds up an already stiff competition to maintain a reasonable load factor which is usually very close to breakeven. A start up airline is usually a loss making airline as it has to sell below operating cost to attract passengers from other airlines (cut throat competition). Other airlines having more staying power than a start up airline would jealously guard their market share and would tend to drive out the start up airline through predatory pricing. Predatory pricing (selling below operating cost) is aimed at driving out new entrants. Whether a start up airline survives or not will depend on its staying power (financial) in the market before its brand is established.

Mergers and acquisitions in airline industry are done to reduce competition in order to improve yield by cutting down overall capacity. Airlines do partner in code share to improve load factors & expand markets geographically. Only well established airlines enter into alliances such as Star Alliance, Sky team, and Oneworld. Member airlines of an alliance also share other resources on the ground such as check-in and ground handling facilities to cut the costs.

Even the code share agreements which are mutually beneficial to both airlines take place only between equal brands and not between a well established brand and a start up brand which has a long way to go to establish its credibility. A successful start up airline should rather pursue its own innovative model and create space for itself within the given market before it could be accepted by its competitors for any kind of partnership.

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How do airlines make money from Frequent Flyer Programmes?

Frequent Flyer Programmes (FFP), is a loyalty programme aimed at keeping its members loyal to one airline. This strategy helps them maintain or enhance airline market share and a constant source of revenue.

FFP members, generally businessmen, are a reliable source of revenue streams, buying expensive tickets in comparison to the ‘price sensitive travellers’ who choose airline offering cheapest tickets.

Airlines usually operate around 80% seat factor, leaving about 20 % empty seats to reward FFP members as and when they become qualified. Empty seats are anyway perishable and do not cost airlines anything other than bit of fuel and catering.

Frequent Flyer Programmes are more popular and effective in Airlines Alliances

What is Code Share Arrangement between Airlines?

In this cooperative arrangement; two airlines operate a combined flight instead of competing each other. The one which actually operates the aircraft is called operating carrier i.e British Airways (BA) and the other as Marketing Carrier i.e.American Airlines (AA). Marketing carrier actually blocks a small percentage of seats (i.e. 20%) of operating carrier as per agreed terms and conditions and sell those seats to their customers under their own brand name (AA). However, it is obliged to inform the passenger that he/she would be actually flying with another airline (BA). The two brands however usually match, because no one wants to lose its loyal passenger for having bad experience with the other airline.

Why do airlines need to enter into a code share arrangement? They do so because it commercially suits both the airlines, on a relatively thin route where achieving breakeven seat factor becomes a challenge for both of them. For operating carrier empty seats are perishable and therefore result in heavy losses. Hence it would be advantageous for it to cut the losses by selling these seats in bulk on a much cheaper rate to marketing carrier usually at cost. The marketing carrier, however, sells these seats with profit margin to its own customers. Unsold blocked seats are released back to operating carrier well in advance i.e. one week. This arrangement reduces competition. That is why code share arrangements require prior approval of Anti Trust organizations of the respective Governments.

Marketing carrier also gains on a number counts. It is able to prevent its loyal customers from switching over to another airline just because it does not serve the desired destination. The marketing carrier also makes a bit of profit without actually operating its own aircraft. It can claim to serve far more destinations without actually operating some of them. It also means that Marketing carrier has a plan to actually start operations as and when the desired level of demand builds up.

Code share arrangements are in fact quite complex because it raises the issue of liability i.e. compensation in case of baggage loss/damage etc.

Code share is good for airlines but not so good for the passengers. It suppresses competition and artificially increases price on the code shared route. In a crises situation like long delays or denied boarding and baggage loss cases etc, the passengers of marketing carrier may feel left out because the staff of operating carrier may be paying more attention to their own passengers

If airlines are such a bad business model then why do businessmen keep lining up to start them?

Businessmen keep lining up to start Airline business because:
  • It is a high profile romantic business: It tends to fulfill social and ego needs of some businessmen wanting to become famous at international level. Airline CEOs/owners get far more public attention than other businessmen.
  • It appears highly profitable to naive businessmen: Businessmen having no relevant aviation experience tend to believe that it is a profitable business and ignore the risks involved in it.
Airlines are a bad business because:
  • It is capital intensive:  The price of a new single aisle 150-180 seat aircraft is between US$ 70 to 80 million.  Start up airlines, therefore, tend to lease required number of aircraft. Even this arrangement requires substantial capital. The security deposit usually demanded by the lessor is upto US$ 2 million per aircraft for a period of 3-5 years. Hence a start-up airline would require between US$ 6-10 million to lease a fleet of 3-5 medium sized aircraft. Capital required to establish other related infrastructure such maintenance facilities etc may require as much additional capital.
  • It is labour Intensive: Airlines are labour intensive employing thousands of the professionals to run an airline. This however depends on the size of an airline. Technology has not been able to replace manpower requirements to run an airline i.e.pilots, cabin crew, engineers and technicians etc. Among a dozen of cost its component, labour cost ranks the highest in Europe and North America where it is about 35% followed by Asia where it is about 18% on the average. Unionized airlines end up paying far more compensation than other airlines squeezing already thin margins.
  • It has very high operating cost: A 1000 km (Karachi-Lahore) short round trip by a medium sized aircraft (A320/B737-800) would cost around Rs 2 million (US$ 20000) and it would cost twice as much on a 2000 km round trip (i.e Lahore – Dubai). Cost of operations on domestic routes would be slightly less in Pakistan due lower airport charges and no route navigation charges.
  • It has very high fixed cost: Operating an empty aircraft costs almost as much as passengers sitting in it because all major costs associated with its operations are fixed such as airport charges, air navigation charges, ground handling charges, variable portion of labour cost, maintenance, insurance, depreciation and cost of operating lease/per hour etc.
  • It is the riskiest business: Airline business is the riskiest because empty seats are perishable.  Diversion to other airports due to bad weather at destination airport may double the trip cost besides upsetting other operations planned for this particular aircraft. Holding in the air because of traffic sequencing costs between US$ 100 to 150 per minute. Breaking out of viral diseases such as SARs & Zika virus, adversely affect demand for air travel bringing seat factor for months in a particular market. War or warlike situation such as Gulf war also affect demand and cost of operations as insurance cost tends to go up. Unpredictable oil prices also affect the bottom line.
  • It has fierce Competition: Airline business is oligopolistic where 3 to 5 airlines compete each other for the same size of the traffic, forcing airlines to cut the prices to attract traffic away from competitors. This inevitably results operations around breakeven seat factor, which is around 80% now a days. Average profit margins are between 1-2% if any. This is because capacity of the aircraft comes in bulk (i.e. 150-300 seats) whereas the passengers come in ones and twos. The passengers are also notoriously price sensitive. They rather do window shopping and it becomes virtually impossible for the airline to fill the aircraft at desired price level because of stiff competition in the market. Hence Revenue Management system comes into play selling seats at different prices. This is a complex computer algorithm programme that takes into account the number of seats available and the time left to sell them. It may also take into account the competitors’ price level and keep changing own prices from day to day, hour to hour and even minute to minute. Their primary objective remains achieving breakeven and holding on to their market share.
  • It is Cyclical: what goes up must come down. Global airline industry’s financial results typically suffer from 8 years business cycle. Return on Invested Capital (ROIC) usually remains below Weight Average Cost of Capital (WACC).

Chart Source: IATA 

  • It has more business restrictions: Regulatory restrictions in airline business are far more severe than any other business. Access to international markets is strictly regulated by a system of bilateral Air Services Agreements between Governments. Passenger Safety, Security and Public interest are strictly regulated in line with International Conventions on ‘Public International Air Law’ i.e. 1944 and ‘Private International Air Law’ i.e. Warsaw Convention 1929,  Rome Convention 1952, and Montreal Convention 1999 etc. Entry / Exit barriers are therefore more severe than other business.

Demand Elasticities in Airline Business

In economics, elasticity measures the response or sensitivity of one economic variable to the change in another economic variable. Demand elasticity measures the change in quantify demanded of a particular good or service as result of changes to other economic variables, such as the price of the that good or service, the price of competing or complimentary goods/services, income levels, taxes,

Demand elasticity at Different Levels: 

Fare Class Level: Travellers  choose between different fare classes (first class, business class, full economy, discount economy, etc.) on particularly airlines. At this level, the elasticities are arguably highest. Travellers can easily switch between fare-class levels, airlines, use of another mode of travel (in some cases), or simply chose to not travel (i.e., other activities act as a substitute for air travel). For example, in response to an increase in the full economy fare on a given airline, the traveller can respond by booking a discount economy fare on the same airline, or book with another airline, or travel by another mode.

Carrier Level: The elasticities at this level reflect the overall demand curve facing each air carrier on a given route. In situations where there are a number of air carriers serving the route, the demand elasticity faced by each carrier is likely to be fairly high – if an air carrier increases it fare unilaterally, it is likely to lose passengers to other carriers operating on that route

Route / Market Level: At the route or market level the elasticity response might be expected to be generally lower than at the fare class or carrier level. Travellers faced with a fare increase on all carriers serving a route (e.g., due to an increase in airport fees and charges), have fewer options for substitution. However, they can chose to travel on an alternative route or not travel

National Level: At the national level, fare elasticities would be expected to be lower still, as travellers have fewer options for avoiding the fare increase. For example, if a national government imposed a new or increased tax on aviation, travellers could only avoid this increase by using another mode (which may not always be possible), or not travelling.

Supra-National Level: This represents a change in prices that occurs at a regional level across several countries. For example, an aviation tax imposed on all member states of the European Union. In this
case, the elasticity is expected to be even lower, as the options for avoiding the price increase are even further reduced.

Credits: IATA

Demand Analysis of Pakistani Airline industry

Air Traffic Size vs Population Size: There is a strong correlation between per capita income of a country and the size of its passenger traffic. In developed countries passenger traffic is 100 – 300 % of their population size (USA, Canada, UK, France, Germany, Australia, Japan etc). Annual Air Traffic in China is about 33% of its population and in India it is about 20% its population though air traffic growth on its domestic routes is the highest in the world (21%). This unusual growth level reflects Government’s decision to remove unnecessary restrictions in air transport sector and encouraging private sector to in airlines and airports including foreign investments. This had to be done against the pressures of Government owned Indian Airlines. Extra ordinary growth in demand on domestic sector is also due to ever increasing size of its middle class, which stands at about 400 million people, and stiff price competition among the airlines, making air travel within the reach of middle class.

Currently Pakistan has about 16 million annual passenger traffic, both domestic and international passenger traffic put together. Given the population of about 200 million, annual passenger traffic is only about 8% of the population. Broken down to domestic and international percentages, it is about 3% on domestic routes and about 5% on international routes which is mainly expats. Annual growth in traffic is about 4%. International traffic in Pakistan mainly consists of overseas Pakistanis travelling to/from Pakistan that too only once in two or three years on the average. Inward tourism, in the true definition the term, is negligible, whereas in other countries it forms a sizable portion of the total international traffic. This should not be surprising given the internal security situation,for last two or three decades. Growth in air travel is also linked with growth in national economy. Growth in domestic air traffic has been negative from 2007-2008 onward. it has recently leveled to about 1% per annum, compare it with Indian 21%.

The Interaction between Own-Price and Cross-Price Elasticities

Demand Elasticity at Class Level: Opportunities for the passengers to switch from one class of fare level to another as a result of fare hike by an airline for particular fare class (i.e. economy) are negligible on domestic routes in comparison to international routes. The reasons are as under:

  • Domestic Routes: Two of the three competing airlines operate all economy class. The third one PIA also has all economy configuration on its A320 and ATRs, though B-777s & A310s do have upto three classes of seating arrangements. But these aircraft primarily operate long haul international routes. Hence the opportunity to switch to higher class or lower class seats does not exist. The opportunity to switch the airline altogether does exist on trunk routes i.e. Karachi-Lahore, Karachi-Islamabad. This opportunity also exists on medium level routes like Peshawar, Sialkot, Multan, Faisalabad and Quetta albeit to a limited extent because of fewer weekly frequencies floated by each airline.  No opportunity, however, is available to passengers to either to switch the fare class or the airline on socio-economic routes such as Chitral, Gilgit, Skardu, Gwadar, Turbat, Panjgur etc. This is because only Government owned airline PIA operates on these routes. Ironically suitable substitutes (road/rail) are also not available on these routes, some for geographical reasons and others for security reasons.
  • International Routes: An increase in economy class fare may result in switching to ‘economy plus’ or business class fare for the passengers travelling by PIA B777 or A310 on long haul routes. Alternatively these passengers can switch over to foreign airlines operating indirectly on long haul routes from Pakistan. On short to medium routes primarily Middle Eastern routes the opportunity to switch over to national and international airlines is great. Hence ‘Fare Class’ elasticity is fairly high on international routes.

At the airline level: A unilateral increase in the travel price of one particular airline on a route can increase the demand for other carriers on the route and the demand for connecting alternatives (IATA).

At the route level: An increase in the price of travel from London Heathrow to Paris CDG can increase the demand for travel on London Gatwick to Paris CDG or London Heathrow to Paris Orly (IATA). In Pakistan, however, there is only one airport in one city. Lahore does compete Sialkot and Faisalabad to some extent but not to a large extent because of lessor opportunities for the passengers to find the desired international connections.

At the national level: An increase in the price of air travel to/from a given country may increase demand for air travel to/from other countries (IATA). This phenomenon holds good for tourist traffic and it relevant in case Pakistan for outward tourism. Inward tourism is negligible for security reasons.

At all levels of aggregation: There may exist cross elasticity effects with other modes of transport. An increase in the price of air travel may increase demand for ground transportation and vice versa (IATA).

There may also be cross elasticity effects between air travel and other leisure or consumption activities. In some cases it may not exist at all (e.g. there is generally no substitute for air travel on long-haul
routes). IATA

Market Forces Affecting Airline Business

Michael Porter’s famous five forces:

1) Supplier power
2) Customer power
3) Barriers to entry
4) Threat of substitutes
5) Industry competitiveness

1) Supplier power:  Airlines have to deal with many powerful suppliers such as:

  • Aircraft Manufacturers: choice between Boeing and Airbus only
  • Airport and Air Navigation Services Suppliers: Being Natural Monopolies fix charges which include cost of inefficiencies. Increase in passengers related charges increases price of the ticket and resultantly decreases the demand. Increase in airlines related charges increases operating cost of airlines and accordingly decreases their bottom line.
  • Fuel Suppliers: Airlines have virtually no control over fuel prices. Some airlines, such as British Airways, or other mega carriers, hedge fuel but it does not always work and when the fuel prices drop unexpectedly they end up paying more than market price. Additionally Governments are entitled to impose taxes on domestic routes, such as sales tax, that airlines have no control over.
  • Labour: Airline Business is labour intensive. Hence cost of labour forms major part of the operating cost. It however, varies depending on whether an airline has a unionized regime or otherwise. Airlines that do not allow union activities are twice as productive and efficient as the unionized ones. Average labour cost in unionized airlines is at least twice as much non-unionized airlines. This explains why average labour cost in European and North American airlines is about 35% of the total operating cost in comparison to Asian airlines where it is almost half— about 18%. Even in Asia some airlines are unionized. These are generally Government owned airlines such as PIA and Air India. Their labour cost is twice as much as non-unionized and private airlines. Their labour productivity and efficiency is also barely half of private airlines.
  • Global Distributors (GDS): GDS such as Sabre, Amadeus and Travelport (Galileo, Apollo) charges are fixed for each sector. However, a limited competition does exist in the global market where the airlines could negotiate prices.
  • Travel agents / consolidators: Bulk auction of seats helps to fill empty seats reducing losses in lean markets; on the other hand they lower airline margins in profitable markets.
  • Financial Institutions: These institutions are generally weary of taking risk in investment in airlines or lending them money. This is because it is one of the riskiest businesses in the world. Losses are almost guaranteed in the first few years of the business. It is said that the quickest way to become a millionaire from a billionaire is to start an airline business.

2) Customer power: Internet booking and price competition has given the customers an unprecedented power to window shop. Customers are hypersensitive to price. Difference in price, no matter how minute, would swing a passenger from one airline to another particularly on short haul routes.

3) Barriers to entry:

  • Capital Requirements: Airline business is Capital Intensive: An average airline, therefore, has to leverage upto 90% of the assets. Requirement of Working Capital is also very high. In Pakistan the minimum paid up capital limit is Rs 500 million or about US$ 5 million for a start-up airline. This amount though appears to be quite large to a potential entrepreneur or an investor but in fact it is barely enough to induct a fleet of 3-5 aircraft of the size of A-320 or Boeing 737-800 on dry lease for a period of 5 years. 
  • Regulatory Barriers: Foreign Ownership Rules: Almost all jurisdictions in the world do not allow more than 49% foreign ownership in national airlines.
  • Restrictions on Operations of Foreign Registered Wet Leased Aircraft: Almost all jurisdictions in the world restrict operations of foreign registered wet leased aircraft for socioeconomic, safety and security reasons. Pakistan has, however, recently relaxed this clause in National Aviation Policy-15. The limit of maximum number of wet leased aircraft has been increased from 25% to 50% of the fleet capacity and from 90 days to 180 days. This has given the operators great flexibility to enhance capacity during high seasons and shed the same during lean seasons.
  • Market Access: Market Access on domestic routes is not an issue for  National Airlines. Foreign airlines however are not allowed to operate on domestic routes (Cabotage). Market access to foreign international airports is a function of the parameters stipulated in bilateral Air Services Agreements. These agreements are concluded by the Governments and foreign airlines as such would usually not be entertained directly. However most of the countries including Pakistan have liberalized bilateral air services agreements with foreign countries. Allocation of desired airport slots remains an issue at the slot constrained airports. In Pakistan airports like Peshawar, Islamabad and Lahore are severely slot constrained.
  • Economic and Safety Authority: In Pakistan just as other jurisdictions, a start up airline has to first acquire a commercial license, which is issued by the Government based on CAA’s recommendations and Security Clearance from Security Agencies. The company itself must be registered with SECP. This process may take as many as six months on the average. Then starts the process of Air Operations Certificate (AOC) which must be completed within 365 days from the date of issuance of license. Failure to do so may result in financial penalties.

4) Threat of substitutes: This depends on the distance and geography of the route:

  • For Short haul routes with good rail and road infrastructure such Islamabad-Lahore, Islamabad-Peshawar, even Lahore – Peshawar and Karachi-Hyderabad; it is more economic and even convenient for the passengers to travel by road or rail rather than by air. However, routes like Peshawar-Chitral, Islamabad-Gilgit or Skardu the geographical barriers make a good case for air travel. Same is the case for many of the small airports in Baluchistan. However, this is not the case on Karachi-Islamabad, Karachi-Lahore, Karachi-Peshawar and even Karachi-Quetta routes.

5) Industry competition 

  • Airline industry is oligopolistic where three to five airlines compete each other on prices. The capacity of an aircraft comes in bulk whereas the customers in ones and two doing window shopping. Hence filling an aircraft at the desired average price becomes a real challenge in a competitive market. Empty seats are perishable and cost almost as much as carrying revenue passengers sitting in them because of high fixed costs. Hence airlines are forced to fill the aircraft through revenue management system that works on complex algorithm computer programme continuously varying prices based on remaining seats and the time left to fill them. Airlines are therefore forced to operate close to breakeven point to survive.
  • An entry of a new airline in the market would upset market conditions for other competitors. Hence the dominant players in the market would let the new entrant sell below operating cost in a bid to establish its market share until it start to raise the prices. This is the time competitors in the market would pounce on it by lowering the prices in a bid to drive it out of market. The new airline having far less staying power than others would soon wind up.
  • Lowering the prices below operating cost by the dominant player in the market to drive out the competitor and subsequently recouping the losses after the target competitor has been driven out is called predatory pricing. It is illegal but very hard to prove even in well established jurisdictions like USA and Europe. Airblue had accused PIA for predatory pricing back in 2005. CAA and Government intervention however resolved the issue.


Why Free Consultancy

I have been thinking for quite a while as to what shall I do in my post retirement life, starting from coming September 2016. Well I shall have to do something to keep myself busy, if nothing else then, for the sake of my mental and physical health.

As is said that one should do what one is best at. It is the same thing that one enjoys doing. As is indicated on the home page, I have reasonable degree of experience in various aviation fields such as Air Traffic Control Services, Airport Management, and Air Transport and Economic Oversight, not to mention military flying training on four types of fixed wing aircraft and two types of helicopters. I enjoyed working in Civil Aviation because each of the assignments offered great challenges and, therefore, opportunity for creativity and innovation.

However, my experience of developing Economic Oversight and Consumer Protection Departments in CAA as well as National Aviation Policy was most satisfying experience of my life. Generating Annual Reports on Financial and Operational analysis of National Airlines, charter Operators, and aviation schools took was even more satisfying experience. The insight into the dynamics of aviation business afforded an opportunity to scrutinize start up airlines business plans and proforma accounts statements. To my surprise I found them far removed from reality.

Giving useful advice to prospective entrepreneurs in terms of market conditions, Operating restrictions, cost of operations, and operating margins sometimes upset the applicants while it also resulted in paradigm shift some cases.

I also realized that many of the applicants were unaware of the dangers of this unchartered territory. And that in some cases their vision of aviation business was almost delusional. I also realized that romanticism attached with the airline business turns the investors almost blind to the ground realities, that it is perhaps the riskiest and most capital extensive business in the world. This situation is fully exploited by some Pseudo  industry experts to create some lucrative position for themselves in the upcoming enterprise. There are many bleeding wounds in the market who got swayed by their compelling ambition to own an airline.

This, however, does not mean that Aviation Business is an absolute minefield for the start up airlines. One must be reasonably aware of its complex dynamics, with highly professional and experienced team and more important be ready to lose a lot of money in the first few years starting the business. After all there are hundreds of successful aviation business enterprises that are surviving and thriving. Therefore, it is advisable that one should step into this business cautiously, with some sort of advice from genuine experts, particularly when it comes free.