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EC2166-Lecture5-Chapter4.pdf
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Economics 2166F-001
Lecture 5
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Chapter 4
• Cost and Production Analysis
Assume that airline company tries to maximize its profit.
Profit is the difference between revenue and cost.
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ASM: available seat miles
RASM: revenue per available seat mile CASM: cost per available seat mile
unit of measurement: cent (US$)
US airlines: CASK versus Average passenger trip length
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World airlines:
RASK (at 2015 prices), 1960 to 2015
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World airlines: RASK and CASK (at 2015 price)
and world airline operating margin
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Cost classifications
• Historical costs
– costs actually incurred
• Current costs
– costs under prevailing market conditions
• Sunk costs
– Costs that have been incurred in the past and
are not recoverable
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Lessons
• Sunk costs should not be included in any financial
decision-making process.
• Opportunity costs should be included in the process.
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Components of cost
• In the short run, total costs (TC) consist of
fixed costs (FC) and variable costs (VC).
• TC = FC + VC
• TC/Q = FC/Q + VC/Q (ATC = AFC + AVC)
• CASM = TC/ASM 10
Marginal cost
• The airline industry generally has very high FC and low
MC. There is a small increase in cost for each additional
passenger since, regardless of the number of
passengers, airlines have to pay the high FC associated
with aircraft ownership, terminal expenses, and
maintenance facilities.
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Accounting cost vs. economic cost
• Suppose you have started a small fixed-based operation
(FBO) at a regional airport. Your explicit costs are:
– Labor $1,000,000
– Materials and supply $750,000
– Finance charge, insurance and others $250,000
– Total explicit costs (accounting) $2,000,000
• You are not receiving a payment for your services,
because the business is new and does not have enough
income. Also assume you have rejected a position, in
which you could have earned $200,000 a year.
– How much is the total economic costs?
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Cost functions
• A cost function is a mathematical relationship between
TC and units of quantity produced.
• TC = 50 + 5Q
• TC = 50 + 4Q + 2Q2
• TC = 364 + 48Q - 12Q2 + Q3
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Economies of scale
• Economies of scale occur when average unit costs
decrease with an increase in production quantity.
– Economies of scale are common in highly capital intensive
industries with very high FC such as aircraft manufacturing,
airline industry, railroads, and steel industry
• Diseconomies of scale occur when average unit costs
increase with an increase in production quantity.
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Economies of scope
• Economies of scope refer to the situation where the
company can reduce its unit costs by leveraging
efficiencies through sharing of resources for multiple
projects or production lines.
Ex) A two-product firm may be able to manufacture and
market its products at a lower total cost than two
single-product firms. These efficiencies are called
economies of scope.
TC(Q1,Q2) < TC(Q1,0) + TC(0,Q2)
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Economies of density
• Economies of density are achieved through
the consolidation of operations.
• Hub-and-spoke system for air travel: airlines have found
it more cost-effective to consolidate operations at a
single airport rather than operate a point-to-point service.
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Figure 4.10 Hub-and-Spoke Route Network
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Figure 4.10 Hub-and-Spoke Route Network
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AIRLINE INDUSTRY COST STRUCTURE
• Costs per ASM, or CASM, are the cost of flying one
aircraft seat for one mile. CASMs can be created for a
variety of costs, such as operating costs, total operating
costs, or simply crew costs.
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Airline fixed and variable costs
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Figure 4.12
US Airline CASM Breakdown, 2011
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Figure 4.13
US Airlines Fuel Efficiency, 2011
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Figure 4.15 Correlation between Fuel
Efficiency and Average Stage Length, 2011
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Figure 4.16 Crew Costs per Block Hour,
US Airlines 2011
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Figure 4.17 US Airline Maintenance Costs
per Flight Hour for 2011
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Economies of scale
• Economies of scale refer to the reduction in average cost
resulting from increased production, and they are
generally achieved through operational efficiencies.
– Due to pilot training and maintenance spare parts for aircraft,
it is less costly to simplify aircraft fleets and to focus on just a few
aircraft types.
– Hub airports
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Economies of scope
• Economies of scope are defined as the process of
reducing the average cost of resources by spreading the
use of productive resources over two or more products.
– Airlines achieve economies of scope by operating various
ancillary programs/services such as frequent flier programs,
maintenance activities, catering, and ground handling.
– Boeing capitalizes on economies of scope when producing
aircraft.
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Economies of density
• Economies of density exist in the airline industry through
the use of hubs and the consequent reduction of flights.
• Economies of density are also achieved by using larger
aircraft.
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AIRLINE BREAKEVEN ANALYSIS
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Example
• Assume that the average list price of an A380 is about
US$ 350 million, its VC of each aircraft produced is $314
million, and the total development cost is about $15 billion
• Calculate the QB-E.
– Airbus will have to sell 420 aircraft to simply recoup the FCs relat
ed directly to the A380 program.
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Breakeven load factor (BLF)
• Breakeven in the airline industry is usually expressed as
a percentage of total ASMs. This provides a breakeven
load factor (BLF), or a load factor which the airline must
meet to recover all FCs.
• BLF is the percentage of seats that must be sold on an
average flight at current average fares for the airline’s
passenger revenue to breakeven with the airline’s
operating expenses.
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BLF
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Figure 4.19 Comparison of Actual and Break
even Load Factors for US airlines, 2011
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Airline operating leverage
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