Economies Of Scale In Airlines Management Essay

Abstract

The following report is aimed at examining the economies of scale concept and strategies in the airline industry. This document is divided into several pieces which discuss the impact of the economies of scale on the main aspects of the airline industry. The last section of the document concludes.

Introduction

The financial aim of firms is to increase the shareholder’s capital (Atril, P., Mc Laney E., 2008). Business’ management, then, have to either optimize asset utilization or reduce firm’s costs. Current economic situation have managed industries to achieve historic levels of asset optimization. Therefore, special emphasis had been put in cost reduction strategies during the last decade (Akan, M., Ata, B., Lariviere, M. A., 2011). Airline companies were one of the industries which suffered, almost immediately, the effect of these new market conditions. To cope with this scenario, the industry implemented several cost saving strategies; among them the ‘economies of scale'(EoS).

The following document is aimed at examining the term EoS and analysing how applicable the concept is to major carriers/airlines. The document is divided into eight pieces. The first discusses how the EoS applies to the airline industry. The remained sections comment on how the EoS affects: the airlines’ purchasing process, managerial procedures, marketing, technology usage, consolidation, and the “open skies” strategy. The last section concludes.

Economies of scale in airlines

EoS can be defined as any cost reductions, responding to increased demand for output, moving along a given, downward-sloping long run cost curve (Grieve, R. H., 2010). In other words, the demand allows firms, in this case airlines, to distribute costs over a greater number of products/services. Airlines have put in place several strategies to increase the number of flights. Among them: ticket-selling process optimization, in-flight meal reduction/suppression, alliances, and consolidations (Harvey, G., 2009).

EoS concept assumes that increasing returns emerge at the level of the firm. However, some authors claim that EoS does contribute to cost reductions, but turnover growth does not generally manifest itself in this manner. Empirical evidence has shown that EoS only helped those airlines which do not lose their ‘identity’ when demand increases. That is, Airlines which do not lose the control of the service delivery even they rely in a complex provider structure. Following this train of thought, EoS are of little importance in accounting for increasing returns, since these return rates are attributable to other factors such as external economies or industrial differentiation (Grieve, R. H., 2010).

A successful example of EoS implementation is Star Alliance. Star Alliance is a network of 24 member airlines. Lufthansa and United airlines have registered an important growth in its passenger airline group during 2010 (DATAMONITOR, 2010). Whereas, a failed implementation, MexicanaClick, a low cost airline which was property of the second largest Mexican carrier (Mexicana), did not produced the expected results (BBC, 2010).

The EoS effects in purchasing processes

The implementation of EoS has forced airlines to change their business model. Traditionally, ticket selling was made in two main forms: over the airline counter or via an agent. Information Technologies (IT) have modified this process. Customer can directly make reservations and buy tickets without by themselves. Therefore, ticket agents have evolved to electronic system which provided the function of searching, reserving, and selling tickets making the purchasing process more accurate, fast, and reliable (Singh, A.Kr., Das, D., 2010).

In the same manner, EoS has managed airlines to establish stronger relationships with their suppliers. For instance, the supply IT systems have allow airlines to avoid intermediaries in the requisition of resources since mid 80s, therefore, their logistic costs have decreased (Caves, D. W., et al, 1984).

Investments in these matters have allowed Lufthansa to be the third largest airlines of Europe, and the world’s fifth largest airline in terms of overall passengers (Singh, A.Kr., Das, D., 2010).

EoS and managerial procedures

Outsourcing is the most recurrent strategy of the EoS. By outsourcing activities, the airline allows market forces to reduce the costs of subcontractors who offer for the business (Harvey, G., 2009). However, some author claim that high specialization, in providers, jeopardize business continuity of the outsourced firm (Grieve, R. H., 2010).

Nowadays, airline employees are based in different parts of the world, sometimes in places where salaries and benefits are lower than their airline-home based colleagues. In this manner, airlines have also relocated business functions to take advantage of lower wages and social charges incurred in some countries. For instance, British Airways relocated its ticket processing function to New Delhi (Harvey, G., 2009).

EoS and marketing

Marketing function has also been affected by EoS. Alliances have switched this function to major airlines. Major airlines are responsible for the marketing trips for routes which are composed of international and local courses. In this manner, major companies deliver the international legs of the trip and regional airlines the local ones. When the complete journey is made by two major companies, the role of major and regional firms are switched. That is, the airline which delivers the international leg is responsible for the marketing duties of that trip and vice versa. Additionally, these functions are, most of the times, outsourced. The flight Atlanta-Barcelona is a good example. British Airways is responsible for the marketing of that route, but it only delivers the track from Atlanta to London. The second leg, London-Barcelona is delivered by Iberia; whereas in the route Barcelona-Atlanta, these functions are switched (Wright, C. P., et al, 2010). In the case of regional or small companies, marketing function is totally absorbed by the major company, since regional/small firms do not have the required infrastructure to perform this task (Forbes, S. J., Lederman, M., 2010).

Technology in airlines

IT systems are the most popular EoS strategy. They have not only changed the airlines’ purchasing process, but also have optimized the occupation and improved the communication with providers (Pilarski, A., 2005). However, that is not enough. Energy represents one of the biggest costs of the airlines. Air France-KLM and Air China reported that fuel costs accounted for almost 39% of its global costs in the fiscal year 2009 (DATAMONITOR, 2010). Thus, better engine technology, logistic, and route planning system will help the airlines to reduce these costs.

Airlines have not been able to apply EoS to aircraft technology since they have a higher dependency in two main providers: Airbus and Boeing (DATAMONITOR, 2010). Generally speaking, the whole industry efficiency depends upon technological advances and cost improvement that these two companies may achieve. Therefore, it can be said that all technology which does not directly depend upon airlines is already optimized.

Air France-KLM and Delta are a good example of technological optimization since some of their process like luggage registering and check-in can be done by the customer himself avoiding long queues.

Consolidation of the airline industry

Consolidation is also a well known EoS strategy. Consolidation is mainly aimed at reducing costs by combining mature and efficient processes into one unique entity (Oum, T. H., et al, 1995). Some authors claim that consolidations make airlines to increase their market share. However, Empirical evidence has shown that market share remains stable. For instance, in the 70s five US airlines controlled 87% of the global market. In 2003, none of these five airlines exist, although the share of the top-10 airlines in all traffic was 86% (Pilarski, A., 2005). On the other hand, consolidations are long and complex processes due to tax and aeronautical regulations.

Alliances have been a optional strategy for consolidations. Alliances is formed by any two airlines that exchange interline passengers and that have a proration agreement for the revenue collected from the sale of interline itineraries. In this manner, an airline can expand its destinations and, therefore, increase its revenues. In 2006, 59% of all worldwide available seat miles were flown by airlines belonging to one of the three largest international alliances: Star, SkyTeam, or oneworld. Alliance activity is expected to continue growing (Wright, et al, 2010). Therefore, alliances seem to be the right strategy for the industry.

“Open skies” strategy

The “open skies” strategy consists on allowing airlines to fly within one country, that is, no restriction in local services. In this fashion, an airline may design routes to cover local routes and directly compete with regional firms. The agreement between US and the EU allows airlines to reduce costs of share codes and to improve their costing schema. European airlines which are already consolidated with American ones can operate as one entity, because they do not have restrictions to operate in both regions and vice versa. However, European Court of Justice has found that this agreement is breaking the law, thus, some amendments have to be done to this agreement (Yu-Chun, C., et al, 2009).

Open skies strategy is not a direct result of the EoS, but a mean to achieve it. This strategy was created to impulse airline industry in the 1940s. Thus, agreements like that in other regions will allow airlines to reduce their costing schema and to increase their market participation.

Conclusions

Airline industry is the foundation stone of the current global commerce. Its high efficiency has allowed firms to sell their products in other regions with competitive prices. On the other hand, this industry is a facilitator for some others. Its relevance has been exposed during natural disasters when airports are blocked and products cannot be transported. Current economy cannot be understood without air transportation. The challenge of airlines, now, is to find creative ways to continue their optimization and profitable continuity. Airline industry allows us not only to reach any part of the world, but also to have a competitive and trustable economic system.