COLUMN: Chris Tarry on the need for speed as airlines cut costs

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A move back towards economics determined by demand will focus attention on how and when to initiate cuts, writes Chris Tarry.

We have written in the past about our concerns of the increasingly supply-side nature of the airline industry, reinforced by "my order is bigger than your order" behaviour which seems to suggest a new race to the bottom in terms of fares. There is a need, we believe, to move back towards economics determined by the demand side, which will inevitably focus further attention on costs. Indeed demand is not only about volume, it is more about how it shows through in revenue, and here the need is to adjust the cost base to the prevailing revenue stream - simple in concept but more difficult in practice.

Although reported profits for the industry in 2011 - with some $16.2 billion at the operating level - are likely to be much closer to the 2010 result of $21.7 billion than might have been expected, the results cover a broad range. What is not in doubt for 2012 is that if fuel stays around current levels, it will be markedly more difficult.

If we take company objectives as being first to survive, secondly to compete and finally to prosper, 2012 will see more airlines in survival or profitless competition categories rather than competing profitably or prospering. All this inevitably focuses attention on a combination of increasing revenue but, more importantly, cutting costs for all airlines. In particular, it raises questions in respect of where and how costs might structurally be reduced.

While expansion provides a means to "grow down" unit costs, this is not widely available. Furthermore, from a planning point of view, although it is possible to estimate the impact of increased capacity on unit costs, the painful rendezvous with reality occurs when trip costs exceed trip revenues, no matter how low unit costs might appear to be. The problem for low-cost carriers is how they can structurally reduce their costs further; or is it a case that the future total cost to a passenger of travelling on such airlines moves even closer to established fares in the market place?

Ideally, management of any company should at least seek to use the "good times" to prepare for worse times; but it is often thought a meeting of management and workforce minds to make changes only takes place when they are looking over the precipice - and then it may be too late.

THE BAD TIMES

The real issue is that the "bad" times for airlines in Europe are going to continue for some time yet. In a number of European countries it appears the traditional economic cycle is broken, and while government measures to stimulate the economy may have bought some time, it was to little avail as the focus for those most challenged is on the nature and extent of the austerity programmes and their consequences.

There are also a number of airlines where, although the external environment continues to have an impact, they face deep-seated structural problems. The only answer appears to involve a kind of "shrink to survive" strategy, with a second phase which sets out how to profitably grow from this new starting point. However, we have already seen the constraints on management from organised labour, as well as cash pressures. While cost reduction should be an ongoing discipline, it is also necessary to be able to attach this to a growth strategy which leads to what some might describe as the "sunny uplands". All of which raises the key question of how and where airlines can reduce costs structurally without a significant reduction in operations.

Clearly improving efficiency is important and a good starting point is to stop measuring and making pronouncements on productivity using ATKs per employee or similar not very useful volume-related measure. For example, it is not always obvious where the labour savings have been achieved after a new process technology has been introduced.

Setting up a lower-cost subsidiary or outsourcing (via a capacity provision model that has been around for some time in the USA) is another route. But here too a key issue is the scope management has to implement the plans in a timely and cost-effective way. In this respect Iberia Express may be an important development for Iberia and IAG, but the reality is its growth is a direct function of the retirement rate of Iberia's pilots - and recently Iberia announced a 20% wage cut.

Going back to the starting point; most of an airline's costs are fixed in an IATA season and most are also externally determined. The reality is the size of the reduction required in residual or controllable costs is almost undeliverable without fundamental change in business processes. It is here the problem lies.

But it has never been any different and what is clear is consolidation, without meaningful cost reduction, will only result in illusory or transitory synergies at best. This returns us to an earlier theme. It is not a shortage of ideas that is the problem, it is the speed, cost and ability to implement the necessary programmes. Which leaves the hanging question: how and why might this change and when, given the "need for speed" in a number of cases?