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Maximizing Financial Flow vs Capacity Discipline — Cuz That's Where the Money Is!

May 31, 2018 | By Mark MacKenzie

What is Capacity Discipline?

When the infamous bank robber, Willie Sutton, was asked why he'd robbed banks, he purportedly said, "Cause that's where the money is!" Capacity Discipline is a buzz phrase that airlines like to use to describe their own version of airway robbery: restricting the number of available seats in many markets by flying smaller airplanes or fewer flights which then drives up the price per seat (law of supply & demand). Most of these markets could support more passengers with larger airplanes or greater frequency, albeit at a lower price per seat and/or a lower load factor (% of full) per flight.

Intuitively, this business strategy makes sense; if an airline is going to operate a flight into a market, it should be entitled to maximizing its revenue per available seat or maximizing its revenue relative to the totally allocated cost of providing that seat. These both appear to be maxims for profitability and success. Unfortunately, for all stakeholders involved (customers, employees and shareholders alike) these maxims are unequivocally false.

Increasing Airline Profits

It is only by using counter-intuitive models that we can see the financial folly of a Capacity Discipline Approach. Airline profit is defined as:

Airline Profit = Total Airline Revenues – Total Airline Costs

If an airline increases its revenue while holding its costs level, it will increase its profits. If an airline reduces its costs while maintaining its revenues constant, it will increase its profits. This second option becomes more and more difficult as the airline attempts to drive its costs towards zero. A third option of simultaneously cutting some costs while attempting to increase revenues is problematic, as the cost cutting often results in lower revenues. Another option, however, appears to be viable; Selectively increasing only those costs which then drive revenue growth by more than cost growth. If targeted cost drivers increase by 500 million dollars but those drivers, in turn, increase revenue by 1 billion dollars, then the airline will have added ½ billion dollars to the bottom line.

What Metrics Should Airlines Use?

To determine which planes, people, parts or processes actually drive revenue growth there needs to be some metric that measures the reality of the airline on a unit level, something less than the entire airline. Because passenger revenue is easily allocated by the seat — passengers purchase seats on flights — it’s not difficult to see why the airlines prefer using ASMs (Available Seat Miles) to allocate and account for both their revenues and costs. And while this may be an easy way to allocate both revenues and costs, it turns out to be a less than profitable way to operate an airline. Revenues are produced and truly variable costs are incurred by the flight and not by the seat. While recent airline profits have broken records much of the profits have been the result of massive cuts in the price of fuel, which is an airline's largest expense.

Airline Revenue is always variable — that is, it varies by the flight, market, date, time-of-day, airline quality / service and seating configuration (First Class, Business Class, Economy Extra, Economy, Window, Middle or Aisle). However, Airline Costs are only sometimes variable. Costs should be allocated to fixed, semi-fixed or truly variable buckets — that is, they are fixed or semi-fixed when they are incurred over time (Annually, Quarterly, Monthly, Weekly, Daily, Hourly or by the Block Hour) and they are truly variable when they are incurred or not incurred by the act of operating or not operating a flight (Fuel, Food, Landing / ATC Fees, Fees for Departure - aka Capacity Purchase Agreements).

Airline Costs are never fixed or variable by the seat. Costs are either fixed or semi-fixed by some measure of time or they are truly variable by the flight or market. CASMs are not real — they are figments of an accountant's imagination. In fact, RASMs aren't real either — they too are figments of an accountant's imagination. RASMs and CASMs are Revenues and Costs divided by an imaginary metric (ASM) that provides little value in making better or more profitable decisions about which flights to operate (or not), what prices to charge and which airplanes or seating configurations to operate in a given market.

Since many costs are fixed or semi-fixed, when scheduling an airplane or airplane seating configuration to operate a flight within a market, these fixed or semi-fixed costs should not be considered. They are fixed over some time period and they do not vary directly with the Flight or Market Decision. Fixed Costs are sunk costs which should not be accounted for or allocated to this Flight or Market Decision. While semi-fixed costs do vary with the Block Hours of each Flight, it is still a time variable cost which doesn't vary between different markets of equal Block Hour lengths.

Only those revenues and truly variable costs which are directly attributed to and inform the Flight or Market Decision should be included in the airline metric.

The Answer? Financial Throughput per Flight

This airline metric is Financial Throughput per Flight — all of the flight’s variable revenue minus only the flight’s truly variable costs. Financial Throughput is measured at an airline’s most constrained resource, its flights. Financial Flow and Profitability for the airline are maximized when Throughput is first maximized and then total Airline Throughput is optimized IRT the Total Fixed and Semi-Fixed costs to operate the airline.

Throughput Accounting is prescriptive accounting (managerial accounting) that's designed to help managers and employees alike make better, more profitable decisions. Throughput Accounting helps airlines focus on, leverage and then maximize financial flow via their most constrained resource, their flights.

Closing Remarks

 

So why should airlines change their focus, metrics and how they account for both revenues & costs? "Cuz that's where the Real Money is!"

Thanks for reading about maximizing financial flow via throughput accounting.

Mark MacKenzie

Airline Profitability and Reliability Advisor

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