Definitions of Fixed and Variable Costs in Regard to the Airline Industry - Case Study Example

Table of contents. Introduction. 2 Definitions of fixed and variable costs in regard to the airline industry. 4 Fixed costs 4 Variable costs. 5 Challenges that affect margin, fixed cost and volume. 6 Rise of fuel costs 7 Factors affecting fixed costs. 8 Factors that would affect the volume. 9 Options available to these challenges. 12 Long term plan for the airline industry. 13 Conclusion. 15 The airline industry. Introduction. The aviation industry can be dated back to early twentieth century in the northern region of Carolina when the first successful flight was made by the Wright brothers; in Kitty Hawk. But back then the public reception of this industry was not so cordial because of the obvious danger of crashing and thus there were fears associated with this industry. But after the First World War, the perception of airplanes and air travel changed because of the efforts put forth by the United States of America (US) in the First World War on using planes which gave some assurance on the security of air travel. But in 1927, after the completion of the first Trans Atlantic flight by Lindbergh, the general public’s interest in flight rose and thus gave birth to the Aviation Corporation that has expanded to form the gigantic aviation industry of today. But the initial function of the aviation industry was to transport mail around the world, a task that was made competitive through a bidding process. This was because of the high cost of travelling and the fact that mails were very light and thus suitable commodities for the airline industry (Michel 2008). The first passenger plane was made in 1938 with a capacity of twenty one people with the rest of the space for mail. These kinds of planes were small with a very limited capacity. But the period of entry into the Second World War saw the research in aircraft manufacturing intensify greatly. In the year 1958, there was the passing of the Federal Aviation Administration Act whose responsibility was to regulate air traffic control. This was a result of the numerous air collisions that had rocked the industry. In the seventies, dramatic changes were made to the industry; such as the hike of fuel prices due to the increase in the number of planes. More than ten years later, the industry underwent deregulation which saw the introduction of small carriers and the fusion of the bigger carriers. This went on smoothly into the nineties when there was an insurgence of air passengers, who included first time passengers, and thus there was a massive reduction in prices and service destinations increased. An Overview of the Airline Industry The aviation industry is undoubtedly one of the largest industries around and it is still growing. It enhances economic expansions, encourages international investments, trade and tourism among others; factors that are all crucial for globalization. In the nineties, the industry underwent a massive expansion of up to ten percent where travel for leisure and business enjoyed immense growth all over the world. During this period of time, many business activities experienced a massive growth and likewise, goods and services too witnessed the same trend simply because there was increased connection between the source of raw materials and the factories or the service providers (Conklin & de Decker 2009). Growth of similar margin was also experienced in 2000s which saw the growth of an equivalence of more than six and a half percent (Michel, 2008). The European and the American regions, which have the most developed airline systems, witnessed lesser growth as they have reached saturation through the growth and development they had experiences in the previous decades. The present airline industry has seen a rapid growth of the number of passenger with more than two and a half billion people using air travel every year since 2005. Initially, the airline industry was mostly government owned but in recent years, many of these state owned airlines have privatized due to poor efficiencies and sprawling debts under state ownership. The US has the biggest market share in the industry, in the nineties; it alone accounted for more than thirty three percent of the total market share but it has since lost some of its market share due to the emerging markets in India and China. The consistency of this market is largely unpredictable since the airline industry has been previously been affected by factors such as the 9/11 terrorist hijackings, wars and economic recession. Today, with most of the airline industry is in private hands and facing difficult challenges that affect the profit margins with regards to fixed and variable costs, the industry needs to put in place a long term plan to prevent losses and even bankruptcy in a extremely competitive industry (Burgati, 2006). Definitions of fixed and variable costs in regard to the airline industry. Fixed costs According to Conklin & de Decker 2009, a fixed cost can be generally be defined as a cost that remains constant in the whole process of production or sales levels. These costs are always present in the daily, monthly or annual operations of any business. They include constant costs like rent, depreciation, interest expenses, insurance and property taxes (Pietersz 2006). They are independent of other factors and they usually remain constant even if there are changes in either sales or production levels. These costs usually have an influential effect on the overall operational gearing costs. The relationship of effect is directly proportional. In fact these costs are time related and with reference to the airline industry, as with any other business organization, these costs can be categorized into a similar category but with an addition of constant fuel costs. The later addition can be said to be fixed in the sense that disregarding the traffic load, the airlines still have to maintain its flight schedules and the same number of flights will have to be made thus requiring the same amount of fuel. This thus qualifies fuel cost into the category of fixed costs. There are also a variety of other fixed costs, some of them being variants between fixed and variable. For example in the category of marketing, most of the costs in there are fixed. This is because the airline industry has to incur costs related to marketing since marketing is done to reinstate the images of the companies involved among their customers. Most of the times, fixed costs are non-dependent on other factors of production and this makes them highly predictable every fiscal year. They usually occupy a larger proportion of the overall costs, taking up more than fifty percent of all costs involved and is incurred as long as the business is in operation disregarding how much how well the business is doing or how much the business has put in as an input for returns to accumulate. Variable costs. These are the type of costs that a company incurs in daily business activities which are dependent on the volumes of input that the company has (Michel 2008,). These costs vary according to the amount of business operations that the company presents. With regards to the airline industry, some of these costs include: Fuel burn costs which are dependent on factors such as pilot flying techniques and air traffic regulation rules whereby optimization reduces fuel burnt as more fuel is required to fly at higher altitudes; Fuel additive costs which involve the use anti-icing agents, unforaged engine fuels, lubricants (includes the transmission oils and the engine oils) and the cost of labor that arises from the daily maintenances of the airplanes (Conklin & de Decker 2009). According to Burgati 2006, other maintenance costs that result in variance of the total variable costs include; part-maintenance, engine parts purchases, airworthiness parts that are purchased due to fluctuating air conditions, age maintenance in regard to the age of the aircraft in use, overhaul costs associated with the lifetimes of some parts of the engine and other parts, check out costs, inventory costs, optional equipment costs and aircraft completion costs. Still in the maintenance variable costs category, there are maintenance of parts which include costs like unscheduled on-site maintenance, avionics and minor engine maintenance costs. In addition, there are other costs in regard to regular periodic maintenances which include wing maintenance (Conklin & de Decker 2009.). Miscellaneous costs which include landing and parking fee are based on the weight of the aircraft and the away from home rule, crew expenses includes the crew accommodations when they are away from home which are dependent on the metropolitan area and catering of small supplies for the cockpit and the cabin including sanitation tools, and flashlights among others. All the in-flight crew is responsible for the all the passengers and the cabin crew. Challenges that affect margin, fixed cost and volume. Like in any other industry, there are a variety of factors that affect aspects of the total margin in the airline industry. The margin in the airline industry is usually affected by factors such as the combination of all the costs that the industry incurs. There are several factors that affect the margin of any given airline industry. These factors are; 1 Recession. According to The Times, 2008, during the recent recessions in major economies of the world, the travel rate of many industries fell under negative influence. For instance, most airline industries had their margins dropping considerably. This is because the most affected were the common folks, especially those who were bound to travel, thus they could no longer afford to make ticket purchases. This meant that many of the airline clients either relaxed their travelling habits or completely cancelled their travelling plans thus causing the occupancy rates in planes to decrease and in turn, the profit margin dropped considerably. This is usually caused by the well known economic crunch that leads to events such as the economic recession. During the last economic recession, many airline companies underwent reductions in marginal profits. This was evident in the American airline industry where most of the airlines reported under-capacities (The Times 20080. Rise of fuel costs Another factor that affects margins greatly is the rising cost of fuel. Over time, the airline industry has witnessed a tremendous growth in the cost of fuel. The rise in fuel cost was due to many factors such as major incidents involving oil producing countries (i.e. the gulf war), and the industrialization of large countries like India and China which increased the consumption of fuel greatly, the supply of oil has also decreased steadily over the years with fewer oil wells discovered; with demand increasing and supply decreasing, the cost of fuel sky rocketed. For instance, the last two decades, due to the large increase in fuel costs, many airlines have been driven into crises, experiencing cut offs in overall margins. The above are factors that need thorough and constant monitoring in order to reduce the risks associated with marginal reductions. Fuel cost rises affected the airline industry greatly, causing all the airlines to lose marginally in terms of profit. For instance in the year 2006, almost all the American airlines operated at losses. These airlines included the number one American airline, The American Corp which operated at a loss of more than 5.1percent during one of the quarters of the year 2006. During the same period of time, Continental Inc. operated on a similar loss margin and Delta Air Lines Inc experienced its greater lost ever in history. Due to the large increase in jet fuel prices most of the stakeholders in the industry headed east, to Asia, so as to get sources of cheaper fuel. This increases in the prices of fuel led to the doubling of fares, a factor that made air travel out of reach for more people thus causing passenger volumes to drop (Conklin & de Decker 2009). For instance in the year 2005, much of the revenue of around six hundred and seventy million dollars collected were mainly from baggage and other carrier airlines. This is because as the cost of fuel shot up, there were increased charges on ticked and most of the passengers gave up the hopes of travelling due to the unimaginable level increases in ticket prices. This thus led to the ripping off of equities especially in the European region, American and the south Asian regions which have full airline activity throughout the year. Factors affecting fixed costs. The fixed costs are usually affected by other factors in the airline industry. As previously previewed, there are several of the airline fixed costs which include insurance charges, depreciation, rent, interest expenses just to name but a few. As is evident, insurance costs might be influenced by government policy regarding insurance charges or the insurance company policies regarding the insurance covers. This heavily results into or is reflected in the profit margin (Conklin & de Decker 2009.). The overall effect on the profit margin is something that hinders expansion plans for most of the airline companies around the world. Depreciation on the other hand makes these companies undergo bigger operational expenses since depreciation is always recurrent whenever the airlines are in operation. Secondly, rental expenses that these companies incur arise from all the premises that these companies use that don’t belong to them. In some areas of the world, rent increases with time and therefore factors like insecurity and/or government foreign policy may affect this cost greatly and driving the margins lower. This is therefore one of expenses that affects companies the most. Factors that would affect the volume. The total output volume depends on the total input that the company gives in terms of the elongation of the output factor. There is therefore a variety of the total factors that affect the total volume of production that a company would give as the total output. Some of these factors include the input which the company puts into the business. Here, the input into the business is directly proportional to the output when the industry highly depends on such factors of production as human labor and processing which is involved in the conversion of goods or services into absolutely new products (Michel 2008). In this sense, there are several factors that would determine the amount of total output from a given industry. These include the amount of costs involved in the production. Since there are many costs involved in the production of the services offered by the airline industry, the costs discussed above are the major in relation to profit margin drops and thus volume affecting factors. For instance, the amount of fixed costs in the airline industry do affect the total volume produced in the sense that if the total fixed costs are beyond the marginal levels, then the total output is affected hence, the volume diminishes. This way, the profit margin becomes relatively small when compared to when the volume produced is high. Suppose an airline company has got a total of fixed costs of more than sixty percent, then the total volume produced by this company is going to reduce since the cost of fixed costs reduce the cost of input thus reducing volume output. Secondly, the total volume produced reduces if the given variable costs influence the total input that determines the amount of production. When the total variable costs are not in tandem with the production process and thus overflowing the given variable costs level, then the total volume that comes out of the production section becomes minimized. This is because the variable costs are expenses and since all the expenses involved in the production of services do realize the generation of lesser volumes due to the fact that all the capital that would have been pumped into the business is instead used as part of an expense. This thus lowers the total volume that undergoes production and therefore the output minimized. Other factors that are of interest in relation to the total volume produced are the external factors in the airline industry. According to Burgati 2006, there are a variety of external factors that lead an airline company into the negative direction since the total volume produced may increase or decrease as regards the total input into the business. Those that can lead the industry into the positive direction are actually said to be facilitative factors. But the negation of the facilitative factors includes weather conditions, flight regulation rules and foreign policies on international airlines. These factors affect the total output greatly; hence the total volume produced by an airline company is also affected. For example, when an airline company is met with harsh environmental air conditions, the time of landing is either delayed or the destination of landing rerouted completely and thus causing the company to incur other costs which emerges unexpectedly. This means that the total amount of production in monetary terms or service would be more demanding and hence make the total volume produced would likely change (Burgati 2006). Similarly, when an airline meets tough foreign rules in some country, it is forced to either shut down flights into that specific country or limit the number of flights into that specific country. This therefore means that the airline’s total volume undergoes a pronounced reduction. This also affects profit margins and has therefore very negatively influence on the total volumes produced. Image 1: Image depicting the trend in the US airline industry. Options available to these challenges. As discussed above, the number of factors that affect fixed cost and the total volume produced vary in regard to the amount that gets into the airline industries. Therefore, in this respect, much needs to be done in order to avert the risks of over expensing the airline industry at the mercies of natural forces. Therefore all has to be put in place to ensure that there are options for the above expensive costs that this industry incurs. First and foremost, the airline industry must be aware of the different foreign policies in each country so as to avert any looming crises that might affect the daily operations of the airline company (Michel 2008). The next option for the airline companies is that should these companies choose to rent premises for their daily operations, then there should be minimization of the amount of finances to be spent on the rentals acquired by any given airline company. As an implication, this means that all airline companies would or should make least premise acquisitions as regards housing and other useful premises in the course of their operations. This is because all the properties acquired do not really undergo comprehensive usefulness and thus end up being wasted in terms of utilization. This therefore increases the operational costs for these airline companies, plummeting their total volume and decreasing the profit boundaries. The leasing of many premises should be non-compulsory to these companies and should only be done when there is a large amount of demands to create such acquisitions. The third option available concerns the variable costs. The airline industry should strive to make full maximization of the variable costs that are incurred in the process of production in this industry. This means that the industry should regulate the amount of variable costs in the sense that despite the massive needs experienced by the industry. This translates to the companies checking on the amount of input to the expected results. This would help these companies greatly in the realization of their maximum profit achievement (Burgati, 2006). Long term plan for the airline industry. The airline industry has always faced plenty of challenges from the time of commencement to the present times. This implies that as long as the airline industry continues to be in operation, challenges shall always form part of their daily operations. But the best step that these airlines should take in the mitigation of the severity of the above challenges would be to ensure that operational costs are minimized. Secondly, there should be consideration of the different foreign policies before setting up business adventures in some regions. Strategic operation should prevail and lastly, the industry ought to ensure maximization of resources in the realization of full profits. As mentioned above, The next option that there is for the airline companies is that should these companies choose to rent premises for their daily operations, then there should be minimization of the amount of finances to be spent on the rentals acquired by any given airline company. This means that all airline companies would or should make minimal premise acquisitions as regards accommodation and other useful premises in the course of their operations. This is because all the premises acquired do not really undergo exhaustive utility and thus end up being wasted in terms of utilization. This therefore increases the operational costs for these airline companies, reducing their total volume and lowering the profit margins. Rental of many premises should be optional to these companies and should only be done when there is much pressure to make such acquisitions. Government role in the airline industry. Due to the amount of taxes collected from this industry and the size of the industry, the many governments have a huge role to play and thus try as much as possible to regulate the industry. For instance, in many countries, major airlines which use the state name are owned or largely controlled by the state or the governments simply because the industry is too huge and serves a national purpose. Secondly, many governments have found the airline industry to be so lucrative in terms of paying taxes hence have vested a huge interest in it. For instance, in the United States, the government lays hefty charges in the airline industry in form of taxes and many people have little knowledge that as much as twenty percent of the money they use to pay for a ticket goes into government revenues as taxes. This thus is an implication that the government interest in the airline industry is huge (Bethune 2007). There is also the regulation of the industry although there was a deregulation which happened some decades ago. For instance, according to Bethune 2007, many governments control the airline industry by laying rules without thought of how the airline industry will manage to comply with those rules. This greatly affects the airline industry because there is need for change in their day to day activities since new governmental rules have to be assimilated and such rules include flight controls in and out specific regions. Lack of new set ups of modern In regard to the engineering industry, this thus affects the industry in terms of expansion in all aspects which include the engineering part of it in the respect that by lack of expanded and modern infrastructure, there is absolute stagnation in regard to airline operational activities. The lack of many governments’ participation in infrastructure development leads to a lot of losses in terms of revenue and total profits collected from this industry. This affects both the growth of these industries in regard to all industrial aspects which include technological aspect. In regard to energy utilization, there is insufficient utilization of the energy resources since the industry capabilities are not exhaustive. Conclusion. From the discussion above, it suffices to categorically state that the aviation industry is certainly one of the largest industries and still emergent. In the course of the aviation industry, trade and industry expansions, global investments, worldwide trades and tourism have all witnessed significant growth. Fixed costs can be generally defined as a cost that remains constant in the whole process of production or sales levels. These costs are always present in the daily, monthly or annual operations of the business. They include invariable costs like rent, depreciation, interest expenses, insurance and property taxes (Pietersz 2006). They are autonomous of other factors and they usually stay put constant even if there are variations in either sales or production levels. These operating costs usually have a powerful effect on the overall prepared gearing costs. The association of effect is direct in comparative. In fact these costs are time related and in reference to the airline industry these costs can be grouped into a similar category as any other business organizations but with an accumulation of constant fuel costs. Variable costs are inconsistent and vary according to the amount of business operations that the company presents. In regard to the airline industry, some of these costs include, fuel burn costs which are reliant on factors pilot flying techniques, air traffic regulation rules whereby optimization affects the fuel burn in the respect that high altitudes affect this variable cost, fuel additive costs which involve costs used in the anti-icing and other costs resulting from unforaged engine fuels, lubricants used in the industry which include the transmission oils and the engine oils, labor that arises from the daily maintenances of the airplanes. There are challenges that affect margin, fixed cost and volume like for instance following the recessive factor in major economies of the world, the travel rate of many industries falls under negative influence. For instance, the recent economic recession affected most airline industries with their margins dropping considerably. This is because the most affected were ordinary people especially those bound to travel and thus could not make ticket purchases. The rise of fuel costs is another factor that highly affects margins as the rising of fuel cost. Over time, the airline industry has witnessed tremendous rates of fuel rise. This is due to political differences between the oil producing countries and the oil consumption countries and as a result there occurs a high rise in prices. But there are usually options available for these companies which include; the airline industry must ware of the different foreign policies in each country so as to avert any looming crises that might result in the sense that there arises a case which might need immediate attention in regard to the daily operations of the airline company. Secondly, there should be minimization of the amount of finances to be spent on the rentals acquired by any given airline company. References. Airline Industry, Aviation Industry, Airlines Industry, Aviation Sector, Airline Sector from http://www.economywatch.com/world-industries/airline-industry-aviation-industry.html Burgati, Rose. 2006, Airline Industry Forecast 2009-2013. Obtained from http://www.iata.org/ps/publications/Pages/airline-industry-forecast.aspx Conklin & de Decker. 2009, Aircraft Variable Costs. Obtained from http://conklindd.com/Page.aspx?cid=1115 Bethune, Gordon. 2007, How to Fix the Airline Mess. New York: The Times. Michel, George. 2008, Airline Industry: Economy Watch. Obtained from http://www.economywatch.com/world-industries/airline/ Pietersz, Graeme .2006, Fixed costs. Obtained from http://moneyterms.co.uk/fixed-variable-costs/ The Times. 2008, Low-cost airlines hit by recession and fuel price escalation. New York: The Times Read More