Airline Economics and Captain Kremin

[Captain Sherm]

Captain Kremin

You know as well as I do that there’ll be no third party review of internal QF pricing practices and consequential internal group accounting practices and figures. So asking for it could well be seen by a mean-minded critic as grandstanding. I would not feel competent to comment on that thought were it expressed.

I would draw to your attention the challenge of doing a lot of the work yourself though. I assume you are skilled at financial analysis and associated areas of policy, analysis, airline economics and competitive strategy, and in particular transfer pricing protocols and reporting requirements and the concepts of economies of scale and scope. I say that I assume you are familiar with these elements of analysis and concept as you make statements that could and should only be associated with someone who had in-depth understanding and background in these relevant and necessary areas of competence.

The QF Group (and associated entities) figures for the year ending June 30, 2009 are available on the Qantas website. These will be updated in a few days with the Interim Results for the 6 months ending 31 December 2009. Many publicly available sources will let you estimate LCC A320 and A330 direct and indirect operating costs and hence will let you work backwards from JQ’s passenger numbers, hours flown, ASKs and Load Factors to determine in $A the likely “free market” cost structure of Jetstar. In other words what it would be if they were an independent company with JQ’s routes as their sole operating environment.

You can do the same for Qantas mainline. As you suggest there could well be areas where there is transfer pricing of activity either from Qantas mainline toward a separate but wholly owned or partially owned entity, or from those entities toward Qantas mainline. Note carefully that some corporate Qantas activity might well need to be estimated, identified and removed as “above” all the Group entities. This might well include Board expenses, Treasury, Safety, Legal, Government Relations. These costs might not readily be allocated to any individual Group entity other than perhaps to fix as a component of each revenue dollar, or per passenger, or per flight. I am sure you will hit on the right allocation protocol.

Anyway, having done all the above you will come up with your beginnings, the “stand alone” estimated figures for each of the Group entities. You can then cross check your initial hypothesis by adding up all the results to check that the “sum of the parts” is indeed greater than the whole total of the Group’s published figures. It should be. That much is not disputed at all.
Now comes the interesting bit. What does this mean?

Let’s say that you have estimated the QF mainline figures reasonably well. You subtract that from the Group figures (minus any extraneous entities). You’ll be left with what some jargoneers might call the Long Run Marginal Costs and Revenues of Jetstar activity. You should find that the Qantas Group operates Jetstar and its mainline sister more cheaply than the combined cost of QF mainline (without any transfers to Jetstar) and a stand alone Jetstar sized airline, completely independent of the QF Group. The gap could easily be as much as 15% one imagines. Maybe more. I couldn’t comment.

You might take this “what if” stuff further and see what the Qantas Group’s costs would be if it operated the whole Group at average mainline costs, but with revenues equal to current mainline plus Jetstar revenues. Have a bottle of VSOP ready though as this set of figures may well scare you witless.

Now Captain Kremin, you need to understand that this (say) 10% gap (the whole being cheaper than the parts) represents the Group’s advantage over other carriers. That it can in fact be Legacy and LCC cheaper than any two other independent entities. This is called Economies of Scope. It is not a subsidy. Let Google do the research if you want and you’ll find heaps of discussion. For example at http://www.investopedia.com/terms you’ll find:

Economies of Scope
What Does Economies of Scope Mean?
An economic theory stating that the average total cost of production decreases as a result of increasing the number of different goods produced.
For example, McDonalds can produce both hamburgers and French fries at a lower average cost than what it would cost two separate firms to produce the same goods. This is because McDonalds hamburgers and French fries share the use of food storage, preparation facilities, and so forth during production.
Another example is a company such as Proctor & Gamble, which produces hundreds of products from razors to toothpaste. They can afford to hire expensive graphic designers and marketing experts who will use their skills across the product lines. Because the costs are spread out, this lowers the average total cost of production for each product.

Having identified this key part of the Qantas Groups competitive advantage you can now answer these questions for us all:

1. What would Qantas look like if someone else had started Jetstar and Qantas was competing with this JQ sized competitor on the current QF mainline cost structure?

2. If yields for Qantas mainline fell say 10% in the above scenario amidst a bloody “price war” (and given that, as you often state landing fees, fuel costs, interest rates etc etc are the same for all carriers) how far would productivity (or aircraft and people) have to rise and in particular, how far would unit and overall labour costs at QF mainline have to fall in order for the Group to regain profitability?

3. To what extent therefore are Qantas yields quarantined from reduction by having the competition “in house” at a lower unit cost, therefore making money for Jetstar and lessening losses by Qantas?

There are many other interesting questions you will be able to answer I am sure. But you will need to this hard analytical work first. Let me know either by PM or by posts when you have done the analysis and we can compare figures and methods.

If you can’t do it then please explain your anti-Jetstar posts and on what basis you make your claims. I sincerely trust you will not be found wanting.

[Sunfish]

Captain Sherm, I suggest you should stick to flying aircraft.

For a start, there are probably no more than Fifty Australian analysts outside of those working at Qantas and VB who would be capable of performing the required forensic accounting analysis of an airline, and at one time I was one of them. None work for ASIC or ACCC, which is why there has been no inquiry, let alone prosecutions, for the disgraceful price fixing, gouging and anti competitive behaviour in the aviation marketplace for at least Thirty years. Furthermore, since the Qantas group is the major potential employer of anyone with aviation accounting experience, none of them are going to risk their future employment opportunities by participating in any meaningful analysis of Qantas.

Your assertion that anything useful in an accounting sense can be derived from QF's published accounts is nonsense. It is the equivalent of stating that I could learn to pilot a B737 by learning the AIP's by heart. The real information that is used to run an airline and that would reveal the true state of QF and Jetstar are the management accounts, not the statutary accounts. Furthermore, even within the management accounts, it is possible to produce any "profit" you like in virtually any location.

The reason profit is so malleable, and why Capt. Kremin has a point, is a little matter called cost allocation of indirect costs. This has been described as "The metaphysics of accounting", accountants argue over cost allocation like medieval philosophers arguing about how many angels can dance on the head of a pin. Subsidies to Jetstar can be easily and secretly incorporated in the "rates" Jetstar pays for various Qantas services, and I defy anyone without detailed technical and operational as well as accounting knowledge to disentangle the fixed and variable, direct and indirect components of each and every cost. I've personally been the meat in the sandwich between a very irate General manager of a subsidiary airline and the Board after he convinced himself that mainline was price gouging and thereby minimising his "profit", I've personally played all these games myself.

To put it another way, there is not a snowball's chance in hell that Jetstar is profitable if it was operating at arms length from Qantas, and had to endure the same capital raising, regulatory and start up costs associated with such a regime. All Jetstar is is an exercise in marginal costing aimed at frustrating Virgin Blue without cannibalising Qantas market share, but no one is ever going to be able to prove it. If you want a more detailed technical explanation of how aircraft costs are allocated by cycles, block hours, engine hours, landings ,etc. we can open a new thread.

To produce a real picture of Jetstars relationship with the rest of the Qantas group requires contribution analysis which is a calculation of direct revenue earned (not simply ticket sales) minus direct operating costs (salaries, wages, fuel, line maintenance) before fixed and indirect costs are subtracted. I would wager that Jetstars contribution is piddling next to mainline, but that its overhead allocation is even tinier leaving a notional "profit". I would expect that not even the Board would be given that information so they can maintain "plausible deniability".

"What about the Auditors?" You ask? Don't make me laugh! I'll bet QF do exactly as I used to - listen to them , tell them what they want to hear, then shove em in an aircraft cockpit for a few minutes and then take them to lunch.


P.S. The best name I've ever heard for a marginal costing operation like Jetstar is "Pissing in the soup."

[Captain Sherm]

Ah, you have me there Sunfish, I was attempting to be both subtle and simple. Though I don't have proof that I am or was one of the "50 analysts who understand this all" I'd like to hope I'm up high in the second tier at least. Perhaps you and I have crossed paths sometime. You may have even mentored lowly Sherm.

Point I was trying to make is that of course QF's strength lies in it's ability to run QF mainline and JQ cheaper and better (to the benefit of both) than could two stand alone entities. OF course there's implicit subsidy and support of yield and costs. Never in doubt. That's the whole issue under "Economies of Scope". Contribution analysis as you know rests on the actual manual of internal transfer pricing protocols. Yes that book exists and the fact that it can exist is a strength, not a weakness.

You mention pi$$ing.....I think that on balance the analogy I would use is to paraphrase LBJ who might have said "If I was Qantas I would prefer to have Jetstar inside the tent pi$$ing out than outside the tent pi$$ing in".

Would appreciate your views on the actual questions I suggested for Captain Kremin:

1. What would Qantas look like if someone else had started Jetstar and Qantas was competing with this JQ sized competitor on the current QF mainline cost structure?

2. If yields for Qantas mainline fell say 10% in the above scenario amidst a bloody “price war” (and given that, as you often state landing fees, fuel costs, interest rates etc etc are the same for all carriers) how far would productivity (or aircraft and people) have to rise and in particular, how far would unit and overall labour costs at QF mainline have to fall in order for the Group to regain profitability?

3. To what extent therefore are Qantas yields quarantined from reduction by having the competition “in house” at a lower unit cost, therefore making money for Jetstar and lessening losses by Qantas?

Sunfish, the question of how, when and indeed whether QF could maintain a dominant and flexible market position under a single brand is the real question. What would the EBA's look like, how much compromise would AIPA have to make, how would productivity need to change, what fleet would you need? etc etc.

Some cynics (or maybe they're realists!) might argue that the mess QF is in now is the result of a horrible witches brew of Sydney centricism, mean spirited anti-labour management ideology and a truly terrible fleet mix centred on aging 767 and 744 units. They might say that and I wouldn't care to comment. They might also say that the yearly cost to the QF Group living in such a protected world that it can survive despite NOT having a fleet of say 30 B777s is far more than any supposed profit made by the JQ operation. Again....I wouldn't care to comment.

[RedTBar]

I don't subscribe to the theory that QF would wither and die if it was not for Jetstar.The Jetstar proponents will tell us that they are there to stop VB and to an extent that is true but the real question is how much has that cost and is expected to cost in the future?
If QF had spent the money used to set up Jetstar as well as it's running costs they could have improved it's own product.They could well have the business sector covered especially in the golden triangle and had QF lite with all Y/C config in the holiday ports.Who would be competing with them in the domestic business market?
Most of us understand that there is the possibility that Jetstar was also created as a tool to lower wages in Australian aviation or at least QF.

However, as much as most of us would like to know the real set up the questioning is futile.

This is because the airline will never tell us.

[QFinsider]

The reality is far simpler,

Any audited set of accounts with the costs correctly appointioned would shine too much light on the J* debarcle. If one investigates the European experience the claimed difference between an established and so called "low cost" airline is 49%

The amount of things the new low wage carrier need to to secure such savings are incredible. J* does very few of them. Hiding the cost appointionment is an easy way to disguise transfer pricing. Are there any aviaton analysts in Australia with the acumen to lay waste to management mantra; NO!

Aviation is part of a transport portfolio at any estanlished broker, a small component at that..

J* is designed to break down the 14 unions scrotum face ( mini me) and the HR Nicolls society want to deal with, a brand new world order. J* will become the flag of convenience in any country dumb enough to host it, the ability of Australians to access any opportunity will be limited to thier ability to undercut the host country...

I hope Emirates and Singapore read this. BA has already spent a lot of money polishing up P class, we cut it out...

[Reeltime]

This is but one example of the way costs are moved from JQ to mainline:

A couple of years ago Qantas was training quite a few guys on the 330. There was limited sim availability in Qantas.

In order to facilitate Jetstars requirements of the sims, Qantas sent its crews overseas to train in other organizations sims. This meant that the QF crews needed to be transported, accomodated, paid allowances, not to mention the cost of the actual training.

This applied to maybe 50 guys..an enormous cost, borne by mainline. It would have been hidden in the bottom line as a training cost, but with no explanation required.

As I said, just one example.

[Sunfish]

Captain Sherm:

1. What would Qantas look like if someone else had started Jetstar and Qantas was competing with this JQ sized competitor on the current QF mainline cost structure?

2. If yields for Qantas mainline fell say 10% in the above scenario amidst a bloody “price war” (and given that, as you often state landing fees, fuel costs, interest rates etc etc are the same for all carriers) how far would productivity (or aircraft and people) have to rise and in particular, how far would unit and overall labour costs at QF mainline have to fall in order for the Group to regain profitability?

3. To what extent therefore are Qantas yields quarantined from reduction by having the competition “in house” at a lower unit cost, therefore making money for Jetstar and lessening losses by Qantas?

Sunfish, the question of how, when and indeed whether QF could maintain a dominant and flexible market position under a single brand is the real question. What would the EBA's look like, how much compromise would AIPA have to make, how would productivity need to change, what fleet would you need? etc etc.

Taking all those questions together, Qantas would look nothing like it did under the reign of Scrotum face.

1. It wouldn't call itself "The Qantas Group". It would have pared away about Six levels of management, starting with "Group General Managers" and "Executive General Managers", cut it's Administration and head office staff to the bone, and most importantly moved the majority of its whats left of it's head office functionality into low cost office accommodation.

2. In support of that process, it would have devolved decision making powers as far down the organisation as possible.

3. It would have restructured its Board, rooted out the narcissists from senior management, and looked for the equivalent of Air New Zealands CEO.

4. It certainly would NOT have opened overseas bases and subsidiaries like Jetstar Asia.

5. It would have moved the bulk of its Maintenance out of high cost Sydney. Get the States to start a bidding war for the relocation of all of it.

6. It would have rejigged its schedules to be less Sydney centric, with much more direct flights from other State capitals, reducing as much as possible, the need for that domestic connecting flight.

7. It would have a huge internal review of its cost base and identified what needs to change.

8. It would go to Boeing and Airbus get them both to compete for a complete fleet replacement program, domestic and international - a complete turnkey package, including financing, the lot. Airbus and Boeing know how to do this.

9. Create a new brand image and market it for all it's worth. Revel in the competition (or appear to). I would also consider a capital raising and a shareholder discount scheme, although the big investors might kill the idea.

10. Armed with the certainty of a new fleet coming, and new maintenance facilities to be relocated, a revitalised Board and management, and, to borrow a phrase "Change we can believe in", I would approach all unions with the same basic story - "are you part of the new Qantas or the old Qantas?" with a list of issues.

My entire internal communications strategy would be that Qantas has to change or go under. I would be counting on the "Freeze, Unfreeze, refreeze" human behaviour to allow me to make great changes in a relatively small period of time. Jeff Kennett did this (almost) to perfection for Two years when he took office in Victoria.

...And of course, the Board and all Management would be leading by example. Otherwise everything fails.

[RedTBar]

Captain Sherm,Jetstar is not the saviour of QF it is merely the favoured child of Darth after disowning AO because it did not live up to his expectations.

It is a means to an end.

Of course QF as Sunfish suggested could have done much much more by

Management would be leading by example

Instead of the old 'Us and Them' style of management and leadership.

[4Greens]

Airline economics:

Business class single fare to London approx $10000.

Return fare approx $8000.

Please explain.

[Capt Kremin]

Sherm, as has been pointed out by others, you don't need a degree in forensic accounting to see what has been going on. Some of the actions, such as lowering of morale are impossible to quantify anyway.

Apportionment of costs to mainline.

I take you back to the introduction of Jetstar International. Qantas A330's on the SYD-PER-SYD route were accounting for 200 mill a year of mainline profit. Qantas management takes four aircraft, almost 25% of the fleet but none of the pilots, away to form the basis of Jetstar International.

Approximately 350 QF A330 pilots become massively underutilised for about 15 months but the pilot costs of Jetstar show up as less than mainline because they employed DEC and FO on substantially less. It doesn't matter that these A330's were extremely profitable, and much more profitable than the hangar queen 747-300's which came off other routes to fly to PER and establish a reputation for unreliability; the establishment of a low yield international airline took precedence.

The costs were all worn by mainline. Even mainline pilots who burnt leave, went back to rotating, and were paid to sit around doing nothing on 151 hour blank lines when formerly they had been flying back to back 175 hour divisors.

Some of the costs will forever defy forensic analysis.

What is the cost to mainline of management telling Qantas pilots they would "pollute the culture" of Jetstar?

Jetstar has never had to build a ground training centre, it is done at Qantas.
Jetstar has never had to build a flight training centre or buy and build a A330 flight simulator.
When there is a surge in pilots required, mainline pays for pilots to go overseas so Jetstar pilots can continue to use the Qantas A330 sims.
Jetstar has never had to expend capital buying and maintaining heavy tugs.
Jetstar got 180 minute ETOPS on the sole basis of using Qantas engineering.
Jetstar, when it does have to use Qantas infrastructure is quoted a price at a significant discount to other airlines.
Jetstar International can cover aircraft unserviceability at much lower costs than any other similar sized international airline buy invoking the "mainline to the rescue" clause.
What is the cost benefit to Jetstar of constantly invoking the Qantas name whenever an incident occurs?

Yet Jetstar is forever quoted by a compliant and unquestioning media as being the saviour of mainline. Patently it is the other way around.

I am not anti-Jetstar employees. I am simply over the constant parroting of an untruth conjured by a management that is pursuing an ideology more than the proper running of an airline that, given half a chance, could be the best there is.

[Jetsbest]

Kremin...

Hear! Hear!

ps It was four A330s from a fleet of 14 at the time; 29%!

[breakfastburrito]

Amen Kremin.
You have just pointed out some examples that can be proven. Imagine the financial engineering going on in the upper echelons that we will never get to conclusively "prove".

Recently I learnt that investment bankers simply disregard the separate profit & loss statements for QF/J*, they are only interested in the combined group numbers. To them, the individual business unit's P&L is simply for the staff's consumption & has no accounting value.

[teresa green]

As I stated before, the gravy train is finished, kaput, over, the days in which I flew when PAX were expected to pay $400 bucks to Mel and 1,400 to DRW are over, finished, and I for one am glad QF owns JQ rather than Loose Rivet Airlines, or whoever. However you rate Dixon this was a good move despite the resentment from QF crew it had to happen. LCC'S are now the way of the world, and it won't be going back to the "good ol days" QF now has to find where it fits in this new world, does it continue as a "mainline" or does it become a "boutique" airline allowing the "joey" to do the bulk of the work and keeping the specialist bases eg: LAX and LHR? Times have changed and will continue to do so, PAX want only the cheapest and safest way to their destination, and the whole industry will have to bend to their wishes, interesting times ahead. Their needs are going to outway yours, so some turbulence up ahead as time goes on.

[breakfastburrito]

Teresa, LCC do not have to mean low wages. Have you studied a little LCC airline called Southwest? Do they pay the lowest wages in the industry?
I suggest you get hold of a copy of Nuts. I literally could not finish it, out of sheer disgust with gross stupidity of management (slash & burn) & the contempt with the treatment of employee's compared to the way it could be done.

Read through the customer reviews from the link, once you have done that, please return and tell us about how the gravy train has left the station for your 3 sprogs and the rest of us.

It doesn't have to be this way, that is the truly sad part. There is a real world highly profitable example of how it can be done right. However, management need to give up the slave owner mentality.

FWIW, QF FLT Ops management did a detailed study tour to SWA many years ago so they cannot claim ignorance. They must have missed the bits about treating your employees with respect & not building empires.

[Shark Patrol]

Teresa,

LCC are holding the upper hand at the moment because of the (relatively) low oil price. Remember the "golden" period, just before the GFC meltdown when oil was well above $100 a barrel? It was the LCC segment that was really hurting then because their passengers are the most price-sensitive. For airlines to maintain a profit, they had to increase the seat price (through fuel surcharges).

Have you noticed since the GFC bottomed-out, that any increase in the stock index is nearly mirrored by the oil price? I reckon that when the world's economies are booming along again, that the oil price will be way up there again. It will then again be the LCCs that will be hurting - those that can wear a higher seat price will pay more while those who can't won't travel. Jetstar will probably be more affected by this than Qantas - as they were before the GFC.

I flew with a Captain when oil prices were very high who said that he foresaw a future where airlines were deprivatised and reregulated, and air travel was once again the province of the wealthy or powerful - this version of the future is very different to yours, Teresa. But how long can airlines sustain low fares if the oil price increases? How long will the world's financiers continue to fund airlines re-equipment plans when the industry continues to lose billions of dollars every year.

I think the worm will turn. LCCs are being used in the short term by airline management to provide cheap fares through the slashing of staff wages and conditions. With a very high oil price, it will (I believe) be again a very different market for LCCs. Hopefully the "legacy" carriers can withstand the current cycle, before airline management around the world essentially redefines industry payscales through their low cost (low-wage) carriers.

[Sunfish]

The real issue Teresa, is that most of the LCC's aren't really LCC's. They lower their costs by creative accounting and operate as parasites off the entire aviation industry.

They are using the "Well I'm not making an adequate return now, but once I send my competitors broke, I'll raise my prices a little and I'll have all that extra volume as well ." I can tell you from direct and bitter experience that this is a common problem in many industries (the printing industry for example).

The problem with this strategy is that the LCC's never cover the full cost life cycle associated with their industry. They always believe that they will keep their aircraft for Ten years and then flog them at a handsome price to buy new stuff, so they don't build any heavy maintenance capacity. They don't build terminals. They treat their employees like trash, believing in a never ending stream of eager trainable recruits. They don't build infrastructure. They believe in contracting everything out.

And guess what smart competitors do when they get undercut by idiots like LCC's? We always send them our worst customers. The ones who are only marginally profitable, or who are disruptive, or who don't pay. The complainers, the Whiners. The ones for whom low cost is everything and who have no appreciation of quality (including safety).

That's not "growing the industry" it's about giving people who can't afford the full cost of flying a chance to fly.

...And eventually the future catches up with them, as it will one day with the likes of Ryanair and Jetstar.

[moa999]

Sunfish,

While agree with a number of your sentiments, particularly that LCCs are very short-term focussed, that is the nature of business these days.

Ultimately the economics will come full circle. If LCCs are the only game in town - the owners of the training machines etc will start charging a proper economic return, there will be very few buyers for 10yo planes (only so many crappy LCCs or African airlines around, and not many with cash)

The one example where a full-airline has gone head to head with a LCC has not ended well. Ireland - Aer Lingus v Ryan Air. Aer Lingus decided to try and stop the rot too late, dropped out of oneworld, began becoming an LCC. Now it finds itself 30% owned by its former competitor and pretty much in no-mans land.

[ditch handle]

QF's decision to reduce First Class seating provides further incentive for company CEOs [who only fly First Class] to transfer their corporate business accounts to the likes of EK, SQ, EH, BA, CA and the like.

Brilliant.

[teresa green]

Well breakfast, two sprogs are in QF, one in JQ and he is the only one not whinging. After yesterdays report and the poor profit, (which would only be gambling money to the Packers) and the report, if not for JQ, QF would be out with a begging bowl, I would have to remain pleased that QF own JQ. This of course is the result of the world downturn, and we should all be grateful that QF has not gone the way of JAL and other airlines (especially American) that have faltered and fallen. Where it all goes from here nobody knows, but as I stated before if I was a young pilot, just coming in from bush bashing with the hours up and looking starry eyed into the future, I would not be rushing into QF if I got a guensey, (this attitude would be unheard of even five years ago but that is how much times have changed) simply because you and I (especially my era ) could expect to see ourselves in the LHS at a certain age, but for any youngster now things are not so defined, so he/she needs to look long and hard at the LCC as perhaps a better future. I believe that eventually that QF and JQ will become a hybred, a merging so to speak, it will need too, to survive in a future world, where it leaves aircrew I shudder to think, and hope I am still around to see the outcome, as I said before interesting times ahead.

[indamiddle]

teresa, i agree with you.
much better job at JQ