Case study: The New Delta Airline Boston-Houston flight I. INTRODUCTION Delta Airlines is considering opening a new direct flight between Boston and Houston in order to compete head-on with its main rival United Airlines, which is currently the only airline operating a direct (non-stop) flight from these two major US cities. Here are some details regarding this projected flight: Departure: 1 PM local (EST) time, from Boston Logan Airport. Arrival: 4 PM local (CDT) time, at Houston George Bush International Airport. Distance: 1,600 miles. Flight time: 4 hours. Aircraft: Airbus A320 neo Number of seats: 150, consisting of 20 business class seats + 130 coach (or economy) seats. Crew: Captain + 1 co-pilot. Flight attendants (6): 2 veterans (5 or more years of experience). + 4 rookies (0 to 5 years of experience). Of this crew of 6 F.A., 2 will be assigned to business class passengers (1V + 1R), and the remaining 4 to coach passengers (1V + 3R). II.COSTS 1) Crew: – The average gross salary of the captain of an A320 is about $200,000 per year. A captain will usually fly about 900 hours in any given year. – The average gross pay of a co-pilot is $75,000 per year, who flies about 1,000 hours per year. – The company pays an additional 30% of gross salary to its pilots and co-pilots in the form of various fringe benefits provided. These include health care, life insurance, pension top-ups, free flights, and per diem pay. – A “veteran” flight attendant receives a gross pay of $60,000 on average, while a “rookie” flight attendant receives about 2/3 that amount. – Fringe benefits received by flight attendants in addition to their regular pay equal about 20% of their gross salaries. – Flight attendants, whether rookies or veterans, work about 90 hours per month on average. 2) On-ground airline staff: This includes primarily passenger check-in staff. Per flight, Delta typically assigns 4 staff members (1 veteran and 3 rookies) for check-in and boarding procedures. On-ground staff receives the same base salary and fringe benefits as flight attendants but they work more hours (38 hours per week on average). Each flight requires an average of 2 hours of work per staff and per flight. 1 3) Fuel costs: An Airbus A320 (first generation) travels an estimated 77 miles per gallon per available aircraft seat. The new A320 neo, more fuel efficient, will travel an extra 15% miles/gallon/available seat. The cost of a gallon of Jet A fuel currently costs $4.10 on average. Assume, for the sake of the exercise, that fuel consumption is always the same for each leg of the Boston-Houston round-trip flight. In other words, disregard headwinds, tailwinds, and varying weather conditions. 4) Aircraft and airport costs: – The price of a new Airbus A320 neo is $107 Million. It has an average life span of 25 years and is expected to fly an average of 9 hours per day. – Aircrafts are typically fully depreciated on a straight line basis (assume no scrap value). – The maintenance cost of this aircraft is roughly $500 per hour of flight. – Airports charge airline companies a fee of $5,000 (on average) every time one of their aircrafts lands (“landing fee”). This helps cover airport security costs, baggage handling, and aircraft assistance provided by airport personnel or by third-party providers. 5) Management and head-office cost allocation: Although these costs are fixed costs, they have been recalculated to amount to an equivalent of $4.00 per available seat. These costs include rent, salaries, marketing and operating expenses incurred by the Delta head-office as well as its regional offices. 6) Food and beverages: On this particular Boston-Houston route, meals and alcoholic beverages are complementary only for business class passengers. Coach passengers receive only complementary soft drinks and a small bag of snacks (pretzels or equivalent). Otherwise, alcoholic beverages and meals are available to coach passengers for a fee. Since this is an early afternoon departure, the company expects a higher number of passengers to order alcoholic beverages and meals than during morning flights. – In business class, the company expects every passengers to order the meal as well as 3 beverages during the flight: o o o 25% will order 1 alcoholic + 2 non-alcoholic beverages, another25%willorder2alcoholicand1non-alcoholicbeverages, theremaining50%willorder3non-alcoholicbeverages. – In coach class, all passengers will be served a total of 2 non-alcoholic beverages each along with 2 small bags of snacks (e.g., pretzels). In addition, the company expects that: o 1 in 5 passengers will purchase a meal at $15 each. o 1 in 10 passengers will purchase an alcoholic beverage at $10 each (average price). – To the company, the cost of these items is broken down as follows: o Businessclassmeal:$15. o Coachclassmeal:$5. o Alcoholicbeverage:$1. o Non-alcoholicbeverage:$0.25. o Bagofsnacks:$0.25. 7) In-flight entertainment: While In-flight entertainment is available free of charge to business class passengers, coach passengers must pay a $13 fee to have access to this service. – It is estimated that 1 in 10 coach passengers will purchase the in-flight entertainment package. 2 – To the company, the cost of the service (royalties/streaming fees paid to entertainment providers) are already included, partly in the depreciation expense, and partly in the aircraft maintenance costs. 8) Checked Baggage: Since May 2008, most US airlines, including Delta, charge coach-class passengers $25 per checked piece of luggage for domestic flights (business class passengers are not charged any fee for checked luggage). Delta does not charge for carry-ons, as long they do not exceed a certain size, above which the bag must be checked in (and the fee paid). Management anticipates that 2 in 5 coach passengers will check a bag and therefore pay the fee. The other 3 passengers will either travel with only a carry- on, or will have had the fee waived for various reasons (e.g., using frequent-flyer miles or paying their ticket with a partnering credit-card provider). 9) Cost of Capital If Delta decides to go ahead with this project, it will purchase the new A320 neo aircraft out of its own cash balance. Its policy, however, is to allocate an 8% per year cost of capital to every project where it allocates its own funds (instead of financing it externally through a loan or a lease). If, in other words, instead of using the funds to buy this plane, Delta could invest these funds in a bond with a similar risk, its expected return on investment would be 8% per year. III. Revenues In the old days, when air travel was heavily regulated by the IATA (International Air Transport Association), airlines would typically have only 2 ticket prices for any given flight: one single fare for a First Class seat and another single fare for a coach seat. With the beginning of deregulation of the commercial airline industry in the late 1970’s, airlines began to offer different fares for the same type of seats in order to capture a maximum amount of revenue per flight. It is about at that same time that “business class” was first introduced. Today, most domestic flights offer business or economy (“coach”) seats, albeit at many different prices. This concept of “revenue management” is now very sophisticated and ubiquitous, not only in the airline industry, but also in many others, such as the live entertainment or hotel & hospitality industries. Once again, revenue management is designed to make sure that flights, hotels, or shows are fully occupied, thus maximizing revenues. 10) Coach class tickets – Assume that all passengers on this flight purchase round-trip tickets. – Now that the industry is highly competitive, Delta management must determine a range of ticket prices that target passengers with very different profiles and willingness or ability to pay. Delta has basically identified 3 categories of coach passengers. The categories and prices (based on a round- trip ticket) are forecast as follows: o 10 passengers will fly for free. This category includes passengers using up their accumulated frequent-flyer miles, or company employees taking advantage of their fringe benefits. o 90passengers(oftencalled“economy-leisure”passengers)willbuynon-refundableticketsat an average price of $400, the actual price depending on how early or how late they purchase their ticket before departure. o Theremaining30coachpassengers(oftencalled“economy-business”passengers)willpayan average of $700 for a fully refundable ticket, or because they purchased their ticket at the last minute. These “business” passengers are less price sensitive (even though they are still 3 unwilling or unable to purchase business class tickets) than “leisure” passengers. This is usually because their employers pay for their fare. 11) Business class tickets Business class passengers usually include business executives or wealthy individuals, both of whom are not price sensitive. Therefore, there is very little price differentiation among business tickets. Here, we will assume that all round-trip tickets are sold at the same price of $900. 12) Fees Various US government agencies charge airline travelers fees to all airline travelers. These fees are included in the round-trip ticket prices that travelers can see when they visit airline websites. These fees are therefore collected by the airlines, and almost immediately paid to various government agencies. These fees are roughly broken down as follows: – Domestic Passenger Ticket Fee (paid to the Federal Aviation Agency- FAA): 7.50% of the ticket price. – Domestic Flight Segment Fee: (paid to the FAA): $4 per travel segment (note: 2 segments in a round-trip ticket). – September 11 Security Fee: (paid to TSA): $5.60 each way. – Passenger Facility Charge (collected for “commercial airports”): $4.50 per passenger (per ticket sold). – Note: Passengers flying for “free” still need to pay the fees. In this case, the fees are calculated based on the price of a fully refundable economy ticket. The company does not consider these fees as “costs” because, as mentioned above, these fees are almost immediately passed on to the airport authorities. Instead, it deducts these fees to obtain its “net ticket revenues”. Questions: 1- What is the average total accounting cost (ATC) of flying a business class passenger? 2-What is the expected accounting profit generated by a one-way flight from Boston to Houston?
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