Airline Costs

The second component to calculate profitability, in addition to revenue, is cost. The airline sector cost structure is very specific as nearly half of the total costs incurred by airlines is concentrated in two items: labor costs  and fuel costs. For example, in 2019 these two combined costs accounted for 50% for the British airline BA, 46% for the Spanish airline Iberia and 40% for the Mexican airline VivaAerobus.

Airlines are very labor intensive businesses, especially in all activities related to the operation of the aircraft including pilots, cabin crew and airport staff. There are, however, important differences between full service and low cost carriers in terms of both the number of services provided and as well as the services that are being outsourced. This therefore leads to higher labor costs for full service carriers. This is confirmed when a comparison is made between the labor cost percentage in 2019 of the two full service carriers BA (22%) and Iberia (23%), which constitutes almost double the labor cost of the low cost airline VivaAerobus (12%).

The salary levels of the country where most of the airline’s labor is based can also have an effect on labor costs. In the above example, Mexico with 10,000 USD GDP per capita, where most of VivaAerobus’ workforce is based, accounts for one fourth of the UK’s 40,000 USD GDP per capita, where BA has its largest workforce.

The other substantial cost for airlines is fuel, which depends on the volume of fuel required for its operations and its price. Airlines try to optimize the amount of fuel used in their operations by flying efficient aircraft, which corresponds to newer aircraft using newer technologies. In that respect, LCCs often operate newer aircraft fleets than FSCs.  The other variable to calculate fuel cost is the aircraft fuel price, which is closely related to the price of oil. Airlines cannot control oil price volatility, however, they often use a financial instrument called fuel hedging to decrease the risk when oil prices go up.

A fuel hedging contract allows airlines to secure a fixed fuel price in the future. This allows the airline to reduce the fuel cost, compared to the market price, when the price of fuel goes up. However, it also has a potentially negative effect when the fuel price goes down as the airline will be paying above the market price. For example, on one hand, the LCC airline Southwest Airlines, who has been practicing hedging for more than 20 years, in 2008 achieved savings of 1.3 billion USD (Brooks, 2012); On the other hand, the International Airline Group (IAG) reported an exceptional expense of 1.3 billion EUR during the first six months of 2020, related to overhedging  (IAG, 2020).

Going back to the example of the same airlines, the actual percentages of fuel costs in 2019 were 28% for BA, 23% for Iberia and 38% for VivaAerobus. Here we can see that fuel, as a percentage of total cost, tends to be higher for LCC than for FSC.

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