How do budget airlines make money?

The Ancillary Revenue business model

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This is Edition #10 of the newsletter. You can find the previous editions here.

Budget Airlines

Budget airlines, as you would guess from the name, offer inexpensive tickets -- sometimes as low as $50 for a one-way ticket. They manage this by cutting their own operating costs. How do they cut costs? There are many ways an airline can trim operating expenses, but budget airlines are most well-known for cutting back on passenger luxuries or making passengers pay for luxuries à la carte.

Budget Airlines make/save money through:

1. Cutting operating costs by flying smaller jets, for shorter distances, with higher frequency to cheaper airports

2. Fuel Hedging

3. Ancillary Revenues

Cutting Operating costs

Small and one kind of plane: An excellent way to cut costs is to use only one kind of plane. Southwest only uses Boeing 737s. This saves money on maintenance and repair since the company only has to stock parts for the one make and model of the plane they use. They also save money on pilot and mechanic training, since they don't need separate training programs for each different type of aircraft.

High frequency to maximize flying time: Airlines, regardless of whether they are full service or budget, do not make any money when their planes are sitting on the ground. For this reason, flight operations demand that planes should depart with passengers on board as soon as possible after landing. Budget airlines take this concept to the next level with their planes often taking only 25-35 minutes to be refreshed and refueled before taking off again.

In addition to the plane’s quick turnaround requirements, the airline crews don’t spend the night at their destinations but instead operate the return flight back. This results in low accommodation costs for the foreign crew.

Cheaper airport fees and remote airports: Budget carriers also often fly to secondary airports where landing fees are way cheaper. This further drives down their operating costs and at the same time give them huge negotiating power with the airports. You won’t find a budget carriers’ hub at airports like London Heathrow but at secondary ones like Gatwick, Stansted, and Luton. 

Though not the case at Changi where all flights board with jet bridges, budget carriers usually opt to board passengers using remote stands and an apron bus because they do not have to pay for jet bridge fees. 

While this is generally okay when the weather is favorable, imagine boarding your wide-body aircraft in the scorching 50-degree heat of Dubai or in the monsoon downpour of a wetted Kuala Lumpur. 

Fuel Hedging

One of the most important ways for an airline to save money is through fuel hedging. All airlines use fuel hedging, but budget airlines seem to be particularly good at it. For example, between 1991 and 2008, Southwest Airlines paid $3.5 billion below the industry average for jet fuel by using aggressive fuel hedging. What is hedging? It's a gamble against the future price of jet fuel. If an airline thinks that the cost of fuel is going to rise in the future, they can sign contracts locking in the current price for months or even years. If fuel prices double in 12 months, the airline would be buying fuel at last year's cheaper rate. However, if prices drop, the airline is stuck paying their "locked-in" higher rate.

Ancillary revenues

The money airlines make from sales and fees for products and services such as food, checked bags, and extra-legroom. The ancillary revenues have grown exponentially over the last 10 years. As per Statista, the total ancillary revenue has crossed $100B in 2019.

As per this report from McKinsey, more than 50% of the ancillary revenue is realized from check-in bags and booking fees.

Other industries where this model works

1. Hotel Industry
   Ancillary revenue in the hotel industry includes revenue from high-speed WiFi, in-room dining, parking, business services, meals, fees for extra loyalty points, late checkout/early check-in fees, in-room entertainment, and trip cancellation insurance.

2. Entertainment (eg. Concerts, Cinemas, Sports Stadiums)
   Ancillary revenues include expensive popcorn, recliner seats, preferred seating and merchandise.

Fun Fact
The world's first low-cost airline was Pacific Southwest Airlines (PSA), which started intrastate flights connecting Southern and Northern California on 6 May 1949. PSA's light-hearted atmosphere and efficient operations were a runaway success early on, and inspired a number of low-cost start-ups across the United States, beginning in the mid-60s. Herb Kelleher studied the success of PSA, and copied their culture closely when he established Southwest Airlines in 1971. Southwest Airlines is now the largest Budget Airline in the world.

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