CVP analysis and business strategy analysis of Air Asia

By | May 25, 2013

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Executive Summary

Air Asia is one of the best low cost airlines in the world with achieving the recent milestone of carrying more than 100 million passengers since its establishment. And without doubt, it has done remarkably well with its low cost pricing strategies to penetrate into the widely competitive airline industry. Market analysis suggests that the concept of low cost budget flights is proving to gain popularity as people prefer to travel cheap with basic facilities. This indicates that several more entrants are expected to join the low cost industry in order to compete with Air Asia. To maintain its competitive edge and market dominance, Air Asia is expected to continuously identify new sources of cost savings to ensure providing the lowest fare on its flights. The target audience is the price sensitive customers. This assignment makes use of the tool of Cost-Volume-Profit (CVP) analysis in order to evaluate Air Asia’s financial performance.  CVP analysis is a useful tool to help the managers understand the linkages between cost, volume and profit in an organization by focusing on the following five factors: price of products, volume or level of activity, per unit variable cost, total fixed costs and mix of products sold. By applying CVP analysis, the board of directors are able to evaluate between past and current performance and make appropriate decisions regarding price setting, route possibility analysis, demand forecasting, and maintenance management and supplier chain analysis.
airasia
 

This assignment analyzed and has understood that Air Asia is dealing with a market which is highly price elastic in nature and changes in air fare have significant influence over revenues and profits. Expenses also play a vital role and Air Asia has to design and initiate competitive cost cutting strategies to remain profitable. Surprisingly, changes in volume of passengers carried, number of employees hired and fleet size had no identifiable relationship with changes in profitability and expenses using the CVP analysis.

 

1.0  Introduction

 Cost advantage plays an important role in the dominance of Air Asia in the Asian air travel market. It is generally accepted that Air Asia has pioneered the budget flight travels in Asia. It is also the first airline in the region to implement paperless e-ticket travel and its slogan states ‘now everyone can fly’. Low pricing and resulting greater number of seats being sold is a major selling advantage of Air Asia. Compared to existing airline companies, Air Asia is relatively a new born no frills airline. With the world lowest unit cost of US $0.023/ ASK and a passenger break-even load factor of 52%(Air Asia Annual Report, 2009), Air Asia is able to compete with the traditional full frills airlines even though its budget services are unable to match with the offerings of normal full frills airlines in terms of quality.

 

This assignment is divided into four sections and following the introduction, section two would focus on the structure and the competitiveness of the air travel industry and the airline market in Asia. Section three would analyze the business strategies of Air Asia. Section four would discuss the performance of Air Asia in the past 5 years by using cost-volume profit analysis, and then finally conclusions and recommendations for future are given.

 

2.0 Industry Analysis

2.1 Macro-environment

According to Sachs (1997), there are several reasons why the low cost carriers would have a long term sustainable growth trend in Asia. The first reason is the ‘demographic fundamental of a large population. According to Asia Population Study, Asian continent had a total of 35,330,000 individuals by the end of 2005 (Asia Research Institute National University of Singapore, 2006). Majority of people in this region reside in a developing economy, and they are eager to avail air travelling services since most of them have not experienced air travel and holidays before. The second reason is that there is a strong rising middle income segment which has enough leisure time to take overseas trip during holiday seasons such as Chinese New Year and Deepavali. The third reason is lack of adequate alternative forms of transportation, that is, trains and bus travel are not recommended for the long distance travel within the region. With the rapid economic development in most developing countries, disposable incomes in this region have also been increasing dramatically. Take Indonesia for example, the demand for aviation is rising unpredictably; in the past one year, there were more than 1. 4 million Indonesians flying overseas for vacation purposes and more than 6 million Indonesians went abroad for business trips. Even within Indonesia, 30% of the Indonesians prefer to travel by Airlines (Guharoy, 2010).  Urbanization trend is another incentive to boom air travel market (Centre for Asia Pacific Aviation, 2002). Moreover, high internet usage enables passengers to cheaply obtain the latest promotional information from the low cost carriers and also plan their trips through online bookings by making purchases using credit cards. In addition, archipelago geographical structure of Asian continent, east and west Malaysia, for instance, the only way for the residents to travel is by airline since there is no other transportation provided for this route (Lawton and Solomko, 2003). Increasing awareness of low cost carrier is another factor to contribute to the rise of this air travel industry. Ten years ago, majority of the Asians were used to highly priced air tickets and were not much aware of the concept of budget airlines which were common then in US and Europe. With the advent of global advertisements on media channels such as TV, internet and newspaper, most of people in Southeast Asia now know Air Asia brand and its concept.  However, air travel sometimes does face negative obstacles to growth, for example through the impact of terrorism such as 9.11 and diseases outbreaks such as SARS and also financial crisis and turmoil. These would have a negative impact on the airline industry.

 

However, in general consensus, low cost carrier industry is expected to have a bright future and sustainable growth in Asia. According to Frost Sullian (2010) , low cost carrier market is expected to a grow to a total number of 217 million passengers in 2012 compared to 116 million in 2008, with a compounded annual growth rate of 16.9 percent. The number of the aircraft in use by low cost carriers is anticipated to grow to 830 in year 2012 from the original digit of only 450 in year 2008 by the annual growth rate of 15.9 percent.  

 

2.2 Micro-environment analysis

 

In terms of Micro-environment Analysis, Porter’s Five Forces (chart 1: Porter’s Five Forces) would be used to examine the micro-environment for low cost carrier industry. Chart 2 shows that how Porter’s Five Force theory is applied in the Low cost carrier industry in Asia.

 

Chart 1: Porter’s Five Forces

 

 

Chart 2: Porter’s Five Forces Applied in Low Cost Carriers Industry in Asia

 

The bargaining power of customers is high since there are no switching costs for the customers to shift from one low cost carrier to another LCC. In addition, the easy access to internet helps customers to make comparisons between airline fares provided by different low cost carriers. The price sensitive customers and first time fliers are easily able to get full information on prices charged by different low cost carriers. The threat of substitute products or services is moderate middle because of the availability of other modes of transportation such as cruise, bus, train. However, due to the archipelago geographical structure of Asia continent, Airline is still considered as the most comfortable, convenient and efficiency way to travel around. Advancement in communication technology such as teleconference may reduce the demand of business travelling. However, it is generally agreed that leisure travelling is no longer an unaffordable dream for most Asians. The bargaining power of the supplier is quite high since there are only two main aircraft suppliers in the world: Boeing and Airbus, Air Asia is the biggest client of Airbus and 132 new Airbus aircrafts are supposed to be delivered to Air Asia by the end of 2013. Airbus has already delivered 82 A320 aircrafts and 7 A330/340/350 aircrafts (Airbus, 2010). Threat of the new entrants is relatively high, although airline industry has a very high requirement for capital and a lot of funds are needed to set up a new airline company. The new potential low cost carriers have to be supported by large amount of funds and need experienced leaders from industry. Government regulations and government barriers such as airline service agreement can act as barriers to entry. However, the deregulation of the aviation industry in Asia has resulted in more new entrants. Take Malaysia for example, in the past three years, there are two new entrants (Firefly and Silverfly) entering this industry and competing with the existing low cost carrier: Air Asia. The low cost carriers set up by established full frills airlines is a threat for Air Asia. Firefly, for instance, is a subsidiary company of Malaysia airlines. It operates on some routes such as Penang-Banda Aceh which are not operated by Air Asia. Nok Air set up by Thai Airways is another example to support this point. Industry rivalry is moderately high because of high exit costs and the competition is quite fierce. In this industry , price is the basis of competition and market participants understand that price war is destructive for them and they implicitly try hard to avoid direct price competition and try to act ‘non-aggressive’ to their competitors. Appendix 1 shows the main players in this industry in Southeast Asia Region.

 

3. Business Strategy Analysis

3.1 Company Profile

Air Asia, one of the leading low fare airlines in Asia, has been expanding rapidly since 2001.  Air Asia was incorporated on 20 Dec 1993 by a government-owned conglomerate DRB-Hicom and was operating as a full-frill airline, and bought over by Tune Management on 8 Dec 2001 and re-launched as low cost carrier (LCC). Tony Fernandes, The CEO of Air Asia Sdn berhad, paid total sum of one ringgit for 2 aircrafts and $12 million in debit (Chu, 2008). Fernandes made a remarkable turnaround, turning a profit in 2002; Thai Air Asia was first joint venture for Air Aisa and was launched on 3 Feb 2004. Indonesia Air Asia was second joint venture company and was launched on 8 Dec 2004 to form One Air Asia. And after the effort of forming new joint venture company, Air Asia manages to operate more than four hundred flights in one hundred and twenty nine routes covering sixty one destinations with only eighty two planes (AirAsia, 2010).

 

To date, Air Asia owns the traveling capacity of more than 55 million passengers and this number could be anticipated to increased if strategically needed by Air Asia with its extensive flight network created jointly with the its partner companies: Thai Air Asia and Indonesia Air Asia.

3.2 Mission and Vision Statement of Air Asia

 

Two major key words in the mission and vision statement of the company show the Air Asia’s simple and difficult business model. The first key word is quality which could be in term of safety and quality service contributed by embracing advance technology and quality staff; the second key word is low cost, the idea of keeping low cost can be seen from its mission and slogan of making “Everyone can fly” (Air Asia, 2008).

 

3.3 Business strategy

 

 

 

 

 

 

 

Air Asia Value Chain Analysis

 

 

 

 

 

3.4 Strategies for Cost Effectiveness

One strategy used by Air Asia to lower the cost is to replace its Boeing 737-300 planes with Airbus 320 to form a single procedure of maintenance so as to lower the scheduling cost, managing cost with a simpler inventory parts because maintenance and administration contribute large part of cost. Since there is only one kind of air craft, all the above mentioned handling and administration becomes easy. Meanwhile, an operations manager of China Southern Airlines Limited confirms that the after sales service and maintenance costs of Airbus aircrafts are more cost efficient than that of Boeing. Therefore, with Air Asia’s plans to introduce Airbus A320s, further cost savings can be expected. 

 

No frills, no free seats preference, single class of travel (for AirAsia only, AirAsia X have dual configuration seating system), and the use of “e-ticket only” policy greatly contribute to a lower cost. Technology also help enhance the low cost advantage by adopting efficient technology. For instance, a simpler but still effective flight procedure could help save around 26 percent of its fuel cost. On the other hand, maintaining a high frequency of using the planes and reducing the turnaround time also help lower the operational cost. And remove of aerobridge also simplify the procedure, the use of aerobridge could only be used upon passengers’ request. What’s more, the chargeable service of shuttle bus and plan advertisement also vary the company’s income sources. And the encouragement of internet booking as the booking through other channel such as call center and checking counter and sale counter would not have promotional price and will also with a higher service charge could also reduced the costs. As Air Asia’s annual report for 2009 states that nearly 70% of all sales were directly done through internet bookings. This not only saves commission costs but also saves on outlets and physical shop costs (Kho et al, 2005) .

 

Meanwhile, emphasis on effective and efficient handing of customer enquiries and complaints, maintaining simplicity, practicing higher disclosure than industry norms, transparency in decision makes Air Asia stand out in the airline industry and also generates customer loyalty.  Further cost savings are enjoyed since Air Asia assigns multi-skilled cabin crews with only 3 crew members per flight compared to 6 in some other airlines. Air Asia also invests in cost-effective training, performance based reward and incentive systems to maintain productive and motivated employees. Business requirements related technologies and cost effective technology supporting are Air Asia’s core competencies, and it actively engages in effective and efficient technology acquisition (IT and communications).

 

4.0 Critical Analysis of the financial performance in the past four years making use of CVP analysis

 

In this section, critical analysis is carried out about the financial performance of Air Asia from 2006 till 2009 using variety of ratios. Emphasis is given on cost and volume changes and how they have affected the profitability levels of Air Asia. All data reported here and used for constructing diagrams is taken from Air Asia Berhad’s Annual Report 2009.

4.1 Changes in volume of passengers carried versus changes in profitability (% change over the previous year):

The following graph shows an unusual scenario. There has been a positive increase in the number of air passengers carried by Air Asia since 2006 but there has been no consistent change in profit levels. This analysis suggests that there are other important factors regardless of volume affecting profitability. In such a situation, volume itself alone is not a significant criterion to make decisions on profitability. Increasing passenger numbers do not have an identifiable affect on changes in profit.

 

4.2 Changes in aircraft fleet size versus changes in profitability (% change over the previous year):

Consistent with our earlier analysis, increasing fleet size has also not reflected similar achievements in profit changes. Air Asia has consistently acquired and increased its fleet size. From the previous ratio, this constant increase in fleet size has been supported by constant increase in the number of passengers carried by Air Asia. However, both increased passenger number and fleet size have failed to match changes in profitability which vaguely suggests volume is not significantly influential on profits.

4.3 Changes in employee size versus changes in profitability (% change over the previous year):

Similar to the other ratios calculated, even this factor does not have an identifiable trend with the change in profitability. The logical explanation at this point can be that during 2008, some other factors were in place which negatively affected the profitability. Increasing employee numbers does not necessarily reflect extra costs cutting down profit levels or greater productivity and efficiency leading to increased profits.

 

4.4 Changes in average fare charged versus changes in profitability (% change over the previous year):

Finally, we seemed to have made a breakthrough in identifying a relationship between two variables. Clear identifiable trend is observable from this analysis on average air fare charges versus changes in profit levels. It is evident that when Air Asia increased its fare by nearly 20% in the year 2008, the profit levels decreased sharply. Similarly, when the air fare was slashed significantly in the year 2009, profits also responded in similar manner. Important conclusion from this analysis seems to be that passengers are very price sensitive and therefore small increase/decrease in air fares can bring about significant changes in profitability of the company. This is not a definite conclusion, but what appears at hindsight from the ratios calculated. We need to look at the expenses ratio as well before concluding air fare alone was the reason for the changes in profitability.

 

4.5 Changes in expenses versus change in profitability (% change over the previous year):

Not surprisingly, it is evident that expenses had risen significantly in year 2008 to cause the profitability to fall while percentage expenses had been later controlled in second half of 2008 and reduced remarkably during the following year and this had a favourable effect on the profitability levels in 2009. It is not reported in the financial statements that what had caused these expenses to rise. We will conduct a few tests to determine what could have possibly caused the expenses to rise in 2008.

4.6 Changes in employee size versus change in expenses (% change over the previous year):

The graph below confirms that increase in employee size is not correlating with increase in expenses and therefore this cannot be blamed for rising expenses. Thus, labour costs are not the reason of the increased expenses as our simple analysis shows.

 

 

4.7 Changes in fleet size versus change in expenses (% change over the previous year):

Similarly, even changes in fleet size are not responsible for the change in expenses as there is no identifiable relationship in the trend between the two. Thus, one cannot claim increased fleet size is accountable for the extra expenses incurred from our simple analysis. So even this is ruled out and this point is illustrated in the graph below.

 

4.8 Changes in passenger carried versus change in expenses (% change over the previous year):

Finally, even when checking for the number of passengers carried, there is clearly no relationship during the years 2006-2009 between expenses and the number of passengers carried. Therefore, one possible argument here can be made that Air Asia should be encouraged to carry as many passengers per flight as feasible (as long as marginal revenue per passenger is greater than marginal cost). Capacity utilization has been approximately 75-80% in these years and an increase in this figure could be useful. This is because expenses are not correlated with passenger numbers but revenue and profits surely are. Also, the analysis means the expenses figure has been affected by external factors not measurable by looking at the published financial statements. Below is a graph showing the relationship between passenger numbers and expenses.

 

 

Due to limited data availability, further analysis on cost volume profit relationship is unable to be carried out. But the results obtained so far do provide some basis for giving conclusions and recommendations.

 

5.0 Conclusions and Recommendations:

From the above analysis carried out, Air Asia needs to pay careful attentions on costs and prices. Volume in terms of air passengers, employees and fleet size seems to be insignificant. Volume appears to be insignificant both for profitability and expenses level.

 

But what appears to have a clear relationship is the air fare charged by Air Asia with profitability levels and also the expenses incurred by Air Asia and profitability levels. Air Asia has to be careful in its pricing decisions as past performance suggests that revenues and profits are price sensitive. This suggests that the air travel market for Air Asia is highly price elastic and therefore, lowering the price can significantly increase revenues and profits.

 

Similarly, expenses also need to be controlled for as ballooning expenses have logically resulted in declining profits. With the limited data, we were unable to identify what factors caused the expenses to increase. It was not volume (passengers carried), not the number of employees or fleet size. Some other factors, possibly financial crisis, rising fuel costs or other costs unknown were reasons behind the expenses rising.

 

Therefore, this report concludes after conducting simple cost-volume-profit analyses, that the volume level of passengers carried, aircraft fleet size and number of employees is relatively insignificant for Air Asia profitability compared to Air Fare charged and Expenses. The management has to design, initiate and implement appropriate expenses reducing strategies while pricing also needs to be formulated to capture as much seats and capacity utilization as possible. The natural economic theory for this decision making is the quantity where marginal revenue equals marginal costs. Air Asia needs to set an air fare price which achieves this profit maximizing point.

 

The low cost carrier industry seems promising with strong potential for growths which are expected to be sustainable in the near future. However, it also invites threats from new entrants. For Air Asia, a combination of low cost pricing policies and efficient cost reducing measures are essential for maintaining the competitive edge and surviving competitions and challenges in the airline industry.

 

 

 

 

 

Reference

 

AirAisa (2008). AirAsia Annual report 2008. Available Online http://www.airasia.com/iwov-resources/my/common/pdf/AirAsia/IR/AA%20Corporate%202008.pdf as at 21st Oct, 2010

 

Airbus (2010), Orders and deliveries, Available Online http://www.airbus.com/en/corporate/orders_and_deliveries as at 18 Oct, 2010

 

Asia Research Institute National University of Singapore (editor), (2006), Asian Population Studies. Routledge: UK

 

Chu, Jeff(2008), Fast 50 2008: Air Asia, Available Online http://www.fastcompany.com/fast50_08/airasia.html as at 22nd Oct, 2010

 

Centre for Asia Pacific Aviation (2002). Low Cost Airlines in Asia Pacific Region: An Exceptional Intra-Regional Traffic Growth Opportunity. Available Online www.centreforaviation.com as at 1 Nov 2010

 

Frost $ Sullian (2010), Asia Pacific Low Cost Carrier Market – Market Outlook and Investment Opportunities, Available Onlinehttp://www.frost.com/prod/servlet/report-toc.pag?repid=N6C4-01-00-00-00 as at 23rd Oct, 2010

 

Guharoy, Debnath (2010). Analysis: Holiday plans changing as disposable incomes rise, Available Online  http://www.thejakartapost.com/news/2010/09/14/analysis-holiday-plans-changing-disposable-incomes-rise.html on Oct 20th, 2010

 

Kho Charles et al (2005), AirAsia-Strategic IT incentive. The University of Melbourne available on line http://sandygarink.tripod.com/papers/AA_SITA.pdf as at 22nd Oct 2010.

 

Lawton, T.C. and Solomko, S. (2003). Low Fare Airlines in Asia: An Exploratory Study of Cost Competition, Market Dynamics, and Sustainable Advantage. Air Transport Research Society

 

Natthia, Taweelertkunthon (2006). The empirical valuation of the potential success in low cost business model in Asian aviation market, UBC: Canada

 

Onwutalobi, A. C(n.d). Understanding Marketing Mix in Air Asia Airline Bhd. Available Onlinehttp://www.codewit.info/articles/onwutalobi31217.pdf as at 21 Oct, 2010

 

Porter, M.E. (1985). Competitive Strategy: Creating and Sustaining Superior

Performance. New York: The Free Press.

 

Sachs, G. (1997). Asia Airlines. Asia Research, October 17.

 

Appendix 1: Main Players in Asia-pacific region

 

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