Longer-term air cargo trends provide a worrying outlook for the industry. There are concerns about chronic overcapacity and deteriorating yield, while demand growth is slowing. Freighters are under scrutiny, in particular, and their ongoing viability is raised in board meetings. In such times, monitoring and optimising the performance of the cargo business is crucial.
Measuring and benchmarking the profitability of cargo departments is challenging. Cargo is often missing from airlines' public financial statements. Those that do publish the data may provide a misleading picture. These are likely to include opaque revenue and cost transfer mechanisms related to the use of belly capacity for cargo on passenger flights. For the few all-cargo airlines that publish financial statements, the comparison will be inaccurate for belly-only and combination carriers since they have different cost structures.
The profitability of belly cargo is arguably very high, at about 65%. This is because belly capacity has the advantage of having a large proportion of aircraft operating costs allocated to passenger activities (eg crew, aircraft, landing fees, over-flight fees, etc). The result is that direct costs of the cargo operation are limited to handling, incremental fuel, sales and general and administrative costs. It can be argued that this view of a subsidised cargo department is unreasonable and biased towards cargo. After all, both passenger and cargo departments utilise the same asset and should therefore split all associated costs accordingly. As a result, accountants will say that it is only fair that a portion of direct costs, such as aircraft ownership or maintenance, should be allocated to the cargo profit and loss.
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The issue with cost transfer mechanisms is that it involves sunk costs. Measuring profitability based on these sunk costs will not reflect cargo's effective performance. For instance, an airline might determine that belly cargo should be allocated 20% of its direct operating costs. Yet this does not mean that discontinuing cargo operations would result in a 20% decrease of the airline's operating costs. Aircraft ownership or maintenance - among other costs - will be paid nonetheless. Furthermore, if with cost allocations, the belly cargo profitability is found to be -10% on a given route, it does not necessarily mean that the airline is better off stopping cargo activity on that route.
Yet many accounting departments set up mechanisms so that this profitability is shrunk to a more industry-comparable level. This is done by re-allocating costs to cargo, and there are many ways of doing so (eg based on cargo's share of total weight, or of total volume, or based on a lump sum amount). Usually these mechanisms drain time and resources. As one airline said: "We dedicate a whole team to the calculation of cargo allocated costs, and the formula itself required us quite some effort to develop." What these mechanisms have in common is their randomness, as there is no one right way to do it. At best, they add to bureaucracy, at worst, they can lead to incorrect commercial conclusions.
The reason why airlines attempt to contain their cargo business in a "full" profit and loss statement is to measure its performance. However, profitability is probably not the right metric, as an airline noted: "We realise that our cost allocation mechanism did not assist us in making the right commercial decisions."
Measuring performance using EBIT of the cargo organisation may not always maximise contribution for the group. Development of key performance indicators such as yield and load factor, over time and vis-à-vis the market, provide plenty of information to understand cargo's real performance. Besides, these indicators are exactly what should be fed into corporate network planning to figure out the cargo contribution on a new and/or existing route.
The point is that airline executives need to understand that every dollar in belly cargo revenue adds 65 cents to the airline's bottom line. This is achieved regardless of the transfer price mechanism in place. Spending resources on fine-tuning a theoretical cost allocation mechanism has limited value. Making sure that revenue is optimised through measuring and benchmarking the performance of the cargo business can create significant value.
Value in the mix
Freighters operate under totally different cost levels, and come nowhere near the contribution levels of belly cargo. While passenger aircraft bellies only bear the incremental operational costs, freighters absorb the entire cost of flying. This may cause route profitability to drop to zero or negative levels, particularly in these economic times. The peculiarity of the air cargo industry is that these two distinct sources of cargo capacity provide practically the same service, but at completely different cost levels. This pressurises industry yields as belly operators can afford to significantly lower rates and still generate positive profit contributions, further eroding margins of freighters.
A majority of cargo capacity is operated by combined belly/freighter carriers (over 60% of global available cargo capacity). With the two sources of cargo capacity operating together, one might wonder how to properly measure the combined profitability. A highly debated question is whether freighters have a positive impact on the belly. In other words, do freighters contribute to belly revenue? Cargo organisations typically argue that this is the case, whereas corporate finance departments may argue otherwise. The real answer depends on the nature of the airlines' operations.
A cargo network can definitely be set up in such a way that freighters feed bellies from trunk cargo routes. This may be the case for Middle-Eastern airlines, but is less the case for carriers like Cathay, which is sitting atop one of the largest cargo markets in the world. In addition, a freighter adds value through other considerations: it is perceived as a better product because of its main deck and guaranteed capacity, which may justify higher yields. It may also enhance the carrier's market share and promotes a better status towards forwarders.
Instead of calculating freighter profitability in a mixed fleet, the question should be what is the freighters' impact on total airline profitability? What if freighters make a small standalone loss, but have a positive contribution to belly revenue that is greater than that loss? For the purpose of measuring contribution from freighters, the issue is not so much about allocating costs (freighter operating costs are easy to segregate), but rather, allocating revenues. On a mixed freighter/belly origin and destination, how do you allocate the revenue to each?
In practice, we have come across three different methods for revenue share allocation. Revenue can be pro-rated on the basis of sector length, such that the longer sector gets attributed a higher share of the revenue. This first method will, however, always ensure the shorter freighter legs appear unprofitable. The second method is to consider the freighter as a feeder and therefore allocate the entire revenue to the freighter. This will likely be an overly optimistic view for the freighter. The third method is likely the most realistic: what upside on belly revenue exclusively comes from the freighter? High demand cargo routes would likely not need additional feed and thus, freighters should not be credited for this revenue. Conversely, low demand routes in need of feed should credit the freighter with 100% of the revenue.
Real Value
Understanding the real added value of the freighter is essential. Some routes may appear loss-making in a "classic" profitability model that does not factor in their revenue contribution to the rest of the network. It is only when capturing their "beyond" added value that we can finally see the actual contribution of the freighters on the network.
Benchmarking the financial profitability of cargo is a complicated task. Besides, it can produce misleading insights and lead to uninformed decisions. Unfortunately, we often observe that greater efforts go into trying to figure out the most appropriate cost allocation mechanism rather than into tracking and optimising the operational and commercial key performance indicators.
As a result, many all-passenger aircraft operators do not realise the fact that their belly cargo capacity drives a significant profit contribution. Belly cargo should be provided with the right amount of attention (market data, efficient analytics, sufficient resources) as every unit of revenue comes with great addition to the bottom line.
Meanwhile, combination carriers continue to evaluate the profitability and viability of their freighters. This can only be answered if the dynamics between freighter and belly fleets are properly understood. The contribution of freighters is then tailored to the type of network they operate on (ie feed/de-feed vs trunk routes). With this in mind, cargo executives can now work on filling their profitable belly network first - and only then supplement with freighters to produce feed for low demand routes. The necessity to right-size the freighter fleet now becomes even clearer.
Gert-Jan Jansen is Seabury's executive director and head of cargo advisory Soufiane Daher is a senior analyst, both are based in Seabury's Amsterdam office. More information at Seaburygroup.com
Source: Airline Business
