The Hindu Business Line : Importance of break-even

THE concept of `break-even' is one of the first things taught in management schools, highlighting the significance of fixed costs in running of organisation. It is one of the simpler, easier concepts to understand and apply readily in a given situation and is one of the finest indices of a firm's health. Corporate history is littered with examples of companies that have gone under due to insufficient scrutiny (and negligence) of the influence of fixed costs on their break-even points.

A recent issue of The Economist (November 12) highlights the concept instructively in a survey of the airline industry. The article starts almost on a sensational note: "Only an idiot would buy a share in BA, which currently owes almost half its £3.5 billion ($6.1 billion) market value to its pension fund". It would appear that factoring in the cost of those whose time would be up eventually could shake the very foundations of BA!

Nearly 80 per cent of the revenues of the industry this year ($400 billion) will go to cover non-fuel costs, according to the survey. The industry has a phenomenally high break-even point. New fixed costs, such as hikes in airport charges and additional security costs, are coming up all the time.

How do airlines — especially established ones — handle this? One route is through consolidation, which can help reduce the load considerably. It has already started in China in a big way; in Europe there is the Air France-KLM merger. Another solution, applicable only to the US, is to seek protection under Chapter 11 bankruptcy laws. Under this statute, payments to some creditors are waived till the airline is able to sort out its cash problems.

United Airlines has been under Chapter 11 for three years now; and recently, Delta and Northwest opted for it too. By freezing some payments, Chapter 11 brings down fixed costs artificially. Airlines tend to be run purely for cash under them — they are able to cut fares and increase traffic volume, which should improve capacity utilisation and bring down break-even levels.

The airlines industry is a highly visible industry and governments are involved in a big way, for understandable reasons, which also explains why the estimated cumulative loss in excess of $40 billion (from 2001 to the end of 2005) does not create too much of a flutter. This is a peculiar industry, where long-lead times are involved on the supply-side, whether it is new aircraft or pilots, and this considerably reduces the scope of manoeuvrability in a rising demand context, such as now (traffic is expected to grow world-wide at 8 per cent per annum).

In India, the national carriers are making an effort to cope with the situation. Their fixed costs must be posing new challenges, given the escalating pilot costs and capacity expansion outlays on top of reduced flexibility, considering that liberalisation has been like climbing a greased pole, thanks to the coalition coefficients. The new carriers that have started operations in India have plenty of examples in the industry to learn how to get a handle on fixed costs and keep break-even levels manageable.

R. T. Narayanan

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