Case_Study_on_Jal

Introduction Japan Airline Corporation was established in 1951. She became the national carrier of Japan in 1953, and has continued to provide air transportation service both domestically and internationally throughout these years. In 2002, JAL merged with Japan Air system, making it the sixth largest airliner in the world by passengers carried. However, the economic downturn in 2009 had adversely affected the commercial airline industry, and, the sharp fall in demand of air travel had negatively impacted the financial performance of all airlines in the world. While the entire industry has been under performing, JAL’s inefficient operations have caused them to be affected even more severely. This is revealed by the fact that they have filed for bankruptcy protection in January 2010, even though other airline companies remain solvent. Furthermore, $3.3 billion dollars of state-backed support is being planned to be injected into JAL, and this is on top of the $1 billion dollar bailout they had received in 2009. JAL files for bankruptcy protection The Japanese government is bleeding into their reserves to intervene and this is definitely not sustainable in the long run. Clearly something needs to be done to ensure JAL’s survivability. Hence, our project seeks to investigate the key expense factors by using various methods of analysis and provide recommendations to bring JAL to profitability. Content Page Industry Overview Company overview CVP Analysis Variance Analysis Capital Budgeting Conclusion Industry Overview [pic] Porters’ five forces is a framework that lays down the competitive intensity of an industry. The fives forces of this framework are: • Buyer’s power • Supplier’s power • New entrants • Threats of substitute • Degree of rivalry Buyer’s power represents the bargaining power of customers, which in this case are those who buy airplane tickets be it for business or leisure travel. The cost of switching from one Airline Company to another is low for customers. Furthermore, tough economic conditions at present means that customers are highly priced sensitive. These two points do increase buyer’s power. However, in terms of absolute quantity, there are a large number of customers, and airlines do not feel the impact of losing an individual customer. Overall, buyer’s power is assessed as moderate. Supplier’s power is the bargaining power of suppliers. The airline supply business is essentially a duopoly industry dominated by 2 large market players, Boeing and Airbus. In addition, airliners have to purchase jet fuel in a commodity market that is subjected to volatility that is not within the company’s control. All in all, the supplier’s power is assessed as strong. New entrants represent the possibility of new players entering into the industry. There is little threat of new entrants into the airline industry due to the high start-up capital required. In addition, established airlines will already hold some control over slots at certain airports, making it harder for new airlines to infiltrate. Overcoming established companies hence becomes a deterrent to new airline companies. Therefore, new entrants are assessed as fairly low. The threat of substitutes represents the existence of products or services that consumers can use instead. This is fairly low for international flights. Considering time, convenience and cost, most travelers would most likely choose to fly to their destination rather than take any other means of transport. However, substitutes would be more applicable to short haul flights, as there are viable alternatives for consumers such as traveling by car or trains. Lately, the use of technology, such as video-conferencing, is starting to pose as a threat too to the air travel business, as it offers a lower-cost means of conducting meetings for colleagues based far apart. However, it is uncertain whether such technologies will replace all face-to-face meetings. Hence, the threat of substitute is assessed as fairly low. And finally, degree of rivalry represents the intensity of competitive rivalry. The growth in recent years of budget airlines has intensified rivalry especially for the short haul flight routes. Furthermore, High fixed costs and high storage costs, such as salaries and maintenance and flying a plane with empty seats increases rivalry. In addition, the introduction of Openskies policies mean that there are many airline companies that fly from and to the same location. Overall, we feel that there is a strong degree of rivalry in this industry. CVP- ryan’s part Variance Analysis The basic principle behind using variance analysis is to compare the actual figures used by the company against standards that are set by companies generally considered to be of the same standard and tier. The comparison between such figures yield variances. The values of such variances and whether they are above or below the industry standards, allow the management to identify and address issues regarding the values involved. Identification of such issues would assist the management with reducing costs and increasing efficiencies. Much of the analysis that has been done regarding airlines involved revenue changes based on routes, seasonality and passenger mix. However, such analysis does not pinpoint the actual issues with the airline. Therefore, in the case of JAL, we proceed with a variance analysis in two aspects. We have selected direct material variances and direct labour variances, in other words, fuel and staff costs, because they are the two major cost drivers in JAL’s cost breakdown. Basis of Analysis For purpose of comparision in the variance analysis, we will establish our industry standards using figures from Qantas, SIA, ANA, Malaysian Airlines and Cathay Pacfic. Direct Material (Jet Fuel) Variances We define the actual quantity as the amount of fuel used by Japan Airlines per 200km of flight while actual price as the amount paid by Japan Airlines per litre of jet fuel. While the standard quantity is the average amount used by our defined industry standard per 200km of flight while price as the amount paid by the industry standard per litre of jet fuel. From the above, there are two inferences we can make. Firstly, Japan Airlines has an unfavourable price variance. Japan Airlines fuel cost is significantly higher than that of the industry average. We attribute this to the poor hedging policy adopted by the management of Japan Airlines. As seen in the diagram below, Japan Airlines purchased spot contract at the peak fuel price of July 2008, expecting fuel prices to continue their upward trend. However, the fuel prices dropped dramatically which resulted in Japan Airlines being contractually bound to purchase fuel at an extremely high price. This is also indicated in Japan Airlines annual report, which reported that the company lost over US$ 2 Billion due to their poor hedging policy. Secondly, Japan Airlines has an unfavourable quantity variance. This indicates that Japan Airlines is not using its fuel as efficiently as the industry standard. Our team attributes this partially to the age of Japan Airline fleet. As seen in the diagram below, the age of Japan Airline fleet is above that of the industry standard. An older aircraft fleet might indicate that the company is not taking advantage of the advancement of aviation technology in particular the improved fuel efficiency of the newer aircrafts. Secondly, an analysis of the type of aircraft used for its domestic routes, our team found that Japan Airlines uses medium-range flights such as the Boeing 777 for its short-range domestic operation. The use of the wrong type of aircraft would result in inefficient fuel usage, as the aircraft is not optimised for its function. Labour (Staff Cost) Variances [pic] We defined the rate using the industry standard for productivity of Available-Seat Kilometre (ASK)/Staff and the price as the cost per ASK. From the above, we can draw two inferences. Firstly, there is an unfavourable price variance which shows that Japan Airlines is paying too much for its employees. As seen in the diagram below, Japan Airlines pays the highest wages per employee. Our team understands the operational nature of Japanese companies, in which it takes pride in the work of its people, such as sending senior Japanese management personnels worldwide to manage all the various local branches. However, taking into comparision its direct competitor ANA, which operates in the similar environment and culture that Japan Airline operates in, the higher wages paid cannot be justified. [pic] In our variance analysis, Japan Airlines also demonstrated an unfavourable rate variance, which points out to inefficiency and labour redundancy in the Japan Airlines workforce. As shown in the diagram below, Japan Airlines has a labour efficiency below that of the industry standard. More significantly, ANA, which operates in the same country and has a similar work culture demonstrated a work efficiency that is greatly higher than that of Japan Airlines. Therefore, the problem lies outside of the country work culture. Our team attributes this signifcant difference in staff efficiency to the possible organisational inefficiency that Japan Airlines face as a large organisation. Large organisations tend to have multiple layers between the top and bottom management, which leads to inefficiency. [pic] Recommendation for Variance Analysis Direct Material (Jet Fuel) Variances Our team recommends the following for Japan Airline Unfavourable Direct Material Variance. a) Introduce newer aircraft to the fleet • The company should consider revitalising its aircraft fleet to take advanatge of the advancement in aviation technology in particular fuel efficiency. b) Lighten load of aircraft • Japan Airlines should evaluate every item on aircraft and seek possible lighter alternatives such as lighter food carts and utilises. A lighter aircraft would equate to a higher fuel efficiency c) Optimise type of aircraft used • The company should utilise aircraft that are built and optimised for its specific function. Japan airlines should use short to medium range aircraft such as Boeing 767 for its short haul domestic flight instead of the current medium to long haul Boeing 777 it is currently using. Using aircraft that are optimised for its task will help the company save significant cost in fuel effiiciency. d) Implement more Fuel Efficient Flight Policy • Japan Airlines should invest more money into research and development of more efficient flight routes such as using computer simulation models to find shorter and more energy efficient routes. Labour (Staff Cost) Variances Our team recommendations takes into account Japan’s Labour Policy and culture of life long employment and that the company should only fire employees as the last resort. Our team recommendations are as follow: a) Set up a Budget Airline subsidiary • Setting up a budget airline subsidiary will not only allow Japan Airline to tap on the budget traveller market but also allow it to transfer the high amount of redundant workforce, that it has aggressively recruited in the past from the main company to its subsidiary. Japan Airlines can also move its older workers such as the stewardess to the budget airline subsidiary as there is a lower requirement of aesthetics. This recommendation will allow Japan Airline to retain most of its work force. b) Wage Cuts • Japan Airlines should capitalise on the crisis and appeal to its workers to take a wage cut to save the company. This will lower operating cost and enable Japan Airlines to compete better in this highly competitive industry. Capital Budgeting: Financial or Operating Lease Over the past few years, Japan Airlines had chosen to decrease the number of aircrafts on financial lease, and increase their number of operating lease aircrafts. In this section, we will analysis Japan Airline’s decision to decrease their proportion of planes under financial lease, and to increase the number of planes acquired through operating leases. Using our analysis, we will determine if this decision is the most cost effective method for Japan Airlines to manage its fleet. Methods of Analysis When assessing if Japan Airlines should take up more operating lease compared to financial lease, we rely on the Net Present Value (NPV) for our analysis. The NPV of financial lease was calculated using the revenue generated, expenses utilised which is detailed in the cost of flight operations and the salvage value of the plane (Using SIA financial depreciation policy as a proxy) whereby 15% of the plane value is salvaged at the end of its operational span. The NPV of operating lease was calculated using the revenue generated and expenses utilised, which is detailed in the cost of flight operations. Cost of Flight Operations For Japan Airlines to own aircrafts under financial and operating lease, it will incur both Leasing and Working Capital Cost, both of which are explained as follows: Discount Rate The discount rate or hurdle rate is the cost of captial for the company. Japan Airlines is a listed company as is able to raise money through the issuance of stocks and bonds. Therefore we use the weighted average cost of capital (WACC) as our discount rate. The WACC was calculated using the weigted average cost of equity and weighted average cost of debt. The WACC used was 7.41%. Financial Projections There is a difference in the lease period of the financial and operating lease. In order to make a fair comparison, we have rolled over the time span of the leases to make them equal. Quantitative Evaluation The Net Present Value (NPV) represents the future cash flow of an investment in today’s dollars. The NPV of financial lease is US$17,742,362, while that of operating lease is US$21,942,595. The NPV of operating lease is significantly larger than that of financial lease. This implies that it might be lucrative for the company to take up operating lease instead of financial lease. Qualitative Evaluation The quantitative figures provide certain guidelines to examine the management’s decisions. However, there are many other factors we should take into consideration when evaluating a firm’s operating plan. The operating lease brings about many advantages that would help the company reduce expenses over time: • Due to dull economic outlook, there is currently an oversupply of planes, which leads to competitive lease prices. The current cost of operating lease is lower than that of the financial lease. • With advancement of aviation technology, planes are getting more fuel efficient, and will save fuel cost, which contributes to a significant portion of their operating expenses. Operating Leases usually involves newer planes thus allowing the company to take advantage of new fuel efficiency technology. • Older planes will incur higher maintenance expenses However, operating lease also brings about disadvantage. Companies taking up operating lease face the possible reinvestment risk. There is a possibility that operating lease prices may increase at the end of the lease period due to a boom in the industry. By taking up financial leases, the longer lease period will enable the company to lock in lease expenses at current value, and avoid incurring possible higher expenses. Lastly, our team also acknowledged that there is a possibility that Japan Airlines management increased its number of aircraft on operating lease and decrease the number of aircraft on financial lease to understate its liability by keeping lease financing off the balance sheet. This will enable Japan Airlines to reflect a more positive outlook on its financial statement as it positively impacts solvency ratios that are often used in credit analysis. Recommendations We can observe that operating lease offers a higher NPV compared to financial lease. Going by the capital bugeting approach, Japan Airlines should continue to increase its operating leases relative to financial leases. Operating leases are also generally cheaper, and the planes leased are generally newer and more fuel-efficient. Using operating lease, Japan Airlines can quickly revitalise its fleet and take advantage of the advancement in aviation technology such as fuel-efficiencies, which will result in decreasing operating cost. The company can also rapidly adjust the configuration of its entire aircraft fleet to optimise the type of aircraft used in different routes such as the use of short aircraft for its domestic routes, hence cutting operational cost on the domestic routes. Our team feels that the probability of reinvestment risk would be quite unlikely, since there is currently an oversupply of aircraft in the market, and it is expected to continue in the future. Taking all these reasons into consideration, we feel that Japan Airlines should continue to increase its proportion of aircraft on operational lease. Project Reflection Takeaways: Through this project and also via the application of management accounting techniques, our group has gained much insight into what makes a company tick. Namely, its key cash inflows and outflows. One way to maximize profit is to cut cost. And our group was pleasantly surprised to learn that JAL practices some extreme cost-cutting measures. Such examples include the types of cutlery used for in-flight dining and many other areas where weight could be reduced onboard. This in turn means a higher fuel efficiency which would lead to lower fuel costs per jet and eventually, noticeable savings for the company. Market research on JAL revealed lots of interesting and logical facts. For example, we learnt that the types of planes in JAL’s fleet and its fleet age could add up to cost as well. As mentioned by Professor Cheng during our presentation, the type of planes used by JAL, should they not be optimized for its respective flight schedule, would actually incur additional costs for JAL in terms of fuel efficiency. As discussed within our team as well, JAL’s fleet age is also a key factor given that 10 years is long enough a period for technological advancement, which would directly impact fuel efficiency exponentially. To learn what was behind the fantastic deals and promotions offered by aircraft carriers the world over was enriching. Why is it that carriers would offer cheaper tickets months before the actual flight, but that same seat would cost so much more if booked only weeks in advance' We related this to the Passenger Load Factor (PLF). If JAL had an empty plane scheduled for Singapore, then that would mean extensive losses in terms of overhead costs and labour costs. It would make much more sense for them to sell their seats at a lower profit margin and incur less loss as a result. It was interesting, yet insightful at the same time, being able to relate this to how it would affect JAL’s profits and losses directly and henceforth, providing a sound recommendation to JAL on whether they should ground the plane or readjust ticket prices depending on the PLF. Difficulties: We settled on doing JAL for our project after much debate. We had initially wanted to go with Cedar Point as mentioned in our project proposal to you, however, upon one of our members foresight, we concurred that for an offshore company relatively unknown to us prior to this project, how well would we really understand its daily operations and organizational intricacies' JAL was not without difficulty to begin with, to start off. We had to understand that evaluating JAL would not be a run-of-the-mill, standard analysis. Given its nation’s ingrained societal and cultural practices, we had to take into consideration the impact that our recommendations would have on the company and advise accordingly. Some sensitive areas, for example, were the labour issues in Japan. It would not be feasible to advise JAL to cut its workforce on the premise of lowering costs at face value. There would have to be a concrete, just cause in order to bring about such a change into effect. As such, our recommendation to JAL to cut down on its workforce came into effect after much careful revision with a substantial and credible reason – given that it was in turmoil after filing for bankruptcy protection. Upon deciding to use Cost-Volume-Profit (CVP) analysis and variance analysis to evaluate JAL, we had to refer not only to their annual report, but also the Internet to get a good estimate of certain commodities such as the price of jet fuel and also issues such as the average amount of fuel consumed by an airliner per flight. As you can see, there are lots of grey areas in the sense that we have to take a very good estimate as it is not really possible to find the price of jet fuel that JAL paid for, during the recent period. This is due to confidential and competitive pricing issues. Adding on to that, how do we arrive at the average distance per flight in JAL’s operations' It would be a complex and extensive exercise just to arrive at a figure for our calculation and as such, we decided to take the global average for the amount of fuel consumed by an airliner per flight for the recent years as a benchmark. ----------------------- Staff Effiency (ASK/Staff) Cost/Employee (USD) Age of Aircraft Fleet [pic]