Lucky Air was founded in 2004 with an initial capitalization of US$2.2 million. As one of Chinas most popular domestic tourist destinations, Yunnan province was seeing significant growth in the number of tourists. Between 2007 and 2008, the number of projected arrivals was predicted to increase from 21 million to over 24 million. To capture this growing tourist market, Lucky Air based its routes on the tourist destinations within Yunnan province, where it has a near monopoly position. By early 2008, Lucky Air set destinations outside Yunnan, totaling 150 weekly flights.

Lucky Air had five airplanes, each with a capacity of 148 seats. In 2006, it carried roughly 500,000 passengers for 5,746 total flight hours with a load factor of 74.7%. In 2007, it carried roughly 1.2 million passengers for 17,875 total flight hours with a load factor of 81.4%. Over the same period Lucky Air more than tripled its operating revenue, from US$31.2 million to US$104.3 million, and achieved profitability just three years after it was founded. Lucky Air had positioned itself as a low-cost, high-efficiency airline. By using a single type of aircraft it reduced maintenance and operational complexity. It offered only one seat class and simple one-way pricing. There were no seat assignments or in-flight entertainment. Most of its routes were short-haul and point-to-point to increase on-time departure and arrival. It operated mostly in secondary cities to avoid congestion and reduce landing costs. However, Lucky Airs cost structure was only about 5% lower than the industry average, mostly due to government-imposed constraints.

Lucky Airs four largest cost components fuel, landing fees, aircraft leasing, and taxes comprised about 70% of its operating cost, yet these costs were heavily influenced by government regulation.

Fuel China Aviation Oil was the sole fuel supplier for Chinese Airlines and the fuel price was set by the National Development and Reform Commission (NDRC). A small airline like Lucky Air had to pay for its fuel in advance until it proved itself as an established airline, adding to the firms financial burdens. Fuel price also differed from region to region and Yunnan happened to have a higher price than the national average. Furthermore, carriers in China were not allowed to hedge oil price risk through financial instruments. Route optimization, another way to reduce the fuel expense, was also prohibited in China due to safety concerns.

Landing Fees In the United States, many secondary airports offered a lower landing fee and were attractive to low-cost carriers. In China, the relative late development of the aviation industry meant that most cities had only one airport. The landing fees for major airports were set by the government and had been rising in recent years. Even for the few cities with more than one airport, airlines were required to pay the same landing fee regardless of the location and capacity. Airports in very small cities (less than 1 million inhabitants) did offer much lower landing fees, but there were usually not enough passengers in these cities to make the routes viable.

Aircraft Leasing All aircraft leasing was controlled by the aviation bureau of the NDRC. Due to safety concerns, the NDRC mandated that airline capacity expansion could not exceed 35% per year. As an airline grew, the expansion cap could fall even lower. Airlines were not allowed to lease aircraft directly from a manufacturer or a third party, who might offer better financial terms. In addition, small airlines were usually lower on the priority list to receive airplanes and sometimes had to wait more than five years. This long lead time often hindered an airlines ability to respond quickly to market dynamics.

Taxes Various government taxes laid an additional burden on an airlines operation in Lucky Airs case, anywhere from 2% to 10%. On top of these restrictions, Lucky Air was also subject to strict pricing regulations as well as fees imposed by travel agents and Chinas ticket distribution system. These limited its ability to increase revenue and achieve Southwest-level margins.

New Way for Lucky Air

Lucky Air and its parent, Hainan Airlines, were growing concerned. The Chinese airline industry was heavily regulated, limiting flexibility for new airlines. Nonetheless, new low- cost competitors were blossoming, and Lucky Air found itself among an increasingly crowded field: there were 11 low-cost Chinese airlines by 2007, and two more waiting for official approval. Anticipating a potential squeeze, Lucky Air was searching for additional competitive advantages.

One option was to focus on e-commerce. Lucky Airs IT operation was backed by Hainan Airlines, which had one of the most advanced web portals in the Chinese airline industry. True, airline e-commerce was still at an early stage in China, but Lucky Air was eager to position itself at the cutting edge of technology and reap the same rewards as Southwest Airlines and similar U.S. competitors. Yet Lucky Airs executives had to decide what was right for their company, customers, and market. If they chose the wrong expansion strategy or missed the mark with e-commerce, then the companys luck might run out forever.

In China a passenger could buy an airline ticket directly from an airline, an authorized agent, or an online distributor. When passengers bought tickets directly from an airline, the transaction was handled by the airlines call center, ticket counter, or website. Many large airlines invested a large amount of capital to set up call centers to handle booking so that they could avoid paying travel agent commissions.

Although Chinas technology infrastructure had improved rapidly in recent years, the e- commerce sector remained relatively unsophisticated. Transaction security was often poor and payment systems expensive or unavailable, so only 15.8% of Internet users were online buyers and only 25% used an online banking service. Credit card companies collected fees averaging 5% to 10% per transaction, further dissuading Internet shopping.

The online travel market in China was relatively small, less than 1% of the total travel market in 2007. The two largest players were Ctrip and eLong, together dominating 75% of the market share. These online travel agencies were becoming increasingly important providers of travel services, appealing especially to young professionals. In recent years, online travel websites had seized considerable market share from the traditional offline travel agents and charged the same commission fees to the airlines as their offline competitors.

Lucky Air sold about 80% of its tickets through agents, paying them a 2% commission, and the rest through its own website. Among tickets sold on its website, 95% were bought by reseller agents who turned around and resold the tickets to individual consumers. Only 1% of the total tickets were purchased directly by consumers on luckyair.net.

China planned to invest US$20.2 billion in upgrading the capacity of existing airports and opening 50 new ones, bringing the total to 190 by the year 2010. These changes could give low-cost airlines excellent opportunities in the next few years. Yet the high growth potential and easing regulatory climate would also attract new entrants and increase competition.

QUESTION :

1. What BUDGETING METHOD should Lucky Air choose in response to their strategic plan?