Problem
Your client wants to give Californians a high-speed train service from LA to SFO Bay Area. You have been retained to evaluate the business merits and demerits of the idea. How would you go about doing your analysis and what would be your recommendation?
Solution
(Note: The client's / interviewer's words are in italics, and the consulant's words are in bold.)
Consultant: Currently, Southwest and other airlines fly every hour from LA to SFO Bay Area and back. It takes one hour each way. I flew once from LA to San Francisco, while interviewing with business schools in UCLA and UC Berkeley. I was pleasantly surprised by the choices offered by various airlines. I don’t remember spending more than $100 for the trip. So, why would travelers prefer this high-speed service? It will not be any faster than the slowest flight?
Interviewer: So, you would recommend the client not to do it? Won’t you like to provide any other reasons besides travel time and cost?
Consultant: Yes, I would like to understand the customer segment the client is trying to address? Are these day travelers, business travelers, or pleasure travelers?
Interviewer: All of these are potential customers. Some business travelers fly round-trip every day. Some others fly out on Sunday evening / Monday morning and return on Thursday evening / Friday evening. Some will fly on business in the middle of the week. There are pleasure travelers who drive, and then there are those who fly.
I see. What would be the cost of a train ticket?
Well, let’s assume you are dealing with the competition of an average round-trip airfare of $220, including taxes. So, you will have to price it lower or the same.
How about time taken by train? Will it be possible to do it in say two hours each way? Otherwise, it will be difficult to entice flyers to switch.
Yes, that is the projected time for travel. During peak hours, trains will leave every hour from two locations in SFO Bay Area: San Mateo in west bay and Pleasanton in east bay. So, there will be a train going towards LA every half hour. Similarly, from LA, trains will leave every hour during peak hours from two locations: Pasadena in northern LA and Anaheim in southern LA.
Great. Has the client estimated how many passengers will be business passengers and how many will be vacationers?
He wants to follow the 80-20 rule. So, 80% will be business travelers, and the rest are estimated to be occasional vacationers.
I see. Do we have any data on how many people go back and forth between LA and SFO Bay Area per day?
Monday to Wednesday, it is approximately 10,000 people per day. Thursdays and Fridays, it is higher at roughly 12,000 people each day. On Saturday, it falls to 1500 passengers. On Sunday, it rises to 2500. Another data point is that LA to SFO is the second heaviest air commute route in United States, with more than 2.8 million people traveling per year.
Do we have any data on how many of these will switch to a train commute?
Exact figures are hard to find at this preliminary stage. Let’s assume the second-mover’s theory from economics, as per which 33% of the business can be gained by the second-mover. So, It would be fair to assume that we can get one third of the passengers to switch.
Also, considering the less number of commuters on weekend, I would assume the train service will become less frequent during non-peak and weekend hours?
Yes.
Dividing the numbers you provided by three, We can get 3333 passengers per day Monday to Wednesday, and 4000 passengers per day on Thursday and Friday. For weekends, we have 500 for Saturday and 833 for Sunday. So, if we charge a fair of $220 roundtrip, it is $110 each way. So, the revenue per week is (3333 * 3 + 4000 * 2 + 500 + 833) * 110 = 19333 * 110 = $2, 126, 520 or 2.1265 million dollars per week. That is 2.126 * 52 = $110 million per year.
Correct! Now, how will you go about calculating the break even for profitability?
OK. We will have to consider the fixed costs and the variable costs. How much will it cost to lay the tracks?
It is estimated at $1 million per mile per track. We will have two tracks, and the distance between LA and SFO is going to be 500 miles. So, it is going to cost $ 2 million multiplied by 500 or a billion dollars to lay the tracks. This excludes the cost of the land that the tracks will go over, which is estimated at two billion dollars.
So, we have our fixed costs at three billion dollars. How about the variable costs?
Good. What will be the ingredients of the variable cost?
Salaries for the employees, energy costs, maintenance costs for the tracks, coaches, engines, taxes, etc.
Good. We have calculated those to $ 10 million per month, or $120 million per year.
So, the revenue of $110 million will not cover the cost of $120 million? So, we can’t break even considering the variable costs alone. The fixed costs of $3 billion will also get sunk.
So, what would be your final advice?
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