Note: Topical when written in 1994,
and ever so true today -- in mid-2001.
Consumer and Industry Issues: Will You Be Able to Afford to Fly?
You can ignore the safety debate. Air travel is safe; among a host of others, the men and women who pilot commercial aircraft have a vested interest in and make sure of that. The real issue in air travel is: will you be able to afford to fly? For carrier executives: will the business clientele that you value so highly be able to afford your prices?
Since its post-war origins, the air travel industry grew and evolved to serve a complex and changing marketplace. Though recently profitable again, the industry faces economic, competitive and regulatory change. And, the industry needs to face up to changes in the demand for its services. Despite the urgency of such a basic issue, it shows strong reluctance to do so.
In an earlier era, when the demand for air travel was based on logistics and necessity, only the wealthy flew. High fares subsidized inefficient operations with resulting high costs. Into the foreseeable future, and following an accelerating trend, the "new demand" for air travel will be based on convenience and value-for-money. This is a continuing, progressive and fundamental change forcing carriers to restructure, to deliver service at affordable prices.
Sadly, many in the industry mis-identify the cause of their firms' inability to deliver services at affordable prices, that can attract and hold the new demand. Those in denial label as a "labor cost problem" what is in truth structural inefficiency. It is the low-hanging fruit of wage rates and work rules that gets all their attention, when it is structural change that offers the greatest leverage on success.
Southwest Airlines is a highly profitable, heavily unionized and among the highest-paying airlines. Paradoxically, Southwest is also the industry's acknowledged low-cost producer and its unabashed price leader. It is Southwest's business strategy and operating structure that produces these very affordable, easily marketed costs. Traditional work rules and above-market wage rates do not interfere with Southwest's ability to compete in and grow the markets they serve. Their employees are recognized for their contributions, well paid and their customers well served.
Travel and related industries are strong economic contributors and collectively, a large employer. A healthy airline industry is a critical success factor for expanding the travel sector and the U.S. economy. By the fact of its intervention in matters among airline management, labor, airport operators and the regulatory agencies -- most recently by establishing the first airline Presidential Emergency Board in 30 years -- this Administration clearly sees the air transportation industry's long-term, profitable functioning as a matter of concern and urgency.
Management's reluctance to embrace the needs of a changed and changing marketplace and the potential impact on the economy of labor unrest and an industry in turmoil or decline, should be viewed as troubling. Quite apart from the current safety debate, this suggests the industry should be a target for deeper scrutiny, short of an application of industrial policy.
The demand for air travel has changed; the industry resists change to embrace it
Basic characteristics of the market for air travel have changed and continue to do so. Air travel demand was once composed almost exclusively of price-insensitive, business-oriented and necessary personal travel, supplemented by middle- and upper-income consumer leisure demand. With the late 1970's economic expansion and deregulation, new low-fare scheduled airlines such as PeoplExpress, and traditional carriers' competitive discount offers stimulated new, broad-based, leisure demand.
The market's response to discounts forced old-line carriers to offer competitive prices, then develop "yield management" systems to throttle their supply of affordable seats and prop up average prices. Old-line firms needed to be price-competitive, even if they were not cost-competitive. Old-line firms' comparatively "deep pockets" supplied a needed subsidy. Most outlived the upstarts.
Twenty years later, the demand for price-sensitive leisure and personal travel dominates all other purposes by more than a four-to-one margin. Even business travel demand is price-sensitive and organized. The majority of corporate business travelers utilize unpublished "negotiated fares", often at discounts averaging 38-40 % from full fares.
During the 1980's, carriers' average input and unit costs dropped, courtesy of new hires at reduced "B-Scale" wage scales. Demand and traffic grew. Industry profits soared. Unfortunately, poorly understood structural costs consumed much of the labor subsidy. Inefficient "hubs" and ubiquitous, worldwide network route structures represented the dominant airline asset allocation and scheduling practice. With the greatest optimism, hubs were established in over-abundance, financed in a "Field of Dreams", build-now, pay-later mode.
With all due respect, P.T. Barnum was wrong.
With an electronic wink and a nod, carriers frequently increase unrestricted fares, to recover the cost of these inefficiencies. Carriers are careful to offer tandem "50%-off sales" and generous negotiated price offers, to try and disguise the increases and minimize the impact on leisure and business travel demand.
The industry has long held that air travel demand is "inelastic" to price reductions. Yet, more than 90% of passengers now travel at average fare discounts exceeding 66%. This percentage increases each year, with it the spread between highest and lowest fares paid for a given trip.
Despite the offer of deep discounts, the application of competent revenue management systems has caused the average revenue per trip to rise. And, aircraft now operate with higher percentages of seats filled, which causes average revenue per seat to rise even more.
With the fare spectrum ever wider, how long will remaining full-fare passengers tolerate being gouged? How long, and in what sorts of boutique markets, outside of the very longest distance trips, will premium products priced at ten times the market rate be able to command these prices?
Unless P.T. Barnum was right, the last few people paying fares three, five or ten times the market are actively looking for a deal. This is an intensely competitive industry, and inevitably, some carrier offers such a deal, whether or not it has the costs to back up the low-price offer.
Ominously, a recent major carrier auction via the Internet of its premium products fetched a small fraction of their retail price. Carriers either have the costs to compete on this basis or they fail, which many have and will.
Airlines must restructure for a changed, affordable air travel market.
This is a "commodity business"; the low cost producer, able to profitably offer the lowest fares wins, especially when the low cost producer expands rapidly to meet growing low-fare demand.
Southwest Airlines is a good example. It is a heavily-unionized, high-paying employer. Despite these presumed handicaps, it is the low cost producer and low-price king of short-to-medium haul air travel. Southwest achieves both results by virtue of its efficient structure and asset deployment.
Consistently profitable, for years Southwest was the only investment-grade, U.S. flag airline. It expanded its network of high frequency, point-to-point schedules through internal growth and by acquisition. Its workhorse Boeing B737 aircraft (a single fleet type offers efficiencies) does not have the range to fly the longer-haul, transcontinental markets. However, its aircraft order portfolio (an updated B737) does contain such capabilities, creating growth possibilities for Southwest and even greater challenges for its higher cost/higher fare long-haul competitors.
Higher-cost competitors face Southwest and other low cost/low fare carriers, in more than half of the major domestic markets. Though present in a high percentage of markets, the low fare operators offer a small (but growing) fraction of the network carriers' capacity. Overseas, U.S. carriers face newly privatized, newly productive competitors possessing comparative advantage.
Instead of acting to meet this challenge by evolving their structure and business strategy towards an efficient model, it appears the prime concern of airline managers (consistent with the mantra favored by other industries' corporate chiefs) is how to cut wage rates, downsize, eliminate jobs and capacity, and with it, consumers and demand. They believe this strategy offsets the higher costs that inevitably result from downsizing, and profits follow. Common sense and experience (outside of bankruptcy cases) say otherwise. A corollary problem to downsizing is how to repair the industry's balance sheet and its debt overhang. A legacy of 1980's hub-and-spoke route network growth, long-term lease commitments and Taj Mahal terminal facility bonds abound. With luck, carriers can downsize -- say, by finding an alter-ego carrier to replace their operations at a hub -- while still servicing this legacy. Evolutionary change, no quick moves to alarm capital markets, will be required. The question remains if there is enough time -- or enough alter-ego carriers can be created -- to accomplish this metamorphosis unaided.
Profitable, core airline operations require a revised strategy.
The issue that drives change is the need for profit and development of a credible strategy by which to restore investment-grade confidence in core airline operations. The present approaches -- downsizing, slow liquidation or "transition" to some other vision of a profitable business, say, (ironically) advising others on how to be successful in the airline business -- do not treat the core airline solvency issue, nor do they facilitate affordable air travel.
High cost carriers continue to rely on stale, 1980's-vintage devices (hubs, frequent flyer programs, linked commission overrides) to defend against competitive incursions. These are costly schemes. None has proven effective against Southwest and low-fare operators. New entrants have developed "bypass" strategies to immune themselves from industry strategies that would impede their growth. It is notable that none of the existing paradigms are utilized by low cost, new entrants.
The new competitive formula: Structural Productivity => Low Costs.
The industry is stuck in a "blame game" rut, blaming its high costs on what objective analysis has shown to be a red-herring issue: labor costs. Managers frequently recite statistics on final output costs that are masqueraded as facts that input costs are too high. Achieving low costs does not require give-backs and subsidies, but it will require restructuring.
Asset costs -- purchase or lease prices, contractual wage rates and benefits inclusive of work rules -- are not the sole driver of final costs. The critical issue is how productively and efficiently any asset is employed.
Low-cost assets, utilized inefficiently or unproductively, yield less product available for sale, higher unit costs, the need for higher fares and less demand. Conversely, high-cost assets, like Southwest's, employed 30% more productively than industry average, produce more product at lower unit costs, and permit lower fares that increase demand. Compare carriers' input costs, structures and operating philosophies, and results in terms of output costs and profits. The real cost drivers are structural.
Structural productivity is the new formula for competitive success, quality job creation, affordable air travel pricing for U.S. business competitiveness and an expanding leisure market. Structure drives productivity and low costs that make low fares and profits possible.
The key difference between Southwest and most other air carriers is its structural productivity. New entrants achieve startling productivity, in various fashions. No low cost producer/low fare carrier follows industry structural conventions, which have caused productivity to decay.
Regrettably, instead of focusing on how to become more productive structurally, most debate revolves around regressive demands for labor subsidies. How much of a wage rate reduction is required to close the gap with this high productivity carrier? How much to come to parity with a low productivity carrier that managed to extract subsidies from labor and other suppliers through bankruptcy (or threats of same as an alternative to achieving concessions)?
What if the industry structured for maximum productivity and affordable prices?
Credible, independent restructuring proposals have been produced and rejected as "Not Invented Here". Some of these have even been quietly experimented with. High cost operators have studied these matters intensely, but external discussion of restructuring concepts or "scheduling projects" is taboo. Management apparently hopes to gain concessions, before engaging in attempts at structural improvement, in order to gain a "double-dip" benefit.
There have been encouraging signs, if little real success. This is typical of early re-engineering results. Constructive projects attempt to address cost by seeking productivity, through re-scheduling and other means, seeing how much cost can be removed without looking for subsidies.
There are discouraging signs as well. Regressive proposals, involving pure wage rate subsidies, in some cases, traded for equity. The Shuttle by United experiment, conceived against the backdrop of a management-labor Armageddon scenario, never achieved hoped-for low costs. Some retiring employees may see benefit from improved share prices, if they are lucky enough to time their exodus with an economic up-cycle.
Unanswered questions for airline industry management: