Low Rates of Return on Investment in the Airline Industry, Delta Company - Assignment Example

1 During the 1990s, none of the five largest air carriers in the US earned its cost of capital. Why do such low rates of return on investment persistin the airline industry? The US Airline Industry has been a controlled industry ever since the late thirties. This control has been exercised through the Civil Aeronautics Board (CAB) and the reason was to induce the airlines to serve both profitable routes as well as loss making routes. They assigned both high density and low density routs to all airlines that they had to stay on. Had this not been done they would have concentrated only on the routes that offered the most returns and the general public would have been deprived of this quick means of transport. The result was that the airlines charged higher fares from those areas and regions that had heavy load factor and this subsidized the regions where the load factor was much lower. But this made the whole system inefficient and the general public had to pay the price. Under pressure from public and to offer a more open skies policy in 1978 the US government relaxed the norms and deregulated through the Airline Deregulation Act and almost overnight fares were reduced. This allowed new airlines, and some older ones to reduce air fares and to operate in the low density regions with smaller aircraft. To compensate for lower fares these Low Cost Carriers (LCC) cut down on all frills including meals and introduced lean methods in operations. Within two years these LCC’s started to give the five majors a run for their money as their operating margins were lower and they offered services on short hauls to and from areas that were not covered by them. They earned huge margins due to much operational efficiency. The public too became more price conscious and gradually shifted their allegiance to LCC’s as a result they started to make forays into areas operated by the majors and ate into their market share. By the early nineties most majors faced heavy losses that resulted in some bankruptcies and a major consolidation of the market emerged with fewer major airlines. However even they could not stem the tide of losses that continue to grow in the industry. The main causes of their loss remained wages that were as high as 42% of their operating cost. The Unions were continuously driving hard bargains and this bloated the wage bill. Apart from this they had to shell out almost 15% as commissions to agents for booking tickets. The next high expense was on meals and food they provided to passengers followed by heavy maintenance on older and larger fleet of aircraft they had to maintain to cater to the large traffic. In effect, the larger number of passengers they flew, the larger was their loss. The nett effect was that these five majors could not even get an adequate return on their capital investments. 2. Despite the challenging industry environment, airlines like Southwest Airlines and JetBlue earned enviable returns. How? In contrast the LCC’s were rolling in money and were highly profitable. Take the example of Southwest Airline. Although they commenced business since 1967, they really took off from 1980 and never looked back. It has never suffered a loss, even during the turbulent years when almost 40% of the US Airlines either applied for bankruptcy for survival or became defunct. It is a low cost/low fare carrier that depends on its low fares, short hauls and the shortest turnaround times. The fares are at least 30% below its competition, maximum flight time is 60-90 minutes between two points, and shortest ground time that is routinely 24-27 minutes between landings and takes off of an aircraft. The cut on maintenance by operating a single type of aircraft and their entire fleet of over 200 consists of Boeing 737’s. They also introduced no baggage boarding that resulted in manning gates with just 2 persons instead of the industry practice of 6 or more. However the real reason of its success is its remarkable Human Resource Policy and its Organizational Culture. Southwest believes, and practices, that its employees are family and the culture is entirely informal. Teamwork is the watchword and practiced from top down. The entire strength of 32000 plus employees work with each other, help out each other, indeed reach out to comfort and support co-workers facing difficult times even in private lives. The company has nine labour unions but they are nowhere like their counterparts in other airlines. Employees are flexible and contribute to other tasks freely to ensure smooth running of the airline. It is to the credit of Southwest that it values its employees at par with its customers. The belief of the top management is that a satisfied employee guarantees a satisfied customer. As a result the employees have been empowered to the extent that a group consisting of all staff of a flight starting from the pilot to the cleaning staff is jointly responsible to turn around a flight in a record 20 minutes from landing to take off. Every one regardless of rank pitches in to ensure this. Once a month every middle manager is expected to move out of his executive cabin and work along with the ground staff to show solidarity with them. This promotes tremendous teamwork and appreciation of work at all levels. This is the intrinsic reward that motivates all workers to ensure that the service is impeccable. In the last decade there has been only one strike lasting six days by machinists. However these seemingly informal practices are highly formalized as it is impossible to have high performance without systems and rules in place. Southwest’s culture of hard work, high-energy, fun, local autonomy, and creativity is taught through training at its own University of People, rewarding performance through contests and recognition of personal initiatives. It is the same story in case of JetBlue. They imitated the Southwest model and despite the fact that they pay higher wages and offer some meals/snacks, they based their services on the use of internet bookings. Technologically JetBlue is a front runner always thinking ahead and continuing to improve and provide for the customers experience with their technology. Neeleman, during his time at Morris Air before JetBlue existed contributed to the invention of ticket less travel. This invention was applied to JetBlue as it became an organization. JetBlue is the only U.S. airline to be 100% ticket less. Customers have the ability purchase their tickets and select their designated seats all with the click of a button. Major airlines operate with a “hub and spoke” model versus a point-to-point service. In other words, a large carrier may not fly direct from Philadelphia to Los Angeles. Instead, a passenger would have to fly from Philadelphia to a hub location, say Dallas/Fort Worth, and transfer to a plane bound for Los Angeles. The larger airlines found that it was too expensive to fly too many direct routes. To take advantage of such scenarios and opportunities, JetBlue has followed in the footsteps of Southwest Airlines and seized the opportunity and focus toward providing a point-to-point and long-haul services. However, they are carefully evaluating the routes and concentrating on those that offer the highest profitability potential. These low cost airlines have cleverly pitched themselves as substitutes of road and rail transport and hence have attracted customers that were never the potential market of the majors. Thus they have created an entirely new market which is quite large. Their fares are usually lower that the cost of travel by either road or rail and certainly they cut down very substantially on the time of journey. These are the major factors that they continue to be profitable as against the majors. 3. Why have all the low-cost subsidiaries of legacy airlines, including Delta Express, failed? The model of the LCC was based on an entirely new concept that just did not lower fares and cut down on services. The central idea was the creation of a separate airline that had a different culture and vision. This was the driver of introduction of low fares, no frills, lower wages, adoption of short haul routes, creation of new markets by competing with road and rail travel, ticketless travel, adoption of technology and above all a totally new administration that worked on these principles. In contrast all the majors just created subsidiaries which had the same set of administrators that still thought in terms of competing with each other and with LCC purely on fares and no frills. They were still throttled by high wages and overheads. They were bogged down by the same procedural bottlenecks faced in their normal operations. They were also unable to cut down on maintenance as these services remained centralized and costs could not be reduced on this count too. The result was that all the ills and problems eventually percolated down to these subsidiaries making them unviable and unmanageable. 4. What are the strategic options available to the cross-functional team that Mark Balloun co-leads in March 2002? Based on the information available to you in the case, what course of action for the Delta Express business would you have recommended to Delta’s board at that point in time? It must be understood that despite LCC’s popularity, the major travelling public is still with the majors. Their market share is still very large and will remain so as they cover the higher density areas where the LCC can penetrate but not dominate. This is due to the financial prowess of the majors. This is also due to the long haul passengers needing meals and frills to sustain long flights. There is simply no competition in this area between the majors and the LCC. As a major airline with a different mission of serving long haul routes, it is certainly not possible for Delta to have a subsidiary working as an LCC. This experiment has failed and will not prove successful in the future. Several options are available but are radical in nature and should be considered. Suggested Alternate Courses of Action ACTION ADVANTAGE DISADVANTAGE Introducing better Aircrafts Will improve load factor and bring in fuel efficiencies and increase profitability Huge loss in replacement cost of old aircraft Introducing premium facilities with high fare as a separate airline aimed at high value corporate passengers Additional revenue from new introductions like packaged car and hotel facilities and on board entertainment Fresh tie-ups required in non-core areas of operations and retraining of staff needed. Union problems likely. Creation of a new company with separate management extending no-frill travel to more areas Will attract new customers and fringe customers and not eat into present existing customer base while brand image will work in its favour Increased investments and creation of new administration which may be influenced at some point of time by the owning stakeholders Going for mergers & acquisitions Will ensure bigger and wider market share May cause Anti-Trust actions and problems of organizational cultures between merged entities Value Addition business like cargo and courier operations Very exciting as couriers like DHL raking money and expanding operations with lower cost of operations Moving away from core business and huge financial commitment on new fleet Organizations have to make choices in order to position themselves and positioning comes out of best set of activities suited to produce those results that satisfy the consumer. These activities have to be performed in a different way to produce unique results enabling the organization to position itself or its products for a destined set of consumers. Here is where the concept of Fit comes into play. A fit is when ideally all activities relate to each other in a tight way and when each is as strongly linked to the other like a chain. Furthermore each link in the chain is equally strong so that the fit is complete and such a fit cannot be copied. Consistency, complementary activities and optimal effort are the ingredients of a fit. This is what brings sustainability in strategy. A strategy has to be sustained for very long periods for pay-back and it should be inimitable by competition. This can happen only when activities are performed differently. Porter (1996) has described three generic strategies; cost leadership, differentiation and focus that are the foundations of competitive advantage or difference. A cost leader lowers cost through different activities while a differentiator asks for a premium due to the unique features of its product or service. The two can combine to form another generic strategy that offers unique feature while remaining a cost leader. The third strategy of focus is aimed at serving a niche segment limiting to serve a segment with its needs giving up other opportunities. In consonance with the theory it is suggested that Delta should pursue some of the above options. The option of stating a separate cargo service seems to be the most feasible one. This will need a new subsidiary company or even a new venture that will generate additional revenues. At the same time it should also concentrate on replacing its fleet with more fuel efficient aircraft. If it could adopt a policy of having just two type of aircraft it will help to cut substantially on maintenance cost. Bibliography Porter M.E., (1996), What is Strategy, Harvard Business Review Read More