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US Airline Industry Case Study

US Airline Industry Case Study

1. Introduction
In the following article, we will analyze an industry that has been heavily criticized due to its inability to generate profits. The financial performance of the US airline industry has been somewhat of a roller-coaster over the past 20 years. It is an industry that has seen its structure change more than once, it has been regulated and deregulated yet it is still a challenging puzzle for many economists and capitalists all over the world. Many investors would agree that putting one’s money into the airline industry is risky business.

1.1 Objectives of Report
An analysis of any industry involves the application of certain economic principles to the industry’s factor markets, consumption trends, and general productivity. The aim of following analysis is to accomplish the following objectives:

  • Understand how the structure of the airline industry drives competition between international legacy carriers and new low-cost carriers and how this competition has affected (negatively or positively) the level of profitability.
  • Evaluate the appeal of entry for industry newcomers by determining the major barriers involved in entry
  • Evaluate how changes such as regulation, deregulation, consolidation and private ownership have affected the structure and interpret this data in order to predict future trends on profitability
  • Identify key success factors towards improvement of profitability and capitalize on them by suggesting hypothetical changes to the industry structure that would favor these factors. Handouts pg. 9 (26)

1.2 Identifying the Current Situation

The structure of the airline industry in the United States has transformed from an oligopoly to a very competitive market. In hopes of identifying the issues surrounding the economic state of the airline industry, a theory supported by many was one of deregulation. In 1978, the Airline Deregulation Act attempted to minimize the barriers of entry and exit by the elimination of many restrictions over domestic flights. After a minor turbulence, the industry steadily blossomed over the next 12 years, with mileage flown growing four percent per year (Grant 26-39).

Shortly thereafter, consolidation took place and networks of carriers were formed. Several important mergers and alliances between larger and smaller firms transpired, which led to a new industry structure. The uprising of many new low-cost carriers had created the need for major carriers to make many price cuts, for example, the separation of price-sensitive leisure consumers (economy class) and price-inelastic business consumers (first-class)(Grant 32).

2. Issues & Problems affecting Profitability & Competition
Concepts covered in Porter’s five forces can be easily attributed to the airline industries. In the past, some forces have had a more significant effect than others. For instance, there was a low level of threat from entrants to industry profitability since the barriers were relatively high. In more recent times, the competitiveness of the industry has seen the minimization of barriers such as capital requirements; technology has created easier and cheaper access to distribution channels and new and efficient business models direct an absolute cost advantage. One can clearly see a direct link between the more prevalent forces, which are: the rivalry between established competitors, the bargaining power of buyers/suppliers and the extent of competitive pressure from producers of substitutes (Lammert 8).

The rivalry between the established competitors had caused a depression in the industry because of the larger airlines firms’ high ratio of fixed to variable costs. For example the larger planes need more fuel and union regulations mandate higher salaries and specific working circumstances for their employees. This type of activity has put a handicap on larger airlines, as the new low-cost firms are able to exercise aggressive price competition to their unique selling point of low prices in the financial crisis and post-crisis periods. This leads to airlines having very little bargaining power over their customers. The myth that business class customers were not price sensitive was debunked and this was illustrated when companies started sending their representatives on economy class flights to cut their own costs.

The airline industry, for obvious reasons, heavily relies on the external factor that is crude oil. Between 2002-2006, the price of crude oil rose from $19 to $78 a barrel. Price of oil was especially a problem for the major airlines, as they did not have the cash flow and purchasing power to protect the subjected firms against rising fuel costs. However, the dramatic rise in oil prices is not the only factor attributing to the losses of $35 billion over this four-year period.

The resource scarcities were coupled with technological advancement in the field of fuel-efficiency to give new companies an even greater advantage. As older airlines were already in a dire financial situation, there was not enough capital to change to fuel-efficient planes. This is similar to the activity in the U.S automobile industry. As the cherry on top of a disaster-sundae, the unfortunate incident that occurred on September 11th, 2001 in New York was a huge obstacle, which only had adverse effects on the industry. The constant reporting of terrorism through the media and the seemingly painstaking process of baggage inspection created a dent in the demand for travel.

Over the next five years, getting the costs under control was the main task of most airlines. The biggest problem in the short term was that many costs were fixed and could not be changed during underperforming periods. However, shouldn’t this have been the focus all along? The demand had been increasing faster than population growth and the laws of the experience curve mandate that each time cumulative output doubles; the cost value of the unit declines 20 to 30 percent (Lammert 4). Airlines’ biggest cost contributors were and still are labor and fuel, respectively. The costs associated with labor include wages for pilots, flight attendance, dispatches and customer service among a collection of others. These costs were hard to negotiate as the unions had a very strong representation. The second greatest expenditure for airlines, which is fuel, affects national firms more so than international firms, as the efficiency of fuel intake is lower due to high take off and landing consumption. Other important costs include flying operations and service and maintenance (Grant 26-39).

3. Analyzing and Exploring Solutions
As airlines experienced instability in capacity and profitability, they introduced new initiatives. The introduction of frequent flyer miles, a currency alternative between airlines and consumers, was a major turning point for airlines (Grant 26-39). It provided a platform for new partnerships, which led to another revenue stream for firms. It also resulted in an increase in customer retention. The statistics show that the activity among airlines has had relative success in reducing costs and increasing margins. However, there is always a chance of a relapse occurring. In order to predict the trend and develop a course of action, one should analyze to what extent are some cost drivers relevant to analyzing the costs of the U.S airline industry (Lammert 14-17).

3.1 Input Costs
In terms of capacity utilization, recent data indicates that between 2003 and 2006, nearly every major airline, with the exception of Jet Blue, increased passenger capacity. At the same time the margins between revenue and expense per available seat increased, with the latter usually decreasing or increasing less gradually than revenues. The correlation indicates that input costs were decreasing and profitability was increasing. Allocating resources in order to determine a way firms’ can continue this trend would be a wise investment (Grant 26-39).

3.2 Product Design
In order to maintain financial equilibrium status in the airline industry, the design of the product must be efficient. This would mean that the highest costs should be attributed to the most important attributes. For an airline, this could be the necessity such as aircrafts, pilots and fuel, as well as the most important needs and wants of the consumer. This does not necessarily indicate that the production of luxury and business class and its relative costs should be abolished or discarded. This is a situation where appropriate marketing research can help reveal unknowns. A firms’ research should indicate in which way the consumers see the brand and its attributes and how they satisfy their needs.

4. Choosing a Course of Action
Firms’ have shown a past willingness to invest large sums of money into extending the core business, such as the start-up of low-cost subsidiaries such as Continental’s Continental Lite, Delta’s Song, and United’s Ted in order to minimize tribulations issued through the external factor of price competition (Grant 33). The fact that these major firms invested in these projects shows that there was evidently a basis for this theory. However, it is possible that the wrong obstacle was targeted. In other words, the focus should have been on another factor.

As we established earlier, the number one cost of an airline is fuel. Even though long-distance, international carriers have it better in the sense of fuel efficiency, the low-cost carriers have the advantage of being able to purchase ahead of time due to their relative abundance of cash flows. This protects them from rising prices. If the major firms’ had better control of their fuel costs, as the new low-cost carriers do, they would be in a more comfortable situation economically.

5. Developing an Action Plan
One way to do this would be to explore the idea of investing in diversification and R&D in the hopes of fuel-cost control. This avenues of execution include some or all of the following steps; use new technology to turn aircrafts fuel-efficient, come to an agreement with oil companies, invest in equity of existing oil companies or even make a consolidated effort to partake in an ownership venture to establish an internal fuel source primarily for airline usage. Granted, this is easier said than done but there are two reasons that dictate why this may be successful. One could first consider the resources that can be freed due to the subsidies presently being offered to larger airlines. Secondly, the investment amount would probably be similar to the total amount invested by firms in the aforementioned low-cost subsidiary experiment.

At the current moment, the major advantage held by smaller private airlines is the ability to price competitively due to their low-cost advantage. Until now, much analysis and investment of time and resources has been aimed to reduce costs of the major airlines. As the world slowly climbs out of the grasps of financial crisis, there may be an option to move away from the cost and price leadership strategy for many of the larger airlines. The ability to differentiate due to more internal processing power can give these airlines a competitive advantage and greater long-term prosperity through value creation and offering a rare service that is hard to duplicate. The move from low cost to differentiation can be successful especially for larger firms, which account for most of the activity in the industry.

6. Overall Reasoning
One may propose that this strategy is realistically not going to work because the costs will be too high. Considering the preceding upstream integration proposal of the development of fuel-cost control can potentially offset the higher costs associated with the differentiation strategy. Both of these endeavors can be executed using the principles of capability development. As the major airlines already have a strong network of alliances, exercising their strong arm can prove to be successful. Either through acquisition or Greenfield development of new services, product design and fuel-efficiency measures in a separate or integrated organizational layout. Offering unique selling propositions such as product sequencing is something that larger airlines can do using their leverage gained through sales of frequent flyer miles. This combination of chain integration and diversification can lead to new business arrangements from other carriers (Lammert 30-39).

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