“Low Cost” isn’t the Airline Industry’s Profitability Silver Bullet

Profitability is a key motive and the ultimate measure of success in any business. For the airline industry, it happens to be a challenge. To illustrate, we can refer to the observation made by Peter Morrell, a professor specializing in air transport economics and finance at the Cranfield University to the effect that US airlines have made an overall cumulative loss over the past 120 years. The big question then is why investors continue to pump money into the industry. Is it a case of “pig-headed denial of observed reality” as observed by Aida Edemariam? On deeper analysis, it turns out that the answer to the preceding question is a “No”. The truth is that the industry’s apparent profitability challenge is a tendency and not a rule. The airline business can be profitable just like any other.

Emergence of Low Cost Model

With the background of profitability challenges as highlighted in the opening paragraph, it is no surprise that cost has always been a point of focus for the airline industry in the recent past. This focus gave rise to the concept of “low cost airline” with its own independent value chain. Coincidentally, a good proportion of today’s consistently profitable airlines follow the low cost model. This coincidence has contributed to the emergence of the misconception that the low cost model is a sort of “off the shelf strategy package” or “silver bullet” capable of fixing the airline business’ profitability challenge. This fallacy is however exposed by the fact that the practices of low cost airlines vary significantly thus proving that the low cost model is more than a “standardized strategy package” for airline business profitability. Moreover, a deeper look at the practitioners of the model reveals a critical success factor that has received less attention from industry analysts.

Defining Features of the Low Cost Model

The features that have defined the low cost model in its evolution can be classified into four broad categories as follows;

  1. Supply Chain / Value Chain focused
  2. Business Simplification focused
  3. Efficiency focused
  4. Customer Value focused

Low Cost Value Chain versus Legacy Value Chain

On the supply front, the airline industry is characterized by oligopolistic tendencies. Consider air frames for example. Two suppliers, Boeing and Airbus dominate this chain. In product distribution, again no more than four suppliers have dominated the industry at any point in time. Against such background, airlines as buyers are Price Takers. The low cost supply chain practices are an attempt to swap the oligopoly driven value chain existing in the legacy environment for a new value chain where there is leeway for airlines to negotiate price. It is an attempt to get rid of the ‘Price Taker” tag that characterizes the legacy value chain.

Business Simplification and Efficiency

Business simplification and efficiency initiatives are also necessary since the legacy model tends to be quite complicated. Intricacies of managing network schedules and connectivity, operational disruptions, competition, pace of change in markets, global distribution and more create a complicated business. Regulation which is aimed at helping the industry achieve operational safety and standardization translates into constraints and add to the complication. These complications have cost and efficiency consequences. According to the International Air Transport Association (IATA), the current simplification project it is spearheading has the potential to reduce industry costs by up to US$18.1 billion every year.

Why the Airline Industry is a “Price Taker

The Low Cost model features discussed so far in the two preceding paragraphs have been given a lot of attention by industry analysts. The third category; Customer Value Focus; has received less attention yet in our view, it has contributed more to the success of the profitable low cost airlines.

As we saw earlier, the airline industry is a price taker in the value chain under the legacy environment. That position does not change when we examine the industry as seller. Airlines have generally not been able to set, maintain and control profit delivering pricing in the markets. This is largely driven by stiff competition, the perishable nature of the airline product, the assumption that charging one economic price would not generate enough revenues to deliver profitability and to a greater extent, the fallacy that the marginal cost of producing an extra seat is low and as such, an airline is better off putting bums on seats at lower pricing.

How Customer Value Focus is Driving Profitability for Ryanair and Southwest Airlines

Examining the customer value focused practices of successful low cost airlines reveals the critical role these practices play in the successes observed in low cost airlines. All successful low cost airlines have a profound business philosophy driving their customer value offer and by extension their commercial strategies. They go beyond the cost and efficiency optimization practices that have been given more attention by analysts and the industry and have falsely been considered as the key drivers of success in the low cost model.

Take Southwest Airlines and Ryanair for instance. Both are very successful low cost operators. Even though they have common practices in the cost and efficiency optimization category, it is their philosophies in the customer value category that differentiates them and drives their sustainable business success.

The consistent profitability of Southwest is down to its “business philosophy” that is centered on employee engagement and operational efficiency and reliability. This approach has enabled it to deliver superior customer value and enabled the company to extract a higher value from the markets. Even though Southwest has deployed resource and cost efficiency initiatives, these cannot be said to be the sources of its long running success. These cost and efficiency initiatives are practiced by all, can be easily copied by competitors and do not offer sustainable competitive advantage. What competitors have not been able to replicate is Southwest’s philosophy with regards to customer value creation.

The employee engagement philosophy is the secret behind Southwest’s ability to offer superior value to the market. The same has enabled the company to shed off the “price Taker” tag that characterizes the airline business in general. Southwest has transformed into a “Price Setter”. They literally decide on the value they want to pack into the product knowing well that they can only extract the same value back from the market. The premium value they build into the product is the reason they are able to take “profit delivering” value from the market.

Ryanair is another unique story. Europe’s most popular airline has the vision to one day offer its tickets for free (zero value) which means it will generate its revenues solely from ancillary sources! That is an audacious goal if at all they are serious about it. To vouch for it to some extent, Ryanair is today the most aggressive low cost airline in the world when it comes to ancillary revenues. Ryanair leads in terms of volume as well as proportion of total revenues generated from ancillary sources. Like the other low cost players and the industry in general, Ryanair also has cost and resource efficiency initiatives targeted at helping it optimize costs and boost profitability. What differentiates Ryanair though is its philosophy on how to generate revenues in the competitive airline industry. The philosophy of innovation drives their value offer and is anchored by the “Cheap Fares” and the “Us versus Them” psychological scenario they have been able to create and use to their advantage.

No Silver Bullet. It is all in the “Success Philosophy”

The contrast we have seen in the practices of Ryanair and Southwest highlights the fact that there is no one magic structure or formula that accounts for the successes observed in low cost airlines. Furthermore, the phenomenon that has come to be referred to as the low cost model also goes beyond focus on costs as we have seen in the discussions in the preceding paragraphs. The low cost reference perhaps arose out of the fact that the only common aspects observed in practitioners of the model related to cost and resource efficiency. Unfortunately, this cost driven reference ended up relegating the unique elements of the model to secondary level even though those elements are arguably of higher value.

Even though the key elements of the business philosophies driving customer value offer and success for Southwest and Ryanair are not cost-related, the two airlines are however famously known as low cost airlines and many imagine that the secret behind their success is lower costs. In my view, it is the “employee engagement driven customer value” and “Cheap Fares and Us versus Them psychological scenario philosophies that differentiate Southwest and RyanAir and has in turn enabled them to enjoy sustainable competitive advantage in the market. Cost and Resource Efficiency initiatives are common and cut across the industry (including the legacy model), can be easily copied and as such cannot offer sustainable competitive advantage.

Conclusion

Based on the above, airlines that want to succeed must go beyond the Cost and Resource Efficiency initiatives that have so far been widely and falsely viewed and accepted as the benchmark features of the low cost model. A unique business philosophy to drive success through Customer Value creation and Commercial Strategy in general is a must. Such philosophy would serve as a sustainable source of competitive advantage just as we have seen with the cases of Southwest and Ryanair.

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