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Airlines: A New Operating Model

Airlines: A New Operating Model



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Published by Mr_BC

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Categories:Business/Law, Finance
Published by: Mr_BC on Oct 12, 2009
Copyright:Attribution Non-commercial


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Airlines: A New Operating Model
Providing Service and Coverage Without the Cost Penalty
 Tom Hansson
Dr. Jürgen Ringbeck
Dr. Markus Franke
Airlines: A New Operating Model
Providing Service and Coverage Without Cost Penalty
Once again the global airline industry is in crisis, and industry icons are fighting for survival. Already, there havebeen high-profile bankruptcies in both the U. S. and Europe, and there is significant risk of more to come. Thescene is reminiscent of a decade ago, when the airline industry struggled through the last recession and theaftermath of the Gulf War. There are too many airlines and too many hubs operating in a competitiveenvironment where exit barriers are high. Market forces and bankruptcy protection ensure that distressedcapacity does not disappear; instead it comes back, potentially at a lower cost level, threatening to trigger pricewars that drive still more airlines into bankruptcy. Only this time, the situation is worse.Financially and structurally, the U.S. airline industry is in more dire straits than it was a decade ago, and thecompetitive situation in Europe is much more unstable as traditional pricing discipline breaks down. The big difference is the impact of Low Cost Carriers (LCCs). Ten years ago, the LCC threat in the U. S. was limited to aregional carrier, Southwest Airlines, and some underfunded start-ups. Europe was not threatened at all. Today,LCCs, operating at half the cost levels of traditional network carriers, threaten to undermine the whole hub andspoke (H&S) system.Clearly, a new business model is needed that eliminates the structural cost penalties of the H&S model whileretaining its key service and coverage attributes… urgently in the U. S. and soon in Europe. Today’s problemsare not merely cyclical; they are structural and, as such, demand a structural solution. The objective of thisViewpoint is to evaluate the nature and causes of this industry crisis and to propose a potential solution,drawing on experiences from other industries that have undertaken fundamental business model transformations.
An Unstable Industry Structure
In the U.S. the gap between costs and revenues has never been wider, and September 11 is only part of thereason. “Industry-leading” labor agreements and rising fuel prices in 1999 and 2000 drove costs to such ahigh level that only boom-period pricing could offset them and allow the industry to break even. While post–September 11 restructuring has reduced capacity, it has had only limited impact on unit costs. Meanwhile,prices may be reverting toward historical trend levels following the longest—and arguably the most intense—economic boom in recorded history (see Exhibit 1). Business travelers, in particular, are no longer prepared topay the high fares tolerated in the late 1990s. Indeed, both corporate and individual travelers are asking forlower prices, high frequencies, and simpler, more efficient service.
| 2
Exhibit 1
An Unprecedented Cost-Revenue Gap Has Opened in the U. S.
   Q   1   1   9   7   8   Q   1   1   9   7   9   Q   1   1   9   8   0   Q   1   1   9   8   1   Q   1   1   9   8   2   Q   1   1   9   8   3   Q   1   1   9   8   4   Q   1   1   9   8   5   Q   1   1   9   8   6   Q   1   1   9   8   7   Q   1   1   9   8   8   Q   1   1   9   8   9   Q   1   1   9   9   0   Q   1   1   9   9   1   Q   1   1   9   9   2   Q   1   1   9   9   3   Q   1   1   9   9   4   Q   1   1   9   9   5   Q   1   1   9   9   6   Q   1   1   9   9   7   Q   1   1   9   9   8   Q   1   1   9   9   9   Q   1   2   0   0   0   Q   1   2   0   0   1   Q   1   2   0   0   2
   C   e   n   t   s   p   e   r   A  v   a   i   l   a   b   l   e   S   e   a   t   M   i   l   e   (   c   /   A   S   M   )   (   A   d   j  u   s   t   e   d   t   o   2   0   0   1   D   o   l   l   a   r   s   )
Unit Revenue and Cost Trend(U.S. Industry)
CASM decline:RASM decline:1979–1992: 1.5%pa1979–1992: 1.8%paCASM increase:RASM increase:1993–1998: -1.0%pa1993–1998: +0.6%pa
Source: Company Financial Statements, Back Associates, Booz Allen Hamilton Analysis
Unprecedentedcost-revenue gap, started before 9/11
Unprecedentedcost-revenue gap, started before 9/11Risk thatrevenues willrevert to “old”trend line
Unit Revenue (RASM)Unit Cost (CASM)
Poor Outlook for Q3/Q42002 
Poor Outlook for Q3/Q42002 
 In Europe, the crisis has been less pronounced, but unrelenting price competition is putting cost levels underpressure. Airline pricing structures are collapsing as industry incumbents address the threat of low-costcompetitors and defend their market positions. In fact, this market is beginning to look like the U. S. market in the early ‘90s, when “value pricing” provoked a fare war that ushered in a period of prolonged losses.Part of the industry’s problem is the very nature of the product it offers. An airline seat is a fixed-costperishable product. The incentive to fill empty seats and fly underutilized aircraft is tremendous. Idle capacityinevitably comes back on the market as start-ups buy the aircraft or established airlines increase the utilizationof expensive assets. Meanwhile, manufacturers continue to build and deliver new aircraft, adding new capacity to the market.Pricing and overcapacity pressures, however, pale in comparison to the impending impact of the cost gap thatexists in the airline industry. By cost gap, we refer to the 2:1 differential that exists between traditional full-service airlines’ unit costs and that of low-cost carriers for a given stage length. LCCs such as Southwest andRyanair don’t operate on the low end of the airline cost curve; they occupy an entirely different cost curve, asExhibit 2 (see page 3) makes clear.

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