Southwest Airlines has long been one of the standout performers in the U.S. airline industry.

It is
famous for its low fares, generally some 30% below those of its major rivals, which are balanced by
an even lower cost structure, which has enabled it to record superior profitability even in bad years
such as 2008–2009 when the industry faced slumping demand.

The U.S. airline industry has long struggled to make a profit. In the 1990s, investor Warren Buffet
famously quipped that investors in the airline industry would have been more fortunate if the
Wright Brothers had crashed at Kitty Hawk. Buffet’s point was that the airline industry had
cumulatively lost more money than it had made. Buffet once made the mistake of investing in the
industry when he took a stake in US Airways. A few years later, he was forced to write off 75% of
the value of that investment. He told his shareholders that if he ever invested in another airline,
they should shoot him.

The 2000s have not been kinder to the industry. The airline industry lost $35 billion between
2001 and 2006. It managed to earn meager profits in 2006 and 2007, but lost $24 billion in 2008 as
oil and jet fuel prices surged throughout the year. In 2009, the industry lost $4.7 billion as a sharp
drop in business travelers (a consequence of the deep recession that followed the global financial
crisis) more than offset the beneficial effects of falling oil prices. The industry returned to
profitability in 2010–2012, and in 2012 actually managed to make $13 billion in net profit on
revenues of $140.5 billion.

Analysts point to a number of factors that have made the industry a difficult place in which to do
business. Over the years, larger carriers such as United, Delta, and American have been hurt by low-
cost budget carriers entering the industry, including Southwest Airlines, Jet Blue, AirTran Airways,
and Virgin America. These new entrants have used nonunion labor, often fly just one type of aircraft
(which reduces maintenance costs), have focused on the most lucrative routes, typically fly point-
to-point (unlike the incumbents, which have historically routed passengers through hubs), and
compete by offering very low fares. New entrants have helped to create a situation of excess
capacity in the industry, and have taken share from the incumbent airlines, which often have a much
higher cost structure (primarily due to higher labor costs).

The incumbents have had little choice but to respond to fare cuts, and the result has been a
protracted industry price war. To complicate matters, the rise of Internet travel sites such as
Expedia, Travelocity, and Orbitz has made it much easier for consumers to comparison shop, and
has helped to keep fares low.

Beginning in 2001, higher oil prices also complicated matters. Fuel costs accounted for 32% of
total revenues in 2011 (labor costs accounted for 26%; together they are the two biggest variable

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expense items). From 1985 to 2001, oil prices traded in a range between $15 and $25 a barrel. Then,
prices began to rise due to strong demand from developing nations such as China and India, hitting
a high of $147 a barrel in mid-2008. The price for jet fuel, which stood at $0.57 a gallon in December
2001, hit a high of $3.70 a gallon in July 2008, plunging the industry deep into the red. Although oil
prices and fuel prices subsequently fell, they remain far above historic levels. In late 2012, jet fuel
was hovering around $3.00 a gallon.

Many airlines went bankrupt in the 2000s, including Delta, Northwest, United, and US Airways.
The larger airlines continued to fly, however, as they reorganized under Chapter 11 bankruptcy laws,
and excess capacity persisted in the industry. These companies thereafter came out of bankruptcy
protection with lower labor costs, but generating revenue still remained challenging for them.

The late 2000s and early 2010s were characterized by a wave of mergers in the industry. In 2008,
Delta and Northwest merged. In 2010, United and Continental merged, and Southwest Airlines
announced plans to acquire AirTran. In late 2012, American Airlines put itself under Chapter 11
bankruptcy protection. US Airways subsequently pushed for a merger agreement with American
Airlines, which was under negotiation in early 2013. The driving forces behind these mergers include
the desire to reduce excess capacity and lower costs by eliminating duplication. To the extent that
they are successful, they could lead to a more stable pricing environment in the industry, and higher
profit rates.

Southwest Airlines has long been one of the standout performers in the U.S. airline industry. It is
famous for its low fares, generally some 30% below those of its major rivals, which are balanced by
an even lower cost structure, which has enabled it to record superior profitability even in bad years
such as 2008–2009 when the industry faced slumping demand.

A major source of Southwest’s low-cost structure seems to be its very high employee
productivity. One way airlines measure employee productivity is by the ratio of employees to
passengers carried. In 2012 Southwest had an employee-to-passenger ratio of 1 to 1,999, one of the
best in the industry. By comparison, the ratio at one of the better major airlines, Delta, was in the
range of 1 to 1,500. These figures suggest that holding size constant, Southwest runs its operation
with fewer people than competitors. How does it do this?

First, Southwest’s managers devote enormous attention to whom they hire. On average,
Southwest hires only 3% of those interviewed in a year. When hiring, it places a big emphasis on
teamwork and a positive attitude. Southwest’s managers rationalize that skills can be taught, but a
positive attitude and a willingness to pitch in cannot. Southwest also creates incentives for its
employees to work hard. All employees are covered by a profit-sharing plan, and at least 25% of an
employee’s share of the profit-sharing plan has to be invested in Southwest Airlines stock. This gives
rise to a simple formula: the harder employees work, the more profitable Southwest becomes, and
the richer the employees get. The results are clear. At other airlines, one would never see a pilot
helping to check passengers onto the plane. At Southwest, pilots and flight attendants have been
known to help clean the aircraft and check in passengers at the gate. They do this to turn around an
aircraft as quickly as possible and get it into the air again—because they all know that an aircraft
doesn’t make money when it is sitting on the ground.

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 Southwest also reduces its costs by striving to keep its operations as simple as possible. By
operating only one type of plane, the Boeing 737, it reduces training costs, maintenance costs, and
inventory costs while increasing efficiency in crew and flight scheduling. The company has the best
turnaround in the industry, between 15 and 25 minutes. The operation is nearly ticketless, which
reduces cost and back-office accounting functions. There is no seat assignment, which again reduces
costs. There are no meals or movies in flight, and the airline will not transfer baggage to other
airlines, reducing the need for baggage handlers. Another major difference between Southwest and
most other airlines is that Southwest flies point to point rather than operating from congested
airport hubs. As a result, its costs are lower because there is no need for dozens of gates and
thousands of employees needed to handle banks of flights that come in and then disperse within a
2-hour window, leaving the hub empty until the next flights a few hours later. The following figure
shows the differences between Southwest strategy and most other airlines strategies.

Source: Adapted from Hill & Jones (2014). Strategic Management: An integrated approach. Cengage
Learning.

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