Airlines industry needs structural changes
By Raquib Siddiqi
Aug 14, 2004, 13:10
The problems facing the airline industry today are not merely cyclical, they are structural and, as such, demand a structural solution, say a study.
The study said the global airline industry is in crisis, and industry icons are fighting for survival. The scene is reminiscent of a decade ago, when the airline industry struggled through the last recession and the aftermath of the Gulf War.
There are too many airlines and too many hubs operating in a competitive environment where exit barriers are high. Market forces and bankruptcy protection ensure that distressed capacity does not disappear; instead it comes back, potentially at a lower cost level, threatening to trigger price wars that drive still more airlines into bankruptcy, it said. The big difference, in recent times, is the impact of low cost carriers (LCCs). Ten years ago, the LCC threat in the US was limited to a regional carrier, Southwest Airlines, and some under funded 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 and spoke (H&S) system. Even the Middle East has seen LCCs starting to operate.
Clearly, a new business model is needed that eliminates the structural cost penalties of the H&S model while retaining and selectively enhancing key service and coverage attributes, the study said. The airline industry in all the regions is undergoing major change. On one hand, the pace of change in regulatory environments is expected to increase mainly driven by governments' willingness to reduce their subsidies to unprofitable flag carriers and to unleash economic development driven by a more vibrant air transport industry. On the other hand, a commitment to develop regional tourism is also spurring growth of air travel.
Airlines, however, continue to suffer from low profitability. High costs and pressure on prices are the norm. Business travellers, in particular, are no longer prepared to pay the high fares tolerated in the late 1990s. Indeed, both corporate and individual travelers are asking for lower prices, high frequencies, and simpler, more efficient service, the study said.
Part of the industry's problem is the very nature of the product it offers. An airline seat is a fixed-cost perishable product. The incentive to fill empty seats and fly underutilized aircraft is tremendous. Idle capacity inevitably comes back on the market as start-ups buy the aircraft or established airlines increase the utilization of 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 that exists in the airline industry.
The study has evaluated the cost gap between full service airlines and LCCs on both sides of the Atlantic, and the similarities are striking. Cost differences exist across the board: pilots, on board services, sales and reservations, maintenance, aircraft ownership, ground handling.
This is not simply a matter of LCCs paying lower salaries or using cheaper airports; rather it is a function of fundamental differences in the LCC business model. LCCs have successfully designed a focused, simple operating model around nonstop air travel to and from high-density markets.
H&S carriers, on the other hand, support a highly complex system of operations. Their business model is predicated on offering consumers a broad range of destinations, significant flexibility (ranging from last-minute seat reassignments and upgrades to complete itinerary and routing changes), and "frills" (e.g. specialty meals, lounges, in-flight entertainment, etc.). It's a model that labours under the built-in cost penalties of synchronised hub operations (e.g. long aircraft turns, slack built into schedules to increase connectivity) and that implicitly accepts a slower business pace to accommodate continuous change, legacy systems, and the added time it takes for passengers and baggage to make connections. In addition, the H&S business model relies upon highly sophisticated information systems and infrastructure to optimise its fundamental value proposition: to take anyone from anywhere to everywhere... seamlessly.
LCCs could potentially-and successfully-participate in very large segments of air travel which could reach more than 70 percent of the US domestic market, the study said.
The only sectors which provide H&S carriers appreciable protection are smaller "connect markets" that cannot be reasonably serviced on a nonstop basis (20 percent of the U.S. domestic market) and longer-haul markets, where onboard services are more prized and the cost differential is smaller (10 percent of the market).
It is the LCCs' impact on overall price levels - not the loss of traffic - that poses the real threat to traditional H&S carriers. LCCs actually stimulate significant new traffic as they enter a market. But they also bring down price levels, and those price pressures manifest themselves in a broad range of markets: in local markets to and from the hub, in shuttle markets, in connecting markets, and in adjacent markets (i.e. those not directly served by the LCC, but available via ground transportation).
The challenges facing H&S airlines are further complicated by the fact that there are too many hubs and too many airlines. The revenue base of a traditional airline is dependent on maintaining the loyalty of its most frequent business travelers and leadership in its home markets, the study said.
To be competitive, an H&S carrier needs to serve a wide range of destinations and provide frequent, comprehensive service. However, this can create much more connecting capacity than the underlying market requires, with many airlines pricing below fully allocated costs in order to fill capacity.
To continue to operate in this competitive environment, H&S carriers need to overhaul their business systems to move costs within range of the LCCs' and reduce their sensitivity to economic and competitive pressures, it said.
To effect this overhaul, carriers must urgently restructure their core operations. In some regions, such as Europe, carriers have the luxury of employing two parallel approaches, given the lower penetration of LCCs. Airlines may chose to introduce low-cost subsidiaries in order to participate immediately in growth markets that its core operations cannot access with their currently high cost structures, while simultaneously redesigning their core network operation to compete effectively with the looming threat of LCCs.
The key to effectively restructuring an H&S airline's core network is implementing a lower cost structure business model without giving up the critical service and coverage attributes prized by high-value customers. Ideally, this restructuring would increase the product differentiation between high and low priced services and would occur in conjunction with network changes designed to reduce competitive vulnerability through more direct flights and/or mergers.
In sum, the industry's major H&S carriers need to design and adopt a new business model, whose "objective function" is to eliminate the costs of complexity and provide a more differentiated service between customer/ product segments.
They can accomplish this goal by designing processes that reflect the simple needs of the vast majority of customers, while focusing discretionary expenditures on those areas where they add consumer value and contribute to the bottom line, the study said.
Such a model will almost certainly result in substantial changes in most airline product attributes and support requirements, including network structure, pricing strategies, fleet structure, and service policies. However, the benefits are substantial.
"The new operating model we are suggesting would improve the defensibility of H&S carriers as services would be more closely aligned with customer needs; cost levels would be substantially lower; and the enterprise would be more closely focused on local traffic,'' the study said.
© Copyright 2003 by The New Nation
