The Airline Industry in the 21st Century - Competition between Network Carriers and Low-Cost Carriers

Table of Contents

1 Introduction

2 Business models
2.1 The LCC business model
2.1.1 The LCC business model of Southwest Airlines
2.1.2 The LCC business model of Ryanair
2.2 The NC business model

3 The role of airports
3.1 Airport requirements of LCCs
3.2 The airport’s point of view

4 Outlook on the future
4.1 Is the network airline business model broken?
4.2 Future of the LCC model

5 Conclusion

6 Appendix

7 Glossary
7.1 Seat Pitch
7.2 Interline connection
7.3 Slot
7.4 Airport charges
7.5 Hub-and-spoke network

8 Bibliography

1 Introduction

External shocks, such as terrorist attacks, wars in Afghanistan and Iraq, the SARS epidemic and the worldwide economic downturn have hit the aviation industry badly. Many airlines have posted substantial losses (Lindstädt and Fauser 2003, 23). According to the chairman of Lufthansa’s supervisory board, Jürgen Weber (“Fliegen, bis der Geier kommt”: 58), about half of the [network] airlines are de facto bankrupt. Franke (2004: 15) argues that “the severe crisis of the global aviation industry has primarily struck the classical network carriers (NCs) with their complex hub&spoke [sic!] operation platforms”. Low-cost carriers (LCCs), however, were not hit by the downturn. With their lean business models they offered a good alternative at a time when passengers began to look for ways to avoid paying the high prices NCs demanded (Franke 2004:15).

This paper analyses the competitive environment in the airline industry. I shall briefly describe the different business models in the industry: the LCC and the NC model. I will then analyze the role airports play. The main purpose however, is to identify possible future scenarios in the industry.

2 Business models

2.1 The LCC business model

Doganis (2001: 144) points out that the LCC business model can operate at about 40 to 50 per cent of the cost of the average NC. Different approaches exist about how the cost differentials can be attributed (Gillen and Lall 2004: 47; Lindstädt and Fauser 2004: 25; Doganis 2001: 142-162; Hansson, Ringbeck and Franke 2003: 4; Franke 2004: 17). However, all those approaches clearly state that the cost gap cannot be fully explained by the assumption of lower wages and the “no frills” concept.

Exhibit 1 in the appendix shows the savings potential of LCCs according to Franke (2004: 17). He underlines the success of the LCC’s lean production philosophy with “quick, streamlined processes”. Franke’s research builds on the fact that “at least one-third of the cost gap comes from the typical LCC production pattern with high-frequency commuter flights between major destinations, resulting in a considerably higher productivity of aircraft and crew”. Other cost-saving success factors are: lower maintenance costs due to a homogeneous fleet of cost-efficient aircraft, point-to-point services as well as lower landing and ground handling fees (Lawton 2002: 38).

2.1.1 The LCC business model of Southwest Airlines

So far Southwest Airlines (SWA) seems to be the world’s most successful LCC. For more than 30 years SWA has been operating as a LCC. By any yardstick, SWA has been an example of “what Harvard strategists would call – sustainable competitive advantage” (Gillen and Lall 2004: 42). Exhibit 2 shows the net income for the US airline industry and for SWA. The airline’s great performance is also reflected in the stock market. “Southwest stock has been the best performing stock in the US since 1972 yielding an annualized return of 25.99 per cent” (Southwest Proxy Statement 2002, quoted in Gillen and Lall 2004: 42). SWA also became the airline with the highest stock market value in the world (Mercer 2002: 6). Exhibit 3 compares the performance of Southwest stocks with the performance of the Dow Jones Transportation Index.

Their claim to be “the only shorthaul [sic!], low-fare, high-frequency, point-to-point carrier in America” (Southwest Airlines 2004a) might not be true anymore. However, SWA has been the first to make “a strategic choice to be different” (Porter 1996: 70) and its first mover advantages now pay back.

Nevertheless at first glance Southwest’s concept does not obviously stand for success. The hub-and-spoke system NCs use allows consolidation of traffic and therefore high load factors. This is what SWA gives up when it provides point-to-point service. Further, short-haul service implies that there are more take-offs and landings so aircraft spend more time on the ground (Gillen and Lall 2004: 42). At closer inspection, however, these are exactly the cost saving characteristics of the LCC model as mentioned in section 2.1.

Gillen and Lall (2004) argue that contrary to popular belief, the Southwest model is not generic. They back their opinion on the work of Gittell (2003), who shows that “the Southwest story is a people story”. According to him the operations agent is of high importance. While in some other airlines operations agents coordinate as many as 15 flights at a time from a remote location the Southwest operations agent is on-site and responsible for one flight only. He is not just an information hub, but also helps to build relationships across functional groups. “This helps the group to work as a team that has to get the job done in a given period of time, thus Southwest pilots will help load bags if that is what is required” (Gillen and Lall 2004: 46).

Gittell (2003) points out that the Southwest system works because of its simplicity and predictability and because information is transmitted from one member of the team to another by using simple forms and devices. At the same time employees are motivated by the team spirit and the work group is strengthened through problem solving, helping other group members, sharing knowledge and goals as well as having mutual respect (Gillen and Lall 2004: 47). Gittell (2003) finds that the heavy use of information technology weakens relational coordination in other airlines.

2.1.2 The LCC business model of Ryanair

Ryanair has taken the Southwest operational effectiveness a step further and is perhaps the best example for this business model, as it is the most extreme in reducing cost (Tretheway 2004: 4). Ryanair directly targets both labor and capital outlay for continuous cost reduction. Moreover, in striving to maximize aircraft utilization, the company indirectly targets fuel expenditure for cost reduction (Lawton 2002: 104). Ryanair even has generated new revenue streams by advertising on seatback trays and headrests and also on the exterior of some of their aircraft (Gillen and Lall 2004: 47). Ryanair outsources everything other than cabin crew, pilots, reservation agents and head office functions. Nevertheless, outsourcing also has its disadvantages. A lot of time has to be devoted to managing relationships with subcontractors, and it is difficult to create a corporate culture (Gillen and Lall 2004: 47). On the other hand outsourcing makes expansion much easier.

If we now compare the Southwest with the Ryanair business model we can see that there are some common characteristics. Both airlines provide short-haul point-to-point services and have a unified fleet, but the similarities probably end here. The service-level of Ryanair is lower than that of SWA and while Ryanair is expanding very aggressively SWA is very conservative about growth. The human resource policies, however, are the crucial difference. Ryanair as well as all the large European LCCs do not imitate SWA’s strategy, but just elements of its sources of operating efficiency (Gillen and Lall 2004: 48).

2.2 The NC business model

After looking at the LCC business model on both sides of the Atlantic it is necessary to have a closer look on the network carrier model.

In the period from 1945 to the end of the 20th century, the world’s airline industry built a remarkable product. “A passenger almost anywhere in the world could purchase a ticket to seamlessly fly to almost any other part of the world” (Tretheway 2004: 3). A complex, but effective set of relationships among hundreds of individual air carriers was used to provide this service called interlining. The International Air Transport Association (IATA) provided the global standards and services to make world-wide connectivity possible (IATA 2004).

In developing this network product air carriers required costly systems and infrastructure to serve their passengers. The same infrastructure was used to serve all passengers. This included both those passengers needing the connectivity, as well as those whose journeys were simple point-to-point itineraries (Tretheway 2004: 4).

Together with their alliance partners, the major airlines have established worldwide nets consisting of linked hub-and-spoke networks. This has enabled them to offer a wide range of products to all kinds of customer needs and at the same time allows them to bundle the traffic flows and thereby increase cost efficiency (Lindstädt and Fauser 2004: 24). Nevertheless Lindstädt and Fauser (2004) argue that “by trying to cater to everybody, network carriers have ended up with a product that is neither able to satisfy the business customers’ quality and service demand, nor the price expectation of the leisure customers.” Furthermore the wish to cater for all customers through the same organization has raised complexity cost significantly. In the end, the strategy for maximization of the product range and minimization of cost simultaneously seems to lead to a dead end.

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