Southwest

James OldroydKellogg Graduate School of ManagementNorthwestern University

J-oldroyd@northwestern.edu801-422-7888650 TNRB

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Where would you recommend?

Baltimore Detroit or Dayton?

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Years of Profitability Since 1938

Cumulative Net Profit of Scheduled US Airlines:

1970 – 2.2 billion profit 1980 – 5.8 billion profit 1989 – 8.2 billion profit 1997 – 5.4 billion profit 1998 – 10.3 billion profit 1999 – 15.6 billion profit2000 – 18.1 billion profit2001 – 12 billion profit

8 Years out of 64 Years

UGLY!

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World’s Largest Airlines

1. AMR 2. UAL 3. Delta 4. JAL 5. Lufthansa

6. British Airways 7. All Nippon Airways 8. Northwest Airlines 9. Continental Airlines 10. Air France

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Stock Performance

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The Relationship between Price and Cost EXPERIENCE CURVES COMPANY PROFITABILITY)

• Different companies within an industry will have similar prices but will have accumulated different amounts of experience

Predictable Unit Cost Differences

Predictable Profitability Differences

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Accumulated Experience (units of experience)

IndustryPrice

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American’s Volume Advantage?

Industry Price

Cost Southwest

Costs American

Number of Units

Cost Per Unit

Cost Disadvantage For Southwest

American Has First Mover Advantage and Crosses into Profitability First.

Time Advantage for

American

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Why don’t we see the results

we expect?

How does Southwest do it?

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Correct Measures

Number of Aircraft?

Number of Employees?

Number of Flights?

Number of Passengers?

Number of Destinations?

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Where are the Majority of Southwest’s Costs?

Where are Majority of Honda’s Costs?

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Costs 2001 AirlinesFourth Quarter 2001

(Source: DOT Form 41)Index

(1982 = 100)

% Change Yr/Yr

(Same Quarter)

% Change Qtr/Qtr

(@ Annual Rates)

Share of TotalOp. Expense

(%)

LABOR (Passenger / Cargo) 183.0 2.1 12.9 36.4

FUEL 68.3 (23.2) (49.2) 11.0

AIRCRAFT FLEET 290.1 9.2 40.7 11.8

INTEREST 51.4 (4.1) 20.3 2.7

INSURANCE 129.4 233.0 576.5 1.0

MAINTENANCE MATERIAL 163.0 (20.8) (42.4) 2.4

LANDING FEES 215.1 12.7 24.2 2.1

TRAFFIC COMMISSIONS 54.5 (30.0) (13.9) 2.3

COMMUNICATION 161.5 17.9 49.0 1.6

ADVERTISING & PROMOTION 49.0 (13.7) (22.0) 0.9

PASSENGER FOOD 104.5 (3.7) (8.6) 2.2

ALL OTHER COSTS 165.7 1.8 (0.3) 25.7

COMPOSITE 154.6 (0.5) 0.2 100.0

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What does your chart look like?

Market Share

Profits

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Measuring Success

Airline ProfitabilityAirline Profitability

In order to survive and profit in this tough environment, airlines attempt to manipulate three main variables:

Cost, calculated as total operating expenses divided by available seat miles (ASM)

Yield, calculated as total operating revenues divided by the number of revenue passenger miles (RPM)

Load Factor, calculated as the ratio between RPMs and ASMs, which measures capacity utilization.

Profitability = [yield X load factor] - cost

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Southwest Airline’s Focus

CEO Herb Kelleher, a Connecticut attorney turned Texan, CEO Herb Kelleher, a Connecticut attorney turned Texan, had the best labor relations in the industry and an excellent had the best labor relations in the industry and an excellent company culture. company culture.

Lowest cost structure in the industry. Lowest cost structure in the industry.

Company vision was to provide low cost airline service to an Company vision was to provide low cost airline service to an increasingly larger number of people. increasingly larger number of people.

Objective to minimize reservation costs.Objective to minimize reservation costs.

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Wal-mart’s Distribution Model

A key to their success

Airlines use the same model.

Does this make sense?

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Point to Point Vs. Hub and Spoke

Southwest

The National Carriers

VS.VS.

Commuter airline that concentrates on city pairs. (Average Commuter airline that concentrates on city pairs. (Average flight is 400 miles or less and takes less than one hour) flight is 400 miles or less and takes less than one hour)

COST ADVANTAGE AT SOUTHWEST“Airlines don’t have revenue problems, they have cost problems.” Southwest.

Conventional Strategy: Meals, pre-assigned seats, membership in airline reservation system, travel agents, and hub & spoke system are key to success.

Southwest Strategy: Lowest cost operations and lowest prices.

Sales/Marketing Operations Human Resource Mgmt.

• Offer direct flights to busy cities of less than 500 miles• No pre-assigned seats• Little reliance on travel agents (saves 5-10%)• Snacks rather than meals• Prices 20-50% lower than the competition

• Fly only Boeing 737s (smallest, most fuel efficient craft)• Train pilots & mechanics only on 737s• Fly to cheaper, less congested airports (i.e. Love Field Dallas; Midway, Chicago)• Don’t transfer baggage to other airlines• Fast turnaround of aircraft (20 minutes vs. 50 minutes for industry)

• Initially non-union, now partially union labor• Cross training, flexible workforce• Employees receive same pay per job hour regardless of location (low turnover overall but accept high turnover in high cost areas; i.e. Calif.)

COST ADVANTAGE AT SOUTHWEST CONTINUED…• Airfares in Southwest markets are roughly 25 percent lower than in non-Southwest markets.

• Southwest has an average 65 percent marketshare compared with less than 40 percent for other airlines in their top 100 markets.

• Unit costs of other airlines are 50-60 percent higher than Southwest’s, except for America West with unit costs that are 20 percent higher.

•Southwest has been the most profitable U.S. airline from 1980-1995.

Source: U.S. Dept. of Transportation

Southwest Profitability vs Industry: 1988-1996

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Operating profit asa percentof sales

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United Flight 815- Chicago to LA Oct 31, 2000

204 tickets were sold and 186 people showed up.

68 passengers originated in Chicago and 118 were from connecting flights.

97 passengers terminated at LAX, 89 continued on another flight.Of the 33 passengers that were only Chicago-LAX there were 27 different fares: • A frequent flyer passenger paid nothing. • A 1st class passenger paid $1,248.51 on the day of the flight. • A coach passenger paid $102.26 on the day of the flight.

• A cash fare passenger paid $87.21 twenty-nine days in advance .

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Quiz - No Need to Discount?

What % of Customers fly at discounts

above 60% of listed prices?

> 90%> 90%

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Industry Problems – Not Labor Costs

Sadly, many in the industry misidentify the cause of their firms' inability to deliver services at affordable prices, that can attract and

hold the new demand. Those in denial label as a "labor cost problem" what is in truth structural inefficiency. It is the low-hanging fruit of wage rates and work rules that gets all their attention, when it is structural change that offers the greatest leverage on success.

Southwest Airlines is a highly profitable, heavily unionized and among the highest-paying airlines. Paradoxically, Southwest is also the

industry's acknowledged low-cost producer and its unabashed price leader. It is Southwest's business strategy and operating structure

that produces these very affordable, easily marketed costs. Traditional work rules and above-market wage rates do not interfere

with Southwest's ability to compete in and grow the markets they serve. Their employees are recognized for their contributions, well

paid and their customers well served.

Source: R.W. Mann & Company, Inc.

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Key Differences

The key difference between Southwest and most other air carriers is its structural productivity. New entrants achieve

startling productivity, in various fashions. No low cost producer/low fare carrier follows industry structural conventions,

which have caused productivity to decay.

Regrettably, instead of focusing on how to become more productive structurally, most debate revolves around regressive

demands for labor subsidies. How much of a wage rate reduction is required to close the gap with this high productivity

carrier? How much to come to parity with a low productivity carrier that managed to extract subsidies from labor and other

suppliers through bankruptcy (or threats of same as an alternative to achieving concessions)?

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Understanding the truth

We must look at the world as it We must look at the world as it is versus how airlines would is versus how airlines would like it to be. like it to be.

Robert L. Crandall Robert L. Crandall

Former CEO Former CEO

American Airlines American Airlines

And as government officials, politicians and consumers would like it to be.

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This industry is always in the This industry is always in the

grip of its dumbest competitors.grip of its dumbest competitors.

Robert Crandall

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A Report to the President and Congress August 1993

It questioned whether the It questioned whether the airline industry has basic structural airline industry has basic structural problems or if it is just a collection problems or if it is just a collection of poorly managed companies.of poorly managed companies.

The National Commission to Ensure a The National Commission to Ensure a Strong Competitive Airline IndustryStrong Competitive Airline Industry

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Commission Reports• The Airline Industry is more competitive than before deregulation in 1978.

• Travelers and shippers are charged less than in 1978.

• The Airline Industry has never made a sustained, substantial return on investment.

• It lost huge amounts of money from 1990 to 1993.

• It canceled many aircraft orders shortly after an unprecedented buying binge.

• Its freedom to compete in international markets is uncertain because of government restrictions.

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Commission Conclusions

For the U.S. to prosper in a global marketplace the airline industry must: • Be efficient and technologically superior.

• Have the financial strength to respond to rapid change and opportunity.

• Efficiently move people, products and services to markets, wherever they exist.

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Commission Recommendations

Efficiency: Reinvent the FAA.

Financial Health: Deal with factors that impact the financial health of the industry.

Access to Foreign Markets: Replace the current bilateral system with a multi-national regime.

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Continued…

To return their balance sheets to To return their balance sheets to

respectability, most airlines would respectability, most airlines would have to achieve profit margins that have to achieve profit margins that are almost unprecedented in their are almost unprecedented in their history, and sustain those margins history, and sustain those margins for years.for years.

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Do you agree?

The shock of September 11th has forced airlines to face an awkward fact: in some respects, aviation is a declining industry.

Nov. 22, 2001

The Economist

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Problems or Symptoms

Despite cutting capacity, the big American airlines are still flying with planes barely 60% full—a figure that would be much lower were it not for hefty discounts.

Boeing and Airbus, the two manufacturers of large jetliners, are offering airlines special financing deals to pay for their purchases in order to stave off outright cancellations.

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Ouch!

American and United, bleed cash at a rate of $10m-15m a day.

In the third quarter 2001, they lost a combined $2.6 billion, even after receiving government aid worth over $2 billion.

American carriers are estimated to lose a total of $9 billion-10 billion in 2001, even after receiving $5 billion or more of aid.

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Air Safety

Fatalities by Transportation Mode

0 5000 10000 15000 20000 25000

Passenger Car

Railroad

Airline 12

530

20,818

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Four Consistently Profitable Airlines

1. Singapore Airlines 1. Singapore Airlines

2. Cathay Pacific 2. Cathay Pacific

3. British Airways 3. British Airways

4. Southwest Airlines 4. Southwest Airlines

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Singapore Airlines

Consistently profitable but experiencing profit pressures. Consistently profitable but experiencing profit pressures. Winner of multiple awards for “airline excellence.” Winner of multiple awards for “airline excellence.” An extension of the country strategy to be the business and An extension of the country strategy to be the business and travel gateway to Southeast Asia. travel gateway to Southeast Asia. An impressive travel infrastructure. An impressive travel infrastructure. Leader of the Orient Airlines Association (OAA) Leader of the Orient Airlines Association (OAA)

– Abacus reservation system. Abacus reservation system.

– Price collusion on major routes. Price collusion on major routes. Nervous regarding U.S. carrier price competition.Nervous regarding U.S. carrier price competition.

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Why isn’t Southwest an International Airline?

Its workhorse Boeing B737 aircraft (a single fleet type offers efficiencies) does not have the range to fly the longer-haul, transcontinental markets. However, its

aircraft order portfolio (an updated B737) does contain such capabilities, creating growth possibilities for Southwest and even greater challenges for its higher cost/higher fare long-haul competitors.

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STRATEGIC IMPLICATIONS OF THE EXPERIENCE CURVE

First movers in a fast growing market will secure a widening cost advantage. Firm’s must grow as fast, or faster, than rivals or be at a cost disadvantage.

Understanding the behavior of costs allows for more sophisticated pricing strategies. The experience curve can be used:• As a basis for pricing a production run or contract• As a basis for market share based pricing strategy• As a basis for planning future prices

Experience curves can be plotted for a company and its competitors to assess how well each company is managing its costs. Companies with the greatest cumulative experience should have the lowest costs (if business is properly defined).

Product life cycles influence how you use the experience curve for pricing. Products with a short product life cycle (rapid development of new models) need to be priced to make money more quickly because they can’t count on a long learning curve and long productions runs.