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Each assignment submission must be in APA format and substantive in nature and follow the assignment grading rubric. The textbook provides a primary source for the theory but makes sure to utilize additional sources for substantive information. Outside sources to validate your writing include and are not limited to: current airline financial statements, news articles in business magazines regarding the airline industry, and airline industry magazines. Applying what you have learned from the textbook readings to a current event today in the airline industry.1. The Case Study is a minimum of 2 pages submitted as a Word Document File. 2. Applies a real-world/current airline industry event to the Case Study Topic.3. Week #1 – Case Study Topic from Chapter 1- Read pages 29-32. Select a legacy carrier and how they are reinventing their business model. All written work must be submitted via Canvas as a Word document and is held to the strictest academic and professional standards. See Rubric included with the Assignment for additional grading detail. Remember, if what you write is not an original thought of yours, you must cite references. Use proper English and grammar. NO abbreviation type writing such as used in Facebook or texting. Remember the sole form of communication in this course is through the written word, so proper English and grammar is not only crucial, it is mandatory. You must cite sources for whatever you write. Post the reference information at the end of each assignment

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PART 1
Strategic Context
When your strategy is deep and far-reaching, then what you gain from your calculations is
much. When your strategic thinking is shallow and near-sighted, then what you gain from your
calculations is lile and you lose before you do bale. Therefore victorious warriors win first
and then go to war, while defeated warriors go to war first and then seek to win.
Sun Tzu
Copyright © 2008. Taylor & Francis Group. All rights reserved.
One point of view is that industry economics are our master, determining what can and
cannot be done. Less deterministically, we can take the view that an understanding of
industry economics is a tool which allows managers to work towards the vision they
have for their airline’s future and to meet the more explicit objectives established by
stakeholders such as customers, employees, shareholders, alliance partners and members
of the wider community. This book takes the laer approach. The single chapter in the
opening part of the book outlines a customer-oriented strategic framework within which
the understanding of industry economics developed in subsequent chapters can be
applied.
1
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1
Strategic Context
Never be afraid to try something new. Remember, amateurs built the ark; professionals built the
Titanic.
Anonymous
CHAPTER OVERVIEW
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Most airlines have a competitive strategy embodying the type of value they intend delivering.
Its choice of competitive strategy is reflected in each carrier’s operating strategy. The performance
associated with an operating strategy depends on revenues earned from delivering expected
benefits to targeted customers and on costs incurred delivering those benefits.
Part 2 of the book will look at airline revenues (traffic × yield) and costs (output × unit
cost).
Part 3 will focus on key aspects of capacity management, which is in many respects the critical
operations management challenge because it lies at the interface between cost and revenue
streams.
Part 4 looks at several key macro-level metrics of operating performance.
What this opening chapter does is outline the strategic context within which costs and
revenues are generated. It begins by identifying the scale of the challenge. It goes on to look at
the theoretical underpinnings of the important but sometimes ill-defined concepts of ‘strategy’
and ‘business model’. It then examines the changes currently taking place in airline business
models. It ends by describing in more detail the structure of the book.
I. The Scale of the Challenge
Airlines have annual revenues of approximately half a trillion dollars and employ over
2 million people. They directly support another 2.9 million jobs at airports and civil
aerospace manufacturers, and may indirectly support in excess of 15 million jobs in tourism
(Air Transport Action Group 2005). Low-fare airlines in Europe are alone estimated to
contribute close to half a million direct, indirect, and induced jobs (York Aviation 2007). The
air transport industry, at the heart of which lie airlines, directly contributes US$330 billion
per annum to world GDP (ibid.) and underpins as much as US$3.5 trillion (i.e., around 8
per cent) if direct output is aggregated with output generated elsewhere in the industry’s
supply chain, with the multiplier effect of corporate and personal spending by industry
participants, and with the catalytic impact airlines have on tourism, trade, and investment
(IATA 2007d). Airlines carry well over 2 billion passengers and between 25 and 30 per
cent by value of world trade each year, and are therefore among the primary facilitators
3
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STRAIGHT AND LEVEL: PRACTICAL AIRLINE ECONOMICS
4
of global economic growth. Commercial aviation in the United States is estimated to be
directly or indirectly responsible for 5.8 per cent of the country’s economic activity, 5.0 per
cent of personal earnings, and 8.8 per cent of employment (The Campbell-Hill Aviation
Group 2006). Yet airlines, taken together, have historically been unable to cover their cost
of capital (Pearce 2006). Table 1.1 illustrates the scale of the problem.
Although many carriers outperform industry averages and a handful generate returns
which do exceed their cost of capital (e.g., Ryanair and AirAsia), the industry as a whole
has not been capable of sustaining profitability throughout an entire economic cycle. At the
end of 2007, the top of the most recent up-cycle, the industry remained almost $200 billion
in debt and earned a net margin of lile more than 1 per cent. A normally competitive
industry would be expected to earn its cost of capital, but the airline industry has yet to
achieve this. The problem has been particularly acute in the United States. Reviewing the
period from deregulation in 1978 until 2005, Heimlich (2007) observes that:
• the median US airline net margin was -0.4 per cent, compared with 5.2 per cent for
all US corporations;
• in their best year the airlines achieved a net margin of only 4.7 per cent, compared
with 9.1 per cent for all corporations;
• in their worst year the airlines’ net margin was -10.3 per cent, against 3.1 per cent
for corporations generally;
• there was accordingly a 15-point spread for the airlines, as opposed to 6 points for
all corporations.
By the end of 2005 the US airline industry had, according to the Air Transport Association
(2007), made a cumulative net loss of US$16.8 billion since 1947. Clearly, the airlines most
responsible for this performance have had to endure considerable strain on their balance
sheets; many entered Chapter 11 bankruptcy protection, some on more than one occasion,
and several have been liquidated.
Whilst the failings of senior management and the obduracy of labour have undoubtedly
contributed to the economic downfall of particular airlines, the fact that underperformance
has been so widespread across the industry over such a long period of time implies that
there are structural impediments at work. The purpose of this book is to explain the nature
Copyright © 2008. Taylor & Francis Group. All rights reserved.
Table 1.1
Summary of airline profits and margins 1997–2008
US$ billions1
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
20073
20084
Operating revenue
291
295
305
328
307
306
321
378
413
452
490
514
Operating expense
274
279
293
317
319
311
323
375
409
440
474
498
Operating profit
17
16
12
11
-12
-5
-2
3
4
12
16
16
Operating margin (%)
5.8
5.4
3.9
3.3
-3.9
-1.6
-0.6
0.8
1.0
2.6
3.3
3.1
2
8.5
8.2
8.5
3.7
-13.0
-11.3
-7.6
-5.6
-4.1
-0.5
5.6
5.0
2.9
2.8
2.8
1.1
-4.2
-3.7
-2.4
-1.5
-1.0
-0.1
1.1
1.0
Net profit
Net margin (%)
Source: ICAO, IATA.
Notes:
1. Figures are subject to rounding errors.
2. Excluding US airline bankruptcy charges.
3. Estimates.
4. IATA forecasts (made in late 2007, before subsequent spike in fuel prices).
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S T R AT E G I C C O N T E X T
5
of the challenge accepted by anybody responsible for an airline’s income statement, and in
doing this highlight the structural changes currently taking place in the industry. Because
‘strategy’ and ‘business model’ are concepts which are prominent in the discourse of
change, and because they establish the context within which the economics of the industry
are explained in subsequent chapters, the next section will briefly define them.
II. Strategies and Business Models: Some Theory
STRATEGY
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‘Our strategy is to be the low-cost provider.’ ‘Our strategy is to provide unrivalled
customer service.’ ‘Our strategy is to be number one or number two in all our markets.’
What each of these statements has in common is that none of them describes a strategy.
They describe elements of a strategy (Hambrick and Frederickson 2005). Strategy can
never be about service, price, output or cost in isolation; it has to address all of them in
a coherent manner. There are many different definitions of strategy, but one which is
compelling in both its simplicity and its information value states that ‘effective strategy is
a coherent set of individual actions in support of a system of goals’ (Eden and Ackermann
1998, p. 4) [emphasis added].
Goals and the actions taken to achieve them will oen be specified in detailed plans,
but some of what is planned will inevitably fall by the wayside whilst alternatives
emerge unplanned from the dynamics of the marketplace to augment or replace original
intent (Mintzberg 1994). What is constant in any effective strategy, however, is a theme.
According to Grant (1998, p. 3), ‘Strategy is not a detailed plan or program of instructions;
it is a unifying theme that gives coherence and direction to the actions and decisions of
an individual or organization.’ Porter (1996, p. 71) argues that, ‘In companies with a clear
strategic position, a number of higher-order themes can be identified and implemented
through clusters of tightly linked activities.’
Whether the above definition is applied at the corporate, divisional or functional level,
there should be a coherent theme uniting strategic action. But what is ‘strategic’? The
word has been devalued, oen being used as a synonym for ‘important’. To be truly
‘strategic’ an action must reinforce or change one or more of the following:
•
•
•
•
•
the scope of the corporation’s portfolio of businesses;
the market (or ‘horizontal’) scope of an individual business in the portfolio;
the value offered to customers of an individual business;
the competitive advantage sought by a business;
the operating strategy used by a business to deliver value to its customers.
These dimensions of strategy will be considered briefly in the context of the airline industry.
Corporate Strategy: The Industrial Scope Decision
The industrial scope decision addresses which businesses a corporation should be investing
in. It is the essence of ‘corporate’, as different from ‘competitive’, strategy. During the
1970s and early 1980s, portfolio planning matrices such as the Boston Box, the McKinsey
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6
STRAIGHT AND LEVEL: PRACTICAL AIRLINE ECONOMICS
Directional Policy Matrix, and the Arthur D. Lile Life-Cycle Matrix were widely used to
help structure industrial scope decisions (Bowman and Faulkner 1997); their underlying
logic was to search continuously for ways to rebalance the corporate portfolio by investing
free cash flow from slow-growing mature businesses into faster-growing new businesses.
Since the late 1980s, emphasis has shied towards analysis of shared competencies and
the search for a beer understanding of how it is that aggregating different businesses
within the same corporate group actually creates more shareholder value than would be
created were each independent; this has contributed to a move away from conglomerate
diversification.
In the context of the airline industry, the industrial scope decision is a maer of whether
and, if so, how far to diversify away from the air transport business. The decision might
result in one of three group structures for an airline or its holding company:
1.
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2.
3.
Single business This is the model adopted by carriers concentrating on air transportation
as their core business and outsourcing all activities considered ‘non-core’ relative to
the carriage of passengers and cargo. Air transportation services might be offered
using a single brand across all markets served, or a suite comprised of a master-brand
and separately sub-branded ‘production platforms’. For example, the JAL Group
comprises master-brand Japan Airlines and sub-brands JALways, JAL Express, J-Air,
Japan Asia Airways, and Transocean Air.
Portfolio of related businesses This model includes in addition to air transport
operations a number of divisions, subsidiaries, and/or joint ventures in fields related
to air transport. How to define ‘relatedness’ is an open question, but generally we
would expect related businesses to share inputs, technology, competencies, and/
or markets and to reap economic benefits from this sharing. Whilst some airlines
(e.g., British Airways) have for many years been focusing primarily on air transport
operations, others (e.g., Luhansa and Singapore Airlines) have been developing
activities related to air transport into significant independent revenue-generators.
Luhansa made a strategic decision in the 1990s to diversify in order to reduce
reliance on volatile earnings from passenger air transportation: it created Luhansa
Technik, Luhansa Cargo, Luhansa Service, and Luhansa Systems, which within
a decade together accounted for approximately 40 per cent of group revenue.
Separately, several European charter airlines and Canadian carrier Air Transat are
themselves a part of vertically integrated portfolios of related businesses within the
leisure travel value chain.
Portfolio of unrelated businesses Most airlines and airline holding companies are now
less inclined than some have been in the past to involve themselves in activities
only tenuously related to air transport; All Nippon has stepped back from the hotel
business, for example, but Icelandair’s holding company has not. A few carriers,
particularly in Asia where there is still a penchant for conglomerate diversification,
are themselves part of broad industrial portfolios (e.g., Asiana, Cathay Pacific, EVA
Air, and Kingfisher).
The corporate strategies of different airlines or airline holding companies can be outlined
by using comparative bar charts to map the percentages of total revenue aributable to
different businesses within their portfolios. Our interest in this book is limited to the
economics of air transport businesses.
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S T R AT E G I C C O N T E X T
7
Competitive Strategy: Horizontal Scope, Customer Value,
Competitive Advantage, And Operating Strategy
Airline managers do not confront the economics of the industry in a vacuum, but within
the context of a particular competitive strategy. Competitive strategy is behaviour intended
to build and/or leverage a competitive advantage. Each business, whether it stands alone
or is part of a broader portfolio, should have a competitive strategy. The essence of a
competitive strategy can be found in the answer to four questions that will be considered
in the next four subsections: In which product and geographical markets should we
compete? What value will we offer to targeted customers (or, more crudely, who would
care if we ceased to exist and why)? How will we create and sustain an advantage over our
competitors in each of those markets? How should we profitably organize the production
of output to deliver the desired value to customers in targeted markets and to exploit our
competitive advantage?
Figure 1.1 illustrates, at a generalised level, how competitive strategy might be
formulated and how it relates to the concept of a ‘business model’. The elements identified
are all discussed below and will be encountered again in subsequent chapters; the purpose
of this framework is to provide a context that can be referred to as necessary when reading
through those chapters.
Horizontal scope: in which markets should we compete? Purchase of air transportation
involves simultaneous participation in both a geographical market and a service market
(Holloway 2002).
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1.
Geographical scope can be:
• Wide-market There are several large international airlines, but no truly global
carriers. Again, different production platforms may be used to serve different
geographical markets; alliances are intended in part to broaden geographical
scope within the constraints of both industry economics and the prevailing
international aeropolitical regime – a regime which, as we will see in Chapter 4,
is still on the whole relatively restrictive in some parts of the world but is rapidly
liberalising in most major markets. An airline’s network is, in fact, now widely
perceived as a core aribute of its service – hence the imperative felt by many
network carriers to build alliances.
• Niche This involves offering either a wide or a narrow range of services into
a small number of geographical markets. What constitutes a geographical
niche and what represents a geographical wide-market strategy is obvious at
the extremes (e.g., regional carriers on the one hand and the US ‘Big Three’ on
the other), but unclear in the middle ground. A large number of the world’s
international airlines make wide-market service offers into a relatively limited
range of geographical markets, and are in this sense ‘geographical niche carriers’
– although they might not think of themselves as such. Many have moved
out of geographical niches by joining global alliances; those that choose not to
make this move will need confidence that they have distinctive and sustainable
cost and/or service advantages with which to defend their niches. At the other
end of the spectrum Belgian carrier VLM, bought by Air France-KLM in 2008,
successfully established a geographical niche linking London’s businessoriented City Airport to near-continental destinations and UK provincial
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STRAIGHT AND LEVEL: PRACTICAL AIRLINE ECONOMICS
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Relationships between competitive strategy, business model and performance
Figure 1.1
S T R AT E G I C C O N T E X T
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2.
9
centres. Similarly, US carrier Allegiant Air was established to link relatively
small communities to Las Vegas and Florida, tapping into thin vacation markets
lacking intense competition. And at the time of writing, 23 of the 39 destinations
served by Spirit are in the Caribbean and Latin American regions – a deliberate
reorientation away from increasingly competitive domestic US markets.
Choice of geographical scope is clearly a fundamental underpinning of any
airline’s competitive strategy. In the mid-2000s, for example, bmi began to shi the
emphasis of its mainline operations at London Heathrow away from short- and
towards medium- and long-haul routes. Most US network carriers are growing their
international operations in preference to expanding domestic output. In both cases
this shi in geographical scope has been a response to intensifying competition from
low-fare airlines, and further downward pressure on yields, in short-haul markets.
Service scope – the targeting of specific segments of demand within geographical
markets, members of which want particular combinations of price and product – can
be:
• Wide-market A portfolio of passenger and cargo transport services is offered
by a single carrier, either under its sole corporate brand or using a mixture of
mainline, divisional, subsidiary, and/or franchised sub-brands to target distinct
segments of demand.
• Niche A single type of service, or a very narrow range, is offered. A typical
example would be a low-fare carrier offering single-class service to one or a
relatively narrow range of segments. Another would be a European charter
carrier, offering single-class service to tour organizers and seat-only retail
purchasers. The premium-only long-haul airlines which began operations in
2005 and 2006 provide examples at the other end of the service–price spectrum
(e.g., Eos, Silverjet, L’Avion). Cargo carriers, including integrators such as UPS
and DHL, are also niche operations insofar as their product range is narrower
than that of combination carriers offering both passenger and cargo products.
Clearly, niche does not necessarily mean small. It relates to degree of focus
rather than size of revenues or scale of operations.
Geographical and service scope are distinct but closely linked choices. Indeed, in a
network industry such as commercial air transportation these two scope decisions are
fundamentally symbiotic: every departure is in itself a product offered to one or more
geographical markets, and different levels of ground and onboard amenities provided
to customers travelling in whatever separate classes are available on each departure can
be characterised as product aributes offered to different segments of those markets. For
example, European low-fare carriers are only able to serve many of the routes they have
opened between secondary or tertiary centres by offering low fares to stimulate demand,
and this in turn requires a type of service which costs less to produce than the traditional
‘full-service’ product that these markets have historically been unable to support.
Customer value: what is the carrier’s value proposition? The concept of utility underlies
neoclassical demand theory. Exchange takes place when two parties each give up something
that provides them with less utility than what they receive in return (Fabrycky et al. 1998).
The utility of a product may be intrinsic in the case of a ‘status good’, but in most cases is
derived from the ability of the product to satisfy a particular consumer’s needs and wants
– hence the old marketing tenet that nobody needs a drill, what they need is a hole. Utility
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STRAIGHT AND LEVEL: PRACTICAL AIRLINE ECONOMICS
and customer value are closely related. Whereas utility (at least according to one definition)
is the satisfaction a person derives from using a product, value is that person’s appraisal of
the worth of utility received net of any disutility – such as price paid, requirement to book
in advance, having to change planes at a congested hub, or minimum and maximum stay
restrictions. Customer value is neither the cost of a product nor its price, but a consumer’s
appraisal of what is to be gained from acquiring that product net of what has to be given
up to acquire it (Lovelock and Wirtz 2004). Different consumers paying the same price may
therefore not receive the same value (Ng 2006).
The question of who decides what amounts to value has been answered somewhat
differently within different traditions of economics. The Austrian-subjectivist tradition
places great store in the subjective opinions of individual actors. As Rothbard (1962,
p. 19) puts it from this perspective, ‘ … physically, there may be no discernible difference
between one pound of buer and another. But if the actor chooses to evaluate them
differently, they are no longer part of the supply of the same good.’ Similarly, the services
management literature holds that perception is reality as far as consumers are concerned
(Carpenter et al. 1994; Holloway 2002). This view is adopted in the present book. Figure
1.2 proposes the following definitions:
Copyright © 2008. Taylor & Francis Group. All rights reserved.
1.
A customer’s perceived benefit from using a service is equivalent to the gross benefits (or
‘utility’) offered by that particular service (e.g., safety, schedule convenience, ontime
performance, inflight comfort, enhanced self-image through brand association,
frequent flyer miles, etc.) less non-monetary costs (e.g., ticket conditionality, queues
at various points in the service delivery system, elapsed journey time lengthened
by having to connect at a hub, crowded airports and airplanes, etc.). This concept
can be monetised by equating it to the maximum price the customer is prepared
to pay.
It is important to stress again that we are talking about benefits as perceived by
customers rather than by airline managers. Mid-1990s UK start-up Debonair tried to
distinguish its low-fare product by adding a few minor cabin service benefits not offered
by competitors such as Ryanair and easyJet. Unfortunately, most potential customers
were either unaware of the incremental benefits or did not perceive them as meaningful
Figure 1.2
Cost, price, benefit and value
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S T R AT E G I C C O N T E X T
2.
3.
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4.
11
to the purchase decision. These benefits therefore generated costs uncompensated by
incremental revenues, and were one factor (among several) contributing to Debonair’s
subsequent failure. In contrast, jetBlue’s service offer was designed at launch to
incorporate benefits that were both well-communicated to target customers and
considered by those customers to be relevant to their purchase decisions.
Value created by a service is the customer-perceived benefit as just defined, less all
the input costs that have been spent right along the value chain in order to create the
service and deliver value to the customer.
Consumer surplus is perceived benefit less the monetary price paid by the customer.
This is widely referred to as ‘customer-perceived value’ or simply ‘customer value’;
although the terms are not always used synonymously, they can be treated as such
for our purposes here. In effect this is the part of ‘value created’ that the customer is
capturing. Because each customer is likely to place a different value on any particular
service, the amount of consumer surplus will vary between individuals; we will revisit
this idea in Chapters 3 and 9, because it is the foundation of price discrimination
and therefore of revenue management. Consumers are generally assumed, certainly
by most economists, to make purchase decisions that maximise consumer surplus
(Bowman and Ambrosini 1998). Sometimes there might be no consumer surplus:
the price paid in this case equates exactly to the value placed by the consumer on
perceived benefits. This is likely only where there is a monopoly supplier who knows
each customer’s valuation of the service and is able to price-discriminate accordingly
(ibid.). (Note that in principle there can never be a negative consumer surplus insofar
as nobody is likely to pay for a service from which they derive no value.)
Seller’s profit is the monetary price paid by the customer less the cost of inputs. This is
the portion of ‘value created’ that the airline – the final seller of the service fashioned
out of all the inputs that went into creating and delivering it – is capturing. In terms
of Porter’s popular five-forces model (1980, 1985), we could characterise it as the
proportion of whatever value has been created that the airline is able to appropriate
for itself given the bargaining power of customers and suppliers (including suppliers
of labour), the intensity of competitive rivalry, and inroads being made by substitutes
and new entrants. The effect of a fare war, for example, would be to put downward
pressure on P and result in reduced profit (lower, or perhaps even negative, P-C) and
increased consumer surplus (higher B-P).
In practice, what has been happening in the post-deregulation era is that because
widening choice has added to customers’ benefits at the same time that increased
competition and greater fare transparency have placed general downward pressure on
prices, consumer surplus has been growing. According to Kahn (2004), the inability of
airlines to equate the prices they charge to each customer’s willingness to pay has been
benefiting US consumers by more than $20 billion a year.
What airlines are, in principle, doing in the marketplace is trying to win business by
manipulating service–price offers – that is, by managing gross benefits, non-monetary
costs, and price. This is not an academic exercise. It is a response to the fundamental
question that every manager with strategic responsibility needs to answer before anything
else is tackled: Why should customers buy my product rather than a competitor’s? Box 1.1
illustrates the point.
If we look at just the low-fare segment of the US industry, there are some very clear
distinctions between value propositions that have been offered. The first generation of
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STRAIGHT AND LEVEL: PRACTICAL AIRLINE ECONOMICS
Box 1.1: Southwest and Mid west – Dif fer ent Types of
Customer Value
When demand evaporated from low-fare carriers in the US domestic market during the
summer of 1996 after a fatal accident involving one of their number, this was because the
core benefit they were perceived to be delivering in respect of safety was being reassessed
by customers. Despite the low prices they continued to offer, the value propositions put
forward by these carriers (with the exception of long-established and highly regarded
Southwest) had been unbalanced by changed consumer perceptions in respect of that key
service attribute. Not even the most price-sensitive end of the US domestic market, it seems,
is driven entirely by price; customer-perceived value is driven by both sides of the service–
price offer, rather than by price alone. Customers may well buy into tight seat pitches and an
absence of frills, but this does not mean that those service attributes that are in fact offered
will necessarily be acceptable irrespective of quality; safety is perhaps the attribute which
most strongly demonstrates this fact.
It is missing the point to assume that, say, Southwest sells on price alone. Southwest sells
on value for money – on the right service–price offer. It has targeted customers who prefer
not to pay as much as other carriers want them to pay, and it gives them good value. Many
of the ‘hard’ service attributes offered by competing airlines until most pared-back their
products after 9/11, such as meals and other amenities, have not traditionally been a feature
of Southwest’s value proposition; value has been embodied instead in emotional benefits
derived from using the brand (e.g., the corporate ethos of ‘fun’) and from a culture supporting
consistent standards of personal service, as well as in high frequencies, punctuality, and
everyday low prices.
Copyright © 2008. Taylor & Francis Group. All rights reserved.
Whenever two competitors match each other’s prices, consumers need to be given a reason
to buy from one rather than the other. Observers who talk about the ‘commoditisation’ of the
industry, because so many consumers are price-sensitive, and who dismiss branding as an
irrelevant luxury miss this point. Southwest, on the other hand, proves it: low costs and strong
branding are not incompatible, and together they help provide value that competitors cannot
match as readily as they can match prices.
With the hallmark chocolate chip cookies and 2