The airline industry has become well known for seemingly being unable to sustain profits. This is of course not true for all airlines. However, the general trend toward unsustainable profitability appears to be fairly consistent across the industry.
While there are pressures and external market factors, we believe this trend is largely self-inflicted by the industry as a whole across the value chain and by airlines themselves.
Overall yield trends
Airlines have faced tremendous challenges with factor input costs, particularly with the cost of fuel rising significantly. To face these challenges, they have made tremendous improvements to lower operating costs – often driving down labour costs, enhancing asset utilization, and removing product elements to reduce the cost of producing and delivering the product and service. Airlines are now more cost competitive than at any time in history breaking even with oil prices above $100 when less than a decade ago they struggled with oil at $30. Why does the industry continue to struggle?
The key problem is that the majority of airlines have also experienced tremendous dilution in unit revenue which is unprecedented when compared to most other sectors. Such dilution in average unit revenue usually only occurs due to a disruptive product offer. Some may argue that air travel has not been supplemented by any disruptive alternative. One cannot “beam” oneself through the air; teleconferencing and telecommuting have not eliminated the need for air travel. Some others may suggest air travel has indeed seen a disruption through the introduction of the no-frills airline (mistakenly called the low cost carrier or LCC).
In reality, demand for air travel has grown steadily, excluding temporary shocks such as 9/11, SARS and the 2008 global financial crisis. While no frills carriers have gained significant popularity, they have largely expanded the size of the market by introducing a product serving a new market segment. By offering a very basic “seat” only product, these no-frills carriers operate at lower costs and bring air travel to a new segment of the market. They certainly cannibalized some existing passenger traffic from full service carriers (mistakenly also often called legacy carriers since there are new full service carriers as well), however, their main impact has been to stimulate the market by bringing air travel to a segment of the population which previously could not afford to travel, or to travel as often.
Where it all unraveled
Existing airlines have mistakenly considered this a significant threat to their core businesses. Struggling to compete effectively with each other and feeling threatened by lower units costs of these start-up airlines, legacy carriers assumed no-frills carriers would dramatically take awake market share. This was natural and airlines certainly were inefficient. The full service airlines chased after those large volumes of low yielding passengers, seeking market share in ever-growing low yield segments. However, as average revenues fell (simple mathematics), the share of fixed costs per passenger rose as a result thus creating the situation of perennial profit pressure.
Rather than focusing on the product, understanding different customer segments and choosing their position in the market, as is done in most other industries, airlines have sought to be “all things to all people.”
Such full service carriers turned to lower costs in order to strengthen margins. The largest contributor to sticky or fixed costs was labour and management sought to lower staffing costs first since addressing other fixed costs related to aircraft and maintenance were more sticky. This led to unrest and higher initial costs, forming the foundation of unrelenting poor industrial relations which continue to haunt the industry for the past few decades.
Add to this sustained higher fuel costs – which have now overtaken to become the higher factor input cost for airlines – and the industry, as recently as a decade ago, seemed doomed.
Lowering production costs
The supply chain has done its best to help airlines be more profitable. Seat manufacturers have lowered seat weights, electronics suppliers have introduced more light-weight in-flight entertainment systems, engine manufacturers have produced more light-weight and fuel-efficient engines and airframe manufacturers have done their part to finally usher in plastic airplanes, dramatically lowering weights while strengthening aircraft structures. And the leasing industry has grown tremendously to help unburden airlines from hefty capital expenditure.
Airlines have done their part to better forecast what they need to carry on board; removing weight in unnecessary magazines, food and duty free; removing lavatories, closets, cutlery; and even reducing the number of flight attendants on board (which saves both fuel and staffing costs).
Over the past two decades the industry has become enamored with chasing lowest CASM or CASK (cost per available seat mile or kilometer). It is a measure of unit production cost.
Trimming the fat has been effective, but in parallel, airlines and aircraft manufacturers have convinced themselves that in order to be more competitive, airlines need to lower their unit costs by operating larger aircraft with more seats, thus spreading the cost of flying an airplane over more passengers. US carriers have been down this road before and found it to be a fool’s errand. They learned this only leads to lower cost “per seat”, not “per passenger” as the latter requires significant growth in passengers carried. Now the rest of the world seems to make the same mistakes.
The chase to lower yields
In theory lowering unit costs seems a natural and necessary step; one which has been long overdue. But airlines have largely ignored the economics associated with elasticity of demand. Deploying larger aircraft did lower unit costs. However, to attract the additional traffic volume needed to fill those extra seats, airlines have diluted unit revenue, or yield, even more; generally at a rate higher than improvements in unit costs. Thus comes the never-ending cycle of fighting to lower unit costs not because the market demands it, but because previous decisions have led to an excess of capacity on an individual flight level – something which is not easily remedied. This excess supply which leads to a need to lower yields and thus the cycle continues.
Full service airlines have lowered yields to unsustainable levels and have stripped down their product and service experience to levels which no longer differentiate them from no-frills carriers. While the price differential between no-frills and full service carriers has shrunk, many of these “new” carriers have turned to enhancing their product mix; a sign that what many customers want is not a pure-LCC, but they are turned off by poor treatment from mainline carriers. This has led to the hybridization of most no frills carriers, save the likes of Ryanair and Spirit which stayed on course. Jetblue, WestJet, Virgin Australia, germanwings and air Berlin have abandoned the path of true no frills carriers. Virgin Australia has gone full service taking the fight straight on to underperforming Qantas. There remains little difference between a well executed a la carte pricing model at a full service carrier and the others named above. Jetblue’s continued move upmarket highlights the need to raise product standards to meet market demand and to deal with rising costs as the airline starts to be burdened by the same issues affecting other long-running airlines.
The way forward
Airlines need to desperately understand the profit equation.
Airlines need to get better at marketing. Not advertising, branding, messaging, etc, but real marketing. The kind which starts with understanding one’s customer. Understanding the competitive product landscape and understanding how the airline can compete. Marketing is too often seen as just “the soft and shiny stuff.” True marketing is based on hard analytics.
Airlines need to carve out their position in the market. Ryanair is not for everyone, but what makes Ryanair a fierce competitor is they have a clear understanding of which segment of the market they’re after. They go after it with ruthless conviction. If passengers in other segments want to fly with Ryanair they’re welcome to. It just increases the price elasticity.
Airlines need to stop trying to be all things to all people. The product and service experience which can be profitably delivered at a fare of $20, 20€ or 100¥ is very basic. Alternatively, the market which demands more product and service attributes such as lounges, mileage, more space, and other comforts is willing to pay more.
Airlines need to contract before they can grow. Since many of the larger full service airlines have tried to fight the LCCs by adding capacity to lower units costs, these same airlines need to now contract capacity. Not because that is the starting point, but because market analysis will show them that some customers are willing to pay more and the airline can be profitable at those levels, but with a better product and thus higher pricing, the airline will lose volume and so capacity should be reduced in anticipation. Delta has done this very well and following the merger, new United is following this strategy as well.
Without a significant change in the way of thinking, the industry is doomed to continue damaging itself and destroying billions of dollars/pounds/euros, etc. in shareholder value along the way.