OVERVIEW OF THE CASE In 2002 Delta airlines faced the unfortunate realization that the competition from low cost carriers like Southwest and JetBlue was becoming a serious problem. Even though Delta had been looking at this problem for a long period of time, the business model of Delta Airlines was organized by function and their solutions generally focused on individual aspects of the firm. For example, the marketing department provided marketing ideas, the customer service department offered customer related solutions etc.
Delta realized that they did not have a comprehensive solution to dealing with the low cost carriers in the market. One of the simplest solutions proposed by Delta management was the idea that Delta could launch its own low cost subsidiary, however, looking at the rest of the airline industry, low cost subsidiaries seemed to be ideas that were either immediate failures or unsustainable over time. According to experts, they had “never seen a high-cost carrier transform itself into a low cost carrier”. With or without this option, Delta would have to find a solution to this problem.
The airline industry in the United States is immense, with more than 620 million passengers and over $81 billion in fares in 2001 alone. Unfortunately, while immense in size, in terms of profit, the airline industry continued to perform below the average for other industries. Many investments made by the larger carriers were not profitable and the tragedy of 9/11 put more pressure on this already struggling industry. For nearly 40 years, the US airline industry had operated within strict and specific operating rules under the Civil Aeronautics Board (CAB).
The CAB determined and assigned routes for each carrier, which were typically a mixture of lucrative and moderately profitable routes. CAB also controlled fares, and dealt with airline labor unions. Salaries and benefits were fair, and income within the airline industry was supplemented by strict work rules that reduced labor flexibility. The airline industry was encouraged to improve service offerings – such as meals and inflight movies, greater capacity and more flexible flight times. As a result of these regulations, the major carriers faced high operating costs and excess capacity.
Consequently, they started to charge prices that were approximately twice as high as their unregulated counterparts (i. e. the low cost carriers) for similar flights. When it was realized that the regulations were inefficient and putting pressure on the industry, the Airline Deregulation Act of 1978 was signed, and by 1980, the low cost airlines had become a major threat to the major carriers. Following deregulation, the average airline companies profits depended on the fraction of its flown seats that were occupied by its paying customers (also known as the “load factor”).
Costs were generally measured by the cost per available seat mile (CASM) – which reflected the cost to fly one seat, occupied or empty, for one mile. The returns or yield calculated by dividing total passenger revenues by the number of revenue passenger miles (RPMs). Daily utilization, depended on how quickly an airline could turn its aircraft and prepare them for takeoff and Southeast airlines was the leader in that area with a 27 minute turn time.
Also, since most cost items did not generally depend on the flight’s length, cost per available seat mile were low for airlines that flew long distances. As a consequence of these factors, most major airline companies developed a system to ensure high load factors. They shifter operations to hub-and-spoke models, where flights on small planes from lightly traveled cities (called “spokes”) would feed passengers into “hubs” in major cities and eventually take them to the desired destinations. This system enabled major airlines to achieve high load factors, and therefore, higher profits.
By the year 2002, most of the major airlines had shifted to this business model. As far as competition was concerned, on routes shorter than 600 miles, the airlines industry had competition from automobiles, buses and railroads, and for routes longer that that – the competition was strictly internal. The industry as a whole was classified into three groups based on revenue – major meant over $1 billion in revenues, national meant between $100 million to $1 billion and regional referred to the companies that earned less than $100 million.
In 2002, there were only ten major carriers within the United States and they were Alaska, America West, American, American Trans Air, Continental, Delta, Northwest, Southwest, United and US Airways. While there were a variety of customers, the primary factor behind choosing a carrier was ticket price. Emphasis on lower prices had forced the industry to offer reduced fares by nearly 45% at that time, and the idea of raising prices was considered impossible.
However, in addition to prices, passengers also decided on airlines based on safety, reliability and convenience, as well as service quality, amenities, entertainment, food etc. The airline industry tried to ensure customer loyalty by offering uniquely tailored frequent flyer programs, different cultures, and other incentives. While that airline industry was taking measures to differentiate itself from one another, the widespread use of the internet and online travel services allowed customers to quickly and easily compare fares, ratings, and read reviews of airlines before making decisions.
In order to maximize their returns, the airline companies developed different tools for “yield management” such as charging high fares for tickets with travel flexibility, or for flights booked at the last minute or for convenient flight schedules (e. g. higher prices if a customer wanted to spend a weekend at home and still get to their destination on time). While these measures ensured higher returns, they also angered customers, particularly business travelers, who felt that they were being taken advantage of and that they were not getting the lowest possible prices.
Additionally, the internet and online travel sites such as expedia and yahoo travel were making airline pricing more transparent to customers. The rapid growth and popularity of these online services placed increasing pressure on airlines to offer the cheapest possible fares to customers. For the typical major airline, employee salaries and benefits were the largest expense that represented almost 40% of total operating costs. Salary structures were decided in collaboration with labor unions, who also negotiated work rules.
Most employees were paid on a sliding scale based on seniority and hours worked, except for pilots (paid for type of aircraft flown, flying time, crew position and tenure). Salaries were supplemented by benefits and also profit sharing and stock option packages. Other costs that the airline industry incurred represented fuel (10% – 15%), airline services (15% – 20%) such as insurance, sales and marketing, commissions to travel agents etc. , and aircraft and facility rentals (15%). In this last category, which included food, the costs varied widely across the industry as some airlines provided full meals while others only provided snacks.
The events of 9/11 were realized throughout the airline industry almost instantaneously while immediate losses of over $650 million. Subsequent government regulations added numerous additional costs to an already burdened industry, from the installation of bulletproof cockpit doors to a completely new airport security tax. Insurance costs for airlines also went up significantly. Combined with the drop in passenger demand, revenues within the industry started to drop, and this decline was only accelerated by the recession that followed.
When it was obvious that many of the airline companies would not be able to survive, the government passed the Air Transportation Safety and System Stabilization Act, which tried to compensate airlines for losses incurred due to recent events. The act provided $5 billion in cash grants and $10 billion in loans. However, despite this influx of government money, carriers such as US Airways, United, and American Airlines laid off over 80,000 employees, and the industry as a whole reported an operating loss of more than $10 billion dollars in 2001 with even larger losses in 2002.
Out of all the carriers in the market, during this time the only carriers that generated profits were the low cost carriers Southwest, JetBlue and AirTran. Southwest Airlines was founded to initially provide intrastate service within the state of Texas, but after deregulation the company expanded its service to include Southwest United States and California, and then moved on to include to East Coast. Southwest set its prices very low to compete with other carriers, and maintained high load factors. When other companies tried to imitate Southwest, they had little success.
Many LCCs either attempted to expand too quickly, made poor decisions regarding route selections or confronted fierce competition from other airlines. Southwest was the market leader for the aforementioned reasons. Jetblue was the most highly capitalized start up in the history of the airline industry with $130 million in venture capital funding. This money enabled JetBlue to buy a fleet of jets instead of lease them. The company owned 23 aircraft by 2002 and was due to acquire 11 more by the end of that year.
The fleet offered services primarily from NYC to Florida to California, and focused on airports that were less used but not entirely unused. JetBlue interacted with its customers primarily over the internet (more than 60% of tickets were sold online), and maintained simple, straight forward fare structures. Through live TV LLC, JetBlue offered 24 channels of in-flight entertainment while only adding only one dollar to cost of each ticket. They did not serve meals and allowed employees to work with very few work rules, creating a flexible, easygoing, and pleasant environment for employees and customers/passengers alike.
JetBlue also declared itself the world’s first paperless airline, where each pilot carried a laptop with operations manuals and software for flight planning. This reduced their lead times significantly and allowed them to remain profitable throughout. JetBlue was considered by experts to be the “biggest treat to industry price stability since Southwest” airlines. Major carriers started to create low cost subsidiaries following the treats by Southwest and JetBlue. These legacy carriers such as Continental airlines attempted to combat the LCC threat by scheduling passengers on a mix of cheap and mainline flights.
But the results were different from what they expected, with passengers becoming confused. It also caused passengers to go entire days without meals, for example because CALites served only snacks while mainline flights served meals. The CALite enterprise was shut down within 2 years of operations after they reported hundreds of millions in losses. Continental airlines was forced to discontinue many of its routes as a result of this failure. Despite the failure of Continental, many of the other airline companies still attempted to launch low cost subsidiaries such as “Shuttle” and “MetroJet” by United airlines and failed with both.
By 2002, virtually all low cost subsidiaries of the major airlines were shuttered. Subsidiaries did not work because they were not truly low cost, instead, the parent’s financials hid their true expenses and they ultimately resulted in nothing but losses for the company. Delta represented the world’s largest privately owned fleet of aircraft and operated primarily within the Southeast United States until its merger with Northeast Airlines, which allowed it to provide flights from NYC to New England to Florida. After another merger, this time with Western Airlines, Delta became the third largest domestic carrier within the United States.
Delta ultimately became a global player in the industry through its acquisitions of transatlantic routes from Pan AM. In 2002, Delta was still the third largest, but not just within the US, the ranking was global. Even after deregulation, Delta was the most profitable out of the three legacy carriers (American, United & Delta), and managed to avoid major losses in the wake of the 9/11 events. Delta’s organizational structure comprised of over 75,000 employees and the pilots were the only group that was unionized.
Compensation and benefits at the company were near the top of the industry, and flexible work rules existed for all employees. Despite its many organizational advantages, by 2002 Delta faced threats from three directions – mainline hub-and-spoke carriers were offering lower fares than Delta; Regional airlines were reducing Delta’s traffic in midsized markets; and LCC’s had made significant inroads into Delta’s Florida market (which accounted for 30% of Delta’s revenues). The company proposed the following three strategies for dealing with the threats – i.
Systematic cost cutting within Delta mainline services to combat the hub-and-spoke competition ii. Using Delta’s industry-leading position in regional jets to defend its market share in midsized markets iii. Creating a low cost subsidiary named Delta Express to combat the LCCs such as Southwest. Delta Express and Southeast both entered the Florida market in the same year and offered the same services, but in different ways. Delta express flights were distinguished by separate gates, with the flight attendants dressed in casual attire, and with specially painted aircraft.
While there were price cuts and concessions within Delta Express, all decisions concerning routing, flight frequency and pricing were made by the parent company and maintenance, pilots, flight attendants and ground services were shared by the parent and the subsidiary. While Delta Express was initially successful, its profitability had declined significantly by 2002. At that time, Delta negotiated with all of its pilots, mainline and Express to make the differences between the two enterprises more uniform, it had to compete with Southeast and JetBlue at the same time.
Despite these challenges, Delta Express was the only low fare subsidiary to survive in the industry after 9/11, and continues to operate within capacity to this day. FINDINGS 1. Problem with Supply Chain of Delta Airlines: The main problems with supply chain management between Delta Airlines and the LCCs involved the following issues – Leasing vs. buying aircrafts – Low cost carriers (LCCs) such as JetBlue purchased their fleet instead of leasing them. This integration allowed them to reduce costs greatly in terms of supply chain management.
The larger carriers preferred to lease aircraft in lieu of the idea that they would be able to get favorable contracts, reduce complexity and simply the maintenance process. , others preferred to diversify their fleets to avoid the leverage a single supplier might enjoy. Additionally, other sources of aircrafts were leasing or the used plane markets. Major airlines rented 55% of their fleet because of comparatively lower leasing rates. The fuel costs of airlines were very high and represented a significant portion of cost which was roughly around 15%.
The Airlines engaged in several activities to hedge fuel costs such as get into long term contracts with the suppliers or go for commodity trading, etc. Unfortunately, after 9/11, the economic downturn put pressure on the suppliers as well, and the cost of supply chain management went up largely for the major airlines compared to the LCCs, who either owned their own fleet or maintained smaller, cheaper aircraft and avoided higher costs. 2. Challenges in providing better service: Although the end product is same for each airline industry, the services which added the value differed from airlines to airlines.
Beyond price, the factors that affected purchasing decisions of passengers were safety, reliability, convenience, service quality, entertainment, etc. Because of online reservation system and ticketing of airlines, passengers could compare prices and take more careful and flexible flight schedules. LLCs made greater efforts to provide better services than legacy carriers. Not only did they offer lower ticket prices than legacy carries, it also provided attractive services to gain consumers, such as -Live TV, Airplane yoga etc. If the flight length was short, then being a low cost flight, consumers did not expect a high value meal.
Hence LCCs enjoyed advantage over legacy carriers where due to longer flight hours, airlines had to supply competitive meals and other frills to stay in the business. Another point to note is that while the larger aircrafts struggled to provide services, the LCCs subsidized theirs using smart strategies – e. g. Southwest airlines signed an agreement with live TV to broadcast their channels in return for advertising. This provided adequate entertainment to their customers while only adding $1 dollar to the cost of each passenger. . Threats from competitors: The airline industry was highly competitive. The increasing number of low cost airlines like Southwest, JetBlue, etc, increased the competition for Delta. Rivalry also existed between LLC and Legacy carriers and the airlines strived for ways to reduce internal competition. To remain competitive in the market, several legacy airlines responded to the LCC threat by establishing low-cost subsidiaries of their own. For example-CALite introduced low-cost subsidiaries though that shut down within two years.
The bars were raised for Delta when Southwest successfully established itself as a low-cost model which few could imitate and JetBlue ruled in in-flight entertainments. JetBlue also introduced flexibility in its working system for its employees like flexible or online working policies which threatened the boastful productivity advantage of Delta. Though Delta responded immediately to the threat of emerging LCCs by introducing Delta Expresses and reached its success initially, the profitability eventually subdued due to this rising pressures until this could no longer be treated as ‘low cost’ carriers. . Drawbacks of the Airline Industry of USA The USA Airline Industry was a highly regulated industry till 1978, huge in size but not very profitable. For 40 years the industry had operated with predetermined set of operating rules enforced by Civil Aeronautics Board (CAB). CAB decided the fare prices and designed the routes the airlines could fly in. The airlines were protected by cost-plus pricings with the pass bearing all the cost hikes but the operating cost was very high, with 40% of the total cost expended for salaries and benefits of the employees.
The industry was highly unionized and thus the companies were forced to compel to the labour demands. Usually there were unutilized capacities and that allowed the airlines to gain a minimum but reasonable profit from the operations. The Airline companies mostly competed each other for their service, offerings like food, movie, etc. After the deregulation in 1978, the competition increased and the companies reduced their fares dramatically to gain profitability. The companies strived to increase their load.
The daily utilization increased but the fixed nature of many of the costs like expensive labour and high fixed costs and the profitability disparity between the long distance flights from the short distance flights led the companies adopt a “hub-and-spoke” system. “Spokes” or small planes were used for flights in lightly traveled cities which carried the passengers to major cities and eventually route them to their destinations by larger aircrafts or hubs. The system enabled major airlines to achieve high load and enjoy market power in the hubs or major cities where they dominated.
From the statistics of Industry Performance given in the case, we can see that the operating revenue increased from $22. 9 billion to $ 130. 8 billion in 2000 with operating profit rising from $1. 4 billion to $ 7 billion in respective years. The yield or the revenue per passenger increased almost two-fold and the load factor or occupied seats increased from 61. 5% to 72. 4% respectively. 5. Challenges of technological advancement and high cost Earlier, starting from 1953, technology like computer system was mainly used for automated customer reservation.
The air fares were adjustable, charging different fares to different customers on the same flight to attract passengers. The airline companies took advantage of price insensitivity of frequent travellers like business persons and charged high price for travel flexibility, late reservations and for trips that did not include Saturday nights. The companies deployed their flights to profitable routes only and responded quickly to competitor prices. But after the deregulation from 1980s computer system became a powerful tool in the industry.
The development of technology changed the way the tickets were sold and made airline pricing transparent to customers. Because of internet, there was an evolvement of travel websites and customer had easier access to information about different airlines and their offerings. Customers could now compare the prices and services of the companies and made careful choices which increased rivalry pressure on airlines to offer best fares possible. The costs of the airlines was mainly measured by cost per available seat mile (CASM) i. e. the cost required to fly one seat, occupied or empty, for one mile.
The marginal cost incurred by adding an additional flight was high because of the fixed nature of the costs involved so CASM was sensitive to the flight distance and the service hours involved. CASMs were lower for airlines that flew long distance than it was for short distance flights. From the New York average fare comparisons of 2002 we can see that Delta offered the highest fares on routes to Atlanta, charging more than the industry average price but had price advantage on routes to Orlando, Palm Beach, Fort Lauderable and Tampa. 6. Other problems
The components of cost were divisible in terms of percentage of costs. Employee salaries and benefits were the largest expense for typical major airlines representing 40% of the total earnings. Roughly 10-15% of total cost was spent on fuels but that varied with the age and the type of aircraft and the route distance. 15-20% of total was spent on providing airlines services and included sales and marketing cost, insurance, commissions to travel agents, etc. The situation got worse when in 2001 after the September 9 attack for the cost of insurance and safety measures increased significantly.
Aircraft and facility rental costs represented approximately 15% of total cost. In the southeast sides of USA, Delta has a great demand. The best example of it is, it has made Hartsfield International Airport the busiest Airport in the world. But the problem is, in other parts of USA, the demand is not that strong. In some cases it is over gauged. The low demand into some smaller cities made Delta run their high expense Boeing 757 with a low load factors. RECOMMENDATIONS 1.
Supply chain management – In order to make supply chain more efficient, Delta airlines could consider purchasing its own fleet of airlines for Delta Express. In addition to purchasing its own fleet, they could also try to control lead times by following in the examples of the LCCs. For example, passengers at Southwest airlines board the plane while it is being cleaned by the cleaning crew (since only snacks are offered, only minimum cleaning efforts are required) – this significantly reduces lead times for aircrafts landing and taking-off from the airport, and adds to greater profitability.
Furthermore, Delta could focus on scheduling flights to airports that were less frequently used, and lead times are faster in these airports and while it takes away slightly from customer convenience, if these airports are used as “spokes” instead of “hubs” they will allow the company to generate more revenue by offering more savings. 2. Improving service quality & the challenges of technological advancements – Passenger entertainment is a significant issue to consider when competing in this market.
Like Southwest, Delta could also look for sponsors (e. g. companies like live TV, Google TV, Sirius Satellite Radio) to provide entertainment on board Delta flights in return for advertisements. This would greatly reduce costs and increase the level of service quality at the same time. In flight meals could be substituted with snacks (in abundance), and the internet could be used to not only sell tickets, but also to provide customers with the option to write reviews about their flight experiences, and share their general view points regarding the airline.
While all reviews may not be positive, this measure will allow Delta to appear more transparent and “in touch” with their customers. 3. Competition – The Florida market generates almost 40% of Delta’s profits, and in this market Delta faces stiff competition from Southwest and JetBlue airlines. Delta’s introduction of Delta express is a possible solution to this problem. However, Delta should avoid making the same mistakes that other legacy carriers like Continental have made in the past, and make sure that they do not expand too rapidly, or try to have their losses from Delta Express be absorbed into the parent company.
Delta should also target lesser used airports, and offer flexible, frequent and simple routes for its passengers. Ultimately, the most important recommendation in this area is for Delta to use its leverage as the third largest carrier in the world to offer similar or discounted prices compared to its competitors to gain market share – at least on a temporary basis and to expand its routes to areas that are relatively free from competition. 4. Drawbacks of the airline industry – at one point in time, government regulations were necessary for this growing industry.
However, when it became saturated and competitive, the regulations were deemed inefficient and the airline industry was de-regulated. While this deregulation worked to the advantage of the major and low cost carriers alike, the events of 9/11 compounded many previously ignored became serious issues. The government bailout that was provided for this industry was not sufficient at all, a recommendation in this criteria would be to seek help from the government in terms of providing temporary assistance to the airline companies to help them through the recession.
CONCLUSION Even though Delta Express was not quite the success that Delta airlines expected it to be, it served its purpose. Delta airlines carried Delta out of the depression that the other major carriers faced, and managed to remain profitable even after the events of 9/11. In fact it was the only legacy subsidiary that was profitable at that time. The example of Delta airlines, and the analysis discussed in this research paper demonstrate how a large carrier, can indeed compete with LCCs by offering similar services and making intelligent management decisions.