Southwest Airlines: Operational Efficiency Analysis

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Table of Contents

Introduction
Business Problem and Critical Issues
Parameters for Analysis
Action Recommendation
Conclusion
References

Introduction

Southwest Airlines has been a strong growth organization over the 40 years and has been a pacesetter in the US airline industry. Using its low fares, fun-loving culture, friendly service, on-time flights, point-to-point operational strategy, the airline has been able to maintain profits and a record growth rate through the years while other airline companies run out of business and file bankruptcy due to depressed market conditions.

Southwest begun offering hauls between Dallas, San Antonio and Houston, and it has diversified its markets and now carry more passengers than any other American air company (about 90 million during 2010) and lately announced the buyout of AirTran Airways for $1.4 billion.

The airline now has a market capitalization of over US$ 14 billion and is placed as one of the strongest airlines in the ailing air transport business (Bamber, Gittell, Kochan & von Nordenflytch 2009).

The entire airline industry appears to be on the mends after enduring expensive labor contracts, soaring fuel costs and reduced consumer demand. However, Southwest has experienced growth in the harsh airline industry because it’s no frills business model focuses on controlling costs.

Southwest targets routes with high customer demand and the advanced experience of Southwest’s staff allow Southwest to fast turnaround aircraft and keep their planes in the air more hours per day than its rivals.

However, although Southwest is in many ways has been a success story for the U.S. airline industry, Southwest airlines is currently facing stiff challenges that are threating its enviable success. Though these challenges do come as a surprise to the company as they have already been experience actross the airline industry and have brought to knees many of the industry leaders to an extend of bankruptcy.

Business Problem and Critical Issues

The airline industry has been faced by a lot of challenges lately, which have brought big companies to their knees and even others files for bankruptcy to avoid litigations and eventual dissolution. Issues are:

Economic crises

The economic hard times have really hit on the airlines industry, with most consumers reducing on travelling to say holiday destinations, and preferring even cheaper modes of travelling like road for shorter distances.

This has really affected the operations of Southwest airlines as the number of flights per day have decreased significantly, while its costs like employee maintenance and plane maintenance have remained constant or even gone up (Rob 1997).

However, this might not seem as a great challenge for Southwest as its well know for its low-cost flights and at a time when customers are cutting on their transportation costs, the airline comes in handy and is expected to reap from the hard times.

Increase in fuel costs, shift in fuel hedging contracts

The high cost of fuel is conceivably the most apparent challenge facing the airline industry currently, with many imposing fuel surcharges on customers. The high costs are a factor for most industries, but fuel is a particularly important factor for airlines.

Fuel represents 25% to 40% of the airlines operating expenses and experts approximate that a $1 per barrel price increase in fuel costs the airline industry US$175 million annually.

With the price per barrel hanging in the high US$ 60 plus mark (the price moved above US$ 50 at the end of February 2005), airline companies are feeling the heat on their bottom-line.

This is so evident that each time crude prices go up, airline stock prices dwindle down because of the knee-jerk reaction from the airline industry investors (Terry 2007).

For the Southwest airlines most of its fund hedge contracts were running until 2010, and now the company had to sign new hedging contracts. Given the uncertainty of the oil industry the company is forced to sign expensive contracts with are rather not in tandem with its cost cutting austerities.

For 2012, ticket prices are expected to jump about 15% and this is a major challenge to Southwest as it aims to provide cheap transport options with effective travel packages.

Increase in maintenance costs

With the cost of almost everything in the global markets going up, every aspect of the airline industry has gone up. Maintenance costs have soared up as the cost of labor and materials have almost doubled up over the last decades. The maintenance engineers are demanding new pay packages

One of the move Southwest airlines has taken to reduce the maintenance costs it to have its maintenance done at overseas facilities, which are rather cheaper considering the extensive overhaul needed for airplanes on a time-to-time basis.

However, American maintenance workers are far more efficient doing the maintenance, but they are very expensive and demand as much as three fold what others demand in the global market (Rugman, Oh & Lim 2012).

The increase in maintenance prices may make its way down to the consumers, thus Southwest may be forced to increase its prices to remain profitable though this might hurt its business models of cheap transport means.

Demand by employees, pilots for more pay

Southwest airline’s mainly unionized employees have been pushing for pay increases to equal the rich contracts negotiated by other airlines.

Currently, Southwest offers a first-year minimum pay of US$ $49,572 for its pilots, considering that the company normally recruits more experienced pilots than other airline companies. Though as of 2010, it was ranked the best paying airline company its pilots are demanding for an increase in their pay.

Parameters for Analysis

Porter’s Five Forces

According to Porter, the success of Southwest’s strategy is due partly to its consistency and integration and the unity that ties everything together. Instead of the classic hub-and-spoke system used by most major carriers, Southwest applies a point-to-point strategy which allows it to pick the most profitable routes to ply.

The airline provides service to 61 airports in 31 states with its fleet of over 500 Boeing 737s. In terms of annual revenue and available seat-miles (ASM) Southwest outdoes many of the legacy carriers and is ranked as one of the largest American carriers.

Nevertheless, Southwest is also categorized as a regional or discount carriers due to its point-to-point operational system and discount services.

Internal Rivalry

The airline industry is typified by several carriers who have very little differentiation in their product. Thus, due to these factors and the current market conditions, the airline industry is in a vulnerable situation.

Over the recent times, four major airlines filed bankruptcy; Delta Airlines Inc, Northwest Airlines Corp., United Airlines and ATA Airlines. The partial differentiation of the products of most major airline companies together with the rising demand elasticity has seen the airline industry use price competition as its major way of rivalry.

This unhealthy price competition has eroded profits as the price-cost margins have reduced tremendously.

Southwest came into the market with its niche as discount airlines. Southwest Airlines is in a unique situation since it is one of the principal driving forces in the current price competition. Presently, Southwest has the lowest cost per available seat mile (CASM) of the major airlines and this makes the company control prices to maintain its profitability level.

Nevertheless, Southwest Airlines cost per available seat mile has been gradually increasing due to increased labor costs and a decreasing fuel hedge.

Though Southwest could be facing challenges, Southwest is expected to have a competitive advantage over other airlines even discount airlines as they are trimming their margins and thus have the potential of a lower cost per available seat mile.

Entry

The airline industry is a highly centralized industry with the top ten players taking more than 90% of total American air traffic as of 2004.

In spite of the consolidation of industry and the depleting earnings of most major carriers, many new players are attempting to venture into the airline industry in past years, for example Jetblue which came into the market in 2000 and has registered positive margins.

However, entry into the industry is rather difficult considering the stiff barriers in the industry.

The big financial liabilities experienced by many major carriers in recently and the decreasing customer demand that has been experienced resulting in the tightening of the capital markets for the financing of start-ups.

However, industry analysts predict that there could be a significant change in both industry demand and profitability that could match with increased access to capital markets for new ventures and thus create an incentive for new entrants (Raynor, 2011).

The distinctive approach of new entrants could be to pursue regional markets that have more profitable routes and offer lower prices that the existing airlines given their low marginal costs since they have lower labor and maintenance cost.

Substitutes and Complements

Airlines compete with other forms of transport. The primary substitute for the airline industry is the automobile. The integrated inter-state highway system in America makes it possible to go almost anyplace by car.

Road travel leads short distance travel because of the unrealistic nature of flying such short distance, though as distance needed to travel lengthens usage of carriers considerably increases and vice versa.

In 2010, only 13% of road trips were longer than 1000 miles, comparing to 75% of airline trips. Also rail transport is another substitute to the air transport.

These regional forms of transportation don’t correspond to a direct substitute for the air transport but they may be a competitive advantage that regional carriers have to consider.

That why Southwest Airlines operates a point-to-point destination schedule between regional cities that may also be connected by considerable bus or railroad traffic.

Increased lag times at many airports as a result of increased security checks means the time advantage gained by using air travel has diminished. Thus, the marginal benefit of using air carriers for transport has decreased and the use of train or automobile may become more viable options.

Supplier Power

The airline industry is susceptible to supplier power through three principal inputs; jet fuel, airframes and labor. However, jet fuel suppliers have the strongest supplier power.

Jet fuel prices may not perfectly correlate with oil prices but since 2005 when the historical price level of oil reached US$ 70.85, the effects have got worse for the airline industry.

Like the rest of the airline industry, Southwest Airlines has been facing dwindling margins due to increasing fuel costs, especially now that the company has got into new fuel hedging contracts after its contracts expired in 2009.

Southwest now utilizes dynamic hedging strategies that allow it to apply hedging to control the episodic nature of jet fuel prices by countering anticipated higher prices in the future.

Southwest currently has an advanced hedging program that is continually trying to determine future cash flows relating to jet fuel prices to optimize their hedges.

Buyer Power

Consumers recently have a significant buyer power over the airline industry. The economic crisis and terrorist threats have had a considerable effect on consumer demand. From their high in 2000, revenue passenger-miles (RPM) have decreased significantly and though they have rallied lately they remain at a low level.

The industry has attempted to reduce available seat-miles to react to reduced RPM but the reaction hasn’t been sufficient thus there is a lower load factors.

Carriers excess capacity and the perishable nature of plane seats have made customers to put a lot of pressure on the price of airline tickets. The demand for airline services is highly demand elastic and consumers react fast.

Southwest was the first airline to offer online reservations as a way of reducing costs (this saves the company over $40 million annually) and the commissions paid to travel agents.

Southwest does not offer joint travel website like most carriers do as the management argues that their competitors will gain competitive advantage over it and work negatively on its brand loyalty.

Action Recommendation

Southwest has suffered considerable criticism from the investment world because of its increasing CASM. Other new regional entrants airlines have entered the market in the attempt to challenge Southwest’s dominant position. As CASM increases, Southwest becomes more susceptible and appears to be losing its most important market advantage.

Southwest needs to counter increasing fuel costs with improved non-fuel cost management and fuel hedging strategy. The non-fuel costs Southwest needs to focus on are maintenance and labor.

Many of the other operational costs will be harder to control but with its current market position, Southwest can take steps now to ensure that it retains its low cost advantage.

Over 40 percent of Southwest’s total CASM is due to salaries, wages and benefits for a labor force that is over 80 percent unionized. Many of these unions’ contracts will become amendable during the next several years.

The outcome of these agreement negotiations, especially the pilots’ union, will have a considerable effect impact on the carrier future cost structure. The airline is currently in a strong financial position but it must take into account the dramatic reduction in labor costs that are occurring throughout the rest of the industry.

Also Southwest’s traditional strategy for growth may not continue to work in the future due to its hub airport strategy of the legacy airlines. Southwest traditionally selects only highly profitable city pair routes on which they can establish a strong market share through low prices and high load factors.

However, Southwest has already entered many of the most profitable markets. Growth opportunities still exist for Southwest in expanding operations in cities already serviced.

It is recommended that Southwest enter new cities especially those that have been serving as hubs for weakened legacy airlines. Also Southwest should to expand by opening service to international destinations using their current operational strategy (Owen, 1999).

Also the company should continue to successfully hedge fuel prices and Improve employee-management relations to avoid disruptive contract negotiations.

Conclusion

Through consistent focus on operational efficiency and cost control, progressive human resources management, upbeat marketing, service to understand markets, and a dedication to quality at every level, Southwest Airlines is poised to remain profitable and dynamic.

References

Bamber, G.J., Gittell, J.H., Kochan, T.A. & von Nordenflytch, A., (2009). Up in the Air: How Airlines Can Improve Performance by Engaging their Employees. Ithaca: Cornell University Press.

Owen, B., (February 22, 1999). Southwest’S Now In A New York State Of Mind | Nuts About Southwest. Blogsouthwest.com.

Raynor, M. E., (2011). Disruptive innovation: the Southwest Airlines case revisited. Strategy & Leadership 39, no. 4, 31-34.

Rob K, (February 21, 1997). Southwest may add cities to Iceland deal. Baltimore Business Journal, 56-89.

Rugman, A. M., Oh, Chang H. & Lim, D., (2012). The regional and global competitiveness of multinational firms. Journal of the Academy of Marketing Science, 40, no. 2, 218-235.

Terry, R. J. (December 10, 2007). Icelandair stopping flights out of BWI. Web.

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