MBA Case Study Solution: Fundamental Service Issues in the Airline Industry

MBA Case Study Solution: Fundamental Service Issues in the Airline Industry

New Backwards Baggage Policy

This summer, three of the major airlines announced they will be charging for checked bags.  Not for the bags being overweight or for checking additional bags, but they are going to be charging for just checking one bag.  Common sense implies that customers, that are already getting gauged by prices due to higher fuel costs, will do whatever they can to carry the bag on the plane.  This will back-up security lines even more.  It is going to be a mad dash to get onto the plane to get one of the overhead compartments before they are filled.  And If more people are jamming the aisles to fit their over-sized carry-on bag into the overhead, won't this delay the take-off?  Yes!  Now customers are paying more to fly, and the flight is more likely to be a bad experience.  

Changes to the Baggage Policy

The obvious logic in this case states that people are not going to want to pay for a service they did not want.  Why not charge for the convenience of taking a carry-on.  In this poor economy, people will be looking to cut costs, so they will be more likely to check their bag.  This will cut down the security lines, make boarding the planes more relaxed, and cut the time it takes for people to be seated ensuring no delay in take-off from people not being settled.  

But the goal of the airlines was to reduce the weight on the plane to cut fuel costs, so how would not charging checked bags help solve their problem?

  

Reducing the weight limit of the first bag can help the airlines accomplish their goal.  Charging for bags that weigh more than the limit should reduce the size.  Charging even more for a second bag will reduce the overall luggage.  

If they were to follow this logic, airlines will now have less carry-on bags, and revenue from three different areas; carry-on bags, first bags that are over the weight limit and any additional checked bags.

  

If my proposed policy was adopted, those who are adept at barging their way first onto the plane will complain loudly. But the rest of us will take great comfort and joy in knowing that they have to pay extra when they jam the overhead compartments with their over-sized luggage.

Financial Analysis of the US Airline Industry

The U.S. airline industry has been in a chaotic state for a number of years. According to the Air Transport Association, the airline industry trade association, the loss from 1990 through 1994 was about $13 billion, while from 1995 through 2000, the airlines earned about $23 billion and then lost about $35 billion from 2001 through 2005. Early in 2006 the association expected about a $10 billion loss in 2005. However, a few U.S. airlines are able to compete successfully.

Dramatic changes in industry structure have occurred against the backdrop of strongly growing airline activity. Growth in air passenger traffic has outstripped growth in the overall economy. The airline industry is highly responsive to economic cycles. Just as most network, airlines are now expected to turn an operating profit, most lost substantial sums in the last several years; The U.S. airline industry remains in the midst of an historic restructuring. Over the last five years, U.S. network airlines have reduced their annualized mainline costs excluding fuel by more than 25%, or nearly $20 billion.

While some of the cost savings were the product of identifying greater operational efficiencies, most of the savings were generated by renegotiation of existing contractual arrangements with creditors, aircraft lessors, suppliers and airline employees and achieved either through the bankruptcy process itself or under threat of bankruptcy. 22 percent of industry capacity is still operated in bankruptcy – down from a high of 46 percent in 2005 but still substantial by any measure. The result is that several carriers that were on the precipice of liquidation just five years ago now have much lower cost structures that should allow them to return to profitability over the short term.

Economic profile of the Air line industry:  The airline industry has always exhibited cyclicality because travelers' demand is sensitive to the performance of the macro economy yet airlines must predict this demand accurately because of the lead time required to acquire aircraft. When airlines over predict demand, which can happen for any number of reasons, they suffer losses. The main components of demand for airline services are business travelers, tourism, freight transport, and mail transport.

Flight schedules tend to be the crucial competitive issues for business travelers, while tourists and personal travel is much more price sensitive. Freight and mail services account for about 15% of airlines total overall revenue, while international freight and mail is closer to one-third of airlines' international revenue. Airline services enable access to other goods, such as vacations, business meetings, or foreign-sourced products. Thus the demand for airline services is closely linked to the demand for these other goods. Supply of airline industry is influenced by the number of aircrafts, frequency, availability of routes, number of air ports etc. While industry analysts expect continued long term growth in the demand for air travel, airline industry profitability has been volatile. High airline fixed costs, significant operating cost sensitivity to fuel prices, and the sensitivity of international travel to business and political conditions make airline profitability depend significantly on macroeconomic factors.

Economic & structural changes have greater impact on the air line industries. For example, September 11th attack affected the whole economy & the airline industry as well. Demand for airline declined to a greater extent & cost of the industry reached a skyrocket due to an increase in security cost, fuel cost etc. This affected the supply of airline industry.

Ultimately, prices increased making air travel very costlier. Airlines have responded to these financial pressures in a variety of ways: liquidating, seeking government subsidies, improving operating efficiency, privatization, and forming alliances with other airlines. The growth of low cost carriers (LCCs) in the U.S. and elsewhere is arguably the single most important factor currently shaping the airline industry. Low cost carriers (LCC’s) increased their share of the market from 23 percent to 30 percent during this time period, bringing prices down on many origin-destination routes (“city-pairs”) to the benefit of air travel consumers.

The rapid growth of LCCs has commonly been cited as one of the primary causes of the financial crisis currently facing the large hub-and-spoke carriers. More generally, the continued growth of LCCs–and the declining market “dominance” of the large network carriers–represent an unfinished chapter of U.S. airline industry deregulation of 1978. The evolving market structure–and the resulting impact on both fares and service–will depend critically on the direction of the competitive clash between LCCs and the major network carriers. Indeed, the impact of LCCs and the competitive responses they evoke from incumbent network carriers is likely to be the dominant theme in the airline industry for many years to come.

At the same time, the percentage of business travelers willing to pay much higher “walk up” or unrestricted fares has steadily fallen. These trends have been enhanced by the growth of the Internet as a mainstream marketing and distribution channel, creating an environment of nearly perfect price information for both leisure and business travelers, further curtailing the ability of network carriers to charge significantly higher prices to the most time-sensitive passengers.

The influence of the economic cycle on domestic traffic is apparent. The high-risk nature of the airline industry tends to discourage entry. Because airlines have high fixed costs relative to revenues, a small change in load factors or fare levels can have a large impact on profits. The industry is therefore highly vulnerable to an economic slowdown. Besides, the airline industry is one of the most heavily taxed in the U.S., with taxes and fees accounting for approximately 20% of the total fare charged to a customer. Thus higher prices of air tickets become a major problem of the consumers.

Competition in Airline industry:  It is important to examine the substantive effect that mergers and alliances may have on competition in general and on consumers in particular. International alliances may have a somewhat different form than domestic mergers, but may have the same substantive effect on competition and thus appear to merit similar review and oversight. Pricing is highly competitive. Deregulation and increasing competition,  while bringing considerable benefits to consumers, have put additional pressure on airline companies’ profits. Several international markets still have unnecessary constraints on competition including the United Kingdom, China, Japan, and several countries in Latin America – that effectively protect foreign airlines and raise costs for U.S. carriers and consumers. Decentralization & deregulation were the two major insights to boost the competition in the airline industry.

Deregulation of airline industry:  Nowadays almost every US citizens fly and it means that airlines’ fares became available for people because of deregulation of US airlines and positioning them in conditions of free competition or market economics. In general US airline deregulation was a very significant and successful step to the development of commercial airlines.

It means that airlines can develop their own policies and standards; they can add new routes, which expected to be profitable, and remove old routes, which considered unprofitable. Airlines received the opportunity to vary amount of airplanes on each route, to set fares by themselves without government interference and to make managerial decisions themselves. Airlines deregulation attracted many new competitors some of them bankrupted, some merged and some prospered.

Government policies:  An increasing number of governments are moving to eliminate economic regulation of domestic airline services under policies known as "open skies" policies. However, even states that have deregulated the airline industry have been reluctant to allow foreign airlines to provide domestic services. In 1992, Congress established the National Commission to Promote a Strong and Competitive Airline Industry. The commission made recommendations concerning FAA's structure, the airline industry's financial health, and foreign ownership limits.

The events of 9/11 accelerated and aggravated negative financial trends already evident in the airline industry. In order for the industry to return to profitability, several steps must be taken to increase consumer demand for air travel, especially business travel, control costs, and address certain pricing issues. The Congress has enacted and the President has signed into law several measures aimed at helping the airline industry to recover and respond to terrorist attacks.

Over the long term, however, the outlook for the U.S. airline industry is more uncertain. The industry faces persistent structural problems that must be addressed if we are to avoid  facing another wave of bankruptcies in the next economic downtown, and if the industry is to take full advantage of the
very substantial progress made in lowering unit costs. If the Federal Reserve increases the interest rate, then investments in airline industry become costlier. Similarly, if government follows contractionary fiscal polices by increasing the tax rates, the profits of the airline industry will be affected. Thus, economic polices & changes in the structure of the economy highly influence the structure of the airline industry as the industry is highly sensitive & dynamic to the policy changes.