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 / Summer 2009 / Issue 55(originally published by Booz & Company)


Reframing Your Business Equation

To put it in mathematical terms, Ohno solved for a different variable. He did not ignore the equation, but instead decided that what others assumed to be a given could in fact be changed. By reframing the prevailing equation of mass production, he broke the existing paradigm, and, in the process, created a breakthrough operating strategy that revolutionized the automobile industry.

Solving for Customers
Companies love to benchmark themselves against industry competitors, but no two firms are ever directly comparable. To compensate, industries tend to develop equations and associated metrics that adjust for these differences. For example, passenger airlines fly different-sized planes over different routes that cover different distances. But, regardless of those specifics, utilization, or “load factor” — which, on a passenger airline, means the percentage of seats filled — drives the economics. An empty seat represents unused capacity that can never be recaptured.

As a result, airlines talk in terms of revenue passenger miles (RPMs), a metric that derives from the available seat miles (ASMs) multiplied by the load factor. ASM measures the number of available seats per plane multiplied by the miles per flight. So a 50-seat regional jet flying 300 miles with an 80 percent load factor (i.e., with 40 paying passengers) will produce 15,000 ASMs and 12,000 RPMs. Alternatively, a 300-seat, wide-body plane traveling 1,000 miles with a 50 percent load factor offers 300,000 ASMs and generates 150,000 RPMs per trip. From a profitability standpoint, the price charged per RPM determines the revenue per flight against a highly predictable cost per flight based on jet fuel, equipment cost, and crew cost.

Focusing on this equation, traditional airlines have priced their seats to generate revenues to cover the cost per ASM, and evolved to a hub-and-spoke routing system to maximize the load factor. Their reasoning was simple and logical. Larger planes offered economies of scale to lower the cost of an available seat mile, and the hub-and-spoke system allowed the large planes to cost-effectively serve smaller cities. Their passengers, destined for a variety of locations, thus found themselves on a single plane routed to a hub airport such as Atlanta, Chicago, Dallas, Pittsburgh, or Minneapolis. There the travelers were sorted and matched with customers from other cities onto other large planes that could be filled only by the combined demand of all the feeder flights. Such pooling of the demand in and out of the hub kept utilization up and costs down.

When Southwest Airlines Company started up at Dallas Love Field in 1967, founders Rollin King and Herb Kelleher didn’t challenge the fundamental logic of the airline equation: They, too, recognized the need to manage the load factor to be profitable. But they focused on different levers seeking to achieving the same objective with a more customer-centric attitude. Southwest offered direct flights between cities and used price as the lever to encourage more demand. The low prices attracted customers who would normally have taken a car or even a bus rather than a plane. Southwest also sought to amortize the high cost of the planes through quick turnarounds that kept them in the air earning revenue passenger miles rather than on the ground accruing costs.

As Southwest grew by adding more and more destinations, it continued to stick with its point-to-point model with aggressive pricing rather than using the hub-and-spoke approach. The big airlines failed to fully appreciate the power of Southwest’s model because the industry equation under which they were operating obfuscated part of the issue. The focus on “flown miles” failed to capture the fact that routing a passenger through a hub adds needless miles to the passenger’s trip. A direct flight between Washington, D.C., and Jackson, Miss., would require only one takeoff and landing to cover the 868 miles. But routing that traveler through an Atlanta hub adds another 260 miles plus an additional takeoff and landing. Because these extra miles are in the denominator of the accepted industry equation for both RPMs and cost per ASM, the hub-and-spoke airlines fooled themselves into thinking their model was more efficient.

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