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Published: December 6, 2002

 
 

Flight for Survival: A New Operating Model for Airlines

It is a turbulent time for major U.S. airlines, but this rough economic weather may be the challenge they need to alter the costly hub and spoke model that’s dragging them down.

One traditional company after another — manufacturers and service providers alike — is facing a vexing problem: Their business models have become so complex that it is harder and harder to generate profits. Over the years, these companies have added layers of product and process complexity to their business models in order to grind out incremental returns. Although each incremental decision can usually be justified on its own, the aggregate revenue benefits often fail to compensate for the overall costs of complexity.

“The airline business model — essentially designed to take anyone from anywhere to everywhere, seamlessly — was a great innovation, but it is no longer economically sustainable in its current form.”
As these companies struggle to remain profitable while serving a broad set of customers with complicated and varied needs, they’re frequently undermined by smaller, nimbler competitors that supply a more focused product, usually to a specific set of customers, at a lower cost. In these situations, a company may know the cost of complexity is dragging it down, but changing its business model is easier said than done.

No companies illustrate this predicament more vividly than the large U.S. hub and spoke airlines. Their business model — essentially designed to take anyone from anywhere to everywhere, seamlessly — was a great innovation, but it is no longer economically sustainable in its current form. Indeed, they are now tied to massive physical infrastructure, complex fleets of aircraft, legacy information systems, and large labor pools.

While the big carriers face a future of red ink, low-cost carriers like Southwest Airlines and Jet Blue are prospering by exploiting a huge cost-of-operations advantage. According to Booz Allen Hamilton analysis, low-cost carriers spend 7 to 8 cents per seat mile to complete a 500 to 600 mile flight, whereas the large airlines spend closer to 15 or more cents.

The Cost of Complexity
Surprisingly, only some 5 to 10 percent of this 2 to 1 cost differential between the traditional and low-cost airlines can be attributed to the extra “frills,” such as in-flight meals and entertainment and other amenities, that the hub and spoke carriers offer. Instead, the pace and the complexity of operations associated with maximizing revenue within the traditional hub and spoke business model account for some 65 percent of the gap. Consider the big airlines’ burdens that low-cost carriers avoid:

  • Flight schedules structured predominantly to attract high volumes of low-yield connecting passengers, which causes congestion, long aircraft turnaround times, and poor utilization of physical assets and personnel;
  • Labor-intensive business processes capable of providing seamless connections to anywhere in the world that accommodate, and partly encourage, last-minute seat assignment changes, upgrades, and itinerary modifications; and
  • A distribution system tailored to selling tickets across the globe and to providing the largest customer base possible to maximize revenue through the yield management system.

By the end of 2000, these factors, combined with expensive labor agreements and rising fuel prices, placed the large airlines in one of the most difficult cost vises in the industry’s history. Boom-period pricing was required for hub and spoke airlines to break even. But the recession and bear market put an end to that option, as did the wide-spread presence of low-cost carriers, which operate a much simpler but still attractive service at significantly lower prices.

“According to Booz Allen Hamilton analysis, low-cost carriers spend 7 to 8 cents per seat mile to complete a 500 to 600 mile flight, whereas the large airlines spend closer to 15 cents.”
As corporations tightened their belts, they encouraged employees to travel less and to seek lower fares by booking reservations well in advance and accepting more restrictive tickets. Business travelers, who have traditionally accounted for as much as 60 percent of mainline airline revenues and well over 100 percent of their profits, were no longer willing to pay the high fares they once tolerated. Before the economy slipped, the traditional carriers were so profitable from being able to charge business travelers top dollar that the rapid growth of low-cost carriers was not a principal concern.

 
 
 
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Resources

  1. “Airlines: A New Operating Model — Providing Service and Coverage Without the Cost Penalty,” by Tom Hansson, Jürgen Ringbeck, and Markus Franke, November 2002. Click here.
  2. “Catching Travelers on the Fly,” by David Newkirk, Brad Corrodi, and Alison James, s+b, 4Q 2001. Click here.
  3. “Airports as Engines of Economic Development: Great Airports Are Critical for a Region,” by Cyrus F. Freidheim and B. Thomas Hansson, s+b, 3Q 1999. Click here.
  4. Airine Merger Integration — Take-Off Checklist,” by Tom Hansson, Gary Neilson, and Sören Belin, January 2001. Click here.
  5. “Punctuality: How Airlines Can Improve On-Time Performance,” by Alexander Niehues, Sören Belin, Tom Hansson, et al., May 2001. Click here.
  6. “Out of the Hangar into the Boardroom,” by Daniel Lewis and Mercedes Mostajo Viega, April 1999. Click here.
 
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