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.”|
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 a result of this fundamental market shift, by the fourth quarter of 2000 — close to a year before the September 11 terrorist attacks would slash air travel even more — the hub and spoke airlines’ cost per available seat mile (CASM) rose above revenue per available seat mile (RASM) for the first time since the first half of the 1990s. This eventually increased to an unprecedented cost-to-revenue gap of close to 2 cents per seat mile in the fourth quarter of 2001.
Now the hub and spoke carriers are faced with a thorny challenge. Changing a long-standing business model is difficult and extremely risky. There is the fear that revenue premiums will be lost, but that costs will not fall commensurately. It is difficult to downsize fixed-cost structures; infrastructure may be underutilized with a new business model; and the installed base of aircraft may not fit the new requirements. But to become consistently profitable and competitive again, the major airlines have no choice but to restructure their business model. A boom in high-yield passengers is not likely to happen again anytime soon; Web-based search tools have made it easier for travelers to find low fares; and low-cost carriers have significant untapped growth potential, especially on the East Coast.
A New Operating Model
To navigate this difficult business environment, the large airlines will have to reduce unit costs by some 25 to 35 percent. This will likely require them to radically simplify their core processes and operations. And they’ll have to achieve this significant restructuring without giving up the critical elements of service and coverage expected by their most lucrative customers.
Successful business model change in other industries — such as automotive assembly, certain segments of heavy manufacturing, and financial services — shows the airlines can reduce the burdens of the cost of complexity. Primary options for restructuring the hub and spoke model in the airline industry include:
• Remove scheduling constraints to achieve higher asset and personnel utilization and increase the pace of operations. At present, the airlines generally schedule flights to arrive and depart in peaks to provide effective passenger connections. This causes longer aircraft turns (to allow passengers and baggage to connect to their next flight), traffic congestion, and aircraft downtime at the origin cities in order to meet connection needs at the hub. The result is low labor and aircraft utilization, and a system structured around the needs of the least profitable customers. Connecting passengers provide significantly lower yields (35 to 45 percent lower revenue per mile than local passengers) and necessitate more complicated logistics. Nevertheless, because of current pricing strategies and fleet deployment, airlines rely on connecting passengers to fill seats that otherwise would be empty.
|“Successful business model change in other industries, such as automotive assembly, segments of heavy manufacturing, and financial services, shows the airlines can reduce the burdens of the cost of complexity.”|
This may require rolling or random hubs, which would allow for more operationally efficient, continuous flight schedules throughout the day. The approach would be particularly attractive at “mega-hubs,” where the scale of operations limits the trade-offs between efficient operations and efficient connections.
Some airlines are already experimenting with rolling hubs. To fully realize the cost reduction opportunities created by this approach will necessitate fundamental changes to airport operations.
• Implement Tailored Business Streams (TBS) to simplify ground-based operations for the majority of passengers. In practice by other industries, TBS’ basic principle is to segment operations into distinct business streams: Specialized processes are created to handle routine and complex activities separately, and to match the capabilities of these distinct operations with the value for which customers are willing to pay. That often entails standardizing or “industrializing” the routine and stable processes, while segmenting and isolating the parts of the operation that are more complicated and variable.
|“With a lower cost structure, the large airlines would be better positioned to launch a marketplace battle against low-cost carriers.”|
The point is most passengers do not need long, multiple interactions with airline staff, and they would appreciate getting through the airport rapidly. Passengers would arrive at the airport, check in themselves and their baggage with minimal assistance from airline staff — or, even better, not need to check in at all — pass through security, and board the plane. Dedicated processing staff would deal with the very small percentage of travelers who need to change itineraries, connect to a different airline, or request other special services. And customers requiring such extra services (except for perhaps the most frequent flyers) would potentially pay for them. Such new procedures would be system-wide, cascading from reservations to front-line staff functions. Significant cost benefits would arise from the reduced check-in and gate staff. Overall, the resulting product would be no less valuable, but the organization delivering it would become much more streamlined.
• Create separate business systems for distinct customer segments. While simplifying their business model, large carriers have to be careful to retain the loyalty of their most profitable and loyal customers by providing more differentiated amenities, lounges, and services than they offer today. This could mean separating both airport and onboard experiences into two (or more) classes, focused on either leisure or business passengers. The purpose would be twofold: to provide more specialized services and to achieve pure business streams. Experiences in other industries suggest that mingling complex and simple operations that have distinct objectives and missions often results in a migration to the highest cost level and lowest service standard. At the extreme, this differentiation might involve distinct aircraft and terminals for the two types of customers; at a minimum, it would likely require a greater degree of product demarcation than is currently provided.
|“It will be important for large carriers to retain the key service advantages they have over low-cost carriers, including destination breadth, superior loyalty programs, and cost-effective onboard amenities.”|
Flight for Survival
By taking all of these actions, and simultaneously addressing remaining distribution disadvantages, the major airlines could reduce their unit cost disadvantage for leisure travel by 70 to 80 percent — from about 15 cents to 8 to 10 cents for a 500 to 600 mile flight — bringing it more in line with that of the low-cost carriers. One downside the hub and spoke airlines would experience with these complexity-cutting strategies is revenue loss from shrinking connecting passenger volumes. But the airlines could make up this revenue loss by using their lower cost base to stimulate market growth and open point-to-point routes that were unprofitable at the former cost levels. In other words, with a lower cost structure, the large airlines would be better positioned to launch a marketplace battle against low-cost carriers, rather than being on the defensive in price wars.
|“Although transformation may seem daunting, the risk of inaction is much greater than the risk of acting and dealing with some missteps along the way.”|
Although this transformation may seem daunting, the risk of inaction is much greater than the risk of acting and dealing with some missteps along the way. At this writing, one major U.S. airline has already retreated into Chapter 11 and others may follow. The first airline to implement a fundamental business model change will shape the new competitive landscape. The prize that awaits first-comers is significant, not just in terms of lower costs, but also in considerable growth opportunities.
Tom Hansson, [email protected]
Tom Hansson is a vice president in Booz Allen Hamilton’s Los Angeles office. He focuses on strategy and operational restructuring in the airlines and travel arena.
Jürgen Ringbeck, [email protected]
Jürgen Ringbeck is a vice president in Booz Allen Hamilton’s Düsseldorf office. He focuses on strategy and transformation for companies in global transportation industries, such as airlines, tourism operators, postal and logistics companies, and railways.
Markus Franke, [email protected]
Markus Franke is a principal in Booz Allen Hamilton’s Düsseldorf office. He focuses on strategy, network management, sales, and distribution in the airlines, transportation, logistics, and rail industries.