The strange business model of airlines

May 7th, 2012 by Patrick Stähler

The airline business is a strange business and in desperate need for business model innovation. On the one hand, more people fly than ever to prices lower than ever. IATA, the industry body, states that the real cost of travel has fallen in the last 40 years by about 60% and the number of travelers increased tenfold. Air freight has grown in this period by a factor of fourteen. (See IATA Vision 2050) That sounds like a very successful industry. Is it? However, on the other hand, airlines are notorious to not even earning their cost of capital and producing unhappy customers.

 

During the 2000s the average airline generated an EBIT margin of just 0.7%. Taken a longer perspective, the figures are as drastic. From 1970 to 2010 the airline industry generated over USD 12,000 billions of revenues in today’s prices, but only a total of USD 19 billion of net post-tax profits; a margin of only 0.1%.

Another dull figures: Around USD 500 billion of investors’ capital is tied up in the airline industry. Normally, investors would expect a return on capital of around 7-8%. Taken the 500 billion that would mean a return of 40 billion annually to cover the cost of capital. But what did the airlines earn? 20 billion or 20 billion less that the capital would have earned elsewhere. The airline industry is a big capital destroyer. Interestingly, other firms along the travel value chain like airports or computer reservation systems earned excess returns. So there is profit in the travel industry but not with the capital-intensive airlines. Airlines are a dismal industry.

So are customers at least happy? Just type in Google the search “airline experience” and enjoy all the customer stories about flights. And watch the film “United breaks Guitars” like 12 million others did on Youtube.

What went wrong and is there a solution to it? And think about it why we all hunt of low prices on traveling while we spent USD 5 for a latte at Starbucks. Why are we so price conscious on travelling and not on coffee?

Here are some thoughts I presented at the 17th international airline conference last fall in Seattle. Thanks to Nawal Taneja, Dietmar Kirchner and Rob Solomon for the kind invitation.

Thesis 1: Airlines are masters of transportation economics, not customer experiences

It seems that all airline managers are great students of economics but not of entrepreneurship and marketing. Since they have a perishable good (empty seats on an upcoming flight are like perishable goods), they believe strongly in variable pricing by exploiting the maximal price customers are willing to pay.

That sounds very reasonable at first, since who wants to argue with economists and their theoretical models, but what airlines have forgotten over time is, that if you treat customers like rational customers then you will get rational customers and extremely price sensible customers in the end.  However, there is a good reason why economics is called a dismal science. So if you follow economists, you get a dismal industry.

Thesis 2: Price differentiation across channels annoys good customers

While customers more or less have accepted that the price differs depending how early or late you book, Airlines have established a system of price differentiation for different channels. For a flight to Hamburg to Zurich I have different prices across channels but even different prices in one channel depending how the flight is labeled due to cross-sharing agreements.

To give you an example from last fall: At eBookers the same flight was 25% more expensive if it was sold under the Swiss brand alone compared to the same flight under Lufthansa and Swiss brand. Finally, the booked price was even 50% lower compared to the highest price. So what do customers think about this strange pricing across channels? At least, I lose even more trust and now I shop around for a even better price for the same flight because I know there is a better price around. So I spent to a lot of time for the feeling of not being ripped-off because I chose the wrong channel. And unfortunately, you get ripped off if you chose the wrong channel.

Thesis 3: Now, customers take revenge. The digital customer is knowledgeable

While in the past large IT systems to optimize the profit per customer (yield management) were only available to airlines, with the Internet customers have even more powerful tools to optimize their travel costs.

The systems of Google, Expedia, etc. can never be matched by the airlines. The airlines started a war on the yields with superior weapons, now the customers take revenge with systems the airlines can never beat or even match. Instead of yield management, airlines got bleeding management.

The digital customer is a knowledgeable customer due to all the information he has. So if airlines treat him still like the stupid customer of the past when he had no access the information, customers will feel even more exploit by the airlines as profit maximizers. The bad joke is that the airlines short-term profit seeking behavior is exactly the reason why there is no profit in the airline industry.

Thesis 4: Airlines have trained customer to hunt for bargains not value. That backfires

Airlines have trained their customer to look for the best price and not for value, and now the customers look via comparison engines for the best price and not value.

Airlines have conditioned their customers in the past on price, now that backfires, since customers have to be retrained about value. And as we all know, unlearning is impossible. Airlines have trained customers for a long time on price to be the sole criteria so value strategies will have serious problems to even reach the customers.

Actually, the same happened in German retailing. “Cheaper, cheaper!” was always the claim and now Germany has the cheapest food prices in Europe but also not the quality you would expect from one of the richest countries in the world.

Thesis 5: Airlines will become even more of a commodity unless they create business models that customers love

That sounds easier said then done due to all restrictions of the past (locations of hubs, contracts with unions, aging fleet, etc.) and the increasing computing power of firms like Google or Expedia.

However, airlines without the impediments will create innovative business models as the Arabic airlines like Emirates or Copa, Southwest or Ryanair did.

Copa attacked the Latin American market with fresh strategic assets (hub in Panama), making flights between Latin American countries much easier by using a hub that is closer to the markets than Miami, the classical hub. The same is true for Emirates. While they profit from deep pockets of their owner, a favorable tax regime and lower fuel prices in the region, the most important part is their hub around which 4.5bn people live within an eight-hour flight. They became the hub between Europe and Asia.

To find business model innovations, you have to question every aspect of your business model including your current hubs, your supply chain (Do you want to backward integrate into airports?), etc.

However, all the former national carriers are not as free as they need to be but the competitors do not care. So either they start to innovate in their business models or they will parish in the current form.

Thesis 6: Airlines can learn from firms that have customer value and trust build into their business model and even beating economics

Airlines should look less at their current competition but at firms that have masters beating economics. The core is to understand that your business is not a commodity – which is ruled  by the dismal science of economics – if you add value and trust into your business model.

How about having a every day low price policy like Walmart has. Therefore, the customer does not have to shop around to find a cheaper place. The same is true for Aldi. Customers trust Aldi, that they have low prices everyday therefore you do not have to shop for the next bargain.

The SBB, the federal railway in Switzerland, has an interesting pricing as an example. They have just one price to go from A to B. The ticket is valid for all rides to your destination and there are no reservations needed for your ride. You can take any train (fast, slow) to your destination, it is always the same ticket. You can take any train any time with your ticket. From an economic point of view that sounds stupid as if the managers have no idea about transportation economics. That might be true on short term, but the SBB is beloved by the Swiss since it is such a comfortable and easy-to-use transportation means that it even riding a car is even more complicated than using trains in Switzerland. In the end “stupid” managers might in deed be very clever.

Here you find the full presentation also for download:

P.S. I wrote this post on a long distance flight to and back from the US. I still enjoy flying with my favorite airlines Swiss and Lufthansa. Not because they are cheap, but reliable and of reasonable quality. That’s all I expect plus some 5 cm more legroom in the economy class since I am almost 2 meters or 6’6″ ;-) What really annoys me about both airlines that I have to check several websites (their own, ebookers and billigfluege.de to get the best price). As I have shown in the presentation, the difference for the same flight from the same airline can be up to 50%. How can I trust the corporate site, if they want to rip me off? It is not the 50 CHF that annoys me but this feeling of being “ripped-off”.

10 Responses to “The strange business model of airlines”

  1. Stefan Says:

    This blog entry completely misunderstands the SBB´s business model.

    The SBB is 100% government or voter owned, and makes half of its revenues not from customers but from the government i.e. voters, for helping people to get away from cars.

    Any attempt to maximize revenue with sophisticated pricing models would only confuse or frustrate the customers, and thereby cut into the other services with which the SBB makes half its earnings. Airlines, which are not paid to see that people don’t take ferries or transatlantic car trips, and whose trip prices often far exceed those of the SBB have entirely different incentives.

    There are easy substitutes for trains and buses such as cars, bicycles, motorbikes and hitchhiking. I have never heard of anyone driving, motorbiking, bicycling or swimming from Switzerland to New York.

    Furthermore, because at least half of the SBB’s earnings, not to mention the goodwill that gets voters to let it run shopping malls on Sundays, is highly dependent on highly content voters.

    This may explain why the SBB chickened away from its plans to price the GA according to use, as some use it very extensively while others use it barely at all.

    In other words, the SBB is highly efficient in getting and spending other people’s money, while airlines have to earn their own.

    In my opinion at least, it is not airlines that are gigantic capital destroyers, but the unions that dominate many airlines. It’s very frustrating to be the CEO of a company where no matter how efficient and profitable you make it, you know that the unions will strike and try to take all of it from you.

    This is why Detroit died, and a significant reason why the American airlines industry is so troubled.

    With the SBB, by contrast, the union, closely allied to the socialist party, squeezes the state for more pay.

  2. Patrick Stähler Says:

    Dear Stefan

    I do not compare the business model of the SBB to airlines. I just compare the pricing mechanism SBB uses with the ones used by airlines. And I know, when it comes to SBB and Swiss(air) the discussion becomes very emotional. Your analysis of SBB is right that they have a revenue model based on government money. And you are right that SBB has to treat their stakeholders differently since people are not just customers, but also voters and taxpayers.

    You are also right when you compare SBB to the flexible transportation means like cars. That is exactly, how SBB defines its competition. A car is the most flexible transportation means when it comes to starting your journey. A train is never as flexible but SBB tries to be as flexible as possible with Taktfahrplan and pricing that allows flexible traveling.

    Written on a train ride from Chur with excellent Wifi connection coming from a workshop with a large airline carrier ;-)

    Patrick

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  4. stefan Says:

    Patrick,

    were you paid to make this truly awful recommendation?

    “What really annoys me about both airlines that I have to check several websites (their own, ebookers and billigfluege.de to get the best price). ”

    http://www.ciao.de/billigfluege_de__Test_8804685

    http://www.ciao.de/billigfluege_de__Test_8765668

    http://www.ciao.de/billigfluege_de__Test_8778348

  5. Patrick Stähler Says:

    Stefan,

    Thanks for the feedback. Feedback like the one via ciao helps to figure that price is not the only decision criteria. But airlines have trained us that price is the only differentiator and that made customers shop around for even cheaper flights. Now, customers have to learn the hard way that there is more than price.

    A great video about this you find at youtube http://www.youtube.com/watch?v=HPyl2tOaKxM&feature=player_embedded

    Best regards

    Patrick

  6. JustaVoice Says:

    Dear Patrick,

    it is always good to see innovative ideas, provided they are either based on solid foundations or are fully brainstormed, without any assumptions. Unfortunately your ideas are partly based on half truths, this weakens their impact. Otherwise, do keep on putting efforts into these thoughts, who knows, maybe someone in the driver’s seat is listening ;).

    One fundamental misunderstanding from your side is related to the assumption that flying is cheaper. Quoting IATA “Over the last four decades the real cost of travel has fallen by about 60% and the number of travelers increased tenfold” should be seen in perspective: there were no low-cost carriers before that time to drive down prices! Now they represent a significant part of the total industry, just look at Ryanair and EasyJet in Europe or the grandfather of the concept, SouthWest, which are definitely no “niche” players any longer. Also, the actual financing of their costs has changed: airports offer suitcases with a stash of cash that are a prerequisite to sit at the same table with Ryanair for example. You will not see these discounts incorporated in the fares and therefore in the statistics, to compensate for the total cost.
    The other misunderstanding is regarding the term “cost”. Or “real cost”, whatever IATA means by that. Actually fuel prices have soared throughout the past decade and it is not so much the past 40 years, but the coming 40 years we should look at: loadfactors have improved tremendously due to more complex methodologies and systems, as a result of which, there will soon not be any efficiencies to be gained there, as we approach the top of a regressive curve. At the same time however, fuel prices will increase even more, considering the higher cost involved in delving for crude oil. No other industry has been hit this hard by the cost factor that determines the biggest cost of the business: Fuel. Chart 11 of the ICAO, IATA analysis shows that we’ve hit bottom in “real price” and believe me, from now on it’s only up to the sky, considering that more efficient aircraft have a price tag attached, fees ever increasing due to CO2 emission regulations. On the IATA’s website, you can see that Total Fuel Cost in the industry has increased from 44 bln USD in 2003 to 207 bln USD in 2012 (as % of operating cost up from 14% to 33% in just 9 years!), with the average price per barrel of Crude up from 28.8 USD to 110 USD for the same period.
    No matter how efficient aircraft have gotten, that curve is degressive and physics just proves there is a limit to fuel saving. Economics however show that oil prices show the opposite growth, resulting in an increased pressure on the bottom-line. As a result, sooner or later, once the low-cost boom will reach its peak by having squeezed the last penny out of the airports that still have funding from the EU or local municipalities to finance a loss-making operation, low-cost airlines will stop expanding and cut back loss-making routes. Then passenger numbers (mostly on the up due to the LCC business) will start to decline, not being able to afford the increased fares (due to fuel increases) anymore.
    Europe will surely not give its traffic rights to Middle-Eastern carriers, just because those can burn as much oil as they want and fly half empty aircraft and the US has its own economic troubles coming up, so this trend will soon be pretty similar worldwide.

    But to avoid ranting on with my doomsday scenario, let’s focus on the essentials: basing your assumptions on the one statement of IATA on decreasing costs (in my opinion a true example of window dressing and wishful thinking by lobbyists to squeeze out a more lenient approach from governments worldwide for airline growth instead of restriction), is in my opinion a superficial approach.
    Anyone you ask in the airline industry will tell you that the biggest impact on the bottom line are the soaring fuel prices, along with the costs due to higher customer demands and the low-cost carriers entering the scene. Putting these together and seeing how the LCC abort any route immediately in case it does not show any profits anymore (having created value where there is no demand, only stimulated/generated one), it is clear to see that further consolidation is to take place in the industry, which will put a stop to the endless growth of stimulated traffic.
    This just shows that it is not the industry that cannot handle this complexity just by pulling some cheap trick out of its sleeve, but it is actually a day-to-day survival, fighting against the elements. Gone are the days where legacy carriers conveniently sit in their chairs and watch profits soar. The industry is aware of its gloomy future and is fighting hard to counter the expected effects.
    Having said all this, I fully agree with you that it was an industry far behind others, until a few years ago. Perhaps the old-school management is still lagging behind and fresh blood is needed indeed.. It has simply been too convenient for decades to watch it all pass by, expecting things will always be like in the 70s: an elite industry type for the chosen few. Nowadays it is pretty much the most challenging industry that requires a broad expertise and (except for pilots and top management) lower pay than elsewhere, with constant insecurity about the future. Yes, everyone else benefits from airlines: airports, fuel companies, IT providers, ground handling, consultants, you name it. Just look at Kingfisher Airlines that made a billion dollar deal with Sabre Airline Consulting from the start and they have never been profitable, losses of 1.27 bln USD accumulated in a few years.
    This attitude is a heritage that is hard to shake for the legacy carriers, despite carriers like Ryanair turning the system upside-down. And at the end of the day, will the purely opportunistic (LCC) airlines survive, when flying is about those who NEED to travel in the first place? I think not.
    So to get back to your thesis:
    Dismal industry, yes.
    Masters of transportation economics, yes. Not of customer experiences, .. yes and no. The industry is far more complex than selling toothpaste or diapers and to handle this complexity requires a flexible business model, not focussed on economics or customer experience only.
    Price differentiation annoys good customers: no. You are focussing on price, but the business passenger on schedule and network. This is where the profits are made and to focus on anything else is the end of the “classic” model. The price sensitive segment (LCC customers mainly) wil fly either way if the price is right.
    The digital customer is knowledgeable and these take revenge: totally wrong, as they are not “The” customer. The knowledgeable customer is the price-sensitive student or the businessman having too much time to spend on writing blogs on his flight trips, being paid by the company and regulated more and more centrally for cost saving reasons or schedule convenience. This is a small segment and not where the money comes from or where the battle is fought and getting into this race is drifting away from the core business for airlines. Battles are not fought with the customer, but with the likes of Travelport, the travel agencies and their reservation systems and the LCC’s direct websites. It is the middleman that is in focus, the customer does not have enough power in this game to decide what will happen. Look at Microsoft, Facebook, Google and their likes: they dictate the trends, not the customer. If needs be, with lousy and expensive products (M$), a total breach of privacy (Facebook) or the sweet illusion of freedom and independence (Google).
    Airlines are too big and slow to follow up on these trends and their assets are not like a snack packaging that you can change overnight.
    I have seen many new-wave managers come and go in the airline business in the past decade. They all have something in common: they only add value in the innovative area of the low-cost business. Changing the traditional model is too big a challenge and most fail at trying. Seenig your blog, I do advise you to try, who knows you’ll invent the egg of Columbus :).

  7. Dietmar Kirchner (@Innotator) Says:

    Commenting on Stefan’s remarks:

    You have to accept unions in a free society. They became strong in the airline industry when it was regulated, fares were set by IATA and every airline had pretty much the same pay scale. (Also, the “protected” US car market did the same). Scope clause rules, seniority promotion and similar features werde developped in those days by unions and management together. And the situation in the mostly “free” labor market of the US regionals shows the trend for the industry..

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