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”.

Tags: airline industry, bad business models, business model innovation, changing competitive landscape, Copa Airlines, Lufthansa, mental models, rethinking business, Ryanair, Southwest Airlines, Swiss, time for change
Posted in business model innovation, corporate life | 8 Comments