Costs make getting off the ground tough for airlines

2/9/2007 - The importance of the airline industry is enormous. Worldwide, it employs nearly 30 million people and accounts for 8 percent of world gross domestic product. But just as significant are the challenges facing airlines today, said an executive of one of the large legacy carriers during a visit to the Kellogg School on Feb. 8.

Daniel P. Garton, executive vice president of marketing for American Airlines, outlined some of the hurdles confronting his company and its peers as they address increased competition from low-cost carriers (LCC) and higher fuel prices while still recovering from an industry-wide decrease in passenger demand after the dot-com crash and the terrorist attacks of Sept. 11, 2001.

“GDP growth fell to less than 1 percent in 2001 and less than 2 percent in 2002,” said Garton, who spoke to about 100 Kellogg students, faculty, and staff in the Owen L. Coon Forum in a visit sponsored by the Kellogg Transportation Club. Passenger demand in the airline industry dropped more than 20 percent after the 9/11 attacks, he added, as fuel costs rose precipitously.

American’s fuel costs doubled, said Garton. As a result, the company initiated its “Fuel Smart” program whose goal is to conserve some 90 million gallons of fuel annually through strategies that include having pilots use one engine while taxiing rather than two. Through this and other measures, American hopes to save $700 million in overall costs to retain its market position.

Perhaps the most persistent threat facing companies like American is that from low-cost competition, such as Southwest Airlines and Jet Blue Airways. These carriers offer inexpensive fares while finding cost savings by trimming back service amenities and paring schedules, noted Garton.

“We’ve got to be ultra-competitive,” particularly on pricing and scheduling options, said Garton, indicating that American’s schedule offers many more options than the typical LCC does, one reason why legacy carriers have maintained their revenue premium against the cost advantages of Southwest and others. But he indicated that carriers such as American also have to make choices about the amenities they are willing to offer. While perks like larger seats and more space between seats may sound like an obvious improvement for a business in a customer-centric service industry, Garton presented the contrarian view.

“We have got to be very selective on hard product frills [like seat space],” he said, citing the expense of losing valuable passenger room, and hence revenue. While “the math is in favor of spending money [on customer amenities] in First Class,” said Garton, doing so throughout the plane’s cabin does not necessarily stand up to a rigorous cost-benefit analysis.

One cost that Garton said American was especially careful about handling properly was its employees. “The employee is valued very, very highly,” he said, noting that while American is the only legacy carrier today never to have undergone bankruptcy restructuring, it has achieved this distinction while “staying committed to paying pensions … and its core business,” rather than trying to create a low-cost “carrier within a carrier,” such as United Airlines’ Ted or Delta’s Song.

“We do a lot to engage the employees in the company,” said Garton. When it comes to labor relations, he said, “We explain that they are protected by a profitable company,” more so than by a union contract.

He also explained that services business, such as airlines, are “fundamentally different” from product-oriented businesses. While products offer “storable capacity” with less variability per unit, services involve “perishable capacity and more variability.” As a result, marketers in service industries face challenges that include excess supply and intense price competition, resulting in a willingness to discount as necessary.

“There are amazing incentives to sell a perishable product,” said Garton, which is why customers often see airfares drop at the last minute. “You want to sell that seat before the plane takes off.”