Estonian Air – Final
Estonian Air – Final
Estonian Air is a regional airline carrier headquartered in Estonia in the Baltic region of Europe. The airline’s hub of operations is located in Estonia’s capital city of Tallinn at Tallinn Airport. This airport is the largest in the country. With the state government of Estonia owning a large equity percentage of the airline, Estonian Air is the national airline of the Country of Estonia. The Company currently operates a fleet of four aircraft providing flights to sixteen destinations throughout Europe.
Within the airline industry, Estonian Air is classified as a regional carrier. Regional carriers have historically pursued business strategies of specializing on short-haul flights within a limited geographic region. Up until the early 2000’s, regional carriers’ competitive advantages were based on their ability to provide geographically focused route services to smaller, underserved markets where larger airlines had limited exposure. These types of regional carriers were historically able to charge higher ticket prices and were able to avoid price competition.
Over the past decade, competition within the European airline industry has increased dramatically. This increase is the direct result of two major factors. The first contributing factor has been the deregulation of the airline industry due to the economic integration resulting from the formation of the European Union. The second factor is the emergence of a new type of business strategy being implemented by several airlines. These airlines are known as Low-Cost Carriers (“LCCs”). They focus on providing low-cost flights to their customers. This is accomplished, by (i) simplifying fleet designs (to reduce training and maintenance costs), (ii)
providing one type of class seating and no other services (i.e. meals), (iii) providing direct point-to-point service, (iv) focusing on shorter routes, and (v) employing non-union workers to lower labor costs.
The combination of deregulation and proliferation of LCCs, has directly affected smaller regional carriers who now face greater competition. Although many of these regional airlines are smaller and do not have the economies of scale to compete with the larger airline companies, many have adopted strategies of expanding their fleets and increasing the number of routes they service.
While competition has been steady increasing, the economy and business of Estonian Air has experienced quality growth over the past several years. On the contrary, fuel prices have increased 32% over the past three years resulting in higher operating costs and decreasing overall profit. This was illustrated in 2006 when Estonian Air increased its overall number of operating flights and experienced a 12% increase in gross revenue. This resulted in escalating operating costs, most notably fuel costs, which triggered a net loss in 2006 of US$ 5 Million.
With the uncertainty of the future economy in mind, Estonian Air must make key decisions to ensure the company will retain positive strategic direction and continue to experience financial growth. The Company’s internal analysis indicates the market will continue to grow 10% – 15% per year for the next several years.
In attempts to take advantage of the predicted market increase, Estonian Air is in consideration of expanding its fleet and adding several destinations. This alteration would aid in getting ahead of competition, managing higher fuel costs, and creating economies of scale. While many of these decisions have yet to be answered, management has narrowed its choice of aircraft, if they proceed with expansion. The current options include the Boeing 737 Jet, the Bombardier Q400 Turboprop, and the Saab 340A.
The Vice President of Operations, Rait Kalda and the Vice President of
Finance, Andrus Aljas, are currently preparing a working financial model and a total cost of ownership (TCO) analysis to break down the different options listed above. These examinations will be presented to the Board of Directors during their next meeting.
Mr. Aljas has informed Mr. Kalda of the underlying problem that the Board of Directors is divided on the growth projections for the airline. There are several members who believe the growth projections in the internal analysis are too high and that there may be certain economic headwinds nearby. If these projections are accurate, it would mean an overall economic recession. Expanding the fleet at the time of a major economic contraction could have decidedly negative consequences for Estonian Air. As such, this decision is of extreme importance to the company and will require elite deliberation. Scope of Work
ART Consulting Group has been retained by Estonian Air to assist in the decision making process related to the possibility of the company’s fleet expansion. Our main focus will be assisting Mr. Aljas and Mr. Kalda in the formulation of decision-making model, as well as providing recommendations on facilitating healthy discussion leading to the adoption of an effective decision. Mr. Aljas affirmed that due to different opinions amongst the Board members, the management team should strive to ensure that judgment errors, bias ideas, and negative group dynamics do not negatively affect Estonian Air’s ability to make the best decision possible. In addition, the growing uncertainty of both internal and external variables should remain in the company’s consideration. Because of the request by Estonian Air’s management, we will briefly touch on TCO analysis, but primarily focus on decision-making.
Strategy & SWOT Analysis Overview
In order to better facilitate discussion about the internal and external environment facing Estonian Air, we have provided a brief SWOT analysis. This model provides an overview of the company’s leverages, constraints, vulnerabilities, and problems.
Estonian Air’s key strategic goal, as stated in their annual report, is to “ensure sustainable and profitable growth through target markets, customer satisfaction, fleet renewal, and employee development.”
-Estonian Air Annual Report
Strengths * Recent Year’s Positive Results * Meeting Industry Standards * Enviable on-time record * Backing of Estonia Government * Lower Borrowing Costs| Weaknesses * Small Fleet * Increasing technical problems and O&M Costs leading to unscheduled downtime * Weakened Balance Sheet * No Economies of Scale| Opportunities * Internal Analysis indicates 10-15% Growth * New Routes| Threats * Economic Downturn * Rising Fuel Costs * Exchange Rate Volatility * Growing Competition|
Based on the above analysis, it is clear why Estonian Air is ready to “implement a growth strategy and invest in the development of its fleet.” Given the opportunity to grow their market, challenged with their small fleet and increasing difficulty of sustaining the maintenance and technical issues of their older planes, it would seem obvious that fleet expansion would be a logical choice. Expanding the fleet would (i) decrease O&M expense, (ii) decrease fuel costs (by obtaining more fuel-efficient planes), (iii) increase economies of scale, and finally (iv) allow the company to expand its route offerings and compete more effectively against the company’s growing competition. In order to quantify a course of action, Mr. Aljas and Mr. Kalda are formulating a Total Cost of Ownership Model, as well as a detailed financial model to assist in deciding how best to proceed. With this said, we have identified several problem areas that should be addressed.
The following section outlines the identification of the core problems facing the managers of Estonian Air with regards to this strategic decision.
Key Decision with High Risk & Uncertainty
The decision to expand the fleet or not to expand the fleet is extremely important. If the company expands and the growth projections are exaggerated, the result could have a seriously negative consequence on the company’s balance sheet. However, postponing expansion could allow competitors a first mover advantage into particular markets and result in increasing opportunity costs to Estonian Air. Two types of decisions that managers face are programmed and nonprogrammed decisions. Programmed decisions are those that are routine and simple. These do not take much contemplation and can be resolved by implementing a new policy. Nonprogrammed decisions, however, are those that are new, complex, and are not routine. The decision facing Estonian Air is observed to be a nonprogrammed decision; primarily because of the complexity of the financial modeling, the obligation of implementing a well thought out decision-making model. Because the decision involves uncertainty and prediction for future events, the decision will and should involve group input.
Split Board – Judgment Errors & Bias
Mr. Aljas stated to our consulting firm that the Board of Directors, and some members of management, believe that the internal growth projections are overstated. Because of the differences in opinions, we expect a lengthy and potentially heated discussion regarding the best course of action. The circumstances will lend themselves to creating opportunities for judgment errors, individual and group bias to inhibit Estonian Air from making the most effective decision possible. These types of judgment errors could include aspects of (i) groupthink, (ii) group polarization, (iii) anchoring, and (iv) escalation of commitment. Problem Analysis
Examining Nature of Decision Models
There are three types of decision models including (i) Rationality, (ii) Bounded Rationality, and (iii) the Garbage Can Model. In the figure below, we show the spectrum of decisions extending from pure rationality on the left and the illogical Garbage Can model on the right. Rationality, by definition, is used in situations where a step-by-step logical approach is used to pick the best alternative. In these situations, we assume to know
or have at our disposal all necessary information to make an informed decision. On the other hand, we have the Garbage Can model, which states that decisions are random. In the middle, we find something closer to the type of decision facing Estonian Air, which is the suggestion that there are limits to how rational a decision-maker can be. This is known as Bounded Rationality. There are always instances where we are limited to having all the necessary information for the decision. In such cases, we often do not have the ability to understand the complexity of the problem completely. We are then forced to make a decision that is the most optimal. This is known as a decision that satisfices the problem at hand.
Understanding the nature of bounded rationality will help Estonian Air understand the context of the decision they are forced with and assist in the formulation of the decision process.
Creating the Decision Process – Evaluating Results
Estonian Air must quickly develop a decision and define a clear approach to addressing the problem. The following diagram outlines the basic steps in the decision process:
Estonian Air Decision Process
Identify Problem:Do we believe growth projections? Do we expand fleet or not?
Establish Objective:The objective is to make a strategic decision to maximize profit and gain market share. More specifically, we have been given a WACC hurdle rate of 11.5% to consider for investments. The difficulty in this decision is the fact that the Board of Directors is split on the projections of economic growth.
Gather Data:We will aid in constructing a financial model and TCO for various options. The model should consist of two areas: operating assumptions and macro-economic assumptions. We suggest in working with the operations crew to get credible operating assumptions. We also recommend constructing a model that is capable of inputting various growth rates so that the model can be stress tested for contingency purposes. The model
should list options with each alternative case having an upside, midside, and downside scenario.
Evaluate Alternatives:Evaluate alternatives and contingencies
Decide on Solution:Make appropriate decision
Implement:Implementation of Decision
Follow up:Revisit final decision after implementation to ensure company is following protocol. Adjust as needed.
Based on the above process, we have constructed the following table showing the scenario case analysis in terms of return on capital.
Upside Case:20% Growth Rate
Midside Case:10% Growth Rate
Downside Case:-15% Growth Rate (Economic Recession)
Estonian Air Case Analysis
All decisions must meet the company’s required WACC hurdle rate of 11.5%, regardless of case selection. In the upside illustration, scenarios 1 and 5 offer the highest return on capital. Both involve the larger Boeing 737. In the midside case, the maximum return on capital is gained through scenario 5 which involves the combination of the Boeing 737 and the Bombardier Q400. The decision has a lower rate of return, but does have a lower volatility then scenario 1, which has the highest volatility ranking. Finally, in the event of an economic recession, all of the scenarios result in negative returns, but one solution, no fleet expansion at all, results in the less severe decline. If management believes that the economy will go into a recession, then scenario 4 will be the best course of action.
Having developed the alternatives, it is clear that the key factors are the projections for growth. Because some of the Board members have opposing views on these internal growth projections, we anticipate that the decision selection portion of the process will include a lengthy and heated discussion. This could lend itself to unhealthy and unstructured decisions.
Judgment Errors, Bias, and Individual and Group Decision Making We have constructed a model that is as effective as can be given what we know about the type of decision that we face. We have also identified that the main areas of contention within the model and in the decision process.
Irving Janis identified groupthink as “a deterioration of mental efficiency, reality testing, and moral judgment.” This concept describes the negative effects of group cohesion. When members of a group feel pressured into making a significant decision, groupthink often presents itself. Key group members may have influence over other members’ opinions and behaviors towards the decision-making process. Another viability for groupthink to occur is when a group consists of like-minded individuals. The similarities within the group will offer little room for an assortment of solutions. Diversity is important in the decision-making process because the most favorable option may be underlying and unapparent. Groupthink also occurs when members are forced to conclude a decision in a short time frame. This causes members to rush without seeking the most applicable possible number of alternatives. Pursuing outside help for decision-making is another option to decrease groupthink. This may assist in decision-making because obtaining an outside member’s consolation may offer unbiased, helpful solutions.
To prevent Estonian Air from falling into the defective concept of groupthink, we suggest that key decision-makers effectively listen and assess all options, while promoting synergy within the group before making a final decision. This may require mediators to be present when all alternatives are being evaluated. Another suggestion discussed in further detail later in the paper is to seek outside help. We suggest this because of the short time frame as well as the magnitude of the decision.
Studies show that groups tend to make more extreme decisions than individuals would for the same predicament. This concept, known as group polarization, emerges from two notions, the social comparison approach, and the persuasive
arguments view. The social comparison approach describes the idea that members in the group perceive their data to be more accurate and relevant than other members of the group. However, during the meeting, members realize their ideas are not what they originally perceived. The second notion, persuasive arguments view, details extreme decisions being made due to members of the group supporting other members’ preliminary thoughts of the subject. If not detected early, both explanations may cause radical movements with the decision-making process.
To prevent Estonian Air from getting trapped into group polarization, we recommend for decision-makers to individually submit their best possible solutions before collaborating as a team. This will hopefully deplete the pressures of making disastrously extreme decisions.
Bias #1 – Anchoring
Often, when making a decision, groups or individuals will use what are known as heuristics. Heuristics are mental short cuts that help simplify complex decisions. One of the downsides to heuristics is that they can lead to judgment errors due to the bias and irrational logic. One of the heuristic traps that we perceive might affect Estonian Air is anchoring and adjustment. In this type of heuristic, initial information serves as an anchor, or starting point, to base future decisions. For example, with regards to Estonian Air, the past 3 years of growth and rising fuel prices may form the basis, or anchor, for which future predictions are based. Sometimes past performance is not necessarily indicative of future performance.
Bias #2 – Escalation of Commitment
In addition to anchoring, another bias or judgment error that could occur escalation of commitment. This occurs when there is an increased commitment to a course of action despite knowledge of contrary information. In this case, if Estonian Air has begun the mental preparation for fleet expansion and they firmly believe in their growth projections and continued positive outlook on the economy, there may be bias opinions to continue this course of action. We already know that the Board is concerned about the growth
projections and possible economic contraction. If the managers are set on expansion, there may be a bias to continue despite warning signs about the economy. Management Recommendations
In order to ensure that the company makes the most effective decision and avoids judgment errors and groupthink, we recommend that Estonian Air utilize one of the following techniques with regards to their discussion and debate regarding future growth projections.
Technique Definition Benefit Brainstorming| Generate as many ideas as possible on a given subject| Could lead to greater creativity with regards to solutions – Promotes Creativity| Nominal Group Technique| Structured approach that focuses on generating alternatives and then choosing one| Good for generating alternatives – but decisions could still be influenced by groupthink or other judgment bias| Delphi Technique| Gathering judgments from experts| Very applicable to, Estonia – Seek outside 3rd Party experts on economics (i.e. investment banks, advisors, Economic development professionals) | Devil’s Advocacy| One person plays the role of critic to different points of view| Should help to prevent groupthink| Dialectical Inquiry| Debate between two opposing points| As there are two sides to the question at hand – this option could prove to be very helpful|
In reviewing these different options, we recommend a combination of two techniques from above. We would advice Estonian Air to use the Delphi Technique, but notably by seeking advice from a 3rd Party expert. We suggest that Estonia pay for the service to dissuade unnecessary promoting of decision outcomes that directly benefit the person providing the advice. An example of this would be an investment bank advising on fleet expansion and offering advice to Estonian Air at no cost. This would be considered corruption in efforts to allow the investment bank to underwrite the securities and make a commission on the sale of the securities on the primary or secondary markets. We would also advise the Board of Directors to meet with management to perform a dialectal inquiry that strongly presents
the position of both sides. We feel this would be advantageous because both sides would bring alternatives to the table and argue their reasoning. With this meeting, we would advise for a mediator to be present in the event that group polarization would need to be diminished. We feel that the combination of these two techniques, will aid Estonian Air in reaching an effective and satisfying decision. Conclusion
Estonian Air faces a difficult and important strategic decision with regards to expand their fleet or not expand their fleet. What makes the decision difficult is uncertainty. We have identified the major variable in this decision as the validity of the internal growth projections, which are based off of assumptions regarding the overall health of the economy. We have formulated a systematic approach to the decision making process and have assisted the company in developing a detailed financial model to assist in this decision. We have recommended that Estonian Air focus on the issue of growth and have advised the management team and Board of Directors to engage in a healthy debate in order to reach an accurate decision. While doing this, we have identified that there may be several potential judgment errors and influencing bias, which might prevent Estonian Air from making the optimal decision. We believe that the use of one or more of the techniques outlined above could help to eliminate the probability of making a strategic error. Post Case Study Update on Estonian Air
Following 2007, a major economic hit both the United States and Europe. Estonian Air had decided on a fleet expansion, as well as the addition of several new routes. The effects of the economic recession caused a massive drop in passengers and resulted in the insolvency of the airline. In 2010, the airline received a bailout from the Estonian government. The bailout effectively nationalized the airline further and wiped out nearly all of the private equity in the deal. In addition, a severe austerity plan was implemented that decreased the wages of pilots by over 30%. In the interim, Mr. Aljus became President of the airline around this time. Mr. Aljus resigned from his position in 2011. In 2012, the company experienced massive financial losses and had to lay off nearly half its staff. Through today, the economic troubles of the airline have continued. In March of
2013, another bailout was announced, along with the European Commission looking into previous bailouts as being illegal. The fleet was reduced from 13 to 10 aircrafts and is expected to decrease to 5 by 2015.