The Way to Survive in Airline Industry

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Cost of Production

According to Southwest’s Airlines annual report the company’s strategy to control costs is to “focus on cost discipline and profitability charging competitively low fares” (Annual Report, 2017) The annual report also gives credit to the use of a single aircraft type, the Boeing 737, the use of an efficient point-to-point route structure, and it’s highly productive employees. (Annual Report, 2017) Another focus that has helped Southwest Airlines control costs is focusing on initiatives that reduce fuel consumption and improve fuel efficiency.

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Fuel and oil expenses remained the second largest operating expense for 2017, up .4% from 2016 as shown in the below table from their annual report.

The number one operating expense cost for Southwest Airlines was salaries, wages, and benefits constituting 41% of the operation expenses for 2017. (annual report, 2017). The company has the most challenges with controlling labor costs due to the collective-bargaining agreements and unionized workforce. 83% of employees are unionized and receive pay scale increases as a result of contractual rate increases.

(annual report, 2017) However, the airline industry is labor intensive, so it’s very important that Southwest Airlines maintains good relations with its employees. (annual report, 2017)

The airline industry uses ASM or “available seat mile” as a way to measure capacity. (airline glossary retrieved from http://investors.southwest.com/investor-resources/investor-faqs/airline-glossary) Southwest Airlines operating expenses include salaries, wages, and benefits, fuel and oil, maintenance materials and repairs, aircraft rentals, landing fees and other rentals, and depreciation and amortization. The below table shows the company’s operating expenses per ASM for 2016 and 2017.

(annual report, 2017)

If you review the financial data for the past five years as shown in the annual report you can see that operating expenses have consistently grown, but so has the operating revenues.

Net income for the year was $3.5 billion, a 55.4% increase year-over-year. This was primarily driven by a $1.4 billion reduction in Provision for income taxes related to the Tax Cuts and Jobs Act legislation enacted in December 2017. This resulted in a re-measurement of the Company’s deferred tax assets and liabilities at the new federal corporate tax rate of 21 percent. (annual report, 2017) When you look at the concepts of variable and fixed costs for Southwest Airlines you can see that most costs for the company are fixed meaning they will remain constant as output changes, such as salaries, rental fees, and administrative expenses. However, the cost of jet fuel is a variable cost as it can change as output changes. Southwest Airlines benefited from a stable fuel environment for 2017. (annual report, 2017) Southwest Airlines is focusing on improving fuel efficiency through fleet modernization and other fuel initiatives like replacing older aircraft with newer more efficient models.

Overall Market

The Airline Industry has experienced major growth over the past several years, but at the same time, they still face challenges such as rising costs and intense competition. According to IBISWorld industry research, the domestic airline industry is expected to continue to grow over the next five years. Consumers are expected to experience rising incomes and the airline industry will remain competitive with increased services provided. (Retrieved from https://www.ibisworld.com/industry-trends/market-research-reports/transportation-warehousing/air/domestic-airlines.html) As illustrated in the graph below, Southwest Airlines is shown to be in the current top 2 with 18.2% U.S. Market Share. This illustration shows statistics from April 2017 to March 2018 with Southwest falling short under American Airlines. (Statics Retrieved from https://www.statista.com/statistics/250577/domestic-market-share-of-leading-us-airlines/) According to Southwest Airlines 2017 One Report, they held 24% of the domestic Market Share for 2017. (One Report, 2017) This shows just how on top of things Southwest will have to stay in order to come in higher than American Airlines for 2018’s reports.

The domestic market share of leading U.S. airlines from April 2017 to March 2018

In 2001, the airline industry dealt with an economic crisis when the U.S. suffered from the events of the 9/11 tragedy. The events caused a decline for the airline industry as a whole and the industry did not return to profitability until 2006. (Harris, USA Today Retrieved from http://traveltips.usatoday.com/history-airline-industry-100074.html) Over the years, with some help from government regulation, the airline has continued to grow and regain trust from consumers. One way to compare markets is to look at the online market share. If you review the below graph of the online market share over the past three years you can see that most of them have retained steady traffic share with Southwest Airlines taking the lead consistently. (Consumer insights, HitWise, 2017 Retrieved from http://www.hitwise.com/blog/2017/04/market-share-us-airlines/)

Even though the competition is high within the airline industry the barriers to entry are very high. If a company would like to enter the airline industry they will need several airplanes to compete, and they also need to take into consideration that operating costs are huge and the government has tight regulations. Therefore the threat of a new entry is low since the barriers are so high. (CFI Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/strategy/threat-of-new-entrants/)

The airline industry is an oligopoly. The market is controlled by a small group of firms and the barrier is high enough to discourage other potential competitors from entry. If you look at the many tables and graphs I’ve provided you can see there are four major domestic airlines, American Airlines, Delta Airlines, Southwest Airlines, and United Airlines. These four major airlines fly about 80% of all domestic passengers. (Segal, Troy, 2018 Retrieved from https://www.investopedia.com/ask/answers/011215/airline-industry-oligopoly-state.asp)

Recommendation

As Southwest Airlines continues to execute its business plan to maintain it’s competitive advantage and ensure profitability in the future, it is always best to stay on top of market trends and always be looking for ways to be better. You can see by the current data presented showing that Southwest Airlines is in second place for the 2018 data that it will be a competitive year for Southwest in 2018 and going forward. We are living in unpredictable times with our government and economy changing so it’s important that Southwest Airlines stay focused on cutting costs while continuing to be ranked the top airline. 2018 will likely be a great year for the airline industry with the new tax reform in place but it is important that Southwest Airlines doesn’t get comfortable with that buffer in place and continue to look for new ways to expand and grow their profit. Sanctions on Iran could possibly send oil prices up and it’s important that Southwest Airlines is prepared for any changes. (Paraskova, T 2018 Retrieved from https://oilprice.com/Energy/Crude-Oil/Sanctions-On-Iran-May-Send-Oil-Prices-Above-90-Next-Year.html)

I think Southwest Airlines needs to focus on safety, reputation, and customer service a little closer moving forward. The deadly crash that occurred in April of this year has likely impacted the airline in a negative way. (Lilley, Ben Mathis 2018 Retrieved from https://slate.com/news-and-politics/2018/04/updates-on-deadly-southwest-airlines-flight-that-landed-in-philadelphia.html) There have also been many news articles in regards to customer service issues. Even if it is not always Southwest Airlines that it occurred with, it’s important to learn from other airlines and be proactive to keep negative things out of the media. Brand and reputation is important for the airline industry seeing as consumers are trusting the company with their lives.

My recommendation for Southwest Airlines is to maintain a competitive advantage by focusing on pricing and cost structure, improving routes, frequent flyer programs, and schedules, increasing technology in order to enhance and optimize operations, and focusing on customer service. Southwest Airlines also has room to grow in the international market. Southwest has already added more “over the water” destinations so they are heading in the right direction. Adding more destinations while maintaining the same low-cost structure will help them continue to be successful. Southwest Airlines should also take a look at how they can change up their labor costs. Many of the agreements are coming up for renegotiation and it’s important they make the right decisions for the long term in regards to labor costs.

Southwest Airlines will be able to sustain their success going forward if they continue evaluating trends in demand and price elasticity. It is important they continue to know and understand what it is their consumers want and expect from them. Using statistics to understand demand in the airline industry market is a valuable tool for Southwest Airlines so that they can be pro-active in making the right moves before the competition. Southwest Airlines should continue to use what they know about the elasticity of demand to maintain their profits. As they do now, they should have a higher price for business travelers and a lower price for vacation travelers. Perhaps Southwest Airlines should do more to target business travelers. Southwest Airlines could partner with non-profits to better help build their brand while also building a reputation with other organizations to build brand loyalty. It is important that Southwest Airlines continues to use marketing and economic tools to maintain their competitive advantage and remain at the top.