Southwest Airlines Possible Solution-hbr Case

2009 CASE ANALYSIS

TEAM AKRITI SINHA ARAVIND KUMAR LIPIKA BRAHMA NIKHILESH BHATTI TARUN AGRAWAL KOWSHIK YAKKALA

EXECUTIVE SUMMARY Southwest Airlines entered the airlines market and within a few years was known amongst the market leaders by following a low cost differentiation strategy. Not only did the airlines win numerous price wars by just religiously following its set of coherent activities but it also gained many loyal customers who wanted to fly in South West and wrote to them for setting up new flight routes. Southwest now had two major issues at hand, one was how would they continue to be the low cost leaders in the industry by making their strategy sustainable. The other was they wanted to foray into new markets or establish new routes to expend their reach in the industry. There were many activities that lead the strategy to be successful including low operating costs, low turnaround time, committed and efficient employees etc. Their strengths seemed to be how well they managed time. They saved a lot of time on flight and in the airport which led to cost savings later. They now were on cross roads and wanted to make their strategy sustainable. The second dilemma was about their expansion strategy. South west had always followed a controlled expansion strategy and always was known for its deliberate and cautious moves to expand. Now they had three options at hand

a) Expand within system, add a new segment between Detroit and Phoenix- where the airport gate and landing fee would be higher than the average Southwest Standards

b) Grow in Chicago by adding a route from Chicago to Dayton- the fee per passenger would be lower than their average in other airports, the airport was fairly uncongested and had room for further expansion c)

Establish base in east coast- kick off service from Baltimore- airport fees was in line with the system

In assessing the best option we evaluated all the three options both qualitatively and quantitatively. We evaluated the risks as well as the returns in each of the three options separately and determined the best option. We forecasted the demand based on past growth rate. NPV and an calculation of the payback period for each of the options gave us an understanding of the returns that each project would provide us with. Risks are always based on the best case, worst case and expected case scenarios of the prices to be offered to the customers since Southwest had to maintain a cost lower than almost 60% of the industry average to be competitive in the industry. They could maintain their low prices only through their low operating costs. In the sensitivity analysis the final option seemed to go very well with the statement “higher the risk higher the return” which does not go very well with Southwest’s controlled expansion theory. The second option seemed to turn very bad in the worst case scenario in which southwest could operate due to entry of new competitors. The first option of expanding within the system was moderate and fared well in both the worst and best case scenario. Looking at it qualitatively the first option seemed lucrative since there were a lot of passengers already asking for the particular route to be established and this would improve the brand image of Southwest since they would be responding to customer.

Contents

Contents.........................................................................................................................................................................................3 THE MAJOR ISSUES FACED BY THE COMPANY.................................................................................................................................4 PROBLEM STATEMENT: ...............................................................................................................................................................4 THE AIRLINES INDUSTRY IN THE 1990s...........................................................................................................................................4 Changing Consumer Perception:..................................................................................................................................................4 ANALYSIS OF PROBLEM 1: SUSTAINING LOW COST DIFFERENTIATION STRATEGY..........................................................................5 ANALYSIS OF ACTIVITIES THAT ARE CRITICAL FOR MAINTAINING THEIR STRATEGIC COHERENCE..................................................5 ANALYSIS OF PROBLEM 2: EXPANSION AND GROWTH INTO NEW MARKETS....................................................................................6 SITUATION 1: DETROIT AND PHOENIX –EXPAND WITHIN THE SYSTEM.........................................................................................6 SITUATION 2: GROW IN CHICAGO BY ADDING CHICAGO-DAYTON................................................................................................6 SITUATION 3: ESTABLISH BASE IN EAST COAST: KICK OFF FROM BALTIMORE..............................................................................6 NPV and Payback period...........................................................................................................................................................7 ANALYSING THE RISKS: SENSITIVITY ANALYSIS...............................................................................................................................7 ANALYSIS OF RETURNS...................................................................................................................................................................8 QUANTITATIVELY:.........................................................................................................................................................................8 QUALITATIVELY............................................................................................................................................................................8 SENSITIVITY ANALYSIS.................................................................................................................................................................8 RECOMMENDATION.......................................................................................................................................................................10 APPENDIX 1: ASSUMPTIONS:.........................................................................................................................................................10 APPENDIX 2: RETURN ANALYSIS....................................................................................................................................................11 APPENDIX 3: SENSITIVITY ANALYSIS..............................................................................................................................................13 APPENDIX 4: WACC CALCULATION................................................................................................................................................13 APPENDIX 5: PORTER’S FIVE FORCES ANALYSIS............................................................................................................................14 Appendix 6: HOW DOES SOUTHWEST ACHIEVE STRATEGIC COHERENCE.....................................................................................15

THE MAJOR ISSUES FACED BY THE COMPANY PROBLEM STATEMENT: Southwest Airlines has two problems at hand now: a) How to maintain the strategic coherence that it currently has and how to make them sustainable in the long term b) Find the best possible expansion strategy amongst the three options of routes

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Expand within the system, add a new segment between Detroit and Phoenix

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Grow in Chicago by adding a route from Chicago to Dayton

•

Establish base in east coast- kick off service from Baltimore

THE AIRLINES INDUSTRY IN THE 1990s Airlines Industry in the 1990s was one of the largest and growing industries. It remained the core for globalization due to its involvement in international investments and world trade. But during the early years of 1990s the industry was hit with recession, Gulf war and the effects of deregulation in 1978. In 1991 the number of passengers decreased with an effect on the financial results which were already at war with the excess capacity losses due to overbuying of aircrafts in the 1980s. According to the reports airlines industry suffered a total loss of around $20 billion from 1990-1994. Changing Consumer Perception: Several low fare airlines were introduced during those times that changed the whole perception of people towards air-travel. As, they were low priced due to which there was a fear in their minds that the airlines might have lower safety standards which proved to be wrong. The deregulation also had some negative effects as well: •

Cost cutting in the operations

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Mergers of airlines to prevent bankruptcy

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Lower wages and job losses

The airlines operating strategies also got changed as a result of deregulation, liberalization and increase in the competition. Rather than focusing on increasing the load factor, the airlines started to work towards increasing the overall productivity with increased profitability through economies of scale.

ANALYSIS OF PROBLEM 1: SUSTAINING LOW COST DIFFERENTIATION STRATEGY Southwest Airlines strongly follows the strategy of low cost/differentiation strategy. They provide the lowest possible fare in the industry. This leaves South West with not much competition in the industry. At the same time South West focuses on differentiating itself on the basis of the service, operations, cost control, marketing, its people and corporate culture. They believe in providing customer focused services. They believe in adding fun element to their services. Their main aim is to offer great service at the lowest cost.

ANALYSIS OF ACTIVITIES THAT ARE CRITICAL FOR MAINTAINING THEIR STRATEGIC COHERENCE MAINTAIN MOTIVATED PEOPLE FORCE Southwest Airlines always banked upon their people for carrying out most of their time saving and cost saving activities. None of them would be possible if the ground staff is not dedicated. To maintain the same amount of enthusiasm amongst the workforce to work efficiently even with wages lower than the industry average

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Selection procedure of employees they should always look out for people who crave psychological satisfaction more out of a job than monetary satisfaction

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Most of the times it was the employees who gave them new ways of saving time and money, so always keep up the org culture of openness and employee involvement in major decisions

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Recognitions and awards should continue to make employees happy and more self confident

TARGET ONLY SMALL CITIES AND CONTINUE WITH THE CITY TO CITY HOPPING ROUTE •

Save up time by selecting less congested airports

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Save up on costs by not following the hub and spoke model, saving fuel and time

TARGET CUSTOMERS: Their target customers mostly would be families who would be in the middle and lower middle class income range who would not mind a little fun while travelling BRANDING THEMSELVES AS THE “OFFICIAL HOLIDAY CARRIER”: Since they attract a lot of people during the vacations they should market themselves as the carrier that brings together the whole family during a vacation at a very low cost. They should start hitting on the emotional side CONTROLLED EXPANSION: They should never go for any city that offers them a lot on revenue but where they might lose out due to bad weather conditions or simply because of culture mismatch. They should foray into markets only after a study of their passengers

ANALYSIS OF PROBLEM 2: EXPANSION AND GROWTH INTO NEW MARKETS For assumptions: See Appendix 1: Calculations: Refer Appendix 2 SITUATION 1: DETROIT AND PHOENIX –EXPAND WITHIN THE SYSTEM REVENUE NET MARGIN NUMBER OF PASSENGERS NPV PAY BACK PERIOD

22158988.89 2740714.334 194377.0955 34251498.4 1.576573362

•

Very high business connection

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Many customers have been writing to Southwest to introduce a new Detroit-Phoenix Flight

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Lots of retired individuals travel in this route and there are a number of passengers who would stop by Phoenix and later stay on the flights till they reach their final destination

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Easier to draw customers to this route

SITUATION 2: GROW IN CHICAGO BY ADDING CHICAGO-DAYTON Why Chose this Option? •

Growth in Chicago

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The Airport was in line with South west strategies of using uncongested airports

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Room for expansion in future

REVENUE

64719812.43

NET MARGIN

4146612.767

NUMBER OF PASSENGERS NPV

743905.89

PAY BACK PERIOD

1.051688724

51,321,417

REVENUE

31463996.68

NET MARGIN NUMBER OF PASSENGERS NPV PAY BACK PERIOD

570905.1022 642122.3813 6,634,766 8.214306391

SITUATION 3: ESTABLISH BASE IN EAST COAST: KICK OFF FROM BALTIMORE

Why Chose this option? •

Establish base in the East Coast

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High Population 2.4 million

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Flight timings more than 3 hours resulted in fuel savings

Why not chose this option •

Bad Weather conditions might result in flight delays

•

Average Flight Distance more than southwest standards

NPV and

Payback period

The NPV for the third option is $51321417 and Payback period is 1.05 years and for the first option it is $34251498 and the Payback period is 1.57 years. So, in considering the risk and return factors, we chose the first option as best for south west airlines

ANALYSING THE RISKS: SENSITIVITY ANALYSIS

ANALYSIS OF RETURNS QUANTITATIVELY: As per our expectation Southwest can get a profit of $2740714 for Detroit route, $570905 for Dayton route and $4146613 for Baltimore route. Though the expected profit is most for the third option but if we would see the range of worst to best situation; in the first option the possible revenue outcomes would be between $18, 59,289 net Profits in the worse situation and in the best case it is $37, 56, 708. For Dayton route, the Company can earn ($1, 92, 529) net profits in the worse situation and in the best case it is $15, 96, 325. For Baltimore route, the Company can earn $22, 55, 947 net profits in the worst situation and in the best case it is $63, 94, 353. Hence It is clear that range is highest in third option so instead of highest expected revenue it has the highest risk. While second option has the least variation but the chances of giving negative returns in worst conditions is high. Hence first option seems to be best option. QUALITATIVELY They respond to customer requests and also keep up the “Luv Culture” – Better Brand image and better connect with customers SENSITIVITY ANALYSIS South west’s competitive advantage rests with pricing or providing services at low fares. From the sensitivity analysis, we come to know that southwest can get the profit of $2740714 for Detroit route, $570905 for Dayton route and $4146613 for Baltimore route where the prices are quoted at $114, $49 and $87. If the price war occurs in these places by the competitors of south west, the company can go for worse fares and increase the revenue still in competing with their competitors. The reasons being:

Cost control activities adopted by South west such as- Cost cutting- Pilots contributing new ideas to save fuels, Fuel costs- Buying fuel from vendors who offer best prices by carrying inventory if possible, Gate costs and landing fee’s- Average fee in small airports is $2.50, and in small airports it is $2.00, No of departures- Maximum productivity of passengers through 20 departures a day, Low cost service- Offering services at low cost as it was 7.3 cents per passenger Risk analysis:From NPV and break even analysis we get the third option as the best as it has least period for break even and highest NPV. The first option comes second and then the second at last. But this does not give us a holistic picture to make any suggestions right away. We should also analyse the risk in a certain investment along with the returns. Some factors which would arise as risk factors are follows: •

Operating cost

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Fuel cost

•

Employee cost

•

Weather conditions

Choosing the best option:After going through the risk and return part will choose the best option. From return point of view it is very clear that third option we should choose. It has $3.2 million NPV while first option has $2.4 million. Third option has only one major risk which is weather condition. Let see how significant it is. Normal “in and out” time is 15 minutes for southwest airlines. It helps to reduce cost and save time also. This is a big differentiating factor for them. In our options it is same expect for the last option which have 90 minutes time for “in and out”. This delay in time by 6 times is very significant from cost as well as revenue point of view. Taking 10 O&D in place for one day, if 15 minutes is in and out time then time for total 10 O&D would be 15*10*2= 300 minutes. If it increases to 90 minutes because of bad weather condition, then it means in same day and same time we have only 300/90= 3 O&D is possible. It means decline of revenue to 1/3rd. Due to more time for “in and out” there would be more fuel consumption which will lead to increase in cost. A flight from Detroit to phoenix, which is around 1000miles, takes 3 ½ hours to cover. It means a flight covers around 5 miles in one minute. So if flight has to wait for 9015=75 minutes more it means it will lost fuel equalling t0 75*5=375 miles. It has given that per hour cost of operation of airline is $4000. So due to delay by 75 minutes operating cost will increase by 4000/60*75=$5000. So after considering the risk part, third option gives negative returns as the revenue is declining and cost is increasing. So we will eliminate the third option

RECOMMENDATION

Southwest should Chose the first option of expanding within the system since this options gives positive return, is less risky and also will help the organization maintain its “Luv Culture”. This option will also improve their brand image as an airline carrier that cares not only for its employees but its passengers as well. This strategy also falls in line with their idea of controlled expansion.

APPENDIX 1: ASSUMPTIONS: •

The loading factor is assumed to be 65% for expected demand and 55% for worst case and 75% for best case.

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Growth rate for the trip is taken as average of last year’s quarter growth rate.

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No of trips per day are 3 for Detroit – phoenix route and 10 for other two routes.

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The price ranges are taken from $99-$129 where the expected case is priced at $114 for Detroit – phoenix route. The price ranges are taken from $46.2-$54 where the expected case is priced at $49 for Dayton-Chicago route. The price ranges are taken from $74$100 where the expected case is priced at $87 for Baltimore- Chicago route

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Operating cost excluding fuel and salary & wages are taken 43% of total revenue following last year proportion. Fuel cost would be 15% of total revenue and it would be reduced for first option as it is a more than 3 hour route.

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To calculate salary & wages, total salary is divided by total employees to get salary per employee and then added for the additional required route. Airport charges are charged by multiplying the number of charges to the no of passengers expected by its given rate for the airport.

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The expenses which are fixed and are common not considered for calculation. As the investment of two aeroplanes is common for all options hence it was not considered to calculate cash flows.

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For NPV, WACC is calculated on the basis of last year data. Tax rate, debt rate has taken from income statement while to find out cost of equity we use dividend discount model (DDM). For DDM

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The life of the project is taken as infinite because of investment done in airport which has the infinite life.

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It is assumed that next year also expenses would be in same proportion.

APPENDIX 2: RETURN ANALYSIS

Detroit-phoenix

Demand(trips)

Q1 270

No.of passengers

178.1

Revenue (Price@ 114) O perating cost (Excluding Sal , Fuel, Dep & land charges)

Demand(trips)

Fuel costs

Sal & wages No.of passengers Airport charges

Revenue(price@87)

Net M argin

Operating cost (Excludg Sal & Fuel)

Initial investment PV of cash flow Fuel costs NPV Pay back period

Sal & wages

Dayton

Q2 Q3 Q4 Total 271.89273.793275.711091.393013 Demand(trips)

Q1 900

194377.0955 No.of passengers

Q2 Q3 Q4 Total 900.9 901.8009 902.703 3605.403601

178.1

22158988.89 Revenue(price@49)

642122.3813 31463996.68

Baltimore

Operating cost 9528365.224 (Excludg Sal & Fuel)

Q1 Q2 Q3 9002659078.667 990 Fuel1089 costs

Q4 1197.9

6647696.668Sal & wages 178.1 583134 Airport charges

Total 4176.9

13529518.57 4719599.503

743905.89

11199199.01

64719812.43

1444774.5

2740714.334Net Margin

570905.1022

27829519.34 54000000Initial investment 34251498.4PV of cash flow 34251498.4 NPV 1.576573362 Pay back period

9707971.865 21175943.73

Airport charges

1859764.725

Net Margin

4146612.767

initial investment PV of cash flow

54,500,000 51821417.06

54,500,000 7134765.908 6,634,766 8.214306391

APPENDIX 3: SENSITIVITY ANALYSIS

Baltimore Worse Expected Best Price/demand 629459 743905 858353 price/demand 74 2255947 2986120 3716292 46.2 87 3237903 4146613 5055322 49 100 4219859 5307106 6394353 54 APPENDIX 4: WACC CALCULATION

Dayton Worse Expected Best 543334 642122 740910 Price/demand -192529 355152 902833 99 -9968.7 570905 1151779 114 316032 956179 1596325 129

Detroit Worse Expected Best 164473 194377 224281 1859289 2303366 2747443 2229353 2740714 3252076 2599417 3178063 3756708

C alculationofW AC C Incom etax(given) revenue incom etaxrate Percentage

Interestexpenses Intexp(aftertax) Debtcapital C ostofdebt D ividenddiscountm odel CashDividend(pershare) Shares Total dividends Equitycapital C ostofequity APPENDIX

55816 146837 0.380122176 38.01221763

58941 36543.42 699123 0.052270373

0.053 92,472,755 4901056.015 854253000 0.102719433

5.22704

calculationofgrow th ROE*Retentionratio 0.09698

5:

W AC Cof new entrants – Low Threat w d *r d + we*re = 0.08002 PORTER’S FIVE FORCES ANALYSIS Supplier Power – Balanced • Product at Competitive Prices • Product Differentiation through adding FUN to Travel and low price • The aircrafts were being • Cost disadvantages independent of scale: Southwest operated in all the uncongested Customer Power – High airports and had committed staff that made operational efficiency easy provided by Boeing that Competitive High RetaliationRivalry in the -industry from current industry players could negotiate with the • Expected airlines at higher prices • The demand was inadequate to support the Customers exercised high large number of aircraft carriers bargaining power as he • The power of the staff employees which form a could have easily • The airlines competed for the high traffic major portion of the switched to other airline routes , hubs and the airports expenses varied offering him a better according to the type of service at lower costs due • The presence of high fixed costs, high person being employed or to the presence of a large switching costs, ability to differentiate and presence of the union. number of carriers at that keep lower prices than others also contributed point of time. to the high rivalry among the carriers

Substitutes - Low •

The substitutes such as automobiles and railroads were present but could not affect southwest airlines to a greater extent because the airlines was so positioned that the prices charged by the airline were lower as compared to the total charges incurred in ground transportation.

•

Moreover the other substitutes as the airlines also posed a lesser threat due the difference in prices at a higher side

Appendix 6: HOW DOES SOUTHWEST ACHIEVE STRATEGIC COHERENCE HOW DO THEY DO IT? The People: •

Employees are motivated and completely dedicated towards achieving customer satisfaction

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The airlines appointed people who were friendly and fun

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Employee training focused on team building

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They provided pension to the employees in form of profit sharing

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Psychological satisfaction that they achieved while working there was enormous as compared to the salaries that they received

Customer Focused: •

They believed in giving first preference to their customers over everything else and therefore came up with strategies which were well suited to their customers.

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They banked upon word of mouth of marketing and hence their customers were considered their ambassadors.

The Organizational Culture: •

The airlines had a strong organizational culture that focused on getting a “fun” element within the organization.

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Fun Element made work less tiring and fun

Boeing 737s: •

South West Airlines made use of Boeing 737 jets only. They had around 150 of them in total and it accommodated around 137 passengers. The other competitors had a fleet that consisted of variety of planes made by Boeing, Airbus industries, etc. this helped SWA on saving up on lots of cost and at the same time fast service delivery.

Limited Use of Travel Agents: •

South West did most of its booking on its own

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Travel agents had to contact the airline directly before booking the tickets for which they were paid standard 10% commission.

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Only 55% of SWA’s tickets were booked by the travel agents unlike the 90% average of the industry.

No Meals: •

The South West airlines did not provide any meal to its customers hence saved up on the time of loading and unloading food on and off the flight.

Reliance on Secondary Airports:

•

The airlines mainly relied on the uncongested airports in the small cities or less congested and smaller airports in large cities. This prevented the passengers from transferring from Southwest to other flights and the same time saved time.

Flew Short Distances: •

Southwest airlines generally flew short distances. The average length of a Southwest flight was 65 minutes. This helped in saving a great deal of time and also enabled them in providing better service.

Turnaround Time of 15 Minutes: The time taken to “turn” an aircraft was around 15 minutes which made Southwest differ from its competitors. The entire crew worked as a team and made it happen which again helped in saving up time and thus enabled them in providing fast service to its customers. Saved up on Fuel Costs: •

The pilots contributed by coming up with new procedures for takeoffs and landings that helped saving a huge amount of fuel.

•

Buy fuel from different vendors depending upon the price being offered by them.