Southwest Airlines' low-cost strategy and business model success

Southwest Airlines

Before 1978, the federal government regulated the U.S. airline industry. Airlines were given profitable routes but were also obligated to serve unprofitable routes in the public's interest. Increases in airline costs were routinely passed along to customers due to the lack of price competition.

In 1978, the airline deregulation act enabled airlines to set their own fares and enter or exit routes without government approval (Lam, 2003). The major airlines responded by dropping the unprofitable routes, in favor of the more profitable ones that were the long haul flights between big cities. Short haul flights still operated, but only as feeder flights to the major airports where the long haul flights departed from. In many cases, passengers had to fly short haul to a hub airport, then connect to another hub airport and take another flight to reach their final destination.

Deregulation allowed smaller regional airlines to expand quickly, being more flexible and carrying a lower level of debt than the major carriers. Their lower cost structure allowed the small regional airlines to position themselves as value airlines, competing with the big carriers on price. In the U.S., air travel rapidly became more popular, due to the size of the country and the lack of competition from alternative forms of long distance travel.

Southwest Airlines began as a small regional airline operating between Dallas, Houston and San Antonio. Deregulation enabled it to expand rapidly and in 1990, it hit the U.S.$1 million mark. Today, it remains a major carrier.

Southwest Airlines has reinvented traditional air travel by implementing super-low airfares and a wacky, irreverent style of doing business. This paper will present a historical overview of the company, discuss the reasons for the company success, identify financial strengths and provide a final conclusion.

PART ONE

I. Company History

In 1971, Rollin King, a San Antonio entrepreneur who owned and operated a small commuter air service, and Herb Kelleher, a lawyer, collaborated their ideas for a new type of airline (Southwest, 2003). Their plan was simple -- they believed that if an airline could offer customers fast, friendly service with low fares, people would choose to fly that airline. Their idea was on target. Today, Southwest Airlines is the fifth largest major airline in America and has flown over 50 million passengers annually to 54 cities all over the southwest and to other cities.

According to the Southwest Airlines website: "We've also got more than 355 of the newest jets in the nation, with an average age of 8.75 years. Included in our fleet are three flying killer whales, Shamu One, Two and Three; Lone Star One, painted like the Texas flag, to celebrate Southwest Airlines' 20th Anniversary in a style and manner second to none; Arizona One, a symbol of the importance of the state of Arizona to Southwest Airlines; California One, a high-flying tribute to the state of California; Silver One, our 25th Anniversary plane; Triple Crown One, dedicated to the Employees of Southwest Airlines for their marvelous achievement of five consecutive annual Triple Crown awards; Nevada One, a high-flying tribute to the state of Nevada; and the newest member of the family - New Mexico One, also known as Zia, painted in the bright yellow of the New Mexico flag."

This brief annual synopsis about the airline explains how the company got off the ground and became one of America's largest and best-loved commercial airlines in history. In 1971, with President Lamar Muse (retired leader) at the helm, Southwest Airlines took off on its maiden voyage and began service between Dallas, Houston, and San Antonio. In 1972, all Houston service was transferred to Houston's Hobby Airport from Houston Intercontinental. Kelleher was quoted, "Why should our customers have to drive 45 minutes to take a 40-minute flight?"

In 1973, Southwest flew with the Texas Aeronautics Commission to extend service to the Rio Grande Valley. RUSH Cargo service, a same-day airport cargo delivery company, was introduced and Southwest had its first profitable year. In 1974, Southwest announced that it passed the one-millionth passenger mark. The company also spent $400,000 to renovate its terminal at Houston's Hobby Airport by adding two new boarding gates and departure lounges. 1975, Southwest was given permission to fly to the Rio Grande Valley via the Harlingen Airport with four roundtrips each business day.

In 1976 Southwest got clearance to begin service to Austin, Corpus Christi, El Paso, Lubbock, and Midland/Odessa. Within five years, Southwest placed its sixth Boeing 737 into service while flying over one and a half million satisfied customers to their destinations. In 1977 Southwest announced that it had passed its five millionth passenger mark. Southwest stock was listed for the first time on the New York Stock Exchange as "LUV."

In 1978, the 1978 Airline Regulation Act gave Southwest the opportunity to really expand with new service to St. Louis, Kansas City, and Detroit from Chicago's convenient Midway Airport. Lamar Muse resigned as President and Kelleher took his place as interim President, CEO, and Chairman of the Board. Later in the year, Howard Putnam was elected President and Chief Executive Officer. Kelleher resumed his position as permanent Chairman of the Board.

In 1979, Southwest offered service to New Orleans from Dallas, which was the first city outside of Texas to be served by Southwest. In 1980, Southwest added its 22nd Boeing 737 to the fleet and named it the "Rollin W. King" in honor of the co-founder of the airline. It was the first 737 to be owned outright by Southwest Airlines. In 1981, Southwest celebrated a decade of "Love Southwest Style." The company launched the new decade by offering fun promotions, games, and more savings for customers and employees alike.

In 1982 Kelleher became Southwest's permanent President, CEO, and Chairman of the Board. New service to San Francisco, Los Angeles, San Diego, Las Vegas, and Phoenix was offered. In 1983, major schedule increases were adopted, three additional Boeing 737- 200s were purchased, and Southwest flew nearly 10,000,000 passengers. In 1984, Southwest was ranked number one in customer satisfaction for the fourth consecutive year.

In 1985, Southwest attracting media coverage by naming the Ronald McDonald House as its primary charity. The company also launched the "Just Say When" campaign, which established Southwest as the most convenient point-to-point carrier in the United States. In 1986, Southwest introduced Fun Fares, offering reduced airfare and hotel packages for vacations. In1987, Southwest celebrated the sixth year in a row as a recipient of the Best Consumer Satisfaction -- a record for any continental U.S. carrier.

In 1988, Southwest and Sea World of Texas collaborated to promote Texas as a major tourist attraction. Through the "New Friends" campaign, Southwest became Sea World of Texas' official airline and created Shamu One, a Boeing 737 painted like Shamu the killer whale. Later in the year, Southwest became the official airline of Sea World of California, promoting its reputation as a "fun" airline. Southwest also won the first Triple Crown: Best On-Time Record, Best Baggage Handling, and Fewest Customer Complaints. In 1989, service started from Oakland's International Airport.

In 1990, Southwest celebrated its billion-dollar revenue mark and became a "major" airline. In 1991, the airline celebrated its 20-year anniversary. The company was awarded the first annual Triple Crown in 1992. In 1993, the airline expanded to the east coast and started service to Baltimore/Washington International Airport. By mid-1994, the company offered ticketless travel in four cities. Morris Air also merged with Southwest in 1994. In addition, Arizona One joined the fleet. Seven new cities opened, including Seattle, Spokane, Portland, and Boise in the Pacific Northwest.

In 1995, ticketless travel became available systemwide. California One debuted in Sacramento. The airline added service to Omaha and was awarded the fourth consecutive Triple Crown in 1995. In 1996, Florida service was added and Southwest celebrated 25 years of service. Online ticketless travel was launched on the Southwest Airlines Home Gate webpage. In addition, Southwest inaugurated service from Providence, Rhode Island.

In 1997, Southwest started out the year with service to their 50th city - Jacksonville, Florida. Jackson, Mississippi became the 51st city added in August. In December, Southwest accepted the delivery of its first Boeing 737-700. Southwest was the launch customer for Boeing of the next generation Boeing 737-700. In 1998, the airline added new service to Manchester, New Hampshire. In 1999, it began new service to Islip, New York.

In 2000, Southwest Airlines introduced "SWABIZ," a tool that assists company travel managers in booking and tracking trips made through southwest.com. New service to Albany International Airport and Buffalo-Niagara International Airport also began. In 2001, Southwest Airlines started new service to West Palm Beach, Florida and Norfolk, Virginia. Southwest also celebrated its 30th birthday, marking the milestone with the unveiling of Spirit One.

II. Financial Analysis

There are many different ratios that can be used by managers and investors to analyze and forecast the profitability and efficiency of Southwest Airlines. The following sections will use various ratios to analyze the company's financial strengths and weaknesses.

Short-Term Liquidity Ratios

To measure Southwest's ability to meet its short-term financial obligations and to assess the ability of the company to convert current assets to cash to reduce current liabilities, we must look at the company's short-term liquidity ratios. The short-term liquidity ratios are used in the evaluation of short-term liquidity to convert current assets into cash in order to reduce the financial obligations of the company as they arise (Horngren, 1996). These ratios are particularly significant to the creditors and investors of a company because they determine the ability of that company to pay off their debts.

In addition, investors focus on the company's definition of current assets and current liabilities since these factors have a direct impact on the amount of available working capital of a company. Typically, a current ratio of 2:1 and a quick ratio of 1:1 are considered to be acceptable (Irwin, 1994).

Financial Ratios for Southwest Airlines

Current Ratio

Quick Ratio

As demonstrated in the table above, Southwest's quick ratio also has remained under 1:1, which is the benchmark value for this ratio. The company has also maintained a higher than average current ratio. These trends indicate that Southwest is in a good position than its competition to meet its short-term financial obligations.

Profitability Ratios

Profitability ratios can be used to determine the profitability of Southwest Airlines. These ratios help evaluate the company's ability to monitor and control expenses and to earn a profit on resources committed to the business. Thus, by looking at these numbers, we can better assess the company's strengths and weaknesses, operating results and growth potential. These ratios measure how successfully the assets are being used to generate net income and sales. The higher the ratio, the more successfully a company is using their assets.

Profitability Ratios for Southwest Airlines

Financial Ratios

Gross Profit

Return on Stockholder's Equity

Return on Total Assets

The gross profit percentage suggests whether the profits will cover operating expenses. Southwest Airlines has a relatively high gross profit rate, mainly due to low operating costs, which gives the airline a competitive edge. Return on stockholder's equity determines the successful use of resources provided by stockholders. Southwest Airlines has had a significant increase in this ratio over the past few years.

Leverage Ratios

Leverage ratios are effective in assessing the debt levels of Southwest Airlines. The main focus of these ratios is the entity's ability to make payments to long-term creditors. Both creditors and shareholders are interested in these ratios and look for low ratios when making investment decisions. These ratios demonstrate the company's ability to withstand poor business conditions without suffering net losses or insolvency.

Leverage Ratios for Southwest Airlines

Financial Ratio

Debt-to-Total Assets

Debt-to-Equity

This table shows a decreasing trend in all of the above ratios from 2000 to 2002. This demonstrates the continuous stability of Southwest Airlines and its ability to meet its long-term obligations successfully without encountering net losses or insolvency.

Dividend Ratios

Divident ratios help determine the return on investment for Southwest Airlines.

Financial Ratio

Price-Earning

Dividend-Yield

Dividend-Payment

The recent decline in the market has affected the Southwest Airline's market price. The dividend-yield for the airline is very low, which means that the company is most likely reinvesting their profit in the future expansion of the company. Investors who plan to see a big cash return on their investment annually would avoid investing in Southwest Airlines.

III. SWOT Analysis

Southwest Airline's success is largely attributed to its ability to find a niche in the airline industry and tailor its growth to focus on that niche (Freiberg, 1996). By analyzing the company's strengths and weaknesses using a S.W.O.T. analysis, this paper aims to identify the direction Southwest should take in the future.

Strengths

Southwest Airline has separated itself from traditional airlines by creating a strong, fun, employee-oriented culture. The company's mission statement stresses these aspects of the business. As a result, the company has developed a loyal employee base that works hard to achieve Southwest's goals. Southwest has also managed to gain loyal customers by offering relatively low cost airfares. The company's commitment to offering a low fare structure to customers has made air travel more affordable to many consumers and has caused a consistent increase in demand for expansion into new markets, as well as increasing price competition within the cities it caters to.

Southwest's founders believed in things that its competitors did not, resisted the temptation to expand rapidly, in both personnel and markets. Southwest avoided the transcontinental and international markets, enabling the company to concentrate on steady growth. The management understood that they were in a price sensitive market, so they chose to eliminate any extra amenities in airline travel, reducing costs and ultimately offering low fares to consumers.

Southwest Airlines focuses on internal strengths and efficiencies, including rapid turnaround time, reusable boarding passes, and single style aircraft, to significantly reduce its overhead. Its low-cost existence allows the company to be more flexible in embracing new opportunities. Southwest claims to welcome new competition against their strategy, insisting that competition only makes them stronger. In maintaining consistent management, Southwest has managed to maintain and improve its corporate and culture vision. Creativity in marketing and negotiation in the face of an obstacle is one of the company's greatest strengths.

Weaknesses

Southwest Airlines has expanded its business so much that it must start to enter more markets where it faces competition by the larger carriers. The company currently operates only in the United States, concentrated in the western regions. Southwest's lack of expansion into transcontinental markets and international markets may cause Southwest to buy a variety of planes.

Southwest Airlines may be losing a significant amount of customers by not catering to business travelers. The company does not have a first-class section on its planes nor does it offer seat reservations. It also fails to offer meals to passengers, instead offering just peanuts and pretzels. This is unacceptable for some markets.

As the company grows, its ability to react to threats of new entries into their market may decrease. Relying on a single type of aircraft and manufacturer, Southwest may be negatively affected by any increases in cost or defects in company planes.

Opportunities

Southwest Airlines' financial strength and consumer loyalty position the company for many new opportunities. Many efforts by competitors to match Southwest's service and prices have been decreased due to operational and financial difficulties, so the company faces little competition right now. In addition, the major competitors have higher operational costs so they have less room to expand.

Southwest's strength and financial status are good reasons for investors to support growth into new markets. Southwest has not yet explored international and transcontinental markets, although research shows entry into these markets would be welcomed. As major carriers focus on international markets, Southwest also has the ability to enter the markets the larger companies have abandoned.

Threats

As Southwest continues to grow, it faces many potential threats. Many major airlines are aggressively competing with Southwest for its market position. For instance, United Airlines recently launched its "We are going to match Southwest" strategy, which places Southwest in a highly competitive environment, as reputable airlines struggle to match Southwest's service and prices. Major competitors have the resources to improve Southwest's idea by offering things that Southwest does not, like seat reservations, first-class sections, and more flights.

In addition, like all airlines, Southwest faces threats from external forces. Fear of terrorism has caused customers to look into alternative forms of transportation, such as high-speed railway, weakening demand for air travel. In addition, Southwest faces threats from higher fuel costs and new taxes.

PART TWO

Implementing a New Strategy

The competitive landscape for Southwest is constantly changing. "Continental Lite" and "Shuttle by United" initiatives were recently adapted by Continental Airlines and United Airlines in an effort to assume Southwest's market share (Freiberg, 1996). Continental's efforts were being scaled back due to operational and financial difficulties. Still, United's initiative remained in effect -- a looming threat to Southwest.

Thus, the question remains: "How can Southwest Airlines continue to grow and maintain its leading positioning as a low-fare airline with exceptional customer service, given a changing competitive landscape and a high competition?"

Based on the SWOT analysis, we have determined that Southwest airline has more strengths than weaknesses, and more opportunities than threats. Still, it is important to maximize the positive aspects of the company and constantly work to reduce its weaknesses and threats. The following chart reveals some of the most important findings of the SWOT analysis.

STRENGTHS

Focus on fun, friendly customer service and an employee-oriented culture.

Ability to offer low fares and point-to-point service to passengers.

Relatively low operating costs.

Strong reputation as an industry leader.

WEAKNESSES

Operations only in the United States, concentrated in the western regions.

No first-class seats or seat reservations.

No food on flight, just peanuts, snacks and beverages.

Reliance on a single type of aircraft and manufacturer.

OPPORTUNITIES

Competitors' efforts to match Southwest's service and prices have been scaled back due to operational and financial difficulties.

Major competitors have higher operational costs.

Expansion of markets.

THREATS

Major airlines may try to match Southwest's service and prices.

Competitors may offer seat reservations, first-class sections, and more flights, in addition to low prices.

Fuel cost changes.

There are many things Southwest Airlines could do to improve its strategy. For one, the company could slightly increase airfares while maintaining its fun, fast and friendly service. This would benefit the company by bringing in more revenue, which would allow it to pay for its advertisements and promotions in new markets.

On the other hand, this strategy could be detrimental to Southwest. The airline would be in greater danger of losing its market share to competitors and of losing its competitive advantage. Southwest is currently positioned as a low-fare airline. If it increased its fares too much, it would lose this position.

Thus, Southwest would have to be careful to only raise its prices slightly. In a competitive environment, raising prices yet maintaining the same service is a risky strategy. In this light, it might be a good idea to consider raising prices and improving service. For example, the airline could increase its fares and offer a first-class section in some of its planes and guarantee seat reservations.

If Southwest increased its fares while improving service, they would ultimately improve the airline with better service. The higher fares would increase revenue. However, offering first-class seats increased operational costs. This means that the company would lose its competitive advantage (low operation costs).

As part of a new strategy, Southwest could retain its existing low fares while expanding its services to new cities. This would increase revenues while allowing the company to maintain its low operating costs. In addition, the company would maintain its position and offer more flights. Thus, the only threat they would face would come from the efforts of competitors, who might lure customers will first-class seats and more amenities.

This seems to be the most feasible solution. Southwest should, in my opinion, keep its current fares and expand the company's flight services to other cities. By doing so, the company will increase its revenues, maintain its positioning, offer more flights, and maintain its low operation costs.

Marketing Plan

Essentially Southwest provides a service. As a product, their core offering of transportation is hard to evaluate objectively, as it is intangible. The quality of service strongly influences the consumer's perception of the company.

In this regard, Southwest tries to separate itself from the competition by providing the customer with lower prices and more value through quality of service and convenience (Lam, 2003). Southwest's focus on customer service has given it a reputation as a top ranking major carrier in punctuality, baggage handling and overall customer satisfaction for many years in a row. In the past, no airline had taken this rank in all three categories for even a single month.

Marketing strategies apply to the internal workings of Southwest Airlines. To provide good service, the corporate culture must perceive customer satisfaction as being one of the important aspects of business. Southwest emphasizes the need for a positive outlook, desire to work hard and compassion for passengers and employees.

To deliver convenience, Southwest has relied on point-to-point service, rather than the hub and spoke service of its competition. This has enabled the majority of its customers to fly direct to their destination quickly and conveniently. Southwest has always recognized that flight frequency is a major consideration. All Southwest planes have a turn around time (time spent on the ground) of 20 minutes or less, compared to the industry average of 55 minutes. This has enabled Southwest to fly more flights more frequently with less planes.

Southwest's marketing strategy relies on the assumption that the value of flying with Southwest is perceived as higher in the eyes of its customers as a result of the better service and more frequent flights.

Southwest's marketing strategy also serves to develop brand loyalty. In the past, there has been little brand loyalty in air travel. The cost of air travel was high and most customers went to the airline that offered the lowest price. Southwest has concentrated on building brand loyalty by rewarding customers that frequently travel on Southwest airlines.

Southwest Airlines plan for expansion aims to increase revenues, offer new flights, maintain low operational costs, and maintain the company's positioning as a low-fare, good customer service company. The marketing plan will be targeted towards the following markets:

Western and eastern United States;

Companies and executives; and Adults (families, tourists)

Southwest's marketing mix will utilize the following strategy. Southwest will market its airline as one that will give customers excellent customer service, on-time flight service, new planes, an element of fun, and snacks and beverages, for a low fare. The company will not offer first-class seats but should provide seat reservations. In order to keep its position, it must continue to offer low-fare tickets.

The best way to increase sales is to increase promotions. Therefore, Southwest will advertise in magazines, newspapers, on television, and through travel agencies. The airline will also maintain its current promotion strategy

Southwest Airlines must continue to monitor its competitors' pricing and promotion strategy, in order to determine price decreases and stay ahead of the game. In addition, the company must be prepared to offer first-class in its airplanes in the future, and flights to more cities in the eastern states if necessary. For Southwest, the most important strategy is to maintain low operation costs, and keep its customers happy.

Southwest should also continue to promote its culture, as it has become one of the most reputable in the airline industry. Most importantly, Southwest must continue to concentrate on the key aspect that has brought it such great success -- its ability to offer low fares to customers.

Southwest's expansion into new cities should be at a slow enough pace to allow effective coverage of new markets. Ideal new cities will enable Southwest to offer non-stop flights. As Southwest adds new aircraft, the potential markets are bound to expand. To accommodate this growth, Southwest must continue to implement new technologies, including ticket less travel and online reservations. New technology also involves commitment to new aircraft, which will result in a young, safe fleet of jets with greater range. All of these technologies would permit Southwest to maintain low costs, expand to more markets, and to maintain its image as an inexpensive, safe and reliable carrier.

In conclusion, Southwest should continue to focus on improving its noteworthy culture. Southwest's fun-loving attitude and dedication to its employees have produced many tangible and intangible benefits. This is a true competitive advantage. Since the beginning of Southwest Airlines, management has been dedicated to their mission. This commitment has enabled the company to achieve great rewards.

Southwest's future depends on its ability to stay ahead of the competition. Eventually a company will probably be able to duplicate the cost savings that Southwest has achieved and will compete effectively with Southwest on price. Without the cost advantage, Southwest will have to figure out new ways to beat its competitors.

The current price level of air travel has fallen to a fraction of its former level prior to deregulation. As a result, price competition has become less important in comparison to the other characteristics of air travel, including overall enjoyment of the flight itself. Due to Southwest's relentless drive to improve service and the difficulty to emulate this, its position as market leader seems to be a maintainable position.