American Airlines: History, Costs, and Competitive Strategy

Introduction and Deregulation Background

The first decade of airline deregulation is reported to have resulted in the profits of the U.S. airline industry declining by 74% from levels that were already unsatisfactory. The American government deregulated the domestic airline market in 1978 under the Airline Deregulation Act. The results of deregulation are reported to have included "increased competition, lower fares, new carriers, frequent-flyer loyalty programs, alliances, and networks" (Tolkin, 2010). The legacy airline carriers following deregulation were up against much stronger competition from the new low-cost carriers, which are reported to have "leveraged the advantages granted under the deregulated market" (Tolkin, 2010).

Route Structure, Product Alternatives, and Differentiation

Frequent-flyer programs (FFPs) were introduced following deregulation and provided customer loyalty rewards including "tickets, cabin upgrades, priority check-in, priority boarding, lounge access, and other benefits" (Tolkin, 2010). These programs were innovative and enabled customers to enroll in an airline's FFP and accumulate mileage points based on distance traveled and class of service, with first- and business-class passengers receiving multiples of the base rate. Passengers could then redeem those miles for rewards such as free or discounted tickets and cabin upgrades (Tolkin, 2010). In addition, non-airline companies partnered with airlines to offer awards and miles for non-airline services and goods, attracted by "the extensive membership rolls the airlines possess and the marketing opportunities as a result of these lists" (Tolkin, 2010).

Loyalty programs were pioneered by American Airlines in 1981 and were soon followed by major carriers such as United Airlines, Delta Airlines, and others introducing their own FFPs (Tolkin, 2010). These programs were found to be often more profitable than other forms of marketing, such as competing on services, routes, and price. In addition to lower marketing expenses, FFPs provided airlines with significant additional revenue (Tolkin, 2010).

Airline carriers are also characterized by a structure known as the hub-and-spoke model. The concept is relatively straightforward: an airline selects an airport with a central geographic location relative to major traffic flows and operates flights in and out of this central hub, enabling more cities — or spokes — to be reached (Tolkin, 2010). The benefits of this model are reported to be numerous. Airlines are able to leverage it to decrease labor and equipment costs; rather than maintaining support staff across many cities, airlines can centralize their operations and lower costs (Tolkin, 2010). These systems decreased unit costs but also created high fixed costs, requiring larger terminals, investments in information technology, and intricate revenue management systems (Tolkin, 2010). Negative aspects of the system included passenger discontent due to increased delays and congestion.

Airline Cost Structure: Fixed, Variable, and Controlled Costs

The cost-price disconnect in the airline industry arose from rapidly rising costs following the September 11, 2001 attacks, compounded by labor agreements made during the prosperous 1990s. A confluence of events — including war in the Middle East — "led airline management to focus on liquidity and CASM [cost per available seat mile] and government assistance in the form of subsidies, insurance, and tax relief" (Dempsey, 2008). Costs were additionally driven by the megatrends of deregulation (Dempsey, 2008). The revenue side of hub operations resulted in geometric growth in the number of city-pairs marketed, creating "monopoly and duopoly pricing opportunities for origin and destination traffic to and from the hub, as well as certain connecting markets fed only by it" (Dempsey, 2008). Airline carriers were also able to take advantage of the S-curve relationship between revenue on one axis and frequency on the other (Dempsey, 2008).

A demand-capacity disconnect was also identified. The excess capacity that the North American industry experienced was described as "a product of the desire of U.S. airlines to offer the frequency levels that attract high-yield business traffic" — a tragedy-of-the-commons phenomenon (Dempsey, 2008). The fifteen interior U.S. hubs were reported to create wasteful network duplication, driving competitive pricing down to variable costs in order to derive some revenue from seats that would otherwise fly empty (Dempsey, 2008).

Variable costs for airline carriers include the price of fuel, which can experience significant fluctuations. Fixed costs — those that are certain regardless of operations — may include employee salaries and the cost of maintaining and upgrading flight equipment. Other variable costs include landing and airport fees, which are calculated on the basis of aircraft weight and passenger levies. Ancillary fees are charged for services such as "checked baggage, food and beverage, seat selection, priority boarding, ticket changes, reservation methods, and carry-on baggage fees" (Dempsey, 2008).

Conclusion

American Airlines managed to bring about a reduction in costs while other airlines, including TWA, simply could not find a way to reduce costs — a challenge further stressed by those carriers' lack of a solid financial base. In the airline industry, just as in other industries, the ability to achieve higher profitability is ultimately dependent upon effective cost-reduction methods. The combination of loyalty programs, hub-and-spoke efficiency, disciplined revenue management, and strategic cost control distinguished American Airlines from those carriers that did not survive the turbulent post-deregulation era.

References

Dempsey, Paul Stephen (2008). The Financial Performance of the Airline Industry Post-Regulation. Symposium 2008, Vol. 45, No. 2. Retrieved from:

McGill, J. I., and Van Ryzin, G. J. (1999). Transportation Science, Vol. 23, No. 2. Retrieved from:

Tolkin, J. (2010). Airline Bankruptcy: The Determining Factors Leading to an Airline's Decline. Claremont Colleges Scholarship @ Claremont, Fall 2010. Retrieved from: http://scholarship.claremont.edu/cgi/viewcontent.cgi?article=1088&context=cmc_theses