The Archetypical Low-Cost Air Carrier: Southwest Airlines
ECON 211 Macroeconomics
Embry-Riddle Aeronautical University
The seventh largest major domestic airline in the United States (US), Southwest Airlines, is commonly known or referred to as a low-cost carrier. Southwest Airlines is the only major airline that provides short-haul, point-to-point service in the United States. In fact it was the first airline of its type ever started; it has become the archetypical low-cost airline. The idea has proven itself so well, that other start-up airlines have based their company strategies upon the basics of Southwest. Today, there are two other low-cost air carriers (the other two airlines are considered national airlines and not major airlines) that are actively and aggressively competing with Southwest Airlines for business and profit turning. The three American low-cost air carriers are currently posting profits even in light of the US economy’s current state of affairs, with Southwest Airlines first, JetBlue second, and Air Tran third, in profits. How is this possible when the major six airlines are reporting losses of millions and millions of dollars each quarter? The answer to this question begins about 30 years ago.
The Archetypical Low-Cost Air Carrier: Southwest Airlines
The product one airline can offer is the same exact product the next airline can offer, a single available seat mile (ASM) for sale. The difference between the airlines lies in the marketing, routing, pricing, executive decision-making, and the operating strategies that each airline chooses to espouse regarding that one product. It is through these strategies that an airline must find productivity in total revenue passenger miles (RPM) flown to be profitable. When the ASM is filled with a fare-paying passenger, sales or income is recognized, and it converts to an RPM. The relationship between the ASM and RPM are directly related and is expressed in percentages known as Load Factors (LF). This LF is a management tool used to determine the efficiency and health of the airline. It is necessary to keep these two variables in balance of each other. Southwest Airlines load factors are represented in Figure 1 and 2.
LF = ASM
Many airlines choose to use the hub network, which induces costly effects in all areas of the airline. It is the point-to-point; short haul airline that is capable of keeping costs low and turn profits, Southwest Airlines has proven just that.
Southwest Airlines survived the initial years of deregulation, years of cyclical business cycles that may have led to recessionary and or inflationary periods, and its 25-year
post-deregulation financial condition remains strong regardless of current economic trends. The airline management has made sound decisions in a governed airline market as well as an ungoverned airline market. It chooses to maintain a conservative financial philosophy and growth is only realized when the company can afford it. Many airlines have been faced with losses on a continuing basis, whereas Southwest has performed consistently and remain unsurpassed through 30 years of service.
“Keeping airfares low is dependent upon the airline keeping costs low which can be conducted through many things; being less unionized which allows for lower wage rates and less restrictive work rules, flying aircraft more hours per day, allowing more managerial discretion in making labor assignments, using less expensive satellite airports or terminals, eliminating “unnecessary” service frills, encouraging travelers to carry their own luggage, not interlining reservations or luggage, eliminating meal services, and possibly using an all coach-class seating configuration” (Meyer and Oster, p. 50). It has been through these ideas that Southwest have been able to guide and conduct its airline operation strategy.
Through the brainstorming of two individuals, Rollin King and Herb Kelleher, a new company was formed and an airline was at the brink of birth. The company decided that the infrastructure and operations of this airline would be quite different from the others and be the first airline of its kind. The company’s operating strategy would be based upon maintaining short-haul frequent flights from airports that were not primary busy airports that did not experience congestion and air traffic delays. Instead, it would service secondary airports that minimize the time aircraft are on the ground and where the local populace could provide enough generated revenue to keep the aircraft flying.
To fully implement and realize their brainstorming to create a new airline, they needed to be able to answer, “What do passengers want?” It is upon those responses of; destination, on time arrival, and the lowest fare possible, that the structure of a new airline was conceived.
The two gentlemen, Rollin and Herb, armed with the knowledge of what they believed a passenger wanted went about how to address each issue. The company decided the best way to address the destination issue was to provide point-to-point service “for more direct nonstop routingstherefore, minimizing connections, delays, and total trip time” for all flights offered (Annual Form 10-K Report, p.3 & 22). This meant that passengers would not need to be routed through the company’s primary hub in Dallas, Texas for connecting flights. With the point-to-point service, this would diminish the total time required by passengers for traveling to their intended destination. Additionally, by-passing the hub connection, this allowed for a higher percentage of on time arrivals for passengers, thus providing the company an opportunity to excel in committed service. Today, the company’s “average aircraft trip stage lengthwas 548 miles with an average duration of approximately 1.5 hours” (Annual Form 10-K Report, p. 3). Finally, the company wanted to be able to offer the fare-paying passenger a service that was affordable. These answers set the motions for the creation of a superlative low-cost air carrier, Southwest Airlines. The airline would be aimed at providing the lowest possible fare without sacrificing quality but yet economically feasible to operate. Rollin and Herb believed the low fare was sure to attract passengers and keep the company and planes operating efficiently. Then on June 18, 1971, Southwest Airlines began its first service in Texas between Dallas, Houston, and San Antonio, utilizing three Boeing 737 (B737) as aircraft of choice.
Another aspect of the operating strategy was to only use one type of aircraft, therefore reducing costs associated with pilot and flight attendant training, maintenance, scheduling, flight operations, and spare part inventories. Southwest Airlines wanted an aircraft that was efficient, short-ranged, and technologically advanced. They chose the Boeing 737 because it is the smallest twin-engine jetliner that accommodates 115 to 169 passengers. It is used for short-to-medium range hauls. It is versatile and easily converts in less than one hour from an all passenger configuration to an all cargo configuration, or a combination of both. Since Southwest Airlines does provide cargo freight services nowadays, this has been a major plus in the configuration capabilities of the aircraft. The aircraft is an aerodynamic aircraft retrofitted with Performance Data and Navigation Computer Systems. The aircraft is designed and certificated to be piloted by a two-man crew, which contributes to its effective cost controls in addition to its many other features available. The pilots only need to be trained on one #######; flight attendants need to only be trained for providing in-flight service for one type aircraft; and the mechanics only need to worry about providing maintenance to one type engine. The engines are located under the wings that provide the ability to perform mechanical requirements easier and the mechanic can stand on the ground to reach the engines. These strategies afford Southwest Airlines to keep their costs down through efficiency of uniformity. It is understandable why Southwest chose this particular jetliner as its aircraft of choice.
Southwest Airlines financial strength is demonstrated through its present and future aircraft fleet. The company “operated a total of 357 B737 aircraft as of December 31, 2002, of which 97 were under operating and capital leases. The remaining 278 aircraft are wholly owned.” “currently intends to retire its fleet of 27 B737-200 series aircraft over the next three years. As of February 1, 2003, Southwest is scheduled to take delivery of 17 new B737-700 series aircraft from Boeing in 2003, 23 in 2004, 24 in 2005, 22 in 2006, 25 in 2007, and 6 in 2008. The company also has a total of 79 purchase options for new B737-700 aircraft for years 2004 through 2008 and purchase rights for an additional 217 B737-700s during 2007-2012. The company has the option, which must be exercised two years prior to the contractual delivery date, to substitute B737-600s or B737-800s for the B737-700s” (Annual Form 10-K Report, p. 6 & 7).
After just two short years the company reports its first profitable year with a net income of $175.00. The company was thrilled with their performance and looked to expand service to the Rio Grande Valley by filing an application for authority through the Texas Aeronautics Commission. In 1975 service authority was granted and Southwest Airlines initial expansion began by flying four roundtrips each day from Harlingen Airport.
By the fifth year of operation, 1976, the company was continuing to post small profits as it continued climbing upward from the bottom of the ladder. This was reflected in the company by two means. Firstly, by placing another B737 into service and expanding the total aircraft inventory to six. Secondly, the Texas Aeronautics Commission granted authority for the company to expand service yet again to other points around Texas. In the same year the company reported of having provided service to over one and half million passengers.
By 1977, Southwest Airlines was still slowly flourishing which was apparent by the gains in economic financial growth that was attributed to the sound executive management decisions and practices of the airline. The airline reported and posted profits that realized a net income of $7,545.00, which had increased from the previous year. The growth of the company was recognized by it being able to offer its common stock on the New York Stock Exchange (NYSE) under the ticker symbol of “LUV”. Today, the ticker symbol LUV is pronounced as “Love” (“A Brief History,” p. 1-5), which has become a common usage in slogans for their marketing and advertising strategies. Not only did the company become a part of the stock exchange it also realized growth in total passenger service by attaining a milestone of carrying five million satisfied passengers.
On October 24, 1978, President Carter signed into law and Congress enacted the “Airline Deregulation Act,” which terminated the governments’ economic involvement through the Civil Aeronautics Board (CAB) of maintaining and or excising control over the routes and fare pricing of the airline industry. This act was comprised of multifold purposes aimed at the airline industry and its consumers. It produced multifold effects at that time and which are still visible 25 years later. The main purposes afforded airlines new opportunities in seeking expansion mainly through route and price structuring; and reduce the cost of passenger fares. The deregulation act forced airlines to become self-sufficient enterprises to seek new and innovative ways to attract passengers. This brought about intense competition between airlines. Many airlines experienced the collapsing of infrastructures and suffered severe negative impacts and adverse affects that elicited the complete demise of many. “These failures illustrated the vulnerability of the airlines” and “the inexperience of airline management to strategically structure their route planning in the deregulated environment” (Wolfe and NewMyer, p. 5) ; (Meyer and Oster, p. 55) (respectively). “Nevertheless, the ability of the National carriers to register profit in contrast to the majors suggests that these carriers were flexible enough to adapt to deregulation even during adverse economic conditions” (Wolfe and NewMyer, p. 5). Since that time, many airlines have come into existence, many have disappeared, and many today are threatened with disappearing.
Fortunately, Southwest Airlines was already operating under the premise of low fare structure, so in that regard, deregulation had no effect upon the airline. The part of deregulation that affected the company was the approval for service routes that were controlled by the government. With the route structuring no longer blocked, the company decided to begin service outside of Texas in 1979. By 1980 the company increased its aircraft inventory again by “adding its 22nd B737It was the first B737 to be completely owned by Southwest Airlines” (“A Brief History,” p. 2-3). Then in 1981 the company celebrated its tenth anniversary and made a commitment to continue providing excellent service to its passengers. By this time, the company was beginning to gain the attention of other airlines due to its young age and continuous trailing profits. The company had again realized a positive net income of $34,165.00, while the other airlines were facing declined cash flows, which led to high interest debt financing to obtain money, due to the country’s general economic environment.
Almost ten years after deregulation, the adverse effects were still widely spread among the airline industry. Many of the airline markets had become highly intensified because of the public demand for air travel. The financial position of the company continued to be strong and this was recognized again through slow but determined service route expansions to other states. Additionally, the company earned several awards for its attention to customer satisfaction and maintaining the “Best Consumer Satisfaction record of any continental U.S carrier” (“A Brief History,” p. 3). It also received many other awards for baggage handling, on-time records, and the least of customer complaints.
The public demand for air travel increased steadily through the mid-1980’s causing increased competition to turn into a flow of profits for the airlines that did survive deregulation. But unfortunately, the airlines were faced with aging aircraft and they needed to be replaced. Many of the companies spent their profits on replacing their fleets with newer and larger various types of aircraft, which immediately depleted any profits gained.
After almost twenty years of “spreading LUV all around” (“A Brief History,” p. 3-4), the company “announces reaching the billion dollar revenue mark and becomes a “Major” airline” (“A Brief History,” p. 4) in the industry. Southwest Airlines now has the full attention of all the other airlines, analysts, and economists. Obviously this is a well-managed company, the mechanics of the infrastructure and strategies of the company have proven over time that they are sound and their intent works.
Through the decade of the 90’s, Southwest airlines continued to expand its service routes across the United States. Today, the airline services 58 cities utilizing over 350 B737’s. The company has done so well that it has been capable of painting schemes on its aircraft in various themes to pay tribute to someone, something, or somewhere. The total net income continues to reflect the healthy economic financial status that Southwest Airlines has come to enjoy. In 2002, the reported net income of the company was $240.97 million dollars. “Although our fourth quarter and full year 2002 financial results are disappointing relative to historical standards our performance relative to that of the industry as a whole has been excellent,” said Chief Executive Officer James Parker (“Southwest Airlines posts,” p. 1).
During the 1990’s the “public dissatisfaction with airline ticketing practices had grown-particularly because of the many restrictions on lower priced tickets and increases in the price of unrestricted tickets” (Transportation Research Board and National Research Council, p. 3). Due to the high cost of business travel, corporations were beginning to conduct their business meetings via video or conference calls, because they too were cutting back on traveling expenses. This down turn of business travelers began to affect the airlines profits. But Southwest Airlines had already been offering low-fares and had established policies in effect and was unaffected by the public dissatisfaction or the declining profits experienced by the other airlines. The Southwest Airlines Company does have certain rule restrictions applicable to tickets and refunds.
The company “employs a relatively simple fare structure, featuring low, unrestricted, unlimited, everyday coach fares, as well as even lower fares available on a restricted basis. The majority of tickets sold are nonrefundable, which is the primary source of forfeited tickets. Tickets that are sold but not flown on the travel date can be reused for another flight, up to a year from the date of sale, or can be refunded (if the ticket is refundable). A small percentage of tickets (or partial tickets) expire unused. Fully refundable tickets are rarely forfeited” (Annual Form 10-K Report, p.3 & 22).
The new millennium brought renewed commitment from the Southwest Airlines Company to continue low-cost fares at unbeatable quality performance from its employees and executive management teams. It claims “a title no other airline in the industry can claim: The only short haul, low-fare, high frequency, point-to-point carrier in America” (“A Brief History,” p.5).
At the turn of the century, the widespread financial problems of other airlines were beginning to be publicly known. Many of the “airlines financial woes, blamed by some on deregulation, can also be blamed on adverse economic conditions” (Wolfe and NewMyer, p. 177). Some blame the terrorist attacks that occurred in September 2001. While others blame the incursion of regional jets, low-cost carriers, heavy tax burdens, and economic trends combined with rising fuel and labor costs were driving the profits of the companies lower and lower. I do agree that regional jet aircraft are economically cheaper to operate, but they do not represent large losses of revenue for airlines. The incursion of low-cost carriers has made the market competitive and causes the other airlines to realize lower if any profits. The airline industry carries the heaviest tax burdens throughout the free-market in the US, and the heavy taxation does impede in overall profits. As for rising fuel costs, let’s face it, airplanes need fuel to fly and the rising fuel costs can and are significantly affecting the airlines. But Southwest Airlines has attempted to keep their costs as low as possible by hedging fuel prices. Personally, I think all of the stated variables culminated with the lack of economic forecasting; the ability to react to current economic conditions; unsound financial consultation, recommendation, and executive decisions have rendered many airlines financial status as unpredictable and unstable. “It must be recognized that the air carrier industry has never been a strong financial performer” (Meyer and Oster, p. 18). The higher wage rates demanded by the unions and prior precedent set by United Airlines, has caused continual problems with the airlines. Southwest Airlines is approximately 80% unionized. But the company offers profit sharing in the company to all of its employees. This profit sharing produces high productivity among employees to ensure the future success of the company, because they have a stake in the company. In fact, analysts say, “The Company’s famously faithful employees insist that Southwest is the most worker-friendly flyer there is” (“Newsweek Web,” p. 1)
There is one factor that does exist today that has had a significant impact upon the entire aviation industry regardless of producer or consumer. On that fateful day, September 11, 2001, the entire US aviation industry was rendered incapacitated for 3 days. No aircraft except military were authorized to fly within the boundaries of the continental US. This complete incapacitation caused devastating economic losses throughout the country regardless of what market.
The aftermath of the attacks brought an array of additional costs required by the federal government through expansionary and discretionary fiscal policy to implement security measures. Unfortunately, the airlines were required to bear the burden of those monetary increases. From the lack of revenue and the increased security costs, the airlines turned to the federal government for assistance. The government responded through the establishment of the Air Transportation Stabilization Board (ATSB) dedicating a total of $10 billion dollars to the airline industry. Each airline received an aggregate amount based upon their aggregate losses from the complete grounding. Southwest Airlines total share of the ATSB monies was approximately $ 283 million dollars. Since several airlines were already experiencing financial difficulty, the attacks just aggravated the financial status and conditions even worse. The monetary funds received from the ATSB were incapable of bringing companies out of the negative.
The attacks affected consumers so badly, that the majority fear to fly since that day; leading to airlines struggling to fill the aircraft to capacity. This holds true especially in the northeastern corridor of the country. People have sought alternatives to their transportation needs, and it hasn’t been air travel.
Southwest Airlines resumed full service after the grounding was lifted. The initial load factors were significantly low but over time they have been slowly increasing. The company continues to offer special low fares to the public that result in Southwest’s ability to post profits. Their forward looking statements sound hopeful, yet they know their streak of 30 profitable years could be broken if the industry cannot return to pre-911 days or consumer confidence returns.
A new Chief Executive Officer (CEO) was appointed over Southwest Airlines in July 2001, just months before the terror attacks in New York City. According to reports, the CEO has done a fabulous job leading the airline through a turbulent time in airline history. He has managed to reduce operating costs, keep in line with aircraft orders, and thwart laying off employees while other airlines have laid off thousands of its employees.
Unfortunately, all the airlines face the same results when a seat is left unsold, it can never be regained back in revenue, and it is lost forever. Right now, the industry has faced and continues to face sharp downturns in the demand for air travel. Unless we find solutions to the empty seat syndrome and the financial problems which are currently plaguing our industry, this country faces losing its major airlines; even Southwest Airlines is vulnerable to these factors which negates poor company strength and stability. The airline industry is grossly affected by economic trends in the general economy whether a recessionary or inflationary gap is in existence. I am uncertain if bailing out or re-regulating the airlines is an answer to the present day industry dilemma.
Airlines today are faced with some tough issues to solve. Many are faced with no recourse other than to restructure the entire airline that is costly, filing bankruptcy, or simply closing the door. But there has been one airline, Southwest Airlines, that continues operating in the black and is still realizing profit, though not as much historically, but it is posting profits!
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