Academic journal article The McKinsey Quarterly

Facing Low-Cost Competitors: Lessons from US Airlines

Academic journal article The McKinsey Quarterly

Facing Low-Cost Competitors: Lessons from US Airlines

Article excerpt

First understand sources of advantage: input costs, product and process design

Then ask, will they sustain growth in new markets?

Four options: withdraw, compete, co-exist, or cooperate

In industry after industry, traditional market leaders are under attack from low-cost competitors. Pet Stuff, Countrywide Mortgage, and Geico serve as examples in the US retail, banking, and insurance industries of low-cost competitors that pose a serious threat, eating into the margins and market shares of their more established rivals. In the US amine industry, traditional carriers have faced low-cost competitors not once but twice, successfully beating them off in the early 1980s only to see a resurgence a decade later.

The first attack came after Congress deregulated the airline market in 1978. This encouraged a number of new carriers to enter the business, most of them offering a cut-price, "no frills" service. Though some were successful at first, it became clear within a mallet of years that they were fighting an uphill battle. Low fares alone were not enough.

One of the most publicized failures was that of People Express, which expanded rapidly by using its low-fare, no frills x\concept on routes abandoned or little served by the major carriers. It thrived until the major airlines retaliated by using their yield management systems to sell spare capacity at equally low fares Thinking that scale and a hub-and-spoke network were the answers to its problems, People Express tried to expand, but overextended itself and began to incur massive losses. In 1987, it was acquired by Texas International.

The demise of People Express and the bankruptcies and acquisitions that swept the airline industry in the second half of the 1980s seemed to herald the death of the low-cost challenge. But these carriers have since reemerged, taking advantage of surplus capacity produced by aggressive fleet expansion in the late 1980s and depressed demand for air travel in the early 1990s. With some airlines driven out of business and others cutting jobs, newcomers were able to pick up bargain aircraft and cheap staff. Valu Jet, which began operating in 1993, bought a number of DC-9s at an average cost of around $2 million each, compared with about $20 million for a comparable, newer model. It also pays its pilots far below the industry average. It boasts the best profit margins in the industry.

Some low-cost carriers seem to have found the key to success. Having slashed fares by as much as 70 percent, low-cost airlines now hold 15 percent of total traffic [ILLUSTRATION FOR EXHIBIT 1 OMITTED]. Dallas-based Southwest Airlines, a low-cost paragon, was regarded as a niche player in the region just a few years ago. Today, it is the eighth largest carrier in the United States, combining a low-cost system with high customer satisfaction and impressive profit growth at a time when the rest of the industry has suffered severe losses.

A brutal battle is still being waged between traditional and low-cost carriers. As in the 1980s, traditional airlines are developing strategic responses to address low-cost competition. Their experiences suggest a five step approach that might prove helpful to any industry facing a similar threat.

1. Understand your competitors' strengths

The first step in addressing the challenge of low-cost competitors is to understand what drives their success. In the airline industry, low-cost operators enjoy specific cost advantages that make them a threat to traditional carriers namely lower input costs, cheaper product design, and cheaper process design. All these advantages are targeted at a customer segment that values the resulting service. The combination of some or all of the three, varying by airline, has helped keep costs as much as 20 percent below those of traditional airlines at comparable stage lengths [ILLUSTRATION FOR EXHIBIT 2 OMITTED].

Lower input costs

Low-cost airlines exploit lower input costs in as many areas of their operations as possible. …

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