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CASE 4 Southwest Airlines: Flying High With Low Costs

Southwest Airlines sent its first flights aloft in 1971. After almost 45 years, Southwest was so successful that the company was considered, in many ways, the crown jewel of the airline industry. The company had achieved the longest continuous stretch of profitability in the history of the airline industry and was consistently ranked in the top 10 on Fortune’s list of “Most Admired Companies,” a list that spanned all industries. Southwest’s executives liked to say that they strove toward a triple bottom-line of People, Planet, and Performance.

In 2021 Southwest was on strong financial ground, despite the fact that the prior 20 years had been some of the most difficult in aviation history. The airline industry had been particularly hurt by the 9/11 terrorist attack, the “great recession” of 2008-2009, and the pandemic of 2020. The company had shown strong and steady growth in revenues and profits over the years (See Exhibits 1 and 3).

Southwest achieved its strong financial performance in large part by having a high “load factor,” the airline industry’s measure of the percentage of seats that are filled on an airline’s flights. In 2010, Southwest hit the highest load factor in its history: 79.3 percent. Following its highly successful “Bags Fly Free” ad campaign, Southwest also saw its domestic market share increase by almost 2 percent. Southwest was known for high levels of both customer service and employee satisfaction. Southwest not only rated as the top airline in a Consumer Reports survey of passengers1 but also reigned at the top of the United States Department of Transportation’s customer satisfaction rankings. Overall, Southwest had an enviable record of performance.

The U.S. Airline Industry

The U.S. airline industry is critical to the health of the United States economy. Airlines provide 11 million jobs in the United States and are responsible for five cents of every dollar of the U.S. gross domestic product (GDP). For every 100 airline jobs that exist, 388 more jobs are supported outside of the airline industry.2

A key turning point in airline history was the deregulation of the industry in 1978. Before deregulation, the Civil Aeronautics Board regulated all passenger fares which meant the price was the same for each flight between two cities. The board also regulated industry entrances and exits; mergers and acquisitions; and even airlines’ rates of return. Typically, any given market had only a few airlines and price competition was essentially nonexistent.

Following deregulation, numerous new entrants moved into both established and unserved markets, and fare prices began to drop quickly. The average passenger fare in 1978 cost about 8.49 cents per mile. In 2009, that price, adjusted for inflation, had decreased 56 percent.3 As prices declined for passengers, however, more than 150 airlines went bankrupt, and eight of the eleven major airlines went bankrupt, merged or closed.

The airline industry’s profit margins are some of the lowest in the world. (See Exhibits 4 and 5.) Airlines paid considerable attention to reducing their operating costs, but their control over those costs was severely limited. In particular, labor costs represented the largest percentage of an airline’s costs but union agreements limited labor flexibility. The sizes of the crew and ground staff were typically proportional to the size of the aircraft they served. Other operating costs were primarily determined by the distance traveled and not by the number of passengers boarded. Most airlines—notably Delta, American, and United—used a hub and spoke system to coordinate flights, which meant that they funneled the majority of their traffic through “hub” airports. Hub and spoke systems were designed to help airlines maximize their load factors, meaning they helped keep planes full going into and out of a hub airport. But they also often increased: a) the distance that passengers had to fly to get to their final destination and b) the time it took for passengers to get to their final destination.

Recessions, terrorist attacks, and cost increases had particularly hurt the industry following the turn of the century. During the decade following 9/11, the price of jet fuel had risen from $34 per barrel to nearly $135 per barrel, and the tax burden on airlines had tripled. Moreover, after 9/11 and during the “great recession” the number of passengers flying decreased, which made it difficult to keep planes flying near full capacity. Between 2001 and 2011, 41 U.S. airlines went bankrupt, and the industry was estimated to have lost $55 billion and 160,000 jobs.4 While most airlines struggled to survive, Southwest had figured out a way to stay profitable throughout its long history. It took the Covid-19 pandemic of 2020 to break Southwest’s streak of 47 straight years of profitability. But despite the loss in 2020, Southwest was on stronger financial footing than most of its competitors.

The History of Southwest Airlines

Legend has it that the idea for Southwest Airlines was first conceived on a napkin while Herb Kelleher met with Rollin King in a San Antonio Restaurant.5 In 1966, Kelleher was practicing law. King, one of Kelleher’s clients, approached him with the idea of bringing a low-cost intrastate airline to Texas. Because federal regulations made it difficult to establish an airline that crossed state borders, the two founded Southwest Airlines in 1967 to focus on point-to-point travel among the three Texas cities of Dallas, Houston, and San Antonio.6 In contrast to larger airlines servicing the cities through connecting interstate routes, Southwest would fly directly to each of the cities, and the flights would take roughly one hour each.

When deregulation hit the airline industry in 1978, Southwest decided to compete with low fares. Demand for travel among the three cities had been rising at the time, and, with little price competition in the market, passenger fares were high. Targeting business travelers and commuters between its initial three cities, Southwest’s fares were typically priced between $40 and $100 round trip in order to compete with the cost of driving.

Southwest was based out of Love Field in Dallas which, although a small airport, offered travelers a more convenient location due to its closer proximity to the city than the larger Dallas-Fort Worth Airport. Using Love Field as inspiration, Southwest adopted a “love” theme for the airline’s marketing and operations. Drinks were called “love potions,” and ticket machines “love machines.” Later, when Southwest went public, its stock ticker would be LUV. The flight attendants were women chosen for their striking looks. They wore boots and “hot pants” (small, form-fitting shorts), which were a fashion trend. Said Kelleher, “You can have a low-cost carrier and people still don’t fly it because they don’t know about it. And so, the kind of fit in with getting known.”7

Southwest also emphasized a culture of fun. Employees were known to sing announcements to passengers and deliver entertaining instructions. For example, flight attendants were known to tell passengers how nice they would look in their life vests or that they will need to deposit 25 cents for oxygen to begin flowing to their oxygen masks. It is easy to find videos on the Internet of flight attendants singing, rapping, and telling jokes to their passengers. Southwest brought the culture of fun to its employees not only through the example of its senior executives but also through its “fun” training programs. The company’s advertising also tended to be a fun, even a little edgy. On one occasion, marketers brought an ad to Kelleher that targeted extra regulations and fees that other airlines stated in “fine print” marked by asterisks in their ads. Kelleher quickly approved running Southwest’s ad, which read, “Some airlines should have their asterisks kicked.”8

The company’s point-to-point service led to frequent departures between city-pair routes. With only three planes operating up until 1974, Southwest had to focus on turning its planes around as quickly as possible. Its choice to fly into less congested airports such as Love Field helped Southwest to make those faster turnarounds. At the beginning, Southwest set the goal of turning its planes around in 15 minutes, which was 30 minutes faster than the industry average.

Southwest also quickly discovered that it could segment its pricing. After starting their fares at $20 one-way, Southwest raised fares for travel before 7:00pm to $26. To target budget-minded leisure travelers, Southwest lowered fares for evening flights after 7:00pm and weekend flights to as low as $13. Such decisions were key to Southwest’s early success and laid the foundation for the company’s successful low-cost strategy.9 Southwest’s business model set it apart from its competitors, and the company began to grow quickly. It took the company only two years to become profitable, and Southwest has been profitable every year since 1973.

Southwest’s Strategy and Operations

Southwest’s strategy involved offering no frills, short haul, high frequency, point-to-point, low fare service. Although Southwest’s approach would later become well known and frequently studied, it started out primarily as a response to the constraints faced by the company. Federal regulations led Southwest to focus on intrastate travel between just Dallas, Houston, and San Antonio. The company’s first planes were three Boeing 737s purchased because they were available at a discount due to overproduction.10 This small fleet caused Southwest to focus on reducing the time to turn its planes around and get them back in the air. Due to its short flights, the airline did not serve meals on its flights. Eventually, Southwest would become renown for these strategies of flying only point-to-point routes between less congested airports, adopting only one model of plane (the Boeing 737), and offering only one class of service, without meals or assigned seating.

Southwest bucked the industry trend of routing planes through a hub and spoke (HS) model by flying its planes point-to-point (PTP) on city-pair routes. The HS model—developed in the 1960s and 1970s and used by full service carriers like American, United, and Delta—was designed to maximize the load factors for each of an airline’s individual planes by bringing customers traveling to the same location together in a central hub from all their different points of origination. The HS model was generally considered to be inconvenient by passengers, and a delay in one flight on a spoke would create a domino effect of delays that would cascade throughout an airline’s system of flights. Southwest determined that it would instead focus on putting as many flights as possible on its PTP routes by turning the planes around as quickly as possible. (See Exhibits 6 and 7.) Southwest also tried to dominate the city pairs where it offered service. Southwest’s market share in its top 100 city-pair markets was 70% (see Exhibit 8.)

As described earlier, Southwest’s initial goal was to turn its planes around in 15 minutes. By comparison, the rest of the industry was turning planes around at an average of 45 minutes. Southwest was able to successfully decrease its turnaround times to close to 15 minutes for a variety of reasons. Flying PTP meant Southwest’s flights weren’t waiting on other flights. Since Southwest’s flights were shorter, its passengers typically checked less baggage. The absence of meals on the airline’s flights meant that there was less cleanup time required. In addition, Southwest focused its employees on working as a team to turn planes and gave them significant latitude to work outside of formal guidelines and do whatever it took to turn a plane around quickly. Finally, Southwest stressed a high-speed boarding process. Most airlines assigned seats to their passengers, but Southwest ignored that method of boarding. Instead, each passenger got a boarding number as he or she arrived at the gate. Eliminating assigned seating meant that the airline didn’t have to reconcile double-booked seats, and it motivated passengers to arrive early. Taken together, these practices combined to help Southwest turn planes around much faster than most of its competitors. By 2009, Southwest was turning planes at an average of 23 minutes which was still roughly half of the industry average.11

In an industry facing some of the highest fixed costs in the world, Southwest’s business model allowed it to keep costs low. Southwest had continued to exclusively use Boeing 737s throughout its history. By 2010, there were 548 Boeing 737s in Southwest’s fleet (451 owned, 97 leased).12 The efficiencies created by the common fleet of the 737s also meant that Southwest spent less money training its pilots, flight attendants, and mechanics and was able to staff smaller teams for its gate crews. In fact, the uniform configuration was so important to Southwest that, following its purchase of AirTran in 2011, all of AirTran’s planes would be reconfigured to match Southwest’s current fleet. Purchasing the same type of plane also gave Southwest some leverage negotiating prices with Boeing—which was not insignificant since a Boeing 737 cost between $75-120 million depending on the features included on the aircraft.

Southwest also limited the commissions it paid to ticketing services and booking agents by refusing to pay fees for any third-party ticketing services except the SABRE system. These fees had historically run 5-10 percent of the price of a ticket, but had moved to a lower flat fee in recent years. Instead, Southwest developed an online ticketing system of its own and in 1995 it became the first airline to sell tickets directly from its own website. In 2010, 79 percent of Southwest’s tickets were purchased online.13 In contrast, only 35 percent of Delta’s tickets were purchased online during the same period.14

While Southwest saved significant money on its operations, it was spending more than the average airline on marketing. In its first year of business, the airline spent ten percent of its budget on advertising. The company had continued to emphasize marketing throughout its history, even increasing its marketing during difficult years. As Kelleher explained, “When do you need advertising the most? When times are bad.”15 When Southwest achieved record profits and load factors in 2010, CEO Gary Kelly credited the company’s highly successful “Bags Fly Free” ad campaign for the success.16 The campaign cost Southwest $159.5 million to produce, which was nearly the same as the combined advertising budgets of Delta, United, American and Continental.17

Although multiple cities were clamoring for Southwest’s business, the airline made an early decision to grow slowly. Even in the best years, Southwest restricted increases to its capacity to 10-15 percent and added only 2 or 3 new cities per year. In 1996, Kelleher’s reflected, “Southwest has had more opportunities for growth than it has airplanes. Yet, unlike other airlines, it has avoided the trap of growing beyond its means.”18 Following the devastating effects of the 9/11 terrorist attacks, Southwest explained in the opening statement to its 2001 Annual Report that, “Southwest was well poised, financially, to withstand the potentially devastating hammer blow of September 11. Why? Because for several decades our leadership philosophy has been: We manage in good times so that our Company and our People can be job secure and prosper through bad times.” In fact, the airline recession after 9/11, the U.S. “great recession” of 2008-2009 and the pandemic all had a strong negative impact on industry profitability (see Exhibits 9 and 10).

As described earlier, Southwest’s initial goal was to turn its planes around in 15 minutes. By comparison, the rest of the industry was turning planes around at an average of 45 minutes. Southwest was able to successfully decrease its turnaround times to close to 15 minutes for a variety of reasons. Flying PTP meant Southwest’s flights weren’t waiting on other flights. Since Southwest’s flights were shorter, its passengers typically checked less baggage. The absence of meals on the airline’s flights meant that there was less cleanup time required. In addition, Southwest focused its employees on working as a team to turn planes and gave them significant latitude to work outside of formal guidelines and do whatever it took to turn a plane around quickly. Finally, Southwest stressed a high-speed boarding process. Most airlines assigned seats to their passengers, but Southwest ignored that method of boarding. Instead, each passenger got a boarding number as he or she arrived at the gate. Eliminating assigned seating meant that the airline didn’t have to reconcile double-booked seats, and it motivated passengers to arrive early. Taken together, these practices combined to help Southwest turn planes around much faster than most of its competitors. By 2009, Southwest was turning planes at an average of 23 minutes which was still roughly half of the industry average.11

In an industry facing some of the highest fixed costs in the world, Southwest’s business model allowed it to keep costs low. Southwest had continued to exclusively use Boeing 737s throughout its history. By 2010, there were 548 Boeing 737s in Southwest’s fleet (451 owned, 97 leased).12 The efficiencies created by the common fleet of the 737s also meant that Southwest spent less money training its pilots, flight attendants, and mechanics and was able to staff smaller teams for its gate crews. In fact, the uniform configuration was so important to Southwest that, following its purchase of AirTran in 2011, all of AirTran’s planes would be reconfigured to match Southwest’s current fleet. Purchasing the same type of plane also gave Southwest some leverage negotiating prices with Boeing—which was not insignificant since a Boeing 737 cost between $75-120 million depending on the features included on the aircraft.

Southwest also limited the commissions it paid to ticketing services and booking agents by refusing to pay fees for any third-party ticketing services except the SABRE system. These fees had historically run 5-10 percent of the price of a ticket, but had moved to a lower flat fee in recent years. Instead, Southwest developed an online ticketing system of its own and in 1995 it became the first airline to sell tickets directly from its own website. In 2010, 79 percent of Southwest’s tickets were purchased online.13 In contrast, only 35 percent of Delta’s tickets were purchased online during the same period.14

While Southwest saved significant money on its operations, it was spending more than the average airline on marketing. In its first year of business, the airline spent ten percent of its budget on advertising. The company had continued to emphasize marketing throughout its history, even increasing its marketing during difficult years. As Kelleher explained, “When do you need advertising the most? When times are bad.”15 When Southwest achieved record profits and load factors in 2010, CEO Gary Kelly credited the company’s highly successful “Bags Fly Free” ad campaign for the success.16 The campaign cost Southwest $159.5 million to produce, which was nearly the same as the combined advertising budgets of Delta, United, American and Continental.17

Although multiple cities were clamoring for Southwest’s business, the airline made an early decision to grow slowly. Even in the best years, Southwest restricted increases to its capacity to 10-15 percent and added only 2 or 3 new cities per year. In 1996, Kelleher’s reflected, “Southwest has had more opportunities for growth than it has airplanes. Yet, unlike other airlines, it has avoided the trap of growing beyond its means.”18 Following the devastating effects of the 9/11 terrorist attacks, Southwest explained in the opening statement to its 2001 Annual Report that, “Southwest was well poised, financially, to withstand the potentially devastating hammer blow of September 11. Why? Because for several decades our leadership philosophy has been: We manage in good times so that our Company and our People can be job secure and prosper through bad times.” In fact, the airline recession after 9/11, the U.S. “great recession” of 2008-2009 and the pandemic all had a strong negative impact on industry profitability (see Exhibits 9 and 10).

JetBlue: A Tough New Competitor

JetBlue was founded in 1999 by former Morris Air president David Neelman. After receiving more than $800 million in funding to establish its base of operations in JFK airport in New York, the airline grew quickly. Over its first five years, JetBlue’s revenues increased by more than 1100 percent, although they slowed significantly during the U.S. recession in the latter part of the decade. In 2002, JetBlue had a successful initial public offering of stock (IPO); the airline’s stock price increased by 70 percent on the first day alone. JetBlue flew both domestically and internationally, with both short and long haul routes. For example, JetBlue could fly long haul flights from New York to Los Angeles which Southwest could not do with the Boeing 737. Jet Blue’s strategy and operations mimicked Southwest in many ways, including flying PTP, using one type of aircraft (Airbus 320 which could fly longer routes; it later added Embraer 190 Jets for short haul flights), not serving meals, and creating a team approach to quickly turning around flights. The airline distinguished itself from Southwest with comfortable leather seating, in-flight television offered in partnership with DirecTV, and assigned seating. JetBlue also offered its passengers simple boxed meals during flights (at an added charge) and charged for checking more than one bag.

Although JetBlue’s revenues were less than one third of Southwest’s, it was still a noteworthy competitor. JetBlue came in second to Southwest Airlines by only a couple points (84 to 87 out of 100) in a 2011 Consumer Reports survey of passengers.26 In 2014, Jet Blue beat out Southwest for the highest customer satisfaction rating among airlines by the American Customer Satisfaction Index (ACSI). JetBlue was also the only airline other than Southwest to show positive operating profits year after year. The airline was steadily growing its fleet of Airbus A320 and Embraer 190 jets and was consistently adding new routes. JetBlue’s strategy finally brought a competitor to the industry that could compete directly, and effectively, with Southwest.

Looking Forward: Challenges with Growth and Competition

By 2018, Southwest was flying more than 550 planes totaling 3,400 flights per day, in 72 cities covering 37 states. The average trip length was 653 miles and took nearly two hours. The average one-way ticket price was $139, and the highest was $514.27 Southwest had set the standard for the industry in multiple areas of operation, including: flying more passengers per employee than any other airline, maintaining a debt-to-equity ratio far below the industry average, and by never having to stop a flight due to a union strike. Profitability at Southwest, and among all of the major competitors, was at an all time high in 2018 as a result of industry consolidation, higher capacity utilization of planes, and lower fuel costs because of the significant drop in oil prices. That all came crashing down in 2020 as most of the airlines experienced record losses. While airline travel started to pick up in 2021, many observers felt that airline travel would stay down until at least 2022. Despite Southwest’s strong historical performance key challenges lay ahead.

Southwest had to assess whether its historical strategy would allow the company to continue to grow going forward. Indeed, Southwest had gradually saturated most of the short haul markets in the United States, with little opportunity to add additional short haul routes. Southwest had historically avoided both long haul and international routes—but if the company was going to grow it would need to expand into those markets. CEO Gary Kelly acknowledged that long haul markets were attractive for two reasons: first, they were the biggest, fastest-growing markets in U.S. air travel and second, these markets had been dominated by the legacy carriers and, consequently, Southwest had room to grow.28

But while the long haul markets represented an opportunity, they also would not be easy to capture. For one thing, there was the question as to whether Southwest could service long haul markets with the Boeing 737, or whether Southwest would need to add a longer-range aircraft, as JetBlue had done with the Airbus 320. Moreover, the traditional carriers dominated those markets and recent acquisitions (and restructurings) had strengthened the positions of these carriers. Delta’s acquisition of Northwest in 2008 made it the industry’s largest carrier, as measured by share of revenue passenger miles, which is the number of times that an airline carries one passenger one mile. To keep pace, in 2010 UAL corporation, parent of United Airlines, announced a merger with Continental airlines. Finally, in 2013 American Airlines acquired US Airways, which made it the industry’s largest carrier, surpassing Delta in share of revenue passenger miles. The consolidation of HS competitors in the industry reduced competition among these players and created an industry where the four largest airlines—American, Delta, UAL, and Southwest—controlled roughly 80 percent of the U.S. air travel market. While American (with US Airways), Delta (with Northwest), and United (with Continental) all had more revenue passenger miles than Southwest (due to more long haul flights), Southwest led the domestic market in the number of passengers boarded annually. But the consolidation (and restructurings) also helped the legacy carriers improve their cost position. Indeed, Delta airlines had higher profitability than Southwest from 2011-2016 and American and UAL were also realizing profits that were closer in line with what Southwest was achieving. In short, the legacy carriers were stronger and better positioned to protect their long haul routes from encroachment by Southwest. This raised key questions about Southwest’s future profitability and growth prospects. Should Southwest invest heavily entering long haul routes in the United States? Should it consider adding a longer haul aircraft to its fleet? Should it target international flights? These were questions facing CEO Kelly and Southwest as it looked for growth in an industry where growth in short haul flights—it’s historical bread and butter—was limited.