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Southwest Airlines

In late January 1995, Dave Ridley, vice president—marketing and sales at South- west Airlines, was preparing to join Joyce Rogge, vice president—advertising and promotion, Keith Taylor, vice president—revenue management, and Pete McGlade, vice president—schedule planning, for their weekly "Tuesday meet- ing." The purpose of this regularly scheduled meeting was to exchange ideas, keep one another informed about external and internal developments pertaining to their areas of responsibility, and coordinate pricing and marketing activities. This informal gathering promoted communication among functional areas and fostered the team spirit that is an integral part of the Southwest corporate culture.

A recurrent "Tuesday meeting" topic during the past six months had been the changing competitive landscape for Southwest evident in the "Continental Lite" and "Shuttle By United" initiatives undertaken by Continental Airlines and United Airlines, respectively. Both initiatives represented targeted efforts by major car- riers to match Southwest's price and service offering—a strategy that no major carrier had successfully implemented in the past. In early January 1995, Conti- nental's effort was being scaled back due to operational difficulties and result- ing financial losses. I However, United's initiative remained in effect. Launched on October 1, 1994, "Shuttle By United" was serving 14 routes in California and adjacent states by mid-January 1995, nine of which were in direct competition with Southwest. When "Shuttle By United" was announced, United's CEO pre- dicted: "We're going to match them (Southwest) on price and exceed them on service."2 In response to United's initiative, Southwest's chair Herb Kelleher said, the "United Shuttle is like an intercontinental ballistic missile targeted directly at Southwest. "

Just as the meeting began, a staff member rushed in to tell the group that United had just made two changes in its "Shuttle By United" service and pricing. First, its service for the Oakland—Ontario, California, market would be discontin-

ued effective April 2, 1995. This market had been among the most hotly contested routes among the nine where United and Southwest competed head-to-head and

1Bridget O'Brian, "Continental's CALite Hits Some Turbulence in Battling Southwest," Wall Street Journal (January 10, 1995): Al, A5.

2Quoted in Jon Proctor, "Everyone Versus Southwest," AIRWA YS Magazine (November/December 1994):6—13.

The cooperation of Southwest Airlines in the preparation of this case is gratefully acknowledged. This case wæs

prepared by Professor Roger A. Kerin, of the Edwin L. Cox School Of Business, Southern Methodist University•

for class discussion and is not designed to illustrate effective or ineffective handling of an adminis-as a basis

trative situation. Certain information is disguised and not useful for research purposes. Copyright 0 1996 by

Roger A. Kerin. No part of this case may be reproduced without written permission of the copyright holders

493

494 CHAPIT.R 8 PRICING STRATEGY

AND MANAGEMENT

Southwest had lost market share on this route since October

1994. Second, the

one-way walk-up first class and coach fare on all 14 "Shuttle

By United" routes

had just been increased by $10. "Shuttle By United" had previously matched

Southwest's fare on the nine competitive routes and, as of mid-January 1995, had

been increasing the number of flights on these routes and the five routes where

they did not compete. Changes in United's pricing and service

for its shuttle operation caught

Southwest executives by surprise. The original agenda for the "Tuesday meeting„

was immediately set aside. Attention focused on (1) what to make of these Unex_

pected developments and (2) how Southwest might respond, if at all, to the new

"Shuttle By United" initiatives.

THE U.S. PASSENGER AIRLINE INDUSTRY

The U.S. Department of Transportation classified U.S. passenger airlines into

three categories on the basis of annual revenue.3 A "major carrier" was an airline

with more than $1 billion in annual revenue. A "national carrier" had annual revenues between $100 million and $1 billion, and a "regional and commuter airline" had annual revenues less than $100 million. Major carriers accounted for more than 95 percent of domestic passengers carried in 1994. Five carriers— American Airlines, Continental Airlines, Delta Airlines, Northwest Airlines, and United Airlines—accounted for over 80 percent of all major carrier domestic pas- senger traffic. Exhibit 1 shows major air carrier estimated market shares for 1994 in the United States.

Industry Background

The status of the U.S. passenger airline industry in early 1995 could be traced to 1978. Prior to 1978, and for 40 years, the U.S. airline industry was regulated by the federal government through the Civil Aeronautics Board (CAB). The CAB regulated airline fares, routes, and company mergers, and CAB approval was required before any changes in fares or route systems could be made. In this

EXHIBIT 1 Estimated Market Shares for Major U.S. Carriers in 1994 Based on Revenue PassengerMiles Flown

Carrier Market Share (%)

1. United Airlines 22.1

2. American Airlines 20.2

3. Delta Airlines 17.6 4. Northwest Airlines 11.8 5. Continental Airlines 8.5

Source: Southwest Airlines company records. Figures rounded.

Carrier Market Share (%)

6. USAir 7.8

7. Trans World Airlines 5.1 8. Southwest Airlines 4.4 9. America West Airlines

2.5

This section is based on information provided in FAA Aviation Forec«sts (Washington, D.C.: U.S. Department of Transportation, March 1995): Standard e Poor's Industry Surveys (New York: Standard & Poor's, January 1995); U.s. Industrial Outlook 1995 (Washington, D.C.: U.s. Depanment of Commerce, January 1995); Timothy K. smith, "Why Air Travel Doesn't work," Fortune (April 3,

and Jon Proctor, "Everyone Versus Southwest," AIRWA YSMagazine (November/

AIRLINES

495

capacity, the CAB assured that individual airlines were awarded highly profitableand semi-exclusive routes necessary to subsidize less profitable routes, whichthey were also assigned in the public interest. Price competition was suppressed,airline cost increases were routinely passed along to passengers, and the CABallowed airlines to earn a reasonable rate of return on their investments. In 1978,the Airline Deregulation Act was passed. This act allowed airlines to set their ownfares and enter or exit routes without CAB approvals. Jurisdiction for mergerswas first transferred to the U.S. Department of Transportation and subsequentlyassigned to the U.S. Justice Department in 1988. The CAB was dissolved in 1985.

Deregulation and a Decade of Transition Public policy makers and industry analysts expected that deregulation would proceed in an orderly manner with multiple existing major carriers serving previously semi-exclusive routes, bring- ing about healthy price competition. However, the carriers responded to deregu- lation with unexpected changes in their operations that would have long-term effects on the industry.

Two changes in particular were noteworthy. First, major carriers turned their attention to serving nonstop "long-haul" routes anchored by densely populated metropolitan areas or city-pairs which had been highly profitable in a regulated environment. This meant that longer routes such as New York to Los Angeles and Chicago to Dallas were favored over "short-haul" routes between smaller city pairs such as Baltimore and Newark, New Jersey. As major carriers pruned or reduced service on these short-haul routes, existing regional carriers and new airlines filled the void. In 1978, the United States had 36 domestic carriers; by 1985 the number had grown to 100. Second, major carriers almost uniformly abandoned point-to-point route systems and adopted the hub-and-spoke route system. Point-to-point systems involved nonstop flights between city-pairs and often "shuttle" flights back and forth between city-pairs. The hub-and-spoke sys- tem featured "feeder flights" from outlying cities to a central hub city, where pas- sengers would either continue their trip on the same plane or transfer to another plane operated by the same carrier to continue to their final destination. The key to this route system was to schedule numerous feeder flights into the hub airport to coincide with the more profitable long hauls, with each spoke adding passengers to the larger aircraft flying these longer distances. Potential increased revenue and some cost economies from flying more passengers longer distances, however, were offset by increased costs resulting from reduced utilization of air- craft as they waited to collect passengers, the capital investment in hub facilities, and the need for a larger ground staff.

Competition to survive and succeed intensified in the airline industry immedi- ately following deregulation. Newly formed airlines and regional carriers, which had been permitted to serve only regional markets in a regulated environment, expanded both the number and length of their routes. These carriers typically retained the point-to-point route system, which was more economical to operate than hubs. Absent the higher costs associated with the hub-and-spoke system, and with lower debt than older major carriers had assumed during the regulation era, these carriers had an immediate cost advantage. This advantage resulted in lower fares on both short- and long-haul routes. Price competition quickly erupted as all airlines scrambled to fill their seats. Price competition lowered the average fares paid on the formerly profitable long-haul routes serviced by major carriers while their operating costs remained high. The profit squeeze caused major carriers to cut their schedules and further reduce the number of short-haul routes.

Within five years after deregulation, the major carriers found themselves in

a price-cost predicament best described by a senior airline executive: "Either we don't match (fares) and we lose customers, or we match and then because our

496 CHAVIT,R 8 PRICING

STRATEGY AND MANAGEME

costs are so high, we lose buckets of money. "4 This situation continued throu

the remainder of the 1980s as a price war of attrition was waged, ultimately result

ing in a flurry of acquisitions by major carriers. Noteworthy acquisitions inc itided

Ozark Airlines by Trans World Airlines (TWA), Western Airlines by Delta

and

Republic Airlines by Northwest in 1986. In 1987, AMR (American Airlines, parent

COrnpany), acquired Air California and USAir acquired Pacific Southwest Airlines

Financial Calamity in the Early 1990s Acquisition activity in the mid 1980s led industry analysts to believe the U.S. airline industry would

soon evolve Into .

an oligopoly with a few carriers capturing a disproportionate share of domestic traffic. By the late 1980s, eight airlines controlled 91 percent of U.S. traffic, but their financial condition was fragile due to a decade of marginal profitability.

Carrier bankruptcy and collapse marked the early 1990s due to a recession a doubling of fuel prices during the Gulf War in 1991, and excess capacity in the industry. The U.S. airline industry recorded a cumulative deficit of $12 billion from 1990 through 1993. (See Exhibit 2, which plots U.S. air carrier Operating revenues and expenses for fiscal years 1979 to 1994.) Between 1989 and 1992 Pan American Airlines (Pan Am), Continental Airlines, America West

filed Airlines

for pro_ Midway Airlines (a national carrier), Eastern Airlines, and TVA all tection under Chapter Il of the U.S. Bankruptcy Code. Eastern, Pan Am Midway ceased operations in 1991. Continental and TWA emerged from bank

, and _ruptcy in 1993 as did America West in late 1994, and the industry as a wholerecorded a modest operating profit in the 1994 fiscal year. Exhibit 3 shows 1994financial and operating statistics for major U.S. carriers.

EXHIBIT 2

B 22

L 20

1 18o

s 16

o 10

A 8

s 6

U.S. Air Carrier Operating Revenues and Expenses, 1979—1994

+ Expenses Revenues

87 88 89 90 91 FISCAL YEAR BY QUARTER

Source: U.S. Department of Transportation.

4 William M. Carley, "Rough Flying: some Major Airlines Are Being Threatened by carri-

EXHIBIT 3 1994 Financial and Operating Statistics for Major Carriers in the United States

American America Trans United

Financial Data ($ millions)

Operating revenue

Passenger

Freight/other

Operating expenses a

Operating income

Other income (expense)

Net income before tax

Operating Statistics

Available seat miles (millions)

Revenue passenger miles (millions)

Load factor (%)

Yield (0b

Cost per available seat mile

Labor productivity d

Airlines (AMR)

West Airlines

$14,895

13,616

1,279

$14,309

$586

$(593)

Continental Airlines

$5,670

5,036

634

$5,921

$(251)

$(399)

$(650)

65,861/

31,588

63.1

7.86

1 ,668

Delta Airlines

$12,062

11,197

865

$12,151

$(89)

$(325)

(414)

130,198

86,296

66.3

12.97

9.33

1,915

Northwest Airlines

$8,343

7,028

1,315

$7,879

$464

$52

$516

85,016

57,872

68.1

12.14

9.26

1,968

Southwest A irlines

$2,592

2,498

$2,275

$317

$(17)

$300

32,124

21,611

67.3

11.56

7.08

2,019

World A irlines

Airlines (UAL)

$(7)

157,047

101,382

64.6

13.40

9.11

1,739

$1,409

1,320

$1,319

$90

$92

18,060

12,233

67.7

10.79

7.30

1,695

$3,408

2,876

532

$3,883

$(475)

$39

$(436)

39,191

24,906

63.5

11.31

9.91

1,502

$13,950

12,295

1,655

$13,801

$149

$22

$171

152,193

108,299

71.2

11.35

9.06

2,125

USAir

$6,997

6,358

639

$7,773

$(776)

$91

$(685)

61,540

37,941

61.3

16.76

12.63

1,451

a Operating expenses include interest expense.

b Passenger revenue per revenue passenger mile.

c Operating expenses including interest expense per available seat mile.

d Thousands of available seat miles per employee.

e Includes the American Eagle commuter airline and transportation business only.

f Continental Airlines operating statistics are for jet operations only.

Source: Company annual reports. Data and calculations (all rounded) are useful for case analysis but not for research purposes. Revenue, expense, and operating statistics also

include international operations.

498 CHAÜER 8 PRICING

STRAIT,GY AND

As existing airlines collapsed, new airlines

were formed. The majority of

new carriers, such as ValuJet, Reno Air, and

Kiwi International Airlines,

tioned themselves as "low-fare, low-frill" airlines.

Benefiting from a cheap sup.

ply of aircraft grounded by major carriers from

1989 to 1993, the availability of

furloughed airline personnel, and cost economies

of point-to-point route

tems, these new entrants had cost structures that

were again significantly below

most major carriers. For example, Kiwi was started

by former Eastern and pan

Am personnel and was largely funded by its

employees (pilots paid $50,000

each to get jobs; other employees paid $5,000).

These new "low-fare, IOW-frill„

carriers reported combined revenues of about $1.4

billion in 1994 compared

with $450 million in 1992. Although accounting for a

small percentage of in.

dustry revenue, their pricing practices depressed fares on

a growing number of

routes also served by major carriers. In 1994, 92 percent

of airline passengers

bought their tickets at a discount, paying on average just 35 percent of the

posted full fare.

Industry Economics and Carrier Performance

The financial performance of individual carriers and the U.S. airline industry as

a whole could be attributed, in part, to the underlying economics of air travel.

The majority of a carrier's costs (e.g., labor, fuel, facilities, planes) were fixed

regardless of the numbers of passengers served. The largest single cost to a car-

rier was people (salaries, wages, and benefits) followed by fuel. These two cost

sources represented almost one-half of an airline's costs and were relatively fixed

at a particular level of operating capacity. Fuel costs were uncontrollable and

the industry had been periodically buffeted with skyrocketing fuel prices, most

recently during the Gulf War in 1991. Fuel cost was expected to increase by

4.3 cents per gallon in late 1995 based on a tax imposed by the Revenue Recon-

ciliation Act of 1993. Industry observers estimated that this tax would cost the

U.S. airline industry an additional $500 million annually in fuel expense.

Labor cost, by comparison, was a controllable expense within limits, and

more than 100,000 airline workers lost their jobs between 1989 and 1994. Recent

efforts by major carriers to reduce labor cost included United Airlines, which

completed an employee buyout of 55 percent of the company in exchange for

$4.9 billion in labor concessions in the summer of 1994. In the spring of 1994,

Delta Airlines announced a three-year plan to reduce operating expenses by

$2 billion, which would involve 12,000 to 15,000 jobs being eliminated.

Carrier Operating Performance Whereas the majority of a carrier's costs were fixed at a particular capacity level regardless of the number of passengers carried, a carrier's passenger revenues were linked to the number of passengers carried and the fare paid for a seat at a particular passenger capacity level. A car-

rier's passenger capacity is measured by the available seat miles (ASMs) it can transport given its airplane fleet, flight scheduling, and route length. An ASM is defined as one seat flown one mile whether the seat is occupied by a passenger or is empty. Carrier productivity is typically tracked by dividing a carrier's total operating cost by available seat miles. Carrier utilization is measured by what is termed a load factor. Load factor is computed by dividing a carrier's revenue passenger miles (RPMs) by its available seat miles. An RPM is defined as one seat flown one mile with a passenger in it and is a measure of a carrier's traffic• Yield is the measure of a carrier's passenger revenue-producing ability and is ex- pressed as an average dollar amount received for flying one passenger one mile• Yield is calculated by dividing passenger revenue by revenue passenger miles•

SOUTHWEST AIRLINES 499

The following expression shows how yield, load factor, and cost combine to

determine the profitability of passenger operations for individual carriers, routes,

and the industry:

Operating income= (yield >< load factor)— cost, or

Operating income passenger revenue RPM operating cost

ASM RPM ASM ASM

By setting operating income to zero and monitoring yield and cost, individual

carriers frequently computed a break-even load factor for passenger operations

which was continually compared with actual load factors. Actual load factors

higher than the break-even load factor produced an operating income for pas-

senger operations; actual load factors below a break-even load factor resulted in

an operating loss.

Industry Trends Exhibit 4 charts available seat miles, revenue passenger miles,

and load factors for all FAA certified airlines for the 1974 fiscal year through the

1994 fiscal year. While revenue passenger miles and available seat miles for the

industry have shown an upward trend, load factor fluctuated due to periodic

imbalances between industry capacity and passenger demand. For example, do-

mestic airline capacity (ASMs) increased by only 1.6 percent in fiscal year 1994

while revenue passenger miles increased 6.5 percent, producing a load factor

of 64.3 percent. This figure represented the highest industry load factor ever

achieved on domestic routes. Domestic passenger yields evidenced a long-term

downward trend for 25 years in real (adjusted for inflation) dollars. In terms of

real yield (discounting fares for inflation), fares in the years 1969 to 1971 pro-

duced an average yield of 21.4 cents in 1994 dollars. By 1994, the average indus-

try yield was 12.73 cents.

EXHIBIT 4 Available Seat Miles, Revenue Passenger Miles, and Load Factors

for All Certified U.S. Airlines, 1974-1994 Fiscal Years

900

800

Load Factor 700

600

500

S 400 300

200

100

1974 75

Revenue Passenger-Miles

77 78 79 80 81 82 83 84 85 86

Available

Seat-Miles

87 88 89 90 91 92 93

Fiscal Year

CHAPTER 8 PRICING

STRATEGY AND MANAGEMENT

500

cost per available seat mile also

exhibited a downward trend since 1978

despite periodic fluctuations in fuel prices.

Nevertheless, labor cost reduction

and productivity improvements coupled with

the gradual addition of more fuel.

efficient and lower cost maintenance

planes by major carriers

had not kept pace

with the declining yields in the industry.

Efforts by major carriers

to reduce labor

cost, described earlier, reflected the continuing

attention to reducing the cost per

available seat mile.

The Airline-Within-an-Airline Concept

only Southwest Airlines, among the major carriers,

appeared able to effectively

navigate the economics of air travel and avoid the

financial calamity that had

befallen the airline industry in the early 1990s.

Operating primarily short-haul

point-to-point routes, with minimal amenities, and able

to make a fast turn.

around of its aircraft between flights, Southwest had much

lower operating costs

than other major carriers. Lower operating costs were

passed on to CUStom_

ers in the form of consistently low fares. From 1990

through 1994, SOUthwest

more than doubled its operating revenues and almost quadrupled its

operat_

ing income. Its operating practices and financial performance prompted

a 1993

U.S. Department of Transportation study to conclude: "The dramatic growth of

Southwest has become the principal driving force in changes occurring in the

airline industry As Southwest continues to expand, other airlines will be

forced to develop low-cost service in short-haul markets."5

With Southwest's operating practices as a blueprint, several major carriers

had already explored ways to implement a low-cost airline service in short-haul

markets and produce a "clone" of Southwest. An outcome of this effort was the

"airline-within-an-airline" concept. This concept involved operating a point-to-

point, low-fare, short-haul, route system alongside a major carrier's hub-and-

spoke route system.

Continental Lite Continental was the first major carrier to implement this

concept. Having just emerged from bankruptcy with lower operating costs and armed with a preponderance of consumer research showing that 75 percent of customers choose an airline on the basis of flight schedule and price, Continental unveiled what came to be known as "Continental Lite" on October 1, 1993. This service initially focused on Continental routes in the eastern and southeastern United States. By December 1994, Continental had converted about one-half of its 2,000 daily flights into low-fare, short-haul, point-to-point service, but was experiencing operating difficulties. In early January 1995, with operating diffi- culties resulting in a sizable financial loss, the "Continental Lite" initiative began folding back into Continental's hub-and-spoke system.

Shuttle By United United, the world's largest airline in 1994, inaugurated its 'airline-within-an-airline" on October 1, 1994. Branded "Shuttle By United," this initiative followed the United employee buyout in the summer of 1994 whenemployee wage cuts and more flexible work rules made possible a lower-costshuttle operation alongside the United hub-and-spoke route system. "Shuttle ByUnited" was designed to be a high-frequency, low-fare, minimal amenity, short-haul flight operation initially serving destinations in California and adjacentstates. If successful, United executives noted that the initiative could be expandedto 20 percent of United's domestic operations, and panicularly to areas where the

5 U.S. Department of Transponation press release, May 11, 1993.

SOUTH\VEST AIRLINES 501

airline had a significant presence. One such area was the Midwest, where tJnited

operated a large hub-and-spoke system out of Chicago's O'Hare Airport.

Beginning with 8 routes, 6 of which involved United's San Francisco hub,

"Shuttle By United" expanded to 14 routes by January 1995. Eight of the 14 routes

involved point-to-point routes separate and apart from United's San Francisco hub.

Nine of the routes competed directly with Southwest. In early December 1994,

United executives reported that the initiative was exceeding expectations and

some routes were profitable. "The Shuttle is working well," said its president, A. B.

"Sky" Magary. 6

SOUTHWEST AIRLINES Southwest Airlines was the eighth largest airline in the United

States in 1994

based on the number of revenue passenger miles flown. Southwest recorded

net income of $179.3 million on total operating revenue of $2.6 billion in 1994,

thus marking 22 consecutive years of profitable operations—a feat unmatched

in the U.S. airline industry over the past two decades. According to Southwest's

chair, president, CEO, and cofounder, Herb Kelleher, Southwest's success for-

mula could be succinctly described as, "Better quality plus lesser price equals

value, plus spiritual attitude of our employees equals unbeatable."

The Southwest Model

Southwest began scheduled service on June 18, 1971, as a short-haul, point-to-point,

low-fare, high-frequency airline committed to exceptional customer service. Begin-

ning with three Boeing 737 aircraft serving three Texas cities—Dallas, Houston, and

San Antonio—Southwest presently operates 199 Boeing 737 aircraft and provides

service to 44 cities primarily in the midwestern, southwestern, and western regions

of the United States. Fifty-nine percent of Southwest's capacity, measured in avail-

able seat miles flown, was deployed in the western United States, 22 percent in the

Southwest (Texas, Oklahoma, Arkansas, and Louisiana), and 19 percent in the Mid-

west. Exhibit 5 on page 502 shows the Southwest route map in early 1995.

Except for the acquisitions of Muse Air in 1985 and Morris Air in 1993, South-

west's management has steadfastly insisted on growing internally and refining

and replicating what came to be known as the "Southwest Model" in the airline

industry. This model was a mixture of a relentless attention to customer service

and operations, creative marketing, and Southwest's commitment to its people.

A healthy dose of fun was added for good measure.

Customer Service Southwest's attention to customer service was embodied in

the attitudes of its people. According to Kelleher:

What we are looking for, first and foremost, is a sense of humor. Then we are

looking for people who have to excel to satisfy themselves and who work well in

a collegial environment. We don't care that much about education and expertise,

because we can train people to do whatever they have to do. We hire attitudes.

A sense of humor, compassion for passengers and fellow workers, a desire

to work, and a positive outlook manifested themselves in customer service at

6 Quoted in Michael J. McCarty, "New Shuttle Incites a War Between Old Rivals," Wall Street

Journal

(December 1, B5.

7 Quoted in Kenneth Labich, "Is Herb Kelleher America's Best CEO?" Fortune (May 2,

CllA1yrER 8 PRICING

STRATEGY AND MANAGEMENT

502

EXHIBIT 5 Southwest Airlines Route Map in Early

1995

R •ahoe

R-ancbco

Burbank

LOS AJWie(LAX) X san D

Cle-dand

Jis nsas City

St. L.oug

lie

buquerque Amarillo

D ingbarn

oaths (LOE new)

I so Mfdbnd/Odessa Aßtin ew Orleans

(Hobby & Intercontinental)

SOUTHWEST Scx.ith ndre Glutd

Source: Courtesy of Southwest Airlines.

Southwest. Pilots could be found assisting at a boarding gate; ticket agents could

be seen handling baggage. So important was the attention to customer service

that Southwest chronicled legendary achievements in an internal publication

titled 7be BOOK on Service: What Positively Outrageous Service Looks Like at

Southwest A irlines.

The Southwest focus on customer service also produced tangible results. In

1994, Southwest won the annual unofficial "triple crown" of the airline industry

for the third consecutive year by ranking first among major carriers in the ar-

eas of on-time performance, baggage handling, and overall customer satisfaction

(see Exhibit 6). No other airline had ever won the "triple crown" for even a single

month.

Operations Southwest dedicated its efforts to delivering a short-haul, low- fare, point-to-point, high-frequency service to airline passengers. As a short- haul carrier with a point-to-point route system, it focused on local, not through or connecting, traffic that was common among carriers using a hub-and-spoke system. As a result, approximately 80 percent of its passengers flew nonstop. In 1994, the average passenger trip length was 506 miles and the average flight time was slightly over one hour. From its inception, Southwest executives rec- ognized that flight schedules and frequency were important considerations for the short-haul traveler. This meant that Southwest aircraft had to "turn" quickly to maximize time in the air and minimize time on the ground. Turn referred to the elapsed time from the moment a plane arrived at the gate to the moment

SOUTHSVT-ST AIRLINES 503

EXHIBIT 6 U.S. Department of Transportation Rankings of Major Air Carriers

for 1994 by On-Time Performance, Baggage Handling, and

Customer Satisfaction

On-Time Customer Performance

Southwest

Northwest

Alaska

United

American

America West

Delta

TWA

USAir

Continental

Baggage Handling

Southwest

America West

American

Delta

Alaska

United

TWA

USAir

Northwest

Continental

Satisfaction

Southwest

Delta

Alaska

Northwest

American

United

USAir

America West

TWA

Continental

Source: U.S. Department of Transportation.

when it was "pushed back," indicating the beginning of another flight.8 More than half of Southwest's planes were turned in 15 minutes or less while the remainder were scheduled to turn in 20 minutes. The U.S. airline industry turn time averaged around 55 minutes. A result of this difference was that Southwest planes made about 10 flights per day, which was more than twice the industry average.

Southwest's operations differed from major carriers in other important ways.

First, Southwest generally avoided major airline hubs in large cities. Instead, air-

ports in smaller cities or less congested airports in larger cities were served. Mid-

way Airport in Chicago, Illinois, and Love Field in Dallas, Texas, were examples of less congested airports in larger cities from which Southwest operated. Less congestion meant Southwest flights experienced less aircraft taxi time and less airport circling while awaiting landing permission. The practice of using second-

ary rather than hub airports also meant that Southwest did not transfer passenger

baggage to other major airlines. In fact, Southwest did not coordinate baggage transfers with other airlines even in the few hub airports it served, such as Los Angeles International Airport (LAX).

Second, Southwest stood apart from other major carriers in terms of book-

ing reservations and providing seat assignments. Rather than making reserva- tions through computerized reservations systems, passengers and travel agents

alike had to call Southwest. As a result, fewer than one-half of Southwest's seats

were booked by travel agents. (Most airlines rely on travel agents to write up to

90 percent of their tickets.) Savings on travel agent commissions to Southwest amounted to about $30 million per year. Also, contrary to other major airlines, Southwest did not offer seat assignments. As Kelleher said, "We still reserve your

seat. We just don't tell you whether it's 2C or 38B!" Instead, reusable, numbered

boarding passes identified passengers and determined boarding priority. The

8 Numerous activities occurred during a turn's elapsed time. Passengers got on and off the plane and

•i

baggage was loaded and unloaded. The cabin and lavatories were tidied and the plane was refueled,

inspected, and provisioned with snacks and beverages.

CHAPTER 8 PRICING

STRATEGY AND MANAGEMENT

504

first 30 passengers checked in at the

gate board first, then

a second group of 30

(31—60) boarded, and so forth.

Third, only beverages and snacks were

served on Southwest fligh(s.

principal snack was peanuts, and 64 million

bags of peanuts were served

Finally, 10 far:

Southwest flew only Boeing 737

jets in an all-coach configuration

claesrseesof(fierrset c10anssl, ecgonomy,

business, etc.) existed. This Practice

differed from other major carriers, which flew

a variety of jet aircraft made by

Airbus Industries, Boeing, and McDonnell Douglas,

and reduced aircraft

tenance costs. Southwest's fleet was among the

youngest of the major airlines at

7.6 years and had 25 new Boeing 737 aircraft

scheduled for delivery in 1995. In

1994, less than 1 percent of Southwest flights

were canceled or delayed due to

mechanical incidents and Southwest was consistently

ranked among the World,s

safest air carriers. The combined effect of Southwest's

operations was apparent in its cost struc_

ture. In 1994, Southwest's 7.08-cent cost per available

seat mile was the lowest

among major U.S. carriers.

Marketing Creative marketing was used to differentiate Southwest from other

airlines since its beginning. As Kelleher put it, "We defined a personality as well

as a market niche. [We seek to] amuse, surprise and entertain."

Southwest's marketing orientation was intertwined with its customer and op-

erations orientation. In this regard, service, convenience, and price represented

three pillars of Southwest's marketing effort. As with customer service and opera-

tions, Southwest's unique twist on marketing set it apart from other airlines. In

the domain of pricing, for example, Southwest had always viewed the automo-

bile as its primary competitor, not other airlines. According to Colleen Barrett,

Southwest's executive vice president with responsibility for customers: "We've always seen our competition as the car. We've got to offer better, more conve- nient service at a price that makes it worthwhile to leave your car at home and fly with us instead." In 1994, Southwest's average passenger fare was $58.44. Marketing communications continually conveyed the benefits to customers of fly- ing Southwest. Advertising campaigns over the past 24 years featured Southwest service in "The Love Airline" campaign, convenience in "The Company Plane" campaign, and most recently, low price in "7be Low Fare Airline" campaign (see Exhibit 7).

Southwest offered a frequent flyer program called "The Company Club,"but again with a difference. Consistent with its focus on flight frequency andshort-hauls, passengers received a free ticket to any city Southwest served with8 round-trips completed within 12 months. For 50 round-trips in a 12-monthperiod, Southwest provided a companion pass valid for one year. Having nomileage or other qualifying airlines to track, the costs of "The Company Club"were minimal compared with other frequent flyer programs and rewarded thetruly frequent traveler. Southwest also flew uniquely painted planes that signified places on its routestructure. Planes were painted to look like Shamu the Killer Whale to highlightSouthwest's relationship with both Sea World of California and Texas. Otherplanes were painted to look like the Texas state flag and called "The Lone StarOver Texas," while others, such as "Arizona One," featured the Arizona state flag

People Commitment The bond between Southwest and its workers was erally regarded by the company as the most important element in the southwest

SOUTHWEST AIRLINES 505

EXHIBIT 7 Representative Southwest Airlines Print Advertising Campaign

WHENYOUWANT

ALowFARE,

LOOKTOTHE

AIRLINETHAT

OTHER AIRLINES

LOOKTo.

SOUTHWEST THE Low Fare Airline*

au travel too-I-FLY•SWA

Source: Courtesy of Southwest Airlines.

model. Herb Kelleher referred to this bond as "a patina of spirituality." He added:

I feel that you have to be with your employees through all their difficulties, that you have to be interested in them personally. They may be disappointed in their country. Even their family might not be working out the way they wish it would. But I want them to know that Southwest will always be there for them.9

9 Quoted in Kenneth Labich, "Is Herb Kelleher America's Best CEO?" Fortune (May 2, 1994):28—35.

506 CHAPITR 8 PRICING

STRATEGY AND

EXHIBIT 8 Southwest Airlines Aircraft

Source: Courtesy of Southwest Airlines.

The close relationship among all Southwest employees contributed to South-

west's recent listing as one of the top 10 best companies to work for in a recent

study of U.S. firms. The study noted that the biggest plus at Southwest was that "it's

a blast to work here"; the biggest minus was that "you may work your tail off." 10

Southwest's commitment to its people was evident in a variety of forms. The

company had little employee turnover compared with other major airlines and

was the first U.S. airline to offer an employee profit-sharing plan. Through this

10 Robert Levering and Milton Mosckowitz, The 100 Best Companies to Workfor in America

(New York: Doubleday/Currency, 1993).

SOUTHWEST AIRLINES

507

plan, employees owned about 10 percent of Southwest stock. Eighty percent ofpromotions were internal and cross-training in different areas as well as teambuilding were emphasized at Southwest's "People University.

Competitive and Financial Performance Southwest's attention to customer service and efficient operations, creative mar-keting, and people commitment produced extraordinary competitive and finan-cial results.

Competitive Performance According to the U.S. Department of Transpor-tation, Southwest carried more passengers than any other airline in the top100 city-pair markets with the most passengers in the 48 contiguous UnitedStates.ll These 100 markets represented about one-third of all domestic pas-sengers. In its own top 100 city-pair markets, Southwest had an average65 percent market share compared with about a 40 percent market share forother airlines in their own top 100 city-pair markets. Southwest consistently ranked first or second in market share in more than 90 percent of its top50 city-pair markets. In Texas, where Southwest began operations in 1971,it ranked first in passenger boardings at 10 of the 11 Texas airports served and had an intra-Texas market share of 70.8 percent in mid-1994. Southwest recorded a market share of 56.4 percent in the intra-California market in mid- 1994, compared with a market share of less than 3 percent in 1989.

Financial Performance Southwest's average revenue and income growth rate and return on total assets and stockholders' equity were the highest of any U.S. air carrier during the 1990s. Exhibit 9 on page 508 provides a five-year consoli- dated financial and operating summary for Southwest Airlines.

Even though Southwest achieved record revenue and income levels in 1994, net income in the fourth quarter 1994 (October I—December 31, 1994) fell 47 percent compared to the fourth quarter 1993. The last time Southwest reported quarterly earnings that were less than the same quarter a year earlier was in the third quarter of 1991. Fourth quarter 1994 operating revenues were up only three percent compared to the same period in 1993. This result was considerably less than the double-digit gains in operating revenues recorded in each of the preceding three quarters compared to 1993. Southwest's fourth quarter financial report sent the company's stock price reeling to close at a 52-week low of $15.75 in December 1994 in New York Stock Exchange com- posite trading, down from a record $39.00 in February 1994.

Southwest's fourth quarter 1994 earnings performance reflected the cumu- lative effect of numerous factors. These included the conversion of recently ac- quired Morris Air Corporation to Southwest's operations, competitors' persistent use of fare sales, which Southwest often matched, and the airline-within-an-airline initiatives launched by Continental and United. Commenting on the fourth quarter financial and operating performance, Kelleher said:

While these short-term results will be disappointing to our shareholders, the re- cent investments made to strengthen Southwest Airlines are vitally important to our long-term success. We are prepared emotionally, spiritually and financially to meet our increased competition head-on with even lower costs and even better customer service.

Il U.S. Department of Transportation press release, May 11, 1993.

12 Quoted in Terry Maxon, "Southwest Forecasts Dip in Earnings," 7be Dallas Morning News (December 8, 03.

EXHIBIT 9 Southwest Airlines Five-year Financial and Operating Summary

(Abridged)

Selected Consolidated Financial Datag

1991 1992

1990

(In Thousands Exce t Per-Share Amounts 1994 1993

Operating revenues:

Passenger $2,497,765

Freight 54,419

Charter and other 39, 749

Total operating revenues 2,591,933

Operating expenses 2,275,224

Operating income 316,709

Other expenses (income), net 17,186

Income before income taxes 299,523

Provision for income taxesC 120,192

Net incomeC $179,331

Total assets $2,823,071

Long-term debt $583,071

Stockholders' equity $1,238,706

$2,216,342

42,897

37,434

2,296,673

291,973

32,336

259,637

105,353

$154,284d

$2,576,037

$639,136

$1,054,019

$1,623,828

33,088

146,063

1,802,979

1,609,175

193,804

36,361

157,443

60,058

$97,38$

$2,368,856

$735,754

$879,536

Consolidated Financial Ratios a

Return on average total assets 6.6% 6.2%" 4.60/oe

Return on average stockholders' equity 15.6% 16.00/0" 12.9%

Debt as a percentage of invested capital 32.0% 37.7% 45.5%

$1,267,897

26,428

84,961

1,379,286

1,306,675

72,611

18,725

53,886

20,738

$33,148

$1,854,331

$617,434

$635,793

2.0%

5.3%

49.3%

22,669,942

11,296,183

22,196

70,659

1,237,276

87,261

(6,827)/

80,434

29,829

$50,605

$1,480,813

$327,553

$607,294

3.5%

8.4%

35.0%

19,830,941Revenue passengers carried

RPMs (thousands)

ASMs (thousands)

Load factor

Average length of passenger haul

Trips flown

Average passenger fare

Passenger revenue per RPM

Operating revenue per ASM

Operating expenses per ASM

Number of employees at year-end

Size of fleet at year-end/

Consolidated Operating Statistics

21,611,266

32,123,974

67.3%

506

624,476

$58.44

11.56C

8.07C

7.08@

16,818

199

18,827,288

27,511,000

68.4% 509

546,297 $59.97

11.77€

8.35C

7.25Cb

15,175

178

27,839,284

13,787,005

21,366,642

64.5% 495

438,184

$58.33

11.78€

7.89C

7.03C

11,397

141

18,491,003 16,411,115

61.1%

498

382,752

$55.93

11.22<

7.10€

6.76@

9,778

124

60.7%

502

338,108

$57.71

11.49<

7.23$

6.73C

8,620

106

'The Selected Consolidated Financial Data and Consolidated Financial Ratios for 1992 through 1989 have been restated to include the financial results of Morris.

b Prior to 1993, Morris operated as a charter carrier; therefore, no Morris statistics are included for these years. Pro forma assuming Morris, an S Corporation prior to 1993, was taxed at statutory rates.

d Excludes cumulative effect of accounting changes of $15.3 million ($.10 per share). e Excludes cumulative effect of accounting change of $12.5 million ($.09 per share). f Includes $2.6 million gains on sales of aircraft and $3.1 million from the sale of certain financial assets. g Includes certain estimates for Morris.

b Excludes merger expenses of $10.8 million.

Includes leased aircraft.

Source: Southwest Airlines 1994 Annual Report.

508

SOUTHAVESI' AIRLINES 509

SOUTHWEST VERSUS SHUTTLE BY UNITED The maiden flight for "Shuttle By United" departed Oakland

International Airport

for Los Angeles International Airport at 6:25 A.M. on Saturday, October 1, 1994.

Later that morning, United's executive vice president of operations, who flew in

from United's world headquarters near Chicago to mark the occasion, spoke to

the media. He said:

What we're doing is getting back into the market and getting our passengers

back. We used to own Oakland and LA, and then Herb (Kelleher) came in. What

we have to do is protect what's ours.13

At the time, Dave Ridley believed that the Oakland flight had "symbolic signif-

icance" for two reasons. First, until the late 1980s, United was the dominant carrier

at the Oakland airport, but left in the early 1990s following head-to-head competi-

tion with Southwest. Second, Oakland had become the main base of Southwest's

Northern California operation and was the fastest growing of California's 10 major

airports in terms of air traffic.

Shuttle by United 14

Created by a team of United Airlines managers and workers over the course of

a year and code-named "U2" internally, "Shuttle By United" was designed to

replicate many operational features of Southwest: point-to-point service, low

fares, frequent flights, and minimal amenities. Lowering operating cost was a

high priority since United's cost for shorter domestic routes (under 750 miles)

was 10.5 cents per available seat mile. United's targeted cost per seat mile was

7.5 cents for its shuttle operation. Like Southwest, "Shuttle By United" featured Boeing 737 jets with a seating

capacity of 137 passengers, focused on achieving 20-minute aircraft turns, and

offered only beverage and snack (peanuts and pretzels) service. Management

and ground crews alike had attended "enculturalization" and motivational classes

that emphasized team-work and customer service. Unlike Southwest, "Shuttle

By United" provided first-class (12 seats) and coach seating. Rather than board-

ing passengers in groups of 30 like Southwest, a boarding process—known as

WILMA for windows, middle, and aisle seat—was used for seat assignments.

Passengers assigned window seats boarded first, followed by middle seat travel-

ers, and then aisle customers. United's "Mileage Plus" frequent flyer program was

available to passengers, with an option that matched Southwest's offer of one

free ticket for each eight shuttle round trips.

"Shuttle By United" was inaugurated with eight routes. Six of these were

converted United routes involving the airline's San Francisco hub. Only three

of the original eight routes competed directly with Southwest: San Francisco—

San Diego, Oakland—Los Angeles, and Los Angeles—Sacramento. On these three

routes, the "Shuttle By United" one-way, walk-up coach fare was identical to

Southwest's $69 "California State Fare," which was Southwest's highest fare on

13 Quoted in Catherine A. Chriss, "United Shuttle Takes Wing," The Dallas Morning News (October 3,

41).

Portions of this discussion are based on Jesus Sanchez, "Shuttle Launch," Los Angeles Times

(September 29, 1994):D1, D3; Randy Drummer, "The Not-So-Friendly Skies," Daily Bulletin

(September 30, 1994):CI, CIO; "United

Shuttle Incites Brings

a Guns War

to Between

Bear," Airline Old Rivals,"

Business Wall

(November StreetJournal

1994):

10; Michael J. McCarthy, "New

(December 1, B5.

510 CHAJTER 8 PRICING

STRATEGY AND

all seats and flights within California.15 One-way waJk-up coach fares variq

on the five noncompeting routes. Service from San Francisco to Burbank

to Ontario was priced at $104. Fares for the remaining San Francisco rout

were $89 to Los Angeles, $99 to Las Vegas, and $139 to Seattle. The "ShUttle By

United" first-class fare was typically $20 higher than its coach fare. "ShUttle By

United" was advertised heavily using print and electronic media.

"Shuttle By United" soon expanded its route system to include six additional routes. All six routes competed directly with Southwest. Service out of Oakland included Oakland—Burbank, Oakland—Ontario, and Oakland—Seattle. Los Angeles to Phoenix and to Las Vegas and San Diego—Sacramento rounded out the new service. Except for the Oakland—Seattle route, all one-way walk-up coach fares were $69 for Southwest and "Shuttle By United." A one-way walk-up coach fare of $99 was charged on the Oakland—Seattle route

12 of by 14

the city-pair

two airlines.

markets, "Shuttle

primarily

By United" also increased its flight frequency in out of its San Francisco hub. Cities served by "Shuttle By United" appear in themap shown in Exhibit 10.

Cities Served by "Shuttle By United"

e Seattle

WASHINGTON

OREGON

NEVADA

Sacramento

San Oakland

Francis

CALIFORNIA Las

Vegas

Burbank ARIZONA

Los Angeles Ontario

San Diego Phoenix

Walk-up fares refer to the fare available at any time, with no no penalties, and no

SOUTHNEST AIRLINES

511

In early December 1994, United reported that the cost per available seat mileof its shuttle operation had not yet achieved its targeted 7.5 cents. In an inter-view, "Sky" Magary said, "We're vaguely better than halfway there.

Southwest Airlines Southwest's

planning for United's initiative began months before the "Shuttle ByUnited" scheduled October 1 launch. In June 1994, a Southwest spokespersonsaid the airline would "vigorously fight to maintain our stronghold in California."Prior to the launch of "Shuttle By United," Southwest committed additional air-craft to the California market to boost flight frequencies on competitive routes. Bymid-January 1995, Southwest had deployed 16 percent of its total capacity (in termsof available seat miles flown) to the intra-California market. Thirteen percent ofSouthwest's total available seat mile capacity overlapped with "Shuttle By United"by late January 1995. Southwest also boosted its advertising and promotion budget for the intra-California market, with particular emphasis in city-pairs where "Shuttle By United"

competed directly with Southwest. Southwest's "The Low Fare Airline" advertising campaign spearheaded this effort. Southwest's walk-up fare remained at $69 dur-ing the fourth quarter of 1994, unchanged from the fourth quarter of 1993. How-ever, Southwest's 21-day advance fares and other discount fares were being heavily promoted. The effect of this pricing was that Southwest's average passenger fare in the markets also served by "Shuttle By United" (excluding Oakland—Seattle) was $44 during the fourth quarter of 1994 and into early January 1995, compared with $45 in the third quarter of 1994. The average 1994 fourth-quarter fare for the Oakland—Seattle route was $51, down from $60 in the third quarter of 1994. Dave Ridley estimated that the average passenger fare for "Shuttle By United" was 5 to 10 percent higher than the average Southwest fare in the nine markets where it competed directly with Southwest, and about $20 higher than the average South- west fare in the five markets served out of San Francisco where it did not compete directly with Southwest. The difference in average passenger fares between the airlines was due to first-class seating offered by "Shuttle By United" in competitive markets and generally higher fares in noncompetitive markets.

THE TUESDAY MEETING The original agenda for the "Tuesday meeting" in late January 1995 focused mostly on operational issues. For example, Southwest would begin scheduled service to Omaha, Nebraska, in March 1995, and advertising, sales, promotion, and scheduling matters still required attention. Southwest's "ticketless" travel system, or "electronic ticketing" was also on the agenda. This system, whereby travelers make reservations by telephone, give their credit card number and re- ceive a confirmation number, but receive no ticket in the mail, was scheduled to go nationwide on January 31, 1995, after a successful regional test. Final details were to be discussed.

Dave Ridley also intended to apprise his colleagues of the competitive situa- tion in California. A staff member had prepared a report showing fourth quarter load factors by route for Southwest and estimated load factors for "Shuttle By

Michael J. McCarthy, "New Shuttle Incites a War Between Old Rivals," Wall StreetJournal

(December 1, B5.

EXHIBIT 11 Daily Scheduled City-Pair Round Trips by Southwest Airlines and "Shuttle By United"and Quarterly Load Factor Estimates Southwest Airlines Daily Shuttle By United Daily

October— Mid- Air

Market (City-Pair) Miles San Francisco—Los Angeles 338 San Francisco—Burbank

San Francisco—Ontario

San Francisco—Las Vegas San Francisco—Seattle

San Francisco—San Diego Oakland—Los Angeles

Oakland—Burbank

Oakland—Ontario

Oakland—Seattle

Los Angeles—Sacramento

Los Angeles—Phoenix

Los Angeles—Las Vegas

San Diego—Sacramento

October—

December 1994

Mid- January

1995

1994 4tb-Quarter Load Factor

1994 3rd-Quarter Load Factor

1993 4th-Quarter Load Factor

359

364

417

678

417

338

326

362

671

374

366

241

481

December January 1994 1995

No Service

United

660/0

47%

74%

77%

62%

52%

48%

61%

Southwest

61%

590/0

63%

57%

66%

65%

61%

65%

United

77%

63%

89%

73%

Southwest

68%

74%

68%

77%

United

640/0

64%

74%

77%

84%

67%

Southwest

63%

700/0

65%

Source: Southwest Airlines records. For analysis purpose, load factors can be applied to daily round-trip flights for both on both legs of a ro-und trip.

61%

lines

56%

67%

SOUTHWEST AIRLINES

513

United." He wanted to share this information with the group (see Exhibit 11),along with other recent developments. For example, a few days earlier, "ShuttleBy United" had reduced its one-way walk-up coach fare on the San Francisco—Burbank route to $69. This fare was identical to the one charged on the Oakland—Burbank route by both airlines. In addition, Southwest's consolidated yield andload factor for January 1995 were tracking lower than the consolidated yield andload factor for January 1994. If present traffic patterns continued, Southwest's consolidated load factor would be about five points lower in January 1995 as compared to January 1994.

Unexpected news that "Shuttle By United" intended to discontinue some ser- vice and raise fares altered the original meeting agenda and posed a number of questions for Southwest executives. For instance, did the fare increase signify a major modification in United's "We're going to match Southwest" strategy? If so, what were the implications for Southwest? How might Southwest react to these changes, if at all? Should Southwest follow with a $10 fare increase of its own or continue with its present price and service strategy? What might be the profit impact of United's action and Southwest's reaction, if any, for each airline? And how, if at all, was United's pricing action linked to the announced withdrawal from the Oakland—Ontario market?