CASE

Delta's New Song:

A Case on Cost Estimation in the Airline Industry

INTRODUCTION

Founded in 1924, Delta Airlines is the third largest U.S. airline in operating revenues and revenue passenger miles flown. 1 Traditionally, Delta's primary competition came from the other full-service airlines, including United Airlines and American Airlines. However, in recent years, the major airlines have increasingly been forced to compete with low-cost, no-frill airlines pioneered by "fly for peanuts" Southwest Airlines. The significant downturn in passenger volume in the third quarter of 2001 (following the September 11 attacks) served only to increase the head-to-head competition between the majors and the low-cost competitors.

AIRLINE LABOR COSTS

Industry Challenges

Airlines must operate within a low-margin, high-fixed-cost environment, making profitability particularly sensitive to decreases in volume, either from environmental factors (e.g., the September 11,2001 attacks) or from competition. Moreover, the airline business is labor-intensive. Labor costs as a percentage of revenues ranges from a low of about 25 percent for the low-fare airlines to almost 50 percent for the large, full-service airlines such as United (see Exhibit 1).

For many airlines labor unions at various levels of the organization are strong, presenting an additional challenge in the management of costs. Labor union (re)negotiations were on the rise during 2003, as airlines tried to pass along an increasing share of the cost cutting to its employees. In the summer of 2002, US Airways won concessions from its workers corresponding to a 27 percent reduction from its prior year labor costs. Plans to terminate the airline's pilot pension plan, however, met with objections and will likely be resolved in US Airway's bankruptcy hearings. In January of 2003, American Airlines requested an $8 billion concession from the three labor unions representing its labor force. Northwest similarly argued for salary concessions as part of a $ 1 billion cutback (Gary and McCartney 2003).

"Labor costs, especially pilot-labor costs, are on the point of the spear again," Capt John Prater, chairman of the pilot union at Continental Airlines, recently wrote to his members. "Airline managements, Wall Street, the [Bush] administration and Congress are once again looking for a scapegoat to blame for the industry's ailments; so-called 'high-priced, under-worked' pilots have once again become their primary target." A senior pilot in the industry typically earns about $250,000 a year, while a senior mechanic would make about $70,000 and a senior flight attendant about $40,000. (Gary and McCartney 2003)

Delta Airlines

With over 81,000 employees, salaries are a significant component of Delta's cost structure, accounting for over 42 percent of the company's total operating expenses and over 46 percent of total revenues in fiscal year 2002 (see Exhibit 2). As with other airlines, Delta pilots and flight attendants are paid for hours flown. Contracts for unionized personnel guarantee a certain level of hours to unionized employees (with federal regulations providing caps on the number of hours that can be flown by an individual in a month). As a consequence, salaries are largely fixed in the short term for unionized employees. However, Delta is the least unionized of the major airlines. In fact, Delta's pilots are the only unionized employee group (with the exception of a very small contingency of flight operations personnel). Delta's flight attendants and ticket agents are not under union contract; consequently, their salaries, as well as hourly personnel (e.g., ticket counter and ramp operations personnel), represent salaries that are more variable in nature. Moreover, contracted maintenance work creates additional flexibility in salaries costs for Delta.

Since interim wage concessions by pilots of United Airlines (which also filed for bankruptcy protection in December 2002), Delta pilots are the highest paid in the industry with an average hourly wage rate for a Boeing 757 captain of $245. The same pilot would earn $178 per hour at Continental Airlines and only $172 per hour at United (post-concession) (Harris 2003b). In February 2003, the Airline Pilots Association (ALPA) successfully blocked Delta's plan to furlough an additional 1,700 pilots (Delta had already furloughed 1,600 pilots citing September 11 traffic declines as "circumstances beyond its control"). The ALPA, however, argued that the furloughs were in fact the result of the general economic difficulties the industry was experiencing and, therefore, were in violation of ALPA contracts that prohibit layoffs due to the company's economic

and financial situation. Delta representatives continue to assert the "continuing need to address overall pilot costs to enable Delta to return to a competitive cost structure and to preserve Delta's long-term future" (Setaishi 2003).

DELTA'S SONG

In November 2002, Delta Airlines announced that it would form a new low-cost carrier, Song. Song began service on April 15, 2003 with its first flight between John F. Kennedy International Airport in New York and West Palm Beach, Florida (Wong 2003). This was not Delta's first attempt to enter the low-fare market. A previous attempt, Delta Express, was initially profitable but eventually failed because of "a lack of a management team to fight budget wars, cost creep, and brand confusion" (Daniel 2003). Despite this prior unsuccessful attempt to operate a low-cost carrier under the Delta umbrella, Delta asserts its belief that Song will be able to successfully compete in the low-fare industry segment, a segment that has been relatively prosperous amid the industry downturn.

Song operations will be based on the low-cost model of Southwest Airlines (e.g., low fares, low frills, and quick turnarounds) and is targeted to compete with successful newcomer JetBlue. Song will be supported by a single-airliner fleet of 36 Boeing 757s and will provide service to Florida and the East Coast. Like JetBlue, Song flights will feature in-flight entertainment competitive with JetBlue's satellite televisions (Harris 2002).

Can Delta Succeed Where It Has Failed Before?

Overall, Delta expects cost per available seat mile to be about 20 percent lower for Song than it is for its current operations. John Selvaggio, Delta executive and future Song president indicates that airplane utilization will be increased and pilots and flight attendants will experience "more flying and less sitting time" (Harris 2002). What Delta won't do, however, is pay its Song pilots less than the current Delta pilots. Given that Delta pilots' per hour wage rates are, on average, $100 more than those of Southwest and JetBlue, industry analysts are skeptical of the ability of Delta to compete in the low-cost carrier segment. "It's very hard for me to see how they can come very close to the costs of JetBlue and Southwest without closing the labor-cost gaps," said Michael Roach, an associate with Unisys R2A Transportation Management Consultants in Hayward, California (Harris 2003a). In fact, Roach estimates that JetBlue and Southwest would still have 10 percent and 30 percent cost advantages, respectively, over Song.

Delta is in a position of evaluating entry into a new product market, namely, the low-cost carrier market. The question is, can Delta succeed where it has failed before? Can the airline create for itself a business model that can compete with the JetBlues and Southwest Airlines of the industry? Moreover, it may be that their options for operational investments are more limited than those of a brand new carrier such as JetBlue, thereby putting Song at a disadvantage. For example, they will be using their current airline fleet and, as a result, will be unable to take advantage of favorable lease terms offered to new carriers (Daniel 2003). The key to success for this endeavor lies in the ability to create a very different cost structure than the one under which it currently operates. Delta must understand how its current costs behave and, more importantly, anticipate how they will behave in the new business model outlined for Song. Can Delta rely on historical data to predict costs into the future for Delta and for Song? Or has the business model (and the environment) changed in such a fundamental way that Delta can no longer assume "business as usual"?

Questions:

What would be the effect of a sharp decline in passengers for a firm with a microeconomic structure such as the one Delta had in place during 2001? Is Deltas operating leverage high or low?

Analyze the proposal to launch Song as a response to the situation the firm is facing.

Estimate the salary cost function for Delta. Despite the fact you can choose between some feasible drivers, please use Revenue Passenger Miles for this part of the case. Use the High Low method.

Estimate the salary cost function for JetBlue. Use the high low method.

What conclusion can you make out of the comparison of both cost functions?

Maybe it the method. Please redo 3 and 4 by using simple linear regression?

Did the result of your analysis change?

Can Delta be successful on the new segment? Is the strategy aligned with the microeconomic structure of Delta? (THIS IS A VERY RELEVANT QUESTION)

Some years after Deltas case situation, salaries were no longer the highest cost for Delta. Fuel prices increased dramatically after 2001. How can you deal with this new profitability threat from a cost management perspective?

If costs cannot come down, how can we improve the profitability of a firm such as Delta? While answering this question remember the components of a profit function.