Delta Airlines is Soaring Again

From 1990-1996, through recession and recovery, Delta Airlines consistendy un-derperformed other airlines. Its profit margins were several percentage points below the induistry average, and well below the most profitable carriers such as American and Southwest. In 1997, however, Delta had one of the highest profit margins in the industry. Why did Delta struggle and how did it turn itself around?

In the introduction to this chapter, we described the strategic positions of several carriers. Southwest has been highly profitable by holding costs well below industry norms and selecting routes so as to avoid competition. American Airlines is another profitable carrier. Its costs are relatively high, but it offers schedules that appeal to business travelers, with hubs in major business cities such as Chicago and Dallas. It is also the dominant American carrier flying to Central and South America. United Airlines has also done well recendy. Aside from the Shutde by United on the west .coast, UAL has used a strategy similar to American's: It has relatively high costs, but it offers convenient schedules for business travelers, has strong hubs, and a dominant route structure to Asia.

Throughout most of the 1990s, Delta's costs were similar to those at American and United. But unlike those two carriers, Delta was not well-positioned to serve the lucrative business market. It has had a successful hub in Atianta, but its other hubs are in Cincinatti and Salt Lake City, both of which lack substantial origin/destination traffic. Most significantly, Delta has lacked a "northern" hub to serve cities in the midwest and northeast. Hence, only a small percentage of business travelers have turned to Delta when selecting a carrier. Delta operates a shuttle service in the Boston-New York-Washington corridor, but this is a

48See chapter 2 of Porter, M., Competitive Strategy, New York: Free Press, 1980.

fiercely competitive market in which a number of carriers have failed to prosper. Finally, Delta has offered numerous flights to Europe. But this is a crowded market with fierce price competition. Delta's fares on European flights can easily be half that of American's or United's fares on comparably long trips to Latin America or Asia.

It is apparent that Delta had failed to match the strategic positioning of its most successful rivals. In some ways, Delta was "struck in the middle;" that is, its shortcomings stemmed from an effort to pursue too many strategies at once, such as its effort to serve the business market both with shutde and full-fare service.49 Whatever the source of its difficulties, Delta clearly needed to rethink its strategic direction.

In 1995, Delta introduced the "Leadership 7.5" plan, focusing exclusively on reducing total operating expenses. This plan was somewhat successful, but Delta also benefitted from the rebounding economy. Two years later, Delta replaced this cost-cutting plan with a strategy that seems to epitomize "stuck in the middle." The "Balanced Plan" is designed to simultaneously reduce costs and increase revenue. Despite the reservations about firms becoming stuck in the middle discussed above, so far the plan is working. Delta has reduced its costs to the point where its operating costs per available seat mile are below that of American and United. At the same time, it is boosting revenue, largely by changing its route structure. By concentrating its routes in Southeast and Florida and expanding into certain profitable routes in South America, Delta is increasingly die first choice for both tourist and business travelers to these growing regions. (Interestingly, the Operational Review in Delta's Annual Report for fiscal year 1997 does not mention the shuttle.)

It is too soon to know if Delta's strategy of maximizing B-C is a permanent success. It does seem, however, that by judiciously choosing its target markets, Delta has found that it is possible to simultaneously reduce costs and increase benefits.

In practice, a firm's advantage is rarely based entirely on lower cost or superior benefits. We can cite examples of companies that seem to deliver a higher B than competitors at a lower C: Emerson Electric in air-conditioning components and Frito-Lay in snack foods are well-known examples. They suggest that the tradeoff between benefit and cost may be less strong than the preceding arguments suggest. The results of empirical studies on the tradeoff between cost and benefit strategies are also mixed. While almost all studies find visible "footprints" of benefit-based advantage and cost-based advantage, they also find that these strategies are not incompatible. For example, Danny Miller and Peter Friesen found that in consumer durables industries, firms that appeared to have achieved benefit advantages in their industries also tended to operate newer plants, had significantly better-than-average capacity utilization,

49One might argue that United has pursued a similar range of strategies, particularly with its Shutde by United. Note that the Shutde by United has helped it to maintain its feeder traffic for its Asian flights. Delta's east coast shutde has not generated similar benefits for its European flights.

and had direct costs per unit that were significantly lower than the industry average. Firms that appeared to have achieved cost advantages also scored highly on measures of relative differentiation, such as product quality, and advertising and promotion expenses.50

From a theoretical perspective, several factors might weaken the observed tradeoff between differentiation and cost positions in an industry.

• A firm that offers high-quality products increases its market share, which then reduces average cost because of economies of scale or the experience curve. As a result, a firm might achieve both a high-quality and a low-cost position in the industry. Figure 12.12 illustrates how. By pursuing a differentiation strategy, the firm raises its average cost at each level of output, represented by an upward shift in its average costs, from ACQ to^Q, But differentiation also shifts the firm's demand curve rightward, from D0 to Dx. Even if the firm raises its price, the movement to the new demand curve coupled with the fact that average cost is a decreasing function of output (reflecting economies of scale) implies that the firm's realized average cost actually goes down, from AC0(Q0) to AC^Q^. Charles River Breeding Labs typified this situation in the

Figure 12.12

Achieving Benefit Advantage and Cost Advantage Simultaneously.

A firm that achieves a benefit advantage itself shifts its demand curve rightward from D0 to Dj and shifts its average cost function upward from AC0(Q) to AC}(Q). Even if the firm raises its price, the movement to the new demand curve coupled with the fact that unit costs are a decreasing function of output implies that the firm's realized unit cost goes down from^Co(Qo) to^C^Qi).

(Volume of output)

50Miller, D-, and P. H. Friesen, "Porter's (1980) Generic Strategies and Quality: An Empirical Examination with American Data. Part I: Testing Porter," Organization Studies, 7, 1986: pp. 37-55. See also Phillips, L. W., D. R. Chang, and R. D. Buzzell, "Product Quality, Cost Position, and Business Performance: A Test of Some Key Hypotheses," Journal of Marketing, 47, Spring 1983: pp. 26-43; White, R. E., "Generic Business Strategies, Organizational Context and Performance: An Empirical Investigation," Strategic Management Journal > 7, 1986: pp. 217-231; Dess, G. G. and P. S. Davis, "Porter's (1980) Generic Strategies as Determinants of Strategic Group Membership and Organizational Performance," Acade?ny of Management Review, 27, 1984: pp. 467-488.

1970s with its germ-free technology for raising laboratory animals.51 The first to adopt germ-free barrier breeding technologies, Charles River Breeders became the quality leader, moved down the experience curve, and established a superior cost position relative to its nearest competitors.

• The rate at which accumulated experience reduces costs is greater for higher-quality products than for lower-quality products. The reason is that production workers must exercise more care to produce a higher-quality product, which often leads to the discovery of bugs and defects that might be overlooked in a lower-quality product/2

• Inefficiencies muddy the relationship between cost position and differentiation position. The argument that high quality is correlated with high costs ignores the possibility that firms may be producing inefficiently, that is, that their C is higher than it needs to be given their B. If so, then at any point in time, in most industries one might observe firms that create less B and have higher C than their more efficient counterparts. Indeed, the entire thrust of the total quality management (TQM) movement is to enable firms to improve production processes to increase B and reduce C.53

Figure 12.13 depicts cost and quality positions in the U.S. heavy-duty track industry in the late 1970s.54 If all firms were producing as efficiently as possible, but were pursuing competitive advantages that emphasized different degrees of cost and differentiation, then firms' positions would line up along the upward-sloping line that we label the efficiency frontier. The efficiency frontier shows the lowest level of cost that is attainable to achieve a given level of differentiation, given the available technology and know-how, including TQM techniques to the extent they are successful. Based on previous arguments, one might expect that the efficiency frontier would be upward sloping. Some firms, such as White Motors and International Harvester, however, have operated above the efficiency frontier. These firms delivered less quality and incurred higher costs than competitors, such as Ford and Paccar. Not surprisingly, these firms were consistently less profitable than their more efficient rivals.

What, then, can we conclude about the notion of "stuck in the middle"? To the extent that it reminds us that the pursuit of differentiation is often not costless (contrary to TQM gurus, quality is often not "free") and that a firm's competitive position should relate in an economically sensible way to its resources and distinctive competences, "stuck in the middle" is a valuable idea. However, even if there is a tradeoff between B and C, a firm need not provide the highest B or the lowest C to succeed. What matters is the magnitude of value-created, that is, B — C, relative to other firms. For example, Dannon in the yogurt market and Breyers in the

^"Charles River Breeding Laboratories," Harvard Business School, Case 9-376-262.

52Phillips, L., D. R. Chang, and R. Buzzell, "Product Quality and Business Performance: A Test of Some Key Hypotheses," Journal of Marketing, 47, Spring 1983: pp. 26-43.

"TQM is often associated with the work of W. Edwards Deming. However, Deming never used the term. TQM was the U.S. Navy's term for its quality program in the 1980s based on the philosophy and techniques summarized in Deming's book Out of the Crisis, Cambridge, MA: MIT Press, 1986.

54This figure is adapted from Hall, W. K., "Survival Strategies in a Hostile Environment," Harvard Business Review, September-October 1980: pp. 75-85.

Figure 12.13

Quality and Cost Positions in the U.S. Heavy-Duty Truck Manufacturing Industry in the Late 1970s.

Cost

High

Average

Freightliner 12.9% Efficiency fronder *Mack 19.9%

* International

Harvester 9% *

General Motors 22%

Paccar 30.7%

Average

* International

Harvester 9% *

General Motors 22%

Average

Paccar 30.7%

7 Quality

High

The figure depicts the cost quality positions of various competitors in die heavy truck manufacturing industry in the United States. The figure also shows each firm's return on assets for the period 1975-1979. If all firms were producing as efficiendy as possible, their positions would line up along an upward-sloping efficiency frontier. The efficiency frontier indicates the lowest level of cost that is attainable to achieve a given level of quality, given die available technology and know-how. Firms that are closer to the frontier are generally more profitable dian firms that are farther away.

Source: Figure adapted from Exhibit VII in Hall, W. K., "Survival Strategies in a Hostile Environment," Harvard Business Review, September-October 1980: pp. 75-85.

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