A Lesson on Cost and Competition From American Airlines

How does your cost structure compare to your competitors? Are you a low-cost producer, or are your costs above the industry average? For many businesses, these are critical questions, because position on the industry “cost curve” can have a real impact on profitability.

In many industries, relative cost position is not very important. Other factors, such as brand strength, number and location of retail outlets, or the level of customer service might be much bigger drivers of profitability. However, when products are relatively undifferentiated, or when prices and/or costs are volatile, cost curve position can be critical to profitability. Why is that?

Undifferentiated products tend to have lower profit margins, which amplifies small differences in cost structure

Volatile prices and/or input costs can cause companies high on the cost curve (i.e., with a significantly above-average cost structure) to become deeply unprofitably very quickly. A high-cost competitor may need to run at significant losses or even cease operations during extended price troughs or cost run-ups

Fluctuating demand and/or persistent overcapacity will cause the most damage to high-cost competitors; low-cost competitors are better able to survive and even thrive in those industries

A decade ago, American Airline was one of the industry cost leaders, along with Southwest Airlines. Both operated with a cost per seat-mile lower than their national competitors. They were the “last man standing” after several competitors (United, Delta, Northwest, USAir) all went bankrupt in 2002-05. But after each of those bankruptcies, American’s competitors gained significant cost advantages:

They were able to rework existing union contracts and either shed (United, USAir, Delta) or defer (Northwest) some pension obligations

They were able to merge with (or be acquired by) rivals, gaining significant economies of scale as they consolidated routes and operations

As a result, American went from cost leader to cost laggard, with above-average employee costs (by one estimate, $800 million per year in additional labor costs) and sub-scale operations. In November, the airline declared bankruptcy, and earlier this month it announced plans to cut 13,000 jobs.

For American to exit bankruptcy and thrive again, they must lower their position on the airline industry cost curve. Regrettably, this may come at great cost to their employees and customers:

American has asked the bankruptcy court to allow them to transfer much of their pension costs to the U.S. government. Current and former employees may find their pensions reduced, and the post-bankruptcy employee pension plans are likely to be much less rewarding

Unless American can eliminate unprofitable routes and consolidate operations, their cost structure will remain uncompetitive. Whether through merger or as an independent, American’s cost-cutting means it will no longer compete as fully in some markets, likely reducing consumer choice and causing prices to increase in some markets

Regrettably as well, the airline industry will remain challenging, for the reasons we outlined above (undifferentiated products, low margins, volatile prices and input costs, fluctuating demand). Therefore, should American successfully move down the cost curve, some other unfortunate airline may take its place at the high end of the cost curve.

Regrettably, serial bankruptcy may be the new industry norm.

A Lesson on Cost From American Airlines