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Cost in Two Hostile Industries

Again, we will look at two domestic industries in overcapacity: the automobile and the airline industries. We call these industries Hostile markets, because returns for most of the players in the industry are low and price competition is intense.

Over the last twenty years, we have studied and worked in many of these Hostile markets. In about three-quarters of the cases, market hostility is caused by the expansion of industry competition, especially expansion by low-cost competitors. Hostility in both the airline and automobile industry is the result of expansion by competitors. In autos, the expansion of Asian competitors, in particular the Japanese, has gradually put a strangle-hold on the three domestic manufacturers, GM, Ford and Chrysler. In the airline industry, the expansion of low-cost carriers, including Southwest Airlines, Jet Blue and their ilk, have done the same thing with the legacy carriers.

Few of us would volunteer to be in a Hostile market. It’s painful on the best of days. But if you had the choice of working in and managing a company in one of these two industries, which would you choose? In which industry would you be more likely to succeed as an industry leader? Would you rather be a GM, Ford and Chrysler, or any American, United, Delta and Northwest? The answer depends on your view of the relative strength of each set of companies against their expanding competition. In this and the preceding blog, we look at each industry’s domestic competitors compared to their expanding rivals on the basis of Value and Cost.

On the second dimension, that of Cost, both the domestic automobile manufacturers and the legacy airlines face a problem of age. But the legacy airlines can do more about it. Both the domestic auto manufacturers and the legacy airlines have well-seasoned work forces who have been with the companies far longer than most of their lower-cost, expanding competitors. These experienced employees are at the top of their compensation ranges and are often protected by work rules that render them somewhat less productive than their younger, and less-restricted, competitors.

Despite these disadvantages, both sets of industry leaders have proven to be more cost effective competitors in the last few years. The domestic auto industry can now produce an automobile using total labor hours that are close to those of its Japanese competition. Bankruptcy and other means of cost reduction have enabled the legacy airlines to reduce their costs drastically over the last five years. They are still more costly than their low-cost competitors, but the difference has narrowed enough so that, in these strapped times, even the low-cost carriers feel the pressure of low prices.

The legacy airlines still face daunting cost challenges. They are still not as cost-competitive as their low-cost, and low-priced, rivals, such as Southwest. The cost difference does not lie with the rate of pay for the workforce. Southwest pays its employees more on an annual basis than do the legacy airline competitors. Southwest continues to expand in the marketplace, even in the face of fully priced fuel on its marginal expansion. Southwest clearly can produce cash on routes that the legacy airlines can not. The explanation for these differences in cost lies in the relative productivity of the employees of these lower cost airlines.

The relative performance of the two domestic industries clearly gives the legacy airlines more hope. The age issue, in the form of retiree benefits, hits both sets of industry leaders hard. But the cost for the auto industry is nearly unbearable because the domestic producers have shrunk. The domestic auto industry has lost so many jobs over the last twenty years that its dwindling domestic employee base must support an ever-growing set of retirees. The legacy airlines face much less of a problem here. They have expanded their capacity over time by opening up new markets, especially international markets. Their problem of handling retiree benefits is much less than that of the domestic automobile manufacturers.

Overall, the airline industry’s legacy carriers are in a much stronger position than are the domestic automobile manufacturers. The automobile manufacturers are weakest in the aspect of Performance where it is most critical to be strong in a Hostile marketplace, Reliability. They have a fixed cost problem in the form of retiree benefits that will continue to get worse until they are able to expand their presence in the marketplace, an unlikely outcome as long as Reliability issues remain. You can’t reduce costs without customers. (See “Achieving The Low Cost Position” in StrategyStreet.com/Tools/Perspectives.) Still, the legacy airlines have yet to prove they can continue their leadership in the marketplace. As they cut back on their capacity, their Function advantages inevitably ebb. As they cut costs in customer service, their Reliability performance is likely to fade. And, within five years, they have to have a cost structure that will enable them to confront, and price to a standstill, low-cost carriers such as Southwest, and probably others, who will be seeking to enter their lucrative international markets to carry their large numbers of domestic passengers further on their way. Both these sets of industry leaders face enormous problems, but the domestic automobile manufacturers face the worst. Neither one will have much fun.

Posted 7/14/08

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