Shedding non-core functions or spinning them off into semi-autonomous subsidiaries or profit centres is easier said than done. But the recent worldwide recession and downturn in the industry, coupled with the quickening pace of deregulation in Europe and elsewhere, has caused many airlines to re-think fundamentally their basic mission and mode of organisation.
After years of talking about refocusing, airlines are increasingly taking the plunge. Several major airlines around the world have recently taken or are now implementing steps to reorganise certain non-core functions into profit centres or subsidiaries. In more radical instances they are actually divesting the operations entirely and outsourcing the functions (see chart).
As this trend gathers steam, the nature of the new airline organisation is becoming increasingly clear. The traditional airline structure, based on the military model, was highly vertically integrated. When the industry was new, third party resources hardly existed and airlines had to be self-sufficient.
They also had little incentive to resist the natural bureaucratic tendency to grow. Regulation propped up fares, insulating airlines from the inefficiencies of their excessive vertical integration. At the same time, regulations also prevented horizontal integration in the form of route expansion.
The result was that airlines were stuck in narrow geographic niches and performed a wide variety of support functions on a sub-optimal scale. Clearly as the regulatory barriers disappear, so will this structure. Comp- etitive pressures will force airlines to expand horizontally via route expansion, mergers, and codesharing alliances. Already they are reorganising their support functions into more efficient and competitive units. In one sense, they are redeploying resources from support to market expansion.
As airlines make these changes, they must determine what functions are at the true core of a modern airline. While this process often involves the slaughter of several sacred cows, the consensus which appears to be emerging is that the core functions are directly related to moving seats that have passengers in them. Specifically, this involves planning, marketing, flight operations, and accounting.
Obviously, this definition excludes much of the traditional airline infrastructure. Among the functions left out are maintenance, training, ground handling, cargo, catering, and perhaps, certain information technology functions. Also excluded is the ownership of aircraft, which are increasingly acquired on lease, sold and leased back, or securitised. So too is the ownership and management of facilities such as airport buildings, considered extraneous to the modern airline core.
Broadly speaking, the management concepts involved in contracting out are hardly new. Decentralisation, pushing decision making down and empowering people are all familiar management buzz phrases. In an era when ITT, the quintessential American conglomerate of the 1960s and 1970s, has decided to break itself up, the conglomerate is dead.
What is new is that these management concepts, while standard elsewhere, are finally asserting themselves in the airline industry. In one sense what we are witnessing is the steady deconglomerisation of the airline industry.
In targeting their restructuring efforts, airlines are focusing on maintenance for the same reason that Willie Sutton once said he robbed banks: 'Because that's where the money is.' In the past year, four of the world's largest airlines have implemented strategies to separate maintenance from the core airline. From January, Lufthansa's maintenance operations became a new wholly owned subsidiary called Lufthansa Technik. Similarly British Airways Engineering was inaugurated in April. Both provide a full range of heavy, light, and line maintenance services to their parent companies and third party customers.
Both of these new subsidiaries are now struggling to redefine their relationships with their parent companies. Such issues as transfer pricing, giving priority to internal versus third party work, and determining the circumstances under which the parent may refer work to other maintenance providers are all highly topical.
In both cases, a several year 'weaning' period has been established during which the subsidiaries must reduce costs so as to achieve pricing parity with the outside market. During this period, the subsidiaries are more or less guaranteed the parent's work flow. At the end of the weaning period, the parties intend to deal with one another at true arms length, with neither the parent guaranteeing its work to the subsidiary, nor the subsidiary reserving its capacity for the parent.
Whether the subsidiaries can achieve a competitive cost structure or will be free to act independently of their parent airlines remains uncertain. However, even a failure to achieve pricing parity with the outside market would include a silver lining. 'If after several years of trying our maintenance operation remains less efficient than the outside market, then we shouldn't be in the maintenance business,' says a Lufthansa planner. Breaking the airline up into several free-standing units appears to be the way to determine such matters.
BA has been emboldened in this regard by the successful divestiture of its primary engine overhaul facility in Wales, which was sold to General Electric three years ago. Experience from that has shown BA that diminished control over maintenance functions does not place the airline at a competitive disadvantage. Engine work at Lufthansa remains a part of Lufthansa Technik.
Air France has also taken steps to make its maintenance functions more autonomous by reformulating them as profit centres. The carrier's operations have been segregated into two units, with one providing heavy maintenance at the main bases, and the other light and line maintenance throughout the system.
In the US, Continental has taken the most radical step of all, having recently divested all of its engine overhaul capacity and all but two of its heavy check lines for airframes. Relatively unfettered by labour considerations, Continental chose not to dabble with the intermediate step of spinning out a subsidiary and allowing it to sink or swim. Its internal studies on the subject indicated that the cost savings from outsourcing most heavy maintenance would be enormous and it simply closed its facilities and laid off the staff.
Several other airlines are viewing this maintenance movement with great interest. United, while very tight-lipped on the subject, is rumoured to be considering a spin-off similar to that effected by its codesharing partner Lufthansa.
On the other hand, the experiences of airlines with long-established maintenance subsidiaries demonstrates that this option is not without pitfalls. Cathay Pacific has long prospered with its independent maintenance affiliate Haeco, and Singapore Airlines has created the spinoff SIA Engineering Company. But Team Aer Lingus has been a different story.
This Aer Lingus subsidiary - along with its affiliated engine shop, Airmotive Ireland - was spun out over a decade ago but has never achieved a sufficiently competitive cost structure. The result is significant downsizing and reorganisation.
While many airline executives cannot bring themselves to accept that maintenance can be separated from the core of the modern airline, no support function seems to elicit as viscerally protective a reaction as flight training. Rightly or not, training is often seen as the cultural temple within an airline, and industry veterans will often baulk at any suggestion of divorcing it from the core.
Even Cathay Pacific, perhaps the earliest of the world's major airlines to push almost every imaginable support function into separate and less than wholly owned subsidiaries, has kept flight training as an internal department. Even as the academy considers expanding beyond Hong Kong, the airline insists that it is not considering training as a subsidiary candidate given its central role in the corporate culture.
Nonetheless the question of cleaving off training is increasingly being raised as contract training becomes more common for both small and large airlines. Northwest, SAS, and SIA each have long-established flight training subsidiaries which operate their full-flight simulators for the benefit of both the parent airline and third-party customers.
Now joining their ranks is Lufthansa, whose flight academy operations in both Germany and the US will become an independent subsidiary next January. Another major US airline, while requesting confidentiality, reports that it is seriously considering such a step.
While each of these companies has made the training function a separate subsidiary, none has given up even partial control of their offspring. That far more radical step, however, has just been taken by Aerolineas Argentinas, which recently disbanded its simulator academy in favour of procuring less costly training on the open market. Though few carriers are willing to undertake so drastic a manoeuvre, many are beginning to reconsider the logic of a fully captive simulator fleet.
If there is a single airline department which positively cries out for treatment as a separate subsidiary, that department is cargo. Unlike the other functions, all of which grew up as cost centres which may produce ancillary revenue, cargo is a true revenue centre.
Cargo serves a wholly different customer base than the passenger side and markets itself in quite distinct ways. Left to its own devices, cargo would have different fleet needs, route structures, schedules, hubs, and wage scales than the passenger airline. Simply put, cargo is a separate business whose primary nexus with the passenger airline is that one of its products is the belly capacity in the passenger aircraft.
All of which has once again led Lufthansa to join several predecessors such as Aer Lingus and American in spinning out cargo into a separate subsidiary. 'As a part of the larger Lufthansa, we were always at a disadvantage in competing for resources,' says a board member of the newly formed Lufthansa Cargo. The same source suggests that as a separate subsidiary, the cargo operation is completing the psychological leap from being a secondary sales agent for passenger aircraft belly capacity to being a logistics company focused on addressing customer needs with a variety of products.
These products include not only Lufthansa's large fleet of dedicated freighters, but also the capacity of other carriers. But while its new corporate form has broadened the horizons of Lufthansa Cargo, not everyone is a believer. At Cathay, generally a disciple of hiving off operational areas, the concept of spinning out cargo has always run aground on the issue of how to allocate the cost of the belly space. 'We have reviewed the matter several times,' says a vice president, 'and we just can't develop an acceptable formula.'
If cargo is unique as a revenue centre among the airline functions, data processing is among the most mundane of cost centres. Yet the same trends are at work.
Often rechristened more zestily as 'information technology', this area incorporates such functions as revenue accounting, frequent flyer plans and scheduling. AMR, the parent company of American Airlines, has long seen information technology as a central pillar in its efforts to diversify away from sole reliance on the airline business and has built several IT subsidiaries within its AMR Services business segment. These subsidiaries both serve the needs of their sister airline, and sell expertise to outside customers.
More recently, both Delta and Lufthansa have split off central IT functions into independent joint venture companies. Given the almost exclusively internal focus which these departments had previously, both of these airlines have chosen at the outset to team with non-airline IT experts so that the joint ventures would have a market focus and arms-length relationship with their respective airline parents. Delta linked with AT&T to form Transquest, while Lufthansa sold 25 per cent of the equity in its new IT subsidiary to EDS.
A variation on the out-sourcing theme for IT has been to retain the function as an internal department but to shift the operations to off shore locations with lower labour costs. BA has recently relocated certain data processing functions to India, Cathay has made a similar move to Australia, and American has moved operations to Barbados.
Once again, however, Aer Lingus provides a cautionary note. After cleaving off several of its IT functions into a separate subsidiary in the 1980s, the Irish carrier is dissatisfied with the results and is seriously considering reabsorbing the subsidiary.
Functional areas where there has been relatively little controversy as to the virtues of shedding in-house departments are airport ramp services such as ground handling, refuelling, and catering. Few airlines consider these functions to be core competencies yielding significant competitive advantages, while the economies of scale achievable through consolidation are simply too great to ignore.
Consequently, airlines worldwide have been shedding these functions in part or in whole by splitting them into separate subsidiaries, selling the operations, or closing them entirely and outsourcing the functions.
A vision as to where this trend may lead is afforded by the catering industry in the US. With the sale in the last two years of the United and Delta kitchens, the only carriers among the 10 US majors to own catering operations are Continental, via its Chelsea subsidiary, and Southwest, which serves no hot meals. Each of the remaining eight US majors, and all of the four largest, have divested their catering capacity and rely entirely on third-party suppliers. These suppliers are now consolidating the catering industry, either by buying kitchens from airlines, or allying or merging with one another. Dobbs, the largest US caterer, consists largely of operations purchased from United, Delta, and others.
Sky Chefs, the former American catering network, has formed an alliance with Lufthansa's catering subsidiary by selling the German company a minority equity interest. Later this summer, Sky Chefs is expected to complete the acquisition of Caterair, the number two US provider.
Thus, the US catering industry has migrated from an internal airline function to an external one, and from an inefficient, atomised industry to an efficient, consolidated one. While less developed, this same pattern is increasingly discernible both in other geographic regions and among other ramp service functions.
The broader question is whether the pattern evolving out on the ramp is also applicable to the hangar, simulator bay, cargo shed, and data centre. Differently put, is the widespread and snowballing tendency to spin off support functions into separate profit centres or subsidiaries an end in itself, or merely the first step on the path to divestiture?
Airline executives are loth to speculate on this issue. As airlines reorganise a variety of functions into more autonomous units, they require the consent and cooperation of a variety of parties, but most particularly of the corporate bureaucrats whose turf this may erode, and organised labour. A fine balance must be achieved in order to proceed with this type of restructuring.
Nonetheless, two driving factors are clear. The first is that these same executives are both passionate and sincere in their belief that regardless of what the future holds, the movement to break up monolithic airline structures into a leaner federation of more focused enterprises is positive for the shareholders, the customers, the broader economy, and in the face of intensified competition, the workers.
Among believers contracting out is perceived as a superior organisational principle which affords greater cost transparency, a much improved response to the marketplace and incentives that are more closely tied to unit performance. As such it ought to be more than sufficient as a goal in itself.
On the other hand, it is equally clear that in forming a new airline today, one would perform almost none of the functions in-house. The third party markets for maintenance, flight training, data processing, catering, ground handling, and refuelling are all well developed, competitive, and more efficient than could be replicated internally.
With limited exceptions, Valujet, Ryanair and Kiwi contract out all these services, and there is no reason to believe that should they grow and prosper in future, they would not continue to do so. These are simply not perceived by many people to be core airline competencies any longer.
So can or should the major established airlines stop at merely devolving these functions into separate profit centres or subsidiaries? Are these support functions business areas in which major airlines should remain at all? The answer to those key questions is not yet clear.
Only time will tell whether the evolving organisational model presented by the US catering industry is of limited applicability, or whether it is the blueprint for the future of a broad array of formerly central airline support functions.
Source: Airline Business
