For the first time in its history, a medium-sized airline faced the threat of real competition. Efficiency and revenue generation had to be improved and costs reduced if the future of the carrier was to be secured. How was it possible in the space of just four months to identify potential savings worth over $150 million in net present value terms?
A top priority for senior aviation executives in today's environment is improving efficiency and reducing costs. Managers know that, as world economies return to growth, the real winners will be those companies able to capitalise on this period to make themselves fit enough to ride out the next downturn. They also know that substantial improvements in productivity and asset utilisation can be achieved by all but a very few organisations.
This task may sound simple, but those ultimately responsible for the future of an aviation company face a more daunting challenge. The problem is, as always, how to drive change of the required order of magnitude through organisations which have long established structures and working practices. A return to industry growth and profitability brings with it the additional risk that managers and employees may feel that they can relax, and in the process lose the momentum towards improved productivity.Four distinct elements are critical for achieving change in an organisation: a catalyst to start the process, a focus for change, a detailed programme of operational improvements, and a system to ensure implementation and monitoring of progress.
External catalyst
In the case of the US aviation industry, an external catalyst was supplied in the early 1980s by deregulation and increased competition: the elimination of route entry controls had a dramatic effect on both prices and costs as can be seen from Chart 1. While unit revenues rose by an average of 1 per cent a year between 1970 and 1981, they fell by an average of 3 per cent a year between 1981 and 1992, forcing airlines to cut their unit costs by 2.8 per cent a year in the same period.
Increasingly open competition in Europe and elsewhere will undoubtedly have a similar impact, and the Gulf war and recession provided a catalyst for all carriers.
However, an internal catalyst is still needed if middle management and workforces are to be convinced of the urgency of the situation before it is too late. Benchmarking has been used successfully by many corporations facing this kind of threat.
The word benchmarking is often coined loosely to describe the process of simply comparing one's own company with another. Used as such, it could rightly be criticised as being only moderately effective. In fact, benchmarking consists of much more than this and, when rigorously applied, it can be a highly effective tool. This is what provides that second ingredient to a successful restructuring - a focus for change.
Initially, a 'high level' comparison is made between your company and others engaged in the same activities, where you have reason to believe that they are more efficient than yourself in some areas of operation. Revenue generation, operating costs and asset utilisation are all analysed.
At this level costs would be grouped into typical departmental categories, such as sales and marketing, fuel, and so on. Based on this comparison, a subset of the best performers for each individual category is selected for detailed analysis, and priorities can be allocated among the activity areas which appear to offer the greatest scope for improvement. This analysis also serves to illustrate the order of magnitude of improvement which can be expected.
For some activities, it may be useful to seek benchmarks outside the airline industry. Companies in other fields may have developed even more effective and creative approaches than the best company in your own industry.
For example, in customer service and passenger handling there are numerous other sectors which 'process' customers, including hotels, car rental firms and retailers. In the marketing and sales areas, interesting ideas for aviation companies can be found by looking at world leaders in fast moving consumer goods. And heavy engineering or avionics repair operations can be benchmarked against similar workshops in the marine or automotive sectors, or in some instances against manufacturing firms.
Even at this aggregate level, a great deal of care must be taken to ensure that an 'apples with apples' comparison is being made. Figures bearing the same description may differ significantly in definition from company to company, and suitable adjustments must be made for different operating characteristics, route structures and so on. Airlines are among the most difficult companies in this regard!
The real value of benchmarking lies in the next stage - using it to produce a detailed programme of operational improvements, from which senior management can set targets. Detailed information is gathered for each of the benchmark companies about the exact composition of the cost blocks under review and the methods by which these cost levels are achieved. This entails a full understanding of such areas as operating procedures, organisation structures and responsibilities, purchasing power, and wage agreements and contract terms. Again, it is critical to ensure that the activities being analysed are genuinely comparable, and this involves a substantial analytical effort.
Charts 2 to 4 contain examples of a benchmarking exercise undertaken for an airline against several others. Detailed research into crew working routines and contracts revealed where improvements could be made. Three of the four benchmarked companies were achieving better overall aircrew costs on a block hour basis, but in different ways (Chart 2).
Company X paid its pilots higher salaries, but achieved lower overall costs through much higher productivity. At the other end of the spectrum, Company Z's pilots achieved little in the way of improved productivity but were paid much less. Company Y's cost variance was achieved through lower salaries and more productive work rules.
Similar considerations applied with flight attendants, although here the issue of manning levels enters the picture (Chart 3). Higher manning levels limit the overall cost gains made by Companies Y and Z.
Labour productivity
Station costs were also identified as offering potential for savings. A comparison with the carrier with the best demonstrated practice revealed that the latter's lower station costs were driven by higher labour productivity (Charts 4 and 5). A station labour cost per passenger of less than half of the client's translated to substantially lower station costs despite higher costs in other areas.
Returning to the analytical process, it is clear that the differences uncovered by benchmarking have to be adjusted to take account of company specific factors. It is important to understand not just what the differences are but, more important, what causes them. During this process creativity should provide further added value to the improvements being considered, to ensure that industry performance levels are leapfrogged rather than equalled. However, the beauty of benchmarking is that there is no need to reinvent the wheel for every improvement. Much can be achieved by building on proven processes observed elsewhere.
Your own company's new cost level for each activity can now be calculated assuming the improvements have already been implemented. This defines the target level for the change management programme. Finally, a detailed implementation programme describing the process changes and assigning responsibilities is worked out with operating managers, and milestones are set for reviewing progress.
In parallel with this external process, the internal analysis required by benchmarking may uncover anomalies in your own cost allocation methods. A comparison at this level of detail reveals the value of 'activity based costing', which traces costs to their causes rather than just allocating them across departments. The true profitability of individual customers, routes or activities cannot be measured with an accounting system which groups costs according to traditional departmental headings. The full power of such a system can be seen in Chart 6, which shows the identification of the causes of cost and revenue variance on a route by route basis.
Contrasting results
The underlying causes of poor profitability may vary considerably from route to route. Route D enjoys lower unit costs than average and an 80 per cent load factor, but its profitability is below par because of lower yields. With a 59 per cent load factor, Route E enjoys substantially higher yields but these are more than outweighed by higher costs, especially user fees and aircraft costs. Route C, with the lowest load factor of the sample and the worst set of costs, performs above the company average as a result of much higher yields.
The final requirement of a successful improvement programme is establishing a suitable monitoring system to measure progress. Such a system must encourage employees at every level to take decisions consistent with the overall corporate goals which have been set at a senior level. Establishing a 'value based management' approach can achieve this.
VBM is built on the recognition that stakeholder value is created by longterm cash generation adjusted for risk and the time value of money. Empirical evidence demonstrates that this methodology correlates far better with actual value creation than more traditional earnings and balance sheet measures. While many companies use discounted cash flow analysis for capital budgeting and project analysis, this approach is less commonly used, but no less valid, for guiding and monitoring day-to-day operations.
An important advantage of VBM for senior managers who need to steer an entire organisation is that one consistent measure (cash generation) can be applied, and is transparent across all activities of the company.
An economic model of the business is constructed, combining all the various operations and calculating the overall value of the corporation. In this way a direct link is established between each individual activity and its impact on the overall organisation and hence corporate cash generation (Chart 7).
The VBM approach does not require the rejection of existing systems, nor does it entail enormous quantities of new data computation. The information necessary for evaluating cash flows is captured by traditional profit and loss and balance sheet reporting.
Having established the 'value driver economic road map', the next step is to ascertain which value drivers have the most impact on the company. Many will be important, but operating managers can only be expected to focus on and communicate a limited number of variables. These must be selected for maximum impact.
Sensitivity analysis is used to identify a subset of the most important value drivers or key performance indicators (KPIs). These can be defined in everyday terms which are relevant at all levels in the organisation, for example the number of bags handled per dollar of labour cost, or pilots' block hours per $1,000 of labour cost. This provides a practical orientation for work routines.
The use of KPIs can also facilitate difficult tradeoff judgements. Take negotiations about employee remuneration and working conditions. A tradeoff between salary levels and the actual number of employees will be critical to discussions with workforce representatives. The VBM approach allows a simple matrix to be constructed showing the impact of various negotiating positions on company value (Chart 8).
In this example, keeping manning levels and real wages level will reduce company value by $9 million in total, whereas real wages growth of 1 per cent a year, combined with a one-off manning reduction of 5 per cent, will increase company value by $3 million.
The final step is to translate the improvements identified in the benchmarking process into corresponding target KPIs. These are set for each department or line manager in a similar manner to traditional budget discussions.
Understandable
The outcome of this process is a set of performance measures embedded throughout the organisation which are more intuitively understandable than accounting based measures such as return on investment. Furthermore, these measures have a direct and transparent link to cash flow and so to company value.
Future success in the aviation industry will be driven by two factors: a product/market vision which captures the imagination of passengers, and a low-cost organisation in which everyone is pulling in the same direction. Benchmarking and value based management provide the tools to implement change within their organisation and thus realise their vision of success.
Value based management was developed by Alfred Rappaport, principal of LEK/Alcar and adjunct professor at the J L Kellogg School of Management at Northwestern University, Chicago.
Source: Airline Business
