5 min readFeb 11, 2016

What Startups Can Learn From the Airline Industry

“If you want to be a millionaire, start with a billion dollars and launch a new airline.” — Richard Branson

Running an airline is a tough business. In the last two decades, almost every major airline has filed for Chapter 11 bankruptcy: United Airlines in 2002, US Airways in 2004, Delta in 2005, and American Airlines in 2012. According to economist Severin Borenstein at the Haas School of Business, the industry in aggregate lost over $60B between 1992–2012. [1] Airline CEOs often demonstrate public angst about the state of the airline industry. Famously, the former CEO of American Airlines Robert L. Crandall describes the airline industry as “a nasty, rotten business.”

While many difficulties in running an airline can be attributed to a hyper-competitive and low-margin industry, the experience of flying on a plane hasn’t changed much since jumbo jets incited the commercial airline industry in the 1970s. In-flight entertainment and wifi are the most notable upgrades in the past decade. What makes airlines such a difficult business to run, and what can technology startups learn from their pains?

Between a Rock and a Hard Place

Airlines are a generally low-margin business with operating margins around 23% at the high end. The largest contributing factors to operating expenses are employee wages and fuel costs, which combine to be approximately 50% of an airline’s operating expenses. [2]

While airfare has depreciated over the last 30 years [3], the decrease has largely been driven by deregulation as opposed to innovation. After an era of government-supported price fixing ended in 1978, competitive pricing pressures forced airlines to reduce airfare [4]. This has come at the cost of profitability though as many airlines roll through bankruptcies to stay afloat.

One would hope to see price reduction driven by innovative breakthroughs in aircraft carrier design, improved flyer experience, logistical and operational improvements, or other organizational efficiencies. The difficulty for airlines appears to be that the major drivers of their costs are often outside of their control. When it comes to labor costs, airlines are at the mercy of their unions, which make it incredibly difficult to drive down those costs.

Fuel prices are also largely out of an airline’s control. Oil prices are driven by complex market dynamics, and since airlines don’t build their own planes they’re not able to drive fuel efficiency either (and given that Airbus and Boeing have an oligopoly on the commercial airline industry, the manufacturers aren’t incentivized to either). An interesting route that some airlines have taken is to use financial engineering to buy hedges on oil prices. For example, between 1991 and 2008 Southwest was able to pay $3.5B less in fuel costs than other airlines by smart investments in oil futures.[5] The economics of this business seem to be so difficult that NPR reports the story of one airline generating more revenue from their investments in oil futures than from their passengers. [6]

Vertical Integration

Financial engineering aside, airlines are between a rock and a hard place as they face pricing pressure from competitors with very little ability to drive their own costs. The airline industry is aggressively competitive and airlines have few opportunities to differentiate. There are no inherent lock-in effects, and from a consumer perspective airlines seem to differentiate via marketing programs like rewards points and VIP lounge access. The flight experience is incredibly unvaried between airlines since Boeing and Airbus supply the mass majority of airplanes, and even in-flight services are supported by third-parties like GoGo.

A photo of a Pan Am flight on a Boeing 747 in the 1970’s. From: Pan Am Archives.

How can airlines differentiate from competitors and build a profitable, sustainable, and innovative business in an industry that has struggled to do so for the last 30 years? And what can new businesses and startups learn from their struggle?

Perhaps the answer is for airlines to expand beyond their existing scope and control more of the flyer experience, from the retail end to the flight itself. Or in business parlance: airlines could benefit from more vertical integration. Many airline tickets are purchased via third party retailers like Kayak or Expedia, flights take off from city-governed airports, planes are purchased from aerospace manufacturers, and fuel is purchased in a dynamic market with fluctuating prices. In the same way that app developers are beholden to the platform they develop on, it seems that airlines are beholden to a number of constituents with few assets of their own to draw on for innovation.

One of the most famous examples of successful vertical integration comes from Apple. Their initial strategy to own the entire end-user experience was initially considered stubborn and even foolish when Apple refused to license Mac OS to PC manufacturers [7] and again when they decided to build their own retail outlets. Many years later, their ability to inflect and manage their entire pipeline from design to manufacturing to retail has given them an unprecedented strategic advantage in the personal computer industry. To build so many core competencies into one business is admittedly a challenging task, but it presents opportunities and leverage when implemented effectively.

Why haven’t any airlines pursued this strategy to integrate more aspects of the flyer experience into their business? One reason might be a 1934 antitrust ruling that prevents airlines from being both the service provider and aircraft manufacturer. The ruling broke up the vertically integrated United Aircraft and Transport Corporation into United Air Lines Transportation Company (United Airlines), United Aircraft Manufacturing Company,and Boeing Aircraft Company [8]. The ruling, meant to address a scandal with US air mail delivery collusion, may have had the unintended consequence of cornering airlines into a difficult position today.

The lesson for startups and entrepreneurs is to be mindful of the aspects of their user experience they control and which aspects they do not. Platforms like the App Store, Facebook, and Twitter offer founders a way to piggyback on a vibrant ecosystem but always face the threat of the platform squeezing them out or replacing them altogether. Twitter’s third party app restrictions in 2012 is the most notorious example, and Apple’s new clone of F.lux called Night Shift is a more recent one. Whether you’re an app developer on Twitter and Apple, or building a SaaS business on top of Salesforce, the airline industry’s problems demonstrate the wisdom of building your option power by owning the end user experience.

Between a Rock and a Hard Place

Vertical Integration

References

Written by Roshan Choxi