The Long and Arduous Journey of the Airline Industry May be Reaching an End

The government deregulated the airline industry in 1978. Since that time, the basic pricing in the industry, as well as airline fortunes, have been more or less continuously on the downward slope. It has been a very long trip down.

The industry may be heading up again, though. In the third quarter of 2010, the average domestic airfare was 11% higher than a year earlier. Profits returned to the industry in 2010 behind higher prices. In some part, these higher prices were the result of the additional fees that most of the domestic carriers charged passengers for checked baggage, better seating, rerouting and so forth. Still, the industry was able to hold its higher prices.

These prices are holding because the major industry players are less enamored of discounted flying. All of the big airlines are finding ways to extract prices from industry customers. Now that airline capacity utilization is high, the industry is more careful about capacity additions. Higher prices are here to stay.

The consumer still is far ahead. Even at these higher prices, ticket prices are a bargain. In fact, ticket prices, adjusted for inflation, are 20% below the levels of 1995. The industry has continuously stripped benefits from the base product in order to save costs. In 2010, the industry added back a few of those benefits (for example, economy plus seating) for an additional charge. We may see more of that over the next few years.

I Guess it Takes Bankruptcy...

In our previous blog (see Here), we described the resuscitation of the comatose manufacturing employment due to renewed flexibility in many union shops, such as GM. I guess it takes bankruptcy to get attitudes to change. Look at American Airlines, for an example.

Over the last several years, its big airline competitors have been getting bigger. United and Continental combined, as did Delta and Northwest. U.S. Airways merged and Southwest has just purchased Air Tran. Through it all, American stood largely on the sidelines.

Most of the other competitors had a real advantage. They went through bankruptcy. Of course, Southwest did not, but the other legacy carriers did. What those airlines and their workforces learned in bankruptcy created a lower cost and more flexible set of work rules for these airlines. Now American Airlines is beginning to pay the price for its competition with lower cost airlines.

American is clearly a high-cost airline. Its 2010 cost to fly a seat mile is 12.76 cents. This is the highest among the six largest carriers. Predictably, its pretax margins for the first half of the year were negative, while its peers produced positive operating earnings.

The problem American faces is primarily due to high labor costs. This may surprise you since several of the unions agreed to give-backs in 2003. Further, the American Airlines pilots claimed to be working at 1993 hourly rates. In short, all the unions working at American seem to be up in arms in frustration over their lack of economic progress.

The problem is less the rate of pay for the workforce than it is the work rules. American is at the bottom on industry measures of productivity because of restrictive work rules. Does that sound like the American automobile industry’s problem before the recent spate of bankruptcies?

Still, the unions are up in arms. Despite long term negotiations, the company has reached little in the way of agreements. Some unions are now threatening a strike. Let’s see. Take a high cost airline that is losing market share, increase its costs and scare away its future passengers with a threat of a strike. That sounds like a prescription to insure the future of an airline and the jobs that go with it, doesn’t it?

Green Shoots and Attitudes and Jobs

Here is something that may surprise you. We are now gaining manufacturing jobs in the U.S. Manufacturing employment has fallen every year since 1998, until 2010. Since the beginning of 2010, there has been a 1.6% gain in manufacturing jobs. That’s twice the pace of the growth in other private sector jobs. The unemployment rate for the manufacturing has improved from 13% in December of 2009 to 9.5% in August of 2010. That’s a better performance than that of the overall labor force.

These gains have come primarily in four industries: automobiles, fabricated metals, primary metals and machinery. These industries have all been losing jobs for several years. What is behind the change? Here is a significant indicator. Recently, the United Autoworkers Union has crafted an agreement with General Motors to encourage GM to invest money to assemble a low-priced sub-compact car in the U.S., with unionized labor.

This will be a first. All other domestic and foreign manufacturers have produced their sub-compact cars offshore. GM’s sub-compact, the Aveo, came from South Korea. Ford’s Fiesta came from Mexico. Chrysler and Fiat are planning to manufacture the Fiat 500 in Mexico. The Honda Fit and the Toyota Yaris are imported from outside the United States.

This new agreement is truly ground-breaking. Under the terms of the agreement, GM will pay 60% of the sub-compact plant’s 1550 workers a wage of $28 an hour. The other 40% of the plant’s employees will make $14 an hour. By GM’s calculations, this would enable the company to build a sub-compact at a profit in the U.S.

This new agreement may, in fact, reduce the average wage rate to competitive levels. Before GM’s bankruptcy, the average GM worker earned over $70 an hour in wages and benefits. After bankruptcy, that rate of cost fell to about $57 an hour…good, but not good enough to compete profitably. (See “Audio Tip #163: Introduction to Step 25 of the Basic Strategy Guide” on StrategyStreet.com.) Toyota has average labor costs of about $50 an hour. The Toyota workers are not unionized. This new UAW agreement with GM should make the new sub-compact plant competitive with the cost that Toyota incurs in the U.S.

A change in attitude at the UAW is behind this job-creating agreement. A senior UAW official explained that this agreement was the result of some very difficult decisions the union had to make in order to safeguard jobs. He further explained that the UAW developed a new understanding of the realities of the 21st century global auto industry while living through the GM and Chrysler bankruptcies. (See the Symptom & Implication, “The industry is reducing costs aggressively” on StrategyStreet.com.)

Three cheers for the UAW/GM agreement. Let’s hope that it creates jobs and profits.

How Hostility Starts

Many years ago, I had the good fortune of living in London for three years. During that time, I would often have lunch in one of London’s many public houses, “pubs” to you and me. They served rich and ample fare such as shephard’s pie, sliced turkey sandwiches and, of course, English “bitter.” Sometimes, after work, I would meet friends for a drink at the same pubs. When I traveled the countryside, I could always rely on a local pub to provide good food and drinks at reasonable prices. They were a more comfortable equivalent of a fast food restaurant. And they were great places to socialize.

Things have changed. A couple of years ago, my wife and I spent a vacation in England. I was anxious to take her to some of my favorite pubs, both while we were in London and while we were in the Cotswolds. To my surprise, most of these pubs were gone. Those that had survived had largely transformed themselves into much more upscale restaurants. Gone were the gorgonzola sandwiches and the cheddar and bread offerings. In their place were white tablecloths and nice silverware settings.

The public house is under significant pressure in Britain. The number of pubs has fallen by 10% in just the last five years. What happened? New competition.

Competition, both above and below pub prices, has reduced the market for pubs. At the lower end of the market, supermarkets easily undercut pub prices with their substantial buying power. At the higher end, the British have expanded their taste for wine. All of this new competition has reduced the sales of beer, the pub’s key product.

This is a picture of the development of a hostile market, where price competition is intense and returns for the industry are often low. A reduction in the number of competitors is a hallmark of a difficult, hostile market. We have studied many of those markets over the last twenty-five years. Most hostile markets are caused by the expansion of competition. The minority examples of hostility are the result of a fall-off in demand. The British pub industry has seen both factors at work. But the most pressing has been the expansion of competition.

For a relatively short summary of how to operate in a hostile market, see these two Perspectives: “Success Under Fire: Policies to Prosper in Hostile Times” and “Use Subtle Strategy in Tough Markets."

Discounts - Much Greater Than Most Assume

Recently, we did an extensive analysis of various forms of price reductions and discounts. In particular, we were interested in seeing how big discounts tended to be. Across roughly 850 instances of discounts, we found that the median discount was 25%. 75% of all discounts were 10% or greater.

Discounts in distressed markets are often much higher. Numerous examples reside in Florida condominiums. This market grew far too fast for demand and then collapsed quickly. Retail prices for condominiums there have fallen from 30% to 40% off their peak prices. If you are a big buyer, one capable of doing a bulk purchase, discounts are even larger. In one example, a condominium project had a cost of $340 per square foot to build. The complex had 375 luxury units which sat in bankruptcy. A developer bought 165 units at an auction sale at a price of $126 a square foot. That works out to a 63% discount on the cost of new building. (See StrategyStreet.com/Improve/Pricing/Reduce Price)

For comparison purposes, the median customer who is able to purchase a large package of a product buys that product at a discount of about 30% off of the retail price. 75% of these types of purchases have discount equal to or greater than 20%.

Pricing in the Dog Days of August

It seems that not many people wanted to spend the weekend in Philadelphia during August. Hotels that might be full during the week were sparsely populated on the weekends. But, Marriott was not taking this situation lying down.

The Philadelphia Marriott came up with an innovative pricing strategy. Any guest who booked a two-night stay starting any Friday during August into mid-September had to pay only the price of the highest outside temperature for the Saturday night rate. So, the guest paid regular prices on Friday night and the heavily discounted rate, based on the day’s high temperature, for Saturday night. A clever approach to discounting.

This is one of several approaches companies have used to get through periodic, or seasonal slow demand times. Companies have used the components of a price in order to bring customers to its products during slow times. For example:

* A construction company changed its list price much as did the Philadelphia Marriott. It priced its services very aggressively for the months of January and February so its customers would move work forward that would normally be done in the spring or summer.

* Other companies change the definition of their product to reach a new, lower, price point. Companies who sell fractional ownerships of private jets offer discounts up to 25% for flying on off-peak days.

* Other companies make direct payments to customers. We can see this approach with the current Orbitz program called Price Assurance. Orbitz refunds customers the differences in fare if a customer purchases an airline ticket and then sees the price of the ticket fall before he leaves on his trip.

* Some sellers throw in a free, or heavily discounted, product from a third party. For example, as the housing market became more difficult, some sellers offered to outfit a media room or pay closing costs for their buyers.

We believe that a company facing a tough pricing environment can gain a lot by studying what other companies have done when facing the same circumstances. We have many of these examples on our web site. (See Improve/Pricing on StrategyStreet.com.)

Situation Bad...About to Get Worse

Over the last year, the U.S. government spent $80 million to prop up General Motors and Chrysler. The intent was to save millions of American manufacturing jobs. The benefits seem to be temporary, at best.

Both Chrysler and General Motors are reducing manufacturing capacity in the U.S. and shifting some of that capacity to Mexico. Over the next decade, Mexico is scheduled to gain most of the GM and Chrysler North American production that is discontinued in the United States. The reason isn’t hard to see. GM and Ford workers in the U.S. earn about $55 an hour, including benefits. The same workers in Mexico earn something less than $4 an hour.

Some in the government are upset about GM and Chrysler opening more facilities in Mexico, while U.S. facilities close. These people simply do not understand global economics. If GM and Chrysler keep their production in North America, all that will happen is that GM and Chrysler, backed by the U.S. tax payers and current shareholders, will pay for the excess wages that the domestic UAW employees now earn. If GM and Chrysler do not move their production facilities to places where costs are lower, other companies will do it for them and take their market share with better cars and lower prices. This has been the scenario for the domestic automobile manufacturers for the last twenty years.

No matter what the U.S. members of the UAW choose to do, their future is going to get worse. (See the Symptom & Implication “Foreign competitors are expanding with low prices” on StrategyStreet.com) Workers in other countries can simply make automobiles cheaper than they can. Chennai, India is a good example. In 2010, this city will produce 1.5 million automobiles. That is well in excess of 10% of the U.S. domestic demand and more than any U.S. state produces. Many major automobile manufacturers have a presence in Chennai.

The investment there is growing much as it is in Mexico. Hyundai, Ford and Nissan are each investing heavily in facilities in Chennai. Hyundai can now produce 650,000 cars a year there. Nissan can produce 400,000 cars annually. This new capacity is coming into a market that already has significant overcapacity in global production facilities. When new low-cost competitors enter the marketplace, they squeeze out the high-cost competitors. Who are the high-cost competitors? Watch where facilities are closing. Oh oh, that seems to be the U.S., where the UAW is holding a significant price/cost umbrella over its low-cost worker competitors, among whom are the Indian and Mexican workers in this story.

This will not have a pretty ending for the United Auto Workers, neither for those working nor for retirees.

Defending the Low Cost Position

The last couple of years have been very tough on the hotel industry. Now, some of the mainline hotel companies are starting to recover, but the high-end hotels continue their prolonged suffering. A typical example are the Four Seasons hotels. Last year the occupancy rate at the chain’s hotels was below 60% and revenue per available room, a key measure of sales, fell 26%. There are 82 Four Seasons hotels. At least 12 of them reputedly are near the breaking point.

The Four Seasons Company no longer owns any of its 82 branded hotels. It, like most of the hotel chains, sold off its hotels in the 80s to companies and investors who had more willingness and ability to carry high levels of leverage on the hotel properties. The Four Seasons, and most other hotel chains today, manage their brands but don’t own them.

The hotel brands tightly control the quality of their hotels through their management agreements. The management company receives a management fee of a percentage of the branded hotels’ revenues and also gets a percentage of the hotels’ profits. The hotel investor gets the use of the brand name and must conform to the rules as written in the management agreements. This arrangement allows for a disconnect between the interest of the hotel property owners and the hotel brand owners. The property owners may wish to find cost shortcuts that the brand owners abhor because the cost savings sully the brand name.

The founder of Four Seasons Hotels & Resorts watches carefully over the brand he created. Isadore Sharp is the founder and Chief Executive of Four Seasons Hotels & Resorts. He started with his first hotel in 1961. He built the company into the chain it is today by providing top notch service to its affluent guests. In the past, the company has weathered market downturns as relatively minor bumps in the road. This downturn has proven to be different. In this downturn, several property owners have petitioned the brand management company to reduce costs, sometimes at the guests’ expense. (See the Symptom & Implication, “The industry is reducing costs aggressively” on StrategyStreet.com.) Mr. Sharp will have little of it.

Mr. Sharp, who remains CEO of the company and 10% owner of Four Seasons Hotels & Resorts, agreed to some cost savings that have relatively little impact on the guest. Hotels may now outsource their laundry. They may simplify menus in the restaurants and even close a restaurant on slow nights on those hotels that have multiple restaurants. Some hotels may discontinue stocking fresh flowers in the lobbies as long as they replace those fresh flowers with sculptures or ornate vases. The property owners may also combine management positions and cross-train employees to work in multiple departments. Mr. Sharp believes that a guest will not see these kinds of cost savings in their visits to a Four Seasons Hotel.

But he refuses to go along with other cuts proposed by some property owners. The property owners may not combine the concierge desk with the check-in duties on the graveyard shift. Mr. Sharp insists that hotel employees continue to turn down guest bed covers each evening. He also refused a request to end room service during the middle of the night. All of these changes a guest would notice. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.)

These decisions by Mr. Sharp tell us a lot about why he has been so successful in his career. He keeps his attention focused on the quality of his guest experience, despite the short-term cost of continuing that form of Reliability. Profits may dip in the near-term, but he believes they will hold up in the long-term as customers return for the consistent quality of high level services they associate with the Four Seasons brand.

Mr. Sharp is protecting the ultimate low-cost position. We have found in our work and research in many industries that the low-cost position in a market is the ownership of a satisfied customer relationship. A company that owns a satisfied customer will not lose that customer to any other competitor unless that competitor can offer a similar product at a discount that begins at 15% and usually is more. We have not seen any market where peer competitors have cost structures that vary from one another by as much as 15%. Hence, the ownership of a satisfied customer relationship is the equivalent of having a 15% of revenue cost advantage on your peer competitors.

Hey, We Got New Features

We have written several times about the Customer Buying Hierarchy. See some examples HERE, HERE, and HERE. This Hierarchy holds that customers buy Function, Reliability, Convenience and Price, and in that order. Most people assume that new Functions or Features drive a great deal of market share change. In most industries, this is not the case. In a Hostile industry, it is not the case at all. I recently read of two industries who stress Function innovation today. One will succeed with this kind of innovation. The other will have, at best, fleeting success with it. Function innovations work best, and are sometimes critical to the success of a company, in high-growth and stable high-profit industries. (See the Perspective, “When to Compete on Features” on StrategyStreet.com.) They are much less helpful in a very tough Hostile industry.

The TV broadcasting industry is stable and highly profitable. It has become somewhat more competitive over the last few years, as cheaper satellite broadcasters take share from the dominant cable TV firms. Innovation has kept prices high and stable. This industry caught a break a few years ago when high-definition television made its debut and caused sales of new televisions to soar. These soaring television sales pulled with them new high-definition channels and premium services offered by the television broadcasters. These were Function innovations. An industry leader had to offer them in order to stay competitive in the market.

Now the industry may have caught a break with another new technology, 3-D. Broadcasters, content providers and television manufacturers are all betting that 3-D will be the next big Function innovation in television. So far, DirectTV has taken the lead in offering 3-D content. This, again, is a Function innovation which should appeal to customers in a fast-growing market.

The hotel industry is Hostile today. The recession has taken the air out of the sales of hotel companies. In response to the fall-off in demand, the leading hotel companies are searching around for their next “new thing” to attract customers away from one another. Obviously, there is less demand to go around, so the only hope a company has to improve its revenues is to take customers from another competitor. Now the industry leading competitors are trying a Function innovation to take market share. This Function innovation is in bathrooms. Many hotels are investing in bathroom upgrades, including better hairdryers, new packaging of soaps and shampoos, larger and thicker towels and bathroom throw rugs, among other innovations.

These Function innovations in a Hostile marketplace will move very little market share. The reason is that virtually all competitors will copy the Function innovations as soon as it is clear that they appeal to customers. We have seen Function innovations fail before. Remember the more comfortable beds? How about the flat screen high-definition televisions? Or what about the new paint and decorations? Wifi in every room? All of these innovations had a very short period of uniqueness. Once hotel competitors saw they helped the top and bottom line, everyone copied them. Now they are all taken for granted.

Sometimes an industry turns Hostile when Function innovations can no longer produce lasting market share benefits. Then customers have to make their buying decision on Reliability, Convenience or Price. Reliability and Convenience are much more costly benefits on which to stake a company’s reputation with customers, so relatively few companies really invest to achieve superb Reliability and Convenience. That is why these benefits usually mark the industry winners in very tough markets. (See the Perspective, “Reliabiilty: The Hard Road to Sustainable Advantage” on StrategyStreet.com.)

Using Finance to Reduce a Price

Dell is struggling to keep up with HP in the personal computer market. There is one part of the market, though, where Dell remains the clear leader, the small business market. Part of the reason for the company’s success in this market is its financing package. It is more generous with financial support than its competition. It may offer interest-free financing when companies purchase $25,000 or more of new computers. The company offers other creative financing deals. In one of these deals, a customer bought $30,000 of computers on a three-year lease plan that allows the customer to keep the equipment when the lease expires. Overall, Dell says that 22% of its small and medium-size business customers use Dell to finance their purchases. This 22% is up from 17% just two years ago. The company is gaining share by using its financing muscle, despite the chancy economic environment.

Offering financing, whether subsidized or not, is a way of extending the time a customer has to make its cash payment to the supplier. This is a form of discount. In our analysis of several thousand price reductions over the last twenty-five years, we have identified fifteen distinct forms of discount. The offering of financing is one of those forms. Many industries have relied on financing to build their businesses, even in difficult times. The automobile industry has used financing to offer attractive lease rates and payment plans to its customers using captive finance vehicles, like GMAC. GE has used its captive finance arm to finance customers in many of its product categories. In fact, GE has seen its captive finance arm grow into a lender in many markets where GE does not even compete as a supplier.

The home building industry has also used financing creatively. For example, last year Lennar offered special financing with no money down and a 3.625% mortgage rate for the life of its loans on purchases of Lennar’s newly built homes. Subsidized financing helped Lennar win new customers in an abysmal market. (See the Symptom & Implication, “Demand in the industry is falling” on StrategyStreet.com.)

Even small businesses use the extension of financing to build their businesses. Faryl Robin is a New York company that sells high-end women’s shoes. In the expectation that it would build its business with long-time customers in a tough economy, the company offered additional financing. In 2009, it offered retail customers with whom it had a long-term relationship an additional sixty days over its normal thirty day payment period for the customer to make its full payment for shoes she had purchased.

A Low-End Competitor with Low Industry Costs

Southwest Airlines is an unusual competitor. Since its inception, the company has been a low-end, discount competitor. What makes it an odd duck is that it provides service levels equivalent to the industry’s large legacy carriers while it also has very low costs compared to the industry’s erstwhile leaders, such as Delta, United and American Airlines. Southwest enjoys this low cost structure because it is less encumbered by onerous union work rules. Southwest has unionized employees, but their work rules are less restrictive than are those of the legacy airlines. Southwest uses this low cost structure to reduce prices and gain share against their larger legacy competitors. This has been going on for long enough that Southwest really is approaching industry leader status, if it’s not there already. Surely flying Southwest has become nearly as convenient and comfortable as flying one of the legacy airlines. The service of the legacy airlines has come to the level of Southwest, rather than the other way around.

Now Southwest has the economic where-with-all to do things that the poorer legacy airlines can not afford to do. For example, the company has made a major financial commitment to a new air traffic control system called “Required Navigation Performance” (RNP) routes. RNP is next generation technology that allows a flight to be less costly for the airline and more comfortable for passengers. (See the Symptom & Implication, “The industry is adding new, more efficient capacity in the effort to reduce costs” on StrategyStreet.com.) Airplanes can shorten their flights because they are able to use narrower and shorter descent patterns, reducing time and fuel. Passengers will find the descent more continuous, quieter and more comfortable.

This new technology will set Southwest back by $175 million. It put each of its pilots through ground school training on the new cockpit equipment and rewrote all of its flight procedures. Southwest made this investment on its own ahead of its competitors. The legacy carriers have delayed their own investments, hoping that the government will subsidize them. They can not afford this investment as easily as can Southwest. So, here we have a low-end competitor who has become an industry leader and continues to invest to reduce its operating costs and improve its performance for customers. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.) These investments slowly bleed away the advantages of the legacy carriers, adding to their economic strife.

There have been other low-end competitors who have been able to rise to industry leader status by taking advantage of the onerous work rules of their unionized competitors. The Japanese automobile manufacturers, especially Toyota, Honda and Nissan, certainly took that path. It appears that Hyundai is now following their lead in today’s automobile market.

New Capacity in a Shrinking Market

Big companies are pulling out of the petroleum refining industry. In the last year, Shell, Chevron, Valero and Sunoco have put refineries up for sale or shut them down. There is simply too much capacity in the industry. But there seems to be one guy coming in through the exit doors in the refining industry. Marathon Oil just opened a new $4 billion addition to its Louisiana refinery. Further, the company announced that it made a profit in all six of its other refineries in the U.S. in 2009. 2009 was a terrible year for the U.S. refinery business. 2010 isn’t much better.

Why would anyone add capacity in a hostile market with clear overcapacity? These capacity additions turn out to be commonplace. (See “Audio Tip #103: Capacity Creep Expansion of Industry Capacity” on StrategyStreet.com.) In Marathon’s case, the company started its capacity expansion in 2007, while the refining industry was roaring along. It simply took until 2010 to bring the refinery addition online. So this addition, while large, is really the result of expansion in the good times. The new capacity shows up when times have turned bad.

But, virtually every hostile industry sees small amounts, at least 1% to 2% per annum, increases in industry capacity every year. This capacity addition is the result of companies learning how to run their existing capacity with greater efficiency and effectiveness. It is almost a free addition to industry capacity. We call this annual capacity addition, despite overcapacity, the learning curve capacity addition. We named it after the well-known Boston Consulting Group strategic concept from the early 70s. The rate of this free capacity addition depends, in part, on the rate of growth in the industry itself. The faster the industry grows, the more free capacity will come online each year due to this learning curve effect. This effect can be pernicious. In the newsprint industry, the learning curve effect added more capacity every year than demand in the newsprint industry grew. During most of the 90s, the capacity industry’s addition due to the learning curve effect outstripped the growth of industry demand. Every year, hostility got just a little worse because of it. Real prices remained under pressure the whole time. (See “Audio Tip #133: What Tells Us Prices Will be Under Pressure?” on StrategyStreet.com.)

Recycling of Capacity in a Tough Market

Sweden is a small country with a proud tradition of producing tough, high-end, automobiles. We call these high-end products Performance Leaders. In a hostile market, a Performance Leader usually suffers from scale disadvantages compared to the much larger industry leaders, whom we call Standard Leaders. Often, these Performance Leaders become acquisitions for the industry’s Standard Leaders. (See the Symptom & Implication, “The industry is consolidating through mergers and acquisitions” on StrategyStreet.com.) That was the case when GM bought Saab and Ford bought Volvo.

Both of these automobile industry Standard Leaders operated their Swedish acquisitions as separate companies. However, as GM and Ford themselves faltered in the market, they both decided to jettison their foreign high-end products. Spyker Cars NV, a Dutch company, has purchased Saab from General Motors. China’s Geely Automobile Holdings Ltd. has purchased Volvo from Ford. Both the Saab and the Volvo brands, then, will continue into the future.

These purchases illustrate the sometimes difficult workings of a hostile marketplace. (See “Video #10: Industry Consolidation and Recycling of Capacity” on StrategyStreet.com.) Both Volvo and Saab were failing as stand-alone Performance Leader competitors. But they did not go out of business. Instead, larger industry Standard Leaders bought them and kept their capacity in operation. This is a first example of the recycling of brands, but more particularly, productive capacity in an industry that already had too much of it. Neither GM nor Ford was able to make a go of it with these Performance Leader brands. Rather than shut the brands and their productive capacity down, however, both the Standard Leaders found willing buyers for the brands and their industry capacity. This is the second example of recycling of the same capacity. In each case, the buyer got the company and its capacity for a cost below the book value of the original seller.

We have found this recycling of capacity to occur in virtually every industry that goes through over-capacity and hostile times. Capacity will not go away until it cannot produce cash for any owner. The recent closing of the San Francisco Bay Area Nummi plant, once co-owned by GM and Toyota, is a clear indication that the plant can no longer produce cash as an automobile plant. It may finally stop producing automobiles forever. It is worth noting, however, that this was a GM automobile plant before it became Nummi. It had already been recycled once in the mid-1980s.

The Math Still Works

Since the year 2000, medical care has increased in cost by 49%. Food is up 32%. But automobiles are flat and apparel is down 8%. Part of the reason for the better performance of automobiles and apparel has been the extreme stress of competition both of those industries have suffered. But the growth in the cost of medical care pales in comparison with the increased cost of college tuition and fees. That’s up 92% since 2000. (See the Symptom & Implication, “The industry has been able to preserve margins by increasing prices” on StrategyStreet.com.) All of this data comes by way of the Bureau of Labor Statistics.

Some people are beginning to question whether the cost of a college education justifies the benefits. It appears they do. The average college graduate with a Bachelors Degree earns about $53,000 a year. In real terms, that’s down 1% since 2000. The average high school graduate earns about $33,000 a year. This figure is also down 1% in real terms since 2000. Clearly, the costs of college tuition and fees have gone up enormously compared to slight declines in the earnings of college graduates. Still, the difference in annual earnings is slightly over $20,000 a year. The average state school probably charges something on the order of $10,000 a year for tuition and fees. A private school would charge considerably more. Some are just crossing the $50,000 a year threshold for tuition and room and board. So, the cost of a college education, without counting opportunity costs of foregone working income, range between $40,000 and $200,000. The college graduate, then, makes up that cost with improved earnings over the high school graduate in as little as two years, or as many as ten. Even if you discount the difference in future earnings, the college graduate is better off well before he or she reaches early middle age.

The pain of high tuition and fees is just beginning to squeeze. The risk is more likely in competitive supply than it is in customer demand. (See “Audio Tip #130: The Problem with High Returns” on StrategyStreet.com.) Young people are likely to continue paying the cost of college fees and tuitions because they earn it back, even if it takes several years to do so. On the other hand, these rising fees and tuition attract new entrants into the education market. That is where the colleges and universities are likely to feel the pain and suffering that result from thirty years of tuition and fee increases greater than the rate of inflation. They are creating a price umbrella for new market entrants.

Yep, Those Germans are the Problem

There has been much press over the last few weeks about the problems in the Euro Zone. Most particularly, we have learned more than we may want to know about the problems of deficit spending in Greece, Spain, Ireland and Portugal. Just recently, though, we may have learned that the problem is not the deficit spending in those recessionary countries. No, the problem seems to be the Germans.

Over the last ten years those nasty Germans have kept the lid on labor cost growth and have jacked up their rates of productivity. (See the Symptom & Implication, “Some competitors automate to become the lowest cost players” on StrategyStreet.com.) These simple actions have enabled Germany to compete on price despite high labor rates and competition from countries in the Euro Zone with nominal lower labor costs. Oh, those countries include Greece, Spain, Ireland and Portugal. Those inconsiderate Germans have produced a Euro 136 billion trade surplus in 2009. Spain, Greece and Portugal ran significant deficits. The Finance Minister of France has suggested that Germany’s export dependent growth model may be causing a lot of the problem in the Euro Zone. Her answer to this problem is for Germany to begin spurring domestic demand. So we see that the problem in the Euro Zone is people who do not deficit spend and who take advantage of all their poorer neighbors who do deficit spend.

This is causing turmoil in the Euro Zone that, in the long run, is almost certainly bad for the Euro. Some countries might have to exit the Euro Zone. Greece has threatened to use IMF resources to continue its deficit spending. The economic disunity in the Euro Zone is creating political disunity as well. There is a question whether the Euro Zone can continue in its present form.

We have similar situations among the states in the United States. The differences are that the states can not threaten to withdraw from the Dollar Zone, nor are they eligible for IMF financing. Our deficit financing states tend to be those with the highest labor costs. As a result, the unemployment rate in these states is higher, often much higher, than that in the country as a whole. In January of 2010, the United States national unemployment rate, as reported by the Bureau of Labor Statistics, showed an average of 10% unemployment in the country. The highest unemployment occurred in Michigan, with a 14.3% rate. Other high unemployment states included Rhode Island, California, Illinois and Ohio. In many of these states, labor costs are not only high, but they are inflexible. Companies can not change work rules, nor adjust rates of labor, to match the current economy. That’s part of the reason that jobs flee these states.

In the Euro Zone, German workers have wages and benefits among the highest in Europe. They average Euro 34 an hour, roughly $48 an hour. Recently, the German Metal Workers Union accepted a new contract with very low wage growth in order to protect their jobs in Germany.

Here is a contrast for you. In 2008, the average worker for the “Big Three” automakers earned $73 an hour in total compensation. Workers at Toyota, and other foreign makers, earned an average of $48 in their U.S. operations. These companies have located their U.S. plants in areas where labor is more flexible. The average U.S. manufacturing worker earned something less than $32 an hour in 2008. These labor cost disparities help us understand how Detroit is losing population. Nearly a quarter of its manufacturing jobs have left. The city suffers from a 50% unemployment rate. Detroit’s woes certainly have contributed to Michigan’s nation-leading 14.3% unemployment rate. But isn’t some of this woe self-inflicted? Why can’t domestic automakers make cars in the U.S. for $48 an hour?

The German unions have learned that they can sustain their high rates of pay only so long as they help their companies become more productive with every hour of labor. The workforce shares a large portion of the improvement in productivity. (See “Audio Tip #187: The Components of Productivity” on StrategyStreet.com.) Apparently, at least one of our leading labor unions does not share that calculus.

Reliability in Tough Markets

The stats for the light vehicle sales in the U.S. during the month of February are out. Of course, Toyota’s sales shrank by nearly 9%. The surprising big winner was Ford, whose sales increased 43%, far more than anyone else. Its nearest competitor, Nissan, had a sales increase of 29%. GM’s sales increased by 12%. What may be driving this superb performance from Ford?

We often use the Customer Buying Hierarchy to evaluate a company’s performance against its competitors. The Customer Buying Hierarchy argues that customers buy Function, Reliability, Convenience and Price, in that order. Customers continue to cycle through their alternatives until they have chosen one supplier who offers something important to the customer that no one else offers. As we have noted before, in tough marketplaces, high Reliability is a hallmark of the best industry performers. (See the Symptom & Implication, “Competitors are emphasizing reliability in product quality” on StrategyStreet.com.)

Ford’s reliability is impressive today. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” on StrategyStreet.com.) The National Highway Traffic Safety Administration measures the complaints it receives about automakers and their products. Their measure is number of complaints per 100,000 vehicles sold. Honda is the leader here, with about 64 complaints. Ford follows at 81, then Toyota at 91 and GM at 104. So, Ford’s quality seems to be somewhat better than Toyota’s today. That is at least one reason why Ford is in the ascendant, and while Toyota is falling off the pace.

Divorce that Customer?

Times are tough for business in many industries. Demand is off, prices are falling, and competition is fierce. Some companies have responded to these difficult conditions by divorcing their high-cost customers. Is this a good idea?

Perhaps this decision will increase profits. In a very tough market, it is not unusual for many customers to be “unprofitable.” (See the Perspective, “The New Pricing Structure” on StrategyStreet.com.) These customers may not produce a return on the company’s cost of capital through a business cycle at the industry’s current low prices. Pricing in the industry has fallen far enough that the price must discourage some of the industry’s capacity from producing. Several companies may find themselves pricing through “profitability levels” to maintain their relationship with a customer. This is more likely in an industry with low variable cash costs, such as most capital intensive industries. In these markets cash generation is more important than profits.

So, when should we divorce an “unprofitable” customer? The simple answer to that question is that you want to eliminate any customer who is not generating cash on sales to that customer. These customers are clearly unattractive in a tough market. They may also be unattractive in a better market. Certainly, today, they cost the business cash and are likely not worth keeping. (See “Video 63: Core Customers Part 1: Defining Core, Near and Non-Core Customers” on StategyStreet.com.)

There are two caveats to this rule. First, the company has to be sure that the reason the customer is unprofitable and, worse, failing to generate cash, is not that the company’s own cost structure is out of line with the competition. If the cost structure is out of line, that is higher than competition, then it must reduce its costs or get out of the business. (See the Perspective, “The Wisdom of Salomon” on StrategyStreet.com.) It is doomed to failure over time. The second caveat is that the customer is one who always pays low prices. The company should evaluate the customer relationship over the last few years, through a business cycle, to determine whether the customer is a perennial low-profit producer. If the customer is a low-profit producer through the business cycle, there is little risk in eliminating that customer. That customer does not generate enough money to support the capital his business demands.

Fewer Customers? Cut Capacity

For a year now the economy has weighed down passenger airline traffic. The industry expects a 4% reduction in passenger volume for 2009’s Thanksgiving season compared to the previous year. And, as demand has fallen, so have prices. Ticket prices this year are down 13% compared to 2008, so the industry is getting hit twice: by a fall-off in passenger seat miles flown, and by falling prices per seat mile. (See the Symptom & Implication “Demand in the industry is falling” on StrategyStreet.com.)

The airline industry thought it had an answer to this developing problem: cutting capacity. The industry has reduced capacity by 6.9% this year in the expectation that the industry could improve its efficiency and raise prices. (See “Audio Tip #116: The Withdrawal of Capacity to Raise Prices” on StrategyStreet.com.)

So, why haven’t prices risen? There are two possible answers. The first is that the industry has panicked and is offering lower prices to keep demand from falling any further than it already has. This answer is certainly in keeping with the industry’s previous practices. But there is a more subtle and more problematic answer as well, and that is that the smaller industry carriers are adding capacity faster than the industry leaders are reducing it.

Over the years we have witnessed many cases where industry leaders would reduce their capacity in order to constrain supply and force industry prices to rise. Time and again industry followers have stymied these initiatives. These followers insist on adding capacity, even as the industry leaders withdraw it. The result is the same, or more capacity, and continued low or falling prices.

To some extent, this addition of capacity by follower competitors is predictable (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?” on StrategyStreet.com). These smaller competitors already added capacity in the face of low industry pricing. They have even more incentive to add capacity as industry prices rise.

A Lay-up for Lay-away

Toys R Us has introduced a lay-away program for large ticket items that they sell. These items include bikes, dollhouses, play kitchens, car seats, cribs, strollers and other expensive items. This new program from Toys R Us follows successful similar initiatives by Sears and K-Mart last year.

Lay-away programs have been relatively scarce for the last forty years. They were popular during the Depression. However, over the last couple of generations they have given way to the easy credit that consumers have had from credit card companies, banks and mortgage lenders. Of course, this day of easy credit seems to have passed. Hence, the lay-away program recovery.

The customer who puts a product on lay-away deposits with the store 20% of the item’s price, plus all taxes and a $10 service charge. The customer, then, has until December 6 to finish the payments for the products. The customer may make these payments at any Toys R Us store.

Toys R Us incurs real costs to offer this program. It has administrative costs, and probably some additional inventory costs as well, in order to make these products readily available once the customer’s payment schedule has been completed. This price component pays for these costs.

This is an example of an optional price component. Optional price components include such additions to the base price as fees on top of the normal basis of charge, penalties or bonuses for the buyer or seller, price caps, differing periods of agreement to maintain a price and extended payment options. A lay-away plan is an extended payment option. The company is offering this price option in order to increase its sales during a period where sales may be slow due to the current recession.

We have found many other examples of these optional price components, which enable a company to be more flexible with prices in difficult times. You may find these examples in the Improve/Pricing section of StrategyStreet.

Hostility's End Game

The late 80’s and 90’s were hostile times for the beer industry. The period saw constant price wars. All the domestic competitors, except for Anheuser Busch, suffered from relatively low returns. A hostile industry is notable for constant pricing pressure and very low returns in the industry. The brewing industry certainly fit that description for a long period of time.

Then came the 2000’s. This decade brought a great deal of consolidation to the market. InBev bought Anheuser Busch. SabMiller PLC consolidated operations with Molson Coors Brewing Company. These changes, and others, produced a consolidated industry. Today, the two largest companies control 80% of U.S. beer sales. These companies have introduced products at every price point so they dominate the market at virtually all Price Points.

This dominance gives the industry Standard Leaders pricing leverage. Over the last year, the price of beer, ale and other malt beverages grew 4.6%, while overall consumer prices in the U.S. fell 2.1%. The beer makers now have pricing power that looks much like that of the breakfast cereal makers and cigarette manufacturers. The brewers are able to raise prices, even in the face of declining unit volumes, just as the cigarette manufacturers are able to do. Profits in the domestic market are rising at more than 25% a year. (See the Perspective, “What Makes Returns High?” on StrategyStreet.com.)

Hostile markets end in one of two ways. (See the Perspective, “What Ends Hostility?” on StrategyStreet.com.) Either demand bails the industry out or industry consolidation shifts pricing power back to the industry. In our extensive work in hostile markets, we have observed that three quarters of the time demand growth bails out a hostile industry. The demand in the industry grows and gradually sops up excess capacity. As the excess capacity ebbs away, pricing power returns to the industry participants in order to encourage the addition of the capacity that the customers will need in the future. In the other quarter of the cases, the industry consolidates until four or fewer competitors own at least 75% of the market. And, all remaining competitors must have reached the conclusion that trying to gain share with low price is an exercise in futility. The beer industry has consolidated far more than the average industry. In the average domestic industry, four competitors to own 85% of the total industry market share. In brewing, it only takes two to approach that concentration. (See more on StrategyStreet.com/Tools/Benchmarks/Market Share)

Not many industries succeed at reaching this degree of consolidation. But once they do, the world is their oyster.