It’s the labor costs, stupid

Tyler Cowen, citing a Washington Post article, offers several explanations for the superior economic performance of low cost carriers.

In general these explanations are on point but incomplete. The story they tell overemphasizes specific decisions about what aircraft and routes to fly and underemphasizes the compounding of poor labor decisions.

The major airlines are often referred to as “legacy carriers” and it’s no coincidence that profitable carriers started in the era leading up to and after deregulation of the airline industry. Certainly many more airlines have failed (such is competition), but those that succeeded started with a blank slate with labor and no built in incentives to capitulate to labor demands.

Prior to deregulation, increased wages were just passed along as higher fares which the entire industry had to go along with. While carriers which “took a strike” were subsidized during their periods of non-operation by other carriers which continued to operate, there was little incentive to actually fight labor demands. Long-time United Airlines President Pat Patterson used to say that unions were important because they could handle crew scheduling for the airline, since they had the best local knowledge of worker needs and preferences. This abdication of management function, combined with little competitive cost to capitulating to labor demands, created a high cost environment at the legacy carriers.

Although not strictly an artifact of deregulation, shortly afterward airlines lost their subsidy for taking strikes. This was mostly a political reaction to the confrontational tactics of Frank Lorenzo at Texas International Airlines (which at one time was the largest airline in the US, having purchased Continental, Eastern, Frontier, and People Express).

Large carriers with large workforces faced difficult choices with each new labor negotiation. They could hold down wages and risk a strike — which in most cases turned out to be more costly than the savings from refusing to capitulate to union demands. Each incremental bargaining session led to higher labor costs.

There’s a pretty reasonable argument that the age of the carrier shouldn’t matter and that it should be able to extricate itself from the shackles of past decision-making. The problem is that a 70 year old airline is going to have more retiree costs than a 30 year old airline or a 5 year old airline. Cash contributions to pension plans and benefits add as much as a third to salary figures.

Moreover, the legacy carriers didn’t just give in to unions on wages and workrules, but on pensions. All of the major carriers have defined benefit plans, whereas Southwest has a defined contribution plan. There are people retiring from Southwest every month walking away as millionaires, the cost of which was paid up front with no liability carried over from one year to the next. The current legislative debate over pension reform is a political response to a problem created during political management of the industry.

I do think there’s hope for the legacy carriers, and it lies in bankruptcy. United’s pilot productivity has improved 61% since bankruptcy. Susan Donofrio of Deutsche Banc Alex Brown calculated pilot cost per available seat mile and found that United’s pilot costs are now 0.91, which is lower than all other airlines except AirTran (.90) and Jetblue (.56). United’s pilot costs are even 2% lower than Southwest’s (.93), which will widen when Southwest pilots’ pay raise kicks in later this year.

This is a significant competitive cost advantage when compared to Delta’s (1.60), USAirways (1.45, which emerged from bankruptcy too soon with too few concessions and has been on the verge of re-entering Chapter 11), Northwest’s (1.90), and Continental’s (1.06).

If Delta had United’s pilot costs, their annual expenses would be $927 million lower and they would have produced an operating profit of $141 million in 2003. Delta needs bankruptcy, desperately.

To borrow the overused phrase, “it’s the labor costs, stupid.”

The other factors just don’t hold a candle.

The hub versus point to point model isn’t a significant factor. Tyler cites

    The low-cost carriers have more point-to-point flights. 40 percent of American passengers have connecting flights, it is only 10 percent for Southwest. Connecting passengers cost more money to serve.

Actually the numbers for American and Southwest are 37% and 14% respectively, using the Department of Transportation’s most recent data which is from the second quarter of 2003. These two data points tell a somewhat misleading story.

Low cost carrier Frontier (the main target of United’s TED operation) has 24% connecting traffic. Airtran has 34% connecting traffic — more than legacy carrier Continental’s 32% connecting traffic.

Discounter America West has 42% connecting traffic, exceeding even American.

There are, however, differences in the models. Major carriers have expensive hub practices which lead to extremely busy periods of the day and much less periods of the day (but where their labor costs do not fall).

The discount carriers tend not to offer the same kind of flight banks. Put a different way, when offering connections the major carriers force planes to wait for people and the discount carriers force people to wait for planes. Even here, the cost difference is labor.

The domestic versus international flying is also not a compelling explanation. While Southwest doesn’t fly outside of the U.S., America West, Alaska, ATA, and Frontier all fly internationally. JetBlue is planning to expand internationally as well.

Besides, European lowfare carriers such as Ryanair certainly don’t stop at their own borders.

And while fleet commonality matters

    JetBlue flies one kind of plane, Delta flies 16 different kinds of aircraft.

This isn’t just a spare parts issue, but a labor issue — pilots have to be trained to fly various aircraft, their work rules dictate that seniority defines the aircraft they’ll fly, and the airlines have to eat the training cost which is constantly compounding as pilots grow in seniority. Furthermore, different mechanics are required to staff different maintenance bays as the number of aircraft expand.

At the same time, though, JetBlue is planning to expand into regional jets so that they can serve smaller cities. The key to their success will be their labor agreements as they move forward, not the specific aircraft types they’re using.

I don’t necessarily disagree with any of the items in the post piece, but the article tends to separate each factor into independent decisions rather than emphasizing the unifying theme of wages and more importantly work rules and benefit costs that the legacy carriers face but that the younger low cost carriers do not.

The continued success of low cost carriers will come from their ability to fend off pricey work rules, and the survival of the major carriers will depend on their ability to extricate themselves from past labor negotiation mistakes. Neither case is assured. And Southwest is currently facing some difficult labor negotiations with its flight attendants.

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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