Identifying Strategic Groups in the U

8/4/2019 Identifying Strategic Groups in the U

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Identifying strategic groups in the U.S.

airline industry: an application of the Porter

model.Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, andin the following two years another three ceased operations.(1) In contrast, since 1991, theindustry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of the

relative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-establishedcompetitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)

BACKGROUND - AIRLINE INDUSTRY GROUPINGS

Identifying strategic groups within an industry is highly desirable from both a qualitative andquantitative perspective. It is easier psychologically to understand the competitive dynamics ofan industry if we can identify three or four similar groups rather than having to characterize eachfirm separately. Furthermore, by dividing the airline industry into meaningful groups,

performance and operating statistics can be separated and analyzed more effectively.

Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were inbankruptcy during the early 1990s and have been controlled for in research models and studiedseparately as a group; an example is the work of Golaszewski and Sanders (1992).(6) TheTransportation Research Board, in its special report Winds of Change (1991), divided theindustry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers inthe past have also singled out "new entrant carriers" that have emerged since deregulation and"non-union" firms for distinct treatment in analysis.(8)

The size and historical groupings discussed above have proven useful and interesting. Tocomplement these groupings, and for a better understanding of the competitive structure of theindustry, it is valuable to classify airlines based on their competitive strategies. This type ofidentification can shed light on successful market positions and suggest future strategicdirections for airline managers to target or avoid.


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In this article, therefore, we first group the nine major U.S. passenger airlines by competitivestrategy, using Porter's typology of generic strategies. We then assess the financial performanceof each airline to validate the appropriateness of the initial strategic groupings.

Finally, we discuss the implications for competition within the airline industry given its

competitive structure.

PORTER'S GENERIC STRATEGIES

Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, andin the following two years another three ceased operations.(1) In contrast, since 1991, theindustry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991

were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of therelative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-establishedcompetitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)


Identifying strategic groups within an industry is highly desirable from both a qualitative andquantitative perspective. It is easier psychologically to understand the competitive dynamics of

an industry if we can identify three or four similar groups rather than having to characterize eachfirm separately. Furthermore, by dividing the airline industry into meaningful groups,performance and operating statistics can be separated and analyzed more effectively.

Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were inbankruptcy during the early 1990s and have been controlled for in research models and studiedseparately as a group; an example is the work of Golaszewski and Sanders (1992).(6) TheTransportation Research Board, in its special report Winds of Change (1991), divided theindustry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers inthe past have also singled out "new entrant carriers" that have emerged since deregulation and"non-union" firms for distinct treatment in analysis.(8)



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Finally, we discuss the implications for competition within the airline industry given its

competitive structure.


Within any industry, companies seek to gain a competitive advantage that allows them tooutperform rivals and achieve above-average profitability. Porter has suggested that the path tocompetitive advantage is the successful implementation of an internally consistent competitivestrategy. Porter identified three "generic" competitive strategies, which have been widelystudied.(9) These are cost leadership, differentiation, and focus.(10)

Cost Leadership

Companies pursuing a strategy of cost leadership seek to outperform rivals by producing goodsor services at a lower cost. There are two potential advantages of this strategy. First, due to itslower cost structure, the cost leader can either charge a lower price than competitors and stillmake the same profit, or charge the same price as competitors and make a higher profit. Second,should price wars develop, the cost leader will be in a better position to withstand price-drivencompetition.

Achieving a low-cost position often requires a high market share so that economies of scale areachieved. Emphasis is placed on reducing costs at every possible point. Hence, it may requiredesigning products or services for ease of manufacture or delivery. Once a low-cost position is

achieved, profits must often be reinvested in improved processes and technologies that furtherreduce costs so that cost leadership can be sustained.

Differentiation

Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, andin the following two years another three ceased operations.(1) In contrast, since 1991, the

industry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of therelative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-establishedcompetitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)


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Identifying strategic groups within an industry is highly desirable from both a qualitative andquantitative perspective. It is easier psychologically to understand the competitive dynamics ofan industry if we can identify three or four similar groups rather than having to characterize each

firm separately. Furthermore, by dividing the airline industry into meaningful groups,performance and operating statistics can be separated and analyzed more effectively.

Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were inbankruptcy during the early 1990s and have been controlled for in research models and studiedseparately as a group; an example is the work of Golaszewski and Sanders (1992).(6) TheTransportation Research Board, in its special report Winds of Change (1991), divided theindustry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers inthe past have also singled out "new entrant carriers" that have emerged since deregulation and

"non-union" firms for distinct treatment in analysis.(8)



Finally, we discuss the implications for competition within the airline industry given itscompetitive structure.



Cost Leadership

Companies pursuing a strategy of cost leadership seek to outperform rivals by producing goodsor services at a lower cost. There are two potential advantages of this strategy. First, due to itslower cost structure, the cost leader can either charge a lower price than competitors and stillmake the same profit, or charge the same price as competitors and make a higher profit. Second,


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should price wars develop, the cost leader will be in a better position to withstand price-drivencompetition.

Achieving a low-cost position often requires a high market share so that economies of scale areachieved. Emphasis is placed on reducing costs at every possible point. Hence, it may require

designing products or services for ease of manufacture or delivery. Once a low-cost position isachieved, profits must often be reinvested in improved processes and technologies that furtherreduce costs so that cost leadership can be sustained.

Differentiation

Companies pursuing differentiation strategies seek competitive advantage by creating productsor services that are perceived by customers as being unique and for which buyers are willing topay a premium price. Successful differentiation provides the company with two primaryadvantages that flow from the perceived uniqueness of its products. First, the company is able tocharge a higher price for its products or services, often with an accompanying higher margin.

Second, customers willing to pay more for a unique product are often more loyal because theirpurchase decision is based more on perceived quality than on price.

Achieving successful differentiation requires clear understanding of customer needs andinvestments in the capabilities necessary to meet those needs. Typically, achievingdifferentiation requires a trade-off with cost position, especially if the activities required to createuniqueness - such as market research, quality materials, and customer service - are themselvescostly.

Focus

The focus strategy differs from the other two generic strategies in that it is directed towardserving the needs of a limited customer group or market segment. Companies pursuing focusstrategies concentrate on serving a particular market niche, which may be definedgeographically, by segment of product line, or by type of customer. Having chosen its "focus,"however, the company may choose to compete within its niche either on the basis of low cost ordifferentiation. It gains competitive advantage by better serving the needs of the chosen segment,whether those needs be lower cost or differentiating quality.

Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, andin the following two years another three ceased operations.(1) In contrast, since 1991, theindustry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of therelative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-established


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competitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)


Identifying strategic groups within an industry is highly desirable from both a qualitative andquantitative perspective. It is easier psychologically to understand the competitive dynamics ofan industry if we can identify three or four similar groups rather than having to characterize eachfirm separately. Furthermore, by dividing the airline industry into meaningful groups,performance and operating statistics can be separated and analyzed more effectively.

Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were inbankruptcy during the early 1990s and have been controlled for in research models and studiedseparately as a group; an example is the work of Golaszewski and Sanders (1992).(6) The

Transportation Research Board, in its special report Winds of Change (1991), divided theindustry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers inthe past have also singled out "new entrant carriers" that have emerged since deregulation and"non-union" firms for distinct treatment in analysis.(8)





Within any industry, companies seek to gain a competitive advantage that allows them tooutperform rivals and achieve above-average profitability. Porter has suggested that the path to

competitive advantage is the successful implementation of an internally consistent competitivestrategy. Porter identified three "generic" competitive strategies, which have been widelystudied.(9) These are cost leadership, differentiation, and focus.(10)

Cost Leadership

Companies pursuing a strategy of cost leadership seek to outperform rivals by producing goodsor services at a lower cost. There are two potential advantages of this strategy. First, due to its


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lower cost structure, the cost leader can either charge a lower price than competitors and stillmake the same profit, or charge the same price as competitors and make a higher profit. Second,should price wars develop, the cost leader will be in a better position to withstand price-drivencompetition.

Achieving a low-cost position often requires a high market share so that economies of scale areachieved. Emphasis is placed on reducing costs at every possible point. Hence, it may requiredesigning products or services for ease of manufacture or delivery. Once a low-cost position isachieved, profits must often be reinvested in improved processes and technologies that furtherreduce costs so that cost leadership can be sustained.

Differentiation

Companies pursuing differentiation strategies seek competitive advantage by creating productsor services that are perceived by customers as being unique and for which buyers are willing topay a premium price. Successful differentiation provides the company with two primary

advantages that flow from the perceived uniqueness of its products. First, the company is able tocharge a higher price for its products or services, often with an accompanying higher margin.Second, customers willing to pay more for a unique product are often more loyal because theirpurchase decision is based more on perceived quality than on price.


Focus


The advantages of successful focus strategies derive from the fact that the firm is able toconcentrate its efforts. Its ability to better meet the needs of its chosen customers means that itmay be able to charge a higher price for its unique products or services. Alternately, it may beable to undercut the cost of the industry-wide cost leader through technologies and processes thatare not cost-effective at larger scales (such as the steel foundry technology in use by the newmini-mills). Finally, concentration within a protected niche may buffer the firm from broadercompetition within the industry as a whole.

Stuck in the Middle


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According to Porter, any firm that fails to develop a viable competitive strategy - whether it below cost, differentiation, or focus - may be termed "stuck in the middle" with no basis forcompetitive advantage. Such firms cannot compete on the basis of price because their coststructure is too high. Nor are they able to charge premium prices because they have failed todifferentiate their products or services in the minds of potential customers. Nor are they

protected by a niche that buffers them from broader industry competition. As a result, firms stuckin the middle are almost guaranteed low profitability and, when there is a shake-out in theindustry, they are the first to exit.

DATA AND METHODOLOGY

As will be explained in more detail at the end of this section, the use of a scatter-plot of airlines'cost and quality positions represents the primary methodology used to identify strategic groups.Given the varied resources and capabilities required to pursue the different generic strategiesdetailed above, not all firms in a given business environment will compete on the same basis.Therefore, an analysis of appropriate firm-level data should distinguish between firms opting to

pursue low-cost strategies, those pursuing differentiation strategies, and those that might befocusing on particular market segments. By default, firms that are not pursuing one of thesestrategies will be considered to be lacking in strategic direction, or "stuck in the middle."

Data

This analysis focuses on the nine major U.S. passenger air carriers during the time period 1991 to1993. A "major" airline is one having revenues of at least $1 billion annually, and these airlinesaccount for 90 percent of all U.S. passenger traffic.(11) To standardize comparisons, cost,quality, and financial data will cover only the domestic operations of these nine carriers.

The evaluation of firms' cost structures is fairly simple because good cost data are readilyavailable for the U.S. airline industry. The statistic "cents per available seat mile (ASM)" is wellaccepted as a measure of airline costs. This figure takes an airline's operating costs and divides itby the number of seat miles flown; the resulting cost per ASM represents the cost to fly one seatone mile. The source of these data, along with revenue and profitability figures, is the U.S.Department of Transportation.(12) However, cost per ASM is subject to interpretation becausecosts vary inversely with average flight distance - an established relationship discussed anddocumented well by Bailey, Graham, and Kaplan (1985).(13) This complication will beaddressed after firms' initial cost positions are established.

Important in this type of strategic analysis is the definition and measurement of differentiationwithin an industry. In the airline industry, firms attempt to differentiate themselves throughservice quality. Fortunately, a validated measure of comparative service quality is available. TheAirline Quality Rating (AQR) computed annually by the National Institute for Aviation Researchat Wichita State University was established in 1991 as an objective method of comparing qualityfactors between airlines and across time.(14) The AQR is a weighted average of nineteen factorsthat have been determined to be important to consumers when they assess airline quality. Thismeasure is predominantly domestic in nature, and includes factors such as on-time performance,safety, frequent flier program assessments, financial stability, age of aircraft, lost baggage rates,


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and other customer service attributes.(15) A recent survey of airline passengers conducted byConsumer Reports corroborates the general integrity of the AQR; of the nine major airlines, bothrankings agree on the best and worst airlines.(16)

METHODOLOGY

Strategic groups have been identified using a variety of means, from competitor mapping tostatistical cluster analysis. We develop our strategic groups using a scatter-plot diagram, thedimensions of which relate to cost and quality. This approach is similar to the competitormapping described by Porter and is more appropriate than cluster analysis given the relativelyfew number of companies in the industry.(17) Cost per seat mile will be the X-axis variable withthe industry cost average separating low and high cost firms. On the Y-axis, the Airline QualityRating (AQR) index calculated by the National Institute for Aviation Research is used as thedifferentiating factor. The scatter-plot will initially divide the industry into four quadrants. Thehigh cost, high quality quadrant will initially identify firms pursuing differentiation. Firms in thelow cost, low quality sector may well be seeking cost leadership. A firm which is able to obtain

both low costs and high quality may be following the focus strategy. Firms in the high cost, lowquality quadrant will likely be without a clear strategy, or "stuck in the middle."

Table 1. Domestic Sector Financial and Operating Data for U.S.

Major Airlines, 1993

Overall Quality Length

Airline Revenue Rating (AQR) Cost/ASM of Haul

American $10.8 bil. .231 8.89 cents 848

mi.

Delta 9.7 .076 9.32 627

United 8.8 .176 8.88 835

USAir 6.4 -.003 11.56 621

Northwest 4.9 -.247 8.85 703

Continental 4.1 -.336 8.40 779TWA 2.3 -.286 9.50 692

Southwest 2.1 .252 7.16 376

America West 1.3 -.294 7.03 642

Average $5.6 bil. -.048 8.84 680

Sources: Cols. 1,3,4: U.S. Department of Transportation, Air

Carrier

Financial and Traffic Statistics Summaries, Office of Airline

Statistics. Col. 2: The Airline Quality Report 1994, National

Institute for Aviation Research. The AQR includes nineteen

weighted rating factors including on-time performance, safety,

age of aircraft, frequent flyer plans, and various other customer

service variables. For more information on the AQR measure the

reader should see endnotes #14 and #15.

After firms are placed in one of these four quadrants, some interpretation may be necessary toconfirm them as strategic groups. Ideally, firms in a strategic group will have their quality/costplots close together. Also, a careful look at each airline's flight stage length will be necessary toestablish that firms with widely divergent flight lengths are not misidentified as having similarcost positions.


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Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, and

in the following two years another three ceased operations.(1) In contrast, since 1991, theindustry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of therelative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-establishedcompetitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)



Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were inbankruptcy during the early 1990s and have been controlled for in research models and studiedseparately as a group; an example is the work of Golaszewski and Sanders (1992).(6) The

Transportation Research Board, in its special report Winds of Change (1991), divided theindustry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers inthe past have also singled out "new entrant carriers" that have emerged since deregulation and"non-union" firms for distinct treatment in analysis.(8)






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Cost Leadership


Achieving a low-cost position often requires a high market share so that economies of scale are

achieved. Emphasis is placed on reducing costs at every possible point. Hence, it may requiredesigning products or services for ease of manufacture or delivery. Once a low-cost position isachieved, profits must often be reinvested in improved processes and technologies that furtherreduce costs so that cost leadership can be sustained.

Differentiation

Companies pursuing differentiation strategies seek competitive advantage by creating productsor services that are perceived by customers as being unique and for which buyers are willing topay a premium price. Successful differentiation provides the company with two primaryadvantages that flow from the perceived uniqueness of its products. First, the company is able to

charge a higher price for its products or services, often with an accompanying higher margin.Second, customers willing to pay more for a unique product are often more loyal because theirpurchase decision is based more on perceived quality than on price.


Focus



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The advantages of successful focus strategies derive from the fact that the firm is able toconcentrate its efforts. Its ability to better meet the needs of its chosen customers means that itmay be able to charge a higher price for its unique products or services. Alternately, it may beable to undercut the cost of the industry-wide cost leader through technologies and processes thatare not cost-effective at larger scales (such as the steel foundry technology in use by the new

mini-mills). Finally, concentration within a protected niche may buffer the firm from broadercompetition within the industry as a whole.

Stuck in the Middle

According to Porter, any firm that fails to develop a viable competitive strategy - whether it below cost, differentiation, or focus - may be termed "stuck in the middle" with no basis forcompetitive advantage. Such firms cannot compete on the basis of price because their coststructure is too high. Nor are they able to charge premium prices because they have failed todifferentiate their products or services in the minds of potential customers. Nor are theyprotected by a niche that buffers them from broader industry competition. As a result, firms stuck

in the middle are almost guaranteed low profitability and, when there is a shake-out in theindustry, they are the first to exit.


As will be explained in more detail at the end of this section, the use of a scatter-plot of airlines'cost and quality positions represents the primary methodology used to identify strategic groups.Given the varied resources and capabilities required to pursue the different generic strategiesdetailed above, not all firms in a given business environment will compete on the same basis.Therefore, an analysis of appropriate firm-level data should distinguish between firms opting topursue low-cost strategies, those pursuing differentiation strategies, and those that might be

focusing on particular market segments. By default, firms that are not pursuing one of thesestrategies will be considered to be lacking in strategic direction, or "stuck in the middle."

Data




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Important in this type of strategic analysis is the definition and measurement of differentiationwithin an industry. In the airline industry, firms attempt to differentiate themselves throughservice quality. Fortunately, a validated measure of comparative service quality is available. TheAirline Quality Rating (AQR) computed annually by the National Institute for Aviation Researchat Wichita State University was established in 1991 as an objective method of comparing quality

factors between airlines and across time.(14) The AQR is a weighted average of nineteen factorsthat have been determined to be important to consumers when they assess airline quality. Thismeasure is predominantly domestic in nature, and includes factors such as on-time performance,safety, frequent flier program assessments, financial stability, age of aircraft, lost baggage rates,and other customer service attributes.(15) A recent survey of airline passengers conducted byConsumer Reports corroborates the general integrity of the AQR; of the nine major airlines, bothrankings agree on the best and worst airlines.(16)

METHODOLOGY

Strategic groups have been identified using a variety of means, from competitor mapping to

statistical cluster analysis. We develop our strategic groups using a scatter-plot diagram, thedimensions of which relate to cost and quality. This approach is similar to the competitormapping described by Porter and is more appropriate than cluster analysis given the relativelyfew number of companies in the industry.(17) Cost per seat mile will be the X-axis variable withthe industry cost average separating low and high cost firms. On the Y-axis, the Airline QualityRating (AQR) index calculated by the National Institute for Aviation Research is used as thedifferentiating factor. The scatter-plot will initially divide the industry into four quadrants. Thehigh cost, high quality quadrant will initially identify firms pursuing differentiation. Firms in thelow cost, low quality sector may well be seeking cost leadership. A firm which is able to obtainboth low costs and high quality may be following the focus strategy. Firms in the high cost, lowquality quadrant will likely be without a clear strategy, or "stuck in the middle."






mi.

Delta 9.7 .076 9.32 627

United 8.8 .176 8.88 835

USAir 6.4 -.003 11.56 621

Northwest 4.9 -.247 8.85 703

Continental 4.1 -.336 8.40 779

TWA 2.3 -.286 9.50 692

Southwest 2.1 .252 7.16 376

America West 1.3 -.294 7.03 642Average $5.6 bil. -.048 8.84 680


Carrier








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cost quadrants. These findings reflect the costs associated with the big three's approach to qualitydifferentiation. They all provide significant amenities beyond basic flight service, and haveinvested heavily in the development of expansive domestic and international operations todifferentiate themselves in the minds of flyers by presenting themselves as the "we fly anywhereyou want to go" carriers.

2. Cost Leadership: America West

From Quadrants III and IV, three firms appear to be pursuing low-cost strategies: Southwest,America West, and Continental. Consistent with Porter, Continental and America West's qualityratings are commensurately low, while Southwest's very high quality ratings demand furtherexamination. Southwest's position does not seem to be compatible with a pure cost leadershipstrategy, and alternative explanations will be addressed shortly. Continental, with above averageflight lengths leaving its costs close to average, is apparently not very successful ataccomplishing the low-cost position it seeks. Firms which unsuccessfully pursue a strategy areconsidered "stuck in the middle" in the Porter model, and this seems to be a fair classification for

Continental. Within the standard Porter framework, America West can be identified assuccessfully pursuing a classic low-cost position.

3. Focus: Southwest

Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, andin the following two years another three ceased operations.(1) In contrast, since 1991, the

industry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of therelative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-establishedcompetitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)



Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were in


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Focus


The advantages of successful focus strategies derive from the fact that the firm is able toconcentrate its efforts. Its ability to better meet the needs of its chosen customers means that itmay be able to charge a higher price for its unique products or services. Alternately, it may be

able to undercut the cost of the industry-wide cost leader through technologies and processes thatare not cost-effective at larger scales (such as the steel foundry technology in use by the newmini-mills). Finally, concentration within a protected niche may buffer the firm from broadercompetition within the industry as a whole.

Stuck in the Middle

According to Porter, any firm that fails to develop a viable competitive strategy - whether it below cost, differentiation, or focus - may be termed "stuck in the middle" with no basis forcompetitive advantage. Such firms cannot compete on the basis of price because their coststructure is too high. Nor are they able to charge premium prices because they have failed todifferentiate their products or services in the minds of potential customers. Nor are theyprotected by a niche that buffers them from broader industry competition. As a result, firms stuckin the middle are almost guaranteed low profitability and, when there is a shake-out in theindustry, they are the first to exit.



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Data



Important in this type of strategic analysis is the definition and measurement of differentiation

within an industry. In the airline industry, firms attempt to differentiate themselves throughservice quality. Fortunately, a validated measure of comparative service quality is available. TheAirline Quality Rating (AQR) computed annually by the National Institute for Aviation Researchat Wichita State University was established in 1991 as an objective method of comparing qualityfactors between airlines and across time.(14) The AQR is a weighted average of nineteen factorsthat have been determined to be important to consumers when they assess airline quality. Thismeasure is predominantly domestic in nature, and includes factors such as on-time performance,safety, frequent flier program assessments, financial stability, age of aircraft, lost baggage rates,and other customer service attributes.(15) A recent survey of airline passengers conducted byConsumer Reports corroborates the general integrity of the AQR; of the nine major airlines, bothrankings agree on the best and worst airlines.(16)

METHODOLOGY

Strategic groups have been identified using a variety of means, from competitor mapping tostatistical cluster analysis. We develop our strategic groups using a scatter-plot diagram, thedimensions of which relate to cost and quality. This approach is similar to the competitormapping described by Porter and is more appropriate than cluster analysis given the relativelyfew number of companies in the industry.(17) Cost per seat mile will be the X-axis variable with


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the industry cost average separating low and high cost firms. On the Y-axis, the Airline QualityRating (AQR) index calculated by the National Institute for Aviation Research is used as thedifferentiating factor. The scatter-plot will initially divide the industry into four quadrants. Thehigh cost, high quality quadrant will initially identify firms pursuing differentiation. Firms in thelow cost, low quality sector may well be seeking cost leadership. A firm which is able to obtain







mi.

Delta 9.7 .076 9.32 627

United 8.8 .176 8.88 835

USAir 6.4 -.003 11.56 621

Northwest 4.9 -.247 8.85 703

Continental 4.1 -.336 8.40 779TWA 2.3 -.286 9.50 692

Southwest 2.1 .252 7.16 376

America West 1.3 -.294 7.03 642

Average $5.6 bil. -.048 8.84 680


Carrier









Once strategic groups are established, profitability data will be used to confirm that this is anappropriate application of the Porter model. Specifically, those airlines identified as pursuing oneof the three generic strategies will be compared as a group to those that are "stuck in the middle."The profitability of this latter group should be significantly lower than the group of airlines

identified as pursuing a strategy within the Porter model.

RESULTS: IDENTIFICATION OF STRATEGIC GROUPS

The scatter diagram of airlines' relative cost and quality differentiation positions is found inFigure 1. While further interpretation is necessary, the resultant scatter plot reveals that groupscan be identified that are largely consistent with the prescriptions of the Porter model.


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Before discussing the makeup of these groups, it is important to analyze each airline's averageflight length in order to determine the accuracy of the groupings found in the scatter plotanalysis. Airlines with below average flight distances have a better cost position than the scatterplot may indicate. Therefore, Southwest, Delta, USAir, and America West's competitivepositions should be shifted horizontally to the left somewhat to better reflect their relative

standings. On the other hand, American, United, Continental, and Northwest should see arightward shift to compensate for their above average flight distances. TWA, near the industryaverage for flight length, would remain essentially in place. While the degrees of these shiftscannot be precisely determined, it is a function of the relative deviation between each carrier'sflight distance and the industry mean. The impact of this analysis would bring Delta closer toAmerican and United on a cost basis, solidifying the big three as an obvious strategic cluster ofhigh quality, but above average cost firms. Likewise, in the high cost, low quality quadrant,USAir and Northwest would both move towards TWA, thus solidifying this grouping. Due totheir shorter flight distance, America West and Southwest would move leftward into even betterrelative cost positions. Only Continental's position is left in doubt; with its flights averaging 100miles above the industry average, its costs would appear to be much closer to the industry

average than the original scatter plot indicates.

Groupings

1. Quality Differentiation Group: American, United, and Delta

From Figure 1, Quadrant I, American, United, and Delta can be identified as firms pursuingdifferentiation based on service quality. Excluding the much smaller Southwest for the moment,these big three airlines have higher AQR scores than the rest of the industry. Consistent withPorter's contention that cost leadership and differentiation are largely incompatible, these threealso have higher costs - individually and on average - than the industry average and firms in low-



From Quadrants III and IV, three firms appear to be pursuing low-cost strategies: Southwest,America West, and Continental. Consistent with Porter, Continental and America West's qualityratings are commensurately low, while Southwest's very high quality ratings demand furtherexamination. Southwest's position does not seem to be compatible with a pure cost leadershipstrategy, and alternative explanations will be addressed shortly. Continental, with above averageflight lengths leaving its costs close to average, is apparently not very successful ataccomplishing the low-cost position it seeks. Firms which unsuccessfully pursue a strategy areconsidered "stuck in the middle" in the Porter model, and this seems to be a fair classification forContinental. Within the standard Porter framework, America West can be identified assuccessfully pursuing a classic low-cost position.


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3. Focus: Southwest

There are two possible explanations for Southwest's position in Quadrant IV. The first is thatSouthwest has adopted a focus strategy, the third of Porter's three generic strategies. Porterdescribes the focus strategy as one where a firm focuses on a given market segment and within

that segment may have a low-cost position, be highly differentiated, or obtain both.(18)Southwest, unlike other airlines, does not use a hub and spoke system, and focuses on short,high-density routes. Traditionally, Southwest has been one of the smallest U.S. major airlinesand has concentrated its route structure in the Southwestern U.S.; this would support theargument that it is pursuing a focus strategy. Alternately, we could argue that the Porter modeldoes not appropriately account for firms like Southwest that achieve both low costs and positivedifferentiation. Southwest can no longer be considered a small niche player in the industry; in thefirst half of 1994 they carried more domestic passengers than Continental or Northwest, andtwice as many as TWA.(19) Furthermore, this airline now serves such northern destinations asCleveland, Columbus, Detroit, and Baltimore, and it has a major flight center in Chicago. In itsrecent rapid growth, it may be that Southwest is moving out of its historical focus position, and

this has implications that will be discussed in a later part of the article. For the current analysisand time period, Southwest's enviable position in Quadrant IV can best be described within thePorter model as evidence of a focus strategy.

Stuck in the Middle Group: TWA, NWA, USAir, and Continental

Since deregulation in 1978, the U.S. airline industry has undergone significant and oftensurprising change. Well-established airlines including Pan Am, Eastern, Western, and Piedmonthave disappeared. Other airlines such as People Express and Midway became highly publicizedsuccess stories and then took a financial nosedive into oblivion. As documented by Rakowskiand Bejou (1992), of the fifteen largest U.S. airline firms in 1985, six didn't make it to 1989, and

in the following two years another three ceased operations.(1) In contrast, since 1991, theindustry seems to have found at least a temporary equilibrium; the nine largest airlines in 1991were the same as those that began 1994.(2) While future change in the industry is likely, thecomparative stability during recent years provides an opportunity to take a snapshot of therelative competitive positions of the nine major U.S. passenger airlines. Specifically, this articleseeks to identify strategic groups within the U.S. airline industry using the well-establishedcompetitive strategy model of Michael Porter.(3) According to Porter, a strategic group consistsof rival firms with similar competitive approaches and positions within the market.(4)



Informally, we know of U.S. airlines grouped as the "big three" - United, American, and Delta -as well as "majors," "nationals," and "regionals" based on government revenue classifications.(5)


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The so-called "Chapter 11 Carriers" - America West, TWA, and Continental - were inbankruptcy during the early 1990s and have been controlled for in research models and studiedseparately as a group; an example is the work of Golaszewski and Sanders (1992).(6) TheTransportation Research Board, in its special report Winds of Change (1991), divided theindustry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers in

the past have also singled out "new entrant carriers" that have emerged since deregulation and"non-union" firms for distinct treatment in analysis.(8)


In this article, therefore, we first group the nine major U.S. passenger airlines by competitivestrategy, using Porter's typology of generic strategies. We then assess the financial performance

of each airline to validate the appropriateness of the initial strategic groupings.



Within any industry, companies seek to gain a competitive advantage that allows them tooutperform rivals and achieve above-average profitability. Porter has suggested that the path tocompetitive advantage is the successful implementation of an internally consistent competitivestrategy. Porter identified three "generic" competitive strategies, which have been widely

studied.(9) These are cost leadership, differentiation, and focus.(10)

Cost Leadership


Achieving a low-cost position often requires a high market share so that economies of scale areachieved. Emphasis is placed on reducing costs at every possible point. Hence, it may requiredesigning products or services for ease of manufacture or delivery. Once a low-cost position isachieved, profits must often be reinvested in improved processes and technologies that furtherreduce costs so that cost leadership can be sustained.

Differentiation


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Focus


The advantages of successful focus strategies derive from the fact that the firm is able toconcentrate its efforts. Its ability to better meet the needs of its chosen customers means that itmay be able to charge a higher price for its unique products or services. Alternately, it may be

able to undercut the cost of the industry-wide cost leader through technologies and processes thatare not cost-effective at larger scales (such as the steel foundry technology in use by the newmini-mills). Finally, concentration within a protected niche may buffer the firm from broadercompetition within the industry as a whole.

Stuck in the Middle




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Data



Important in this type of strategic analysis is the definition and measurement of differentiation

within an industry. In the airline industry, firms attempt to differentiate themselves throughservice quality. Fortunately, a validated measure of comparative service quality is available. TheAirline Quality Rating (AQR) computed annually by the National Institute for Aviation Researchat Wichita State University was established in 1991 as an objective method of comparing qualityfactors between airlines and across time.(14) The AQR is a weighted average of nineteen factorsthat have been determined to be important to consumers when they assess airline quality. Thismeasure is predominantly domestic in nature, and includes factors such as on-time performance,safety, frequent flier program assessments, financial stability, age of aircraft, lost baggage rates,and other customer service attributes.(15) A recent survey of airline passengers conducted byConsumer Reports corroborates the general integrity of the AQR; of the nine major airlines, bothrankings agree on the best and worst airlines.(16)

METHODOLOGY

Strategic groups have been identified using a variety of means, from competitor mapping tostatistical cluster analysis. We develop our strategic groups using a scatter-plot diagram, thedimensions of which relate to cost and quality. This approach is similar to the competitormapping described by Porter and is more appropriate than cluster analysis given the relativelyfew number of companies in the industry.(17) Cost per seat mile will be the X-axis variable with


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the industry cost average separating low and high cost firms. On the Y-axis, the Airline QualityRating (AQR) index calculated by the National Institute for Aviation Research is used as thedifferentiating factor. The scatter-plot will initially divide the industry into four quadrants. Thehigh cost, high quality quadrant will initially identify firms pursuing differentiation. Firms in thelow cost, low quality sector may well be seeking cost leadership. A firm which is able to obtain







mi.

Delta 9.7 .076 9.32 627

United 8.8 .176 8.88 835

USAir 6.4 -.003 11.56 621

Northwest 4.9 -.247 8.85 703

Continental 4.1 -.336 8.40 779TWA 2.3 -.286 9.50 692

Southwest 2.1 .252 7.16 376

America West 1.3 -.294 7.03 642

Average $5.6 bil. -.048 8.84 680


Carrier









Once strategic groups are established, profitability data will be used to confirm that this is anappropriate application of the Porter model. Specifically, those airlines identified as pursuing oneof the three generic strategies will be compared as a group to those that are "stuck in the middle."The profitability of this latter group should be significantly lower than the group of airlines

identified as pursuing a strategy within the Porter model.

RESULTS: IDENTIFICATION OF STRATEGIC GROUPS

The scatter diagram of airlines' relative cost and quality differentiation positions is found inFigure 1. While further interpretation is necessary, the resultant scatter plot reveals that groupscan be identified that are largely consistent with the prescriptions of the Porter model.


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Before discussing the makeup of these groups, it is important to analyze each airline's averageflight length in order to determine the accuracy of the groupings found in the scatter plotanalysis. Airlines with below average flight distances have a better cost position than the scatterplot may indicate. Therefore, Southwest, Delta, USAir, and America West's competitivepositions should be shifted horizontally to the left somewhat to better reflect their relative

standings. On the other hand, American, United, Continental, and Northwest should see arightward shift to compensate for their above average flight distances. TWA, near the industryaverage for flight length, would remain essentially in place. While the degrees of these shiftscannot be precisely determined, it is a function of the relative deviation between each carrier'sflight distance and the industry mean. The impact of this analysis would bring Delta closer toAmerican and United on a cost basis, solidifying the big three as an obvious strategic cluster ofhigh quality, but above average cost firms. Likewise, in the high cost, low quality quadrant,USAir and Northwest would both move towards TWA, thus solidifying this grouping. Due totheir shorter flight distance, America West and Southwest would move leftward into even betterrelative cost positions. Only Continental's position is left in doubt; with its flights averaging 100miles above the industry average, its costs would appear to be much closer to the industry

average than the original scatter plot indicates.

Groupings

1. Quality Differentiation Group: American, United, and Delta

From Figure 1, Quadrant I, American, United, and Delta can be identified as firms pursuingdifferentiation based on service quality. Excluding the much smaller Southwest for the moment,these big three airlines have higher AQR scores than the rest of the industry. Consistent withPorter's contention that cost leadership and differentiation are largely incompatible, these threealso have higher costs - individually and on average - than the industry average and firms in low-



From Quadrants III and IV, three firms appear to be pursuing low-cost strategies: Southwest,America West, and Continental. Consistent with Porter, Continental and America West's qualityratings are commensurately low, while Southwest's very high quality ratings demand furtherexamination. Southwest's position does not seem to be compatible with a pure cost leadershipstrategy, and alternative explanations will be addressed shortly. Continental, with above averageflight lengths leaving its costs close to average, is apparently not very successful ataccomplishing the low-cost position it seeks. Firms which unsuccessfully pursue a strategy areconsidered "stuck in the middle" in the Porter model, and this seems to be a fair classification forContinental. Within the standard Porter framework, America West can be identified assuccessfully pursuing a classic low-cost position.


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3. Focus: Southwest

There are two possible explanations for Southwest's position in Quadrant IV. The first is thatSouthwest has adopted a focus strategy, the third of Porter's three generic strategies. Porterdescribes the focus strategy as one where a firm focuses on a given market segment and within

that segment may have a low-cost position, be highly differentiated, or obtain both.(18)Southwest, unlike other airlines, does not use a hub and spoke system, and focuses on short,high-density routes. Traditionally, Southwest has been one of the smallest U.S. major airlinesand has concentrated its route structure in the Southwestern U.S.; this would support theargument that it is pursuing a focus strategy. Alternately, we could argue that the Porter modeldoes not appropriately account for firms like Southwest that achieve both low costs and positivedifferentiation. Southwest can no longer be considered a small niche player in the industry; in thefirst half of 1994 they carried more domestic passengers than Continental or Northwest, andtwice as many as TWA.(19) Furthermore, this airline now serves such northern destinations asCleveland, Columbus, Detroit, and Baltimore, and it has a major flight center in Chicago. In itsrecent rapid growth, it may be that Southwest is moving out of its historical focus position, and

this has implications that will be discussed in a later part of the article. For the current analysisand time period, Southwest's enviable position in Quadrant IV can best be described within thePorter model as evidence of a focus strategy.

Stuck in the Middle Group: TWA, NWA, USAir, and Continental

Quadrant II firms TWA, Northwest, and USAir are "stuck in the middle." All three suffer fromcosts that are above and quality ratings that are below industry averages. Continental can beadded to the group if we consider its below average cost position as overstated as discussedearlier. These firms may have ended up in this undesirable position for different reasons, but theyall can be classified as firms that have failed to achieve one of the three generic strategies as

outlined by Porter. For example, USAir's quality rating is close to the industry average, but itscosts are the highest in the industry. From this it can be inferred that USAir has pursued - butfailed to achieve - a quality differentiated position. Conversely, Continental has clearly attempteda low-cost strategy, but has not obtained a cost leadership position. The positions of TWA andNorthwest suggest that they are truly stuck in the middle; their strategic direction with respect tocost and differentiation is ambiguous.

Validation of Results

The Porter model and previous industry studies strongly suggest that firms which pursue one ofthe three generic strategies will have superior financial performance compared to those "stuck inthe middle." Using profitability data from 1991 to 1993, as found in Table 2, we can test thevalidity of our strategic group identifications.

The five airlines identified as pursuing one of the three generic strategies had an average 1.39percent operating profit margin between 1991 and 1993, while the four "stuck in the middle"firms had an operating margin equal to -3.57 percent. While neither group appears particularlysuccessful, one must keep in mind the difficult airline environment in 1991 and 1992 due to theGulf War and recession. Using a small sample difference of means test, the 4.96 percent spread


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industry into "strong" and "weak" carriers to illuminate financial performance.(7) Researchers inthe past have also singled out "new entrant carriers" that have emerged since deregulation and"non-union" firms for distinct treatment in analysis.(8)

The size and historical groupings discussed above have proven useful and interesting. To

complement these groupings, and for a better understanding of the competitive structure of theindustry, it is valuable to classify airlines based on their competitive strategies. This type ofidentification can shed light on successful market positions and suggest future strategicdirections for airline managers to target or avoid.





Cost Leadership


Achieving a low-cost position often requires a high market share so that economies of scale areachieved. Emphasis is placed on reducing costs at every possible point. Hence, it may requiredesigning products or services for ease of manufacture or delivery. Once a low-cost position isachieved, profits must often be reinvested in improved processes and technologies that further

reduce costs so that cost leadership can be sustained.

Differentiation

Companies pursuing differentiation strategies seek competitive advantage by creating productsor services that are perceived by customers as being unique and for which buyers are willing topay a premium price. Successful differentiation provides the company with two primaryadvantages that flow from the perceived uniqueness of its products. First, the company is able to


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charge a higher price for its products or services, often with an accompanying higher margin.Second, customers willing to pay more for a unique product are often more loyal because theirpurchase decision is based more on perceived quality than on price.

Achieving successful differentiation requires clear understanding of customer needs and

investments in the capabilities necessary to meet those needs. Typically, achievingdifferentiation requires a trade-off with cost position, especially if the activities required to createuniqueness - such as market research, quality materials, and customer service - are themselvescostly.

Focus

The focus strategy differs from the other two generic strategies in that it is directed towardserving the needs of a limited customer group or market segment. Companies pursuing focusstrategies concentrate on serving a particular market niche, which may be definedgeographically, by segment of product line, or by type of customer. Having chosen its "focus,"

however, the company may choose to compete within its niche either on the basis of low cost ordifferentiation. It gains competitive advantage by better serving the needs of the chosen segment,whether those needs be lower cost or differentiating quality.

The advantages of successful focus strategies derive from the fact that the firm is able toconcentrate its efforts. Its ability to better meet the needs of its chosen customers means that itmay be able to charge a higher price for its unique products or services. Alternately, it may beable to undercut the cost of the industry-wide cost leader through technologies and processes thatare not cost-effective at larger scales (such as the steel foundry technology in use by the newmini-mills). Finally, concentration within a protected niche may buffer the firm from broadercompetition within the industry as a whole.

Stuck in the Middle





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Data

This analysis focuses on the nine major U.S. passenger air carriers during the time period 1991 to1993. A "major" airline is one having revenues of at least $1 billion annual

Documents

Identifying Strategic Groups in the U