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Feasibility Analysis of a Low Cost Strategy for Long Distance Flights

A View from a Full Service Carrier in the Airline Industry

Bachelor Thesis 2015 78 Pages

Business economics - Investment and Finance

Excerpt

Table of contents

List of Abbreviations

Index of figures and tables

1. Introduction
1.1. Problem
1.2. Ambition, Methods and Structure
2. Theoretical concepts of growth strategies

2.1. Concentration
2.2. Horizontal integration
2.3. Vertical integration
2.3.1. Backward vertical integration
2.3.2. Forward vertical integration
2.4. Diversification
2.4.1. Related diversification
2.4.2. Unrelated diversification

3. Theoretical concepts of competitive strategies
3.1. Differentiation strategy
3.2. Low cost strategy
3.3. Best cost provider strategy

4. Information about Lufthansa and Eurowings
4.1. Growth strategy of Lufthansa
4.2. Competitive strategies of the Lufthansa Group

5. Analysis of the Eurowings low cost strategy for long haul flights

5.1. Comparison between the Eurowings low cost and the Lufthansa full service long distance product

5.2. Low cost carrier strategy - factors of success and examination of the transferability of these factors to long distance flight circumstances

6. Results, conclusion and outlook

Bibliography

Index of Abbreviations

illustration not visible in this excerpt

Index of figures and tables:

Figure 1: Vertical Intergration

Table 1: Competitive strategies (Without best cost provider strategy)

Table 2: Competitive strategies (With best cost provider strategy)

Table 3: Business areas of the Lufthansa Group

Table 4: Fares Germanwings and Eurowings

Table 5: Comparison of ticket prices

Table 6: Possible savings of a Low cost carrier

1. Introduction

On the ITB 2015, Europe’s largest tourist trade fair, an executive board member of Lufthansa, Karl Garnand, announced the first routes for the coming low cost long distance flight product of the company. Lufthansa is going to start this project with its brand Eurowings. The first flights to three destinations will be operated as from November 2015, tickets are already bookable.1 The low cost carrier business prospers for a long time. Its market share in Germany, measured by the number of passengers, grew from 4,8% in 2002 to 25% in 2014.2 However, this success refers exclusively to short and middle distance flights. Eurowings is not the first try of an airline to establish a low cost product for long haul flights, but there is no example with economic success. This thesis focuses on the economic feasibility of a low cost strategy for long distance flights, based on the example of Eurowings in the product portfolio of the full service carrier Lufthansa.3

1.1. Problem

Main research question of the thesis is:

- Can a long distance low cost carrier be economically successful in the portfolio of a full service carrier?

This analysis focuses on Lufthansa as full service carrier and Eurowings as its low cost product on long distance flights. To provide a scientific solution for this issue these two dependant sub questions will be analysed economically:

- Does a different long distance product fit in the product portfolio of Lufthansa?

Aim is to verify whether the unique features, the competitive advantage and the feasible level of diversification to the existing long distance product allows a positive assessment of the Eurowings long haul product in the Lufthansa portfolio.

- Can the typical low cost strategy be transferred to the circumstances on long haul flight business?

The main success factors of the typical low cost strategy will be numerated and analysed. A comparison of each aspect with the circumstances of long distance flights and its transferability will be checked.

1.2. Ambition, Methods and Structure

Ambition of this thesis is to provide a prediction for the economic prospects of a low cost product on long distance flights from the view of a full service airline. The current approach of Lufthansa to establish the low cost long distance product Eurowings in its portfolio serves as example of this prediction. The structure correlates with the approach to provide an analysis which is based on a sustainable theoretical fundament on the one hand, but with immediate relevance to the mentioned practical example on the other hand. The theoretical chapters and practical information are based on specified professional sources. The necessary theoretical knowledge is provided in chapter two and three, relevant practical information in chapter four. To constitute the thread of this work it is divided in two theoretical chapters, one about concepts of growth strategies and one about competitive strategies. The outcome of the theoretical basis of growth concepts is the analysis of Lufthansa’s growth strategy in the first part of chapter four. Chapter three provides the necessary theoretical foundation about competitive strategies in general, to pave the way for the comparison of the different competitive strategies of Lufthansa as full service and Eurowings as low cost airline in the second part of chapter four. Furthermore, the practical relevance is shown in this chapter, too. This methodological structure leads to the competency to answer both above mentioned sub questions in chapter five and, as a result, to a scientific prediction of the economic prospects of Eurowings as low cost carrier in the product portfolio of the full service carrier Lufthansa in chapter six of this thesis.

2. Theoretical concepts of growth strategies

Before growth and competitive strategies can be analysed in chapter two and three, the term strategy should be defined in general. This work orientates its self on the comparatively common and widely accepted definition of the economist Alfred Chandler. He defines strategy: “as the determination of the basic long-term goals and objectives of an enterprise, and the adoption of a course of action and the allocation of resources necessary for carrying out these goals”4 The focus in this thesis is on strategy’s core characteristics which are reflected in Chandler’s definition. These characteristics are the medium to long term approach, the explicit conception of goals and the associated allocation of actions and resources.5

Regarding prospects of a company’s future size, three major strategies are relevant. The stability-, the retrenchment- and the growth strategy. These, often called grand strategies, are an important part of a company’s orientation.6

Stability strategy means that the status quo should be kept. Reasons for companies to choose this strategy can be for example expected bad conditions for growth, personal reasons of owners or an uncertain environment. The management tries to preserve the company’s present size by avoiding relevant changes.7

Retrenchment strategies are often used in connection with turnarounds. The focus should be on a company’s strength. Divestment of weak parts of the organisation is one aim of this strategy. The company should be scaled down by its management in those cases.8

According to its relevance for this thesis, the focus here is on growth strategies, in some literature also called expansion strategies9. A company grows if it expanses its operations. Increase of sales, revenues, number of employees or market share can be incitements for a company to establish a growth strategy. It works best if the industry to which a company is related or wants to expand to, prospers. In growing industries there are new customers, new markets and space to establish new products. Expansion can be achieved by different strategic approaches. If a company expands its existing business, economists call it the concentration strategy.10 The concentration strategy is an internal growth strategy. This implies that the growth originates from new operations by using the company’s own resources. External growth strategies assume mergers or acquisitions of other companies or joint ventures. Mergers are agreements between two companies to pool their resources and joint together to better compete in a business or industry.11 An acquisition is the purchase of a company by another.12 “[…] a joint venture can be any relationship where two or more business entities (including individual professionals) combine some of their efforts or some of their assets to create a new entity” or: “[…] any collaborative effort among firms, short of a merger” 13 Summarised, Vertical and horizontal integration, as well as the diversification strategy are external growth strategies.14 Vertical Integration means that the company acquires or creates business above or below in its value chain as delineated in figure 1. In comparison, horizontal strategy means that a company integrates a company on the same level of the value chain.15 A company which tries to grow by new products and/or entering new markets chooses the diversification strategy. Growth strategies can be classified as aggressive because each of the mentioned methods pursues the goal to increase some section of the business by acquiring other companies’ market share.16 In the following chapters the four growth strategies will be described and analysed in order to provide the theoretical foundation for the practical components of this work.

2.1. Concentration

The concentration strategy focuses on internal growth. Own competences and resources are used to achieve a growth process. Professional literature often uses the word organic growth due to the fact that the company grows because of its own effort. Merger and acquisition of another company is redundant. Some economists e.g. Wheelen and Hunger argue that the concentration strategy implies also external growth.17 This paper however agrees with the more common understanding of organic growth as an exclusively internal growth strategy. There are many examples of approaches to gain organic growth. Additional sales people, product development, geographical expansion, opening new shops, new manufacturing facilities or new distribution channels can be actions to grow internally.18

There are several conditions that induce companies to favour the concentration strategy. A good environment which is indicative of assuming a satisfying growth of the single operating business would be one. This can be applicable if a product is in the growth or early maturity stage. Another reason for concentration strategy could be if a company acts risk averse to avoid uncertainty19

There are huge, in some cases publicly owned companies which operate in only one single business without trying to grow by mergers and acquisitions. To name a few of them Harisson and St. John give some examples: “Federal Express, Domino’s Pizza, Lands’ End and Delta Airlines are firms that participate in just one business.”20 Hence, there are international, large scale enterprises which operate successfully without entering other parts of the relevant value chains.21 Domino’s Pizza for example started with a small pizza parlour in Toronto in 1967 and has now more than 9000 company owned and franchise pizzerias worldwide. This growth was created internally without m&a.22 According to successful international organisations which pursue the concentration strategy there are some crucial advantages of this strategy.

Advantages of the concentration strategy:

Pursuant to the single business approach and the associated specialisation, these companies usually can provide a deeper knowledge of what they do than multibusiness companies can. Executives are qualified for high performances due to their specialisation and concentration on only one business. This can increase the operational excellence of a company and limit the risk of strategic mistakes.23 Using the example of a company which has been in the pizza business for 40 years (Domino’s Pizza), a strategic goal would probably be, based on the expert knowledge, more matured and realistic than the goals for a pizza company bought by a car manufacturer a short while ago (s. chapter 2.4.).

“Competitive advantage [...] grows out of value a firm is able to create for its buyers that exceeds the firm’s costs of creating it”24 A company which decides to embark on the concentration strategy can focus on only one point that it has to do well. It can use its financial, human and natural resources just for one goal. This can contribute to a considerable competitive advantage for differentiation as well as to a cost leadership approach25 (s. chapter 3.). As a consequence, Domino’s Pizza is able to allocate its resources more carefully than a multibusiness company like Siemens can (s. chapter 2.4.1.).

Multibusiness firms often record involuntary proliferation of its management levels and stuff functions. This leads to high overhead costs and a limited flexibility of the business units. This proliferation is often caused by complexity and missing complete business overview. Firms that only focus on one business segment are less complex, so they can prevent proliferation better.26 To stay with the pizza example, it is comparatively easy to stay on top of things if a company has to manage only one business segment.27

Another important advantage of the concentration strategy is that profits can be reinvested in where they were gained. Harmful internal competition as it is conceivable in multibusiness companies is no issue for the concerned companies.28 Domino’s Pizza would be able to reinvest its profits in the core business, a company like Siemens could require movements of capital between its 12 business units.29

Disadvantages of the concentration strategy:

For a company which is dependents on only one product or only one business area a change of the concerned sector can have severe influence on the company’s performance. If conditions of an industry change to the worse, single business companies are usually affected stronger than more outspread constructed firms. Missing stabilisation function of the different business segments is the reason for this risk enhancing disadvantage of the concentration strategy. Recession of the industry, delivery problems of raw material or fickleness of the markets are examples for circumstances which can affect single business companies much harder than multibusiness ones.30 If e.g. a shift of trends or a health affair affected the fast food industry to the worse, Domino’s Pizza would have no possibility to compensate for this by own businesses of other industries. The car manufacturer which bought a pizza company would be able to manage this crisis better by compensational effects due to its not affected car industry business.

Companies which focus on a primary line of business at a great extend could have problems to ensure that its management is highly motivated. Due to the routine which is implicated with a single business company, which is not looking for exter nal growth opportunities, it is difficult to keep up a good motivation of the executives. Limited challenges and a kind of organisational inertia are mentioned as reasons for the motivation problem of single business company’s managers. If the internal growth slowed down, the excitement and the promotion opportunities could be affected in a negative way.31 For example executives who focus only on the narrow pizza franchise business are more likely to have negative routines than managers who are confronted with new challenges and opportunities daily.

If a company expands through concentration, large cash flows are needed for example to build up new assets for the growing company. When the business matures, there is a comparatively high cash flow but only little scope for investments in the current business. Companies often decide to change their strategy and look for possibilities for external growth at this stage of business development.32 Therefore Domino’s pizza could reach a certain point when necessary investments in assets, franchise system, R&D etc. are done. If these boarders of internal growth are reached, they may look for more attractive external growth options to invest in.

2.2. Horizontal integration

In 1997 Boing merged with another aircraft manufacturer, McDonnell Douglas. Both were successful companies in the same industry. If players of the same industry work together due to merger or acquisition, growth through horizontal integration strategy is performed. Through horizontal integration a company enlarges itself, but still works in the same industry with the same customers and the same markets. (One exception can be other geographical markets)33 Another example is the supermarket chain EDEKA which grew with its purchase of SPAR Deutschland in 2005 to one of Germany’s largest actor in the business.34

The horizontal integration growth strategy coincides with the concentration strategy (s. chapter 2.1.) in some parts. Growth in the same industry is what both approaches have in common. The main and determining difference is that the concentration strategy assumes internal growth and the horizontal strategy requires merger or acquisition of a third party company of the same industry. If a company leaves the borders of its sphere into the domain of other firms doing their business in the same industry, it goes over to the horizontal integration. Due to intersections between both approaches some of the advantages and disadvantages mentioned in point 2.1. are transferable.35

Advantages of horizontal integration:

On the basis of the company’s bigger size due to horizontal integration by buying a competitor, the company can benefit from a stronger competitive position. If a supermarket chain buys another supermarket chain, is adopts its market share. This narrows the industry’s rivalry due to the smaller market shares of the competitors and the fact that there are fewer competitors left in the industry after a horizontal integration. Furthermore the company which integrates horizontally has a better position towards suppliers and customers due to the enlarged market power.36

An enhancement of a company’s cost structure can be reached by horizontal integration. Per-Unit costs get smaller if a company can spread its fixed costs over a larger base. If for example a shoe factory buys another shoe factory, it can distribute the fixed costs on a more comprehensive range of products. In fact, the company benefits from economies of scale. „Economies of Scale exist if the firm achieves unit-costs savings as it increases the production of a given good or service.” 37 Some resources can be deployed more effectively. Due to the better utilisa tion of assets economies of scope are reachable through horizontal integrations, too. „“Economies of scope exist if the firm achives savings as it increases the variety of goods and services it produces.”38 The two shoe factories do no longer need two HR departments or two purchasing departments. The integrated companies can bundle a wider range of products. This offers the opportunity for optimized product differentiation39 (s. point 3.1.).

Disadvantages of horizontal integration:

Problems due to horizontal integration can be caused by different corporate cultures, „[…] informal, non-rational matters, which cannot be presented in descriptions of structures, roles, competences, technology, strategy and other “traditional” organizational concepts.” 40 This is one of the reasons why companies miss the target of higher profitability due to integration. The assumption that companies, just because they act in the same industry, feature a high similarity can be a fallacy. Due to this misbelieve, managers might overestimate the benefits of integration within the same industry and underestimate the necessary effort to merge the company’s operations. Partly it is not possible to merge different corporate cultures. If the integration is hostile and managers change to the integrated company, this problem can even be intensified.41 One example could be a clothes shop chain with an efficient converted low cost strategy (s. point 3.2.). If this company tries to integrate horizontally by buying another clothes shop chain which has a long tradition and sells sustainable, bionomic and high priced quality products, it is conceivable, that differences in corporate culture in connection whit new operations etc. can lead to implementation problems.

Another aspect companies which think about a horizontal integration have to consider, is a legal one. If a company would occupy a dominant market position due to a horizontal integration, it can arouse a conflict with the cartel authority. If a company would reach market power which would enable it to raise prices on a higher level than it would be possible with more competition, the cartel authorities can stop a horizontal integration. Consumer protection is the justification for the cartel authorities to take action. More competition should strengthen the customers by inducing lower prices. Any merger or acquisition the cartel authorities perceive as risky because of too much consolidation or too much power for a single company can be blocked.42 One example is the attempted takeover of Tengelmann by Edeka in 2015 which was blocked due to the above mentioned reasons.43

2.3. Vertical integration

Vertical integration is an external growth strategy. Usually merger, acquisition or a joint venture are basic prerequisite. Companies try to add value to their core product to sustain long term profitability. There are two possibilities. On the one hand the backward vertical integration, a company buys a company to produce inputs for their core product. On the other hand the forward vertical integration, a company buys a company which e.g. uses, sells or distributes its core product. Both refer to the same industry, but backwards vertical integration to an earlier stage of production and forward vertical integration to a later stage of production.44

Figure 1: Vertical Integration:

illustration not visible in this excerpt

Both, the backward (s. chapter 2.3.1.) and forward (s. chapter 2.3.2.) vertical integration are analysed separately to show their individual attributes, advantages and disadvantages.

2.3.1. Backward vertical integration

PepsiCo, a company in the food and beverages industry which produces, among other products, the famous brand Pepsi Cola bought its two largest bottlers in 2010. In this example Pepsi Cola is still the core product, and its producer bought suppliers which produce inputs for this product which makes it a typical example of a backward vertical integration.45

Advantages of backward vertical integration:

[...]


1 Cf. FVW 2015 - Screenshot attached

2 Cf. Freyer 2014, p. 594

3 Cf. Schwenker, Wulf 2013, p. 120ff; Bjelicic 2007, p. 14ff; Clark 2010, p.56; Doganis 2009, p.161

4 Chandler 1970, p. 13

5 Cf. Whittington 2001, p 12f

6 Cf. Wheelen, Hunger 2010, p. 255

7 Cf. Kozami 2005, p. 172

8 Cf. Orcullo, Norberto A., Jr 2008, p. 79ff

9 Cf. Kazmi 2008, p. 165

10 Cf. Lussier 2015, p. 136f

11 Cf. Hill, Charles W. L, Jones 2012, p. 311

12 Cf. Hill, Charles W. L, Jones 2012, p. 311

13 Lerner, Ryland 2000, p. 5

14 Cf. Nieman, Pretorius 2004, p. 111f

15 Cf. Harrison, St. John, Caron H 2008, p. 89ff

16 Cf. Flouris, Oswald 2006, p 100ff

17 Cf. Wheelen, Hunger 2010, p. 120ff

18 Cf. Capon 2008, p. 247; Cf. Sherman 2011, p. 1

19 Cf. Phadtare 2011, p. 92

20 Harrison, St. John, Caron H 2008, p. 119

21 Cf. Klonowski 2015, p. 287f

22 Cf. Wood 2013, p. 157

23 Cf. Harrison, St. John, Caron H 2008, p. 119f

24 Rolstadås 1995, p. 43

25 Cf. Harrison, St. John, Caron H 2008, p. 119f

26 Cf. Harrison, St. John, Caron H 2008, p. 119f

27 Cf. Poole 2014, p. 171

28 Cf. Harrison, St. John, Caron H 2008, p. 119f

29 Siemens 2015 - Screenshot attached

30 Cf. Kazmi 2008, p. 152

31 Cf. Kazmi 2008, p. 152

32 Cf. Kazmi 2008, p. 152

33 Cf. Babkina 2000, p. 25

34 Cf. Horstmann 2007, p. 127

35 Cf. Kazmi 2008, p. 177

36 Cf. Kazmi 2008, p. 154

37 Besanko 2010, p. 43

38 Besanko 2010, p. 43

39 Cf. Kazmi 2008, p. 155

40 Alvesson 1995, p. 127

41 Cf. Hill, Charles W. L, Jones 2012, p. 316

42 Cf. Hill, Charles W. L, Jones 2012, p. 316

43 Cf. Hecking, Clausen 2015 - Screenshot attached

44 Cf. Hill, Charles W. L, Jones 2012, p. 180

45 Cf. DePamphilis 2012, p. 21

Details

Pages
78
Year
2015
ISBN (eBook)
9783668089143
ISBN (Book)
9783668089150
File size
810 KB
Language
English
Catalog Number
v310370
Institution / College
University of applied sciences, Düsseldorf
Grade
2,0
Tags
Lufthansa Eurowings Airline Industry Low Cost Carrier Competitive Strategies growth strategies

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Title: Feasibility Analysis of a Low Cost Strategy for Long Distance Flights