Alliances: don't forget to calculate the costs as well as the benefits June 1999

Securing entry into one of the global alliances appears to be a matter of urgency for most of the world’s large and medium–sized airlines. But do airlines’ managements truly know the full implications of joining a global alliance, and what will alliances expect of their airline members over the next few years?

Alliance fever has as its foundation hard economic logic — by allying with others, airlines can reap huge economies of scale and scope. In an industry where one or two per cent net margins are seen as an aspiration, knocking the odd $100m off costs or increasing revenue by the same amount — in one quick and easy step through joining a global alliance — appears too good to resist.

And alliances do — theoretically at least — offer this kind of impact on the bottom line. For example, excluding aircraft, Star airline members purchase an estimated $15bn of goods and services per annum — and Star believes joint purchasing will knock 7% off this bill, or $1bn p.a. The table below lists some of the other claimed revenue and cost benefits of alliances.

So, on purely economic grounds, joining a global alliance seems a no–brainer. However, there is another side to the alliance story, and one that some airline managements appear reluctant to contemplate.

Over-inflated forecasts?

The first problem is that forecasts of the financial benefits of alliances may be optimistic. Much airline financial reporting is fiction anyway — there are too many accounting tricks and differences in international accounting standards for any figures to be regarded as 100% accurate. In particular, the airlines’ own ability to calculate alliance benefits is questionable. Incremental cost and revenue calculations of any strategic move are very difficult, particularly when revenues and costs are being apportioned with another airline with different accounting periods, methodologies etc.

Some airlines conveniently forget to calculate the tangible costs of an alliance, but there are many — for example the cost of IT systems’ integration, increased overhead, greater FFP redemption etc. And even if all the tangible costs of alliances are included in forecast figures, in most cases calculations do not include the non–financial costs of alliances. These include:

• Loss of control. Decision–making in a global alliance is collective, not individual. And will one airline tend to dominate a global alliance over the long–term?
• Brand dilution. Airlines risk being only as strong as the weakest member of alliance, and a customer’s poor experience with one alliance member will affect the brand reputation of others.
• Exposure to problems at other alliance members. From union unrest to safety concerns, the principle of all for one and one for all also has a downside.
• A re–regulation backlash. Another cost of the increasing global alliance trend is regulatory concern about anti–competitive practices — e.g. the requirement for slot surrenders for approval of the British Airways/American link.
• Culture clashes. Will member airlines’ staffs be able to work with each other? This so–called “soft” aspect of alliances is often overlooked, but differences in mundane practices such as timekeeping, attitudes towards customers etc. between two airlines’ workforces can often lead to disparagement and resentment from one set of staff to another.

Of course, putting figures on these non tangible effects of alliances is an extremely difficult task, but it is one that must be undertaken if airlines want to make the correct strategic decision.

Another factor that may distort logical cost/benefit appraisals is the possibility that certain airline managements believe that joining an alliance will help paper over problems at their own airline. It may be easier to try to join a global alliance in the hope of achieving an instant boost in revenues rather than address fundamental problems at their own airline (almost always high costs and/or union problems). This may particularly be the case when an airline is going through a privatisation process: joining a global alliance is sexy and appealing to investors; hard–bargaining with an intransigent union is not.

This trend is probably made worse by increasing signs of exclusivity by the global alliances. Lufthansa’s Weber has said that “Star will not become the United Nations of the sky” — although the previous limit of a maximum of 10 Star partners has been raised to 12. But the major global alliances do appear to be in place right now (although Air France could upset the $1), so it will be increasingly difficult to get into them if they decide they only want one or two members per global region.

And the future?

What will happen to alliances in the future? Some analysts believe that 100% equity consolidation is the logical conclusion of global alliances, whenever regulatory constraints against cross–border airline mergers (i.e. bilaterals and rules forbidding foreign ownership of domestic airlines) are loosened.

Whether an airline wants equity consolidation is entirely up to itself and its shareholders, but carriers must not be fooled into thinking that alliances will be much easier to back out of than equity ties. Barriers to exit are easier for non–equity alliance members in the short–term — but as alliances become longer–lasting and more successful, the barriers to exit start to increase.

For example, as relationships between alliance members become closer, service levels become standardised (hopefully upwards) and passengers become used to the same level of service throughout the alliance, whatever airline they fly with. Alliance steering committees may then start pushing the concept of the alliance super–brand, at the expense of the national brands/identities. This could start with marketing pushing the super–brand, with member airlines listed underneath in large letters — and then over time member lettering gradually gets smaller, until just the super–brand is promoted, with no mention of the member airlines.

With service levels standardised across the alliance, and the super–brand now dominating all marketing — even in the home markets of individual member airlines — steering committees may then call for the dropping of all national brand identities (i.e. oneworld replaces British Airways logos everywhere, from liveries to staff contracts).

This would be a key moment for member airlines. If they agree to this, the barriers to exit rise substantially, because once a national airline identity goes it will be very difficult to get it back — i.e. this is a “virtual merger”, without the equity.

Of course Europe in three or four years’ time — with a common currency — may be very different from today, and the surrender of national airline identities may be acceptable in some countries. On the other hand a hint of things to come may have been given by the rows over British Airways’ tailfin logo redesign, or over British Aerospace’s plans to drop the “British”.

This scenario may seem far–fetched at present, but it serves to make the point that in entering alliance an airline must think about the long–term consequences of its actions. And at the very least, an airline must make a detailed calculation of the economic net benefits of joining a global alliance in the short- and medium–term.