40 Years of Profitable Service: A Case Study on Southwest Airlines and Target Pricing

Tim Smith, PhD, Chief Editor April 2011 <back | | next>

Most pricing strategists would agree that having a low price does not, in and of itself, constitute a competitive advantage. In fact, thinking that low prices are always a good strategy for competition is deeply misguided. However, at times, targeting low prices can lead to a strategic focus which delivers tremendous results. For example, Ikea, Wal-Mart (WMT), and Southwest Airlines (LUV) all have low prices and profitably take market share. In this article, we will examine the flaws of assuming low prices leads to a competitive advantage, then demonstrate how one firm, Southwest Airlines, redefined the product through target pricing to win the market profitably.

Why Low Prices Alone Is Not a Competitive Advantage In studying competitive advantage, we have gone a long distance from Porters three generic strategies of niche, mass, and low-cost. Modern competitive strategy will often examine firms from a resource based view. According to the resource based view, competitive advantage derives from leveraging an inimitable resource to deliver value at a lower cost than the competitors. Price is a completely imitable resource. Any company can match the prices of its competitor if it so chooses. Hence, arguing that a low price is a strategic resource, or that it leads to a competitive advantage in and of itself, is illogical. Observation supports the viewpoint that price is inherently imitable and therefore not a competitive advantage. Though low prices may deliver a large market share, that market share usually comes at the cost of profits. Given the choice between being big but unprofitable, and being small but profitable, a wise businessperson would choose the latter. Herb Kelleher, Former CEO, Southwest Airlines, stated a similarly: Market Share has nothing to do with Profitability. Market share says we just want to be big: we dont care if we make money doing it. Thats what misled much of the airline industry for fifteen years after deregulation. In order to get an additional 5% of the market, some companies increased their cost 25%. Thats really incongruous if profitability is your purpose. Likewise, Sergio Marchionne, the Chief Executive of Chrysler, noted, Unprofitable volume is not volume I want We have a very good track record on how to destroy an industry run the [plants] just for the hell of volume, and youre finished. The Importance of the Marketing Orientation of the Firm We should also note that Herb Kelleher was a master at achieving low prices. Moreover, low prices are a core part of Southwest Airlines strategy. It has permeated and stayed with Southwest Airlines for over 4 decades and has delivered both growth and market share. To make low prices work towards a firms advantage, the firm must redefine the product using the marketing orientation.

According to the marketing orientation, firms exist to serve customer needs profitably. This marketing orientation is in contrast with the production and sales orientation of the firm. In the production orientation, firms attract customers and succeed because they can produce the product. However, in todays capital market, this claim is relatively ridiculous. Anyone with capital can start an airline, and there are enough people with enough capital to do so. Hence, owning and utilizing the means of production alone doesnt deliver a competitive advantage or ensure success. y In the sales orientation, firms attract customers and succeed because they can advertise and sell to convince customers to buy. But again, in todays marketing communication markets, anyone can hire a good marketing communications team to produce a catchy advertisement and get the word out regarding a product. Hence, selling and marketing communications alone doesnt deliver a competitive advantage or ensure success. y In the marketing orientation of the firm, every aspect of the firm is focused on serving a specific customer need, and serving that need better than all alternatives. Rather than relying solely on firm directed communications, the firm will encourage peer to peer communications between customers to get the word out regarding the product. Because the firm is serving a specific need better than its competition, customers will gladly exhibit both loyalty and a willingness to promote that firm. This leads to success, but only as long as the firm can continue to satisfy that specific customer need better than the alternatives. In this sense, the strategic resource of a firm is its customers and its ability to construct an operation which effectively fits together to serve those customers specific need. The Marketing Orientation and Value Based Pricing
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The pricing difference between these production and sales orientations versus the marketing orientation were well captured by Nagel & Holden in discussing the difference between costbased pricing and value-based pricing. Cost-based pricing derives from a production and/or sales orientation, wherein the firm begins with its product, determined the cost to produce, adds an acceptable markup, and then uses selling pressure to get customers to buy. Cost-Based Pricing Product >> Cost >> Price >> Value >> Customers In contrast, value based pricing begins by seeking to understand the value customers demand and the price they are willing to pay to achieve that set of benefits. Only after the price is determined does the firm then work to uncover means to produce the product at a cost below the willingness to pay of its customers. Value Based Pricing Customers >> Value >> Price >> Cost >> Product In the marketing orientation of the firm, the firm exists only to serve a customer need profitably. If it cannot serve that need profitably, the firm will either not enter that industry or choose to exit the industry if it is already in it. Target Pricing In keeping with the marketing orientation of the firm, the price of a product will guide the definition and development of the product. This is sometimes known as target pricing, where the price becomes the target and the product is then designed to fit that target profitably. To enable a product to hit its price target profitably, the firm will re-conceptualize the product in comparison to its competitors offerings. This requires strategically subtracting high-cost features that its target customers do not particularly value, and then adding low-cost features that they do. The result is a value engineered product, one which has been completely guided by the value demanded by the target customers, at the price necessary to capture those target customers, and at a cost which lies comfortably below the targeted price.

Target Pricing, Market Orientation, and Southwest Airlines Southwest Airlines has used the marketing orientation and target pricing since its infancy back in 1971, even though these concepts were not fully defined back then. First, starting with the customer and the value they sought, Southwest Airlines initial target were customers traveling between cities in Texas, specifically, between Dallas and Houston or Dallas and San Antonio. While Texas is larger than many countries, it isnt so large that people cant drive from city to city. Hence, the most comparable alternative to Southwest and therefore its prime competition wasnt other airlines initially. Instead, it was the car. In uncovering the car as the competing alternative, Southwest was able to also identify the targeted price of its offering. Back in 1971, the average fuel efficiency was a mere 13.7 miles per gallon and the price of gas was only $0.30 per gallon. The IRS standard mileage rate for deducting automobile use from federal taxes was $0.12. The distance between Dallas and Houston is 242 miles, making the estimated cost of driving $29.04 in gas and auto usage plus 4 hours in time in 1971. Similarly, the distance between Dallas and San Antonio is 278 miles, making the estimated cost of driving $33.36 in gas and auto usage plus 5 hours in time in 1971. Second, to compete with the car, Southwest Airlines had to price their service relatively similar to the cost of car travel. With this target in mind, they chose $20. While $20 is lower than the government allowable tax deduction for travel, it is also significantly higher than the price of gas alone to drive between these cities. Thus, at this $20 price, Southwest Airlines could be confident that it would capture many of the travelers that would have driven and convert them into short-hop air travelers. Third, the product was redefined to serve customers at this low price profitably. Consider what was removed from air travel and what was included instead. The below list can be lengthened, yet serves as a good starting point. Removed Reduced reservations flexibility: Reservations primarily made directly Southwest Airlines as they eschewed working with travel agents. No connections between airlines: Southwest Airlines would not transfer baggage between flights. No long-haul flights: Southwest Airlines customers could only take Southwest between a city pair, not across the country nor even across state lines initially. This greatly reduced cost of complying to CAB rulings, as Southwests operations were not subject to interstate commerce rulings. No in-flight meals: Southwest Airlines only offered peanuts and beverages. No seat assignments: First come, first seated. No first class: One class service. Included or Added Simplicity in Pricing: Flat rate of $20 per leg of the journey. Reduced also the cost of price management, as no yield management system was needed initially. Higher convenience in on-time arrivals. With a simplified fight route between lessor used airports, Southwest was able to operate more reliably. Higher convenience in flight frequency: With point to point flights, Southwest could offer service between Houston and Dallas with the same plane roughly every 2.5 hours.

No frills.

Fun: Friendly flight attendants provided jokes, costumes, and made light of flying with warm and caring service. Faster boarding times leading to faster flight turnarounds. More seats: With one class of service, Southwest Airlines could put 137 seats in a 737 versus 128 in a United Airlines 737. None valued for a 30 minute flight.

From this list, we see a number of items which an airline would usually use to define superior value removed from Southwest Airlines offer. A Southwest customer couldnt be treated to first class, couldnt get food, couldnt book them as part of a larger trip, couldnt book with them through an agent, and couldnt even preselect their seat. All of these features are exactly what defined a competitive airline at the time. And, all of these features added cost. Instead, Southwest Airlines selected a specific target customer, A Texan traveling between cities in Texas, and then determined what it would take to satisfy that customer. That customer was far more interested in travel efficiency than travel class. That customer would be glad to forgo a meal, especially in exchange for a friendly flight attendant and a Dr. Pepper. That customer was trading off driving for flying, and needed flexibility in booking rather than navigating through the decisions and planning related to yield management. This service described does not meet the wants of every customer that could have flown Southwest Airlines, but it does describe those of the target customer. And, given the choice of mediocrely satisfying everyone at a high cost or highly satisfying a select few at a low but profitable price, Southwest Airlines rightly chose the latter. As a result of tightly defining the value sought by customers (efficient and flexible travel), and the price ($20), Southwest was able to meet the needs and surpass the expectations of their target customer. Moreover, it was able to do this at a significantly lower cost than a standard airline. Profitable Results Southwest Airlines has succeeded because of their marketing orientation. This marketing orientation has led to target pricing, or pricing from the customers perspective of value backwards to the product definition and cost. The result has been one of the most profitable airlines in the history of commercial air traffic. A lot has changed since 1971, but the core of Southwests market strategy hasnt. It still focuses on simplicity, efficiency, and fun. It still delights its customers with a less conventional service than its competitors. It generally still offers lower prices and is generally still profitable. As a result, it is still growing. So can low prices deliver a competitive advantage? NO, not alone. But target pricing, where the price and benefits demanded by customers leads to a strategic focus that drives a redefinition of the product and service, can deliver a winning competitive advantage. One where a customer need is met at a cost below the price the target market is willing to pay. References
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Thomas T. Nagle and Reed K. Holden, Strategic Pricing, The Strategy and Tactics of Pricing, 3rd edition, (Upper Saddle River, NJ 2002), p. 4.

Michael F Klein Jr. (1972) Limitations on the use of per diem and mileage allowances, The CPA Journal (pre-1986) 42, no. 000001, (January 1): 94. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed April 2, 2011). y JP Morgan, Short-haul Competitive Update (April 16, 1996) 3; Wendy Zellner, Southwests New Direction, Business Week, February 8, 1999. y Vivian Lee, Impacts of Deregulation and Recent Trends on Aviation Industry Management, Bankers Trust Research (August 30, 1996): 16. y R. Myerson, Air Herb, New York Times Magazine, (November 9, 1997): 36. y J. Freiberg and K. Freiberg, NUTS! Southwest Airlines Crazy Recipe for Business and Personal Success. (Bard Books, 1996). y Southwest might have been able to charge more a little more than $20 in 1971, but it should be noted that a large number of their passengers are price sensitive leisure travelers who would have focused more on the cost of gas alone than the fully loaded cost of driving. y Other factors, notably the relationship between Southwest Airlines and labor, have also made a strategic difference, yet this article is focusing on pricing. Please see other articles for that argument. Note: At the time of writing, the author is not currently a direct consultant to nor investor in any of the firms listed in this article.
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____________ Author Tim J Smith is the managing principal at Wiglaf Pricing and adjunct professor at DePaul University. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures (South-Western Cengage Learning, 2012).