For want of a nail, a shoe was lost…

The United States has now had more than three decades of neo-liberal globalism which has favored outsourcing, off-shoring, margin improvement and earnings growth above all else. Encouraged by the capital markets, corporate America has privileged short-term efficiency over long-term efficacy.  Capital spending on hard assets is down as a percentage of sales; intangibles are up. A benign post-Cold War geopolitics and an addressable labor cost differential allowed us to import deflation. We’re not quite at the “virtual” enterprise level, but we’ve moved beyond the polite and acceptable “service” economy that replaced our prior “manufacturing” engine.  At the same time, declining interest rates provided a financial tail wind to support the process. The shift to asset-light business models and just-in-time supply chains won the battle of Wall Street.

Over the past two years, the cycle has come to an abrupt end. The geo-political landscape has changed dramatically and the financial tail winds have reversed. As a result, Corporate America is now due for a major investment “reset” that will amount to many hundreds of billions of dollars. It has not been necessary in the past few decades—the system “worked”—but it will be desirable for many companies in the years ahead.  It is time to lean more in the direction of operational efficacy, even at the expense of financial efficiency. We are seeing that play out in real time.  Intel, for instance, has announced a much-publicized major spending plan over the next five years in an effort to catch up to its peers and make its operations map tighter.

On a recent business trip, I had reason to experience one of these “had been penny wise, but is now or will soon be pound foolish” decisions.  Several weeks ago, I set off on a business trip to Asia. Based in Pittsburgh, I had to make a connection at a gateway to Asia of my preferred airline, Delta. In this case, it was Detroit. The flight from Pittsburgh to Detroit was delayed by more than an hour because of a mechanical problem that grounded the inbound plane (from Detroit). Apparently another plane was substituted for the round-trip flight. But once we boarded, we sat on the ground for nearly another hour as an overhead bin—yes, an overhead bin—would not close. It took that long for a third-party servicer at Pittsburgh airport to board the plane, remove the bin door, and place it in stowage. By the time we landed, in Detroit, more than two hours late, 10 people on our small commuter flight had missed their connection to Incheon, South Korea.  That was the only flight to Asia from Detroit that day. And it was also too late to get to Asia  through any of the airline’s other gateways. I cannot speak for the other affected passengers, but I ended up spending the day in the Detroit airport and then flying East to Paris, then to Amsterdam, and then to Bangkok, my ultimate destination.

From one perspective, it was a very impressive showing: Although Delta does not have extensive service to Asia, it and its SkyTeam partners were able to get me there with less than a 24 hour delay after I had missed my first connection. And kudos to the Delta gate agent in Pittsburgh who saw the problem developing in real time, the purser on the DTW-CDG leg who tried to lend a hand, and the Air France transfer agent who finally figured out how to get me where I needed to be.

On the other hand, the delay resulted in two reroutings, an extra stop, an extra red-eye flight, a lot of time in airports, and a great deal of inconvenience and presumably incremental expense for the airline.   All for want of a nail.

What’s the link between the upcoming corporate reset and a complicated business trip? Here’s the point: The flights between Detroit and Pittsburgh aren’t operated by Delta at all. They are operated by a regional carrier partner, Republic Airways. It provides similar services to American and United at their respective hubs. Why? For the same reason that your costumer service representative at the other end of that 800 number is based in Bangalore or Manila. Cost. The regional carriers operate at a lower cost structure compared to the majors, and so have been incorporated into the business models of the latter. In effect, the majors have outsourced flying you to and from their hubs to lower-cost subcontractors.

I’m not here to opine on the cost structure of the majors. They have complex operations and higher-cost union contracts. Their CASM (cost per available seat mile) is higher than the CASM for the regional carriers, who have different cost structures and different labor contracts. This model was developed over decades and has worked well. Up to a point.

We’ve reached that point. As with so many other US industries, the major airlines should consider bringing more of their services back in house. While in-house labor is clearly more expensive, it is also likely to be more reliable. It’s time for that greater emphasis on efficacy, even if it comes at greater cash cost.

And it’s not even clear how much longer outsourced labor will be sufficiently less expensive to make the prior business model so obviously superior. Reflecting the current labor shortage, the website of Republic Airways is offering $60k bonuses for pilots. So much for the yawning cost differential.  ( landing page, as of September 6, 2022). To be fair, the majors are also paying up to rehire former staff and bring new people on board. My point is that the prior paradigm of much less expensive regional staff and much dearer mainline staff may not be the reality going forward.

My broader point is that privileging efficacy means owning more of your value chain, outsourcing less, and taking more responsibility for product delivery. I have the greatest respect for the often younger, relatively less compensated staff at Republic Airways and their management team that has created a successful business serving mainline airlines. The question is whether the outsourcing model will work as well for the next thirty years as it has in the past. If it doesn’t, the mainline carriers will pay an even bigger price in terms of less reliable service. How many airlines have failed for operational weaknesses? It is a long list. Now is not the time to be penny wise and pound foolish.

McKinsey and Bain will scoff at any challenge to their persuasive powerpoint decks about maintaining the outsourced, low-cost business model. Let’s check in in a decade and see who’s right.  I say pay for the nails, fix the horse shoe now, and the business battle ahead will go much more according to plan.

Comments and constructive criticism welcome.