Outsourcing: An air carrier's perspective on its' pros and cons

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This is a paper I submitted for one of the classes I took at ERAU

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Outsourcing: An air carrier's perspective on its' pros and cons

  1. 1. OUTSOURCING: AN AIR CARRIER’S PERSPECTIVE ON ITS’ PROS AND CONS by Mersie Amha Melke An Aircraft Maintenance Management Research Paper Submitted to the Extended Campus in Partial Fulfillment of the Requirements of Master of Aeronautical Science ASCI 609 Embry-Riddle Aeronautical University Worldwide Online March 2010
  2. 2. ABSTRACT Researcher: Mersie Amha Melke Title: Outsourcing: An Air Carrier’s Perspective on its’ Pros and Cons Institution: Embry-Riddle Aeronautical University Degree: Master of Aeronautical Science Year: 2010 Outsourcing is one of many business strategies used by industries to save cost, focus on business functions and increase productivity amongst several other business- oriented targets. Commercial aviation is one of the industries using this business strategy. However, the unique regulatory and operating environment effective on the air carrier industry makes it susceptible to challenges not common to other industries. Thus, outsourcing is not necessarily efficient for air carriers’ goals such as cost cutting. In this paper, the author will analyze the advantages and disadvantages of outsourcing from an air carrier’s perspective. ii
  3. 3. Table of Contents Page INTRODUCTION 1 REASONS FOR OUTSOURCING IN THE AIRLINE INDUSTRY 2 DETERMINATION OF THE PROS AND CONS OF OUTSOURCING 5 CONCLUSION 9 iii
  4. 4. INTRODUCTION The word outsource is a merger between two words, out and source. This word refers to the activity of obtaining services, goods, consulting etc or a combination of these from organizations that are not under the managerial hierarchy of the obtaining company. Several authors have defined outsourcing in various ways. One example could be the definition given by Varadarajan (2009, p.1) which states, “Outsourcing refers to the practice of a firm entrusting to an external entity the performance of an activity that was performed erstwhile in-house.” In today’s competitive business world, all industries function to minimize costs and maximize profit. In the process of doing so, these industries come up with a variety of potential proposals that might achieve this. One of these proposed solutions is outsourcing. The outsourcing of jobs to call center workers in India and other countries with cheaper work force is a real world example. However, a detailed study is necessary before branding outsourcing as a true solution for any kind of business. Consequently, one of the industries that could potentially benefit from this type of business strategy is the airline industry. This industry is cyclical in nature (Wells & Wensveen, 2005). However, the equipment necessary 1
  5. 5. 2 for the functioning of the industry like airplanes is uniquely regulated and expensive. Therefore, outsourcing activities should accommodate such kinds of uniqueness. Thus, this paper will analyze a customized version of outsourcing to the airline industry, in order to get the air carrier’s perspective of this business strategy. The analysis shall focus on the pros and cons of outsourcing on the industry. REASONS FOR OUTSOURCING IN THE AIRLINE INDUSTRY Perhaps the foremost reason for outsourcing is cost reduction. Cost saving is the main advantage of outsourcing because most repetitive jobs can be performed by specialized providers. Consequently, companies can save on salaries and other benefits and enjoy the economies of scale that can be achieved by the contracting company, which does one kind of work for many airlines (Ghobrial, 2005). Here, the term economies of scale refer to the decrease in a firm’s long run average cost as the size of its operations increases (Wells & Wensveen, 2004). Subcontractors that get the outsourced jobs usually have advantages like greater specialization of resources, more efficient utilization of equipment, reduced unit cost inputs, opportunities of utilization of by-products and
  6. 6. 3 growth of auxiliary facilities as compared to the outsourcing air carrier (Wells & Wensveen, 2004). Legacy carriers(those air carriers that have endured through the 1979 deregulation age until now) have found their markets increasingly open to both international rivals and new entrants such as low-cost operators (Morrell, 2005). Industry liberalization as well as growing competition that has accompanied a world-wide lowering of economic and trade barriers has impacted airline business as well (Rieple & Helm, 2008). However, as Pilling (2002) has pointed out, this process seems to be happening rather later in the airline industry probably because airline operations are still influenced by government intervention. Commercial aircraft need to undergo a series of maintenance checks to remain airworthy. These maintenance activities are on either the aircraft or the component of the aircraft. In addition, these activities call for air carrier proficiency in maintenance capacity and capability. For many years, airlines have retained maintenance, repair and overhaul (MRO) capabilities as a core activity that is best managed and controlled by the airline itself. In many cases, there has been over-capacity and excessive inventory (Al-Kaabi, Potter & Naim, 2007). Outsourcing may give access to the best available service in terms of capacity
  7. 7. 4 and cost. It also provides the flexibility of avoiding the air carrier’s problems of capacity or capability (Al-Kaabi, Potter, Naim, 2007). Another relevant reason for outsourcing in the airline industry is the drive to focus on core functions of the business thus increasing productivity. Outsourcing is a management approach by which an organization delegates some non-core functions to specialized service providers (Franceschini, Galetto, Pignatelli & Varetto, 2003). By outsourcing, companies can focus their efforts on core businesses, medium or long-term targets and diversification opportunities (Franceschini et al., 2003). The core function of airlines is to make profit by selling airline seats in their various routes of flight. Theoretically, all the accompanying work of airline seat sales like, maintenance of the aircraft, advertising of the seats, market research for new routes etc are non-core activities. Before its bankruptcy, Pan Am was on the verge of outsourcing its global network, applications development, data center operations, personal computer support, and maintenance of all equipment worldwide in order to achieve the concept of focusing on core business functions (Ghobrial, 2005).
  8. 8. 5 A third reason could be to realize an air carrier’s goals to break in to a market. When air carriers set up ticket offices or regional offices, the presence of locals in the payroll will help in understanding and fine-tuning the air carriers’ working procedure. This way the air carrier will make positive advances in its business, which may be impossible with out a local presence. DETERMINATION OF THE PROS AND CONS OF OUTSOURCING A number of theoretical frameworks are available to examine the benefits of outsourcing. One model is Transaction Cost Economics (TCE). Another term for TCE is new institutional economics (Rieple & Helm, 2008). TCE, which bases on five principles is fundamentally concerned with the question of whether it is advantageous, in terms of cost, for transactions to occur within the hierarchy of an organization or externally in the open market (Rieple & Helm, 2008). Rieple & Helm (2008) assert that the picture that emerges from using the five principles of the TCE theory show the true nature of advantages and disadvantages of an outsourcing decision. A concise definition of these principles follows. One principle is the concept of opportunism, which is the potential risk of seizure of key assets by outside suppliers. Another relevant concept is
  9. 9. 6 that of asset-specificity which refers to the degree to which an asset is valuable in the context of a specific transaction; this is relevant because of its interplay with opportunism. Frequency of use, the third principle, implies that an organization’s hierarchy should only accommodate transactions that are in frequent use. Examples could be heavy maintenance activity of aircraft components rarely done. Another principle is that of bounded rationality which refers to the degree of difficulty in forming transactional contracts because of the limitations of managers’ knowledge and perceptions. This might lead to signing of a deal, which is to the disadvantage of the air carrier. Environmental uncertainty is the fifth principle of the TCE theory. Environmental uncertainty increases the problems arising from bounded rationality. Contemporary business environment has proved to be highly uncertain. For instance banks, the foundation of other businesses, declared bankruptcy, which depicts a volatile environment. Consequently, this principle also plays a role in the determination of the pros and cons of outsourcing. In addition, these five dimensions interact to predict whether
  10. 10. 7 in-house or outsourced business strategies would better address the air carrier’s activities. Although the TCE model examines the decision of outsourcing from cost efficiency perspective, additional analysis is necessary to determine its advantage or disadvantage. In making outsourcing decisions, airlines ought to consider such factors as the quality assurance of the work, from a regulatory standpoint, the turn-time, and the reliability together with cost (Ghobrial, 2005). From a regulatory point of view, air carrier’s are responsible for the oversight of maintenance of their aircraft, even if they have given the job to a third party maintenance organization that is FAA certified. A potential source of this mandate could be the recommendations of the national transportation safety board (NTSB) accident report regarding the ValuJet airlines DC-9 crash in May of 1996. The NTSB had stated the following regarding maintenance outsourcing in its report for this accident, The safety board recognizes that air carriers can successfully subcontract many of the functional areas of their operations; however, it is the safety board’s position that air carriers engaging in subcontracting remain responsible for the safety of their operations and the airworthiness of their airplanes, and
  11. 11. 8 therefore must properly oversee their outside contractors ………… An air carrier cannot delegate its responsibility for safety of its operations and maintenance to its subcontractors (NTSB, 1997; pp. 122-123). In addition, despite the apparent economic advantages of outsourcing, there appears to be some concerns about the impacts of outsourcing on airline employees’ loyalty and pride; and sometimes, safety of operations. Outsourcing has complicated the situation even further by eliminating functions previously performed by airline employees (Ghobrial, 2005). Although many airlines attempted to re- locate their employees within the organization or to be re- hired by the outsourcing company, many employees have indeed lost their jobs or accepted jobs with the outsourcing companies at lower salaries (Ghobrial, 2005). Ghobrial (2005) also asserts the following about employee satisfaction and consequent disadvantage of outsourcing. Airline employees understand the value of their jobs for their airlines’ image and competition with other carriers. This attitude might be different for employees of outsourcing company. Because most outsourced functions are performed by the contracting
  12. 12. 9 company for many airlines with employees being paid relatively low salaries, one would not expect them to value their services to the airlines nor would they demonstrate loyalty and pride. Apparently, this is a non-quantifiable area of the possible disadvantages of outsourcing. However, the fact that it is not measurable does not hinder it from affecting the outcome of an air carrier’s decision to outsource its work. CONCLUSION Commercial aviation is an increasingly competitive industry. In addition, it is subject to regulations that impose constraints on its business strategies. Outsourcing is a potential business strategy used in other industries for cost efficiency amongst other advantages. This paper had tried to analyze, the advantages and disadvantages from an air carrier’s perspective. On a positive note, outsourcing cuts costs, increases productivity by letting the air carrier focus its resources on its core business. In addition, strategic plans of air carriers’ to expand in to new markets can be realized by outsourcing activities that would give them access to the local market from the perspective of the locals themselves. On the contrary, outsourcing can also erode the loyalty, pride and other immeasurable assets an air carrier
  13. 13. 10 gets from its employees. Despite their unique character, these qualities of an employee can affect the productivity of an air carrier and indirectly affect its cost efficiency. In addition, outsourcing exposes an air carrier to business agreements that could potentially damage it from the perspective of product delivery, product quality and product or service monopoly. Consequently, the dynamic nature of the industry makes it vulnerable to business dealings that may change with time. Evaluating the above summarized pros and cons of outsourcing; one may assert that outsourcing is a business decision that is necessary to excel at the demanding requirements of commercial aviation. However, concurrent with this assertion, checking this business decision from different angles mentioned in this paper is necessary. In addition, recurrent review of the business decision to gather the continuous advantages is important. With out these checks, one can be sure that the decision to outsource is lacking in details, and this poverty of detail could potentially reverse the desired advantages and end up damaging the air carrier.
  14. 14. 11 REFERENCES Al-kaabi, H., Potter, A. & Naim, M., (2007). An outsourcing decision model for airlines' MRO activities. Journal of Quality in Maintenance Engineering, 13(3), 217-227. Franceschini, F., Galetto, M., Pignatelli, A. & Varetto, M., (2003). Outsourcing: Guidelines for a structured approach. Benchmarking, 10(3), 246. Ghobrial, A., (2005). Outsourcing in the airline industry: Policy implications. Journal of Transportation Law, Logistics, and Policy, 72(4), 457-473. Morrell, P., (2005). Airlines within airlines: an analysis of US network airline responses to low cost carriers. Journal of Air Transport Management 11(5), 303–312. National Transportation Safety Board (1997, August 19). Aircraft accident report in-flight fire and impact with terrain ValuJet airlines, flight 592 DC-9-32, N904VJ Everglades, near Miami, Florida May 11, 1996. (AAR 97-06). Washington, DC: Author Pilling, M., (2002). Drive to outsource. Airline Business 18, 38–43. Rieple, A. & Helm, C., (2008). Outsourcing for competitive advantage: An examination of seven legacy airlines. Journal of Air Transport Management 14(5), 280-285.
  15. 15. 12 Wells, A.T. & Wensveen, J.G., (2004). Air transportation: A management perspective. Belmont, CA: Brookes/Cole – Thomson Learning.

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