How successful was Virgin, through its low-cost subsidiary, Virgin Blue, and British Airways, through its low-cost airline, Go, in overcoming the disruptive strategic innovation that was the low-cost, no frills airline?

I INTRODUCTION
” The leading companies were facing a dilemma: Their attackers utilized strategies that were both different from and in conflict with their own. Thus, if the established companies were to respond by adopting the strategies of their attackers, they would run the risk of damaging their existing business and undermining their existing strategies. However, they couldn’t simply ignore the disruptions. What, then, was the appropriate response? ” (Charitou and Markides, 2003: 55)

This was the question facing many of the traditional airlines in recent years. When the skies around the world became increasingly deregulated during the 1980s and 1990s, a new breed of airline came to fruition, the low-cost, no frills, point-to-point airline (Calder, 2003). Southwest Airlines was well established in the US market, with other firms including jetBlue and Delta Airlines also making inroads (Gittell, 2003; Peterson, 2004; Wynbrandt, 2004), whilst Asia was inundated by low cost services, including Air Asia, Skynet Asia Airways, Tiger Airways and Virgin Blue, amongst others (Attitude Travel, 2005). The European market also saw tough competition between Ryanair, easyJet and Go (Cassani and Kemp, 2003; Creaton, 2004), with Buzz, BMI Baby and Virgin Express also in the fray.

The entrance of low-cost, no-frills airlines is a classic example of a disruptive innovation of a strategic nature. Whilst much literature is focused on product or process innovations – what is offered by the firm in question or how that offering is created and delivered – strategic innovation is more compelling, having a long-term impact on the success of a firm. Much innovation can be considered incremental or continuous, in that a firm will gradually adapt to its marketplace and technological advancements. In particular, by improving its products and processes in a step-by-step fashion. However, from time to time, firms face strategic innovations, changes in their external environment that are so fundamentally different that they can force a period of discontinuous change on a firm. Whilst firms are not immune to these changes, they face a choice over how they should react to such changes (Tidd et al., 2001). As Charitou and Markides (2003) suggests:

” Disruptive innovations are not necessarily superior to the traditional ways of competing, nor are they always destined to conquer the market. Rushing to embrace them can be detrimental for established companies when other responses, including ignoring the innovation, make more sense ” (55).

The airlines industry has not been the only one to experience such disruptive strategic innovations in recent years. The computer industry has been shaken up by Dell’s strategy of selling its computers direct to the customer using sophisticated technologies. The book and music industry have witnessed the likes of Amazon eat into their market share by introducing a new way of distributing goods through the Internet. The retail-brokerage industry, indicative of high commissions and catering largely for the more affluent investor, has seen the entrance of E*Trade and others, offering online trading at affordable prices. The list of industries and disruptive strategic innovations that have made a significant dent in the market share of incumbents goes on.

With regards to the industry in question and the focus of this paper, Charitou and Markides’ (2003) research showed that of the 98 companies that they investigated, two-thirds had responded to their industry’s disruptive innovation by setting up a separate unit (or firm) to combat this or attempting to tackle it within their existing business infrastructure. This is indicative of how British Airways responded in the European airline market and how Virgin Atlantic acted in the Australasian market, albeit for very different reasons. However, to set up a separate unit is just one of the five ways that Charitou and Markides (2003) suggest that an incumbent can respond to a disruptive strategic innovation. These are set out below and discussed. This is important because although this paper focuses on a response that involves creating a separate unit, the two companies in question didn’t simply respond in one way. As such, an understanding of these five possible responses helps to establish the context within which the relative success of the separate unit set-up by the firms in question can be assessed (The headings of the five responses used within this paper have been taken from the paper by Charitou and Markides (2003) upon which they are based, namely: ” Responses to Disruptive Strategic Innovation. ” The author of this work does not claim that they are his own.). Since this paper will analyse the fortunes of two separate units within the airline industry, the following responses will be discussed in the context of this industry.

Response One: Focus on and Invest in the Traditional Business
In a short space of time, the entrance of low-cost operators into the airline passenger market had resulted in their capturing a significant proportion of the market. However, the speed at which they have achieved this growth often masks the reality that such growth will not simply continue until a whole market is captured. Markets are broken up into a number of segments, each with customers that require different product and service attributes. In the airline industry, airlines attempt to differentiate themselves not just on price, which is the focus on the low-cost operators, but also the quality of their products and services. For example, British Airways and Singapore Airlines are two award winning, traditional airlines that are known for the quality of their product and service attributes. This perhaps explains why budget airlines have captured no more than around 20 percent of the total market.

As such, airlines that understand that strategic innovations take on these characteristics – rapid initial growth followed by a levelling off – may best combat these disruptions by focusing on and investing their own traditional business model. In this respect, rather than focusing on the disruption, they build on their existing model, highlighting why they are different and the benefits of these differences to the customer. This may be a logical choice to some in the airline industry that have invested huge amounts of money and other resources in building their existing culture, fleets, operations, and other important business processes around their traditional model. After all, in terms of market share, the customers that subscribe to the traditional model and the products and services that this caters for still lead the way by a huge margin.

Response Two: Ignore the Innovation – It’s Not Your Business
The logic of the second response follows on from the first. This suggests that some airlines may be better suited to ignore the innovation altogether. It could be argued that the types of customers the low-cost airlines attract, the value proposition required to deliver appropriate products and services to this group and the competences and skills required to do so are so divergent from traditional airlines’ main business and area of expertise that to do so would be foolhardy (Charitou and Markides, 2003). In fact, a large body of literature on the relative benefits of traditional versus relationship marketing and their impacts on customer loyalty would suggest that the strategies low-cost airlines follow in respect of traditional airlines is completely divergent because of the nature of the customer that they serve (Sheth and Parvatiyar, 1993; Gronroos, 1994; Morgan and Hunt, 1994; Buttle, 1996; Reichheld, 1996; Gummesson, 1997; Egan, 2002).

The traditional airlines compete on the basis of the quality of their products and services, using relationship marketing based techniques to capture the loyalty of their customers over the long-term. No-frills airlines, on the other hand, compete predominantly on price, using traditional marketing techniques to acquire new customers that they must fiercely try to win and then retain after each purchase. This reinforces the point that whilst the low-cost airlines are competing within the same industry as their traditional counterparts, they are not competing for the same market segments. The low-cost airlines are predominantly poaching those customers who previously had no choice but to use the traditional airlines, but whose preferred attributes were price over quality of products and services, such as airport lounges or in-flight entertainment. This response distinguishes itself from the first because unlike the first it does not see the disruptive strategic innovation as a significant threat to its business.

Response Three: Attack Back – Disrupt the Disruption
Perhaps one of the most apparent responses to a disruptive business model is to simply fight back and thereby disrupt the disruption. Here, the logic is that if a competitor, such as easyJet or Ryanair, in the case of British Airways, is taking away a number of their customers, they should launch counter services that represent improvements on the quality of their own services over their competition. For example, when easyJet entered the market, it focused almost exclusively on flights and the price of those flights. However, over time, they added to this offering, including services such as hotels and apartments, car rental, airport parking, insurance and the use of airport lounges as add-ons (easyJet, 2005). By doing this, they were not only attacking British Airway’s dissatisfied customer base who wanted lower cost fares, but also more loyal customers who required additional services, but perhaps at a lower price than British Airways was offering. As such, British Airways responded by emphasising the comfort and luxury of its products and services by launching the world’s first airline flat bed and promoting the luxury of their airport launches. Likewise, Virgin Atlantic introduced an onboard bar and limousine services to pick up their high paying passengers from the airport and take them to where they wanted to go.

Response Four: Adopt the Innovation by Playing Both Games at Once
Alternately, if a firm decides that the disruptive business model has worked and is going to remain in the long-term, damaging their own business success more and more, it may decide to both adopt the innovation and continue with its existing operations. However, this does pose a number of risks. Not least, the firm does not have the benefit of starting from scratch, but carries with it into its new venture all the peculiarities of its existing business culture and infrastructure. This makes the way in which a firm adopts and manages a strategic innovation critical to its success. Of the two thirds of firms in Charitou and Markides’ (2003) study who adopted the strategic innovation, around another two thirds of those did this by setting up a different unit. The two firms that are the focus of this paper, British Airways and Virgin Atlantic, both adopted this route, despite also responding in some of the other ways discussed, which partly explained their relative success. This will be discussed in more detail later.

In those businesses that chose to set up a different unit, the vast majority gave that organisation a separate name, put a new CEO in charge, usually from within the traditional company and shared back-office systems with their corporate parent. In order to succeed, these business units required a high level of autonomy from their corporate parent to let them run their own operations as they deemed appropriate, discretion to set their own budgets and investment policies, an ability to create their own corporate culture and values, but keep their reward mechanisms similar to those of the corporate parent. Charitou and Markides’ (2003) research showed that the success of these units rested predominantly with how they were managed along these dimensions, rather than their simply being separate.

Response Five: Embrace the Innovation Completely and Scale It Up
The final response is for the traditional airline to completely embrace the disruptive business model and alter their own business model to adapt to it, scaling up their enterprise to dominate the new entrants. Whilst the case for this may be appropriate in very small number of industries, this is certainly not the case in the airline industry, which has a very divergence set of market segments that prefer considerably different product and service attributes. As such, a company must decide which of the responses is appropriate for their firm. Here, Charitou and Markides (2003) argue that:

” The answer depends on the company’s position in its industry, its competences, the rate at which the disruption is growing, the nature of the innovator that introduced the disruption and so on ” (63).

In addition to these factors, their research highlighted that two key factors determine how they should respond, namely a firm’s ‘motivation to respond’ and their ‘ability to respond’. They propose the following decision matrix:

On the basis of these five possible responses, it is evident that the focus of this paper is on the fourth response, how two companies responded to the invasion of a disruptive business model by setting up a separate unit. In this case, British Airways responded to the threat that these low-cost airlines where posing to their European market and the damage that they had already inflicted on their business model by launching a low-cost subsidiary, called Go. On the other hand, half way round the world, Virgin Atlantic (a subsidiary of Virgin), which was trying to build it long-haul network across to destinations including Singapore and Australia and saw the low-cost model more as an opportunity than a threat, responding launching a low-cost subsidiary in the Australasian market, called Virgin Blue. In order to assess the relative success of those separate units, this paper is not going to focus on traditional measures such as gains in profitability and market share although these will be considered. Rather, it will analyse the performance of these separate units against the factors that Charitou and Markides (2003) identify as essential for such units to succeed, as well as the appropriateness of their type of response. Therefore, the success indicators are as follows:

• Did Go and Virgin Blue respond to the disruptive strategic innovation in the appropriate way bearing in mind their ability to respond and motivation to respond?
• Were the separate units set up appropriately, having a different name, a new CEO, but capitalising on the back office systems of the corporate parent?
• Did Go and Virgin Blue have the level of autonomy required to make the vital decisions that were required to succeed in their respective marketplaces?
• Were the separate units in a position to set their own budgets and investment policies?
• Did Go and Virgin Blue manage to create their own culture and values that were different from those of the corporate parent, or at least appropriate for the marketplace in which they were competing?
• Were the separate units able to maintain the same reward systems as their corporate parent?

During the remainder of this paper, these six success indicators will be discussed in turn with comparisons made between British Airways’ subsidiary go and Virgin Atlantic’s separate unit, Virgin Blue.

Did Go and Virgin Blue respond to the disruptive strategic innovation in the appropriate way bearing in mind their ability to respond and motivation to respond?
In the case of Virgin and its main airliner, Virgin Atlantic, the motivation to establish a separate unit to cater for the domestic market in Australasia was high. After all, this would allow the carrier to service its UK and Hong Kong demand in the area. As such, it was recently announced that Virgin Atlantic would sign a code sharing agreement with Virgin Blue in order to meet such demand more effectively (The Age, 2005). It could also be argued that Virgin had the capability to operate such a low cost airline in this market. The company already operated in Asia through Virgin Atlantic and understood the market, as well as already having set up a low cost carrier, Virgin Express, to compete within the European market. Using Charitou and Markides’ (2003) grid, this suggests that appropriate strategies for Virgin would include adopting the disruptive strategic innovation using a separate unit, or adopting it and keep it internal to the firm, or attacking the disruptive strategic innovation and disrupt it. Since Virgin’s strategy is to start-up separate companies to tackle new markets, albeit under the Virgin brand, launching Virgin Blue as a separate entity appears to be wholly appropriate.

Whilst Robert Ayling was at the helm of British Airways, he recognised the potential threat that low-cost airlines would have in the European market and the affect that they were already having on the airline. However, the motivation to launch a low-cost airline was very low from other parts of the company, with quite a degree of hostility in some areas, who believed that British Airway’s response should be to ignore the threat and concentrate on their own business model. Go CEO, Barbara Cassani stated that:

” Many former colleagues at British Airways didn’t think it was a clever idea to create a new company that might cannibalise the existing business, but I think they missed the point. The world had changed forever in a deregulated market. Europe would never be the same for traditional airlines. A new, more profitable sector was emerging. Why shouldn’t British Airways participate in it and reap the benefits for its shareholders? Certainly, British Airways needed to continue to reduce its own cost base, but if we could pull off having the best low-cost airline as well as the best full-service airline, that would be a coup indeed for shareholders ” (Cassani and Kemp, 2003: 55-56).

In fact, when the opportunity had presented itself in previous years to launch a low-cost airline when Ryanair entered the market, British Airways turned their head. This low motivation was to be mirrored by Rod Eddington, who took over the airline when Ayling was fired and was quick to show his belief that British Airways shouldn’t be in the low-cost business, allowing the company to be sold off. Indeed, contemplating selling Go to one of the major rivals in the low-cost arena, easyJet, which eventually happened, only highlighted the belief amongst many in British Airways that the low-cost arena was not a threat to its existing business model and it should play no part in it. In terms of ability to respond, British Airways certainly had the financial muscle to respond even if it lacked experience in the low-cost business model. However, it was made very clear from the start that Go was to receive no support from British Airways and would have to rely on a meagre start-up budget upon which it was expected to break even in three years without any further support from its corporate parent (Cassani and Kemp, 2003). This highlights the conflicts of response that Go faced. Even when it launched, it lacked the motivation and financial backing (ability) to adopt a separate business unit strategy. However, it was clear in time that the airline should have simply focused on its existing business. This was to ultimately lead to Go’s demise.

Were the separate units set up appropriately, having a different name, a new CEO, but capitalising on the back office systems of the corporate parent?
Both Go and Virgin Blue were identifiable as separate brands from their corporate parents although by name, Virgin Blue was much more closely associated with its corporate parent, Virgin. Go, on the other hand, made a strong attempt to distance itself from British Airways and spent £270,000 with acclaimed advertising firm HHCL in order to create their own, strong identity. Despite this, Go had endless problems in differentiating itself, not helped by easyJet who took every opportunity to promote Go as an anti-competitive airline launched by British Airways to irreparably damage the competition and then re-establish high prices (Cassani and Kemp, 2003). Needless to say that such tactics had rested within British Airways’ arsenal in the past, as portrayed by Martyn Gregory (2000) in his book, Dirty Tricks: British Airways’ Secret War Against Virgin Atlantic. At the same time, both Go and Virgin Blue installed new CEOs to run the companies. Brett Godfrey was made the CEO of Virgin Blue whilst Barbara Cassani was brought across from British Airways to head up Go. Both companies also relied on their own back office systems rather than those of the corporate parents.

In terms of these success indicators, Virgin Blue had a key advantage over Go, in that its association with its corporate parent, Virgin, was seen in a very positive light due the success of the Virgin brand in general, as well as the successes it had through Virgin Atlantic and Virgin Express. On the other hand, Go never completely managed to separate itself from British Airways, despite managing to build a good brand image over time. Due to the predatory nature that was associated with British Airways, Go’s connection to its corporate parent, despite helping it secure adventitious supplier contracts that smaller airline might not have, many a time worked against it from the customer’s point of view (Cassani and Kemp, 2003).

Did Go and Virgin Blue have the level of autonomy required to make the vital decisions that were required to succeed in their respective marketplaces?
Both Go and Virgin Blue certainly had considerable levels of autonomy given to them to enable them to make the best decisions in their own interest. As Cassani stated:

” Bob’s [Robert Ayling, CEO British Airways] support reassured us that we would be independent and left along to get on with it. And that turned out to be a trust blessing for us ” (Cassani and Kemp, 2003: 55).

Virgin’s set-up also facilitated such autonomy of decision making, backed up by support from the corporate parent:

” Our companies are part of a family rather than a hierarchy. They are empowered to run their own affairs, yet other companies help one another, and solutions to problems come from all kinds of sources ” (Virgin, 2005).

However, ultimately, Go’s problems rested with the fact that it was wholly owned by British Airways and had to report to its Board of Directors if it wanted to take actions that went outside the originally agreed business plan. When Go wanted to expand its fleet, investing some $2 billion in order to grow sufficiently to challenge the main players in the European low-cost market, Ryanair and easyJet, the Board didn’t ratify the decision. This created problems throughout Go’s existence and ultimately resulted in its sale to easyJet (Cassani and Kemp, 2003). Virgin, on the other hand, has a significant share in Virgin Blue although it is not the majority shareholder, which gives it greater flexibility and decision making autonomy than Go (Virgin Blue, 2005).

Were the separate units in a position to set their own budgets and investment policies?
As stated above, Virgin Blue, despite having Virgin as a major shareholder, is very much a separate entity from its corporate parent. It sets its own budget and investment decisions in line with market circumstances as they arise and its long-term strategy. This was not the case for Go, on the other hand. The British Airway’s Board had to approve Go’s business plan, budget and investment policies. Whilst the day-to-day budget rested with Go management, British Airway’s ultimately agreed to Go being given £25 million for its first three years of business, after which it was expected to break even. This was all the support Go was to receive and it was expected to operate as a completely separate unit from British Airways in order to avoid anti-competitive disputes that may otherwise arise. However, bearing in mind that not long prior to this investment in Go, British Airway’s had lost some £125 million because of an internal labour dispute, Go’s meagre £25 million investment highlighted that the company was always going to struggle with the small investment that British Airways were prepared to make in the airline. When Go later requested that it improve its position in the market by increasing its fleet, purchasing $2 billion worth of aircraft, the British Airways Board did not ratify the decision. As such, Go was continually required to lease its aircraft, making the company’s cost structure less competitive than its rivals, who owned their planes.

Did Go and Virgin Blue manage to create their own culture and values that were different from those of the corporate parent, or at least appropriate for the marketplace in which they were competing?
If there was one thing that Go did do well, that was to establish its own, strong culture that fit within its market. At the centre of this were the Go MAD awards, which stood for ‘Make a Difference.’ This was something that Go were often commended for. The culture and values were encouraged employees to strive to do better for the company, which was fighting for its survival, as well as suggesting that the company should give something back to its employees. Go did this by awarding employees shares before the company was sold to easyJet, which gave them a small fortune, as the value of their shares rocketed from 10 pence each to £14.15. Throughout the company’s existence, Go employees always went the extra mile, coming into the office unpaid when demand was high and mucking in to ensure that passengers always ‘got home’ whenever their was a problem (Cassani and Kemp, 2003). Virgin Blue also had a strong culture although unlike Go, this did not differ significantly from its corporate parent. Virgin states that:

” In a sense we are a community, with shared ideas, values, interests and goals… Virgin stands for value for money, quality, innovation, fun and a sense of competitive challenge ” (Virgin, 2005).

Indeed, Virgin Blue also stated that its:

” …entrepreneurial spirit, enthusiasm and vibrant culture wins a bigger share of the market ” (Virgin Blue, 2005: 22).

Whilst Charitou and Markides (2003) suggest that the culture of the separate unit should be different from the corporate parent, there is a strong case that Virgin’s culture, which is clearly different from the traditional airlines with which it competes (in terms of Virgin Atlantic), could be successful in both a traditional and low-cost marketplace.

Were the separate units able to maintain the same reward systems as their corporate parent?
It is not clear whether the reward systems at Virgin Blue are similar to those at Virgin itself. Whilst Virgin tries to instil its culture in its operating companies, it is not explicit about its reward systems. In the case of Go, it could not be said that it shared the same reward systems as its corporate parent. As Barbara Cassani stated:

” We needed to have low costs to be competitive, so we simply couldn’t be tied to the apron strings of British Airways, with its traditional structure of pay and conditions, expensive overheads and operating procedures appropriate for a global, complex airline ” (Cassani and Kemp, 2003: 55).

Again, whilst Charitou and Markides (2003) suggest that to be successful, the separate units should maintain the same reward systems, clearly this would not have been possible in the low-cost arena. However, it has been suggested that perhaps this was another point upon which British Airways, with its delicate relationship with the trade unions, felt that Go put unnecessary pressure on its traditional business model.

Conclusion
By the time that Go was finally sold to easyJet on 16th May 2002 for £400 million, the company was about to make a purchase of brand new planes worth some $2 billion, it was planning for 40 percent growth following a successful previous year and it exceed £10 million in profit for the year. However, despite the apparent financial success that the company was having, the low cost business model, whilst disruptive, simply did not fit with British Airway’s long-term strategy and existing business model. As a result, its attempt to set up a separate unit failed according to the indicators set out.

Virgin Blue, on the other hand, has had considerable success, despite it short operating time. During the later part of 2004 and to May 2005, its on-time performance has been increasing and is now at 93 percent, extremely high for a low-cost airline. During the 2004-05 fiscal year passenger loads increased to 11.6 million, up 28.1 percent on the previous year. Net profit after tax was some $158.5 million, which put the airline amongst the most profitable airlines in the world. Currently, it has 44 aircraft serving 43 routes to 22 destinations, more than Go had after five years of operation. Whilst the success indicators showed that Virgin Blue succeed for a number reasons, predominately, it was its appropriate fit with the business model of its corporate parent that has ensured its success to date.

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