discussion paper

FS I 96- 307

The German Model of Industrial Strategy in Turbulence: Corporate Governance and Managerial Hierarchies in Lufthansa*

Mark Lehrer

April 1996 ISSN Nr. 1011-9523

Paper prepared for the Conference: "Modell Deutschland in the 1990s”, held at the Wissenschaftszentrum Berlin für Sozialforschung on April 11,1996. ZITIERWEISE/CITATION

Mark Lehrer

The German Model of industrial Strategy in Turbulence: Corporate Governance and Managerial Hierarchies in Lufthansa

Discussion Paper FS I 96 -307 Wissenschaftszentrum Berlin für Sozialforschung 1996

Forschungsschwerpunkt: Research Area: Arbeitsmarkt und Labour Market and Beschäftigung Employment

Abteilung: Research Unit- Wirtschaftswandel und Economic Change and Beschäftigung Employment

Wissenschaftszentrum Berlin für Sozialforschung Reichpietschufer 50 D-10785 Berlin Abstract

This paper describes the strategic adjustment of Lufthansa to altered competitive conditions in the 1980s and 1990s: (1) the attempt to apply the aviation equivalent of “diversified quality production” (DQP) in the 1980s, (2) the failure of DQP, with an explanation of the reasons for this failure, and (3) Lufthansa’s 1992 crisis, turnaround, and new corporate structure of 1995. Building on recent research about the influence of national institutional frameworks on the types of product market and innovation strategies firms pursue, this paper argues that the institutional framework of the Federal Republic allowed Lufthansa to prosper up to the 1980s when technological change in the airline industry was gradual and continuous, but constituted a handicap after the mid 1980s when altered market conditions called for more radical innovations. Two institutional factors are highlighted: top-level decision­ making in German corporate governance and the internal iabor market for managers within German firms. Lufthansa, in conforming to these national patterns, was ostensibly handicapped in its ability to adapt to discontinuities in the competitive parameters of civil aviation and more recently has had to devise organizational solutions arguably designed to compensate for constraints imposed by its national institutional context.

Zusammenfassung

In diesem Forschungsbericht wird die strategische Anpassung der Lufthansa an veränderte Wettbewerbsbedingungen in den 80er und 90er Jahren beschrieben: (1) der Versuch, in den 80er Jahren das Äquivalent einer “diversifizierten Qualitätsproduktion” (DQP) auch für den Luftverkehr zu entwickeln; (2) das Scheitern der DQP-Strategie sowie die Gründe für dieses Scheitern; (3) die Krise von 1992, der Turnaround, und die neue Konzernstruktur von 1995. Im Rückgriff auf die jüngste Forschung über den Einfluß nationaler Institutionsgefüge auf die Produktmarkt- und Innovationsstrategien von Unternehmen wird argumentiert, daß das Institutionsgefüge der BRD Lufthansa bis Mitte der 80er Jahre begünstigt hatte, solange die Luftfahrtindustrie durch einen allmählichen und kontinuierlichen technischen Fortschritt bestimmt war, jedoch ab Mitte der 80er Jahre ein Hindernis für die Lufthansa darstellte, als veränderte Marktbedingungen radikalere Innovationen notwendig machten. Zwei institutioneile Faktoren werden besonders betont: zum einen die Art der Entscheidungsprozesse auf Spitzenebene in deutschen Unternehmen und zum anderen der betriebsinterne Arbeitsmarkt für Manager. Indem die Lufthansa dem deutschen Muster in diesen Punkten weitgehend entsprach, war sie offenbar benachteiligt in der Fähigkeit, sich den veränderten Rahmenbedingungen des Luftverkehrs anzupassen, ln letzter Zeit hat Lufthansa organisatorische Reformen vorgenommen, die u.a. darauf abzielen, die durch das nationale Institutionsgefüge bedingten Hindernisse auszugleichen. Table of Contents

Page

1. Introduction...... 1

2. The Rise and Fall of “Diversified Quality Production” at Lufthansa ...... 2

3. Beyond Just Quality: Adjustments in Lufthansa’s Product Market Strategy...... 6

3.1 Service Quality Levels...... 6

3.2 Schedule and Geographic Domain...... 8

3.3 Pricing and Revenue Management...... 11

4. Corporate governance and managerial hierarchies at Lufthansa...... 14

5. After the crisis of 1992: Lufthansa’s turnaround and new corporate structure...... 23

6. Outlook: Lufthansa’s new corporate structure 27

Bibliography ...... 29

Figures...... 32 1. Introduction

The purpose of the present paper is to bring a political economy lens to bear on the corporate strategy of a single company, Deutsche Lufthansa AG. The focus on a single corporation finds its theoretical justification in the intersection of two offshoots of the comparative research on national policy styles in economic adjustment (Katzenstein, 1978; Richardson and Jordan, 1982; Zysman, 1983; Hall, 1986): on the one hand, inspired by the recognized diversity of institutional arrangements among sectors within nations, the literature on sectoral-level governance structures and “meso-corporatism” (Cawson, 1985; Wilks and Wright, 1987; Hollingsworth, Schmitter et al., 1994), and, on the other hand, recent considerations of the ways in which national industrial frameworks constrain companies from successfully pursuing certain types of product market and innovation strategies while providing resources and incentives for pursuing other types of strategies (Streeck, 1992a; Soskice, 1994). This latter research stream has proven particularly fruitful for generating a stylized understanding of the German type of post-Fordist production regimes in the 1980s. Taking advantage of new micro-electronic production technology, German firms in a number of manufacturing sectors were able to adopt the techniques of “diversified quality production” (Sorge and Streeck, 1988) and thereby occupy an attractive market niche in-between the conventional alternatives of craft and mass production, combining the revenue advantages of customized high-quality goods with the cost economies of high-volume throughput. The orientation of the German manufacturing sector toward high quality, high value- added goods rests on a constellation of labor, banking, vocational training, and corporate governance institutions favorable to the implementation of DQP adjustment strategies (Streeck, 1995; Vitols, 1995).

A review of Lufthansa’s adjustment strategies in the 1980s and 1990s and the way these were impacted by specifically German business institutions sheds empirical light on questions currently raised by observers of Germany. First, will the traditional German industrial strategy based on high wages, high investment (including in human capital), and high-quality goods prove viable in the future, or does it risk being undermined by new techniques and technologies permitting more international competition in high-quality market segments, by the globalization of German companies’ productions sites and intra-firm exchanges, and by the financial burden of German unification? Second, at a time when manufacturing employment in Germany is rapidly shrinking and only the service sector offers realistic prospects for employment growth, to what extent does or can the traditional German industrial strategy extend to non-manufacturing sectors? With over 40,000 employees since 1988 in a sector characterized by annual growth of 7-8% in recent years, Lufthansa is clearly a major employer. In scheduled (non-charter) services, Lufthansa accounted for over 99% of (West) German production (measured in passenger

1 kilometers) into the 1990s and can therefore be taken as a proxy for the entire sector of scheduled airtransport services offered by German carriers.1

At first glance, applying the framework of diversified quality production (DQP) to the commercial aviation sector may seem like an odd procedure. German industrial strategy, and the national prosperity and relatively egalitarian distribution of income to which it has given rise, has generally been thought of as an attribute of the manufacturing sectors in which the Federal Republic’s comparative advantage lies. Moreover, parts of the institutional infrastructure prominent in sectors like machines tools or automobile production do not exist in commercial aviation. Lufthansa does not belong to any German industry association either for negotiating sector-wide wage agreements nor for accomplishing any other strategically important tasks characteristic of “business-coordinated market economies” (Soskice, forthcoming). Like the German chemical giants (Grant, Paterson et al., 1987), Lufthansa operates in an industry whose financing is so internationalized that German companies in the sector do not benefit from the specificities of German financial institutions. Nor does the renown “dual system” of apprenticeships coordinated with vocational schooling play a substantial role in Lufthansa other than in its maintenance operations. Thus, Lufthansa inhabits a sector of comparatively weak institutional “embeddedness” in a country otherwise known for the “strong embeddedness” of its internationally competing firms (Sally, 1994). What this leaves and highlights all the more is the German institution of corporate governance, which will form the backbone of the following analysis.

2. The Rise and Fall of “Diversified Quality Production” at Lufthansa

If there are a priori reasons for doubting the relevance of DQP for German commercial aviation, there are far more powerful ones for affirming it, the most important being the strategy and beliefs of Lufthansa’s own top management in the 1980s. A pillar of Lufthansa’s strategy was that it could survive and prosper in a deregulated market by occupying the high-quality niche of the industry on its routes and thereby charge the higher fares needed to support its German labor costs. Lufthansa conceived itself quite literally as the aviation equivalent of Porsche, BMW, and Mercedes. In the early 1980s, Lufthansa and Swissair were clear stand-outs among European carriers for their service quality and both were considered to offer above-average board service, safety, and reliability at above-average prices. The 1

1 More recently the situation has admittedly changed as the European Commission’s three “packages” of market liberalization in air transport (1987, 1990, 1992) have abolished the conventional duopoly privileges of European flag carriers on routes within the EU and eroded the distinction between scheduled and charter services. Thus, since 1 January 1993, carriers in Germany’s much more liberalized charter segment have the right to begin scheduled services between countries within the EU.

2 extent of price and quality competition was limited, it is true, by bilateral restrictions on traffic rights and fare-setting. The significant point is that faced with the progressive liberalization of the European market from 1987 on, Lufthansa actually enhanced the centrality of “German quality” and “German productivity” in its strategic thinking. Lufthansa took the parallel with successful car manufacturers so seriously that it appointed a BMW marketing man to a newly created Vorstand position in Product Development and Marketing in May of 1989, and after the Vorstand member in Sales resigned in early 1990, Lufthansa eyed VW’s illustrious Daniel Goeudevert as a replacement candidate: “We need a man like him, but we can’t afford him” (Manager-Magazin. Sept. 1990).

Lufthansa was a “typically German” company in other ways as well. Almost to the point of caricature Lufthansa reflected the technical orientation typical of German business culture (Lawrence, 1980). Taking advantage of rapid depreciation provisions in the German tax code, Lufthansa generally sold its planes at a profit after ten years of use and maintained one of the youngest fleets in the world with the latest aviation technology. Its prestigious and large maintenance division (Technik) supplied a series of influential top managers in the Vorstand, including the highly respected Reinhardt Abraham as deputy chairman (stellvertretender Vorstandsvorsitzender) in the 1980s and the current CEO Jürgen Weber, the Vorstand chairman since 1991. Whereas the sales and marketing side of Lufthansa, as discussed below, struggled to find able Vorstand members in the 1980s and 1990s, the Technik division has provided a steady stream of orderly internal successions throughout this period.

Until the 1980s, scheduled air transport to and from Germany was regulated by bilateral agreements which with few exceptions conferred exclusive traffic rights on the respective countries’ flag carriers and provided for joint government approval of routes, schedules, prices, and often even anti-competitive capacity and revenue sharing. Confronted with the inevitabiiity of eventual EC/EU market deregulation, Lufthansa in 1987 adopted an aggressive growth strategy, doubling its fleet over the next five years. The commercial pillar was a “made in Germany” high-quality reputation (hence Lufthansa’s rejection of growth through foreign acquisition for fear of diluting the made-in-Germany image). The strategic thinking of Lufthansa’s then CEO Heinz Ruhnau (1982-91) was that deregulation in Europe would lead to market concentration (as it had in the US) and that Lufthansa would be able to crowd out new and existing competition. As a top-level marketing manager explained in 1987:

The reactive possibilities of Lufthansa to this development are limited: ‘Our production costs are downwardly inflexible’ has been noted in a position paper. A reduction of unit costs is mainly to be achieved through growth ... In this environment of growing quality awareness of customers Lufthansa has only one chance to achieve growth: It must make customer orientation the highest motto of entrepreneurial action. (Lufthansa Jahrbuch ‘87)

To support this growth, Lufthansa in 1987 also began implementing an organization reform consistent with the concept of diversified quality production. At

3 considerable financial and internal political expense, some 200 personnel were relocated from the administrative headquarters in Cologne to the operational base in Frankfurt and assigned to the Sales and Marketing Division. The idea was to debureaucratize and decentralize sales and marketing responsibility so that Lufthansa’s products and sales strategies could be adapted to the needs of different markets. Several planners were recast as “route managers” responsible for deciding the appropriate cabin configurations and service levels for their respective geographic markets.

All of the strategic initiatives thus far described - appointing a BMW marketing man to the Vorstand, aggressive growth, and the system of decentralized “route management” - failed to achieve their aims. The BMW man, Dr. Falko von Falkenhayn, producing rhetoric about serving the customer whose concrete ramifications his Lufthansa colleagues could not discern, earned the unflattering nickname Wirko von Wirrenkopf, and was forced out (Manager-Magazin, Oct. 1990). Lufthansa’s growth strategy naturally entailed a manifold increase in company debt and left the company vulnerable to Gulf War and the ensuing collapse of traffic. Following the introduction of decentralized route management, Lufthansa's fleet came to be subdivided into 38 configurations to meet specific route requirements with, as a result, low flexibility, as each configuration had its own specific cockpit and cabin requirements, galley equipment, and so forth. Efficient scheduling became impossible as overiy specialized aircraft, together with past agreements on working conditions for crews, imposed heavy restrictions on Lufthansa’s ability to make optimal use of its planes and crews. In 1991, the route management system was dropped in favor of “Area management,” discussed below (Lehrer, 1995).

Despite mounting evidence that there was something wrong with Lufthansa’s marketing approach, the BMW/Mercedes analogy remained firmly entrenched in top management’s thinking. Even a change of CEO in 1991 did not change this. As late as November 1991, well after the Gulf War had ended, the new Vorstand chairman Jürgen Weber held up Mercedes as a model of product-oriented differentiation for Lufthansa to follow, albeit now with the explicitly stated need to “adjust the production cost to the different products” (Airline Business, November 1991). Nonetheless, as the airline crisis deepened, with Lufthansa’s average yields falling by 7% in 1992 and by another 6% in 1993, the premises underlying Lufthansa’s high-cost, high-quality product came increasingly into question. The decline and fall of Lufthansa’s product quality ideals can be traced in the following declarations:

Pre-crisis. "We have to reduce our personnel costs. But to bring them down to 24% of turnover like at BA is unrealistic ... German products are successful worldwide because of their high quality. In Germany we build BMW, Mercedes, Porsche, because there’s a market for these cars in this country. The same holds for Lufthansa. Customers demand quality in this country.” (CEO Heinz Ruhnau, interview in Per Spiegel. 24 Dec. 1990)

Mid-crisis. "The most recent sales study shows that unclear notions about the Lufthansa product exist among customers and agents. Poor knowledge of the product, insufficient

4 sales training, and lack of understanding of the complex quality output of Lufthansa often lead to agents overlooking the product and quality characteristics of our offerings and fall back on simple arguments about the price." (Sales and Marketing Vorstand member, early 1992, in Lufthansa Jahrbuch ‘92).

Post-crisis. “That we are in the commodity business means that we have very narrow manoeuvring room for product differentiation vis ä vis the competition. A manufacturer of machine tools or chocolate has more possibilities for distinguishing his product.” (CEO Jürgen Weber, speech for Lufthansa staff, 1995)

Along the way Lufthansa had to undo past mistakes. A characteristic one was a 1989 decision to retain a first-class cabin for European services after the concept had been abandoned as unprofitable by all European airlines except Swissair. First- class had been the subject of an extremely heated discussion within Lufthansa in the late 1980s, and when the failure of its retention proved manifest, first class on German and European routes was abolished in 1992.

Having documented the rise and fall of the aviation equivalent of DQP at Lufthansa (at least in the mind of top management), it is appropriate to answer a couple of central questions. First, why did the strategy fail? That is, what were the gaps in Lufthansa’s strategy relative to industry conditions and what business- institutional factors help account for these gaps in Lufthansa’s strategy? Second, how did Lufthansa recover and what “flexible rigidities,” to use Dore’s (1986) phrase, also explain why Lufthansa, in contrast to so many other majority state-owned European flag carriers, was able to return to profitability by 1994? Lufthansa was something of a cause celebre in the 1990s, facing the prospect of financial disaster in 1992 (with share prices falling by over 35% between April and June alone) but then stunning the entire business community with the rapidity of its turnaround. The following statistics give some idea of the turnaround, though for reasons of accounting discretion that need not detain us here, they actually smooth out the magnitude of change in Lufthansa’s financial performance in the 1990s:

Table 1

LUFTHANSA AG 1994 1993 1992 1991 1990 1989

Net profit (loss) DM Mill. 283.4 -110.8 -372.8 -444 6.7 121.6

Total revenues DM Mill. 16,000.7 14967.0 14955.1 14317.6 12806.0 11812.1

Employees 44,121 46,818 50,759 50,283 47,102 43,169

Productivity/employee ton kilometers 356,200 308,200 277,100 258,600 265,700 256,800

Aircraft 220 219 233 219 174 154

Net indebtedness DM Mill. 2082.3 4171.2 4632.1 4391.3 3259.8 1831.1

Source: Annual Report, 1994

5 As these figures show, employee productivity grew significantly between 1992 and 1994. Nonetheless, productivity is only part of the story. The depth of the 1992 crisis forced Lufthansa to rethink its approach to markets and pricing, and it is to these elements in Lufthansa’s product market strategy with which the next section will be concerned.

3. Beyond Just Quality: Adjustments in Lufthansa’s Product Market Strategy

To understand why DQP failed at Lufthansa, it is first necessary to understand the nature of product market decisions in the airline industry. Focusing on the core passenger business of an airiine (i.e. leaving aside cargo, catering, maintenance, etc.), there are roughly three important areas of product market strategy: 1) Service quality levels, also known as “products” in airline terminology, 2) schedule and geographic domain, and 3) pricing and revenue management. Service quality levels concern aspects such as the number of seating classes (first, business, second), the seating arrangements and culinary services of each, lounges, ease of check-in, etc. The schedule and geographic domain concern the choice of markets (city destinations) the airline chooses to serve and with what frequency of service; as European airlines are constrained by bilateral aviation agreements and limited airport slots on the routes they can fly, their objective is to use to their existing traffic rights and airport slots to best advantage. As regards pricing and revenue management, it is important to remember that airplane seats, unlike machine tools or autos, are perishable goods. The market value of a first-class seat may be $500 two weeks before take-off, and then $100 or $1000 an hour before take-off, depending on the residual demand. Thus airlines have had to devote considerable resources to information systems optimizing the prices charged on seats. In the past 15 years no less than four generations of increasingly sophisticated revenue management tools have been developed for airlines.

3.1 Service Quality Levels

The special quality reputation of Lufthansa was diluted in the course of the 1980s by the enhanced competitiveness of other carriers. Over the North Atlantic, Pan Am and TWA were gradually displaced by the much stronger mega-carriers American, United, and Delta. Within Europe, carriers like SAS and British Airways (whose initials BA stood for “Bloody Awful” in the early 1980s) vastly improved their service levels and image thanks to systematic use of market research, publicity campaigns, quality control, and less bureaucratic organization. The German monthly Manager- Magazin noted in July of 1987: “Much too late the Lufthansa management recognized that the quality criteria occupied by the German carrier like safety,

6 reliability, and punctuality ... long belong to the standard of all large carriers.” In place of these technical parameters of competition, other factors like the helpfulness of staff, board service, airport amenities, and especially prices had emerged as important differentiating factors influencing the choices of customers.

The case of British Airways helps to illustrate the weakness in Lufthansa’s quality strategy. After becoming CEO in 1983, Colin Marshall began an orchestrated campaign to focus the efforts of staff and managers on how to improve the way BA served its customers. These included staff training programs, a variety of cross-functional teams responsible for monitoring the quality of service delivery and the development of new ideas, and rapid promotions of young , dynamic marketing managers. A milestone in its pioneering marketing techniques came in 1986 when it began entrusting the design of its cabin configurations (e.g. intercontinental long-haul, European economy class, etc.) to bona fide brand managers hired from fast-moving consumer goods companies like Mars, Unilever, Whitbread, and Proctor and Gamble. Each new cabin design became a new “product” with all of its constituent parts, from seat size to the color scheme to the cutlery, carefully packaged in a stylized way that made for a specific product identity and idea! promotional launch. Though the concept was eventually imitated by other airlines, it generally took them several years to implement the necessary organizational reforms.

The key point of BA in the current context, however, is that by carefully studying the nature of demand and differentiating the airline’s service quality levels accordingly, the UK flag carrier was able to occupy the entire spectrum of profitable price/quality niches in air transport. In other words, BA was able to position itself as both a high-priced, high quality carrier for wealthier passengers and as a low-priced, commodity-type carrier for budget travellers. Suggestive evidence in support of this claim is contained Figures 1 and 2.

Figure 1 shows fare developments of BA on its London-Johannesburg over the period 1984-94. The gap between its highest and lower fares progressed significantly and continually. Data collected by the UK’s Civil Aviation Authority (CAA) on BA routes from London to Singapore, Sydney, Tokyo, and Los Angeles reveal the same pattern (CAA, 1994: 167-69). In other words, BA was able to practice an ever greater level of price discrimination over time among passengers travelling within the same aircraft. Figure 2 compares the range of sampled fares on routes from New York to various points in Europe in May, 1994. Although these fares do not apply to BA alone on the London route (or to Air France alone on the Paris route, etc.), they do give an idea of the comparative range of price differentiation on one of these carriers’ bread-and-butter routes. The higher range on the London route is suggestive. On the CAA’s comparisons of price ranges on routes from Europe to destinations like Tokyo and Singapore where prices levels are much more tightly regulated, the variation from one European airport to another is

7 significantly less significant than over the more deregulated North Atlantic routes (CAA, 1994: 190-204).

3.2 Schedule and Geographic Domain

An important element of product market strategy for an airline is the choice of geographical markets served. Reflecting the heritage of the bilateral system, most European flag carriers regarded themselves as serving routes to and from their home country: Lufthansa served routes to and from the Federal Republic, BA to and from the UK, and Air France to and from France. The airline business was comfortable enough for these flag carriers to turn a blind eye to companies like Swissair or KLM who made incursions into other countries’ natural markets by offering better service (Swissair) and/or lower prices (KLM) to induce passengers to fly via Zurich or Amsterdam. As bilateral restrictions were loosened, however, irresistible pressures for carriers to expand their range of markets began to build up.

A fundamental principle of airline competition is that little competition takes place on routes served by a monopoly or duopoly, but competition becomes more intense as soon as there are three or more carriers on a route. Thus, on routes between two EC/EU states, there was little incentive for carriers to compete, as each route was generally served merely by the two flag carriers from the respective countries. However, the situation was very different for long-haul routes to North America or Asia. To fill their intercontinental flights, European carriers had a genuine incentive to siphon off customers from neighboring countries, using their European routes to haul passengers into their own hub airports where they would change planes. Thus, European liberalization had the paradoxical effect of encouraging EC/EU carriers to compete with each other more intensely on intercontinental routes than on intra-European services (CAA, 1993:22-5). In other words, Lufthansa's competitors over the North Atlantic were not merely the American mega-carriers. KLM and British Airways could "steal" Lufthansa's passengers by channeling them through their Heathrow or Schipol hubs. From a glance at a map of Europe it should be clear that KLM and British Airways are geographically well positioned to swipe transatlantic passengers from continental carriers.

However, this “theft” pre-supposes the carrier being armed with the proper accounting systems, hub connections, and scheduling capabilities. Though the European flag carriers studied by the author (Lufthansa, BA, and Air France) had a massive incentive on paper to use their liberalized European networks as feeders to their long-haul routes, a major finding of this research was the extraordinarily variable speed with which they did so. Compartmentalized responsibility meant that the managers in charge of the various long-haul operations concerned themselves only with profitability on their routes while the managers of short-haul services did the same. The bilateral system explains this in part. The internal organization of

8 European flag carriers had historically mirrored the organization of civil aviation into a sets of country pairs, with the traffic between each pair of countries constituting the subject of a bilateral and therefore constituting a separate market. Thus, Germany-France, Germany-Japan, Germany-USA, and Germany-Greece each constituted a separate market in the eyes of Lufthansa managers. The organizational reform of 1987, creating several positions for independent route managers, actually reinforced this separate route-for-route orientation, while new accounting systems were being developed to measure profitability even more accurately on a route-by-route basis.

Only an abrupt change in production regime and the way the airline was organized could enable these carriers to move from a management system based on geographical profit center optimization to a system of network optimization, where decisions about flight scheduling, hub connections, pricing, and seating capacities are made with a view to enhancing the profitability of the route network as a whole. Although Europe’s largest carriers Lufthansa, British Airways, and Air France ultimately converged on the network optimization paradigm, they did so at surprisingly variable rates. In each case, a critical impulse toward the new paradigm came from the realization of sub-optimization of the overall route network caused by trying to manage the airline’s different geographical market areas as separate profit centers. Yet even structuring the airline as geographical profit centers represented an advance over an airline organized in the classic functional fashion with the commercial side of the airline responsible only for revenues (but not for costs) and the operational side responsible only for costs and efficiency (but not revenue). Thus, the three airlines progressed through the three stages of functional organization, geographical profit center organization, and network optimization, and did so at the following rates:

Table 2 Year in which Year in which the Year in which the major geographic need to optimize crucial org. markets were set the overall network reforms to permit up as profit was clearly network Airline centers recognized optimization were made British Airways 1983 1984 1986 Lufthansa^ 1991 1992 1993-95 Air France 1994 1994 1994-

Again, the contrast with British Airways is illustrative. BA decentralized its passenger operations into eight geographical profit centers in 1983. But experience quickly revealed the interdependence of markets, and in 1985 BA began a concerted campaign to develop Heathrow as a hub: flight connections, ground

2 Lufthansa’s 1991 profit centers (the “Areas” discussed above) were actually more “revenue centers” than actual profit centers, not having operational control and cost responsibility for dedicated fleets and crews to the extent of BA or Air France. The principle was much the same, however.

9 service, accounting systems, and pricing instruments were all modified to attract and conduct more foreign transit traffic through the London hub airport. The capstone came in 1986, when BA created a global sales organization with the expressed mission to maximize its global revenue across all geographic areas. Lufthansa was seemingly oblivious to all these developments The company awoke with a start in 1992 to the need to optimize the network. McKinsey consultants were called in to develop computer tools to optimize the schedule and the rotation of aircraft and crew (Manager-Magazin, July 1992; Lehrer, 1995). Lufthansa ultimately recentralized its route network functions (fleet planning, flight scheduling, pricing, revenue management) in a Network Department in late 1993, eventually also creating a more centralized structure for its various geographical sales and marketing operations as well in May 1995.

The organizational evolution of Lufthansa’s Passenger Division from a functionally organized operation to one of decentralized route planning (1987), to one structured around geographical Areas (1991), to an operation recentralized around its network information technology tools (1993-95) can be placed within the discussion of Post-Fordist production regimes (Piore and Sabel, 1984; Hyman and Streeck, 1988; Boyer, 1991). Like a traditional industrial enterprise, Lufthansa had long been organized into functional departments (each under the responsibility of a Vorstand member), in particular, flight planning, marketing, and sales were separate and sequentially performed with little cross-functional integration. A disadvantage of this system was that it could not readily assimilate local market knowledge into the company's basic planning process, as the planners in Cologne were far removed from local markets. This is the reason why, as the marketplace became more competitive, Lufthansa began “diversifying” its production in 1987 with individual route managers to tailor the company's planning of products (i.e. catering, seat configuration, advertising, ground service, etc.) to the customer expectations and competitive conditions of local markets. The danger of decentralized decision­ making is that individual managers may allocate resources or make pricing decisions that optimize results in their own area of the company but detract from the results of the company as a whole.3 Unfortunately for Lufthansa, the technological frontier was continually moving and in ways that actually favored centralized decision-making. In a company with such interdependencies between operations as an airline, advances in information technology were making it feasible and indeed

3 An example of the conundrum Lufthansa was facing over its entire route network is the following purely hypothetical situation: The manager in charge of London-Frankfurt routes assigns capacity and prices tickets in such a way as to maximize revenue on that route. In doing so, however, these decisions may harm the efforts of Lufthansa’s manager in charge of Japanese traffic who wants to compete for passengers on the London-Tokyo market by selling tickets on the route London-Frankfurt-Tokyo. This kind of problem was very real in Lufthansa and led to conflicts between the managers of the different geographical Areas after the 1991 reform (Lehrer, 1995). The same kind of conflicts can arise in scheduling as well: the optimal schedule on London- Frankfurt for passengers travelling between only these two points may be sub-optimal from the standpoint of connecting flights from Frankfurt to other international destinations. Again, this was no merely theoretical problem, and in the years 1992-94 Lufthansa centralized its flights around its Frankfurt and Munich hubs in order to increase the density of flight connections and reduce its dependence on point-to-point traffic (source: CAA, The single European aviation market: Progress so far, London, p. 6).

10 necessary to entrust ever more resource allocation and pricing decisions to sophisticated information technology. Yet even the return to a more centralized structure of decision-making in the Lufthansa’s Passenger Division in the 1990s did not take place without considerable discussion and controversy within Lufthansa management (Lehrer, 1995). The organizational experimentation of Lufthansa thus confirms Dankbaar’s (1988) underlining of the role of managerial discretion in the choice work organization and warning against deterministic conclusions about the impact of new technology on the selection of production regimes.

3.3 Pricing and Revenue Management

The component of product market strategy that most distinguishes commercial aviation from industrial products is the nature and sheer complexity of pricing decisions. Airline passengers today purchase their tickets amidst a wide array of prices and conditions. In contrast to the price rigidity of air transport in earlier days, airlines in a deregulated environment may change thousands of prices per day. Ticket prices displayed on computer reservation systems (CRS) change somewhat like stock prices, albeit less continuously. Indeed, the proliferation of CRS in the 1980s was a major factor in causing European airlines to lose control over their distribution channels and be subjected to greater price competition. The challenge for Lufthansa was not merely to build up its own CRS with other European airlines (Amadeus) and avoid dependence on the CRS of American carriers. Even more so Lufthansa had to develop the software tools in “revenue management” (also known as “yield management”) needed to determine and post the optimal prices on its flights.

As earlier as 1989, Lufthansa’s regional manager for the British Isles noted: “The absence of an effective yield management system is costing Lufthansa half a million Marks daily, in terms of lost revenue” (Der Lufthanseat, 9 Feb 1989). More than three-and-a-half years later, the problem was still not solved, and when CEO Weber was asked at a Lufthansa “town meeting” in Frankfurt, “What does BA do differently to make profits?” he replied that there were three reasons: 1. BA long possesses a sophisticated yield management system with 20 booking classes, giving BA a seat-load factor (i.e. percentage of the plane filled) of 14% higher than Lufthansa. 2. BA’s centralized hub structure in London, whereas decentralized services are becoming less profitable 3. Profitable North Atlantic operations, thanks to the UK-US bilateral, much more favorable than the Germany-US bilateral (Der Lufthanseat, 16 Oct 1992).

Before investigating the reasons for Lufthansa’s lag in implementing the latest revenue management technology, it is worth gauging the relative importance of the

11 matter for Lufthansa’s bottom line. A clue is provided by Lufthansa’s emergency recovery program, Programm ‘93, which it agreed with the unions in the summer of 1992. The program was to provide a rapid 10% improvement in Lufthansa’s result; the DM 1.5bn improvement was slated to result from: - a DM 800m reduction in the cost base (DM 500m personnel costs and DM 300m non-personnel costs) - a DM 700m improvement in revenues, due to refinements in scheduling, selling, etc.

On the revenue improvement side, Lufthansa expected the new IT tools under development to produce a better result of at least DM 300m in the schedule (Lehrer, 1995). This leaves up to DM 400m to come from improvements in its pricing systems, which at 2.5% of Lufthansa revenue is well within the 6-8% range of revenue improvement that an Air France study indicated was possible by implementing the type of revenue management tools that it too was purchasing from American’s subsidiary SDT (Bordes-Pages, 1994:57).

While the number of booking classes handled by Lufthansa’s reservation systems increased from 3 to 5 in 1989, from 5 to 8 in 1991, and from 8 to 15 in 1993, British Airways introduced a state-of-the-art reservation system in 1985 enabling it to track up to 26 different booking classes on any flight.4 Why did Lufthansa, famous for its modern planes and always insisting on the latest technology, fall behind the world industry leaders in the adoption of revenue management techniques? The reasons are to be sought in the intersection of technological and institutional factors. On the one hand, while Lufthansa was certainly technical in its company orientation, its specialty and pride was its expertise in aircraft technology, making it the design associate and launch customer of many Airbus models, for example. As will be argued in the next section, this was not merely a matter of individuals, but of corporate institutions. Changes in industry conditions made it necessary for airlines to shift power and resources massively away from the technical and operations side of the company to the sales and marketing side. In the absence of a dire crisis, this sort of power shift is precisely what Germany’s democratic institution of corporate governance may be less well equipped to facilitate.

On the other hand, Lufthansa’s difficulties in staying abreast of developments in revenue management were also due to the fact that it was chasing a moving technological target. To enable airlines to maximize potential revenues, no less than four generations of revenue management have been developed over the past fifteen years. Explained in very basic terms, these four systems for setting and changing prices are:

4 Sources: Fremdenverkehrswirtschaft Intern 4 July 1989; Der Lufthanseat, 19 June 1992 and 22 Jan 1993, British Airways News, 13 Sept 1985.

12 Table 3 Airlines compile historical records of flight cancellation patterns so First Generation: as to forecast the number of seats that will ultimately be occupied on Overbooking each flight. This enables them to estimate the number of extra tickets they need to sell on each flight in order to fill the planes to the optimal level. Second Generation: There may be different booking classes within the same cabin of the Use of Fictitious aircraft and hence different prices for seats. Airlines make use of Classes so-called “fictitious” booking classes to practice price discrimination, even among passengers who purchase the same service. For example, it may be profitable to charge different prices according to how far in advance the reservation is being made, the point of sale, or the historical loyalty of the individual customer. Third Generation: First- and second-generation revenue management systems Virtual Nesting operate on a flight-by-flight basis, without taking into account the O&D (origin and destination) of individual passengers. For example, on a London-to-Frankfurt flight, earlier systems were unable to distinguish between passengers flying only to Frankfurt and those flying on to Moscow, Athens, or New York. A third-generation revenue management system reassigns booking classes into so- called “buckets” according to the overall revenue contribution made by a passenger's total itinerary. Fourth Generation: Bid Bid pricing represents a technical refinement of virtual nesting which Pricing dispenses with “buckets” and employs a superior algorithm for maximizing revenue. This was the system Lufthansa and Air France were racing to implement in 1996: Both companies had contracted with American Airline's SDT for a system update and were attempting to catch up with British Airways, an industry leader in the development of revenue management systems.

It will be immediately seen from this review that technology in this area was continually developing. Lufthansa was stymied by the fact that just as its IT people were sorting out the architectural and logistical problems of installing one generation of revenue management, the company became aware of a new generation of the technology requiring new investments. It can also be seen that beginning with the third generation, the geographical and pricing/revenue dimensions of product market strategy began to merge. It is for this reason that the notion of network optimization came to occupy such a critical strategic role for Lufthansa and other major European carriers. Why Lufthansa fell behind other leading global airlines in catching onto the strategic importance of this principle and other developments in commercial aviation will now be explored.

13 4. Corporate governance and managerial hierarchies at Lufthansa

Only in stable industry environments are the firm’s decision parameters simple enough for company strategy to be left to top decision-makers. In turbulent industry environments, companies are dependent on information-sharing mechanisms that enable them to integrate the knowledge and perspectives of functionally differentiated specialists (Lawrence and Lorsch, 1967). In a deregulated airline industry, for instance, no single person in an airline possesses the necessary knowledge to make informed unilateral decisions about product market strategy or the re-organization of production tasks. Decision-making inputs may be sought from board meetings, task forces, department heads, staff specialists, and consultants, but when confronted with complex strategic decisions large companies in practice face the dilemma that managers higher up in the organization are generally out of touch with day-to-day developments whereas managers at the operational level are usually familiar only with their own areas, unaware of developments in other areas of the company and the way the various parts of the company are linked together. In a turbulent industry like European aviation from the mid 1980s on, the quality of an airline’s strategic adjustments hinged upon the extent to which the critical information about the way the industry was evolving could be assembled and integrated out of the complex information jungle of daily market signals and converted into concrete action plans.

Institutional differences in the way companies of different countries operate may be expected to affect top management’s resources for segmenting, integrating, and reorganizing managerial activities within the firm and hence the array of top management’s procedural choices in reacting to changes in its competitive environment. The present section focuses on two institutional factors in particular, German corporate governance and the nature of German companies’ internal market for managers. It argues that Lufthansa, in conforming to these national patterns, was ostensibly handicapped in its ability to adapt to changes in industry conditions in the 1980s. It is not argued that German business institutions constitute a handicap generally for German companies. Rather, the argument echoes the findings of Zysman (1977), Kitschelt (1991), and Soskice (1994) suggesting that national institutional patterns in business confer a set of both comparative advantages and handicaps on a country’s firms, facilitating certain types of adjustment to industrial or technological change while hindering others. In the case of the Federal Republic, it has been accepted that German firms are among other things generally weak at radical innovation but strong at incremental innovation because of the institutional framework on incentives and constraints embedded in the German economy and society (Soskice, 1994). An analogous argument is made here, namely that Lufthansa was able to prosper up to the 1980s when technological change in the airline industry was essentially continuous (involving new models and generations of aircraft), but found itself at an institutional disadvantage in the 1980s when discontinuities in the industry’s competitive parameters shifted the crucial

14 dimensions of technology away from aircraft and flying to areas like information systems, marketing, and pricing.

Corporate governance as conceived and studied here goes beyond preoccupations with the articulation of shareholder interests and with the separation of ownership from control (Berle and Means, 1967; Fama, 1970; Jensen and Meckling, 1976; Griffin, 1995). Nor is it restricted to co-determination and joint- decision making between capital and labor representatives in large German companies (Streeck, 1992b). Rather it is necessary to consider in greater procedural detail the way decision-making at Lufthansa as a large German company works and the constraints that are inherent on the discretion of top managers. For it is not merely the voice of labor in the works councils, Aufsichtsrat (supervisory board), or even in the Vorstand (executive board, through the position of the “labor director”) that imposes constraints. Rather, it is the legally enshrined two-tier structure of management boards (Vorstand, Aufsichtsrat) with rigidly codified voting rules that helps explain why the pattern of corporate decision-making at Lufthansa in the 1980s and 1990s followed the course it did and why Lufthansa could not and did not follow the same course of strategic adjustments that the ascendant British Airways was able to pursue, it was not just the ways internal and external interests were represented in Lufthansa’s system of corporate governance, but the way that decision processes were structured by it that affected the path of strategic adjustment and the rapidity with which Lufthansa went down this path.

Let us begin with the role of the Aufsichtsrat (supervisory board). Since the Co- Determination Act of 1976, the parity principle holds, meaning that in Lufthansa’ case management and labor each elect ten representatives to the Aufsichtsrat. While the labor side includes the chairmen or chairwomen of the major works councils as well as representatives from the major groups of employees (cabin, cockpit, ground operations, maintenance, etc.), the management representatives from the world of business, finance, and politics were all selected by the Federal Transport Ministry, acting on behalf of the Bund, Lufthansa’s majority shareholder until 1994. Along with its legally prescribed authority for approving quarterly accounts, dividend payouts, and major expenditures or acquisitions, the primary function of the German Aufsichtsrat is to ensure the competence of the Vorstand (Charkham, 1995:22). According to the 1976 law, appointments to the Vorstand normally require a two-thirds majority of the Aufsichtsrat. Moreover, the Aufsichtsrat normally deliberates on the best candidate for each position on the Vorstand individually; the CEO (Vorstand chairman) of a German corporation is usually not free to install his or her own team. At Lufthansa, the individual heading the scouting searches for able managers to fill Vorstand positions was always the Aufsichtsrat chairman.

This, along with the principle of one-person, one-vote majority voting in the Vorstand, meant that newly appointed Lufthansa CEOs had little unilateral power, and in the case of the last two CEOs, Heinz Ruhnau (1982-91) and Jürgen Weber

15 (1991-present), phenomenally little compared to their American or British counterparts. The appointment of Ruhnau was nothing less than a cause celebre in its time. In mid 1981, confidential documents on a 1977 Lufthansa transaction with an oddball travel promoter mysteriously reached the press and obliged the Transport Ministry and Aufsichtsrat to re-open a previously terminated investigation. The result was a censure of the Vorstand and forced resignation of the Vorstand chairman. But by the fall the CDU and most of the German business press was convinced that the disclosure of the affair was a convenient pretext for the Aufsichtsrat chairman, the transport minister, and the secretary of state for transport Heinz Ruhnau to place the SPD loyalist Ruhnau at the helm of Lufthansa. Yet neither public outcry, nor the protests of virtually the entire company management against the “politicization” of Lufthansa, nor a petition of 10,000 Lufthansa employee signatures to the German Chancellor could prevent Ruhnau’s appointment: Ruhnau obtained the minimum 14 votes from a coalition of management representatives and labor representatives associated with the ÖTV union. The result was that Ruhnau chaired a Vorstand on which he had no friends. Indeed, perhaps to appease the CDU (among other reasons), Lufthansa the same year appointed a CDU man to a newly created Vorstand position in finance. As a later middle management representative on the Aufsichtsrat said; “Ruhnau came alone, without brining any of his own managers. That was courageous" (personal interview).

Yet even Ruhnau’s unanimously elected, internally promoted successor Jürgen Weber in 1991 enjoyed little unilateral power. For one thing, a glance at issues of Manager-Magazin and Spiegel suggest that half of the Vorstand by this time reflected the preferences of labor on the Aufsichtsrat. The Vorstand members in charge of Personnel and Flight Operations were portrayed as quite close to the unions and pilots respectively. The search for a suitable candidate to occupy the all- important Sales and Marketing seat on the Vorstand had taken up the greater part of 1990, until for lack of an emergent favorite among applicants or a consensus on the ideal profile the job was given to the strategic planner, the employee representatives’ preferred choice. What this shows is not that co-determination at Lufthansa led to a neglect of business imperatives at the executives, but simply that the pattern of German governance, with its procedures for selecting Vorstand members, did not bestow upon Lufthansa’s CEO anything like a unified top management team with a commonly shared approach.

Another German feature of Lufthansa is its employment security for managers. Whereas British Airways conformed to the hire-and-fire model of Anglo-Saxon companies, Lufthansa was a fairly secure haven for managers below the Vorstand level and promotion was mostly internal. Company-specific agreements made it virtually impossible to terminate employees after 15 years of service, and until 1994 employees' pension entitlements, set up under a special government-sponsored fund (VBL), could not be transferred if they left the public sector, thereby limiting employment flexibility at Lufthansa. Yet such contextual factors merely amplified a general pattern in German companies of significantly higher job tenure than in US or UK companies (as evident in OECD statistics; see Streeck, 1995:10). Nor can these

16 variations be ascribed only to differences in national industry specialization, for matched samples of firms in identical industries in Germany and the UK similarly reveal that German middle managers had spent far longer in their present jobs than their German counterparts (Stewart, Barsoux et al., 1994).

A comparison of the corporate governance and employment security for managers in the three airlines is as follows:

Table 4 Lufthansa British Airways Air France unilateral authority of low high high (given CEO government backing) manager career high low high security

Whereas Colin Marshall within months after becoming CEO of BA in 1983 fired 60 the company’s top managers and filled the top ranks with mangers in their 30s and 40s, the Lufthansa CEO has no such authority. He cannot even hire except in the staff departments that report to him; the bulk of the airline reports to Vorstand members who head the operational and commercial divisions. Nor can he make any decision without the majority approval of the Vorstand and (for major decisions) the Aufsichtsrat. Though some Vorstand chairmen may be able to dominate their Vorstände and Aufsichtsräte under certain circumstances (Lawrence, 1980:41), this was not the case at Lufthansa, which judging from press accounts and interviews clearly functioned much more like a textbook case of German corporate democracy, with the CEO having to build Vorstand and Aufsichtsrat coalitions in order to implement changes.

If we compare Lufthansa with Air France prior to 1993 (when the government installed a new CEO and gave him the exceptional authority to demote and replace virtually all the top managers) and British Airways after 1983 (when Colin Marshall became CEO), we arrive at the following matrix:

17 Table 5 Hire and fire; Managerial job security;

Generalist managers specialist managers

High CEO control;

Generalist CEO; British Airways Air France Limited ability of corporate governance to monitor quality of top management

Limited CEO control; Vorstand of specialists; Lufthansa Considerable ability of corporate governance to monitor quality of top management

In addition to the level of unilateral CEO control and the presence or absence of a hire-and-fire system for managers, this table captures other distinguishing characteristics of corporate governance and managerial hierarchies at Lufthansa. First, German companies are generally pervaded by a specialist culture at all levels, whereas the managerial ranks of UK and US companies are likely to have a much higher proportion of general managers moving more freely among departments and functions within the firm. Lufthansa and British Airways conformed to this pattern, albeit recent interviews at Lufthansa indicate that a more generalist orientation in managers is sought by the company and that employment security and prospects of guaranteed career progression are in the process of declining. Air France conforms to a French pattern of specialists in the managerial ranks led by a generalist from the national state-business elite (Cohen and Bauer, 1980). Second, while the high degree of authority to act conferred upon Anglo-Saxon and French CEOs brings with it some strategic advantages, one disadvantage is the comparative difficulty of evicting entrenched management. The German Aufsichtsrat is usually considered a more effective watchdog than US or UK boards or the French conseil d’administration (Charkham, 1995).

Having now very roughly stated the independent variables in the analysis, it is time to apply them to the dependent variables, namely Lufthansa’s adjustments in its product market strategy and the organizational reforms required to support this strategy. In hindsight, the implementation of the product market strategy

18 adjustments described above required abrupt changes in the organization and in the organization’s “routines” (Nelson and Winter, 1982). A product market strategy based on network optimization requires an abrupt mind-shift in the way an airline positions itself in the global aviation market. Instead of seeing itself as a carrier designed to serve passengers flying to and from the home country, a network optimizer sees itself as the potential carrier for international passengers in all the countries it serves - and this means, in the case of European flag carriers, in a great deal of the world’s major markets. Yet for all of the European flag carriers studied, the transition from the protected-home-country paradigm to the global-market- positioning paradigm was neither a self-evident nor automatic nor easy executed development. With the benefit of hindsight, two organizational requirements posed by the recognition and implementation of the new strategy can be discerned:

1. The enhanced power of the marketing function over operations. In a purely functional organization, Operations is responsible for the planning and delivery of ground and flight services, whereas the job of Marketing and Sales is to sell the wares supplied by operations. The disadvantage of this bifurcation of tasks, generally speaking, is that operations managers worry only about minimizing costs (without calculating the effects of their decisions on revenues) whereas sales and marketing managers worry only about maximizing revenues (without concerning themselves with the cost implications of their demands). Thus arose the temptation to create geographic profit centers with operational costs allocated to selling areas, each responsible for generating more revenues than costs on its assigned route bundles. Once the need for network optimization is recognized, airlines create centralized departments that piace the planning functions (network functions, products) under the control of Marketing and often some of the delivery functions as well (ground and/or board service, for example).

2. Cross-functional interfaces. In hindsight, industry evolution in the 1980s called for tight coordination across airline functions in undertaking adjustments in product market strategy. It did not suffice for airlines merely to alter the reporting and power structure. For one thing, integration of information across functional areas was critical in being able to assess exactly which adjustments in product market strategy and in organizational structure to pursue. For another, certain tasks inherently required cross-functional teams, think tanks, or special staff because they could not be easily performed through the conventional hierarchy. Good examples are the interface between marketing and flight operations or between the sales organization and the network department.

Unilateral control and discretion in corporate governance can be reasonably expected to facilitate top management’s ability to decree power shifts like these. Similarly, a hire-and-fire culture can help make it easier for top management to overcome internal resistance to radical change. Furthermore, for promoting coordination between Operations and Marketing, a generalist managerial culture may be expected to provide an organizational asset in a period of rapid industry

19 change. Beyond reviewing the ways the absence of these stylized attributes of Anglo-Saxon firms appears to have affected Lufthansa’s capacity to adjust to changes in European aviation, the following narrative attempts to capture some of the specific effects of Lufthansa’s pattern of corporate governance on major strategic decisions. To provide a basis for comparison, discussion is prefaced by analogous changes instituted at British Airways.

Enhanced power of marketing. On 1 May 1982, British Airways restructured itself into three divisions (International Services Heathrow, European Services Heathrow, Gatwick Services). Yet hardly a year later, in July of 1983, all three division heads had been “retired” and an entirely new airline structure had been designed and put into place, this time based around eleven profit centers, entrusted to young internally promoted managers with a marketing orientation. All profit centers reported to a newly appointed Marketing Director. Though the cause of this flurry of activity was the appointment of Colin Marshall to chief executive in early 1983, the enabling condition was the formal authority vested in the chief executive under the UK system of corporate governance. Needing little more than the backing of the board John King, Marshall could unilaterally alter top management appointments.

At Lufthansa, we recall that Lufthansa’s CEO (Vorstand chairman) from 1982 to 1991 was Heinz Ruhnau, a product of elite political circles. Though it might be thought that Ruhnau’s civil service background would constitute an impediment to proper business decision-making and a handicap to Lufthansa’s strategic development, the record does not support this interpretation. Since his appointment, Lufthansa, the Vorstand, and especially Ruhnau were subject to intense scrutiny by the business press which regularly reported on decision-making and disagreements within the Vorstand. Ruhnau was under pressure to prove that he was no bureaucrat and he did: it was Ruhnau himself who in the mid 1980s campaigned against over-centralized decision-making and commissioned a consultant’s report lambasting the civil service mentality and organization of Lufthansa (Wirtschaftswoche, 29 Aug 1986). An important objective of the 1987 reform spearheaded by Ruhnau was precisely the objective of transferring the route and product planning functions to the commercial area, which meant taking them away from one Vorstand member (Finance) and giving them to another (Sales and Marketing).

This Ruhnau could not do unilaterally. Executive power is exercised by a collegial Vorstand, which has consisted of 6-7 members, generally including the Chairman, Finance, Personnel, Flight Operations, Maintenance (Technik), and Sales & Marketing. In fact, the decision to institute the organizational reforms of 1987 (decentralized route management and sales) was decided by a 5-2 Vorstand vote (Manager-Magazin, July 1987); the losers on the Vorstand announced their resignations by the end of the year. In retrospect, the reorganization was but the first in a string of Vorstand efforts to delegate decision-making, especially on the

20 sale and marketing side, to lower levels, even if this meant reducing the scope of consensus decision-making at the Vorstand level; as one trade magazine wrote, the Vorstand member for Sales and Marketing “has responsibility concentrated in one hand for which the whole Vorstand is responsible” (Deutsche Verkehrszeitschrift, 18 Sept 1986).

In fact, the struggle with marketing began much earlier. By 1984 at the latest, Lufthansa knew it had to improve its marketing image. Doing something about this was institutionally difficult. As mentioned earlier, the technical side of Lufthansa enjoyed a great deal of prestige and influence, as embodied by world the Vorstand member in charge of Technik, the highly influential deputy chairman Reinhardt Abraham, incontestably an expert on aircraft design. In 1984, the new Vorstand appointments in Sales & Marketing and in Flight Operations were warned via the business press: “As soon as the two divisions are led by inexperienced people, it will become clear where the strong men in the Vorstand sit: in the technical and finance- technical divisions, where authority tends to prosper on the basis of systematic thinking and attention to detail” (Per Spiegel. 3 Dec 1984). Gunther Becher (Finance) and Abraham allegedly formed a “technocrat cartel” in the Vorstand with whom even the “politician” Ruhnau had not yet found grace, and one of them warned: “It takes at least two years for a newcomer to get his way against the Vorstand routine of the others, and they can make a lot of mistakes at first from pure inexperience” (Ibid.). Clearly, such a corporate culture was antithetical to the rapid implantation of a marketing culture based on anything other than technical criteria.

Ruhnau knew he had to do something to upgrade the marketing side of Lufthansa. But German corporate governance institutions gave him little scope to do more than to propose new heads of Sales & Marketing on the Vorstand, especially when faced with a new Aufsichtsrat chairman close to the CDU Finance Minster from 1983 on. As it was, the marketing seat on the Vorstand turned into an “ejection seat” (Frankfurter Allgemeine Zeitung, 19 March 1993), a ten-year succession of appointment misfits. The 1984 appointee turned out to be largely an administrator and was forced into resignation in early 1990. He had not been able to revitalize Lufthansa’s marketing strategy, and in 1989 his division had been split into separate Sales and Marketing divisions, with the new Vorstand member of the latter being the above mentioned Falko von Falkenhayn (“Wirko von Wirrenkopf”) from BMW. The search for a new Sales Vorstand member lasted for the first nine months of 1990, with no Aufsichtsrat consensus on the ideal candidate emerging. Ultimately the Aufsichtsrat elected to promote Lufthansa’s corporate strategy director, acceding to the preferences of the employees’ representatives and against the preference of Ruhnau (interview sources; also mentioned in Wirtschaftswoche, 27 Sept 1990). Yet he too did not fit the bill, and not until 1993 did Lufthansa find a Vorstand nominee able to effectively lead the (reunified) Sales and Marketing division.

21 Though the form of corporate governance and Lufthansa’s technical orientation were clearly not an asset in enhancing the power of the marketing function, they do appear to have solved certain other problems rather well. Strikes were very seldom. As long as the Bund held the majority of shares, management and labor conspired effectively against shareholder interests to keep dividends low and build up hefty hidden cash reserves through accelerated depreciation of new equipment.5 Harmonious relations between management and labor allowed Lufthansa to come to a rapid agreement on introducing the two-man cockpit and compensating the flight engineers made redundant by the new technology; the issue was resolved by early 1983, whereas across the Rhine efforts to implement the two-man cockpit remained an object of chronic strikes at Air France and Air Inter until about 1989. Finally, though this is a personal judgment, Lufthansa’s system of corporate governance was relatively effective at monitoring the effectiveness of Vorstand members. Less able performers could be forced to resign, and the power of the CEO could be checked when necessary. The latter eventuality arose in the late 1980s when it became clear that Ruhnau’s do-it-alone growth strategy and overly ambitious projects (takeover of Interflug, excessive flights in Berlin, etc.) were motivated more by patriotic vision than by cool business sense. By 1989 at the latest, while the aviation business was still booming, the Aufsichtsrat was clearly manifesting defiance. (In contrast, Ruhnau’s far less able counterpart at Air France could not be evicted until 1993 when Air France employees occupied the runways).

Cross-functional coordination. In this area, too, the contrast with British Airways is illustrative. In 1985, the company launched a now famous training program for all BA managers called Managing People First. This exercise, tailored especially to BA’s needs, gathered many of the world’s most noted academics and consultants on managing change; the objective was to expose managers to feedback from other people on how they were perceived and to engender trust and cooperation between managers by teaching them to communicate better with one another. Perhaps more importantly, BA excelled at moving managers between functions, even and especially at a very high level. Since the importance of informational technology was indicated above, two career paths in IT serve as illustrations. The head of the IT department, John Watson, later became the director of Human Resources and then later the co-ordinator for the alliance with US Air. The IT strategy director, David Jones, had formerly worked in several back-room marketing functions (tariffs, yield, distribution, market research) and on cabin design (relaunch of Super Club), and after leaving the IT department he became head of Corporate Strategy.

The lack of cross-functional coordination and the dramatic need for it at Lufthansa may not have been entirely self-evident to the company’s management prior to its crisis of the 1990s. As recounted in the next section, events that transpired in the crisis year 1992 shed light on how the organization had functioned up until then as a set of functional chimneys, each reporting to its respective

5 “In no Lufthansa shareholders’ meeting of prior decades were the Vorstand and Aufsichtsrat so attacked by the private shareholders and different representative agencies.” Handelsblatt, 18 July 1984.

22 Vorstand head. Profound organizational reforms of the commercial side of the airline in 1987 and 1991 show how committed Lufthansa’s management was to decentralizing and delegating initiative to lower levels, yet also how these reforms failed to address the interdependencies between the company’s different operations. Lufthansa’s lag in recognizing the need to optimize hub connections and revenue management across its network fundamentally reflected the extent to which decentralization efforts simply prolonged an ingrained company heritage of functional compartmentalization. Lufthansa’s organizational reforms prior to 1992 were aimed at carving up responsibilities differently to counter the tendency of central bureaucratic control but not at promoting the strategic integration of activities across departmental and functional boundaries. All this can be inferred from the narrative in the next section.

5. After the crisis of 1992: Lufthansa’s turnaround and new corporate structure

The thesis of this section is that in adapting to pressures from its competitive environment, Lufthansa’s Vorstand was obliged to search for alternative routes to Vorstand-levei control of its operations. In other words, and somewhat pointedly expressed, top management was looking for solutions to dysfunctions associated with the system of German corporate governance. When in the first half of 1992 the monthly figures showed continuing losses due to declining yields, Weber and the Vorstand knew that drastic things needed to be done, especially after a chilling presentation to the Vorstand by the corporate strategist in March of 1992 extrapolating current trends and anticipating effects of European market liberalization analogous to the US experience (interviews; Manager-Magazin. July 1992). But what could the Vorstand do through hierarchical control? The Vorstand members are technical specialists of the most heterogeneous sort, not appointed by the CEO, but by the Supervisory Board as experts in their particular areas, and under the German system of corporate governance, the Vorstand chairman (Weber) had only one vote out of six. They could expertly monitor the numbers produced by their respective operational or functional areas, but were levels removed from that at which the impact of programmed cuts or other fundamental reforms could be assessed on an area-by-area basis. Thus even with a competent and cooperative board, a Vorstand-level coordination of the restructuring effort was technically unfeasible. As press reports disclose, Weber was deeply frustrated by the fact that Lufthansa’s problems were endlessly talked about, but nothing was done (Manager- Magazin. July 1992).

As documented in two inside case studies on Lufthansa (Mölleney, 1995; Lehrer, 1995), the Vorstand became attentive of a group of 25 middle managers one level below the Direct Reports. These selected middle managers, having attended

23 four weeks of off-site management seminars on change, became intent on inspiring action within their company. Study of other companies, especially Asian ones, had convinced these managers that to achieve competitiveness Lufthansa needed a fundamental "mental change" from compartmentalized responsibility to spontaneous unbureaucratic mutual assistance and informal networking across departmental boundaries. Such a culture change, in their view, could not be imposed by fiat; people needed to be persuaded to adopt new behaviours out of conviction. Thus, they resolved to campaign for change within their respective areas and undertake a number of cross-departmental initiatives that would demonstrate the benefits of the new culture, eventually engulfing the rest of the organisation. They called themselves "Samurai of Change", wore custom-made T-shirts with this motto at their workshops’ conclusion, and then began a campaign within Lufthansa to spread the gospel of cross-departmental cooperation and assistance. Their theory was that if they could set an example of spontaneous cross-departmental cooperation and produce results, other Lufthansa employees would emulate them.

Impressed though they were by the Samurai and their rallying cry of "mental change," the Vorstand had to decide how best to use them. In April, the Vorstand endorsed the idea of holding "mental change" workshops for the direct reports (the top managers reporting directly to the Vorstand), sensing that the change process could not be driven from the middle management level of the Samurai. The term “mental change” - in English! - became an integral part of company terminology. Two weeks before the event, in view of the deteriorating financial situation, Weber changed the workshop title from "mental change" to "crisis staff meeting.” It was clear that drastic actions were needed immediately.

Weber opened the June meeting with an impassioned plea: 'Lufthansa ist ein Sanierungsfall! We cannot count on Bonn to give us a subsidy. If we can't stop the bleeding, we face bankruptcy.” With most of Lufthansa’s top managers present, the group had the authority and knowledge of internal operations to work out a recovery plan to improve results by DM 1.5bn annually through a formula of personnel cost reductions, non-personnel cost reductions, and revenue improvements. The involvement of employee and union representatives in monitoring Lufthansa’s results and management practices was very high. This explains why once the rescue program was more or less finalized in August, it could be almost seamlessly introduced into the current round of wage negotiations on the contract expiring August 31. A new contract with DM 500m of labor concessions was signed on August 31 without a strike, the unions agreeing to a wage freeze (a "zero round") and greater flexibility in work assignments.

The crisis workshops also deepened the understanding of the need for a central "brain" to maximize network benefits. Managers from the different geographic regions (“Areas”) agreed to present a recommendation to the Vorstand for the creation of informal horizontal links across the organisation, to complement and compensate for the formal division into Areas. After having its attention drawn to the

24 matter by McKinsey consultants, top management was now clearly focused on “network maximization”; this was one of the fundamental conceptual outputs of the 1992 “mental change” process (source: interviews), and in the fall Lufthansa and McKinsey analysts began work on vastly improving the IT tools for scheduling and pricing. “Up to now the success of individual routes stood at the center of our efforts; in the future we have to concentrate on the profitability of the entire network” (IT head Dr. Peter Franke in Der Lufthanseat. 5 Mar 1993). The decision to set up a formal centralized network management department, by now only a question of time, was taken in November of 1993.

Another major strategic adjustment that emerged from the turnaround process concerned Lufthansa’s partner strategy. It was clear that Lufthansa needed a US partner if the company was to build up a proper global network and regain profitability over the North Atlantic. Until 1993, the prevailing wisdom for European carriers was that taking an equity share in one of the smaller US airlines was the only way of assuring both stability and equality in the relationship. But as the appropriate US candidates either selected other foreign partners or proved unsuitable investments for other reasons, Lufthansa ultimately realized it had to risk an alliance with one of the mega-carriers and opened negotiations with American and United. This required another round of “mental change” within Lufthansa, for it signaled a dilution of Lufthansa’s identity as a German carrier ,6 An agreement with United was signed in October of 1993, and after marathon negotiations with the US government a German-US memorandum of understanding in March of 1994 gave the green light to code-sharing (allowing Lufthansa to list partner's connecting flights under Lufthansa flight numbers and vice-versa, effectively merging the two networks). The alliance was a resounding success, generating 1000 excess bookings per day since its inception. Lufthansa subsequently added Thai Airways (1994) and SAS (1995) to its global web of alliances.

This episode in Lufthansa’s strategic adjustment is also pertinent to the present discussion for another reason: the shift in alliance strategy and the tasks required to implement it constitute one of those discontinuities that required intense cross­ functional coordination within the company, in this case between Marketing, Corporate Communications, Corporate Strategy, and Aviation Policy. The manager in charge of Lufthansa’s aeropolitical negotiations told the following illustrative anecdote of how political resistance on the American side was overcome:

We listed all the points [showing that Lufthansa didn't have the same rights to compete in the US market that American carriers had in Europe]. But we needed a motto to neutralize the American motto of "open sky." And the motto we found was "occupation rights." The aviation agreement of 1955 was a product of American occupation rights at the time. We undertook concerted action. I gave many interviews on television and in the papers, here and with German reporters in the US. Mr. Weber also gave interviews and we always sent the same message: this is an unfair agreement, a relic of occupation rights, it's protectionist,

6Indeed, in December of 1993, a newly reformulated marketing strategy clearly stated that Lufthansa was a European rather than German carrier (Der Lufthanseat, 10 Dec 1993).

25 the US clings to it because of American interests. It was in all the papers, and "occupation rights" was something the layman could grasp (unlike "code-sharing" or "fifth freedoms"). Pressure mounted on the US government when its German embassy began reporting that this was a major topic in the media of a leading trade partner ... And we told potential partner carriers in the US that we had to do all this in order to create a legal basis for an enduring strategic alliance.

This story shows that aviation policy today is much more interdependent with Communications, Strategy, and commercial interests. No longer can I institute my own separate work process and say: "First Marketing and Sales have to define our interests, then I go to Bonn and ask the government to renegotiate, and then I carry the result home and report on it to the company." If it weren't for the Samurai workshops, I would never have coordinated aviation policy with the other departments in the way I did. (quoted from Lehrer, 1995)

Returning to the DM 1.5bn recovery package mentioned earlier, it is worth noting how implementation of the package preceded as an indication of the extent to which CEO’s power was circumscribed by the German governance system, where neither fire-and-fire nor unilateral CEO control was possible. It was one thing to obtain some verbal commitments on cost reductions and the like, quite another to make sure they were followed by concrete, and painful actions. The Vorstand appointed twelve senior managers, mostly from the workshop group, to a special "San Team" (Sanierungsteam') to monitor implementation of the agreed measures (with help from the corporate controller). The San Team met three times during the summer, but soon proved too large and heterogeneous to function effectively. Attendance dwindled as members were too occupied by regular business to attend lengthy discussions of detailed matters unrelated to their own area. Implementation of the recovery package became the task of a small team of initially just three trusted managers and one external consultant designated by Weber, the "Operations Team" or Ops team for short.

Though never invested with much official power, the Ops team set up shop in the symbolically important vicinity of Weber's office in Frankfurt. They set the agenda of the San Team while it lasted; produced minutes, analyses and position papers; co-ordinated where they could and, most of all, they talked with many managers individually about the earnestness of the cost-cutting program. Together with the Controller’s office the Ops team tracked progress against targets. Extensive calibration efforts were required among different parts of the company, each of which went about cost-cutting in different ways. As the Ops team's knowledge of the organisation increased, they began to propose changes of their own, especially in the highly complex Passenger Division whose head had his hands full with revenue- and yield-enhancing projects. Just how critical the Ops team was - and its link with nature of German corporate governance - was attested by Weber:

The way I selected the Ops team was on the basis of trust, in both competence and loyalty. I had to walk a very narrow path between maintaining a working atmosphere in the Vorstand and getting difficult and necessary things done for which a quick consensus of the Vorstand was not possible. The San and Ops teams contributed a lot. The early regular meetings of

26 the San team allowed me to personally increase the pressure on a whole range of line managers. The Ops team pointed us down the right path, sign-posted this path and, though excessive at times, it was never in the wrong direction, (quoted from Lehrer, 1995)

To argue that the process by which top management implemented and monitored Lufthansa’s restructuring was conditioned in part of the nature of German corporate governance is not to deny that the same sort of process could occur in an Anglo-Saxon airline or that a more directive top-down implementation and monitoring would be impossible in a large German firm. There doubtless exist English firms whose board composition significantly restrains the unilateral power of the chief executive, just as, inversely, Vorstand chairmen in some German companies may enjoy such unwavering support from the Vorstand and Aufsichtsrat as to be able to impose their will almost unilaterally. The argument made here is simply that the rules of German corporate governance make it far more unlikely the Vorstand chairman will have the same unilateral powers as the CEO of an English or American company and will therefore have to envision means other than direct hierarchical control to engender and monitor the fundamental restructuring of the company.

6. Outlook: Lufthansa’s new corporate structure

Even after returning to profitability, the saga of finding alternatives to Vorstand-level control over decisions continued. Weber and his colleagues knew that in the longer term yields would continue to decline while profit pressures would increase with privatization. An ever greater share of Lufthansa’s revenues was generated outside of Germany, yet its cost base was still largely in the expensive Standort Deutschland. As further wage concessions could not be expected,7 Weber pinned his hopes on a new corporate structure of internal markets to create greater cost transparency and initiative at lower levels. Concretely, the plan was to split Lufthansa into several legally separate companies: Cargo, Technik (maintenance),and Systems (data processing) would all be separated from the mother company Lufthansa AG. The Aufsichtsrat approved the business plans for three units becoming legally independent companies on or before January 1, 1995: Lufthansa Cargo AG, Lufthansa Technik AG, and Lufthansa Systems GmbH (data processing, with a 25% share sold to EDS).

The new corporate structure required a deep change in the functioning of the Vorstand, Lufthansa’s executive board. It had previously been composed of a chairman and five functional heads (Finance, Personnel, Maintenance, Flight

7 By 1994, steward and stewardess positions had been more or less deprofessionalized. Cabin crew positions at Lufthansa are filled mosty by young people with modest pay who do not and cannot expect to hold to have lifetime career in cabin service.

27 Operations, Marketing) who decided policy on a collegial basis with majority voting.3 Under the new corporate structure, the mother company Deutsche Lufthansa AG was left with only the Passenger Division and the corporate functions: the formal Vorstand functions finance and personnel, plus others such as corporate controlling, strategy, facilities, and government relations, all reporting to one of the Vorstand members. Though remaining a collegial decision-making body, the Vorstand would be henceforth composed of two distinct roles (see Figure 3).

On the one hand, three Vorstand members (Chairman, Finance, Personnel) would have corporate-wide responsibilities, while other two (Marketing, Operations) had functional responsibility for the activities of the Passenger Division. The rationale was that while the Passenger Division would transact with the newly formed legal subsidiaries on an increasingly arms-length basis, the Vorstand would monitor the overall process. Moreover, even within the Passenger Division, the reform was designed to institute more market-like relationships between Marketing and Operations; the idea was that Marketing might eventually contract out for planes and crews to outside suppliers (just as Operations might contract out for maintenance to suppliers other than Lufthansa Technik AG) while Operations might conversely find supplemental purchasers of its capacity outside the Lufthansa group (Lehrer, 1995).

The upshot of this corporate reform is that it reduces the scope of company issues subject to consensus decision-making in the Vorstand. Arguably, the decision to go for legally independent units rather than merely internal company profit centers was again necessitated by a German governance system based on consensus decision-making at the top and substantia! job security for managers. Whereas a firm like British Airways could and did impose harsh profit and cost targets on individuals units with stiff employment consequences for non-fulfillment, Lufthansa was institutionally locked into a system of units reporting to different Vorstand heads having the responsibility of understanding the interests and problems of their particular areas. It can be argued that whereas a company like British Airways with unilateral CEO control and hire-and-fire personnel policies can effectively impose cost reduction and profit improvement pressure fairly effectively through the hierarchy, Lufthansa with its governance structure and longer-term employment contracts could only realistically hope to do so by exposing these units through legal company independence directly to market pressures.

8 Major decisions required the backing of Lufthansa’s Supervisory Board as well, with its ten shareholder and ten employee representatives.

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31 sooo

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Source: CAA (1994:167) FIGURE 1

Figure 5.1 BA Fare Developments 1984-1994: London-Johannesburg Europe - New York

New York - Europe

Fares Between Europe and New York 33

Source: CAA (1994:190) FIGURE 2 New Structure of Lufthansa Group

Oktober 1995

FIGURE 3