Over at Conde’ Nast’s Daily Traveler, Cranky Flier argues that profitable airlines make investments in product and the title of the post asks whether airline fees are starting to pay off for passengers — the idea is that fees helped make airlines profitable, so fees are driving a better flight experience.
Hack My Trip contends therefore that coach passengers are subsidizing the premium cabins since it’s passengers in back paying ancillary fees while those up front get the better amenities.
And then he talks himself into a headache making heads or tails of his own argument.
Now we have a twisted circle where economy class passengers pay ancillary fees to subsidize amenities for first class passengers in order that first class fares remain competitive so that first class passengers will still buy tickets and subsidize the economy class fares. It’s all starting to give me a headache.
And I start to wonder, do we all just need to step back and remind ourselves how airline pricing works, and about the difference between average cost and marginal cost?
Both High and Low fare Passengers Can Be Profitable
Airlines practice ‘revenue management’ in order to charge passengers as close as possible to the amount they’re willing to pay. If a customer isn’t price sensitive, if they really need to travel, why charge them $200 when they’ll pay $1000?
At the same time, if you aren’t going to fill up all the seats on the plane at $1000, you are happy to see the extra empty seats go for very little. Because it costs next to nothing – certainly less than $50 – to cover the incremental cost of an additional passenger. Virtually any revenue you get is going to be gravy, enhancing your bottom-line.
Airlines live off of high fare passengers, and especialy frequent high fare passengers. But once they decide to fly a route, and once any seat is otherwise going to go empty, the revenue from low fare passengers goes straight to the bottom-line.
They won’t make money on low fare passengers alone. But once they’re going to operate a flight, a decision driven by expectations of a certain number of those higher fare passengers (for most airlines), the cheap tickets will help fill seats that tip them from running in the read to being profitable on a given flight.
Why Airlines Charge Ancillary Fees
On the whole coach seating is an unpleasant experience, although some would argue that a little bit more legroom on JetBlue or the pimped out entertainment technology on Delta or Virgin America can make things a bit more tolerable.
Consumers love to rail at the airlines but we get the coach product we actually want, or at least the product that on the whole people are willing to pay for.
American Airlines experimented with ‘More Room Throughout Coach’ — extra legroom for all passengers in the cabin. But they couldn’t get people to book away from other airlines with the product, and they couldn’t earn a revenue premium with the product. It didn’t make financial sense for them, and they ripped out the seats, since people still preferred the lowest price for less comfort (at least enough people did that they couldn’t afford to give everyone more room).
In contrast, United’s ‘Economy Plus’ model survived where a certain number of seats on each flight have additional legroom, and customers get those seats either by buying frequently from the airline or by paying extra for them on a given flight. They earn more from those seats, so it makes sense to offer them.
Ancillary fees accomplish two things:
- They unbundle prices, to let consumers pick and pay for those services that they want and not those they do not.
- They shift funds away from the ticket price. Airfares are subject to a 7.5% federal excise tax. Ancillary fees are not. So the more revenue that can be moved out of the ticket and into ‘fees’ the lower the tax and more revenue kept by the airline.
When – And Why – Airlines Don’t Charge Ancillary Fees
Elite frequent flyers may or may not be paying a high fare on a given trip, but airline frequent flyers contribute an outsized portion to the bottom-line. Frequent customers as a group are profitable and treating them well retains them, at least that’s the bet, so if some services are offered free it creates a reason for those customers to continue to choose the same airline.
While there may be individual unprofitable customers, airlines are making money on their frequent flyers even if they give them the occasional free checked bag.
Certainly their total revenue contribution to an airline is much greater than the occasional passenger, even if the once a year traveler pays a checked bag fee. And since in an industry with high fixed costs and low marginal costs the determinant of whether an individual flyer adds value to the bottom line is the total revenue generated (as low as each ticket is sold meaningfully above marginal cost), the airlines make money by comping those checked bags.
Additionally, paying high fares such as intenrational business class tickets — which may cost $4000 or $10,000 or more — companies may be willing to shell out the fare but not pay for individually itemized charges like cocktails on an employee’s expense report. Bundling free drinks and bedding is a way of encouraging the employee to select the airline, directing their employer’s resources to that airline’s seats. It’s precisely because those customers are profitable that airlines want to spend more to bid for their business.
The very fact that airlines ‘give free’ bedding and drinks and checked bags is an indication that the airline believes the fare paid is a profitable one. And in fact they aren’t giving the passenger those things for free, they’re just bundling them into the ticket price.
Do Coach Passenger Fees Go to Pay for Business Class Blankets?
That’s a pretty easy one, no.
Airlines aren’t a charity, looking to have (as Hack My Trip says) “Joe Sixpack paying baggage fees so Ritchie Rich can get Heavenly bedding and a lie-flat seat?” Airlines aren’t regressive redistributionists, either.
They are charging ‘Joe Sixpack’ what they can for the services provided. And they are giving services they believe necessary to compete for the business of ‘Ritchie Rich’ or whatever mid-level manager is buying the premium cabin seat as well.
The confusion comes in because Cranky Flier suggests that premium services and investment in product comes from profitable airlines. But it’s not that they’re using the profits to then ‘pay for’ the premium services. They’re paying for the premium services as a way to seek even greater products.
When airlines are losing money, the first thing they try to do is stop the bleeding. It’s harder to justify an extra olive in a first class salad because usually there’s little evidence to suggest that the olive will make a difference either way in a customer’s purchase decision.
Unprofitable companies tend to have an accumulation of decisions over time that are costly, and a bankruptcy process or other restructuring including cutbacks can be a way to start fresh. Sometimes you cut good investments along with the bad, but if you don’t do that then it’s easy to make the case one-by-one for each status quo decision — the sum total of which were leading to losses.
In addition, unprofitable carriers don’t have nearly as much access to capital , or inexpensive capital, as profitable ones.
Turn things around and you can buy expensive new products at lower interest rates. Profitable carriers pay less for new product investments, so those investments can make more sense.
But none of that has anything to do with taking checked bag fees and ‘using that money’ to pay for champagne or pajamas up front. Rather ancillary fees have been a part of the way the industry has recovered — raising more revenue on customers who are obtaining greater service from the airline at a time when flights are also filling up and they’re in a position to do so. And newly profitable carriers then look to invest in product as the next way to making more money, attracting more high yield passengers, since planes are full and they can’t just sell more seats without engaging in even costlier strategies like operating more flights (where they’d likely b trying to fill seats at a lower price).
So Who Is Subsidizing Whom?
The premium product investments that Cranky Flier and Hack My Trip are talking about are:
- A partnership with Westin to bring their Heavenly bedding to business class cabins.
- The installation of those lie-flat beds in business class cabins.
- Renovation of Delta SkyClubs.
- Adding WiFi and Economy Comfort seats to the economy class cabins.
Oddly enough these are the least likely candidates for accusations of ‘subsidy’.
There’s a cross-marketing relationship between Delta and Starwood designed to generate incremental business for both companies, so branding bedding with the Westin name doesn’t come out of someone’s checked bag fees. United previously tried a marketing tie-in with Westin (ironically enough, United used to own Westin hotels). And they had a Westin ‘Renewals’ lounge in at least one of United’s Red Carpet Clubs about four years ago.
Lie flat beds are what people are paying several thousands of dollars for, several multiples the price of a coach ticket, it seems uniquely odd to say that an $800 ticket is subsidizing the $8000 one. And if it was, why would the airline do it?
Delta has been renovating Skyclubs but also cutting back on the free booze and increasing the price of those clubs. I don’t think there’s a credible claim that the profit and loss accounting for the clubs requires a transfer payment from checked baggage.
Charging for inflight wireless internet is something that currently isn’t even bundled into the price of a premium cabin ticket, it’s generaly paid for by both coach and business class passengers alike. Moreover, airlines install wifi because if they don’t passengers will book tickets on other carriers instead. US Airways made their decision a year ago to install wireless internet not because they were going to make money on usage fees, but because they saw they were losing business to airlines with wifi.
The idea of a ‘subsidy’ in this context just doesn’t make sense. You have high fare passengers covering an airline’s fixed costs, and low fare passengers more than covering the airline’s marginal costs. Together they can generate profits.