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How Airlines Can Cut Costs — Without Annoying Customers

Date: June 14, 2021

By Daniel Deneffe and Herman Vantrappen, Harvard Business Review

As airline companies prepare for recovery, they have a unique asset to leverage — their loyalty programs. These programs are valuable both from a balance sheet perspective because they can be used as collateral for loan programs and from an income statement perspective. Airlines can use frequent flyer miles in an “a-la-carte options” approach to reduce those costs that are under their control without annoying customers. In fact, they can make customers equally well or better off.

Some business sectors chronically lose money but are adored by customers — ride-hailing services, to take one example. Other sectors are highly profitable yet not so well-regarded; tobacco may come to mind. And then there are sectors that are barely profitable and intensely disliked by customers; airlines certainly are a candidate here.

The Covid-19 pandemic obviously had a dramatic negative impact on air travel demand, but weak profits long predated the pandemic. Average economic profits of airlines (i.e., the return on invested capital minus the cost of capital) were negative for 20 years until 2015, when they turned slightly positive before dipping back into the red by 2019. The story isn’t much better when it comes to customer experience: Airlines are among the five most hated industries in the United States and have been in the bottom 20% of companies ranked by the ACSI (American Customer Satisfaction Index) since it was introduced more than 20 years ago.

Fortunately for the industry, however, it is not all doom and gloom. Travel is expected to return to a growth path over the next few years. And as airline companies prepare for recovery, they can leverage a unique asset — their loyalty programs. These programs are valuable both from a balance sheet perspective because they can be used as collateral for loan programs and from an income statement perspective since frequent flyer miles can be used in an “a-la-carte options” approach to reduce costs under airlines’ control — without annoying customers.

What are a-la-carte options?

A-la-carte options differ from the traditional a-la-carte pricing through which airlines, in an attempt to increase revenues, charge passengers for all kinds of ancillary services. For some, such as Spirit, these fees can account for about 50% of revenues.

But the effectiveness of these practices is limited because, as behavioral economics research tells us, people typically prefer to avoid losses over acquiring equivalent gains, and, when customers have to pay for something that used to be free, they interpret this as a personal loss. Perhaps as a result, a-la-carte pricing has led to a public backlash against some airlines, such as Ryanair, which was forced to drop a plan to charge a fee for the use of restrooms.

There is a ceiling to what customers will pay for the total flight experience, and some may simply switch to other airlines that don’t charge these fees. The sky is not really the limit. Consumer demand is.

The a-la-carte options approach is a better way for airlines to control costs because it applies a reward-instead-of-penalize logic. First, it identifies services that have a sizeable variable cost component and that competitors offer for free — for example, the use of third-party airline lounges or late check-in windows. It then offers customers the option not to use costly services and rewards them for exercising the option with something less costly: frequent flyer miles.  While these have a high perceived value to passengers (as we saw in the movie Up in the Air), the actual value to them is only about 1.3 cents per mile. For the airlines, miles are very low cost, with estimates ranging from less than $0.001 up to $0.01 per mile.

How a-la-carte options could work in practice

Consider the case of lounges not run by the airline or one of its alliance partners. Business-class tickets typically offer passengers the option to use lounges, and when access is free, passengers are likely to do so if visiting is even just marginally more desirable than not. That’s fine if the airline or a partner owns the lounge, since the marginal cost of a passenger visit is small. However, if the airline does not own the lounge, the third party charges the airline about $25 per visit. Passing that fee onto the customer is out of the question since the benefit is included in the higher-class ticket price. But with a-la-carte options, the airline could propose the following: “You are welcome to use the lounge. If you choose not to, we are happy to credit your account with 250 miles.” Assuming a $25 cost per lounge visit, the airline gains anywhere from $22.50 to $24.75 per passenger who chooses this not to visit the lounge due to this option.

Moreover, this option doesn’t hurt any passengers, as those who value the lounge can still use it at no charge. Waste is thus being eliminated in a win-win way. Using the $22.50+ gain and some reasonable estimates of the number of business-class passengers who would take advantage of the option leads to annual savings (excluding the cost of adding this option) of millions of dollars.

Another example of how a-la-carte options could reduce costs is by incentivizing passengers to check in early at airports. For long-haul international flights, many people still check in on site, so the airline needs many agents at its counters at peak times. While airlines do recommend arriving three hours before non-domestic flights, most passengers check in only one to two hours before departure, which means agents have plenty of idle time to talk about their weekend plans.

While airlines cannot penalize passengers for checking in closer to their flight times, they can offer an a-la-carte option, such as a credit of 100 miles in exchange for arriving two to three hours early instead. Again, the cost of offering these miles is negligible. However, with more people checking in earlier, agents would be continuously busy and airlines wouldn’t need as many of them working each international departure. We estimate that this could lead to annual savings that again run in the millions.

Some hotel chains have implemented a similar strategy, offering rewards points for guests who choose not to have their rooms cleaned. The benefits of a-la-carte options are higher in the airline industry than in others because of the asymmetry in customer value and supplier cost:  the value of an airline mile is much higher to the customer than its marginal cost to the airline. In addition, an a-la-carte options approach does not require extensive data analyses about “miles elasticity” before implementation, simply because miles are so cheap. If 100 miles does not induce much change in customer behavior, just raise the incentive to 250 miles and see what happens.

The above examples show that a-la-carte options schemes are likely to both reduce costs and increase loyalty and revenues. No passengers are worse off, and those who exercise the option are better off since they chose to do so.  That means they will also be more likely to select the same airline in the future.

Admittedly, a-la-carte options will not have a bottom-line effect of the same magnitude as, for instance, fuel price changes. However, fuel prices are not under airlines’ control. Given the limits to a-la-carte pricing of ancillary services, airlines would benefit from brainstorming and creatively identifying other a-la-carte options beyond the two illustrative examples above. Eliminating the abuse yet not the use of costly services is a vehicle to tackle dwindling profits.

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