NB: This is a viewpoint from Alex Dietz, principal industry consultant for the SAS hospitality and travel practice.
American Airlines’ recent announcement that it has revamped its domestic fare structure is a big deal.
While American has previously tried to simplify domestic airline pricing (1992’s well-documented “value pricing” structure), I fully expect this latest move to take hold because it is a logical next step in airline pricing and revenue management – one that ties in with recent industry trends.
However, this type of pricing structure places further pressure on revenue management systems, which are desperately trying to keep pace with the industry’s structural price and distribution changes.
The Development of Airline Revenue Management
After decades of stability, the airline industry saw its first big change (from a pricing perspective) following the deregulation of the US domestic market in 1978.
Besides simplifying the process for forming new airlines, and allowing airlines greater flexibility in choosing where to fly, this act gave airlines control over how much to charge for their service. Airlines did indeed proliferate, and many new types of fares were introduced.
By the late 1980’s, the industry had begun to settle into a carefully-coordinated set of practices commonly known today as revenue management, which utilized analytics to forecast passenger demand and optimize pricing on each and every flight. Revenue management systems were developed based on sophisticated algorithms – and airlines with better technology in this area had a distinct advantage in maximizing revenues.
A New Era of Competition
The period from the mid 1990’s through the early 2000’s saw two significant trends that would begin to shake the structure of airlines that depended on sophisticated revenue management solutions:
- Low fare carriers expanded aggressively. These carriers distinguished themselves from their grown-up counterparts by focusing on cost, rather than revenue. Their simplified services and fare structures set a significant challenge for the network carriers.
- Internet distribution allowed customers to shop in a way never before been possible. Suddenly, every difference in price was visible to even casual buyers. This had an immediate impact on the leisure market – but the real long-term impact was on business travel. Business’ purchasing rules regarding travel became more stringent, enabled by fare visibility.
These changes resulted in reductions in the number of fare restrictions on many fares – and a resulting reduction in the overall number of fares in each market. Simplified fare structures had won the day.
The Hidden Cost of Fare Simplification
Lost to most consumers, but clearly recognized by airline revenue management practitioners, was the cost of these changes to airline revenue management. Airline revenue management algorithms were tightly tied to the older, more complex fare system of tight restrictions. Those restrictions had allowed revenue management systems to presuppose a certain level of independence between the purchase behaviors of customers on different fares – in essence, assuming that a customer for one type of fare was not really a customer for another type of fare.
In a simplified fare market, this assumption began to fall apart – and the more simplified fare structures became, the more 'sticking plasters' were required to enable revenue management systems to deal with these fare structures and attempt to optimize revenues.
The Unbundling Period and American Airlines’ New Approach
If the first post-deregulation period was about revenue management, and the second period was the “low fare” or “fare simplification” period, then the third wave is clearly the unbundling period.
Unbundling – charging separately for services like baggage handling and meals that were previously included with every fare – has swept the airline industry in the post-2008 recession period. According to the annual Amadeus Review of Ancillary Revenue Results, airlines produced $22.6 billion in ancillary revenues in 2011. Amadeus recently projected that this number would reach $36 billion in 2012.
From a marketing and revenue management perspective, there are a number of problems with airline unbundling, including:
- Unbundling makes purchase transactions more complex – something that increases costs, which customers do not like, and will avoid
- It opens up opportunities for carriers to differentiate themselves – based on the fact that they choose not to charge for ancillary services
- Most unbundled services cannot be purchased via online travel agencies – a primary outlet of ticket sales
American’s approach to fare re-simplification is to simply re-bundle services that it had previously unbundled – but to do so with a fare structure that places explicit charges into the ticket for these services.
American is not the first airline to create branded “fare families” – other carriers have used common, branded fares to simplify their offerings to the customer. Other carriers have also dabbled in creating fare families using previously unbundled services. It is for exactly this reason – the overall approach is far more evolutionary than revolutionary – that I expect this move to stick.
The Revenue Management Impacts
From a revenue management perspective, this change has both benefits and drawbacks. On the positive side, allowing previously-unbundled services to be purchased at the time of ticket purchase will allow American to include those revenues when segmenting travelers and determining fare availability on each flight – something that is difficult when those purchases are made separately. Of course, some passengers will still purchase these services a la carte, so not all of the unbundled service revenues will be controllable.
On the other hand, while American’s fare structure is simplified from a customer perspective, it is actually quite complex from an analytic perspective. Just as earlier simplified structures offered the customer opportunities to choose from different options, rather than being pre-slotted into a specific segment, this new structure gives the customer choices.
The difference is that now those choices are going to be driven by a variety of incentives – baggage fees, frequent flyer points, seat choice and boarding priority, and so on. And once again, existing revenue management algorithms are poorly suited to the task.
A number of academics and revenue management scientists have postulated that the time series forecasting techniques that have driven revenue management systems would be better replaced by choice models – models that predict customer choices based on attributes (such as price and, in this case, the attributes of each fare) – and how consumers have chosen when similar alternatives have been presented in the past.
Choice modeling is very exciting and sophisticated – and a process that has already seen use by airlines in the context of setting flight schedules. But choice models are extremely data-hungry, and capturing the full complexities of airline fare choices in these models is not easy – nor is using such models to determine optimal pricing, even if the models could be properly calibrated.
I fully expect choice modeling to continue to dominate discussions regarding the future of airline revenue management – and I expect airlines to continue to innovate in the form of fare structures and bundling. These programs have already proven their value, and revenue management science will need to catch up to the realities of the market once again.
NB: This is a viewpoint from Alex Dietz, principal industry consultant for the SAS hospitality and travel practice
NB2: Shopping trolley image via Shutterstock