THE ECONOMICS OF UNBUNDLING AIR TRAVEL SERVICES. Richard KLOPHAUS

Transcription

1 Klophaus 1 THE ECONOMICS OF UNUNDLING IR TRVEL SERVICES Richard KLOPHUS Worms University of pplied Sciences, Competence Center viation Management, Erenburgerstraße 19, D Worms, Germany Phone: , Fax: , klophaus@fh-worms.de STRCT Many airlines have adopted a strategy to unbundle their services in order to create additional revenue from non-ticket sources. The present paper first provides an overview on the airline practice of unbundling air travel services into core air travel and optional services. The modelling approach focuses on the economics of offering à la carte features at an additional charge. Despite of its widespread use no economic literature exists on the optimality of unbundling air travel services. y contrast, there is voluminous economic literature on bundling. Unbundling air travel services into its core product and optional services turns bundling into its opposite. Hence, by reviewing normative guidelines on bundling the present paper examines the profitability of unbundling. s a result, this paper derives some guidance for airlines trying to increase revenue and profit through unbundling. 1. INTRODUCTION ncillary revenue has become a key revenue component for airlines throughout the world. The present paper focuses on ancillary revenue generated by à la carte pricing. It describes the practice of à la carte pricing among European airlines using the example of Ryanair, the leading LCC in Europe. Ryanair is often considered as pioneering airline of the à la carte business model unbundling its services into core air travel, charging very low base fares while offering an increasing list of optional services at a fee. No published research exists on the optimality of unbundling air travel services. However, the advantage of unbundled sales of components of a composite product by one firm has been subject of research on bundling in economics and marketing. Today, a plethora of normative guidelines can be found for the bundling of two or more products and/or services to specially priced packages as recently reviewed by Venkatesh and Mahajan (2009). Unbundling services into core product and à la carte items is the opposite of pure bundling. Hence, building upon previous research on bundling the present paper evaluates the impact of à la carte pricing with add-on services to basic air transport on airline s revenue and profit. The following section outlines the current practice of à la carte pricing among airlines to generate ancillary revenue. Then the main section of the present paper examines the economic rationale for à la carte pricing using the methodological framework provided by Guiltinan (1987). The purpose of the analysis is to identify demand conditions under which à la carte pricing and unbundling lead to gains or losses in revenue and profit. The closing section summarizes the paper s results. 2. NCILLRY REVENUE ND À L CRTE PRICING ncillary revenue has been defined as revenue beyond the sale of tickets (Ideaworks, 2009). Further, three categories of optional services leading to ancillary revenue have been differentiated: À la carte features: seat selection, priority check-in, onboard sales of food and beverages, etc. Commission-based products: commissions earned on the sale of hotel accommodation, car hire, travel insurance, etc., primarily via the airline s website. Frequent flyer program: sale of miles or points to program partners.

2 2 Transportation and Urban Sustainability The present paper focuses on ancillary revenue generated by à la carte pricing. This label is taken from the hospitality industry. If you eat à la carte, you choose each dish from a separate list instead of eating a fixed combination of dishes at a fixed price. Each item on the menu has a separate price. À la carte pricing clarifies the value of optional services. The success of à la carte pricing depends not only on the proper control of price variables but the right combination of marketing tools, that is the entire offering to consumers often referred to as the 4 Ps of the marketing mix. À la carte pricing in the airline industry first involves decisions on the product, for example, how to unbundle air travel services into basic air transport and optional services in order to meet the needs of specified target markets. The sale of optional services does not necessarily occur at time of booking (website, call center, travel agent) but also during travel at places like the airport or onboard during the flight. With regard to promotion of unbundled services an important question is how and when information concerning add-ons and the respective fees is communicated to the target audience. From the consumer s perspective à la carte pricing can be beneficial. More specifically, there is a plausible argument that consumers who do no book add-ons only pay for basic air transport without cross-subsidizing other consumers. The present paper exemplifies à la carte pricing among airlines using the example of Ryanair. It is not only the leading LCC in Europe but has also become the world s largest international scheduled airline by passenger numbers. t the end of the fiscal year 2009 Ryanair operated a fleet of 181 oeing and transported 58.6m passengers. Ryanair s ancillary revenues increased by 22.5% from 488.1m in the fiscal year 2008 to 598.1m in the fiscal year 2009 (Ryanair, 2010). This represents 20.3% of Ryanair s total operating revenue of 2,942.0m. The ancillary revenue stream from so-called non-flight scheduled operations amounted to 425.8m and includes revenues from excess baggage charges, debit and credit card transactions, sales of rail and bus tickets, accommodations and travel insurance. In-flight sales of beverages, food and merchandise led to 83.2m and internet-related sales, that is commissions received from products sold on websites linked to Ryanair s website to another 56.9m. contract with Hertz car rental added 32.2m revenue. ncillary revenue per booked passenger was It is not difficult to generate test bookings on Ryanair.com where à la carte fees are a multiple of the base fare even without fees charged for travel extras like sporting equipment. Ryanair s ancillary revenue earned from à la carte pricing alone cannot be estimated from the published components of ancillary revenue. The category of non-flight scheduled operations as the primary source of ancillary revenue contains revenue from à la carte features but also from commissions. On the other hand, Ryanair does not count fees on checked baggage as ancillary revenue. These fees are added to the so-called scheduled revenue of 2,343.9m in the fiscal year Some of Ryanair s à la carte items and associated fees are published on the airline s website (Table 1). The price list for onboard sales of drinks, snacks etc. is not available on the website. Table 1. Ryanair s à la carte items (excerpt) Item Description Fee Online check-in Not charged, only on some promotional fares 5 online / 10 call center dministration For payments made with credit card; per passenger / per one-way flight 5 Priority boarding Per passenger / per one-way flight 4 online / 5 other* 1st checked bag 15 kg allowance / per one-way flight 15 online / 35 other* 2nd checked bag 15 kg allowance / Per one-way flight; maximum 2 bags per passenger permitted 35 online / 70 other* Excess baggage Per kilo, can only be purchased at airport 20 * ooked via call center or at airport; Source: Ryanair.com, visited 30th June 2010.

3 Klophaus 3 It is arguable whether online check-in should be listed as an à la carte item. ll passengers need to check-in. Since October 2009 airport check-in is no more available for Ryanair s customers. Hence, they can avoid the check-in fee only on some promotional fares when online check-in is not charged by Ryanair. Similarly, not every passenger is a holder of a Mastercard Prepaid Debit Card, the only payment form to avoid an administration fee of 5 per passenger and one-way flight. The fees for priority booking and checked baggage are lower when booked via the Internet in comparison to sales via call center or at airport. pproximately 99% of Ryanair s flight reservations are made through its website (Ryanair, 2010). The lower online fees further strengthen the Internet as predominant distribution channel. The communicated success of à la carte pricing has created an ancillary revenue movement within the airline world not confined to European LCCs. Major US-based carrier like merican, United or Delta implemented à la carte baggage fees. However, implementation of à la carte pricing is more difficult for network carriers than for LCCs due to connections via hubs with through-checking baggage, interlining, codesharing, integration in global airline alliances but also the still existing multi-channel distribution and higher product expectations of passengers. These difficulties may be already sufficient to explain why European network carriers like ir France, ritish irways or Lufthansa have not introduced à la carte pricing for checked baggage. However, the following section questions more generally the economic rationale of unbundling à la carte items from basic air transport. 3. PROFITILITY OF UNUNDLING ND À L CRTE PRICING The commonality of à la carte items is that they are complementary to basic air transport. Consumers can enjoy air travel without paying for priority boarding or food and beverage but à la carte items have no value to them except when used together with the basic product. Therefore, à la carte items can be considered as one-way complements. Economic justification of à la carte pricing to date is rather vague. No published research exists on the optimality of unbundling air transport services. Unbundling air transport services into basic air transport and optional à la carte items turns bundling defined as the practice of selling two or more products in a single package to its opposite. Hence, the existing literature on bundling can be applied to analyze when and how airlines benefit from à la carte pricing. The literature identifies three alternative bundling strategies (Venkatesh and Mahajan, 2009): Pure bundling: The seller offers the bundle alone. Mixed bundling: The seller offers the bundle as well as the individual products. Pure components (or unbundling): The seller offers only the individual products. Given certain assumptions, Schmalenbach (1984) concludes: The advantage of pure bundling is its ability to reduce heterogeneity in consumers willingness to pay, while the rationale for unbundling is to collect a high price for each good from some customers who care very little for the other. In order to analyze the economic rationale for à la carte pricing with add-on services to basic air transport, the present paper applies the methodological framework provided by Guiltinan (1987). Let P + P, P RP + = core product (basic air transport) = add-on service (e.g. checked baggage) = price of bundle with components and = prices of unbundled products and = reservation price for bundle RP, RP = reservation prices for individual products

4 4 Transportation and Urban Sustainability RP / X O X N ß with 0, ß 1. = reservation price for given = number of bundle buyers = number of non-customers of bundle = share of X O who become buyers of only = share of X N who become buyers of The parameters a and ß recognize that the success of an airline s decision to unbundle air travel services and apply à la carte pricing will depend on revenue losses due to customers who become non-buyers of the add-on service, and the generation of new customers for the core product who have previously been non-customers (e.g. buyers of competitors products). Reservation prices stand for the maximum amounts consumers are willing to pay. The present paper does not assume any distribution of reservation prices among the buyers and non-customers of the individual products and the bundle respectively. If and are independent in demand, the reservation price for the bundle equals the sum of the individual reservation prices (i.e., RP + RP = RP + ). fter unbundling, the add-on service has no value to consumers (i.e., RP =0) except when used together with basic air transport. Some consumers might not appreciate the add-on service at all. For the others the add-on service as an one-way complement is worth more if is purchased (i.e., RP / > 0). Let us assume positive reservation prices satisfying: RP + RP = RP (1) / + and no price discount on the bundle, i.e. + P = P P + (2) (1) and (2) together rule out the possibility that unbundling leads previous non-customers to become buyers of and. If RP + < P + than also RP + RP / < P + P holds. Similarly, bundle buyers cannot turn into non-customers. Fig. 1 shows the possible customer flows resulting from unbundling add-on service from basic air transport. (1 - ) X O buyers of and X O buyers of bundle X O buyers of only ß X N buyers of X N non-customers (1- ß) X N non-customers Figure 1. Possible customer flows resulting from unbundling add-ons from basic air transport For bundle buyers who become buyers of only as well as for new buyers of the following conditions hold: RP > P and RP / < P. The customer flows depicted in Fig. 1 increase the carrier s total revenue if ( P P ) (1 α ) X + P α X + P β X P X > 0. (3) + O O N + O

5 Klophaus 5 With P +P =P + that is excluding the impact of a higher sum of the two prices for the unbundled products and, the condition for a revenue gain resulting from unbundling can be restated as α P X O + β P X N > 0. (4) If the revenue loss associated with former buyers of checked baggage is compensated by revenue gains through new buyers of basic air transport the total revenue impact is positive. Rearranging (4) leads to P X O α + β > 0. (5) P X N Equation (5) allows to identify conditions under which à la carte pricing increases the airline s revenue even without specifying distributional assumptions for consumers reservation prices: Low share of bundle buyers who become buyers of only. Low price ratio P /P. Low ratio of bundle buyers to non-customers X O /X N. High share ß of non-customers who become buyers of. These intuitively plausible conditions lead us to conclude that if airlines sell individual service components instead of air transportation services as a bundle, their revenue may not increase. This conclusion depends largely on the assumption made in equation (4) that the bundle price equals the sum of prices for the components. Hence, revenue gains reported by airlines practicing à la carte pricing may not be the result of unbundling services but of price increases (i.e., P new + P new > P + old). The profitability of unbundling depends on the changing number of buyers of and but also on the relative size of profit margins P - C and P - C with C and C representing unit costs of and respectively. The profitability of unbundling is enhanced if is the lower margin product and is the higher margin product. If an add-on service offers a relative low profit margin unbundling may be reasonable to reduce demand for the add-on while increasing the number of buyers of the core product. For illustration, the outlined methodology is applied to the case of Ryanair. In ugust 2007 Ryanair started charging for 1st checked baggage. In the meanwhile the online fee for 1st checked baggage rose to 15 representing additional ancillary revenue created through à la carte pricing. However, during the period from 2007 to 2009 Ryanair s average base fare decrease from 44 to 40. Further, before charging checked baggage, some 80% of Ryanair s passengers were travelling with checked-in luggage. That figure fell to 30% in 2009 (Ryanair, 2010). Let us assume that the decline in Ryanair s average base fare is determined by the carrier s decision to unbundle checked baggage. Then with the notation defined above the price variables take the following values: P + =44, P =40, P =15, P +P =55. In the fiscal year 2009 Ryanair transported X O =58.6m passengers. pproximately =30% of these passengers checked-in luggage. The value for ß cannot be directly taken from Ryanair s annual report or other published information by the carrier. Instead the price elasticity of =1.96 on intra-european short-haul routes derived in a synoptic study by Intervistas (2007) is used to calculate the effect of unbundling checked luggage on Ryanair s sales of its core product. Hence, lowering the average base fare for air transport by 9% from P + =44 to P =40 created approximately ß=18% new customers buying product. This allows to calculate the minimum X N required for unbundling to increase Ryanair s total revenue. Solving equation (5) for X N leads to a required sales potential of 36.6m non-customers. This value of X N depends on the price elasticity of demand. The lower the higher is the required X N. In view of approximately 200m passengers carried by the ten largest European LCCs in 2009, the actual sales potential for Ryanair beyond 58.6m already transported passengers may or may not be higher than 36.6m. Therefore it is not clear whether Ryanair increases its total revenue through unbundling checked baggage. This result is in line with the general conditions under which à la carte pricing increases total

6 6 Transportation and Urban Sustainability revenue derived in the previous section. Whereas the strong reduction in checked in baggage penetration rates reflected by high =30% and the high price ratio P /P seem to make gains in total revenue due to unbundling impossible, the relatively low ratio of bundle buyers to non-customers X O /X N in combination with a high share ß=18% of non-customers who become buyers of tend to increase total revenue. The empirical example of Ryanair illustrates that gains in total revenue from à la carte pricing and unbundling air transportation services are far from certain. In the case of Ryanair the potential cost savings due to reduced checked baggage may be the primary reason for implementing a separate checked baggage fee. 4. CONCLUSIONS usiness decisions on unbundling previously bundled products require estimates of distributions of reservation prices including conditional reservation price distributions. However, the methodological framework presented above allows to derive demand conditions under which unbundling air travel services is likely to increase airlines revenues without specifying such distribution of reservation prices. These demand conditions were applied to the case of Ryanair. This leading low-cost carrier decided to unbundle checked baggage from basic air transport some years ago. With the empirical data available it is unlikely that unbundling checked baggage led to an increase in Ryanair s total operating revenue because of a high share of previous bundle buyers with reservation prices for the optional service below the charged fee and a high ratio of the checked baggage fee compared to the base fare. Hence, the primary motivation for Ryanair s decision to charge a separate fee seems not to be revenue maximization but cost savings. In general, revenue gains reported by airlines practicing à la carte pricing may not be the result of unbundling services but of higher prices. Hence, the often proclaimed benefit of unbundling for consumers to pay only for services required may be offset by price increases. In order to ensure à la carte pricing to become a successful marketing strategy, airlines are likely to reduce the ability of consumers to compare air fares. Hence, consumers may accept increases in total air fares not transparent to them. This asks for regulatory efforts to ensure clarity of airlines websites and other advertising to allow consumers to compare total fares. Within the European Union under rticle 23 of Regulation 1008/2008 on common rules for the operation of air services each carrier when operating from an airport located in the territory of a Member State should indicate the final ticket price from the beginning of the booking process. To be in accordance with rticle 23, services that are in fact unavoidable should be correctly specified and included in the basic air fare and add-on services shown in the booking process should be on an opt-in basis. However, these efforts to regulate airlines price information need to keep in mind that today s complex fare structures are an outcome of the deregulation process of removing price restrictions in the airline industry. During the last years many airlines have proudly reported increases in ancillary revenue. However, what really counts is total revenue and eventually profits. This paper questions the economic rationale for unbundling air travel services. If unbundling of components of air travel services lead to reduced demand for optional services like in Ryanair s case with checked luggage the question is how much cost savings are possible without abusing bargaining power vis-à-vis airports or handling service providers. Hence, the in-depth analysis of à la carte pricing and unbundling air travel services on airlines profitability is an interesting issue for further research, airline executives as well as for policy makers.

7 Klophaus 7 REFERENCES Guiltinan, J.P. (1987) The Price undling of Services: Normative Framework. Journal of Marketing 51, Ideaworks (2009) The guide to ancillary revenue and a la carte pricing. Shorewood, WI. Intervistas (2007) Estimating ir Travel Demand Elasticities. Study commissioned by IT, Vancouver, C. Ryanair (2010) nnual Report 2009, Dublin. Schmalensee, R. (1984) Gaussian Demand and Commodity undling Journal of usiness 57, Venkatesh, R. and Mahajan, V. (2009) The design and pricing of bundles: a review of normative guidelines and practical approaches. Handbook of pricing research in marketing, ed V.R. Rao, pp Cheltenham, UK.