News of a Justice Department investigation into possible collusion among the major airlines took many by surprise, including me: but perhaps not for the reasons you think. As a former pricing analyst for Delta Air Lines and long-time industry observer, my initial reaction was that collusion sounded farfetched.
The truth is, as federal investigators hunt for a smoking gun on collusion, they are more likely to uncover plenty of evidence revealing how far the industry has fallen in terms of pricing their No. 1 product: airfares.
Nearly two decades ago, with the publication of Robert G. Cross’ seminal book on Revenue Management, the business world learned how U.S. airlines were using sophisticated, analytics-driven strategies on airfares.
Cross, subsequently hailed as “the guru of Revenue Management” by The Wall Street Journal, built his reputation in what was then a relatively unknown field by helping Delta Air Lines and others create billions of dollars in additional revenue. (Disclosure: Cross is now the CEO and Chairman of Atlanta consulting firm Revenue Analytics, where I am a partner.)
Almost 20 years later, airlines, once pioneers of pricing and Revenue Management systems, have taken a back seat to other industries in terms of their analytical sophistication. This is especially true in regards to airfares.
While the airline industry has been aggressive in collecting fresh revenue from previously free items such as baggage, headphones, meals, and even that pillow and blanket, this transformation was born purely out of survival mode. Despite a healthy head start versus other industries, airlines have never figured out how to truly optimize seat pricing to maximize revenue growth from this, their core product – nor have they shown any signs of a breakthrough.
Today, airlines lag behind a slew of industries, such as cruise lines, entertainment and media companies, rental car companies, automakers and hospitality firms, who leverage powerful predictive analytics and advanced pricing strategies to precisely understand customer willingness-to-pay. As a result, billions of dollars in incremental seat revenue have been left on the table.
The industry’s turbulent history is partly to blame. Prior to airline deregulation in 1978, pricing wasn’t a problem. Fares were set by the federal Civil Aeronautics Board (CAB) with a guaranteed rate of return. All that airlines had to do was control costs and profitability was assured. The CAB also controlled access to routes, preventing the rise of startup airlines.
All of this worked for the airlines, but not for consumers. The cost of an airline ticket was prohibitively expensive. For example, a 1960 United Airlines roundtrip flight from Des Moines to Columbus was $98 – or $783 in today’s dollars.
Eighteen years later, deregulation delivered daunting challenges. Lower-cost startups emerged, increasing competition on previously profitable routes and driving down fares. The impact for airlines was devastating and long-lasting: the average price (adjusted for inflation) of a seat plunged from just under $1,450 in 1978 to about $270 by 2011. All the while, airline costs were rising.
This was a recipe for failure. After all, what other industry in recent memory has watched its core product get cheaper AND survived? Not surprisingly, over the last 25 years, 347 airlines filed for bankruptcy – at a rate 10 times higher than the rest of the business world.
In this newly deregulated world, arrivals like PEOPLExpress went on a wild flight to democratize air travel. They sold seats at 50-70 percent lower than the majors while operating at half the cost. In 1985, PEOPLExpress was the fastest growing company in U.S. history.
PEOPLExpress’ downfall began as American Airlines and others discovered a way to match the low fares of PEOPLExpress – but only for those seats that they predicted would otherwise be unsold. Instead of relying on a roomful of people to allocate those discount seats, the airline installed innovative and dynamic inventory management systems that could accurately forecast passenger demand for different fare classes. The system also had the ability to deftly save seats for late-booking, higher-paying passengers, and to allocate leftover seats to a variety of fares with advanced purchase restrictions.
This ability to offer discounts with laser-precision enabled American to offer an Ultimate Super Saver Fare which was below PEOPLExpress’ lowest price. Using these sophisticated inventory management systems, American, Delta and others could offer a broad range of fares (for example from $69 to $699) which gave them tremendous flexibility in matching consumer willingness-to-pay with the airline’s available capacity. PEOPLExpress, unable to respond, saw its load factors drop from 85 percent to 30 percent and its losses hit a staggering $50 million per month.
In recent years the airline industry has gone from leader to laggard in Revenue Management. Resting on your laurels rarely breeds innovation.
What we have witnessed for more than a decade is a conservative game of price-matching. An airline may float a fare increase, even leave it out in the market for several hours, but if nobody else quickly matches it, the increase is pulled back. This means many consumer-differentiating pricing and Revenue Management techniques such as market segmentation, demand forecasting and competitive alternatives are not being adequately leveraged.
Meanwhile, average airline prices continue to fly at lower altitudes, while average prices in industries such as hotels and rental cars continue to soar. If the Corvette Stingray shared the same pricing history with the airline industry, the car’s price today would be under $6,000 – instead of the actual $55,000+ sticker price.
Airlines must awaken to the reality that they have a pricing problem the size of an Airbus A380. Yet they insist on only treating the symptoms, not the core problem. They continue to rely upon outdated pricing schemes, such as 14-day advance booking and the Saturday night stay-over, which the entire world is aware of and expertly games.
At the same time, they have neglected advances in the field of measuring consumer price response, instead relying upon overly simplistic segmentation of their customers. Disregarding the explicit measurement of price sensitivity and ignoring advancements in price optimization techniques has resulted in a failure to reflect and extract value from brand preference and airline loyalty programs. It has also resulted in resorting to irrational first-class seat pricing and an over-reliance on add-on fees.
Ill-equipped to price their fares optimally, airlines are left to maneuver the control stick they know best: capacity. Cutting capacity is not a long-term strategy for success.
Charging fees for ancillaries has been the industry’s financial salvation thus far, but they have been a crutch, and roundly criticized by consumers. In addition, the financial success of ancillary fees has also camouflaged the failure to effectively price seats. In a recent conversation with an airline executive, he told me that optimized pricing of these ancillaries could soon be worth an additional $1 billion in revenue for his airline.
However, as much as they’re pursuing advancements in the area of ancillary revenue streams, some airline execs contend that the innovative Revenue Management tools currently being deployed in other industries won’t work for the airlines. Another executive recently said to me: “Airlines know they need to become more sophisticated on seat pricing, but nobody wants to go first.”
Unless an airline boldly takes that first step, the entire industry faces a day of reckoning that will make the early years of deregulation – or a federal investigation into collusion – look like a cakewalk. At its current pace, revenue from ancillaries will eclipse revenue from seats within just a few years. And when the core product is no longer profitable on its own, air carriers are in real trouble. By not getting its seat pricing right, the industry risks stagnant growth, or worse . . . it could drive away consumers by charging them more for everything else.
Airlines, once the proud leader of the pricing pack, can reclaim that top spot, but only by implementing the kinds of transformational pricing capabilities successfully deployed across a variety of other industries. With a new and unwelcome investigation into their pricing strategies, there has never been a better time for action than now.