WHINE AND CHEEZ
by Sean Mendis
Transition of Macroeconomic Revenue Models
28 January 2003
Ever since the mid-80s, the trunk carriers in the United States have used YIELD BASED revenue models. In layman's terms, this means that the unit cost of providing the service often had very little relation to the unit retail pricing of that service. In most cases, this allowed the airlines to sell a small proportion of their seats at high yield, thus enabling them to be competitive in the marketplace by discounting the remainder of their inventory for discretionary sales. A flight could make money even half full, provided that the seats occupied were the high yield variety. This model was the backbone for developing such innovations as 3-class product range, Frequent Flyer Programs, etc... that we often take for granted today.
Seemingly in a parallel universe, there have also been a number of low-cost carriers whose revenue models are LOAD DRIVEN. In layman's terms, it means that unit retail pricing is averaged out to a narrower range, the value of which is calculated primarily based upon unit costs. These carriers market a much narrower product range to the passenger and almost always offer a single class of service. As the model name suggests, they make their money by targeting higher loads but at lower price. There is also a strong focus on controlling unit costs, because cost drives the retail pricing model and that must remain marketplace competitive.
These two models targeted completely different markets in the past, but over the last decade we have seen the carriers with the latter model expanding their systems into a more compehensive network. Inevitably, that means conflict between the two models. There are some markets where the former model is more sustainable (eg. Transcontinental, International) and others where the latter is more sustainable (eg. Florida snowbird traffic). Whereas the discounters and niche carriers are able to simply pick-and-choose the point-to-point markets to serve by examining the potential acceptance of their model there, the network carriers do not have that luxury. They command their yield premium on the strength of their network accessibility driven by the hub-and-spoke concept.
As a result, the onus has been on the network carriers to tweak their business models to compete effectively with the pricing model of the discounters. In the past, they have done so via means such as product differentiation (eg. meals, entertainment, etc..). This product differentiation also means incresed costs, but as mentioned above overall unit costs and individual unit revenue bear little relation to each other in a yield based model. As a result, a number of the network carriers made the cardinal error of pegging their costs to the absolute apex of revenue during the height of a booming economy. When the economy began to go sour, their ability to attract the same high yield premiums declined while their costs remained constant. This forced them to look for MORE high-yield customers, who alas were simply not out there anymore. That left them with the only option of cutting their costs by eliminating elements of the product differentiation. As a result, their product model began moving closer towards the discounters.
The airlines with visionary management noticed this shift in product model early and were able to modify their pricing models concurrently to align more closely with that of the discounters in competitive markets. A prime example of this would be Northwest Airlines who have been transitioning to a QUASI LOAD DRIVEN model for a few years now. Another example, although a late entrant to the party, would be Delta Air Lines who have experience with the latter model through their Delta Express unit. Ironically enough, United Airlines, the airline who conceived this theory used by others, was unable to implement it successfully with their Shuttle by United concept. Their West Coast network had been vulnerable early on to the discounters, primarily due to the geography of the area. They compounded their woes by inflating their cost structure to an absolutely unsustainable level.
The QUASI LOAD DRIVEN model which appears to be the most appropriate one for today's environment basically segregates passengers into two distinct groups - premium travelers and discretionary travelers. The object of the model is to provide basic price-competitive services to the latter group while providing additional services to the former group and deriving a premium from them. Pricing follows seperate tracks entirely, with the premium pricing based upon value-oriented concepts and the discretionary pricing based upon the load driven model. This is the model that has been very succesfully used by many European and Asian airlines.
There is a three step process involved with implementing this model. The first step is to DEVELOP/DEFINE the premium product, then to SEGREGATE the premium product and finally to TRANSITION to the load based model for the discretionary traveler. The first step of the process requires capital outlay and brand development, the second involves a short term revenue hit as brands realign and the third is where the payoff arrives. Ideally, the next step would be the product segregation. However, due to market forces brought about by the sinking economy and the annus horribilis of 2001, airlines have been forced to implement stage 3 of the process ahead of the completion of stage 2 in order to keep afloat. That means that the transition to the load based model (which has already shown its face in terms of consistently cheap fares in volume driven markets) preceded the segregation process. Hence, there was an interim period where consumers were able to take advantage of discretionary pricing to access the premium product using benefits defined under the old yield based system.
What we are now seeing is a belated attempt to implement stage 2 of the process while minimizing the goodwill and revenue losses that are inevitable at this stage. United was a latecomer to this party (American is even further behind, although they have begun their DEVELOP/DEFINE stage with the shift to 2-class 767 services) and are struggling to catch up. United's additional problem is that their cost structure currently cannot support a purely load driven model, meaning that they have to chop those numbers down for this model to be somewhat succesful. It is not easy to implement these changes sequentially at the best of times, but to be forced into it due to the Chapter 11 process and with a clock ticking is significantly harder, meaning more collateral damage (most likely in goodwill) will be the result. United is bargaining that the end model will be strong enough for them to offset these short-term goodwill losses.
I dont think there is any question that this is the wrong TIME for United to be doing this. However, the ideal time would have been a long time ago rather than anytime in the future. United is fighting for their entire existence right now, and they cannot persist with a broken revenue model if they want to survive. This is an essential move in the transition to the QUASI LOAD DRIVEN model which is their only hope for succesfully surviving and emerging from Chapter 11.
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