MIAMI — Earlier this week, American Airlines shifted to a revenue-based frequent flyer program, joining rivals Delta Air Lines and United Airlines as the last major full service carrier to eliminate distance-based earning of frequent flyer miles. American had maintained radio silence for almost a year after United and Delta pulled the trigger on shifting to revenue-based programs, maintaining that it had no plans to shift AAdvantage from its mileage-based roots. However, the cautious optimism from the opportunistic and economical segments of the traveling population that American would continue to reward raw distance traveled proved to be unfounded, leaving Alaska Airlines and Hawaiian Airlines as the only major US network airlines to offer mileage-based earning.

Rewarding customers based on their value

As we stated back when Delta made the switch to a revenue-based program, this is a better way to reward an airline’s best customers. At the end of the day, the thing that matters most to an airline is how profitable each customer is – and customers that pay a higher fare are almost always more profitable.*** So a program that rewards passengers that pay a higher fare with more points is rewarding an airline’s most valuable customer.

The most common criticism that is usually leveled against revenue-based frequent flyer programs is that they don’t reward loyalty enough. And it is certainly true that engendering loyalty is perhaps the central goal of frequent flyer programs. But this criticism falls short along two axes. First and foremost, loyalty isn’t valuable in a vacuum. For example, a passenger that buys 5 full fare first class round trip tickets between New York JFK and Los Angeles at $5,000 a pop is certainly more valuable to American than the customer that buys 20 deeply discounted economy-class tickets at $400 per round trip.

But under American’s prior earnings scheme, that discount economy flyer may well have qualified as a Platinum or Executive Platinum member, whereas the first class flyer would only have qualified as a Gold Member, completely inverted from the actual value each provides to American’s bottom line. So rather than say that frequent flyer programs are exclusively aimed at building loyalty amongst passengers, a better way to think about their purpose is to say that they are aimed at building loyalty amongst passengers that are valuable.

When such programs were initially launched, there was a direct correlation between distance flown and revenue/profits generated. But in today’s airline industry, that relationship no longer holds. So rather than see the shift to revenue-based programs as deviating from historical norms, it is actually returning to the original purpose of such programs.

Beyond the misinterpretation of the purpose of frequent flyer programs, there is a more fundamental problem with the criticism that a revenue-based program doesn’t reward loyalty. Quite to the contrary, it rewards loyalty and marginal loyalty far more on a relative basis. And observers confuse the fact that ultra-loyal passengers (elites) may earn fewer total miles with the (incorrect) fact that they are no longer being rewarded for their loyalty.

Frequent flyer programs have two components – earning and spending of miles and elite status. Previously both of these were configured to reflect pure loyalty (i.e. miles or segments flown). Now, the first is configured to reflect the value of a passenger (revenue generated) while the second still measures loyalty.

With that in mind, elite passengers (i.e. the most loyal ones to American) actually earn more on a relative basis under the new program. For example, under the current AAdvantage program, an Executive Platinum passenger paying $2,000 for a 5,000 mile flight would earn twice as many redeemable miles (10,000) as an unaffiliated passenger would for the same flight (5,000). Under the new program, the Executive Platinum member does better (22,000 redeemable miles) relative to the unaffiliated passenger (10,000 redeemable miles) earning 2.2 times as many redeemable miles (RDMs).

Gold passengers do better relative to unaffiliated passengers (1.4 times as much under the new system versus 1.25 times as many RDMs under the current system), while Executive Platinum members do about the same relative to Gold members. Executive Platinum members also do better against Platinum Members (1.2x vs. even), who are the only group to be rewarded relatively worse under the new system (even vs. 0.8x against platinum members, 1.6x vs. 1.3x against Gold members, and 2x vs. 1.8x against unaffiliated passengers).

But the ironic thing about this is that Platinum members becoming worse off means that the new AAdvantage program is actually doing an even better job of rewarding relative loyalty. Each incremental indicator of loyalty (all the way up to Executive Platinum) is now marked with an uptick in your earnings of RDMs.

***The case where this isn’t true is on the margins, where there’s potentially a huge opportunity cost. Take a 50 seat E145 for example. Normally passenger #40 (i.e. the 40th person to book a ticket) paying $300 is less profitable than passenger #50 paying $400, because the cost of processing each passenger is constant (say $200). But the only case where this isn’t true is if there was someone else who would have been willing to pay $700 for that last ticket but couldn’t buy the ticket because it had already been sold to the passenger paying $400. In this scenario, the true cost of that 50th ticket is the $200 in tangible costs plus the $300 in lost revenue ($700 – $400) or opportunity cost for a total cost of $500. In this scenario, the $300 passenger represents a $100 net profit whereas the $400 passenger actually represents a $100 ($400 – $500) net loss.

The true value of a frequent flyer mile to an airline

Frequent flyer miles have two different valuations corresponding to how they were earned. The first valuation is based on a simple calculation of per-mile revenue earned when frequent flyer miles are sold to credit card, while the second is a more nebulous valuation based on the value generated by keeping a profitable customer loyal to your airline. In either case, from an airline’s perspective, there is a certain value assigned to each frequent flyer mile based on how much revenue (tangible or hidden) that it generates.

The cost side of the equation is more opaque. The first component of the cost of a frequent flyer mile is calculated by taking the direct cost of the flying the passenger on the route they purchased with miles and then amortizing that cost across the number of miles used. The second component comes back to the concept of opportunity cost and represents the revenue that could have been generated from that seat or seats had they not been traded for miles (once again amortized per mile used). These costs are then weighted by the percentage of earned or purchased miles that will not be redeemed (due to expiration, forgetfulness, or other factors).

Frequent flyer programs deal in huge numbers

While the specific net impact of each mile to an airline’s bottom line tends to be variable based on an airline’s situation at any given moment, looking at the aggregate figures surrounding frequent flyer programs can provide an illustrative picture of the overall impact. On the revenue side, the direct revenues are the easiest to account for and they are certainly big business in their own right. For example, Delta makes $675 million per year selling miles to American Express.

The cost side is partially reflected in operating costs but mostly is recorded on the balance sheet. Each frequent flyer mile technically represents a liability for an airline, because it can be used to tie up a seat that would otherwise be paid for in cash plus it represents a cash cost (of servicing the passenger) that the airline must incur. Here the aggregate numbers are also interesting to look at. Delta’s aggregate liability amounts to $3.9 billion, United’s to $4.9 billion, and American’s to $2.6 billion.

Airlines have an economic incentive to reduce RDMs

Those latter numbers are particularly worrisome for airlines because they are tantamount to debt. Every time an airline gives out a frequent flyer mile, it is adding debt to its balance sheet. So there is a strong incentive to reduce the total number of RDMs being added to circulation, particularly when those miles are being earned for flying (and thus not generating direct dollar revenues). At the same time, airlines do still need a way to reward their best customers, on a relative basis if nothing else.

Now think about what revenue-based frequent flyer programs do. Do they reduce total RDMs earned and thus total airline liability? Yes… And do they continue to reward an airline’s most valuable (loyal and high-paying) customers? Yes… in fact, more so, on a relative basis. Given these two facts, the switch to a revenue-based frequent flyer program was a no-brainer, regardless of how mad it makes a segment of the traveling population and media.