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Dirt-Cheap Tickets Can Be Profitable for Airlines

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Dirt-Cheap Tickets Can Be Profitable for Airlines

Dirt-Cheap Tickets Can Be Profitable for Airlines
June 13
09:25 2016

MIAMI — Every couple of weeks, the internet at large and a newly emergent closet industry of airfare deal websites reaches a fever pitch over the latest spectacular deal for a dirt cheap domestic or international ticket. There have been a number of variations on these fare deals over the past year and a half after fuel prices collapsed, most commonly focused on Scandinavia (thanks to fierce competition from Norwegian Air Shuttle), and recently on Australia and the South Pacific.

Domestically, flyers have long been sensitized to these kinds of ultra low fares thanks to rigorous competition since the deregulation of America’s airlines in 1978, but are routinely used to paying more than $1,000 roundtrip for intercontinental travel. But with increased competition thanks to more efficient long haul airplanes and liberalized air service agreements (ASAs) including more than 100 Open Skies ones (no restrictions on frequency or capacity), sub $800 roundtrip fares on intercontinental flights have become surprisingly common.

Low fares originate for two reasons

Dirt-cheap fares generally fall into one of two categories. The first is mistake fares, when an airline (or more precisely an airline employee) accidentally codes the wrong fare for a route, or some sort of pricing algorithm breaks down. These are the insanely cheap (e.g $100 for first class from Montreal to Zurich) fares that for a while in the late 2000s and early 2010s were remarkably prevalent (at least two to three major ones per year). But the rise of blogs, social media, and the increasing pace of virality allowed these deals to spread rapidly to hundreds, if not thousands of customers. At those volumes, the cost of mistake fares began to skyrocket for airlines, in the worst of cases jumping into the hundreds of thousands of dollars. With increasingly profit minded management teams looking to cut their losses, the airlines pushed for a regulatory solution (as profit minded business with the opportunity for regulatory capture are wont to.)

The historical legislative precedent for mistake fares had always been forcibly recognized by the airlines, who regardless of their intent had published and offered said fare for sale. In cases where an airline refused to recognize a mistake fare, they could often be sued in court and held liable for thousands of dollars in damages. In the last few years, airlines have argued for a new paradigm, pushing the notion that while passengers should not face any undue financial burden as a result of a mistake fare (ignoring the psychological burden of thinking themselves able to enjoy a vacation and then having that vacation turned away), the airline should not be forced to give away a product for less than it’s intended price. Despite an overall bent towards increasing passenger compensation, governments in the EU and US both gave this idea credence, and the policy on both continents has shifted to basically allow the passenger to be refunded for all travel costs incurred in association with the mistake fare without forcing the airline to honor the initial experience and class of travel. So the prevalence of mistake fares as actual purchases for passengers will continue to decrease.

Fare Wars and ULCCs

But mistake fares have always been a small subset of the overall pool of dirt cheap fares. Instead, the most frequent occurrences have always arisen from fare wars. After the development of hub and spoke networks made every airline a competitor on pretty much every American city pair, fare wars have been a frequent, if uneven reality of the US airline industry. The cyclicality of head to head competition and the resultant plunge in prices in specific markets usually peaked in one of three scenarios. The first was whenever a new entrant or low cost carrier (LCC) and now ultra low cost carrier (ULCC) invaded a legacy airline hub. From Legend Airlines in Dallas to Virgin America in San Francisco and Newark, this has been a consistent theme in the industry since deregulation. In fact the famed “Southwest Effect” is primarily a statistical artifact of this type of competitive response – in monopoly markets there’s honestly not a lot to differentiate Southwest’s pricing from that of the legacies.

The industry-wide manifestation of this is whenever there are too many airlines (2004-2007 in the US is a prime example of this) or a massive shift in the balance of power in a region (witness the pitched battle between Delta and Alaska in Seattle – the heart of the Pacific Northwest air travel market). This is what produced such gems as American flying a nonstop between Austin and Orange County in the mid 2000s, and Northwest’s famed “Heartland Strategy” a few years prior. In a consolidated industry, this has mostly ceased to be an issue.

But the final driver behind airline pissing matches is periods of capacity growth emboldened by low real fuel prices – the kind of fuel prices that can make United think “we’re going to add LaGuardia to Raleigh as a misguided retaliation for Delta adding Raleigh – Newark and not completely lose our shirts,” and not be totally crazy for thinking so. Add in the rise (finally) of a somewhat viable ULCC on trans-Atlantic routes in Norwegian (and the lower cost presences of WOW Air and Icelandair in Iceland), and the present environment is exactly right for deals like a $386 round trip to Auckland.

That ticket isn’t necessarily unprofitable for the airline

So at first glance, it would appear that the airline is selling seats below their cost. And it is indeed true that United is selling this ticket below the average cost per passenger of operating the flight. Say, for example’s sake that the airline in question chose to fly via San Francisco to Auckland on United’s Boeing 777-200ER, which might cost, say, $130,000 to operate on the route, and as the jetliner operating the route seats 269 passengers, that yields a per seat cost of $483. Add in a cost of say $100 for the LA – San Francisco domestic leg and all of a sudden you’re looking at a deficit of close to $200 for the overall trip. And United is clearly going to go out of business after selling below cost.

But it’s not that simple, for a variety of reasons. The first is that you really have to look at cash operating costs per route. Remember, capital costs represent 30-40% of an airline’s operating costs depending on type of aircraft, and they almost always have to be paid irrespective of whether an airline actually operates a flight or not (with charters being the main exception to this rule). So if you strip out a capital cost of 30%, you actually end up with a cost of $91,000, or $438 per passenger inclusive of the connecting leg, and really close to $400 if the same marginal adjustment is made on the domestic connecting leg. So right there, United has almost broken even in a practical sense.

Note – these figures are not precise operating calculations but rather back of the envelop ones that are directionally accurate.

The second piece to consider is the reality that an empty seat on a flight that operates is essentially a wasted opportunity to collect additional revenue. Above some ridiculously low threshold (something like $50-60 on a long haul international flights), every dollar of revenue collected on a seat that would have otherwise flown empty is pure (marginal) profit. No this doesn’t mean that a flight is necessarily profitable with all seats filled with cheap fares, but it is nonetheless true that a flight with 150 seats filled representing $n in revenue is going to have a worse financial result than the same flight operating with 151 seats representing $n + 386 in revenue.

But what seals the deal is the fact that the airline simply isn’t selling all of the plane’s seats at this dirt cheap fare – rather it’s selling a small subset of the overall plane’s capacity. On the same plane from San Francisco to Auckland, there are perhaps 2-3 passengers in First Class who paid $4,000 each one way, 30 passengers in BusinessFirst who paid $2,200 one way, 80 passengers in Economy Plus who paid $600 one way. This means that even before the (say 90) economy class passengers pay a dime, the flight has essentially broken even with $122,000 in revenue. If all 90 of the passengers paid that $386, United would walk away with a cool $27,000 in profit for the flight. And in reality many of the economy travelers will pay more than the lowest possible fare (for restrictiveness or schedule concerns among others).

Now obviously not every flight has the money work out nicely like this for the airline (perhaps loads or fares are weaker), but the fact remains that the variation in fare mix can enable airlines to make money on dirt cheap pricing. These routes often have some degree of justification for commercial strategy reasons (American booting legend out of Love Field probably added millions of dollars to its bottom in the years that followed. There is also an intangible benefit in terms of spreading the brand, as dozens of “headline” stories across the internet will frequently carry the deal and airline in question. If an airline limits itself to selling 5-6 dirt cheap flights on a site, the press from that alone can generate 2 times as many bookings at a 20% higher fare.

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About Author

Vinay Bhaskara

Vinay Bhaskara

Senior Business Analyst, Big Airline Enthusiast, Avid Airport Connoisseur, Frequent Flyer, Globetrotter. I Miss Northwest Airlines Every Day. vinay@airwaysmag.com @TheABVinay

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