Subscription Pricing For Unbundled Offerings

The problem with unbundled pricing (pricing separately for each component of a monolith) is the multiple purchase decisions the customer has to make. Every time the customer opens the wallet and pays for an extra, they feel increasing pain (Prospect Theory). Customers will see each transaction as a loss and according to Prospect Theory the pain from multiple small losses can be more than the pain from a single loss of same magnitude.  The pain from losses do not increase linearly with amount paid but the pain is felt every time customers have to pay.

Take the case of airline unbundled pricing, specifically the baggage fees. Profit from baggage fee is nothing to be sneezed at. For someone who travels a few times a year and checks-in bags, it is painful each time they pay for bags and leads to brand erosion. United has come up with an innovative way to reduce this pain by reducing number of payments – they now offer an yearly subscription for baggage check-ins for $249.

Forget about first and second bag fees for an entire year. With Premier Baggage, you and up to eight companions can check up to two standard bags each without fees, where applicable, every time you travel in the United States

Premier Baggage also makes a great gift for a frequent traveler.

This is a great pricing plan in many ways:

1. It addresses the multiple pain instances by reducing payments.
2. It captures value upfront.
3. Someone buying this subscription is going to prefer the same airline for the entire year even though they should not (because after they paid the fee it is sunk and they should compare the cost of available options for each trip).
4. The best possible case for United is people buying it not using it.
5. The worst possible case is a group of eight companions checking in two bags even once. But in that case they are generating so much revenue from the tickets that it more than makes up for lost baggage fees.
6. They have a good chance of getting businesses to buy it for their employees or gifting to their clients/customers.
7. To United there is really no cost, all of this is profit. The only cost is the opportunity cost of lost baggage fee from high volume and or frequent users but that is made up and more from ticket sales.

Now if only they can turn profit from the rest of the operations.

Profits From Airline Baggage Fee

Just when Continental airline decided to extend its baggage fees from US flights to international flights, SouthWest stepped up its campaign against airlines charging extra for bags. Is SouthWest following the right strategy to not only choosing to implement unbundled pricing but also align their messaging around this? How much profits are they leaving un-captured?

In Q2 of 2009, rest of the airlines brought in close to $670 million baggage revenue. Last year it was just $178.  (Data source WSJ print edition, 9/22/2009, page B4). Since there is no significant marginal cost per bag and almost all the costs are fixed and paid for, we can conclude that most of the increase from $178 to $670 is pure profit. There was one study last year (I am unable to find the reference) that put the cost per bag at $15.  This must include fixed allocation and not just marginal cost. This gives a margin of 40%. But since the costs are mostly fixed, we can assume that margin in 2009 is close to 80%. So the decision to charge for bags brought in about $536 million in profit for all the airlines combined.

For SouthWest, leaving its share from that profit  is a better decision only if they captured higher profit from increase in utilization from passengers choosing the airline because of its no-fee policy. Judging from their last earnings statement we can safely say that has not been the case.

British Airways – Charging for Seat Selection

Suppose you are traveling on leisure with your family, how much do you value sitting together with your loved ones?

How much do you value having our teenagers sit as far away as possible? (or how much do your teenagers value that?

You are a business traveler planning to catch up on the marketing deck or your sleep – how much do you value not sitting close to kids or babies?

While most airlines do not ask these questions, British Airways started implementing a pricing plan for seat selection. If a service adds value to customers (note that the value-add is not the same for all) then the marketer must get a fair share of the value add. That is the first component of effective price management.

What British Airways is implementing is an unbundled pricing, separating  a service that has always been offered and seen as a monolith into its components and charging separately for each. As a proponent of effective price management, I fully support and applaud such a move. But British Airways customers are not amused:

“This is fundamentally dishonest.

“It isn’t about listening to customers at all. It’s about getting extra revenue.

“It looks like those willing to pay will be able to jump the queue and this will force up the price.”

Of course the comments above are not those of customers but those of a politician. Nevertheless BA should have anticipated this. Unbundling pricing is about identifying revenue opportunities, by finding what each segments value and realigning prices to better match the value provided with prices charged. But it is not enough to have strategy, the marketer needs to understand consumer behavior and have an execution plan that will reduce customer backlash and increase acceptance.

We have seen before USAir backtracking on its $1.99 in-flight soft-drinks fee. I have studied and written in detail about unbundled pricing. One common pattern I found with customer backlash is that it results from marketer’s failure to manage customer reference price. Customers do not like paying for something that used to be free even if this adds value to them because they had never paid for this service before. In a controlled experiment for Airline unbundled pricing, I found that improving customer reference price improves customer acceptance of new charges.

Recently SouthWest, that still steadfastly refuses to charge for extras, announced its plan to charge for priority boarding.  SouthWest does not pre-assigned seats, customers find their seats when they board.  SouthWest realized that there exists segments that are willing to pay for the convenience of boarding early and finding seats they like and hence introduced this service. Unlike BA, they did not face customer backlash because this is a new service they started offering.

What should BA have done? BA should have offered options, say one option is to charge a fee for the flexibility to reserve seats three days before the flight  otherwise making it first come first served. This is just one example and I am not giving detailed options here. In any case the idea is to improve reference price before charging for something that used to be “free”.

I would like to point out another idea on what could be causing customer backlash – fairness effect. Mr. Reed Holden, author of Pricing With Confidence, wrote about the extra fees and whether customers perceive them as fair or unfair:

Whether to a general population or to specific segments, when those fees are viewed as fair—they can be effective ways to call out the special features and services that customers can receive if they want to pay.   When fees are viewed as unfair by an increasing percentage of the population, however, they can cause increased switching and a declining population of loyal customers–something that has to be monitored over time.

However, I posit that in case of unbundled pricing whether or not a customer perceive the extras as fair or unfair is contained within the reference price.  I will write more on the last point at a later time.

Gourmet Airline Food Sets High Reference Price

When US Airways tried to charge $1.99 for soft drinks it faced customer backlash and ended up rolling back to free drinks. As my team’s consumer behavior experiment showed, the plan would have succeeded if they had improved customer reference price before charging for drinks. In our experiment we found that the presence of high priced options, like $4 Evian water, increased customer acceptance of $1.99 for ordinary bottled water. Today I saw an article in The Wall Street Journal that airline food is going gourmet.

One of the best-selling items, Delta says, is a $6 fruit-and-cheese plate with smoked Gouda, Havarti and Derby cheeses paired with grapes, pecan halves and dried apricots.

For $10, American serves you a chicken Carver sandwich, bag of potato chips and a soft drink (still offered free by the airline). Another offering: the popular nut mix American serves to first-class passengers has been packaged for coach customers, at $3 per serving.

On Hawaiian, passengers can get free manicotti with chocolate cake, or pay $10 for Caesar salad with grilled chicken or satay chicken in vermicelli noodles. The best-seller is a sushi bento box with California rolls, edamame and teriyaki chicken.

Airline sales data show  about 4-6% of passengers buy these premium products. The may not look much but the opportunity is in charging for the basics for the rest of the passengers. The high priced premium offerings may not be a profit source  but their presence help to improve customer reference price and hence their willingness to pay for the freebies. On a plane with 130 passengers, premium items priced at $10  bring in a revenue of $80 but even if only 50% of the  passengers buy the $1.99  soft drinks, that is an additional $130 in revenue.

The true impact of the premium priced airline gourmet food is in improving customer reference price enabling further unbundled pricing.

Southwest Unbundling Pricing

Southwest ran  marketing campaigns about its “No Hidden Fees” model. They did not charge for baggage, drinks, pillows or like Ryan Air for the toilet. Despite the rest of the airlines charging for baggage etc., Southwest did not gain market share. When every airline was practicing unbundled pricing, everyone assumed Southwest was doing so as well. Their messaging about no fees did not create differentiation they sought. I wrote then how this was not a good move for Southwest and how they were leaving money on the table.

Now Southwest, after seeing their first ever loss, is slowly tipping its toes into unbundled pricing.

The Dallas-based airline, which flies more passengers within the U.S. than any other carrier, said customers can move up the queue at its gates for a $10 fee starting Thursday. Unlike most other airlines, Southwest doesn’t have assigned seating.

I completely support this move. Unbundling is about exposing revenue opportunities, identifying components that are of value to customers and charging for it. In the case of baggage fees, not all customers, especially the business travellers, were not using the service. For those who used the service, it was of considerable value so the airline started charging for it.

Southwest’s Vice President of Marketing, Mr.Kevin Krone said,

“What other folks are doing is charging money for what they used to do for free. What we’re doing is offering new things that we hadn’t done before,”

This is true. Even though the services added value to customers, they were not willing to pay for these because their reference price was $0. Southwest will have an easier task of selling new services because they do not have to surmount the reference price hurdle as long as they are  charging for new services. According to an analyst, baggage fees will bring in $500 a year for Southwest. If they want to go that route  they have to focus on increasing customer reference price (think options).  And about all  those Ads about “Fees Don’t Fly With Us”?  Customers are not going to remember and again reference price improvement will help address that.