The Danger of Throwing in a Freebie

Southwest steadfastly refuses to charge for bags (at least the first two bags). Their marketing campaign, “Bags Fly Free”, says it all. In the short run they are missing out on the profit from baggage fees. The total airline industry profit from baggage fee for last year was around $536 million. Southwest is betting on increasing capacity utilization by attracting and keeping customers who are fed up with all the extras while other airlines are training the customers to pay for the extras.

Before airlines started to unbundle their services customers viewed the service as a monolith as opposed to a “bundle”. My monolith, I mean, a product service that is marketed and perceived as one entity even thought it is made up of different components. A bundle, on the other hand, is put together from several components, is marketed as a sum of its parts and is perceived by customers as such.  Unbundling has changed the perception of airline travel from a monolith to a bundle – a bundle consisting of:

1. the main component – the ticket
2. convenience of paper ticket
3. convenience of seat selection
4. ease of boarding
5. check-in bags
6. and in one extreme case – use bathrooms

So what Southwest sells with its “Fees Don’t fly with us” is a bundle in which every component of the bundle except the ticket is marketed as free. What is the danger of throwing in freebies with bundles? According to consumer behavior researchers from three universities, who published their results in Journal of Consumer Research, April 2009,  it is the long term erosion in customer willingness to pay for individual components.

Authors Michael A. Kamins (Stony Brook University-SUNY), Valerie S. Folkes (University of Southern California), and Alexander Fedorikhin (Indiana University) found that describing a bundled item as free decreases the amount consumers are willing to pay for each product when sold individually. They call this the “freebie devaluation” effect.

Why does a freebie decrease the price consumers are willing to pay for each individual product? Our research shows that consumers tend to make inferences about why they are getting such a great deal that detract from perceptions of product quality,” the authors explain. “For example, consumers figure the companies can’t sell the product without this marketing gimmick.” [quote Source].

In the case of Southwest’s bundle in which everything but the ticket is free, the research implies that customers will expect lower ticket prices if they want only parts of the bundle. A customer who is not checking in bags, in essence, is purchasing only one component of the bundle but is paying for the entire bundle. The “freebie devaluation” effect will push down customer’s willingness to pay for tickets when they do not need to check in bags.

What does it mean for Southwest? Unless their customer travel indicate that most customers check in bags they run the risk of lower ticket price expectations from their customers, further depressing their profits.

What does it mean to other marketers who throw in freebie? The same research provides the answer – there is no difference in customer willingness to pay for the bundle whether or not one or more of its components are marketed as freebies. So resist the temptation to increase sales by either throwing in freebies. If you are offering a bundle – you might as well price it same as the sum of the prices of the components.

 

Training Customers To Pay For Extras

Are airline passengers turned off by the unbundled pricing? Especially the baggage fee? Southwest, whose marketing campaigns push  “Bags Fly Free” , says it has data that shows customers do not like paying baggage fee. In one of my previous posts I wrote about the total profit of $536 million   that other airlines brought in the past year from baggage fee. Southwest’s Vice President of Marketing and Sales, Mr.Kevin Krone says, there is more to it than this expected profit from baggage fee.

The Dallas company says it has commissioned several comprehensive market studies that show the public has not accepted baggage fees, even as it pays them. Company officials also believe that passengers are still sorting out the idea that not every airline charges a fee for luggage, and they believe Southwest ultimately will benefit as public awareness spreads. “If [bag fees] were accepted, then I think we’d have to think really hard about it,” Krone says. “But our research shows that people are upset by [fees]. It is emotional. It’s hard to avoid it.”

On the other hand, US Airways wrote in a newsletter to its employees:

“When airlines first introduced charges for checked bags and a la carte-style pricing, customers resisted the change. Now, with the majority of major airlines collecting these fees for more than a year, customers are less likely to complain to the DOT.”

Can both arguments be true? Yes. It depends a lot on the segments they were studying and how the questions were posed. There is also the difference between attitude and behavior.

Customers did not like paying extra for the bags at first because their reference price was $0. If we were to survey customers about their willingness to pay  $15 (or $25) for bags, they are not going to accept the fee. This is what my colleagues and I found in a research. But if we positioned it differently customer’s resistance goes down. So  Southwest is correct in that in general customers will not prefer to pay but there are ways to overcome this. That said, I am not sure if Southwest did conjoint analysis to find customer preference for different factors and found that customers assign  high negative utility values to baggage fee. (We have done this study but we have not published the results.)

US Air’s claim is supported by their passenger data. There is also previous  research that find reference price is not a fixed number. Customers can be trained. Reference price  is malleable  according to Thomas and Menon (Journal of Mkt Research, 2006).  So USAir is correct as well. After an year of paying for bags and after seeing almost all airlines doing it, the reference price customers assign for checking in bags increased as well. Southwest’s goal, with its marketing campaign is to keep the reference price anchored down at $0.

Consumer behavior research shows people tend to discount future costs at a much higher rate than they do future benefits. This is the reason we do not mind eating fatty food and easily put off exercising. When booking a ticket, the customers see only the current price they pay and are oblivious to additional fee they might pay for bags. Even if they do (like some websites help customers see the total price) the mental discounting might push them to pick the option that has lower ticket price.

Questions  come to mind on whether people consider  Southwest as their first choice and whether the fact that bags fly free comes to customers mind when they look at Southwest vs. another airline.  Southwest also spent money on their current Bags Fly Free campaign while other airlines did not have to. Could Southwest have spent the marketing dollars on training customers to accept the fees and turned higher profit than their current profit from the reported  increase in passenger traffic?

Is it Nuts To Charge For Bags?

Southwest is still the only major airline that does not charge for first and second bags checked in. Recently United introduced a subscription plan for bags at $249 a year. I wrote why that is a good move for multiple reasons, strategically and tactically. Southwest’s blog “Nuts About Southwest” has a post on this fee that asks, “Why do they hate your bags?“.  Can South West continue to offer  “Bags Fly Free”? Barrons .com columnist Bob O’Brien writes,

Shares of the average stock in the sector have declined 2% in Thursday’s trading, nothing like the 7% setback that has been inflicted on Southwest shares

Southwest introduced  unbundled pricing, by charging a fee to board first. O’Brien adds that Southwest generated $10 million in revenue from other extra fees but may be hitting the wall on creativity.  Just how big is the opportunity for profits from baggage fees? From my previous calculations, rest of the airlines that charged for the first and second bags, took in a total of about $536 million.

Southwest is trying to generate more profit by cutting capacity in loss making legs. But how long  can it continue to ignore the size of the profit pool, facing declining stock price? They charge for the flexibility to board first, because it adds value to customers who are willing to pay for the flexibility.   If carrying bags adds value to the customers, shouldn’t they be charged for it?

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.