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?

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.

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.

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.

Cutting It Too Close

Salons, surprisingly, practice effective price management more often than most other businesses. Sometime back I wrote about unbundling, and multi-version pricing in salons. It came as a bigger surprise to me to see the article in The Wall Street Journal about more people are cutting their salon trips and moving to cutting their hair at home. Salon market is highly fragmented and there are too many players. There is not much growth (other than population growth) – you cannot convince people to cut more often. Now this, recession will be cutting down volume.

I hope salons do not react by resorting to cutting prices. Once they are cut it is not going to be easy to grow them back to original levels as customers become trained to expect lower prices. They should continue to look at further unbundling and add versioning if their current practice is simply based on length.

Some New York salons are unbundling the stylists from the salon. This helps to create different versions of the product and helps preserve reference price in the minds of customers.

Another method is using the power of the middle. For instance, simply change the current single price for haircut into 3 different prices. There need not be any real differentiation but you need to create differentiation in the minds of customers. The lowest advertised price will bring customers in but presented with 3 options customers will be nudged to pick the middle option.

The problem however is that in this fragmented market there is going to rush to steal market share and this is going to cause a price war.