JOCResearch
THE CASE FOR A COMPENSATORY
FARE STRUCTURE
Written September 26, 2001
These full service carriers can also provide appropriate service and generous legroom for
the higher-fare class levels; in other words, value for money. For half a decade these carriers and their foreign
counterparts (like British Airways, KLM, SAS, Lufthansa, Aer Lingus et al) have been
bruising business and full fare travelers with fares two to three times the level of
compensatory tariffs.
Instead of the current $5000 to $7500 for a New York–London business class ticket (business
class), a compensatory fare - i.e. that fare which returns a sound profit
margin with two-thirds of the seats filled -should be on the order of $1800. Looking at a domestic route example, instead of a
full economy fare of over $2000 for a transcon
New York–Los Angeles roundtrip, the compensatory full economy fare
should be $700; and first class should be under $1300.
(Southwest’s compensatory full economy fare should be, and is, on the
order of $400, precisely because its full operating cost curve structure has always been
some 35 to 40% below that of legacy carriers like United, USAir, Northwest, Alaska,
American and Delta.)
International business class travelers, and domestic first and business class passengers -
together with full fare economy passengers - are where establishment airlines make the
bulk of their profits. They do not make
profits on ultra-low discount advance-booking fares (because they are not low-cost
carriers like Southwest). These establishment
airlines have destroyed the loyalty and goodwill of business travelers, especially
small-business employees and professionals who are unable to negotiate corporate discount
deals.
A range of compensatory fares should be established by US carriers, with or without the
cooperation of their foreign counterparts (who are not so much competitors, as they are
code-and-revenue sharers, i.e. in essence, pooling partners).
Some foreign airline executives (British Airways, incidentally, immediately raised
fares after September 11) will argue that it is impossible to establish so-called
compensatory fares. That is incorrect. It is entirely possible to do so. I argued the point as a U.S. aviation consultant
before the UK Civil Aviation Authority and Lord Boyd-Carpenter twenty-five years ago when
British Airways was trying to eliminate several smaller European airlines with
non-compensatory early-bird and part-charter predatory fares.
It is comparatively simple to calculate approximate compensatory fares for Southwest
Airlines, because LUV (as Wall Street calls the carrier) has only one class of service, a
uniform seat pitch, and a nearly uniform fleet of Boeing 737 model aircraft types. Total operating cost (direct and indirect costs,
including depreciation and interest or lease ownership) can be analyzed from reports,
calculated and plotted as a cost-curve versus range in terms of cents per seat mile. The average seasonal and peak/off-peak load factors
are known. Building in 20 to 22 percent
pre-tax profit margin, the analyst can plot a target yield-curve on the basis of cents per
passenger mile. The yield-curve thus
identifies the average compensatory fare at any distance (such as between nonstop market
pairs) by simple multiplication of yield times distance.
Southwest does publish and charge compensatory fares; and Southwest has
always made a profit.
For multiple-class, full service, higher-cost scheduled carriers, computation of
compensatory fares is more complex. However,
the starting point is much the same as in the example above.
In the first iteration the analyst should put aside any theory of
cross-subsidization. That can be debated
later. (Cross-subsidization is the
overcharging of business class, first class and full fare economy passengers in order to
offset losses incurred in carrying deep-discount ultra-low-fare traffic categories.) First step is to calculate the total operating cost
for the aircraft type or types mostly used by that carrier on the route/s being analyzed,
and translating such total cost to a cost curve as before.
The assumption should be made that the aircraft is in full
economy configuration, i.e. as if it were being operated in a charter mode at 32 inch
pitch. With a maximum charter-type load factor
of, say, 92% the total operating cost plus profit margin can be translated to a target
yield curve. This provides a band of lowest
compensatory discount economy fare/s that the airline in question should publish and
charge. (However, the airline/s may elect to
lower profit margin on some routes, depending on competitive pressures, and such
variations can be incorporated and/or assessed: They
should not include negative profit margins.)
To calculate compensatory full economy fares (as opposed to discount economy fares)
the load factor should be changed to circa 60% in the equation above and seat pitch to 34
inches, and the exercise rerun. To calculate
compensatory business class fares the seating should be reduced, from ten to six
abreast (or six to four abreast depending on aircraft type); pitch increased to 40 inches,
say; and certain indirect cost account levels increased for appropriate escalations in
service. A load factor of 60 % should be
assigned, plus profit margin, and the exercise rerun.
All assumptions can be similarly reassigned to calculate compensatory first
class fares. These are not complex economic
issues.
The resulting compensatory US domestic and transoceanic fares from such analyses need not
be defined as being precise, but should be indicative of reasonable bands of compensatory
fares for the different classes of service and the different levels of discounted advance
purchase economy options (i.e. just as Southwest has bands of peak/off-peak, weekend and
seasonal compensatory fares). What has become
patently clear, to expert and layman alike, is that a $5000 business class roundtrip fare
for a Boston-Dublin flight on Aer Lingus or American, or a $7500 business class fare for a
Boston-London roundtrip on British Airways or American (they are all linked together in
the same alliance anyway) is outrageous. And a
$2000 economy class fare for a coast-to-coast domestic roundtrip is usury and smacks of
collusion cooked up at Conquistadores.
An example of how far astray establishment airlines have gone in their pricing can be
illustrated as follows. British Airways
747-400’s were scheduled on the Boston-London route in 1999/2000. Total operating cost for the 13-hour roundtrip, on
this aircraft type, with three classes of service was $200,000. The business class section alone had nearly 80
seats. The BA business class fare at that time
was $5000. For the whole flight to break even,
the requirement would be to fill forty business class seats at full business class fares. In other words, BA had only to fill fifty percent
of the business class section to break even… the rest of the airplane could be empty. No economy class passengers, no first class
passengers, no freight in the belly, no mail, no duty free sales. Just 40 passengers out of total of 400 seats. Ten percent load factor!
What happens of course is that most of the business people traveling in the business class
section are not paying the full business class fare. The
employees of large corporations and financial institutions have been given bulk travel
deals, usually 50% positive space. Some
occupants of the business class section have been upgraded from economy, or they are using
frequent flyer miles for a free trip. Those
that pay full fare are the small firm executives, self-employed professionals and the
like.
With a compensatory fare structure, there would be no need to give the big firms half fare
deals with small firms having to cross subsidize them.
Going back a decade, Mr. Crandall tried to introduce (or force through some might say) a
new domestic fare structure, in April 1992, called “value pricing” which might
have gone part-way toward compensatory disciplines. But
the other carriers balked at AMR’s dictatorial process, which led Northwest to offer
the free adult-with-a-child gimmick fare, which led AMR to cut all fares in half and
scuttle the industry.
It is now time to get the progression of fares to a compensatory level for all
classes of travelers. Particularly
after 9/11/01. New fare structures will
stimulate the higher yield travel market, and decrease the need for government-backed
subsidies. Healthy airlines will help get the
U.S. economy back on track and out of recession faster than otherwise. It does not require re-regulation of the U.S.
aviation industry. It does not require
anti-trust collusion. It does need a short
public debate and, perhaps – but not necessarily - unified action by certain major
airline presidents. It is not only a feasible
concept; it is entirely do-able.
Juan O’Callahan has been in the
aviation industry for 45 years (Boeing, World Airways, Pacific Airlines, GPA Group, and as
principal of his own consulting firms TAI Ltd. and JOCResearch). He was a director of America West, Morgan Stanley
Aircraft Finance, WorldCorp, Avitas Inc., GPA Corp. He has testified as an expert economic
witness before aviation authorities in the