Airlines’ Costs and Revenues

Legacy Carriers vs. Low Cost Carriers

Airline Costs

Airline Revenues

Are Baggage Fees Justified?

Pricing Fairness

Alternatives to Baggage Fees

According to the CAPA Centre for Aviation, it was early 2008 when the US airlines started charging customers to check their first and second pieces of luggage. “Previously, additional charges were not applied until the third bag was checked. The claimed reason behind the baggage fees was to help the carriers offset high fuel prices.”

Scott McCartney in The Math Behind New Baggage Fee, reports that since the airlines started charging passengers to check even their first bag, more passengers have been bringing their luggage on-board the plane with them as carry-ons, causing flight delays as passengers vie for space in the overhead bins:

To avoid checked-baggage fees, more travelers are carrying more bags onboard with them. At the same time, airlines have packed flights with more passengers, on average. That's led to a real-estate crisis in the cabins—not enough space in overhead bins to accommodate all customers. So more flights are delayed when customers struggle to cram bags into full bins and airline workers have to send bags that don't fit down to cargo compartments.

McCartney further indicates that the costs associated with the flight delays caused by passengers grappling for space to store their carry-ons is now being used by the airlines to justify charging passengers fees for carry-ons. Checked baggage and carry-on fees have caused “consumer outrage, Congressional scorn and federal investigation,” according to McCartney.

Are the baggage fees justified? Why are passengers so outraged at the fees? Is there a better alternative to the current structure of checked and carry-on baggage fees?

Airlines’ Costs and Revenues

The first thing to understand about the US airlines industry is the market is served by two very different sets of carriers: the legacy airlines and the newer low cost carriers (LCCs). The two sets of carriers have very different cost and revenue structures from one another.

Legacy Carriers vs. Low Cost Carriers

The legacy airlines are the larger airline companies that have been around since the market for commercial air travel began, including American, United, and Delta, whereas the LCCs, such as Spirit and JetBlue, are the newer airline companies without all the legacy costs (e.g. pension liabilities) of the legacy carriers. Southwest is in its own class and exhibits characteristics between the other two sets of carriers. The most significant points of differentiation between the different sets of carriers are

• Each of the legacy carriers cover the entire US, whereas LCCs tend to be regional. (http://www.airlineroutemaps.com/USA has good route maps for each of the airlines.)
• The legacy airlines generally employ a hub and spoke flight system, whereas LCCs employ a point-to-point system.
• The legacy airlines tend to have higher labor costs, due to historically strong labor unions together with associated pension liabilities for current and retired employees. Being newer companies, the LCCs do not have as large historical pension liabilities, and their current labor costs tend to be lower.
• Being newer to the industry, the LCCs tend to have newer aircraft, which are both more fuel efficient than their older counterparts of the legacy carriers and require less maintenance On the other hand, the legacy carriers are larger than the LCCs (in terms of annual passenger miles flown), which means they use more fuel, and might receive volume discounts (pay less per gallon for fuel than the LCCs). At the same time, the average flight segments for the legacy carriers are longer (national) than those of LCCs (regional), and longer flights benefit from greater fuel efficiency. On balance, then, it is not clear whether the legacy carriers or the LCCs would have lower fuel costs. 

Airline Costs

Figures 1 and 2 compare the cost distributions of American Airlines (legacy carrier) to those of Spirit Airlines (low costs carrier).

Figure 1

Figure 2

Notable from the cost comparisons is that:

• Fuel costs constitute a smaller portion of costs for American (24 – 32%) than they do for Spirit (31 – 42%)
• Labor costs constitute a larger portion of costs for American (23 – 30%) than they do for Spirit (19 – 23%)
• Airline rental costs constitute a smaller portion of costs for American (3%) than they do for Spirit (13 – 16%)
• There is a significant jump in relative fuel costs from 2007 to 2008, when the airlines started charging extra fees to check passenger luggage;
• There was a significant drop in relative fuel costs for both airlines from 2008 to 2009, as the financial crisis hit, the price of fuel dropped with the drop in economic activity, and air travel slowed dramatically; and
• There were significant increases in relative fuel costs for both airlines from 2009 through 2011, as fuel prices and air travel have slowly inched back up with the anemic economic recovery.

Finally, there are two remaining components of the airline’s cost structure that are relevant to the analysis at issue: the costs associated with (i) baggage handling and (ii) flight delays. When passengers check luggage through the airlines, the airlines incur the following types of costs:

• Time costs associated with flight attendants checking and tagging the luggage;
• Time costs associated with ground workers loading and unloading the bags into and out of the cargo compartments;
• Fuel costs associated with carrying the luggage weight;
• Financial costs associated with injuries sustained by flight crew members or passenger associated with handling luggage; and
• Financial costs associated with compensating passengers for lost or damaged luggage.

On the other hand, when passengers carry luggage onboard the airplane with them, the airlines incur fuel costs associated with carrying the luggage weight, plus costs associated with delays in flight schedules associated with passengers holding up the boarding process while trying to find space to stow their luggage. (When passengers carry luggage onboard the plane rather than checking it, there are also additional costs for passengers and airports associated with passing the extra luggage through airport security.) Flight delays, including those caused by passengers trying to stow carryon luggage, are very costly to the airline industry. Research commissioned by the FAA reported that 2007 costs of delays in air transportation totaled almost $33B:

Costs of Air Transportation Delays in 2007

Costs to Airlines: $8.3 billion

included increased expenses for crew, fuel and maintenance, among others. Nearly half this cost is due to padded schedules, the hidden delays that are built into schedules because the airlines anticipated them.

Costs to Passengers: $16.7 billion

calculated based on lost passenger time due to flight delays, cancellations and missed connections, plus expenses such as food and accommodations that are incurred from being away from home for additional time.

Costs from Lost Demand: $3.9 billion

lost demand from potential airline customers who used alternatives such as traveling by automobile, or conducting their business using telecons and video conferencing, rather than face airline delays.

Total Direct Cost: $28.9 billion

Impact on GDP $4.0 billion

inefficiency in the air transportation sector increases the cost of doing business for other sectors, making the associated businesses less productive.

Total Cost: $32.9 billion

In other words, there are costs to airlines associated with baggage, notably fuel costs associated with carrying the weight of the luggage, whether passengers check the luggage through or carry it onboard the planes. As one airline blogger, Eric Joiner, Jr., so elegantly put it

…the majors [Legacy Airlines] discourage checked baggage. They don't want you to bring luggage in the first place because you screw up their network planning. Most majors don't want you to have ANY bags. They don't want to carry them and especially they don't want the liability for tracking and reuniting you with a bag left behind because of network mismatch. 

Airline Revenues

Legacy and low cost carriers also differ in the structure of their revenues. Legacy airlines have regional subsidiaries or affiliates (e.g., American Eagle, United Express, Delta Connection), to and from which the feed passengers on their national routes. The legacy airlines collect revenues (and pay fees to) their regional subsidies. Furthermore, when there is extra space available in the cargo holds (of the larger airplanes), legacy carriers generate revenues from sales of cargo services. In contrast, LCCs have no subsidiaries and generate no revenues from sales of cargo services. Rather, they are wholly dependent on sales of tickets and ancillary services to their passengers.

Figures 3 and 4 illustrate the distribution of revenues for American Airlines and Spirit Airlines over the past several years.

Figure 3

From American Airline’s 2011 10K Report:

Other revenues, which approximate 10.8% of total revenues, includes revenue from the marketing services related to the sale of mileage credits in the AAdvantage program as discussed above, membership fees and related revenue from the Company's Admirals Club operations, and other miscellaneous service revenue, including administrative service charges and baggage handling fees. Other revenues have been increasing as the Company unbundles its services and charges for ancillary services.

Figure 4

From Spirit Airline’s 2011 10K Report:

Our ULCC [Ultra Low Cost Carrier] business model allows us to compete principally through offering low base fares... Since 2008 and 2007… we have unbundled components of our air travel service that have traditionally been included in base fares, such as baggage and advance seat selection, and offer them as optional, ancillary services for additional fees (which we record in our financial statements as non-­ticket revenue) as part of a strategy to enable our passengers to identify, select and pay for the services they want to use. While many domestic airlines have also adopted some aspects of our unbundled pricing strategy, unlike us, they generally have not made a corresponding reduction in base fares.

We have lowered our base fares significantly since initiating our unbundling strategy in 2007, with the goal of stimulating additional passenger demand in the markets we serve. We plan to continue to use low fares to stimulate demand, a strategy that generates additional non‐ticket revenue opportunities and, in turn, allows us to further lower base fares and stimulate demand even further. This unbundling and low base fare strategy is designed to support profitable growth.

The two illustrations of the airlines’ revenue distributions indicate that non-ticket revenues (e.g., checked baggage fees and fees for other ancillary services) constitute a small but slowly growing portion of American’s revenues, whereas non-ticket revenues constitute a large and quickly increasing portion of Spirit’s revenues.

Are Baggage Fees Justified?

“Strategic Report for Southwest Airlines” prepared in April 2006 by The Pandora Group provides a concise summary of the recent economic trends in the airline industry (emphasis mine):

While Southwest has gained market share in recent years, legacy carriers have struggled due to depressed market conditions. The entire airline industry has endured expensive labor contracts, soaring energy costs and reduced consumer demand. Southwest has continued to grow in the harsh airline industry because its no frills business model focuses on controlling costs. Southwest targets routes with high consumer demand and the advanced experience of Southwest’s personnel allow Southwest to quickly turnaround aircraft and keep their planes in the air more hours per day than its rivals...

Southwest has experienced remarkable growth in the airline industry by steadily taking market share from large legacy airlines. However, Southwest’s success has brought considerable change to the market conditions of the airline industry. The struggling legacy airlines have been forced to streamline operations and new airlines with aggressive low-cost strategies have entered the industry. Damaging price wars have forced many airlines to drastically alter their cost structure in order to remain competitive. By its success, Southwest has begun to alter the market conditions that were partially responsible for its success.

The unbundling of airline fares starting in 2007 to 2008 was a response to the increases in price competition by the carriers. By excluding ancillary services from base fares, the airlines could lower their prices in response to competition from rivals, while at the same time earning back much of the revenues excluded from the base fares by charging passengers separately for such services as checking baggage, selecting seats, and receiving food.

As the price of fuel started increasing rapidly in 2008, so did the airlines expenses, since fuel constitutes such a significant portion of total airline expenses. However, the pressures from price competition from rival airlines, especially the low cost carriers, meant that if the airlines raised their (base) fares as the cost of fuel increased, they risked losing passengers to lower priced rivals.

The implementation of fees for checking baggage served as a means for the airlines to recoup some of the increases in the fuel costs through ancillary fees, without directly raising their ticket prices and risking their competitive positions vis-à-vis the other airlines. Of course, if the full price (base ticket price plus ancillary fees) to passengers of using different airlines to travel were fully transparent, then the distribution of price between base price and ancillary fees would make no difference. However, there is not, in fact, full transparency, so the distribution does end up mattering. (There are efforts underway to force the airlines to create more transparency in pricing by having them explicitly report all ancillary fees. See for example http://regulationroom.org/airline-passenger-rights/baggage-and-other-fees/.)

At the same time, however, the airlines’ implementation of fees for checking baggage led passengers to carry more luggage onboard planes rather than to check it through. While airlines still had to bear the costs of the fuel needed to transport the luggage, they traded baggage handling costs for boarding delays, imposed greater security costs on passengers and airports, and created ill-will from passengers due to the added costs and inconvenience.

Furthermore, if the airlines thought the baggage fees through, they should have anticipated the need to eventually charge passengers fees to carry luggage onboard the planes, so as to stem the costs of boarding delays. In turn, carryon fees should have been anticipated to cause further outcry/ill-will from passengers.

The baggage fees have definitely helped the airlines recover some of their fuel costs. Specifically, the Centre for Asia Pacific Aviation and Bureau of Transportation Statistics, reported the portion of US airlines’ fuel costs recovered through baggage fees from the second half of 2008 through the second half of 2009 in Figure 5:

Figure 5

One might argue that the airlines were “justified” (however one defines it) in the following sense. The costs savings associated with checking fewer bags and the revenues generated from baggage fees are certain and tangible. At the same time, the added costs incurred associated with boarding delays caused by passengers needing extra time to stow their added carry-ons are uncertain and intangible. However, this seems a specious and naïve argument.

From an economic standpoint, the baggage fees would be considered economically justifiable if there is a strong correlation between the price passengers pay to check their luggage and the cost to the airlines of fuel.

Since fuel use increases with the total weight of planes and their cargo, it clearly takes more fuel for the airlines to transport a passenger with luggage than it does to transport the same passenger without luggage. However, the extra fuel required to transport the luggage is independent of whether the luggage is checked or carried onto the plane. In this sense, then, passengers who check their luggage are being penalized with respect to equivalent passengers who carry their luggage onboard. In other words, a baggage fee would only be justified if it applied to all luggage, whether it is checked or carried on.

Furthermore, suppose you have a child who ways 50 pounds and has one piece of luggage that weighs 25 pounds. Compare the fuel costs of transporting the child and her piece of luggage with that of transporting an adult with no luggage who weighs 150 pounds. In this case, the costs of fuel associated with transporting the child and her luggage is less than that for transporting the adult with no luggage, yet if the child checks her bag, she will be paying more than the adult for her transport.

Given these two examples, it does not seem that the baggage fee is an economically justified means of recouping fuel costs.

Pricing Fairness

At least part of the reason there has been so much outcry by passengers about the fees imposed by airlines for checking luggage has to do with perceptions of pricing fairness. Anytime a consumer considers the price of a good or service, he makes an assessment as to whether or not the price being charged is fair. Consumers generally assess the price of a good or service either by comparing the price being charged for the item (i) to the price being charged for the same or similar items by other vendors, or (ii) to the price the consumer paid for the same or similar items in the past.

In “The Price Is Unfair! A Conceptual Framework of Price Fairness Perceptions” by Lan Xia, Kent B. Monroe and Jennifer L. Cox, the authors make several statements that are directly relevant to the case of the airlines’ imposition of fees for checking baggage:

Price comparisons lead consumers to one of three types of judgments: equality, advantaged inequality, or disadvantaged inequality. A perception of price equality normally does not trigger a fairness perception, or if one is triggered, it may lead to perceived fairness. A perception of price inequality may lead to a judgment either that the price is less fair than the equal prices situation or that it is unfair…

…perceived unfairness is less severe when the inequality is to the buyer’s advantage than when it is to the buyer’s disadvantage…

A buyer may have feelings of unease or guilt when the inequality is to his or her advantage but feelings of anger or outrage when the inequality is to his or her disadvantage…

…perceived price unfairness increases buyers’ price consciousness. Because price-conscious buyers tend to focus on the monetary sacrifice of a price, higher perceived price unfairness increases perceptions of monetary sacrifice.

So as they apply to the airline situation, the above passages suggest that when the airlines imposed the fees for checking baggage, passengers compared the new fees to the prices they had paid in the past to check luggage – zero for the first and second pieces of luggage – and concluded that the new fees were unfair.

The unbundling of airfares by the airlines may very well have led to lower base fare prices. However, to the extent that passengers noticed that the (base) prices were lower, as per the article on pricing fairness, they would have perceived the “unfairness” as being to their advantage and thus as being “less severe” than any equivalent increases in ticket prices associated with checking luggage. Furthermore, the sense of pricing unfairness associated with the new baggage fees would have led passengers to focus on the “monetary sacrifice” and experience “feelings of anger or outrage”, hence the outcries over the new fees reported in the media.

Better Alternatives to Baggage Fees

Given the large public outcries over the baggage fees and the loss of goodwill it has cost the airlines, one must wonder if there couldn’t have been a better way for the airlines to recover the increases in their fuel costs due to increasing fuel prices.

The authors in the article on Pricing Fairness indicate

A perception that a price is unfair results not only from a perceived higher price but also from consumers’ understanding of why the higher price was set. The seller’s cost plays an important role in buyers’ assessing of whether a price or a price increase is acceptable or fair … [A]n unavoidable increase in a firm’s costs may make the price increase acceptable…

What this suggests is that rather than implementing new fees to check baggage, the airlines might have been better off by simply adding a fuel surcharge onto the ticket prices, as they (and other companies, such as FedEx and UPS) have done in the past. Passengers would have seen the justification for the surcharge and not experienced the same outrage as they did with the baggage fees.

On the other hand, when the price of fuel dropped after the financial crisis hit in 2008, the airlines would have been expected to remove or decrease any fuel surcharges, whereas with the baggage fees, the airlines continued to collect revenues. However, fuel prices are in fact expected to rise in the future as the global economy becomes more productive. In the long run, fuel surcharges could definitely be a viable alternative.

Alternatively, consider the example posed above with the child and her piece of luggage versus the adult with no luggage. Another possibility might be to have each passenger together with all his carry-ons stand on a scale and be charged for the total weight. Of course, there would be great outcry from people who do not want their weight to be made public. However, the point is to have weight categories for the passenger and luggage and charge each person accordingly. This would solve the delays created by having people bring all their luggage onboard and delay takeoff while they try to find space for their bags. It would also prevent the imminent outcry when airlines start charging for carryon luggage as well as checked luggage.