Here’s an explanation, but don’t bitch to me!

As I sip my diet Coke in seat 3B aboard a flight to California, I’m thinking back to a conversation I had with a couple of Twitter friends just 36 hours ago about airfares and how wildly those fares fluctuate from minute to minute or even seat to seat.  I figure, I’ve got five hours to kill, so I think I’ll tackle that general inquiry with a little bit of “Airfares, he wrote.”

I’m not an airline industry dilettante, nor am I an expert in airline revenue management.  But I have advised clients in the industry enough to have had to understand the pricing “end goal.”  So let’s see how well I can breakdown a seemingly complex topic via a light narrative to give folks insight into how airline fare pricing and strategy works.

For this example, I’ll use a theoretical airline and route that carries ten passengers flying from a destination named ‘Point A,’ to another destination called ‘Point B.’  Everything in-between (no pun intended!) will be ultra-simplified leaving out things such as fluctuations in fuel prices and the financial impact of ground delays (for example, due to weather or equipment failure) on this ten-passenger flight.  The ten passenger scenario fits very nicely into the roundabout percentages (each seat representing a percentage of passengers affected on a flight elsewhere) and how those affected groups impact the expense and revenue dynamics of an everyday flight.

The easiest way to understand how the pricing process works — again, in spite of this not necessarily representing the industry’s expert workflow — is to do this backward.  So we’ll start the story here, with Star Spangled Airlines and their flight from Point A to Point B and the variables it knows will impact this flight.  Things like:

• The cost for fuel to accomplish this flight is estimated to be $1,000.
• The cost for human resources and other operational items is estimated to be $500.
• The airline’s government fees are estimated to be $100

Star Spangled Airlines’ Revenue Manager, who is in charge of pricing seats for the airline now knows that this flight, in order to simply break even must sell fares totaling at least $1,600.  Mr. Revenue says that if Star Spangled Airlines only makes $400 profit on this flight, “he’s doing business just fine.”  So the goal has been set:  Star Spangled Airlines needs to sell ten seats, all totaling $2,000 in fares, to meet its goal set by pricing guru Mr. Revenue.

Running Tally; chart reference:  Flight expenses of $1,600 highlighted in red.

It’s six months before this Star Spangled flight even takes off.  Mr. Revenue is looking for a way to kick start the process to fill seats on this flight, and he instructs Star Spangled Airlines’ marketing manager to offer a sale of seats on this flight.  After one week of a “published fare sale,” Star Spangled Airlines has sold two seats at $100.  That’s 20% of the flight’s total seats at half the price of the average per-seat cost that Mr. Revenue had set as a goal.  But since Mr. Revenue authorized the sale, he realises he must authorize other means to make-up the loss in revenue.

Running Tally; chart reference:  Flight expenses of $1,600 with 2 seats at $100/each in revenue; Current loss is $1,400

Star Spangled Airlines’ Mr. Revenue calls the airline’s “Load Manager” to discuss what the anticipated load factor (capacity and demand) will be for this flight from Point A to Point B.  Ms. Load says there’s always one commuter (common term for a frequent flier who uses a specific route) who books late, but doesn’t mind paying more.  Otherwise, Ms. Load indicates the flight is expected to be at or near capacity.  Mr. Revenue interprets that to mean he may sell 9 or 10 seats.

Note:  I’ve oversimplified the responsibilities of a ‘load planner’ in order to convey a general concept instead of explaining the intricacy involved in what a load planner does and who he/she interacts with to ascertain anticipated capacity as well as potential demand for a particular flight.  To get a better understanding of what an actual load planner does for an airline, you can view a sample job description for the position.

Great information from Ms. Load, Star Spangled’s load manager.  Based on Ms. Load’s information, Mr. Revenue holds one seat (which will not be available for sale until a few days before the flight departs), but prices that seat at a minimum of $300.  This is in consideration for that commuter who is likely to book and pay early.  Make a mental note of this particular seat.

Star Spangled’s Mr. Marketing rings Mr. Revenue to say a competitor airline has released a fare promotion for a similar flight and now, seats for this competitor airline are selling for $50.  Worried that his flight might be too empty to break-even because he’s being undercut by a competitor, Mr. Revenue authorizes another fare sale at $50 each for anyone buying in the next month.  Mr. Marketing says the sale is wildly successful.   They sold 30% of the flight at $50 per seat; so three seats at $50 were sold.

Running tally; chart reference:  Flight expenses of $1,600 with 2 seats at $100/each, and now 3 seats at $50/each in revenue; Current loss is $1,250

Now that Star Spangled’s competitor has completely sold-out of its undercut seats, there are no $50 seats available anymore.  Star Spangled realigns its fares on the flight from Point A to Point B at $175.  This is a strategy Mr. Revenue and Mr. Marketing have devised in order to entice people to buy this fare, but keep it close to its original break-even-per-seat fare.  And it seems to work; two seats or 20% of the flight are sold at $175 each.

Running tally; chart reference:  Flight expenses of $1,600 with 2 seats at $100/each, another 3 seats at $50/each, and now 2 seats at $175 each in revenue; Current loss is $900

At this point Ms. Load calls Mr. Revenue to say, “Look, you’ve got just 20% of the flight available, not counting that one seat you left out of inventory assuming Mr. Commuter will take it.”  Mr. Revenue already knows this and he realises why Ms. Load is calling:  How is he going to make-up the lost revenue so far if he wants to simply break-even?  Can he even make the $400 profit, which was his goal?  Mr. Revenue runs the risk of tarnishing his good reputation as a great revenue manager.  He’d be scheduling a flight and pricing it in a way that LOSES money for Star Spangled Airlines.  Not a good look.

Mr. Revenue does a bit of research on this route from Point A to Point B.  Only three airlines serve this particular route and of those three, only the under-cutting competitor flight (which is sold out, if you remember) will arrive at roughly the same time as Star Spangled Airlines’ flight.  The timing of a flight’s departure is significant because many in many cases, arrival times impact the demand for a particular flight.  Now Mr. Revenue realises his flight with just 30% available (made up of the 10% for Mr. Commuter and the free-and-clear 20% available), will be in high demand.  As a result, Mr. Revenue reprograms fares on the remaining seats on this flight to now sell at a minimum $500 per seat.

But before seats are sold, Mr. Revenue reaches out to Star Spangled Airlines’ sales manager to see if traffic to internet fare sites and Star Spangled’s own site show interest in the flight.  Mr. Sales says:  Yes, demand is high; There were thousands of website hits doing fare research for this  specific trip from Point A to Point B.  Mr. Revenue then tells Mr. Sales he’s slicing available inventory in half.  Essentially, half of the remaining 20%  (which doesn’t include that set-aside fare for the yet-to-materialise Mr. Commuter) will be priced at $700 and the other half left at $500.  Mr. Sales obliges, and now when passengers search for seats and fares on the trip from Point A to Point B they’ll see varying fares; there’ll be one fare for $500 and another fare for $700.  Keep in mind, there is still that seat being held “just in case.”

Five days before this trip departs, the two remaining seats are sold; one for $500 and the other for $700.  Mr. Revenue is delighted, his flight is looking up after all.  But he’s still nervous, so he releases the set-aside seat guessing that Mr. Commuter would’ve booked by now.

Running Tally; chart reference:  Flight expenses of $1,600 with 2 seats at $100/each, another 3 seats at $50/each, 2 seats at $175 each, and now 1 seat at $700 and another at $500; Current profit is: $300

At this point, Mr. Revenue has almost reached his original goal of generating a profit of $400 for this trip from Point A to Point B.  The simple math tells him that if he just prices the last remaining seat that he’s released (originally it was being held for Mr. Commuter, if you recall) at $500, he’ll look like a superstar.  Not only will he increase profit for this flight (which means he exceeds his goals and impresses the airline’s top brass).  Mr. Revenue prices this last seat at $500.  It’s up for grabs; anybody can take it!

And someone does take that last seat.  Ms. Jane Q. Flyer paid $500 for this last seat.  In a perfect world, this flight will take-off completely full, and will turn a profit for Star Spangled Airlines a decent $800.  Not bad — If you believe in perfect worlds, that is.  And if so, there’s no need to read any further.  Based on this ‘perfect world’ flight, and referring to the left chart below, Star Spangled Airlines spent $1,600 on this flight from Point A to Point B and took-in revenue of $2,400 with a net profit of $800.  Stellar — of course, in this ‘perfect world’ — for Mr. Revenue!

But let’s give Mr. Revenue some excitement in his life as an airline revenue manager.

Turns out, Ms. Jane Q. Flyer isn’t the “Mr. Commuter” Mr. Revenue had been advised about.  And in fact, one day before the flight, Mr. Commuter shows up to purchase a seat on this flight.  Anyone who’s experienced Murphy’s Law realises, things happen.  And in thinking this, airlines will often overbook flights.  So Ms. Load sees no problem in assuming 1% of the passengers on this flight from Point A to Point B will either show up too late to fly or miss the flight altogether.  As a result, Ms. Load releases a “+1″ seat, which will overbook the flight.  She then advises Mr. Revenue to sell this additional seat at the cost commensurate with the value of a proverbial “impossible-to-find” seat.  Mr. Revenue obliges, and sells this seat to Mr. Commuter for $750.

Keep in mind, the highest-priced fare for this trip was $700.  Which means even if the passenger who paid the most so far doesn’t show up, Star Spangled Airlines still anticipates to make a profit on this flight.  Everyone’s excited!  Mr. Revenue, Ms. Load, Mr. Sales, and Mr. Marketing all meet for beers after work and praise each other for doing their respective jobs well.

Fast forward to flight day:  As passengers start to check-in, Ms. Load calls Mr. Revenue to say because this flight is overbooked, she’s monitoring who’s checked-in so far.  She says it’s 90% checked-in, which means there is 1 seat left, but potentially two passengers who still haven’t checked-in.  An hour prior to departure, the flight is 100% checked-in and Ms. Load calls Mr. Revenue to say she’s crossing her fingers that the last passenger doesn’t show up.  But Ms. Load’s done some research and she finds that the only passenger not checked-in is Mr. Commuter.  Since Mr. Commuter buys “full fare” airfares, he can cancel or modify his reservation without a fee, so Ms. Load tells Mr. Revenue, not to worry since Mr. Commuter sometimes decides at the last minute not to fly.  Mr. Revenue is eager to see this flight off, so he just waits.

Now it’s 45 minutes to departure and an alert appears on-screen for the agents managing the boarding of the flight; “Checked-In Status OB.”  This means there are now 11 passengers checked-in for a 10-passenger flight.  Gate agents will need to start asking for volunteers to surrender a seat.  Ms. Load isn’t worried; she calls Mr. Revenue and says, this route is full of leisure travelers and someone — perhaps even two — will volunteer their seats.  Mr. Revenue isn’t worried either.  Alas, Ms. Load was right, one volunteer appeared at the gate desk; it’s the $700 passenger.

But if you’ll recall, it’s this $700 passenger whom Mr. Revenue earlier figured wouldn’t cause the flight to take a loss even if this passenger didn’t make the flight.  Look back carefully though, the assumption of this passenger not having the potential to cause a loss was based on this passenger not showing up.  The assumption wasn’t based on this passenger volunteering a seat.  This matters because in cases of overbooked flights where passengers are “bumped,” the airline is expected to compensate such passengers.  A “bumped” passenger is a confirmed ticket holder who has been denied boarding (read: he has not volunteered) because a flight is overbooked.  In this case, a “bumped” passenger is provided a level of compensation that may or may not be lower than the value of compensation offered to a passenger who offers his/her seat for an overbooked flight.

So back to the $700 passenger and the seat that has now been volunteered.  Gate agents have provided Mr. Volunteer with an $800 travel voucher good for a future flight.  Content, Mr. Volunteer is rebooked on a different flight.  And now Star Spangled Airlines can proceed with a departure of its flight from Point A to Point B — with its ten passengers.

Everyone seems happy, except Mr. Revenue.  And here’s why:  The expense and revenue dynamics of this flight have now changed.

Refer to the chart below and notice that the passenger who had originally paid $700 for the flight has been replaced in Seat 10 by the passenger — yes, Mr. Commuter! — who paid $750 (highlighted in yellow).  That’s an increase in revenue, so what’s the big deal?  The big deal is:  This flight has incurred an additional $800 in expenses (also highlighted in yellow) that represents the compensation provided to the $700 passenger who had volunteered his seat.  And that small move of one seat, roughly 1% of the flight’s seats, eliminated the ‘perfect world’ profit of $800 down to a paltry $50 in profit.

And with that, Mr. Revenue has missed his profit goal.  Sad for him.  Yet, while our ten sample passengers probably had the times of their fare-sale-loving lives in Point B, real life awaits them in Point A along with another set of variables that will inevitably impact the pricing structure on any given flight from Star Spangled Airlines.  Or on any other airline trying to eek out a  sustainable business model.

[Cue old lady piano music as I ride away on my basketed bicycle.]

But just in case you either don’t believe my scenario — which, I repeat, is a generalisation-turned-short story — or would prefer a more direct, straight-from-their-mouth-to-your-ear delivery on how airlines price fares on their flights, I offer a couple resources; namely:

• An explanation from The Cranky Flier (2009), who also happens to be on Twitter as @CrankyFlier and who runs a popular aviation-related blog called CrankyFlier.com
• An expose done by CNBC about American Airlines (2003) and that airline’s answer to “How many fares do you offer per flight?”