Nadja Killisly & Ravindra Bhagwanani at Global Flight Management OFFENBACH
If airlines value the loyalty of their best customers then they should recognise the value of the frequent flier miles which keep them loyal. The second of two articles on FFP schemes sets out a method of calculating this value and for forging a link with yield management.
No airline would seriously doubt the value of keeping its best customers loyal. That is, after all, the fundamental reason for setting up a Frequent Flier Programme (FFP). Yet few have taken the next logical step and begun to count the true financial costs and benefits of their loyalty schemes. By doing so they could finally begin to put a hard revenue value on the miles granted to their frequent fliers and even start taking rational yield management decisions about their award flight request.
In the first part of this article, Global Flight Management, a consultancy specialising in loyalty programmes, outlined the basis of a measurement model through which to gauge the operational success of an FFP (see Airline Business April 2001). Here, the second part completes this model with an approach to measuring financial performance of an FFP.
Many airlines still see the FFP operation as an overhead, usually carried by the marketing department. It should rather be considered as a cost centre in its own right. The most radical way to reach that point would clearly be to outsource the entire function. Among others, Swissair and its partners chose this option by creating the Qualiflyer Loyalty joint venture as a standalone limited company. A similar approach has been used to create Miami-based Latin Pass, the company owned by various Latin American carrier members. It is not necessary for others to go quite so far, but such an approach does provide a good example of how to think about loyalty schemes.
The basic aim should be to gather all FFP profits and losses together into a clearly identifiable cost centre operation. The primary mission of such a unit is not to make huge profits, but to contribute to a growth in revenues for the airline as a whole. This means that even a loss-making FFP cost centre may be acceptable.
Valuing award flights
Once there is an accountable cost centre, the next and more important step is to look at a way of determining the revenues it should receive from award flights. At first glance, the concept of attaching revenues to such flights may seem foreign. Indeed, many airlines consider the revenue as zero and just calculate the cost. As a consequence, they would try to only allocate seats for award travel through their yield management system that are otherwise likely to go empty. That is almost certain to result in conflicts and frustrated frequent fliers, especially against a background of rising demand.
A central part of the problem - and the solution - stems from the way in which airlines view FFP travel. In fact, award tickets should not be seen as free. They are nothing less than tickets purchased far in advance by the airline's most loyal customers through the accumulation of award miles. And these miles generate an actual revenue stream for programme operators. In the case of the fixed-price sale of miles to programme partners, the revenues are directly measurable. But miles accumulated on the scheme's parent airline need to be included in the model too. These should be considered as an investment in customer loyalty and need to be treated as such internally.
In this way, the virtual revenue stream is turned into a real one. Since the aim is to forge a link between the FFP operation and yield management, it is logical to base this investment on a fixed proportion of the corresponding revenue rather than on the basis of price per mile purchased. For instance, the proportion could be set at 1% for short-haul flights and 2% for long haul. Internally, the parent airline should be considered simply as another programme partner buying miles from and selling award flights to the FFP cost centre.
With these streams of income and outgoings clearly established, it is possible to establish a basic profit figure for the FFP centre. Revenues consist of miles sold to the parent carrier and to outside airlines or non-air partners. On the cost side, there are operating costs of the FFP (including depreciation of set-up costs) and the purchase of award flights.
Here, the whole charm of freeing the FFP operation to mind its own financial results becomes clear. In order to improve profitability, the FFP management must actively seek out new partners to maximise its revenue streams. This increases the programme's value for its members and therefore also for the parent airline in terms of building loyalty.
Admittedly, it is easier for larger programmes to achieve a positive bottom line by taking advantage of economies of scale on the cost side. Nevertheless, there is nothing to prevent smaller schemes from showing a profit if they are well organised. It is perhaps significant that the independently run Qualiflyer operation, rather than larger schemes, was the first in Europe to break even.
However, the profitability of the FFP cost centre alone only gives a part of the picture. Besides the direct costs and revenues attached to the centre, there is also the underlying benefit which the scheme is delivering to the parent airline in terms of air travel sales from loyal customers. Clearly this indirect benefit cannot be directly measured. An FFP is rarely the only element in a decision to book a flight. Some airlines estimate that some 20% of their revenues are due to their FFP. Others may choose to be more prudent. But even at a few percentage points, the FFP will be yielding a significant bottom line benefit, especially for an industry which has traditionally struggled to take operating margins into double figures.
In any case, the expected return compares pretty favourably with the suggested investment of 1-2% of revenue covered by the FFP. Neither does a loss from the FFP cost centre necessarily change that picture. Even in the worst case, such losses are highly unlikely to climb above 0.5% of total revenues.
Having given the FFP operation its own financial responsibility, the next question is how to bring yield management disciplines to bear on the loyalty scheme. Here, the starting point is to find a way to calculate the yield of an award flight. The cost side of the equation has always been straightforward. It essentially amounts to totalling up the incremental expense of carrying one additional passenger as well as customer services, such as booking and ticketing.
Based on the model already outlined, the revenues too should be fairly easy to calculate. All miles are given an average value depending on how they were collected. Miles earned on the scheme's parent airline are likely to be of the lowest value, but crucially they are now recognised as having a value. Miles earned on partners - either other carriers or, better still, non-airlines - will have a higher value related to the actual revenue stream involved. So it is possible to determine the average value of one mile for each of the three accrual methods over all outstanding backlog miles. The real revenue streams that were recorded when the miles were credited are taken into account.
It is worth noting that in this context the "value" is not related to the benefit that the customers see when they redeem a mile against a regular ticket. Rather it is the value for the airline based on the accrual structure.
Managing yields
When a member wishes to claim an award and presents the necessary mileage points, the overall revenue that these miles represent can be calculated based on how each was accrued. In the case of awards based on a mix of revenue tickets and mileage redemption (upgrades, companion tickets, mixed cash/miles awards or express fees), the real revenue part of the ticket needs to be added to the calculation.
A more sophisticated approach would be to calculate the value of miles on an individual basis for each scheme member rather than use an overall average. The mileage value would therefore increase for members who accumulate miles on higher revenue tickets - an important point for yield management.
The point is illustrated by the example shown in Table 1 (see over page). Two scheme members each travel coach class on a short-haul flight and both get a credit of 500 miles. However, while the first member paid a discount fare of only $60, the second member purchased an unrestricted ticket for $200. For both tickets the airline paid 1% of revenues to its FFP cost centre. Accordingly, the second member's miles have a higher value and should earn a higher priority in the yield management system when they come to be redeemed.
In a next step, the yield for an award flight can be calculated on this revenue basis. Table 2 shows such a calculation for a roundtrip award flight in coach class between Chicago and Orlando, requiring 25,000 miles. It assumes that 40% of the miles used towards this award were accumulated on own flights, with the rest split between airline and other partners. Latest average values per mile are applied for each category, based on their real value when originally collected. A fixed percentage deduction is made - in this case 10% - to contribute to the expenses of the FFP cost centre. The revenue of such an award comes to $195.75. The yield would be 6.14ó per revenue passenger kilometre (RPK).
Table 3 does the same calculation for a one-way upgrade from an unrestricted $500 economy fare to a business class seat between New York and London. The member pays 10,000 miles giving, in this example, a yield of 10.39ó per RPK.
The FFP cost centre purchases the flight at these award revenue values from the airline - in other words at breakeven. A profit can only be realised through partner awards purchased at prices below the total mileage value and through unused expired miles.
The 6.14ó yield in the short-haul example is well above the level that would be generated by most discounted tickets. Nevertheless, paid fares, however low, usually enjoy a higher booking priority than award flights in the yield management system. That is because the award tickets are wrongly assumed to be issued at zero revenue and therefore zero yield.
Moreover, such an assumption leads to the unacceptable situation where a once-in-a-lifetime leisure traveller on a heavily discounted ticket can take up a seat, while a premium loyalty scheme member wishing to use some of his hard earned miles is turned down.
In the long-haul example, however, it is likely that a higher revenue could be achieved for this business class seat on this specific flight even with a heavily discounted fare. As a result, this upgrade award should be held back until it becomes clear that the seat cannot be used for a regular revenue ticket. And then, it still needs to be ensured that the total award revenue is above the incremental costs for the airline.
High-yield rewards
The suggestion to include the whole FFP issue as an integrated part to the yield management comes at no surprise on this basis. Award flights should enjoy a booking priority according to their yield generated. Such a priority may be higher or lower than today - but it is far more justifiable from a financial point of view. It would not only be a fairer approach, but also maximise revenues for every flight.
As a direct consequence, seat availability for award flights would be determined by yield. An award flight could therefore take priority over the sale of a seat at a heavily discounted paid fare, so long as the yield was superior. Unlike today, low revenue award tickets would be last-minute in character rather than blocking the possible sale of higher revenue seats for up to one year in advance. The Fly Smart awards introduced on Lufthansa's Miles & More scheme (and also available on partner Austrian Airlines) could be seen as a first step in this direction. These restricted off-peak awards are priced up to one third below standard values, but cannot be booked earlier than 14 days prior to departure.
It can also be seen that yields increase with the proportion of miles accrued on partners. This is yet another reason to pursue the trade of loyalty points which increase the revenue for the parent airline.
A final step is to apply this model at the level of individual members. The objective would be to benefit high-yield travellers by giving them a higher priority on the award-booking ladder. However, this calculation should not take into account the extra value attached to miles earned from partners, compared with those from the parent airline. Although partner miles generate higher revenues for the FFP cost centre, the parent airline will hardly benefit by penalising members which earn points on its own services.
In order to meet both objectives, the suggested approach is to use the average value calculations for miles accrued on partners, but to use an individual calculation for the points built up on the parent airline. There is plenty of room for further fine-tuning, for example to give priority to higher tier members.
Besides the internal advantages associated with such a system, there is another potential customer-related benefit which should not be underestimated. Much of the internal FFP operation can be based on a revenue rather than a strict mileage basis, but while maintaining customer-friendly unified mileage credits per class of service. There is no need to be seen to be going down the unpopular road of giving different credits to every passenger according to the fare paid. That differentiation does take place, but behind closed doors. What the customers really want to feel is that they are receiving the appropriate reward that their loyalty deserves. That is exactly what the airline should finally be in a position to deliver.
Source: Airline Business
