Question

MANAGERIAL CHALLENGE Why Charge $35 per Bag on Airline Flights?

American Airlines (AA) announced that it would immediately begin charging $35 per bag on

all AA flights, not for extra luggage but for the first bag! Crude oil had crushed from $54 to $20

per barrel in the previous 3 months. AA’s new baggage policy applied to all ticketed

passengers except first class and business class. On top of incremental airline charges for

sandwiches and snacks introduced the previous year, this new announcement stunned the

travel public. Previously, only a few deep discount U.S. carriers with very limited route

structures such as People Express had charged separately for both food and baggage service.

Since American Airlines and many other major carriers had belittled that policy as part of their

overall marketing campaign against deep discounters, AA executives faced a dilemma.

DEMAND AND SUPPLY:

A REVIEW Demand and supply simultaneously determine equilibrium market price

(Peq). Peq equates the desired rate of purchase Qd/t with the planned rate of sale Qs/t. Both

concepts address intentions—that is, purchase intentions and supply intentions. Demand is

therefore a potential concept often distinguished from the transactional event of “units

sold.” In that sense, demand is more like the potential sales concept of customer traffic than

it is the accounting receivables concept of revenue from completing an actual sale.

Analogously, supply is more like scenario planning for operations than it is like actual Jet fuel

surcharges had recovered the year-over-year average variable cost increase for jet fuel

expenses, but incremental variable costs (the marginal cost) remained uncovered. A quick

back-of-the-envelope calculation outlines the problem.

If total variable costs for a 500-mile flight on a 180-seat 737-800 rise from $22,000 in

2007 Q2 to $36,000 in 2008 Q2 because of $14,000 of additional fuel costs, then competitively

priced carriers would seek to recover $14,000/180 = $78 per seat in jet fuel surcharges. The

average variable cost rise of $78 would be added to the price for each fare class. For example,

the $188 Super Saver airfare restricted to 14-day advance purchase and Saturday night stay

overs would go up to $266. Class M airfares requiring 7-day advance purchase but no Saturday

stay overs would rise from $289 to $367.

Full coach economy airfares without purchase restrictions would rise from $419 to

$497, and so on. The problem was that by 2008 Q2, the marginal cost for jet fuel had risen to

approximately $1 for each pound transported 500 miles. Carrying an additional 170-pound

passenger in 2007 had resulted in $45 of additional fuel costs. By May 2008, the marginal fuel

cost was $170 – $45 = $125 higher! So, although the $78 fuel surcharge was offsetting

the accounting expense increase when one averaged in cheaper earlier fuel purchases,

additional current purchases were much more expensive. It was this much higher $170

marginal cost that managers realized they should focus upon in deciding upon incremental

seat sales and deeply discounted prices. And similarly, this marginal $1 per pound for 500 miles

became the focus of attention in analyzing baggage cost. A first suitcase was traveling free

under the prior baggage policy as long as it weighed less than 42 pounds. But that maximum

allowed suitcase imposed $42 of marginal cost in May 2008. Therefore, in mid-2008, American

Airlines (and now other major carriers) announced a $35 baggage fee for the first bag in order

to cover the marginal cost of the representative suitcase on AA, which weighs 25.4 pounds.

Discussion Questions:

a. How should the airline respond when presented with an overweight bag (more than 42 pounds)?

b. Make a list of some of the issues that will need to be resolved if American Airlines Decides to routinely charge different prices to customers in the same class of service?

c. What would you do if you were the CEO of AA? Define and justify your Pricing strategy.

Answer 1

Ans (a);

The American Airlines (AA) should respond to this issue with their clients using empathic approach and specify free baggage which is allowed on the flight first followed by additional baggage charges in slab format if the baggage weight is more the eligible free limit. The slabs should be designed in such a way that it may not seem painful to the clients such as incremental slab system beyond free limit. This would help in retaining its clients and recovering the additional cost on baggage.

Ans (b);

The American Airlines (AA) may consider below few points if in case decides to charge different prices to customers in the same class of service. It may be the review of marginal cost on per flight basis if the cost is lesser than the revenue then American Airlines (AA) should check other strategies such as reliable demand prediction, past booking and cancellation trends demand in peak hours and off peak hours categorically which may include long weekends and vacations as well. Further the American Airlines (AA) should also review its marketing budget and most importantly it should work on customer centric approach and reinforcing some referral schemes which will indirectly lead to profit of the airline while maintaining high satisfaction of employee because if employees will be highly satisfied with their job they will play incremental role in client satisfaction.

Ans (c);

If I were CEO of American Airlines (AA) I have used different strategy to maximize customer satisfaction and human centric approach which may had indirectly lead to profit maximization. Other activities such as loyalty program, referral schemes and most importantly i have had given a tagline “peoples airline” through exceptional service experience. This could have helped the airline to gain more popularity amongst people which can help in profit maximization.

My pricing strategy may have been based on experience which people feel during the entire journey starting from flight journey. The strategy may include buying behavior of the consumer, survey and direct communication with existing clients, industry trends, value based approach and most importantly human centric approach. These above points are justifiable because creating a delightful experience to the consumer while considering its worth may definitely increase employee and client satisfaction which will lead to revenue maximization.