Airlines and the Fundamentals of Finance and Economics

I travel a fair amount for my work with HCA. I am fortunate not to have to travel every week but I probably fly somewhere two to three times a month. Over the past two years I have become a fan of Delta Airlines because of their standing as a preferred airline with HCA but also because of their service and the availability of flights (connecting mostly through Atlanta).

When Mandy and I traveled to China this past summer to pick up our daughter, we also flew on Delta. Our decision was based on price, flight availability and the fact that they had a direct Detroit-to-Hong Kong option all on their planes (which was discontinued in August). We purchased two round-trip tickets for ourselves and a one-way ticket home for our daughter.

When we booked our flights the price differential between coach and business class was about $5,000 per ticket, which most certainly put a business class seat out of our reach. I watched the seat availability online closely as our trip approached and noticed that there were only three or four seats sold in business class as of the day before our flight. Knowing that most people do not book a trip to China the day before a departure I decided to get to Detroit and then inquire about upgrading.

I waited until about two hours before our departure (the flight was 16-hours non-stop) and approached the gate agent, who was very polite throughout the entire exchange. I asked about the cost to upgrade to business class and I was told that we would have to upgrade our tickets to a full-fare business class seat at a total cost of a little more than $10,000.

When I asked why the cost was so high given the fact that the seats would be flying empty otherwise I was told that Delta did not want to upset the passengers that had, in fact, paid full fare for business class by selling the remaining seats at a lower cost.

My pledge to keep silent on the matter was not accepted. I guess I looked like someone that could not keep a secret. Mandy and I ended up having a pretty comfortable flight to Hong Kong but I was still shocked by the airline’s basic understand of the fundamentals of finance and economics.

When considering costs, most businesses will classify their costs in to one of three large buckets: Sunk costs, fixed costs and variable costs.

Sunk costs are those costs that have already been spent and cannot be recouped or saved. For an airline, an example of a sunk cost would be the cost of the plane (I will not worry about the concept of plane leasing for the moment). Regardless of whether or not Delta flew that flight to Hong Kong, the company had still purchased the plane. Yes, they have a fixed asset that has value, but the money spent to purchase the plane is gone and most financial professionals would advise them to ignore any sunk costs when making future financial decisions.

Fixed costs are those costs that are known in advance of operating the plane. Examples of these types of costs would include labor, fuel, meals and landing fees. Once a plane takes off these costs are known and unavoidable. In the case of labor costs, Delta was going to incur the costs for the flight attendants in the business class cabin regardless of whether there was one passenger in that cabin or if it was sold out. The only uncertainty is the average costs per passenger in the cabin. The more passengers in the cabin, the lower average costs and vice versa.

Variable costs are those costs that can be forecasted in advance but change in relation to the demands of the business or customers. An example of a variable cost for an airline would be water in the restrooms and alcohol (some of which is free on most international flights). The costs incurred by the airline would grow in direct proportion to the consumption of the passengers. Water not used to wash hands could be used on the next flight. Similarly, alcohol not consumed could be served on the next flight. (Meals are different because they have more near-term expiration dates and cannot typically be carried over from one flight to the next.)

So Delta had sunk costs that should be ignored, fixed costs that would be incurred regardless of how many passengers are in each cabin, and incremental variable costs that are extremely limited based on a handful of storable consumables. Additionally, Delta had already agreed to fly the plane for a certain amount of revenue. It would be nearly impossible for the airline to lose additional money on the flight but they certainly could have made additional money on the flight.

Why not hold an auction one-hour prior to boarding for the remaining business class (or even first class) seats? Start the bidding at $500 per seat and let the passengers decide if they are willing to pay that or not. If someone chooses to upgrade, the airline stands to gain additional revenue for virtually zero incremental variable costs. Conversely, if no one chooses to upgrade, the airline still flies the plane with the expected—and accepted—cost and revenue figures.

Granted, there are risks associated with this approach in terms of upsetting passengers that did pay full-fare for an upgrade. Most likely, however, the individuals flying in business class were either flying for actual business (and, therefore, did not actually pay for the ticket themselves), used frequent flyer miles to upgrade to business class, or were flying outright on frequent flyer miles. Only a select few individuals would spend over $7,000 of their own money on a business class ticket so the risk of upsetting these individuals by selling the remaining seats at a lower cost would be limited.

I will continue to choose Delta whenever I can, (and, in fact, Delta provides upgrades to first class based almost exclusively on frequent flyer status on domestic flights at zero incremental costs to the passengers) but an idea such as the one I have outlined above for international flights does not sound difficult me. What do you think: Am I off-base and missing something or does this idea make sense to you too?

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