A discussion of how airlines can break out of the commodity ticket price trap and capture more their customers wallet.

1. This piece was published before the May 2007 rebranding of
Mercer Management Consulting, Mercer Oliver Wyman,
and Mercer Delta Consulting as Oliver Wyman.
Oliver Wyman
Oliver Wyman is building the leading global management consultancy, combining
deep industry knowledge with specialized expertise in strategy, operations, risk
management, organizational transformation, and leadership development. The firm
works with clients across a range of industries to deliver sustained shareholder
value growth. We help managers to anticipate changes in customer priorities and
the competitive environment, and then design their businesses, improve their
operations and risk profile, and accelerate their organizational performance to
seize the most attractive opportunities.
www.oliverwyman.com

2. Breaking the Yield Barrier
How airlines can create new revenue streams by
merchandising ancillary goods and services
By Andrew Watterson and Raj Lalsare
Airline passengers represent a huge potential market for food, insurance,
package tours, and other products that are adjacent to the core product of a
seat in an aircraft. Carriers in search of high-margin growth can cultivate this
market by building awareness, generating traffic, closing transactions, and fill-
ing the “shopping basket”––in short, by learning how to think like a retailer.
D espite recent successes in raising fares,
the airline industry continues to experi-
ence long-term price deflation on its primary
and some customers seem willing to pay a bit
more for that. For most other airlines, how-
ever, yield and the profitability of a ticket will
product: a seat on an airplane. It has proved continue to decline.
difficult for airlines to break through this Over the past five years, airlines have
“yield barrier” to increase revenues (Exhibit 1). aggressively reduced costs only to see soaring
The problem is that for most customers air fuel prices eat away much of their savings.
travel has become a commodity based prima- Even Southwest Airlines, which has one of the
rily on ticket price and a convenient flight. lowest cost structures in the business, realizes
Some airlines, such as Virgin Atlantic, have that revenues have to grow and raised its top
tried to offer a different travel experience, fares in March and July of 2006. This is a sure
sign that cost reduction, while imperative, is
Exhibit 1 The long-term decline of airline yields not sufficient to achieve financial stability.
All industries face the threat of commoditi-
Index: 190 zation of their core products at one point or
1985=100 another. Demand curves shift and drive inno-
CPI
vation for better products and services.
170
Pharmaceutical firms, for example, confront
the challenge by developing derivatives of
existing drugs or drugs for adjacent disease
150
areas. The good news is that, as in other indus-
tries, airlines can achieve new levels of growth
130 by addressing customer demand that is adja-
cent to the core product of an airplane seat.
When purchasing their tickets, Internet-
110 enabled passengers are notoriously adept at
Real yield finding the lowest price. But once travel has
100
begun, passengers may be far more willing to
90
1985 '87 '89 '91 '93 ‘95 '97 '99 '01 '03 ‘05
trade price for convenience, just as people
Source: Air Transport Association
who buy a 2-liter bottle of soda at a discount
Note: Yield is defined as the average revenue from sold seat-miles;
real yield adjusted to 1985 dollars.
retailer for 99 cents will pay the same price
Andrew Watterson is a Dallas-based director and Raj Lalsare is a Dallas-based senior associate of
Mercer Management Consulting. They can be reached at andrew.watterson@mercermc.com, and
raj.lalsare@mercermc.com.
52 Breaking the Yield Barrier Mercer Management Journal

3. for a .35-liter can at a vending machine. forecast projects that passenger revenues per
Several industries have been particularly seat will grow between 3% and 4%, driven
adept at capitalizing on customers’ different largely by ancillary revenues, which are pro-
demand elasticities for different purchase jected to grow 30%.
occasions. Gas stations are a well-known European low-cost carriers have developed
example. In a perpetual price war for their three types of non-transport revenue models:
basic product of fuel, they looked for new
sources of revenue and profits and began Partnership deals, in which co-branded
offering food, beverages, tobacco, and other partners market their services and prod-
items that didn’t warrant a trip to the super- ucts across the carriers’ travel chain as if
market and could easily be combined with a it were a real estate property or a mar-
fill-up. Hence the term “convenience store.” A keting channel. These carriers have culti-
decade ago, non-fuel sales contributed less vated strong brands in order to draw
than one-fifth of the gross margin at gas sta- customers directly to their websites, and
tions, whereas today almost half of the gross partners have been willing to pay for the
margin comes from non-fuel sales, according brand association and channel leverage.
to the National Association of Convenience Ryanair markets packages for events such
Stores. British Petroleum, after merging with as the Grand Prix and wine-tasting tours.
Amoco in 1998, embarked on a major mar- EasyJet markets car rentals for Europcar,
keting campaign to re-brand itself and ski packages for several resorts, lodging
remodel its gas stations into a welcoming for many hotel chains, and has even co-
place under the slogan “beyond petroleum.” branded air sickness bags on board with
In the movie theater business, over 90% of photo developer Klick Photopoint.
profits now come from concession stands and
advertising. The average movie ticket in the Retail sales, where the carriers sell add-ons
U.S. costs about $6.50, while in most theaters, such as trip insurance and in-flight food,
a medium-size drink and bag of popcorn cost beverages, and merchandise. Here again,
$7.50. Two major theater chains, AMC and easyJet has been aggressive, co-marketing
Regal Cinemas, report that they barely break lounges on a per-use basis with Servisair
even on movies; it is the ancillary products operators at select airports. Via easyJet’s
that contribute to the movie experience and website, customers can purchase entry to
keep them in business. use in conjunction with their trips.
Many hotels, casinos, and theme parks have
also dealt with the commoditization of their Service fees and penalties related to luggage,
core product by cultivating adjacent demand. seat assignment, and other aspects of
Host Hotels and Resorts, for instance, reported travel. Flybe, which has a rapidly
that 38% of its revenue for the first quarter of expanding network of European and
2006 came from non-room sources. In Las domestic flights from regional U.K. airports,
Vegas, casinos have added 3 million square has been charging customers £4 a bag per
feet of new retail space over the past five one-way flight for checked-in luggage since
years, with many of these shops, restaurants, February, 2006. The fee drops to £2 if cus-
and spas becoming some of the most prof- tomers pay via the website up to two
itable retail real estate in the country. hours before the flight departs. Other U.K.
airlines are charging extra for an exit row
The European Experience seating assignment. To be sure, there is an
Among airlines, it is the innovative carriers implicit risk in charging customers for
in Europe that are leading the way in cap- something they may perceive as part of
turing high-margin revenue from adjacent their travel purchase; nonetheless, service
demand. For instance, easyJet’s 2006 earnings fees are a new source of revenue.
Mercer Management Journal Breaking the Yield Barrier 53

4. North American airlines, particularly the few products that do exist, such as buy-on-
legacy hub-and-spoke carriers, have been board food, and they lack robust transaction
slower to harvest adjacent demand. Most of systems at the point of sale. As a result, cus-
U.S. carriers’ non-ticket revenue comes from tomers still perceive the travel experience as
loyalty-program-related partnerships, and is one, all-inclusive product, which remains a
stagnating, while most of the European low- hurdle to selling add-ons.
cost carriers’ non-ticket revenue is generated As managers at legacy carriers and other air-
via retail sales and brand partnerships, and is lines start to experiment with developing ancil-
growing rapidly (Exhibit 2 ). lary revenues, they can benefit by studying
The U.S. carriers’ experience in this area has some powerful principles from the retail sector.
emerged primarily through frequent flyer pro- As we have seen, well-run retailers are adept at
grams, which they have monetized through developing products and services around their
partnership deals and consumer product core offerings.
selections. In 2005, Air Canada raised $200 mil-
lion by selling 12.5% of its loyalty program, Think Like a Retailer
Aeroplan, into an income trust; this implied a A retailer’s management of the shopper’s
total valuation of $1.6 billion for Aeroplan. experience and the firm’s method of cap-
The top three North American airlines turing value can be simplified into five steps
derived 8% to 10% of their 2005 revenue from (Exhibit 3):
non-transport sources, mostly business part-
nerships. They have also turned to penalty- Build awareness. Retailers spend enormous
based sources of revenue, charging for ticket resources to build a brand and secure con-
changes, excessive baggage weight, or talking sumers’ attention. Wal-Mart’s entry into gro-
with a reservation agent. However, such ceries and fresh produce is a great example.
service fees may undermine customer loyalty, Just a few years ago, Wal-Mart was a discount
no matter how clear the fine print. store. Wal-Mart ran a steady campaign to
At the same time, these carriers have been create awareness of its Supercenter grocery
slow to cultivate other non-ticket revenues. concept. Awareness grew in just a few years
They have not made customers aware of the as Wal-Mart effectively expanded its “always
Exhibit 2 European low-cost carriers are aggressively growing non-ticket revenues
CAGR
$15
United 3%
Ryanair 11%
Non-ticket 10
revenue,
$ per Delta 2%
passenger
easyJet 15%
5
0
2000 ‘01 ‘02 ‘03 ‘04 ‘05
Source: Company annual reports, The Airline Monitor
54 Breaking the Yield Barrier Mercer Management Journal

5. low prices” guarantee to groceries. In many to pay a premium for certain products. Some
regions, it has become the preferred destina- airlines have realized that this dynamic
tion for grocery and fresh produce shopping. exists, and their agents ask at the end of the
In selling a seat on an aircraft, airlines pro- reservation process whether a rental car or
mote their brands, prices, and sometimes hotel booking is needed. The propensity and
their products, so that customer awareness of capability to sell ancillary products and serv-
travel choices is generally high. Awareness of ices needs to be embedded in airlines’ entire
new purchase opportunities could be created value chain.
for far less money, as the target segment has
been reduced to those already planning and Create a transaction. Many retailers try to get
buying travel. consumers to make a purchase through “loss
leader” products or everyday low prices. In
Generate traffic. Based on a perceived need selling seats, airlines and travel resellers have
and brand awareness, consumers come to the put a lot of effort into improving the “look to
retailer’s store or website to assess the prod- book” ratio, and like retailers, their tactics
ucts’ attributes and value. While the Internet often center on price. For ancillary products
may have reinforced the commoditization of and services, there are several points in the
many products, including the aircraft seat, it customer experience where transactions can
has also generated a lot of traffic to the vir- be created:
tual store window. At Amazon.com,
throughout the book browsing and buying At the time of booking, suitable for travel
process, customers are informed of related “add-on” and partner sales, which do not
titles and authors, which increases Amazon’s drive up costs by adding a complex
chance of making an add-on sale. delivery chain
For airlines, sales of the aircraft seat gen-
erate traffic for the ancillary store. Not all At the airport, when price sensitivities
passengers will buy, of course, but as each generally decline, suitable for product
passenger goes through the travel experi- enhancements such as club entry, exit
ence, he or she is progressively more willing row seating, and cabin upselling
Exhibit 3 Thinking like a retailer
Increase the
Build awareness Generate Create a
value of Build loyalty
traffic transaction
transaction
What it • Make customers • Invite and channel • Develop the organiza- • Develop product and • Make the retail
means aware of value-added customers to try the tional and technical service extensions, to experience into
products and services products and services. capability to convert capture incremental a proposition that
across their travel traffic into transac- share of wallet. customers would
experience. tions. consider again.
Examples • EasyJet’s website • At Lufthansa boarding • In its buy-on-board • Ryanair’s average fare
offers an airport gates, marketing reps • Carriers such as Air offering, Hapag-Lloyd is $53 and it has a
parking space reserva- typically offer an hour Europa and easyJet Express has “virtual” cult-like following
tion service to address of free onboard have been success- combo deals, which of customers who
the growing shortage Internet access on fully selling food on are assembled from repeatedly spend an
of parking spaces; international flights; board, but U.S. the à la carte choices. average of $10 per
customers get a beyond the hour, airlines have strug- This increases the trip on Ryanair’s car
discount for reserving customers pay for gled because they value of the transac- rental, hotel, and
early––an attractive continued access. lacked point-of-sale tion, without the apartment finder,
proposition for time- transaction need for pre-assem- on-board food, car
and cost-conscious capabilities. bled boxes. insurance, and even
customers. an online lender.
Mercer Management Journal Breaking the Yield Barrier 55

6. On board the aircraft, where products are on a website, at an airport, or on an aircraft, it
often consumables such as food, a pur- is critical to maximize cash margin per unit
chase point akin to a convenience store of space.
The second area for development, opera-
Increase the value of the transaction. Once tions, addresses the fact that even the best
the consumer has put an item in the basket, products with the best placement don’t sell
there is enormous leverage to be gained from themselves. Airlines need to deploy the right
filling the basket with other products. point-of-sale devices and give front-line staff
Retailers are becoming increasingly sophisti- the right type of training for high-volume and
cated at using in-store advertising and dis- non-routine transactions.
plays to expand their share of wallet at each Just as airlines have been evaluating which
touchpoint. Supermarkets place impulse-buy aviation activities should be outsourced and
products with high margins at the checkout. which kept in-house, airlines may not want
Here, airlines must walk a fine line of pro- to develop all the skills needed to create
moting additional products and services ancillary revenues. Even retailers do not per-
without bombarding the customer with too form all these activities in-house, as evi-
many offers. At each transaction point, the denced by the famous collaboration between
messaging and mechanisms should match P&G and Wal-Mart, where the supplier man-
the type of sale—“meal deal” pricing on board ages levels, stocking, and product selection
the aircraft and product images at the airport. within certain categories. A similar partner-
ship can be arranged with airline suppliers.
Build loyalty. Just as there is leverage in filling
the basket, it is also valuable to know the prof- ***
itability of each existing customer and, for Airlines cannot count on the current tem-
them, skip the awareness and traffic steps. porary firmness in ticket prices to lead them
Instead, reinforce their loyalty via targeted to sustainable profitability and revenue
promotions, an activity that airlines know growth; the commoditization of travel will
well. Once customers grow accustomed to continue. Capturing adjacent demand
buying additional products and services through ancillary products and services is the
around the seat purchase, airlines can use loy- most feasible alternative. North American
alty programs’ offer and reward systems to network carriers started the process with
deepen the relationship and increase mar- their loyalty programs, but European low-cost
keting ROI. carriers have taken the lead in this area.
Non-ticket revenues can create new rev-
Learning How to Merchandise enue streams at attractive margins, while
To effectively execute on this approach, air- addressing customers’ needs and improving
lines need to develop capabilities in two areas their flying experience. To do so, airlines must
of retailing, among both headquarters execu- adopt a merchandising mindset. This doesn’t
tives and the front-line staff. necessarily mean investing large sums in new
The first area, merchandising, is the analyt- capabilities or departments. Rather, it involves
ical approach that retailers use to help them incorporating a retail element into the
gain insights into customer behavior and strategy, selectively building capabilities, and
decide which products to stock and how to above all understanding what passengers
array them. Given the expensive real estate want and are willing to pay for.
56 Breaking the Yield Barrier Mercer Management Journal