A new formula for airline profits

New formula for airline profits

This article originally appeared on Forbes.com.

There's never been a more challenging time for airlines: Delta Air Lines, struggling to emerge from bankruptcy protection, fends off a hostile bid; meanwhile, United Airlines, recently reorganized, is talking merger with Continental Airlines.

In addition to this drive for consolidation, airlines face overcapacity, mounting security concerns, inflexible labor contracts and a host of other pressures. But beyond all this, there's an often overlooked factor that makes airlines a particularly tricky business.

For most other consumer purchases—everything from shampoo to autos to yogurt—typically one-third of all customers buy on price, one-third on quality and one-third on brand. But airlines have long been an anomaly.

Bain & Company research shows that 85% of all leisure passengers buy tickets based primarily on price. Business passengers buy largely on price and schedule—and only about 15% are loyal to a brand when the price is close.

That puts pressure on carriers to differentiate from the competition by adding more services that travelers value—and for which they are willing to pay an extra fee. The trouble is, with each new service an airline offers, it risks increasing the complexity of its operations, which can send costs spiraling out of control.

In our experience, companies can reduce costs by as much as 35%, along with increasing sales by up to 40%, by mastering the "innovation fulcrum"—the point between service variety and operating complexity. Some airlines are now discovering that by offering a no-frills base fare and adding back optional selected services for which passengers are willing to pay, they can give customers what they value—and only what they value—while also keeping operating costs in check and improving their growth.

Australia's Virgin Blue Airlines is a leader in that race. The low-cost carrier offers the lowest possible base fare, but charges extra for everything from food to entertainment to seats in the front or exit rows, which it has renamed the "Blue Zone." For example, on transcontinental flights between Sydney and Perth, travelers can pay $15 Australian extra for movies, music and live TV, or $30 Australian extra to sit in the roomier Blue Zone seats; and they can choose from more than 30 a la carte menu items.

To avoid the added complexity, Virgin Blue outsources its food service to a caterer, thus eliminating such operating headaches as tracking which items sell and which don't. The airline's Velocity loyalty program is similarly simplistic, offering passengers 6 points for every dollar spent. Such programs are helping the low-cost carrier attract high-value business customers. The airline, Australia's second largest, saw the number of passengers increase by 7.5% for the first nine months of 2006, while revenue rose 8.5%.

For its part, American Airlines (nyse: AMR - news - people ) discovered a way to produce a new revenue stream, while also improving the management of seats. For a $25 fee, U.S. and Caribbean passengers without a fully refundable ticket can earn the right to confirm a seat on an earlier or later flight on the day of departure. It's a convenience for passengers.

And for the carrier, the service solves multiple problems: It ensures that a particular seat will be filled, gives the airline advance notice for reselling seats that are vacated, and opens up seats for people who will pay higher fares. Consumer acceptance has exceeded expectations, and the offering has been a noticeable revenue generator.

Other airlines are innovating specialty services without increasing complexity. El Salvador's TACA airlines has branded itself as the baggage-friendly carrier. After reducing labor inefficiencies and boosting operating margins, the airline found it still needed to generate additional revenues to stay afloat. The solution: adding a service that was highly valued by its customers.

Many of TACA's passengers are U.S. residents bringing excess baggage to family or friends, such as boxes of goods that are hard to find in Latin America. Travelers repeatedly told the airline they were willing to pay extra to stow them aboard. While many other carriers refuse to take odd-sized or overweight baggage, TACA now welcomes those objects—for a fee.

Combined with the cost-cutting moves, and despite sometimes having to fly airplanes half full of passengers (given weight limits), the new policy has helped TACA's profits rise to make it one of the most profitable airlines in the Americas. The company turned itself around without adding significant operating complexity.

With such new business models, airlines are hoping to establish distinctive brands, ones that make passengers less price-conscious. That is the great success of Hertz, the car rental company with the largest market share worldwide, despite that the fact that its prices are often the industry's highest.

Hertz has found the balance between offering highly desirable extras without adding major costs and complexity. It provides covered parking lots, locations close to the airport, and the perception that its employees speed customers through the rental process. Those attributes have helped build Hertz's phenomenal branding success.

Airlines can achieve such results, too, by stripping their services down to the bare bones and then carefully adding back those services—and only those services—that customers want.

Mark Gottfredson, a partner in Bain & Company's Dallas office, leads the firm's Performance Improvement Practice.