On Tuesday night, I booked a return flight from Sydney to Melbourne on Jetstar. I've travelled on numerous low cost carriers all over the world, so I am quite familiar with the seemingly endless array of add-ons that one can purchase, but even I was surprised by the extent of the extras available at Jetstar.
I counted up to 20 add-on services, including those that have been a part of air travel for a number of years such as the purchase of a more flexible ticket, upgrades and the purchase of extra checked-in baggage.
There were also more exotic services such as hot meals, entertainment units and comfort packs, earning frequent flyer points, on-line check-in of baggage, itinerary sent by SMS, seat selection, seats with extra leg room, seats closer to the front of the aircraft, travel insurance, car hire, tourism activities, purchase of carbon offsets and donating to charity.
Fairer pricing
In some instances, the default option is to consume these add-on services and so one must uncheck the option to avoid payment. Consumers have to be on the ball during this purchase process, otherwise they could be paying for services that are either not needed or unwanted.
Despite this caveat, unbundled pricing is a much fairer system because it allows consumers to avoid paying for services that they don't consume, thereby stopping one set of passengers cross-subsidising others.
This issue of cross-subsidy is a greater issue with full service airlines where passengers pay for the full service regardless of whether they consume it or not. For example, passengers that say no to the air meal are paying for a service that they are not consuming, as are passengers that only take carry-on baggage on a full-service flight.
Ancillary revenue
The proliferation of add-on services has been a boon for airline revenue. Over the year to September 2012, the low cost carrier Air Asia earned between 15 per cent and 17 per cent of total passenger revenue via ancillaries.
Tiger Airways Holdings earned 19 per cent of its revenue as ancillary, while the European low cost carriers Ryanair and Norwegian airlines earned 21 per cent and 12 per cent respectively.
Credit card add-on
The add-on service that surprised me the most because of the magnitude of the fee relative to the base airfare, however, was that for payment by credit card. For the Sydney to Melbourne trip that I booked, paying by credit card cost $8.50. The same fee applies to all domestic travel, with a higher $12.50 fee for some longer international sectors.
The airfare itself between Sydney and Melbourne was $55 each way, so the credit card surcharge component was 15.5 per cent of the base airfare. On the basis of the average merchant service fee that is paid for credit cards in Australia, which according to the Reserve Bank of Australia was 0.86 per cent in 2012, one could draw the conclusion that Jetstar was charging excessively for credit card usage.
And it's not just Jetstar. Qantas and Virgin charge $7.70 for domestic sectors and $30 for longer international sectors.
Surcharge fees
But it's not as simple as examining the credit card surcharge relative to a single internet fare. The law of averages is important here.
For starters, the fare that I paid was in the cheapest fare class. As I booked a few weeks in advance of departure the fare I actually paid is what aviation analysts call a lead-in or enticer fare. I therefore paid the cheapest ticket in the lowest fare class.
The cheapest fare within the lowest fare class is not representative of the average airfare that is earned by a carrier. Dividing the credit card surcharge of $8.50 by this cheap internet fare is not a reasonable assessment of the burden of the credit card surcharge.
A much more reasonable assessment requires dividing the surcharge by the average airfare. This can be up to two times the lead-in airfare in the lowest fare class.
Distance-invariant
Secondly, the domestic credit card surcharges of Jetstar, Virgin and Qantas are invariant to the distance flown – you pay the same charge for Sydney-Canberra as you do for Sydney-Perth. While the $8.50 charge for Sydney-Canberra may look high for that route, it looks relatively small for Sydney-Perth because fares are greater for Sydney-Perth.
This distance-invariant surcharging approach appears to be adopted by airlines to reduce pricing complexity. The problem with this, however, is that it creates a dislocation between price and unit cost – the cost to the airlines of accepting credit cards for payment is a function of the value of the airfare, and thus the distance travelled, but the surcharge they set is not.
This generates two sets of problems. The first is that they cannot be sure that they are recovering costs, which may pose problems for the airlines with the Australian Competition and Consumer Commission because the ACCC generally requires cost recovery if the price component of a bundled product is advertised as a surcharge.
Secondly, the airline is in the business of making a profit. If it is setting a price component that bears no resemblance to cost, then it is almost impossible to know if it is going to be able to meet its profit objectives.
Tony Webber was Qantas Group chief economist between 2004 and 2011. He is now managing director of Webber Quantitative Consulting http://www.webqc.com.au/ and associate professor at the University of Sydney Business School
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