Op-Ed: Unit-Based Airline Contracts No Longer Make Sense
Business seeks growth. Based upon supply and demand, business expands into every viable opportunity. Labor, suppliers and customers jostle each other for the optimum price. Expansion is thrilling since everyone has an opportunity to benefit. But during periods of expansion, business also moves closer to the edge—the edge of how much it can grow, discount and pay for services.
Living on the edge is precarious. Change can unfavorably tip business conditions and make yesterday's success tomorrow's formula for failure. Today we face the domino effect of change. A stalling economy and uncertainty act to contract the economy and ruin yesterday's best-laid plans.
The failure of old practices to meet today's challenges is evident in airline corporate contracts and is, in part, why carriers find themselves in distress. Deals cut in better times are failing today.
Airlines provide corporations with discounts based on long-term commitments to buy in volume. These commitments may be measured one of three ways: count of flights, amount of revenue and share of purchase compared with competing airlines. Count and amount requirements, or unit-based contracting, evolved from early meeting and group contracts. Companies earn discounts based upon attaining a prescribed number of flights or revenue goals. Fulfillment is easy to measure since all of the information is available from an airline's revenue accounting system. Unit-based contracting became the norm for several carriers in the rush to secure contracted corporate customers.
But there is a serious flaw in the method. Unit-based contracts assume that business conditions will remain constant. Under good circumstances, when a company's travel spend grows, unit-based terms set expectations too low because they fail to recognize the customer's increased revenue. If a company's share falls below the airline's average for the market, the carrier discounts flights that they naturally may have flown. On the other hand, when a company's travel rapidly declines, customers fail to meet revenue requirements.
Labor disputes, the slow-down in the economy and the fall off in travel have caused corporate spending to plummet. As spending declines, revenue-based contracts fall short of performance requirements. Airlines are faced with a terrible dilemma—cut off discounts to their best customers, renegotiate contracts or continue discounts despite poor performance. A company with an estimated 30 percent discount and a 30 percent revenue shortfall will cost the airline more than half of its operating revenue. Under these circumstances, the high-yield business traveler, the gold standard of all airline marketing plans, becomes less profitable than grandma with a Saturday night stay does.
Airlines are hemorrhaging cash, in part, because of failing revenue contracts. Revenue contracting was fatally flawed from the beginning. Count and amount dealing only work over a limited period of time for group and meeting fares. The extremes of today's business conditions make revenue dealing's flaws apparent. Worse, continuing failing approaches on reduced routes will lead to the same result—discounts without performance.
A savvy corporate travel buyer might reason that discounts without enforced performance requirements benefit the company, not so. A preferred carrier in financial distress puts corporate travel operations at risk. Routes are cut, service declines and options diminish. With less choice, negotiation options and discounts also decline. Poor contracting practices also harm customers.
The only rational approach to long-term corporate dealing is to base contracts on share performance. Share is defined by an airline's percentage of a company's activity. Share requirements are far less vulnerable to changes in business conditions. When a company expands through growth or acquisition, the share remains the same and revenue grows for the carrier. When a company spins off a subsidiary or the economy declines, the share requirement remains the same and the carrier maintains the incremental revenue required to fund the discount. It is no coincidence that carriers with share requirements are faring much better than their counterparts with revenue contracts.
Most importantly, customers benefit from share requirements. When business declines, travel managers can still meet share requirements. Revenue requirements put travel managers at risk during declines. Will the deal be canceled or will a preferred carrier still be in business? Business is interdependent. The failure of a company or carrier harms everyone. Likewise, the failure of corporate contracts harms everyone.
The future is uncertain. Carriers cannot continue discounts indefinitely without fulfillment of contract terms. Whether airlines renegotiate current contracts or abandon discredited contracting practices is a toss up. Airlines are ponderous organizations. The safety of inertia is often more compelling than the necessity of change.
Michael Whitesage is president of Prism Group Inc., a global travel information and technology firm.