How Airline Rewards Programs Actually Work

The Reason for Rewards Programs – Loyalty and the Points Market

You could be forgiven for thinking loyalty programs are a costly marketing initiative designed to keep airlines relevant – and it probably started that way – but the truth is the exact opposite. Make no mistake about it; rewards programs are a cash cow, a veritable money tree for airlines, in two ways, which we will delve into separately.

- Loyalty: This is the classic, intuitive reason for the existence of rewards programs. Loyalty means a lower marketing expenditure per customer and lower price sensitivity. The airlines basically spend less on enticing you to spend more, double windfall.

- Reward Miles Sales: This is where it gets interesting, airlines make enormous margins from selling miles to credit card companies and other players to give to their own loyal customers.

Customer Loyalty – Individual Customer Experience

The key to loyalty is personal service, or at least, the illusion of personal service. Think of the local butcher around the corner. If you are a loyal customer, they will remember you when you come in, and make you feel special.

Because of course you are special, more than you think. Your loyalty is perhaps the one most important asset this corner store possesses. You are a dependable source of revenue (low risk), you’re less likely to ask questions (low maintenance) and probably less likely to challenge their prices (low price sensitivity), so you really are invaluable.

Airline Rewards Programs Are Like the Butcher

By segmenting their customers in tiers such as Silver, Gold, Platinum, Diamond etc., airlines know exactly how to treat each individual customer depending on their habits. The butcher won’t remember you if you come in twice a year, but they’ll roll out the red carpet to the weekly meat lover, as well they should.

The higher you climb on the airline loyalty ladder, the faster and better the service. If you’re a loyal rewards card holder, you’ll be addressed by name, offered a glass of champagne and unburdened of your luggage, all by a steady stream of smiling faces. If you’re merely the occasional traveler, not so much. In fact, you may even be actively given poor service in the lower rungs in order to make the higher levels of membership seem that much more attractive.

Points and Miles

But wait, there’s more; we now have a tiered system that enables airlines to segment their customers, but this is no longer enough. If you’ve set your foot in a crowded business class lounge, you’ll know, it doesn’t always feel like the premium experience it promises.

Enter frequent flyer miles and points, which give airlines surgical precision when it comes to gauging the value of individual customers. A gold card holder with a 500,000 points balance will be made to feel more “important” than the holder of the same gold card but with a 100,000 points balance.

In this way, customer cardholder segmentation coupled with frequent flyer miles and credit card points afford airlines wider margins and more revenue in real, hard cash terms. They ensure high-value customers stay high-value (i.e. keep spending), and encourage an increase of patronage from those on the lower rungs of membership (i.e. increase spending).

High Margins – How Airlines Make Money From Selling Their Points

Now consider this insane fact: Frequent flier programs are worth more than the airlines themselves today. How is this possible? Of course, the value of airlines has been depressed since the outbreak of the pandemic but still, that doesn’t sound right, does it? According to a recent analysis by the Financial Times, Delta is worth about $19 billion but the Delta SkyMiles program is worth $26 billion. What’s going on here?

The key to understanding this dynamic is to understand that there is a market for points, and it’s thriving. If you earn airline miles from your credit card, you know you tend to earn 1-3 miles per dollar spent, which is why you’re spending a couple hundred dollars in annual fees. Credit card companies (and others) have come to understand that you are willing to pay for the privilege of amassing airline miles, this is why airlines are able to sell their miles to them, and at high margins to boot. And this is where it gets interesting; what is meant by high margins here? In order to understand this, we must first unpack what the cost of an airline mile actually represents to the airline.

Why Miles Cost Airlines Less Than You Might Think

Isn’t it expensive to give away high-value first and business class seats for points, when they might otherwise have sold for hard cash? It may seem that way, were it not for unsold inventory. Just like a hotel, an airline seeks to maximize its capacity, in other words, fill as many seats as possible. Let’s say a given flight needs to fill 50% of its seats to break even financially, this means that any seat sold beyond this first 50% carries almost 100% margin because pretty much all of the costs associated with a flight are fixed (fuel, staff, depreciation, service, etc). In other words, additional passengers do not increase the cost of the flight, they are pure revenue gain.

The Airline Knows

Given that the airline flies it's routes all day every day, they can use the law of large numbers and apply advanced algorithms that tell them exactly which seats will sell and which seats will go empty on any given flight on any given day. They learn very quickly which flights tend to sell to capacity, and simply remove the availability of award seats on those flights. It’s a little bit more complicated than that of course but the point is that airlines try to limit award travel to seats that they already know will not otherwise be sold.

This explains why it’s very difficult to find award seats during the holiday, or to popular destinations. They want you to use your points for off-season travel and to less-popular destination.

Alliance Award Seats Are Cheap

Unsold inventory explains how airlines can give away seats to their own customers, but does not explain using points on partner airlines. The answer is actually similar; because airlines know which seats will not sell for cash, they can sell them for cheap to their partner airlines, who can offer them to their own frequent flyers for points. In this case, there is an actual dollar cost associated with these partner award seats, but that cost is so low that it is worth it for the airlines.

Although cheap, these partner award seats aren’t in fact free, as we'll explain further down, and since the airlines are currently strapped for cash we have actually seen a noticeable decline in the number of partner award seats available. Some airlines even put a full halt on all partner award travel for a few months at the height of the pandemic, but are slowly starting to release them again.

Under the Radar

This is an elegant way to sell seats for cheap that would otherwise have gone to waste, because they do so under the radar without damaging their brand equity, in other words the perceived value of these seats out in the world is not eroded. Airlines could never sell a first-class seat to Dubai to a customer for under $1,000 because that would ruin their brand, but it’s better than $0 if nobody finds out about it, which is what happens when an airline sells an empty seat to a partner airline, with the added value of increased loyalty from that customer!

The Market Value of Miles and Points

Do you get a sneaky feeling that you’re somehow getting shafted when you use your miles to book your travel? Although we have no direct insight into the actual price that airlines and credit card companies pay each-other for points and miles, a bit of simple math might give us an indication, and will help us understand if we are actually getting a good deal or not.

- An intercontinental long-haul return ticket in Business Class costs around $3,000. We guess that an unsold inventory seat might be sold inter-alliance for 20% of the price, so let’s say $600.
- That same seat booked using miles would set you back 135,000 miles, a “cost per mile” of roughly ¢.44 for the airline.
- Airlines can thus sell their points to credit card companies for ¢.5 each and make a small profit. However, they know that many points never get used, they expire or are spent on low-cost items such as coffee onboard, so we think the cost is probably half of what it seems, say ¢.2 each. That’s 150% margin for the airline.
- An elite level airline credit card will give you about 1-2 points per dollar spent depending on what you spend it on, but let’s stick to 2 points per dollar for the purposes of this exercise, which is generous. Credit cards charge merchants about 3% for each charge so a $100 charge will generate $3 revenue, and your 2 points per dollar at half a cent per point will have cost them only $1. That’s 200% margin for the credit card company.

Add to this the yearly fees that credit card companies charge, this is quite a good business for them as well as the airlines.

Are You Getting Shafted?

Yes and No. Airlines and credit card companies are certainly making hay from this business, but it enables them to offer a wide range of travel options and other things that would otherwise not be available, it’s actually capitalism at its best. Not to mention the efficiencies that come from filling empty seats, to the environment and to the cost of travel in general. It also seems to be saving the airlines in the short term as they are leveraging the value of their points programs to raise more cash to survive the pandemic, money that otherwise likely would have come in the form of more bailouts from the government, i.e. you.

Moreover, and crucially for us here at Chatflights, the fluid and dynamic nature of the award market means that there is massive value to capture if you pay attention and know what you’re doing. You can use the system to your advantage, this is what we love doing and we are here to help when you need it.

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