How do frequent-flyer programs work?
Frequent-flyer programs are incentives given to customers by airlines to increase customer loyalty by awarding free miles on tickets purchased. The program comprises hosts (the airlines that operate the program) and partners (other companies that participate as members of the program). Partners can either be earning partners (allowing customers to accrue miles) or redemption partners (allowing customers to redeem earned miles) or both.
Revenues and costs of frequent-flyer programs
Frequent-flyer programs have proven to be effective marketing programs, so partners benefit by participating in the programs. Earning partners purchase miles from the host at a price (one to two cents per mile) for the benefit of savings on marketing costs and additional customers gained through the host’s program. When a customer earns 10,000 miles by flying in the partner’s flight, the partner has to pay $100 (10000*0.01) to the host. The partner accounts this expense under advertising and travel agency commission costs. According to the IATA (the International Air Transport Association), the largest U.S. programs hosted by Delta (DAL), United (UAL), and American Airlines (AAL) generate more than $1 billion annually in partner payments.
Costs of the program include:
- Direct cost of flying an extra passenger in terms of meals and fuel use
- Costs of running the program, including staff cost, IT implementation, and communication costs
- The host has to pay the partners a specific rate per mile if their customer decides to use partners’ products to redeem miles
How airlines account for the liability
According to the IATA, the time between earning and redeeming miles is 30 months and 17% of the miles aren’t redeemed. Airlines use two methods to account for this liability.
- The deferred revenue method recognizes redeemed frequent flyer miles at the amount at which the award credits could be sold separately.
- The incremental cost method applies the marginal cost of redeemed miles to the balance sheet (fuel and meal costs for the extra passenger).
United’s frequent-flyer program is called Mileage plus, Delta’s is SkyMiles, American Airline’s is AAdvantage, Southwest’s is Rapid Rewards, and JetBlue’s is TrueBlue.