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Editor's note: Through a new partnership, The Motley Fool is excited to present stories from Knowledge@Wharton, the Wharton School's wonderful online business journal.
A fee is simply defined as a "charge for service." Its synonyms include basic accounting terms like "cost" and "payment." So why has such an innocuous word stirred up so much frustration and anger among consumers in recent years, particularly when they are dealing with industries like airlines and financial services?
Perhaps it is the fact that two-thirds of travelers are hit with a surprise fee after arriving at the airport, according to a survey from the Consumer Travel Alliance. Or the revelation that all U.S.-based financial institutions made $37 billion in overdraft fee income in 2009, according to Lake Bluff, Ill.-based research firm Moebs Services.
Despite these startling statistics, companies are convinced that the growing number of ancillary fees has a legitimate place in the marketplace and that fees can work to consumers' advantage if they just pay a little more attention. "Companies need to find that just-right balance where they can charge fees but their customers are well aware of [this] and everyone can live with it. Otherwise, they're shooting themselves in the foot for nickels and dimes," says Peter Fader, a Wharton marketing professor and co-director of the Wharton Customer Analytics Initiative.
In the pricing world, the main type of fee is a premium fee, according to Robert Docters, a principal at New Canaan, Conn.-based business consulting firm Abbey Road Associates. These are charges for special services and modifications, like using an out-of-network ATM. Docters, who is also the author of Winning the Profit Game: Smarter Pricing, Smarter Branding, says that these premium fees can be well received if explained properly and understood by the consumer. He notes that companies often use these kinds of fees, or the lack thereof, to reward valued customers -- like high-mileage air passengers who are often exempt from the extra charges levied against less frequent fliers.
According to Wharton marketing professor David Bell, businesses also charge ancillary fees because they allow consumers a degree of self-selection and customization. Some consumers will then be motivated to avoid fees and get what they perceive as a better deal, while others will be willing to pay for more specialized services (even if they were once free), like checking baggage. "Consumers will pick and choose, and this will create efficiency in the system and also potentially extra revenue," Bell says.
Wharton marketing professor Jonah Berger says that, despite what consumers might think, companies are aiming for fees that will be considered reasonable. Making people pay $5 for a sandwich seems reasonable on a short domestic flight, for example, but if airlines start charging for basic beverages on international flights, where consumers have no other options, that seems unfair and is more likely to provoke outrage. "Consumer perception of fees is less about money and more about fairness," Berger notes.
What is fair, he adds, is determined simply by how a company can spin it. For example, he notes that in the case of charging for checked luggage, if the company makes it clear it is instituting this fee to make the tickets cheaper for consumers who do not have any luggage, then customers might be willing to accept such changes as reasonable.
The bottom line
Still, in any fee transaction, a business collects money from a customer; no matter what the higher-level motivation, economics is always a factor. And there is no doubt that ancillary fees are a great income booster: Across all industries, premium fees can often represent more than one-fourth of a company's income, Docters says.
During the third quarter of 2010, U.S. airlines collected $2.1 billion in fee income (including $906 million from the notorious baggage fees), representing about 6% of their total revenue, according to the U.S. Department of Transportation. Spirit Airlines -- which caused an uproar last April by becoming the first airline to charge fees for carry-on luggage -- topped the list, collecting fees totaling 27% of its income. And airlines are looking to increase fees even more, as many are now considering charging extra for infants sitting on an adult's lap or for carry-on bags that weigh more than 25 pounds.
Banks and credit unions earned a record $37.1 billion in overdraft fees alone in 2009, with the median overdraft cost coming in at $27, up from $20 a decade before, according to Moebs Services. Bank of America (NYSE: BAC ) alone made 10% of its total income in "service charge" fees in 2009.
With regulators drastically restricting overdraft fees in mid-2010, banks are looking to make up this income in other ways. Last month, Bank of America announced a new suite of accounts that include monthly maintenance fees, some as high as $25. Overall, the number of banks and credit unions that offer free checking declined 11% from 2009 to 2010, according to a study by Moebs Services. The study points out that, to recoup these lost fees, banks are pushing e-statements and direct deposit and may levy fees against customers who decline to use these features.
While the prospect of increased revenue might encourage companies to charge fees, Docters advises them to clearly think about their motivation for adopting this strategy. He says a business should never charge a fee simply because it needs quick cash to close a budget gap. If such a scenario should occur, customers who feel cheated will eventually abandon the business, hurting overall income. "Yes, fees can increase the bottom line in the short term," he notes. "But companies have to look at long-term effects."
The breaking point
Experts say that what businesses perceive as a "reasonable" fee becomes an intolerable fee in the eyes of consumers when the psychological pain becomes too great. According to Fader, the whole idea of fees -- i.e. individual charges for specific services -- creates unhappy consumers. By way of explanation, he points to "prospect theory," which states that people prefer their gains in smaller increments to spread out their joy but want losses to be concentrated so the pain arrives in one hit. "It's ... ironic that companies don't charge enough to begin with," and then compound their problems by spreading out the rest of the cost in the form of unpopular fees, Fader says.
He adds that in this anti-fee environment, companies could easily change from a fee-based structure to an all-inclusive price: "A move towards a more transparent price scheme with no fees would be welcomed as a positive gesture by many customers, even if you completely ignore the specific economic aspects associated with it."
According to Berger, consumers would rather pay more upfront than a base price plus a trickle of smaller charges. "I think it's a fairness issue," Berger notes. "People feel like they are getting nickeled and dimed, and, psychologically, the cost is greater when fees are separated" from the initial purchase -- such as charging to check baggage at the airport, when the consumer likely paid for his or her ticket weeks earlier.
Indeed, many consumers feel that an onslaught of fees is an attempt by the service provider to squeeze a few extra dollars out of them without their prior knowledge. Sometimes that is the case. When Docters helped AOL (NYSE: AOL ) with the pricing of its Internet service years ago, his firm advised executives to price the service, which was automatically charged to customers' credit cards, in smaller increments just under $20, as studies showed that consumers are less likely to notice credit card charges under that amount.
While consumers become disgruntled with companies that charge numerous fees, competitors of those firms are trying to cash in by touting their fee-less ways. For example, low-cost air carriers like Southwest (NYSE: LUV ) are trying to win over customers with an onslaught of advertising promoting "no change fee" and "bags fly free" policies. And in 2009, GMAC rebranded its banking unit as Ally Bank and followed up by heavily marketing itself as the "anti-bank" with a "no fine print" policy and a lack of ATM fees.
Bell says this is "savvy" marketing because these companies understand customers have a breaking point. And he says that such a no-fee policy can be economically sustainable if the right results occur. "If the firm thinks that an increased number of customers -- disgruntled customers of competitors or increased transactions per customer -- will result then they can win from this."
So is it possible to have a world where businesses charge fees and consumers do not revolt?
According to Bell, for consumers to accept fees, three factors need to be in place: Customers need to understand the need for the fees, perceive them as fair, and feel that they have received some benefit from the fee. "Absent these conditions, consumers are likely to be frustrated," Bell says.
Docters adds that the key to fee happiness on both sides of the table is visibility and clear explanations: "Fees must reflect the context of the event prompting the fee. If the fee is consistent with a customer's expectations, then customers tolerate a surprising level of fees."
While consumers are not necessarily embracing fees from airlines, some have changed the thrust of their protests to push for more transparency. In January, 115 of the largest travel companies in the United States formed Allies for Airfare Transparency, in hopes of prompting the major airlines to share breakdowns of their ancillary fees through all booking channels, including online ticketing sites. This came just three months after 50,000 air travelers celebrated "Mad as Hell Day" by submitting a petition to the Department of Transportation urging the regulator to require airlines to properly disclose all fees.
"Airlines should be able to make a fair profit, and set fares and fees that allow them to do so, as long as travelers can see and compare all of those fees in advance," says Paul Ruden of the American Society of Travel Agents in a statement from the "Mad As Hell Day" group. "This is not about fees, but about fairness."
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