Revenue management

• Revenue management (RM) – the allocation of the capacity to different fare classes over time

• The goal being maximization of revenue• It refers to both strategy and tactics of the

company• The first industry, that introduced RM was

passenger airlines

When is it applicable….

• The seller is selling a fixed stock of perishable capacity

• Customers book capacity prior to departure• The seller manages a set of fare classes, each

of which has a fixed price (at least in the short run)

• The seller can manage the availability of fare classes over time

• Revenue management is a special case of pricing with constrained supply

• But, it is not based on setting and updating prices, but the availability of fare classes

• The objective of fare class management is a legacy of RM from it’s early days as passenger airlines built their reservation systems so as to utilize the capability at hand*

• Later, RM has been adopted by a number of industries, including hotels, rental cars, freight transportation and cruise lines, many of whom also use the reservation systems

• Thus the term revenue management industries*

The deregulation of the airline industry

• Prior to 1978 both schedules and fares tightly controlled by the Civil Aeronautics Board (CAB)

• The industry was to be deregulated by 1983• The goal had been to guarantee reasonable ROI• As we will see, RM has brought about a more

efficient airline operation• All restrictions on domestic routes were

removed as well as fares were deregulated

A new entrant….

• was PeopleExpress• It offered a bare-bones service– Extra fees for baggage handling and onboard meals– Had a significantly lower cost structure than the

major airlines– Fares up to 70% less than competitors*

• Had discovered a previously untapped market segment – price sensitive students and middle class leisure travelers

PeopleExpress

• At first it entered underserved markets – and competed with bus or car travel

• In 1984, after 4 years of phenomenal growth it entered key markets of American Airlines – Newark – Chicago – New Orleans – Los Angeles

American Airlines

• If it matched the low prices, it would not cover the costs

• Otherwise the customers would be siphoned off

• In a deregulated market PeopleExpress could move on to all AA’s core markets

• It only seemed have a choice between a slow death and a rapid one

January 1985 – AA’s „Ultimate Super Saver Fares“

• In order to qualify, a passenger would need to book at least two weeks before departure and stay at his destination over a Saturday night

• Others paid a higher fare– PeopleExpress had no such restrictions

• AA restricted the number of seats sold at discount– PeopleExpress allowed every seat to be sold at a

low fare

AA’s two-pronged approach

• Vast majority of discount passengers were leisure passengers, able to book early and more price sensitive

• The later-booking passengers were primarily business passengers; who were less price sensitive, but needed a seat at the last moment

• Both groups of passengers preferred AA’s superior service to the bare-bones approach

• In effect, American Airlines had segmented the market between leisure and business travelers and used differentiated pricing to attack a competitior

• In September, Texas Air bought PeopleExpress for less than 10% of the market value it had enjoyed a year before– „We had great people, tremendous value, terrific

growth. We did a lot of things right. But we didn’t get our hands around the yield management and automation issues“ CEO Donald Burr

• American, United, Delta, Continental– In 1980 and well into 1990s invested millions of

dollars in implementing computerized revenue management systems and establishing revenue management organizations

• Marriott was a pioneer in hotel revenue management

• Hertz and National were pioneers in rental car revenue management

• Vendors such as PROS and Talus Solutions developed and sold commercial software packages

• Cruise lines, passenger trains and various modes of freight transportation followed

• Development and investment in revenue management continues in many of these industries today

Levels of revenue management

• Strategic– Segment market and differentiate prices (quarterly,

annually)• Tactical– Calculate and update booking limits (daily, weekly)– The „brains“ of the process – forecast future demand,

run optimization algorithms, set and update booking limits

• Booking control– Accept/reject bookings (real time)

Artificial restrictions to create an inferior product@lower prices4price sensitive cust.

• Product versioning• Airlines: products targeted to many segments - government,

senior citizens, groups, tour operators, cruise lines• International airlines: regional pricing• Airlines: channel pricing (the Internet cheaper than travel

agents)• Hotels and car rentals: corporate, leisure and business

segments have different products; e.g. the kamaaina rates for residents of Hawaii – available during slack periods

• Cruise lines – do not have early bookers in the traditional sense, but sell to the incentive segment (early) – bulk purchases as incentives to corporate employees; (e.g. a medical company to reward the top 20 North American sales managers)

• Cruises also charge different prices in different cities – regional pricing.

RM in the context of Information Systems (IS)

• AA used an IS – SABRE, from 1964, back when it was a technological marvel – as the products could be distributed and bookings received globally*– Computerized reservation system (CRS)– Global distribution system (GDS)

Distribution channels for an airline*

Systems were developed first and RM capabilities added later

• Americal Airlines – SABRE• United Airlines – Galileo • Northwest Airlines – Worldspan• A consortia of airlines – ABACUS, AMADEUS• Following a federal ruling that eliminated the ability to give preferential

treatment to own flights on GDS, airlines largely divested their GDSs • In the past more than 80% of bookings went through the GDSs – there

are more than 180 000 terminals in the world – most are placed with travel agents, but some in travel offices of large companies

• Most airlines, hotels, car rental companies and cruise lines have contracts with all the GDSs

• The systems were built on large mainframes using 1960s-vintage software and modifications are expensive and time consuming

Booking control (decision is taken within 200 milliseconds)

• Y-Class (business), M-Class (full fare), B-Class (deep discount); as a consequence some reservation systems limit the number of booking classes per product to 26

• Booking limits• Protection levels• Allotments• Dynamic nested booking control

• The booking limit for a class is the upper bound on the total number of bookings (for that class) that will be accepted

• NB! No-shows and cancellations• The protection level for class i is the total

number of seats available to class i and all higher classes

Tactical revenue management

• Calculates and periodically updates booking limits

• Transmits the booking limits to the reservation system

Resources, products and fare classes

• Resource – a unit of capacity; a flight departure, a hotel room night; a rental car day; all resources are constrained

• Product – what customer seeks to purchase; may require one or more resources; a seat on Flight 130 St.Louis to Cleveland on Monday, June 30 – uses one resource; A two-night stay at the Sheraton Cleveland for a customer arriving on March 19 and departing on March 21 uses two resources

• With each product one or more fare classes are associated; Fare class is a combination of a price and a set of restrictions on who can purchase the product and when; fare classes can be used to establish different virtual products, for group pricing, for regional pricing, or for combinations of all these

Resources and products in four revenue management industries*

A supplier controls• a set of resources with fixed and perishable capacity• a portfolio of products consisting of combinations of one

or more of the resources• a set of fare classes associated with each of the products. The tactical revenue management problem is to choose which fare classes should be open and which closed for sale at each moment in order to maximize expected total net contribution.The fact that fare classes are being opened and closed does not make a big difference from the customer’s point of view – they just see the lowest available fare changing over time

• Most airlines believe the need to match the advertised, or „head-line“, fares offered by their competition in key markets in order to drive demand

• As bookings arrive, revenue management enables them to „shape“ demand to the limited capacity of each flight

• Revenue management supplements rather than replaces pricing

Components of tactical revenue management

• Capacity allocation• Network management• Overbooking

• Capacity allocation is important if the same unit of constrained capacity is sold at two or more different prices; e.g. passenger airlines, rental cars and hotels; sporting teams – how many to sell on discounts or promotions versus holding to sell at full price; air freight carriers have agreements with different customers specifying different rates

• However resort hotels, discount carriers such as Southwest, and passenger trains maintain only a few prices for the same inventory

• Network management is important for selling products that consist of combinations of resources

• Passenger railways, rental cars, business hotels – more important than rate class management; important for airlines with hub-and-spoke systems, but not as important as capacity allocation and overbooking

• Not important for those industries that sell a single resource – cruise lines, point-to-point airlines, sporting events and theater

• Overbooking is important whenever customers are allowed to cancel or not show with little or no penalty

• Airline tickets, business hotels, rental cars – although it has become somewhat less important as the fraction of nonrefundable tickets has increased

• Not important for resort hotels, cruise lines, because of the high perceived costs of denying service; generally not used for sporting events and theater, where tickets are nonrefundable and seats individually assigned

• Includes a database with fares for all product/fare combinations, capacities on all flight legs, passenger variable costs by product; This information is extracted from the pricing system, the scheduling system and various accounting systems;

• The forecasting module generates and updates forecasts for all product/fare class combinations for all future dates; The first forecast will be given a year in advance, when the ticket will at first be sold; monthly updates for the first six months; daily updates for the last two weeks;

• Probabilistic forecasts – e.g. including mean and standard deviation

• Delta Airlines employs a group of more than 30 „revenue management analysts“, who continually monitor the forecasts and booking limits generated

• For example, if Estonia hosts Eurovision on a given year, this induces additional demand for plane tickets for May

Updating booking limits

• Periodic updates, occuring with an increasing frequency

• Event-driven updates are triggered when a booking class closes, there is a change in aircraft or unanticipated spike in demand

• Requested updates are launced by a flight controller or revenue manager based on competitive actions, changes in fares, anticipated changes in future demand

Net contribution in revenue management

• We are actually maximizing the expected net contribution, which also takes into account incremental costs

• The term revenue management originates from the era, when airlines had their passenger variable costs well below the fares and could be assumed to be zero

• In 1990s, however, discount fares began a steady decline, to the point, where the difference between the deepest discount fares and incremental costs was small

• Also, industries such as freight transportation and cruise lines that now also implemented RM have a significant incremental cost associated with customer commitment

• Relatively high in cruise lines and container shipping. For example, for cruise lines, food is a major expense

• At the other end of the spectrum, relatively low in theater and sporting events

• Somewhere in between are hotels, rental car companies and passenger airlines

Variations by channel and market segment

• For example, in 2004, still GDS accounted for 60% of bookings for a typical airline and about 68% for a typical hotel, leaving plenty of scope for future savings

• SABRE chages $3 to $4 per flight segment for airlines and about $4 per room for a typical hotel booking

• Hotel’s web site variable costs are $1.50• The figure represents a channel-pricing opportunity – which fare

classes are open for which channel • Furthermore, there is a tremendous economic incentive to steer

demand through lower-cost channels

Activity-based costing model for a rental car company*

• Airline passenger – a beer, duty-free goods or the Internet

• Hotels – outgoing calls, minibar, room service• Rental cars – insurance is highly profitable side

business• Sporting events and theater – important• Hotel/casinos – gambling is a dominant source of

revenue and profitability

Ancillary contribution

• RM company needs to estimate the ancillary contribution for each booking request

• This must be estimated based on the customer, product, channel – Harrah’s Entertainment uses its CRM system to

track the gaming patterns of 28M customers, who belong to its Total Rewards loyalty program. There are 64 segments – for each the demand for rooms is forecast, there is a gaming profit that Harrah’s will realize on the average for that segment

Measuring revenue management effectiveness

• Load factor shows the percentage of seats that are full

• Before the deregulation of 1983, the prices were set in a following way: if airline meets the break-even load factor, 75%, they cover their total costs; the rest is profits

• After deregulation the load factor was not the only feasible indicator – otherwise just sell all the seats to deep discount customers and you fill up the planes

• Hence, another indicator – yield, which is essentially revenue per passenger mile

• Sometimes the goal of managing bookings was to increase yield, thus another term of yesteryear for our topic – yield management

• Yield of course has another setback – just fill the plane with only late-booking business customers, fly it almost empty and you’ll have a high yield

• The solution is in „Revenue per Available Seat Mile“ (RASM) : a full 100 seat aircraft with 1800 mile flight with a total revenue of $50000 has a RASM of $50000/(100*1800) = $0.28

• The same flight with 50 passengers paying $1000 each (still $50000 of revenue) and a corresponding load factor of only 50% would still result in the same RASM

• This is the right focus from the revenue management point of view – a policy that resulted in $51000 from a flight is more successful than one that resulted in $50000, notwithstanding a possibly lower load factor

• From PRO point of view net contribution per available seat mile (NCASM) is an even better metric; assume from the flight above, there is a per-passenger operating cost of $50; Then 100 passengers paying $500 each would result in an operating margin of $50000 – 100*$50 = $45000 and NCASM $0.25, while 50 passengers paying $1000 apiece would result in an operating margin of $50000 – 50*$50 = $47500 and an NCASM of $0.26

• That is, we should once again move from revenue to total contribution

Meanwhile in other industries

• Revenue per available room night (REVPAR)• Revenue per available rental day • Revenue per berth• It is possible to compare performace across markets and

within a single market over time• Filghts that are achieving high RASM are generating a higher

return to the company’s assets than those with low RASM; it is also a useful benchmark among different airlines

• RASM does not guarantee high profitability (or any profitability at all), since it is strictly a revenue-based metric and ignores costs entirely

Revenue management in action

• Every major airline, hotel, rental car company, or cruise line has a revenue management department

• At most major airlines it is considered to be a key management function

• The practice of revenue management has spread to other industries, including hotels, rental car companies, cruise lines, railroads, tour operators, broadcasting and freight transportation

• An important area of current research is on how to better incorporate customer behavior, lifetime customer value, competitive response into revenue management decisions

• The research continues in RM companies, at universities, and at consulting companies and system vendors

• There are numerous efforts to adapt revenue approaches to the needs of new industries, ranging from oil and gas pipelines to health care to made-to-order manufacturing; as in each of these industries constrained perishable capacity plays a role and RM has the potential to supplement existing pricing approaches, leading to improvements in profitability

• It would be nice to end here, but currently it is the carriers with expensive and sophisticated RM systems (American, Continental, Delta, Northwest, United Airlines and US Airways) that are going bankrupt while their low-cost, low fare rivals (Southwest, JetBlue, AirTran) thrive :(

• As is evident, average RASM is 25% than their low-cost competitors, which is an impressive achievement as seats are rapidly becoming a commodity and the Internet is enabling unprecedented fare visibility

• However, the Big 6 are getting clobbered in the cost game as their average cost per available seat mile is 50% higher than that of the low-cost carriers

• On the one hand the Internet has enabled the airlines to slash their distribution costs by cutting out the middleman – especially the travel agencies, who used to be the dominant distribution channel for travel products

• Still, the Internet is providing unprecedented fare visibility and eroding some traditional „product fences“ that used to keep segments apart

• The Internet has lead to the rise of new online intermediaries, such as Expedia, Travelocity, and Priceline, seeking to become the dominant retailer of travel products on the Internet; thus, a consortium of US airlines created Orbitz; for a foreseeable future a variaty of online retailers, airlines’ own Web sites and the traditional channels are here to stay

• The new „inferior“ products, like Priceline, which allows customers to bid for travel without knowing the exact departure time or airline they are purchasing; this has been explicitly marketed as an „inferior“ product that airlines can safely sell at a high discount without cannibalizing their mainstream products; other airlines and hotels are experimenting with selling „distressed inventory“ (i.e., empty capacity close to departure) at deep discounts

• Revenue management companies will need to manage a large portfolio of products and market segments through many different channels

• As others outside the travel industry are adopting revenue management approaches to managing availability, the revenue management industries might have to become experts in understanding customer response and including that in the combined models