Revenue Management Revolution

Through dynamic pricing, airlines can increase yields and capture detailed information about potential customer behavior, then use this intelligence to support a more customized pricing strategy. Moving to a more dynamic and segmented pricing approach can also support the overall stimulation of demand in a multimodal environment.

Deregulation and globalization of the airline industry created a major transformation in customer marketing techniques. Specifically, pricing and revenue management have been instrumental in enhancing airlines’ competitive position as well as generating incremental revenue.

Today, airlines around the world — as well as hotels, train operators and many other industries facing deregulated competition and globalization of their markets — acknowledge that pricing and revenue management are crucial to compete effectively against local and global rivals. However, with the drastic change of market forces (in particular, the increase in customer power against fragmented travel-chain providers), is it time for a revolution rather than an evolution of pricing and revenue practices?

Pricing And Revenue Management

When discussing the role and potential evolution of pricing and revenue management within the marketing planning process, it is beneficial to highlight the historical reason of the creation and development of these techniques. It dates back to Oct. 24, 1978, with the signature of the Airline Deregulation Act that shifted over four years from an administrative to a market-driven commercial policies establishment.

In other words, capacity, schedule, pricing and, to some extent, customer-relationship responsibilities were transferred to airlines rather than the bureaucratic Civil Aeronautics Board.

It led to a fierce competition that moved from quality of the meal and cabin-crew services to:

  • Capacity optimization via hub and spoke,
  • Improvements to schedules, increasing aircraft utilization,
  • Price competition with the introduction of discounted fares,
  • Creation of a pricing structure.

The results over five years were both a decrease in average fares of 9 percent (net of inflation) and a load factor moving up from an average of 50 percent in the 1970s to 75 percent in the 1980s.

To manage such drastic and rapid transformation of commercial and marketing practices, airlines had an enormous impetus to develop new fares (because of the new entrants as well as enhanced capacity) and gain a more granular control of the available seat inventory (through better customer segmentation to avoid yield dilution). Basically, airlines were trying to address what still remain key pricing and revenue management business issues — traffic spill, market recapture and demand stimulation — using four main levers:

  • Overbooking — The process of selling more reservations than physical seat capacity to compensate for the effects of cancellations, no-shows, duplicate bookings and passenger misconnects. Hence, it has a significant revenue impact in filling up incremental seats as well as providing customers a higher probability of being accepted as their first choice for travel.
  • Class allocation — The process of selectively accepting and rejecting reservations requests based on their true value to maximize the captured revenue versus total revenue opportunity.
  • Group management — Applies class allocation techniques to large parties.
  • Fenced pricing — A scientific technique using demand/price elasticity concepts to design the price within a fare structure that will support the development of airline revenue. It is a fairly complex task because a route usually has hundreds of fares available at any given point.

During the last few decades, pricing and revenue management techniques have become much more sophisticated with the introduction of origin-and-destination inventory controls, or restriction-free pricing and revenue management. Today, it is widely acknowledged that pricing and revenue management are a strict necessity to compete effectively in a fiercely competitive global market.

This holds true for airlines, hotels and railway operators. More importantly, no one within an airline will challenge the role and benefits of the revenue management and pricing department. Nor would an airline envision operating — or starting its operations — without it. In short, revenue management has been at its pinnacle of fame for many years, and it will likely be for many years to come.

Airline Deregulation Act
Success Of Revenue Management

Deregulation stressed the urgent need for pricing and revenue management techniques and practices as well as the high benefits for an airline implementing it. However, its success over time is mostly due to the characteristics of the transportation industry.

Most industries practicing revenue management are characterized by high fixed costs due, in particular, to the cost of both their assets and infrastructures, with recurring high expenses associated with maintenance and manpower to operate the assets. The airline industry, like other travel-related industries, is capital intensive, with billions of dollars worldwide being invested annually in the purchase and maintenance of modern aircraft and infrastructures, as well as the associated specialized manpower to operate it. Therefore, cash flow is important, and pricing and revenue management practices are widely used to make tactical inventory adjustments and demand stimulation to meet quarterly financial objectives.

The second financial challenges are the variables costs, proportionate to both total traffic and distance travelled. Clearly, the current high fuel costs highlighted this issue, partially offset by ticket surcharges. Nonetheless, the main issue for carriers, in addition to fixed costs, is that most of their costs are variables and based on the distance flown, while fares — and, therefore, flown revenue — are based on the mechanisms of a free market, with fixed supply and seasonal demand as well as perceived value by their customer.

Consequently, without sound pricing structures and inventory-control policies, airlines will not be able to steer, stimulate and recapture demand to maximize their revenue and enhance their profitability. Marginal costs in filling an empty seat are limited. They are essentially related to the level of service on the ground and onboard the aircraft, and they are quite insignificant. This is assuming that passenger behaviour is not changing by taking advantage of lower-priced fares, in which the lost revenue of having an incremental passenger can be significant and counterproductive for the profitability of the airline.

The parallel implementation of a hub-and-spoke system, with the removal of restrictions on market entry and exit, supported more efficiency in the utilization of capacity and increased the available seat kilometers. The conjunction of a cost structure where marginal costs are minimum (hence, marginal profit maximum), development of a hub-and-spoke network structure and the constraint of having a perishable inventory greatly boosted the research and implementation of pricing and revenue management techniques. Initially implemented by North American carriers, it was rapidly followed by their international counterparts and later by other industries.

Revenue management is a clear industry standard. It is now referred to as an industry prerequisite since almost all airlines worldwide have implemented pricing and revenue management techniques and business practices and, quite often, leg/segment or more-sophisticated origin-and-destination revenue-optimization decision-support systems.

Revenue Management Evolves

Revenue management and pricing tactics have been instrumental in enhancing transportation operators’ revenue per available seats. However, if the foundations of revenue management are still applicable, several key evolutions since its creation and development have not been, or only partially been, captured today.

A significant limitation of all pricing and revenue management solutions today is that they mostly address the visible part of the demand but not the total multimodal demand (air, rail, bus and car). While customers, at the same time, make travel decisions based on a comparison of the cost and benefits of each means of transportation.

Going for a short holiday weekend, today’s travellers compare destinations with length and cost of travel. They make purchasing decisions based on the total travel time compared to the total cost of the trip. When determining the mode of transportation portion of the trip cost, the customer compares perceived quality of service and comfort versus the price of the different modes of transport that are possible.

For example, in Western Europe, most customers have the choice of travelling by air, high-speed rail or highways — either by car or express bus — to a wide area of destinations. To some extent as well, online travel agencies support customer choice not only for the same destination, but also among different destinations. In other words, for a given budget, the key question for a customer is whether he will drive four hours for destination A, fly one hour for destination B or travel by train for a couple of hours to destination C.

Focusing only on one means of transportation is particularly restrictive in an environment where information for the traveller is not only widely distributed via various media, but also inexpensive to acquire using the multiple pricing search engines flourishing on the Web — assuming that the air-rail-road infrastructure supports such comparison.

One could argue that this situation is only applicable to a few markets, which is partially true. However, more and more countries, including China, Russia and Argentina, are massively investing in high-speed rail infrastructures. The continuous development of highways, either directly financed by the government or toll system, and widespread automobile adoption, specifically in under-developed countries, is making car usage an alternative to other means of transportation. This is because consumers make choices based on out-of-pocket expenditure, not indirect costs.

Thus, to recapture market share from competitors, revenue management is key, but to recapture market share in a multimodal environment, or simulate demand for air transportation, pricing and revenue management, analysts have limited, if any, information and decision support.

The second limitation of revenue management is that all airlines practice it. Therefore, it is necessary to, at minimum, be at parity with competitors. However, traditional revenue management is no longer a competitive advantage; therefore, its benefits are being limited. Moreover, with electronic and mobile distribution, the lowest fares for a given origin and destination are visible to all customers and easily comparable, limiting the benefits of the traditional revenue-managed class allocation, and pushing down passenger yield.

Ancillary revenue is a successful attempt to increase passenger revenue by selling additional products and services, thereby offsetting a declining yield. However, in the long term, the “base fare” to capture customers will most likely continue to decline due to the price visibility offered by fare comparison engines and online travel agencies.

Finally, revenue management is mostly based on historical forecasts. In an extremely dynamic market with multiple competitors, relying only on historical data is a risk. While alternative forecasting techniques exist, only a revenue management model incorporating the concept of dynamic pricing and demand/price elasticity can capture the online dynamic of the market.

A New Paradigm

According to Thomas Samuel Kuhn, an American historian and philosopher of science, a new paradigm appears when the rules of the game are changing, redirecting research and questioning what was accepted as the base assumptions to create a new core of assumptions. As such, it appears that revenue management and pricing are at the premises of a new paradigm.

Pricing is now a key element to the competitiveness of any transportation operator since passengers, as ultimate decision makers, have direct access to schedules and fares. It also has a high impact on airline profitability since a 1 percent increase in the price paid by passengers will lead to an increase in operating profit of 19 percent on average.

Clearly, pricing decisions have become, and will continue to be, more tactical and dynamic by nature. At the same time, the benefits of traditional revenue management, such as discount allocation on a leg/segment or origin-and-destination base, will see their influence reduced by the high visibility of the base fare offered to customers.

In a world where customers are fully controlling the purchasing process as well as having all information readily available at almost no cost, capturing customers is all about having a competitive range of base fares to fill up the remaining empty seats. Base fares, coupled with ancillaries, preserve and enhance the profitability of airlines.

Therefore, dynamic pricing gives airlines opportunities to increase yields by quickly and opportunistically changing the price over time, leveraging online available fares information with customer data and profiles to develop sophisticated pricing strategies. The ability to capture online detailed information about potential customer behavior, either from an airline’s website or online travel agencies, supports the definition of a more customized pricing practice. This will give airlines a better understanding of demand as well as help develop tailor-made fare packages for each customer or customer segment.

Moving to a more dynamic and segmented pricing approach also supports the overall stimulation of demand in a multimodal environment. While pricing visibility is a challenge, it also presents an opportunity. Gaining more intelligence about all transportation competitors’ fares and allowing other competitors to set up segmented pricing actions will help recapture demand from other modes of transportation.

In addition, dynamic pricing, supported by a segmented offer using customer data and a multimodal and multi-distribution channel approach, will support a better stimulation of the market demand since the specific pricing offer will consider the travel options of the targeted customers segment in its entirety. It will support the shift of traffic from one mode of transportation to another.

Because of the proven benefits of implementing sound revenue management practices, it has always been and still remains a key function within an airline. This is due, in part, because of its widespread presence within the industry, but also because of the drastic change in the information available to passengers.

Consumers now have all pricing information at their fingertips. They make travel decisions based on fares, across all potential means of transportation when alternative services are available. To compete and capture (or recapture in some cases) passengers, airlines must focus on setting up a real-time dynamic pricing strategy, supported by stronger customer segmentation, using customer relationship management tools as well as customer purchasing patterns from online stores.

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