The science of who, when, where
What the travel industry can teach you about revenue management
Anyone who has ever booked a vacation has experienced the dynamics of revenue management from a consumer’s perspective: making reservations off-season for lower hotel rates, finding the perfect combination of flights to fit your budget, cashing in loyalty program points for upgrades. But behind the scenes, revenue management is a complex science that combines marketing, analytics and customer relationship management for increased loyalty and profits.
Traditionally applied in service industries or markets with fixed capacity and perishable inventory such as airlines and hotels, revenue management is getting more attention beyond these industries as economies tighten, consumer spending declines and operating costs continue to rise. Businesses are finding they need to invest in systems that apply sophisticated, reliable analytics, taking them beyond traditional decision-making considerations (like seasonality) to more accurately predict demand, set prices for maximum profitability and manage inventory.
Begin by determining whether revenue management is right for your company. Revenue management is most effective if most of the following characteristics apply to your business.
Perishable inventory – Unlike traditional retail industries, where if the product is not sold one day, the exact same product can be offered for sale the next day, firms that can benefit from revenue management cannot store their products in anticipation of future demand. For example, once the airplane takes off, the airline loses the opportunity to sell any seats on that flight. Similarly, if a 200-room hotel has 10 empty rooms on a given night, they cannot sell 210 rooms the next night.
Relatively fixed capacity – Once capacity is established, it is difficult or expensive to add additional capacity. For example, if a store notices that demand for Coke is high one week, they can order more; however, a hotel cannot add additional rooms if they notice that demand has increased one week.
High fixed costs, low variable costs – Marginal sales costs are low but marginal production costs are high. For example, if the airplane is already scheduled to fly, adding one additional passenger costs very little (additional gas, a can of soda and the paper to print the boarding pass) when compared to the cost of buying and maintaining the aircraft. The cost of adding one more passenger is minimal; therefore, the additional revenue can be used to offset fixed costs.
Advance sales – Firms that accept advanced reservations or advanced sales face the challenge of deciding which business to accept. Revenue management helps firms feel confident when saying no to low-valued demand because they expect enough higher-valued demand to fill their capacity.
Time-variable demand – There is a need to be selective during peak periods and to stimulate demand during slow periods. Revenue management can increase occupancy in lower periods and raise prices in higher periods, increasing revenue using volume and pricing.
Segmented markets – Different groups of customers with different buying behaviors, groups of customers that the company would want to market to separately. For example, business travelers plan travel at the last minute and are willing to pay a higher price for the flight itinerary and hotel room that best accommodates their schedule. Leisure travelers, on the other hand, tend to plan further in advance and can be more flexible with schedules. However, they might be more price-sensitive, so they will book in advance and accept alternate itineraries and hotel locations in exchange for a discounted price. Understanding the buying behavior of these two segments can not only help hotels fill rooms in advance when sales are needed, but also turn away the lower-rated leisure travelers when demand from business travelers is high.
Once you determine that your company can benefit from revenue management, you’re ready to take the following steps:
Define your market segments
Nearly every industry has market segments that behave differently and are more sensitive to price levels than others. The travel industry, for example, might segment by leisure travelers, who usually incorporate a weekend stay, and business travelers, who typically travel during the week. The healthcare service industry might segment by urgent care and postponable care; the broadcast industry might segment by guaranteed spots, pre-emptable spots and rotating spots; utilities might segment by urgent, nondiscretionary service and non-urgent, uninterruptible service.
Determine peak and off-peak pricing
The element of time often plays a role in how a service is priced. These time-bound requirements are often referred to in revenue management as “rate fences.” The objective is to minimize discounts during peak periods and encourage demand during off-peak times. For example, you may require a Saturday night stay, 21-day advance purchase, or offer a senior citizen discount during specific periods. The idea is to divide existing demand according to product preferences and purchase behavior, and then market to those specific characteristics in order to increase your revenue potential.
The firm can charge higher prices to those market segments that are not responsive to changes in price level and charge lower prices to those market segments that will accept a condition or restriction in exchange for a discount. The expectation of the lower price point is that it will encourage bookings during periods when utilization of the fixed capacity is projected to be very low, therefore increasing overall revenue for the firm. These prices would not be offered during peak periods when customers are willing to pay higher prices for access.
Managing the uncertainty about the future demand for a service is the essence of revenue management – and what makes revenue management so valuable.
Good demand forecasts translate directly into increased revenue in the form of higher average rates per customer, without a loss in orders. This is because the more confident you are that high-rate-class customers will materialize, the lower the risk in reserving inventory for them.
The search for improved forecasting techniques continues to attract a considerable level of investment, even among companies with relatively mature revenue management programs. A potential side benefit of developing good demand forecasting capabilities for revenue management is that the customer volume forecasts can often be put to good use elsewhere in the company. Functions such as supply ordering and staffing can often be planned more accurately with access to the detailed customer forecasts produced by a revenue management system.
The objective of revenue management is to maximize revenue and profits in the face of uncertain levels of demand. So how do you allocate inventory among various price levels and market segments in the face of this uncertainty? The key is to determine the lowest price you are willing to accept per unit, understanding the probability that a higher-paying customer is likely to show up. Your ultimate goal is to confidently make statements such as: The lowest price that we should accept from a customer standing in front of us is $100. If someone offers us more than $100, we sell; otherwise, we do not.
One of the main benefits of revenue management is the confidence to never sell a unit of capacity for less than you expect to receive for it from another customer. But if you can get more for it, the extra revenue may go straight to the bottom line.
One of the main benefits of revenue management is the confidence to never sell a unit of capacity for less than you expect to receive for it from another customer.
A revenue management checklist
If most of the following characteristics apply to your business, you might benefit from implementing a revenue management approach:
- Perishable inventory.
- Relatively fixed capacity.
- High fixed costs, low variable costs.
- Advance sales/reservations.
- Time-variable demand.
- Segmented markets.