Revenue Management (#248)
/In this podcast episode, we discuss several revenue management concepts. Key points made are noted below.
Revenue Management Principles
Proper revenue management is based on a few underlying principles. One of them is that customers love a discount and hate to be charged a premium. For example, a hotel could quote you a price for a more expensive room, and then point out that, for a reduced price, you could get one of their standard rooms. This is exactly the same as the hotel starting off with a low-priced quote for a standard room and then pointing out that, for a premium, you can get one of their better rooms, maybe with an ocean view. The difference is that, in the first case, it looks like the hotel is looking out for your best interests by offering a discount, even though both deals are exactly the same. Studies have shown that when people are offered a discount, they’re more likely to upgrade, so the seller makes more money by presenting prices using the discount approach.
Let’s turn the situation around and do it from the perspective of an airline. Years ago, the airlines used to present their prices using bundling, which means that everything they did was contained within one price. Then they switched to unbundling, which means that most airlines now charge for everything individually, such as the flight, the baggage fee, seating upgrades, change fees, food, and so on. Obviously, they did this to make more money, but the effect was that everything involving an airline requires paying a premium over the base price. And as I just noted, customers hate to be charged a premium. And so, by and large, people hate airlines.
The funny thing is, the airlines did not unbundle their prices for people in business class, who pretty much still pay just one lump sum. That’s because the people in business class are the most profitable customers, so the airlines can’t afford to piss them off, like they do with everyone else.
Revenue from Incremental Customers
Which brings me to the second underlying principle of revenue management, which is that incremental pricing adjustments are usually made to bring in new customers who are not the core customers of a business. Which is to say, when a business runs some sort of a discount program, it doesn’t want its core customers to take advantage of the program. After all, this group is already paying full price.
Rate Fences
The trick is to offer deals that have rate fences built around them. A rate fence is some sort of rule or restriction that segregates customers based on their needs or willingness to pay. There’re all kinds of rate fences. For example, consider a rebate. Rebates are really pretty awesome from the perspective of the seller, because it looks like they’re available to everyone, and the seller can advertise the price of whatever is being sold, net of the rebate amount. But what actually happens is that full-price customers almost never go to the trouble of filling out the paperwork and mailing in the rebate. Instead, only those shoppers who are really sensitive to prices will go to the trouble – and this group may not have been attracted unless the rebate was offered. Therefore, a rebate is subtle kind of rate fence.
Another rate fence involves student pricing. You have to show a student ID in order to buy something at a seriously reduced price. The intent here is to sell to people who might buy the product again later on at full price, when they’re employed and maybe can pass the charge through to their employer. Because a student has to show an ID, people who normally pay full price can’t take advantage of the special discount.
And one more example of a rate fence is when a resort hotel offers discounted rates to locals. The prices never appear on the hotel’s website, and you have to show a driver’s license that identifies you as a local. This is useful for filling hotel rooms during the off season, and tourists have no way of knowing that the discount exists, and couldn’t take advantage of it even if they knew.
So let’s assume that some sort of rate fencing is in place. How do you maximize profits by offering special deals? This involves figuring out how many customers are willing to pay full price, and how that compares to the available capacity. The easiest example is an airline. Let’s say that a flight has 100 seats, and the historical sales for the flight will include 25 people who are willing to pay full price at $500 each. So that leaves 75 seats that can be sold at a lower price. The airline offers the remaining seats at $250, but there’re some catches. The payment is nonrefundable and it has to be made more than three months prior to the flight. These rate fences are designed to keep business travelers away from the lower-priced seats, since business people usually have to travel on short notice, and may have to change their reservations at the last minute. And on top of that, the airline might decide to only offer the discounted seats on a separate website that’s run by a discounter, so that business people will never see it.
The Booking Limit
This method of setting aside a certain number of seats at a discount price is called the booking limit. When enough passengers finish buying up that block of 75 seats, the booking limit has been reached, and at that point only the more expensive $500 seats will be available. But this introduces a problem from the revenue management side of things, which is what to do if more than 25 people want to buy the higher-priced seats. In this case, you want to maximize revenues, so the system invokes what’s called a nested booking limit, which allows higher-priced ticket sales to intrude on the block of lower-priced seats. So if 30 people buy the higher-priced seats, this automatically cuts the allocation for lower-priced seats down to 70 seats. It would be theoretically possible for 100 full-fare passengers to buy out an entire planeload of seats, which means that no discounted fares are offered at all.
Overbooking
Another revenue management tool is overbooking. Everyone hears about overbooking on airlines, but that’s not the only place where it happens. A hotel can overbook rooms, a restaurant can overbook seats, and even a retail store can offer something for sale without having enough units to back up the sales. These are all cases of overbooking. The main overbooking scenario that annoys everyone is the airlines, so let’s take a closer look there.
On average, a flight experiences a non-show rate of 10%. So on a flight with 100 seats, the airline can expect 10 seats to not be filled that it had expected to fill. That’s a pretty major opportunity to increase sales. The airline maintains a record of the no-show percentage for every flight for every day of the year, so it can estimate the amount by which it can overbook each flight. Of course, the actual no-show rate is going to vary from expectations on almost every flight, so the airline won’t get it exactly right. Which brings up the problem of denied boardings.
Strangely enough, customers sometimes like it when the airline pays them to get off a flight, so airline approval ratings can increase as the result of a voluntary denied boarding. When the denied boarding is involuntary, though, an airline can earn an enemy for life and get a lot of bad publicity. And by the way, involuntary denied boardings currently run at about 1 person for every 10,000 passengers.
So, revenue management in regard to airline overbookings is a pretty complex process of applying historical trends to the present and having a system for paying off anyone who’s kicked off a flight.
Overbooking can be a pleasant experience in a hotel, since it usually means that they bump you up into a more expensive room for free. In the rare cases when there’s absolutely no room, they get you a spot somewhere nearby, which isn’t anywhere near as big a problem as being kicked off a flight, since it only involves a short drive to another hotel.
Restaurants also overbook, but you may never notice it. If a time slot is unexpectedly filled up, you end up waiting a few minutes, and get inserted into the next time slot. Eventually, somebody does not show up for a later booking, which eliminates the wait.
And when a retailer overbooks, it can either issue a rain check to a customer, or it states up front that quantities are limited. In the first case, the customer has to wait a bit longer for the goods to be backordered, but the retailer still makes the sale. In the latter case, customers tend to queue up at the beginning of the sale period in order to make sure that they get one of the units that’s available at the discounted price.
This was only a brief view of revenue management, but you can see that there’re lots of ways to tweak the amount of revenue, and hopefully generate more profits.