The Relationship between Revenue Management and Pricing Strategies in Airline Industries - Research Paper Example

? Insert Page here Outline Introduction Literature Review Discussion Conclusion Revenue Management refers to pricing methods that aim to increase revenue from perishable capacity. Pricing strategy is the model applied to determine the right price to sell a product. There are many terms used to describe revenue management, which came up after airline deregulation in 1978. Revenue management works when there is a large perishable capacity to offer services. The relationship between revenue management and pricing strategy is multifaceted. The facets include uncertainty in pricing, multiplicity of motives guided by business objectives, demand driven model, and the possession of a positive time correlation. The Relationship between Revenue Management and Pricing Strategies in Airline Industries Revenue Management (RM) falls under the dynamic pricing models. There are several terms used to describe revenue management. The most common on is yield management, or a combination of several terms such as Price and Revenue Management (PRM), or Perishable asset revenue management (PARM) (McAfee & Velde 2005; Bieger & Agosti 2005). It normally describes a pricing method where the cost of buying the product or service changes over time to take advantage of the variation in consumer willingness to pay a certain price for the product. Depending on the industry, the prices either increase or decrease with time. In the electronics market for instance, the price of a product is normally higher during the launch compared to the prices charged after some time. In the airline industry, prices typically increase towards the scheduled time of the flight. Pricing strategy refers to the framework that a producer uses to set the prices for a particular product. Pricing strategy is very crucial because it affects the potential for success of a product. The most basic pricing model is unit cost pricing model, which assigns the price of an item based on the cost of production and the expected margin. Pricing is not normally a straightforward affair because forces of supply and demand affect it. The price of an item tends to be closer to what the market is willing to pay for than the simple arithmetic of cost of production and margin. Dynamic pricing models tend to seek to maximize revenue based on the prevailing demand. In some cases, dynamic pricing actually disregards the cost of production. In the case of the airline industry, unit cost is an unstable way of organizing pricing because of the large upfront cost Revenue management is the most dominant pricing model in the airline industry because of its potential to boost profitability in that particular industry. It came about after the liberalization of the industry in the late seventies. Airline executives found themselves in a tight spot because of increasing competition in the fledgling industry. They sought to find ways of increasing the profitability of the airlines in the industry based on their existing carrying capacity. However, the airline industry is not the only industry that uses yield management. The hotel industry also uses it and other industries such as printing firms, bus companies, car hire firms and private lodges also use it to maximize revenue against a backdrop of fixed capacity and highly perishable products (Koenig & Meissner 2011). The goal of this paper is to investigate the relationship between revenue management and pricing within the airline industry. In the first part, the discussion will seek to examine the important issues surrounding revenue management, followed by an analysis of how those factors affect pricing strategy in the second part. Literature Review The Concept of Revenue Management There is a wide variety of terms, concepts, and approaches to the study of revenue management. Some scholars use all the related terms interchangeable stressing the greater meaning of time sensitive pricing. Older researchers used yield management and revenue management to mean the same thing (Boella 2000; Bieger & Agosti 2005). Recent works point to a differentiation between these terms. For instance, Kotrba (2011) pointed out that the traditional use of the word yield referred to a specific way of handling revenue while newer approaches to this discipline use the term pricing. One such expression is the phrase, “dynamic pricing” (McAfee & Velde 2005, p. 1). Another relatively new term used in the general context of revenue management is “efficient frontier” which stands for specific niches within the broader framework of revenue management that leads to better returns (Phillips 2011). These selected examples show that research in this field of pricing is very active and it is only prudent to anticipate more changes in the field as new niches develop. It is possible that all the terms in use currently will give way to new ones that will seek to expand the meaning or describe the methods in ways that are more relevant. The Origin of Revenue Management There is unanimity that revenue management started immediately after the deregulation of the airline industry in 1978 (Pavlovich 2005). In America, American Airlines was the first airline to use revenue management to garner competitive advantage (McAfee & Velde 2005). There are claims that British Airways (then known as BOAC) developed the methods before their widespread application in the American market (Koestler 2011). The eighties saw many airlines use revenue management to grow their market share and to stay afloat amidst a very difficult operating environment. The basic question that drove airline to starts using revenue management techniques was that airlines realized that there was a high fixed cost for offering their services and it was possible to sell the excess seats at a lower price to spruce up the revenues. Revenue management resulted from the attempts to sell the excess units produced by the airlines at a bargain provided customers were willing to pay for them in advance. The Conditions Necessary for Effective Application of Revenue Management Any product must fulfill two conditions for the successful application of revenue management in its pricing. The first one is that the marginal cost of producing it must be high regardless of demand. In the airline industry, it refers to the cost of putting a plane in the air. It includes airport fees, salaries paid to staff, fuel, and service and maintenance costs. It is impossible to meet these costs at unit level. The second condition is that the product must be perishable, usually over a very short duration. In other words, after production, if no one consumes the product, it loses all its value. If an airplane takes off with an empty seat, there is no way to make money from that seat again. These conditions occur frequently across many industries that use revenue management. The Benefits of Yield Management The major benefit of revenue management is that it has the potential of boosting revenue significantly, and in the process, increasing profit margins. It is about getting a return for products that could have gone to waste. This comes from the fact that to sell a new unit, no extra cost goes into the production cost. Mather (2012) reported that yield management brought about significant changes to several organizations from different sectors. An analysis by Mather (2012) showed that United Parcel Service saw their revenues grow by one hundred million in 1998 after the introduction of revenue management, while the American Airlines increased their revenue by fourteen percent and grew their profits by forty eight percent in 1985 after the introduction of yield management. These examples show that yield management has the capacity to increase the profits of an organization considerable because of the fact that it does not cost anything significant to offer services after the recovery of the marginal costs. Beyond the operational costs, all revenue goes towards buffeting the profit margin. Fairness of Revenue Management Another name for revenue management is price discrimination. In essence, the provision of the same service or product to two consumers at different prices appears discriminatory (Kimes & Wirtz 2003). The thinking behind revenue management is to offer a product at the highest possible price, and at the most convenient time, to customers willing to pay. Consumers who feel that they should pay the same price for the same product often feel cheated when prices vary a lot between the highest and the lowest options. On the other hand, there are customers who feel that it is fair to have the option of paying lower fares if they book early. From the airline operator perspective, the point is to offer the same product to different clients because they have varying needs. It is an attempt to meet the needs of different clients using the same resources. People who feel that yield management is unfair also use the term “rate fences” to stress its discriminatory nature (Kimes & Wirtz 2003). Risks Associated with Revenue Management Koenig & Meissner (2011) looked at the process of determining the prices for different market segment from a risk management perspective. The basic process of setting up the prices for use by each segment relies on the capacity of the pricing manager to forecast demand. On one hand, the airline runs the risk of not filling the seats in a plane if the prices are discordant with the consumer demand. This is the result of prices set too high for the market segment or the availability of a cheaper alternative for the customers. On the other hand, there is a real risk of setting the prices too low leading to the forfeit of profit (Koenig & Meissner 2011). The airline can fill the seats but still make little profits because of setting the prices lower than the market rate. It is very difficult to mitigate completely these risks. This shows how managing a revenue management system is very uncertain, hence the basis for considering it a risky aspect of business. Impact of IT on Revenue Management With the development of faster information processing options such as faster computers, powerful analytical tools, and a robust information technology and professional support services in yield management, the practice continues to grow in complexity. The development of IT infrastructure for yield management comes from two issues. First, revenue management is a full time endeavor, requiring real time data input and monitoring. It is more efficient to deploy IT resources to handle the analytical work and leave only the decisions that a human being must make. Secondly, there is a lot that IT can do in when it comes to “forecasting and optimization”, yielding results quicker to allow for immediate decision-making (Phillips 2011). Discussion Based on the literature reviewed, it is clear that there is a complex relationship between revenue management and pricing in the airline industry. There are four key elements of this relationship. First of all the pricing process is not certain, but is an art. It is a delicate balancing act between maximizing revenue and risking alienating potential customers one hand, and on the other hand risking lower profits because of undervaluing the seats in the plane. Secondly, revenue management is not just profit driven. There are many motives behind the use of this pricing model. Thirdly, demand drive the prices fixed by revenue management methods and are not entirely at the discretion of the airline. The fourth observation is there is a relationship between time of ticket purchase and the pricing models used by airlines that apply revenue management. Pricing Uncertainty Unlike the simple pricing models where the price of the product is a simple computation of costs and expected profit margin, revenue management is a complex affair. This pricing strategy takes place under conditions of uncertainty and depends in the insight of the revenue manager and the fidelity of the analytical tools available. The uncertainty comes from the fact that the revenue manager needs to set a price high enough for the airline to maximize its revenues, but low enough for the customers to be willing to pay. It is not simple arithmetic to determine this number, but a complex tax mediated by decision support systems (Lee, Roberts & Sweeting 2012). Worse still, these circumstances change as time progresses, hence the need to shift the model constantly to fit the dynamic demand. The analytical tools available to the revenue manager enable him to determine the actual demand levels based on historical data and personal experience. Revenue management calls for bid pricing to see whether there are people interested in the product at the beginning price and adjusts as the demand rises (Li, Granados & Netessine 2011). This lack of certainty is central to the practice of revenue management because it makes the process of fixing prices and finally projecting profits extremely difficult. In this regard, it is clear that one of the aspects of the relationship between revenue management and pricing is that the process of fixing the prices is uncertainty. There are Multiple Motives behind the Pricing The second issue undergirding the relationship between revenue management and pricing in the airline industry is that there are multiple motives guiding the process at any one time. Apparently, profit is not the only motive driving airlines when they implement revenue management. Pricing strategies emanate from overall business strategies that the specific airlines need to meet (Kotrba 2011). Among the motives that drive the pricing strategy, include quest for market share, optimization of the revenue management systems in place and revenue growth to attain healthy balance sheets in order to win shareholder confidence. Revenue management in these cases is a tool, or philosophy of pricing that allows businesses to meet their wider objectives. When airlines are seeking to increase their market share, they adapt their prices to appeal to their target segments (Johnson, Klassen & Haywood-Farmer 2006). For instance, to grow the business flyers segment that normally pays the highest fares, revenue managers may seek to make it more attractive for them to fly with their airline by offering discount pricing. If competitors are oblivious of the business objectives at play, they may end up lowering their prices and destabilizing their customer profile in the process. The second motive behind revenue management efforts include streamlining of the revenue management system in place (Phillips 2011). This helps the airlines to operate their revenue management systems efficiently by maximizing their returns from each segment. It affects seat allocations for different types of customers. The third motive behind revenue management efforts is to attain an attractive balance sheet position. Stock analysts do not use profits alone to judge the performance of a company. Healthy revenue plays an important part in determining the health of a company. Therefore, an airline may choose to reduce its profits if this allows them to have better revenues and hope to turn the increased business into profits over the long term. In conclusion, the motives that inform the way airlines use revenue management depends on several motives, which may not include short-term profitability. Demand Drives the Prices Fixed Under Revenue Management The third significant trend that demonstrates the relationship between revenue management and pricing strategy is that invariably, prices fixed under revenue management regimes follow demand. The two key aspect of demand are market segmentation and seasonal demand. Under market segmentation, airlines generally know that business travelers like to have greater flexibility in their travel schedules (Iliescu 2008). This segment likes the flexibility that comes with the opportunity to get an air ticket on short notice. In this sense, airlines tend to charge them much higher than the rest of the passengers. In addition to the short notice, tickets sold to business people are normally transferrable at a little or no cost depending on the airline. The nature of the demand by this segment influences how the airline prices their tickets. On the other hand, leisure travelers plan their trips around predictable dates and schedules (Li, Granados & Netessine 2011). They can afford to take advantage of lower ticket prices by early booking. Since they have time to shop around, airlines fight hard to win their business. Normally, cheaper tickets do not have the option for transferring to a later or earlier flight except at a steep cost. This tactic ensures that after selling a ticket to a leisure traveler, the airline is certain to make money. On the issue of seasonal demand, airlines know that there are seasons when many people fly on particular routes. Therefore, the prices set for that period tend to be higher than normal times. This influences the margin the airline gets from seasonal demand. Based on this relationship, it is clear that demand influences the application of revenue management in pricing strategy. There is a Time Relationship between Revenue Management and Pricing Strategy The final relationship between the revenue management and pricing strategy is time. In variably, the airline industry uses time as a major factor in determining the price of a ticket. Tickets bought closer to the date of travel tend to be costlier, while those bought earlier on come with significant discounts. However, demand is elastic, therefore, the graph of demand versus time changes shape. The original demand for low cost tickets is originally low and increases steadily as the date of the flight approaches. Leisure travelers book their tickets early because of their predictable schedules, while business travelers book their tickets close to the date of travel when their schedules are more predictable. There are indications that some customers have developed strategic buying habits to take advantage of the significant discounts that buying tickets early bring (Lee, Roberts & Sweeting 2012). Conclusion In conclusion, there exists a complex relationship between the revenue management and the pricing strategy used by airlines. In this paper, the four variables considered in this relationship includes the uncertain nature of the pricing process based on the fact that prices developed under revenue management processes use models and demand forecasts. Secondly, the motives that drive the revenue management efforts do not always come with the need to make profit. There are other motives driven by business objectives that have an immediate influence on the pricing strategy. Thirdly, there is strong place for demand in the fixing of prices under revenue management regimes. Finally, there is time relationship to re4venue management and pricing. There is an increasing prominence of the use of IT in revenue management because of the increasing data processing, and modeling capacity. In addition to these, there is real time communication that the internet makes possible. The advances in both the thinking and the practice of revenue management will yield more views and approaches to revenue management because of the expected increase in the number of passengers using airlines the world over. References Bieger, T & Agosti, S 2005, 'Business Models in the Airline Sector: Evolution and Perspectives', in Strategic Management in the Aviation Industry, Ashgate Publishing, Ltd, Hampshire. Boella, M 2000, 'Legal Aspects', in A Ingold, I Yeoman, McMahon-Beattie (eds.), Yield Management, Cengage Learning, London. Iliescu, DC 2008, 'Customer Based Time-to-Event Models foe Cancellation Behaviour: A Revenue Management Intergrated Approach', Dissertation, Georgia Institute of Technology, ProQuest, Gorgia. Johnson, F, Klassen, R & Haywood-Farmer, J 2006, 'Yield Management at American Airlines', in Cases in Operation Management: Building Customer Value Through World-Class Operations, SAGE Publications, London. 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