Airline Revenue Management - Literature review Example

Airline Revenue Management Name: Course: Tutor Date: Introduction A critical aspect of any airline is sustenance of profitability irrespective of the season of operation. In essence, airlines have to maximize revenue from their given sets of assets to ensure that they survive in the highly competitive aviation industry. The prevailing competition has led to a proliferation of airfare on most routes. This is determined by how airlines manage their revenue with respect to the sum of costs they incur. The algebraic equation of the two factors determines the level of any airline’s profitability. An airline’s revenue generation is a function of the capacity of its aircraft to carry a substantial load over a given route distance. This in turn depends on the market conditions in terms of the fares to be charged, the level of market share, the airline’s competitive outlook as well as variations in demand. In addition, international operators are affected by other factors such as currency exchange rates as well as the ability to repatriate profits. All these factors must be clearly analysed in order to get a clear estimate of the airline’s revenue generating capacity. It is clear that maximization of revenue must be accompanied by lower operation costs in order to increase profitability. Airlines resolve this issue by the manner in which they handle the concepts of yield management and revenue management. This paper will evaluate how airlines manage their revenues in order to maximize profits. This will involve definitions and discussions on the concepts of “yield management” and “revenue management”. In order to clearly elaborate on the issues, the discussion will involve detailed examples of how some airlines have acted to maximize profits in their operations. Overview of revenue management by airlines Since the 1970s, airlines have been rapidly experimenting with deeply discounted fare services and products. Such measures are implemented in order to enable the airlines to fill seats that would otherwise be empty when their aircraft fly on particular routes (Cross, Higbie & Cross 2009 p. 57). The measures have had twofold impacts: one, that by creating innovative products, airlines generate substantial revenue from aircrafts’ unused capacity and two, that low-cost products are likely to cause high-fare passengers to shift to the news products. The second point may however be seen to be disadvantageous in that when high-fare passengers fly on low-cost fares there is some form of dilution since they are initially expected to fly anyway (Cross, Higbie & Cross 2009, p. 57). In order to deal with the probable problem of revenue dilution, airlines have instituted a number of measures, the first being stringent rules on the use of the low-cost products. For instance, there may be a 21-day advance booking for passengers intending to use the low-cost products, thus ensuring that the number of passengers using search advance booking services is greatly minimized (Gilbert, Child & Bennett, 2001, p.8). The second strategy has been to limit the number of seats sold at a discount. In order to ensure effective discount control, airlines have been required to have detailed tracking plans for customers depending on demand patterns and ensure protection of seats so that they can maintain high-fare passengers (Cross, Higbie & Cross 2009, p. 57; Gilbert, Child & Bennett, 2001, p.8). With time, this systematic process of predicting demand as well as controlling seat inventory within aircraft has led to the concept of “yield management.” This occurred mainly because yield is a very important airline statistic that represents revenue per passenger mile (Cross, Higbie & Cross 2009, p. 57). With the increasing complexity of airfare structures, need has arisen for larger databases, highly disciplined processes, as well much more technological sophistication to guarantee an appropriate mix of fares sold on each flight. Thus, there have been more strategies to effectively manage revenue in spite of the increased costs of staff, technology and processes. A key issue in revenue management has been that lower fares are conferred upon seats that would otherwise not be filled, and last minute seats are reserved for passengers willing to pay higher fares. It is against this backdrop that the CEO of American Airlines in the 1990s, Robert Crandall, denoted that yield management is the single most important development in air transportation since the airline started business (Cross, Higbie & Cross 2009, p. 57). In view of this, the following section therefore explores the concept of “yield management” with particular reference to how various airlines have worked out their plans to ensure maximum profitability. Yield Management Yield management is a factor that determines the number of seats that are to be availed to each fare class on any particular flight. This is done by setting booking requirement limits on low fare seats within an aircraft (Belobaba 2006). Characteristically, yield management involves the use of a set of differentiated products as well as prices and flight capacity. The motivation behind yield management is that airlines aim at having a high percentage of fixed operating costs for particular committed flight schedules thus leading to profit maximization. Further, the main objective of yield management is to protect particular seats for later booking passengers, who are expected to pay higher fares (Belobaba 2006; Zhang & Cooper 2005; Harris & Uncles 2007). From a theoretical point of view, such a motivation would only be fruitful if airlines are guaranteed of late booking passengers. However, an economic standpoint would indicate that such late booking may only be prevalent in some seasons such as high profile conferences in which there may be high traffic flow to one destination and an eventual shortage. As mentioned previously, yield management involves a premeditated control of an airline’s seat inventory. This has several implications: one, that too much focus on yield (that is revenue per passenger mile) may lead to an acute limit on fares and consequently result into lesser overall load factors. Secondly, when too many seats are sold at lower fares, the situation causes an increase in an airline’s load factors while reducing yield. This ultimately leads to an adverse corollary on the airline’s total revenues. How airlines act on yield management According to Hanlon (2007), airlines avert instances where customers may be motivated to resell their tickets by making the tickets non-transferable. This is facilitated by entering the customer’s name on the ticket and ensuring that for international travel proof of identity in the form of a passport is produced at the point of check-in (p. 249). Hence, the process of arbitrage that would ordinarily occur in the conventional market for goods cannot be practiced in the aviation industry. In practice, it is not possible for some customers to purchase cheap tickets in advance with a motivation to sell them to other customers whose need for booking arises near the departure time (Hanlon 2007, p. 249; Peister 2007, p.73). This point naturally allows airlines to have both low-fare and high-fare services within one aircraft, thus making maximum use of the aircraft’s carrying capacity and potentially maximizing profit. In addition, airlines typically offer a wide range of price classes, including as maxi-saver, full-fare, and supersaver (Mimes 2002, p. 22). Based on their research, airlines understand that high-income travellers, corporate travellers and those travelling for urgent personal reasons (such as to attend a funeral) have a demand that is relatively price-inelastic (Hanlon 2007, p. 249). In the same scope, airlines are cognizant of the fact that holiday makers, people travelling to visit their relatives or friends and students on vacation are very sensitive to demand on the fares that are charged (Hanlon 2007, p. 249). In view of this, common sense would have it that price inelastic travellers are likely not to book their flights in advance, but they need fast and ready access to seats on flights of their own choice and would like flexibility of their flight details within short durations of notice. On the other hand, the price inelastic travellers are willing to subordinate any preferences they may bear in terms of booking arrangements, access to seats, reservations and so forth provided they travel at the lowest possible cost (Hanlon 2007, p. 249). These differences between low-fare and high-fare passengers present airlines with good opportunities to segment the market and thus form the basis of price discrimination. What comes out is that if a balance is struck between low-fare passengers and high-fare passengers, airlines are able to operate comfortably in both dimensions by capitalizing on travellers’ preferences while ensuring that profit maximization is enhanced. Yield management among airlines is inevitable because naturally it is not possible for them to fill their carrying capacity with full-fare passengers (Kimes 2002, p. 22). When airlines segment their prices as a factor of yield management, two issues are notable. One is how they can recuperate customers who are unwilling to pay a relatively high sale price that covers the cost price while also giving enough margin. The second is how not to reduce turnover by under use of the existing service capacity (Malaval & Bénaroya 2003, p. 268). In view of this, American Airlines of the United States and SAS of Europe have been vibrant by capitalizing on late booking passengers, decreasing the availability of reduced price seats, setting up complex procedures for overbooking, and accepting more restricted volumes of traffic (Malaval & Bénaroya 2003, p. 268; Bertsimas & Popescu 2003, 37). Proper yield management and profit maximization In order to facilitate proper yield management, airlines need to have a large market share, such as possession of very large carriers and have the ability to dominate hubs. Profit maximization is also a factor of reduced costs (thanks to the hubs). Airlines that operate in highly penetrative markets such as the United States rely mostly on leisure travellers, who are sensitive to price variations while in the less penetrative market they rely on high-fare passengers. As such, yield management can be regarded as selling the “right product to the right customers at the right time and at the right place” (Malaval & Bénaroya 2003, p. 268). A good example of how airlines sell their products by embracing market segments is the case of American Airlines. In the late 1980s, the airline introduced “Ultimate Super Saver Fares” in which passengers had to book their flight at least two weeks in advance and stay at their destination over a Saturday night. Passengers who failed to meet this requirement would be charged higher fare. In addition, the airline restricted the number of discount seats it sold on each flight in order to save a considerable number of seats for full-fare passengers who usually booked their flight less than two weeks to departure (Phillips 2005, p. 122). The two-pronged approach embodies the profitability of airlines by focusing on two dissimilar sets of customers. Giant airlines such as Air France do not rely solely on seat capacity, they also maximize on cargo to make more gains. According to Malaval & Bénaroya (2003), Air France realizes gains of between 4 and 5 percent of their turnover due to involvement in cargo hauls. This is a pointer that airlines operating large carriers such as Boeing 777 and Airbus A380 have an opportunity to maximize profits not only through yield management in terms of price segmented seats but also through other features or their aircraft such as underbellies for handling cargo. Revenue Management According to Belobaba (2006), the term “yield management” is used by airlines since it involves a proper balance of a carrier’s load factor and yield, but is it is a rather old concept. However, in recent times the term “revenue management” has become popular. According to Phillips (2005), the term refers to the identification of customer segments and establishment of services and products that match those segments (p. 123). Revenue management involves a combination of diverse strategies aimed at maximizing profits. Key among these strategies are overbooking, use of fare class mix (also referred to flight leg optimization, and network optimization or traffic flow control (Belobaba 2006). revenue management decisions are thus based on three levels of management as detailed in table 1. Table 1: The three levels of revenue management decisions Level Description Frequency Strategic Segment market and differentiate prices Quarterly or annually Tactical Calculate and update booking limits Daily or weekly Booking control Determine which booking to accept and which to reject Real time Source: Phillips (2005), p. 123 Strategic decision-making involves market segmentation as was discussed under yield management. This section will therefore focus on tactical and booking control decisions with reference to overbooking, use of fare class mix and network control. Tactical decision-making arises when making critical verdicts, such as about overbooking. This involves revisiting past flight data, from which probable trends can be discerned (Zeni 2001, p.16). In line with this, most airlines allow overbooking, or accept reservations that exceed the available aircraft capacity in order to compensate for revenue losses that may arise as a result of some passengers failing turn up (Belobaba 2006). This is a achieved by use of nest booking, by which high-fare passengers are allowed to book seats that are available to low-fare passengers (Zeni 2001, p.16). According to British Airways information, the company’s revenue management experts make tactical decisions about 650,000 flight sectors, in which they have split their services into 26 yield bands or classes (British Airways 2009). Flight leg optimization implies that airlines determine the revenue maximizing mix of seats that are available to each booking (Belobaba 2006). This involves limiting the number of seats that may be booked in a particular class. It is a critical area that warrants keen attention since there are twofold consequences of bad forecast when allocating seats. One is that if the forecast projects high travel for corporate passengers, too many seats may be reserved for business travel but end up empty during flight. Two, when low corporate travel is projected, too few seat may be reserved for business travellers, resulting in low revenue when most seats are sold to leisure travellers (Zeni 2001, p.16). Network optimization or traffic flow control involves distinguishing the seats available with consideration for short-haul (or one leg) versus long-haul (or connecting) passengers (Belobaba 2006). Airlines venture in the routes they consider to be most vibrant in order to maximize profits. In the same light, airlines should be very judicious when selecting routes. Low-cost carriers such Ryanair avoid long haul routes that are frequented by full service airlines in order to focus on short-haul flights in which their services are most preferred (Gilbert, Child, & Bennett 2001). Such a move not only lowers competition but also gives passengers choices to make. With few exceptions, such as Virgin Express, most low-cost carriers only sell point-to-point sector tickets, thus avoiding probable problems that could be encountered in handling multi-sector tickets (McGill 1999; Doganis 2001, p. 152) Other strategies through which airlines manage revenue include cutting down on operating costs. Since purchasing aircraft is an expensive venture, airlines oftentimes employ a mix of ownership and lease schemes in order to optimize ownership costs as well as capital investment. A good example is the case of Oman Air. In order to survive in the highly competitive Asian market, the airline employed a mix of judicious owned and leased aircraft in order to reduce fleet ownership expenses (Rajasekar & Moideenkutty 2007, p. 121). The strategy made the airline to save a lot; including a 20 per cent reduction in ownership expenses, 30 per cent saving in maintenance costs, a 50 per cent decline in fuel costs, and 15 per cent reduction in overall costs (Rajasekar & Moideenkutty 2007, p. 121). This is an indication that airline revenue management requires a multifaceted approach, from practical management of passenger services to handling technical details pertinent to the aircraft in use. Conclusion The concept of profit maximization by airlines has been discussed in detail. It has been noted that there are two important terms related to profit maximization. Through yield management, airlines segment their seat capacity in order to handle both low-fare and full-fare passengers. On the other hand, revenue management involves more detailed strategies including market segmentation, control of networks and overbooking. Further, airlines are involved in strategies that reduce their operating costs in order to maintain substantial revenue. References Belobaba, P P 2006, Introduction to Revenue Management: Flight Leg Revenue Optimization 16.75 Airline, Available from http://ocw.mit.edu/NR/rdonlyres/Aeronautics-and-Astronautics/16-75JSpring-2006/E38DFD66-EF69-4FB6-91C8-362AD801733B/0/lect18.pdf (26 October 2009). Bertsimas, D & Popescu, I 2003, Revenue management in a dynamic network environment, Transportation Science, 37(3): 257-277. British Airways 2009, Strategy: Revenue management, Available from http://www.britishairwaysjobs.com/baweb1/?newms=info66 (26 October 2009). Cross, R G, Higbie J A & Cross, D Q 2009, Revenue Management's Renaissance: A Rebirth of the Art and Science of Profitable Revenue Generation, Cornell Hospitality Quarterly,50: 56-83 Doganis, R 2001, The airline business in the twenty-first century, Routledge, London. Gilbert, D, Child, D & Bennett, M 2001 A qualitative study of the current practices of ‘no-frills’ airlines operating in the UK, Journal of Vacation Marketing, 7: 302-311 Hanlon, J P 2007, Global airlines: competition in a transnational industry, Butterworth-Heinemann, London. Harris, J & Uncles, M 2007, Modelling the patronage behaviour of business airline travellers, Journal of Service Research, 9: 297: 313. Kimes, S E 2002, Perceived fairness of revenue management, Cornell Hotel and Restaurant Administration Quarterly, 43: 21-32. Malaval, P & Bénaroya, C 2003, Aerospace marketing management: manufacturers, OEM, airlines, airports, satellites, launchers, Springer, New York. McGill, J I 1999, Revenue management: Research overview and prospects, Transportation Science, 32 (2): 233- 256. Peister, C 2007, Table-Games Revenue Management: Applying Survival Analysis, Cornell Hotel and Restaurant Administration Quarterly, 48: 70-82 Phillips, R L 2005, Pricing and revenue optimization, Stanford University Press, Chicago. Rajasekar, J & Moideenkutty, U 2007, Oman Air: Challenges of repositioning through business level strategy, Asian Journal of Management Cases 2007, 4: 117-141. Zeni, R H 2001, Forecast Accuracy in Airline Revenue Management by Unconstraining Demand Estimates from Censored Data, Universal-Publishers, New York. Zhang, D & Cooper, W L 2005, Revenue management for parallel flights with customer-choice behaviour, Operations Research, 53(3): 415-431. Read More