Challenges of Revenue Management in a LowFare Environment


1
Challenges of Revenue Management in a Low-Fare
Environment

• Bruno Miller Ph.D.
• Northwest Airlines
• AIAA Economics Technical Committee Mtg.
• Pasadena CA
• Jan. 24th-25th 2007

Note The material contained herein is the sole
responsibility of the author. All opinions are
the authors. Please do not distribute without
prior consent from the author
2
Introduction

• Overview of revenue management (RM)
• Description of a low-fare environment
• Challenges of RM in a low-fare environment
• The way ahead

3
Basic Terminology

• Available-seat-mile (ASM) Unit of capacity.
  Equivalent to a seat flown one mile
• Revenue-passenger-mile (RPM) Unit of demand.
  Equivalent to one paying passenger flown one mile
• Load Factor Measure of utilization. Defined as
  the ratio of RPM to ASM
• RASM Measure of revenue per unit of capacity.
  Defined as Revenue/ASM
• Yield Measure of revenue per unit of demand
  (indicator of average fare). Defined as
  Revenue/RPM

4
Leg vs. O-D Pair

• Leg Travel segment between two points

Origin
Destination
Leg 1
Leg 2
5
Leg vs. O-D Pair

• Leg Travel segment between two points
• Origin-Destination (O-D) pair Market segment
  connected by either non-stop or connect service

6
Leg vs. O-D Pair

• Leg Travel segment between two points
• Origin-Destination (O-D) pair Market segment
  connected by either non-stop or connect service

• Dichotomy of supply and demand
• Demand for air travel is at the O-D level (from A
  to C) but supply is leg-based (from A to B and
  then from B to C)

7
Overview of Revenue Mgt.

• Goal
• To maximize revenue by optimizing the mix of
  traffic demand and inventory allocation

Traffic demand
Inventory
Flight 1
Flight 2
. . . Flight N
8
Overview of Revenue Mgt.

• Goal
• To maximize revenue by optimizing the mix of
  traffic demand and inventory allocation

Traffic demand
Inventory
Flight 1

Flight 2
. . . Flight N
9
Overview of Revenue Mgt. (2)

• Basic premises
• Airline seats are perishable products once the
  airplane departs unsold seats are spoiled
  forever
• Different people are willing to buy different
  products

• Business pax
• Time sensitive
• Less price sensitive
• Tend to book closer to departure

• Leisure pax
• Less time sensitive
• Price sensitive
• Tend to book farther from departure

10
Overview of Revenue Mgt. (3)

• Spill
• With no adequate protection seats fill early
  with low-paying pax leaving no seats left for
  (i.e. spilling) high-paying pax

T1
T2

Open
Open
Open
11
Overview of Revenue Mgt. (4)

• Spoil
• If seats are over-protected seats might leave
  empty (i.e. spoiled) because high-paying demand
  did not materialize and low-paying demand went
  elsewhere

T1
T2
Open
Open
Closed
Closed
Open
12
Overview of Revenue Mgt. (5)

• RM becomes a means to balance spoil and spill

Revenue Management
Spill Seats fill early with low-paying pax
leaving no seats left for high-paying pax
Spoil Seats leave empty because demand does not
materialize
13
Elements of RM

• Fare structure demand segmentation
• Forecaster anticipate demand to come
• Overbooking reduces spoil by anticipating
  no-shows
• Optimizer set inventory levels to maximize
  revenue by choosing optimal mix of traffic

Note RM focused on maximizing revenue not cost
because costs assumed fixed by the time RM starts
working
14
Historical Evolution of RM

• Early 1980s extract data from CRS
• Mid-1980s adjust inventory levels by flight
• Late-1980s Third-generation leg-based
  forecasting and optimization

Source Barnhart C. Belobaba P. and Odoni A.
R. (2003) Applications of Operations Research in
the Air Transport Industry Transportation
Science vol. 37 No. 4
15
3rd Generation RM System
Revenue Data
Historical Booking Data
Actual Bookings
No-Show Data
Forecasting Model
Optimization Model
Overbooking Model
Recommended Booking Limits
Source Barnhart C. Belobaba P. and Odoni
A. R. (2003) Applications of Operations Research
in the Air Transport Industry Transportation
Science vol. 37 No. 4
16
Historical Evolution of RM

• Early 1980s extract data from CRS
• Mid-1980s adjust inventory levels by flight
• Late-1980s Third-generation leg-based
  forecasting and optimization
• Early 1990s to today O-D revenue management
  (DAVN HBP)

Source Barnhart C. Belobaba P. and Odoni A.
R. (2003) Applications of Operations Research in
the Air Transport Industry Transportation
Science vol. 37 No. 4
17
Leg vs. O-D

• Basic terminology of air travel demand

• Dichotomy of supply and demand
• Demand for air travel is at the O-D level (from A
  to C) but supply is leg-based (from A to B and
  then from B to C)
• Implications for Revenue Management
• Need to balance simplicity of a leg-based
  approach with complexity of a realistic network
  approach

18
Historical Evolution of RM

• Early 1980s extract data from CRS
• Mid-1980s adjust inventory levels by flight
• Late-1980s Third-generation leg-based
  forecasting and optimization
• Early 1990s to today O-D revenue management
  (DAVN HBP)
• Current challenges
• Incorporate passenger choice logic into
  forecasting
• Joint pricing and inventory optimization

Source Barnhart C. Belobaba P. and Odoni A.
R. (2003) Applications of Operations Research in
the Air Transport Industry Transportation
Science vol. 37 No. 4
19
Keys for Effective RM

• Internal to the airline
• Demand segmentation
• Stratified fare structure
• Optimal inventory allocation
• Relative competitiveness
• External to the airline
• High load factors
• Robust economic conditions

20
Keys for Effective RM

• Demand segmentation
• Recognize passengers with different willingness
  to pay
• Offer different products at different prices to
  maximize revenue

Price
Consumer surplus
P1
P2
P3
Demand
P4
P5
Q1
Q2
Q3
Q4
Q5
Quantity
21
Keys for Effective RM (2)

• Stratified pricing structure
• Business and leisure demand has traditionally
  been segmented using fare rules e.g.
• Saturday night stay
• Advanced purchase requirements
• Change fee

Price
Restrictions
200
0
Days to departure
22
Keys for Effective RM (3)

• Optimal allocation of inventory
• Protect seats for late-booking high-yield
  passengers
• Tricky balance between demand forecasting
  no-shows and overbooking
• Knowing when to choose between local and connect
  traffic can increase revenue
• In this example the overall value of two local
  passengers is higher than the value of one
  connect passenger

Pax1250
Pax2250
Pax3400
23
Keys for Effective RM (4)

• Relative competitiveness
• Competitors actions have great influence on a
  carriers decisions
• Superior RM systems hold an advantage over less
  sophisticated RM systems

T1
T2
Simpler RM
Open
Open
Open
Superior RM
Open
Closed
Closed
Open
Open
24
Keys for Effective RM (5)

• High load factors
• Difficult to promote sell-up on empty flights
• Can manipulate only one side of the LF equation
  (capacity) the other (demand) depends on many
  factors (market competitors etc)

Outside of airline control
Demand (RPMs)
Load factor
Capacity (ASMs)
Within airline control
25
Keys for Effective RM (6)

• Robust economic conditions
• A strong economy stimulates demand for air
  travel leading to higher load factors
• Passengers willing to pay higher fares
• Companies have larger travel budgets business
  air travel demand increases

26
Summary of Key RM Factors

• Internal to the airline
• Demand segmentation
• Stratified fare structure
• Optimal inventory allocation
• High load factors
• External to the airline
• Relative competitiveness
• Robust economic conditions

27
Demand For Air Travel Has Changed

• The US as a whole is spending a smaller
  percentage of economic output in passenger air
  transportation

Systemwide Passenger Revenue as of Nominal GDP
_at_ 26B
Historical Band
Four-quarter rolling passenger revenue derived
from government filings of passenger airlines
whose annual operating revenues exceed 100
billion. Sources ATA Airline Cost Index Bureau
of Economic Analysis U.S. Department of
Transportation
Source Meenan J. (2006) Current State of the
US Airline Industry. Presented at the 2006 FAA
Aviation Forecast Conference Washington DC
Feb. 28th 2006
28
Low Fares Have Moved In

• Between 1990-2000 nominal yield had an average
  annual growth less than inflation (1.0 vs.
  3.0)
• Real yields at a low since 1978 (airline
  deregulation) yes air travel is less expensive
  today!
• Dislocation in the industry between 2000 and 2002

Sources DoT Form 41 BEA
Measured in terms of the US Consumer Price Index
(CPI)
29
1990-2000 RASM

• Network carriers hold an approx. 18.4 RASM
  advantage over LCCs
• Average load factors 66 for both

Source DoT Form 41
30
2002-2005 RASM

• Considerable drop in RASM after 2002 for both
  Network and LCCs
• Increase in average Load Factor for both groups
• Network carriers still hold RASM advantage w.r.t.
  LCCs but gap narrowed 4 points from 18.4 to
  14.4
• Network carriers have a 3 point LF advantage of
  LCCs (75 vs. 72)

Source DoT Form 41
31
1990-2000 Yield

• Network carriers hold an approx. 17.4 yield
  advantage over LCCs
• Average load factors 66 for both

Source DoT Form 41
32
2002-2005 Yield

• Considerable drop in Yield after 2002 for both
  Network and LCCs
• Increase in average Load Factor for both groups
• Network carriers still hold average Yield
  advantage w.r.t. LCCs but gap plummeted 8 points
  from 17.4 to 9.4
• Network carriers have a 3 point LF advantage of
  LCCs (75 vs. 72)

Source DoT Form 41
33
Summary of Industry Changes

• Pre-2000 travel demand for Network Carriers
  growing at about the same rate as the economy
  pace slows down considerably after 2002
• In contrast growth in travel demand for LCCs
  outpaces economic growth by far

34
Summary of Industry Changes

• Pre-2000 capacity of network carriers growing
  slower than demand after 2002 capacity shrinks
  leading to higher load factors
• LCCs growing at a quick pace in both periods
  load factors experiencing positive growth

35
Summary of Industry Changes

• RASM growth rate similar for both Network
  Carriers and LCCs
• Yields grew pre-2000 but have shrunk after 2002

36
Summary of Industry Changes

• Network carriers loosing ground in RASM and Yield
  with respect to LCCs
• LCCs have higher rate of growth for RASM and
  Yield
• Network carriers are maintaining their load
  factor advantage

37
Low-Fare Environment

• The current low-fare environment is the result of
  a combination of factors including
• Growth of Low-Cost Carriers (LCCs)
• Increased transparency for travel planning and
  ticket purchasing through the internet
• More flexibility for customers to shop around for
  best deal
• Intense competition
• Network carriers forced to lower prices or else
  risk loosing demand to LCCs
• Deltas Simplifares
• Economic cycle
• Demand for air transportation heavily dependent
  on the state of the economy
• Recent economic downturn (2000-2002) forced many
  Network carriers to re-organize under Chapter 11
  bankruptcy protection

38
Growth of LCC Carriers

• LCCs not new but traditionally held small
  percentage of the market
• LCC presence relative to network carriers
  increased significantly during the 1990s and
  ballooned after 2000
• Currently 35 of domestic US industry capacity
  provided by LCCs

Source DoT Form 41
39
Growth of LCC Carriers (2)

• Expansion of LCCs fairly constant throughout
  period
• Contraction of Network carriers after 2002 major
  factor accelerating percentage increase of LCC
  presence

Source DoT Form 41
40
Growth of LCC Carriers (3)

• LCC ASM/RPM growth rate around 12/13 per year
• Network carriers ASM/RPM growth rate around 1/2
  per year
• LCCs have not had any periods of net negative
  growth network carriers have

Source DoT Form 41
41
Implications of LCC Growth

• LCCs offer low fares and have a simpler fare
  structure than network carriers
• Loss of demand segmentation ability poses
  challenges to RM

Traditional Network Carrier Fare Structure
LCC Fare Structure
42
Internet Reduces Information Asymmetry

• Travel web-sites allow customers to compare
  prices like never before forcing airlines to
  vigorously revise prices to remain competitive
• Use of internet very prevalent among travelers

Source Travel Industry Association (TIA) 2004
43
Delta Simplifares

• Introduced in January/05 as an attempt to
  simplify pricing structure similar to that of
  LCCs
• Main characteristics
• Change fee reduced from 100 to 50
• No Saturday-night stay
• Price caps in US48 499 one-way coach 599
  one-way first (increase by 100 each in July/05
  because of rising fuel costs)
• Less advanced-purchase periods 3 7 14 21 days
• Other Network carriers reacted by adopting
  similar fare structures to remain competitive

44
Air Travel Deeply Linked to the Economy

• Demand for air travel follows economic cycles
• Declining economic growth since 2000 lead to a
  slump in air travel demand in 2001-2002
• Industry recovering as the economy grows
  post-2001

Sources Bureau of Economic Analysis and Air
Transport Association
45
Air Travel Deeply Linked to the Economy (2)

• Arguably Network carriers more affected by
  economic downturns
• Business passengers adjust by paying cheaper
  fares creating revenue erosion at Network
  carriers
• LCCs remain attractive because of already low
  fares
• Since 2001 four Network carriers have filed for
  Chapter 11 bankruptcy protections
• United US Airways Delta and Northwest
• Need to focus limited resources on
  re-organization instead of fighting LCCs

46
Low-fare Environment Summary

• Growth of LCCs
• Advent of the internet
• Intense competition
• Deltas Simplifares
• Economic downturn

47
Implications of a Low-Fare Envt on RM

• Low-Fare Factors
• Growth of LCCs
• Advent of the internet
• Intense competition
• Deltas Simplifares
• Economic downturn

• Keys for RM
• Demand segmentation
• Stratified fare structure
• Optimal inventory allocation
• Relative competitiveness
• High load factors
• Robust economic conditions

48
Implications of a Low-Fare Envt on RM

• Low-Fare Factors
• Growth of LCCs
• Advent of the internet
• Intense competition
• Deltas Simplifares

• Keys for RM
• Demand segmentation
• Stratified fare structure

• The current low-fare environment characterized
  by simpler fare structures that hinder market
  segmentation makes traditional RM tools less
  effective

49
Implications of a Low-Fare Envt on RM

• Low-Fare Factors
• Growth of LCCs
• Advent of the internet
• Intense competition
• Deltas Simplifares
• Economic downturn

• Keys for RM
• Demand segmentation
• Stratified fare structure
• Optimal inventory allocation
• Relative competitiveness
• High load factors
• Robust economic conditions

• Economic downturns depress fares and demand for
  business travel making RM less effective but
  more important (to capture the fewer business
  travelers still flying)

50
Keys for Effective RM (4)

• Relative competitiveness
• Competitors actions have great influence on a
  carriers decisions
• Superior RM systems hold an advantage over less
  sophisticated RM systems

T1
T2
Simpler RM
Open
Open
Open
Superior RM
Open
Closed
Closed
Open
Open
51
Implications of a Low-Fare Envt on RM

• Low-Fare Factors
• Growth of LCCs
• Advent of the internet
• Intense competition
• Deltas Simplifares
• Economic downturn

• Keys for RM
• Demand segmentation
• Stratified fare structure
• Optimal inventory allocation
• Relative competitiveness
• High load factors
• Robust economic conditions

• Economic downturns depress fares and demand for
  business travel making RM less effective but
  more important (to capture the fewer business
  travelers still flying)
• Capacity reductions during economic downturns
  increase load factors which is favorable for RM

52
Way Forward for RM

• Focus on strengths over which there is a fair
  degree of control

• Keys for RM
• Demand segmentation
• Stratified fare structure
• Optimal inventory allocation
• Relative competitiveness
• High load factors
• Robust economic conditions

• Invest in new RM systems
• Stay ahead of the competition especially LCCs

53
Future Directions in RM

• Joint pricing and inventory optimization
• Relax assumption that fare structure is given and
  de-coupled from inventory allocation
• Use passenger choice logic and demand elasticity
  models to infer proper pricing structure to
  optimize inventory and revenue
• Extend inventory optimization from individual
  paths to the entire set of paths in a market
• These efforts can lead to better market
  segmentation and hence more effective RM

Source Barnhart C. Belobaba P. and Odoni A.
R. (2003) Applications of Operations Research in
the Air Transport Industry Transportation
Science vol. 37 No. 4
54
Summary

• RM is a key tool to increase revenue and maintain
  a competitive revenue position
• Air travel industry very different today than in
  the 1990s
• Current low-fare environment poses a challenge to
  traditional RM tools
• Market segmentation difficult
• Prevalence of low fares
• Investments in RM technology are a key to
  maintaining competitiveness especially w.r.t.
  LCCs

55
Thank you!

• Bruno Miller
• brunom_at_alum.mit.edu