Title: Challenges of Revenue Management in a LowFare Environment
1Challenges 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
2Introduction
- Overview of revenue management (RM)
- Description of a low-fare environment
- Challenges of RM in a low-fare environment
- The way ahead
3Basic 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
4Leg vs. O-D Pair
- Leg Travel segment between two points
Origin
Destination
Leg 1
Leg 2
5Leg 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
6Leg 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)
7Overview 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
8Overview 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
9Overview 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
10Overview 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
11Overview 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
12Overview 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
13Elements 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
14Historical 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
153rd 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
16Historical 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
17Leg 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
18Historical 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
19Keys 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
20Keys 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
21Keys 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
22Keys 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
23Keys 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
24Keys 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
25Keys 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
26Summary 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
27Demand 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
28Low 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)
291990-2000 RASM
- Network carriers hold an approx. 18.4 RASM
advantage over LCCs - Average load factors 66 for both
Source DoT Form 41
302002-2005 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
311990-2000 Yield
- Network carriers hold an approx. 17.4 yield
advantage over LCCs - Average load factors 66 for both
Source DoT Form 41
322002-2005 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
33Summary 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
34Summary 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
35Summary of Industry Changes
- RASM growth rate similar for both Network
Carriers and LCCs - Yields grew pre-2000 but have shrunk after 2002
36Summary 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
37Low-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
38Growth 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
39Growth 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
40Growth 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
41Implications 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
42Internet 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
43Delta 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
44Air 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
45Air 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
46Low-fare Environment Summary
- Growth of LCCs
- Advent of the internet
- Intense competition
- Deltas Simplifares
- Economic downturn
47Implications 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
48Implications 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
49Implications 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)
50Keys 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
51Implications 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
52Way 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
53Future 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
54Summary
- 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
55Thank you!
- Bruno Miller
- brunom_at_alum.mit.edu