Airline Yield Management

Following deregulation of airline pricing in 1978, fare information provided to travel agents became more extensive. Discount airlines and dynamically adjusted pricing became a common response strategy.

Over time, the complexity and opaqueness of airline pricing has increased, driving the need for Yield Management Systems to ensure service profitability and airline economic viability.

Airline pricing is very challenging. Dynamic pricing, also known as yield management or revenue management, is a set of pricing strategies aimed at increasing profits by combining primary factors such as multiple product characteristics and secondary impacts of those primary factors.

For instance, once the first product expires [hotel rooms, airline flights, or time-dated 'sell before' products], capacity is augmented only at a relatively high marginal cost. This creates the potential for very large movements in the opportunity cost of sale. The opportunity cost of sale is a potential foregone subsequent sale.

The value of a unit in a shortage situation is the highest value of an un-served customer. Forecasting this value given current sales and available capacity represents dynamic pricing.

Yield management techniques can have a significant impact on airlines amounting to hundreds of millions of dollars per year. This can result from thousands of dynamic prices changes per day.

Other factors of yield management include:

• Damaged Good – such as stay-over restrictions which facilitate static price discrimination
• Efficient Allocation - rather than the profit-maximizing allocation. Many gains attributed to profit-maximization are actually consequences of the dynamic efficiency.
• Selling Options - late arrivals may have significantly higher value than early arrivals, suggesting the airline ought to sell two kinds of tickets: a guaranteed use ticket and a ticket that can be delayed at the airline’s request.
• Demand Pricing – including discrete prices, time-dependent demand, overbooking, resupply and cancellations, holding costs and discounting, and variable initial capacity.
• Customers willingness to pay - unknown when they request a ticket.
• Capacity - time-dependent logistic equations with maximum annual-sustainable yield. Seat inventory control is especially complex in allocating seats in a multiple origin and destination flight network.
• Time sensitivity - provides the option of re-stocking at a unit cost.

Yield Management Strategies

There are a number of yield management strategies:

Revenue Maximisation - Most yield management solutions focus on how to maximize revenue. However, this must be balanced by long term customer lifetime value. If supporting a customer request has a short term cost, the long term customer satisfaction component will also pay back dividends in future sales.

Capacity Management - Rather than dynamically changing prices to maximize revenue, some airlines ration capacity with price classes to ensure that high-paying customers are served, effectively implementing a mark-up policy based on remaining capacity and, if seat allocation between classes is dynamically controlled, remaining time.

This requires determination of:

• Demand and a fixed cost for creating each price class
• The optimal number of price classes
• The optimal number of capacity units [ hotel rooms] allocated to each price class
• Optimal price at each class.

In doing so, one cannot assume that all low-fare customers will arrive before high-fare customers, thereby forcing all high-fare customers to pay their full acceptable price.

Demand Segmentation - controlled through sales restrictions - such as advance purchasing, or minimum trip duration for segmenting demand. Optimal restriction policies can be applied to airline pricing, where leisure travelers’ relative price elasticity compared to business travelers permits the efficient use of restrictions.

Optimal pricing - under uncertain demand, increase in value with the level of competition, meaning setting multiple price levels on flights at different times can shift demand from the higher-demand departure time to the alternate flight, even when it is unknown which time is the peak.

Flight Network Management - In markets with competitive and monopoly factors, high-fare customers may benefit from price dispersion as well as low-fare customers. In multiple flight-leg analysis, comprising of a network of multiple origins, one hub, and one destination. Prices for each flight leg are distinct, and demand at each origin is subject to a nested fare structure for inventory control.

Analytics can find the optimal time thresholds for closing origin-hub flights, then extend results to allow multiple fares on each origin-destination flight and time-dependent demand.

Allocating seats in a flight network assumes a non-nested seat allocation system, normally distributed random demand that is independent between price levels, and a fixed number of fare classes. Considerations must be made for varying demand on each day of the week, and airline capacities.

Analysing network-wide effects may increase revenue by 2-4%, but only when the load factor is very high.

Marginal Revenue Management - Using a functional form for demand as a common assumption, marginal revenue is price minus a constant. A monopolist would choose to charge a price which is marginal cost plus a constant. This feature of exponential demand makes the solution to the monopoly problem reduce to the problem of calculating marginal cost, a simpler problem.

Marginal revenue management is impacted by the arrival rate, requiring the capability to detect the behavior of buyers when demand conditions have changed.

Peak-load pricing- impacts dynamic pricing. In general, prices increase due to a correlation between high demand and high prices.

Pricing To Sell Out - discounting to sell out is commonly held as a bad strategy. In the hotel context, zero discounting works as hotel bookings are made in advance but applies regardless of payment not being made until the time one stays in the hotel. The same discount factor is used for early or later bookings. With airline tickets, generally payment is made at the time of booking, not at the time of departure. The time intervals are long enough for discounting to be significant, given the tickets may be booked six months in advance.

Next: Pricing and Profitability

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