Introduction to Revenue Management as a sustainable value creator for the company

Value creation is driving companies at every stage of their activity: from products to shareholders, including employees, the community, the environment, etc. The definition of Value creation is wide, and there is no consolidated literature about it: IndustryWeek has a whole section dedicated to value creation, and companies have their own view on this issue (see what value creation is according to BHP Billiton). The finance oriented approach is central. Corporate Finance from Brealey Myers & Marcus explains extensively own a project "creates value" for its owner/investor. Marketing Management, from Kotler and Keller, drags the concept of value creation all along the book. Strategy mainstream authors, and especially Michael Porter  in his early papers (Competitive Advantage, 1985) prefer to define it using the concepts of competition and the company : Competitive advantage brings a sustainable added value vs. competition and the market. We believe this last definition symbolizes the most Revenue Management in its expected effects. Now, let's try to make our own generic and simple definition... there we go: Value creation is what brings a superior worth to a good or a service, on the perspective of a market. A good can be a company, a business unit, a product and it is to be viewed as positioned within an environment.

This is much discussed at every level of the corporate ladder. We believe this question is key for any RM implementation proposal. It is the role of the manager supporting the idea to bring some milestones along.

Evaluating the financial benefits of the implementation of an RM system in a company quickly proves to be complicated: We will dedicate an article to address this issue. Indeed, one can calculate an expected rate of return on an investment in software, machines or any tangible asset, where the material’s life span, cash flows and depreciation period are known a priori. 

Here, we are talking about a change that is probably one of the most difficult to assess in a company: The impact of a new, structural management methodology, which is all but certain. The greater the expected returns are, the higher the risk is (yes... we have heard of this too!).

In this context, we think the concept of sustainability makes sense. Implementing a new management methodology is a long term project. To create value, Revenue Management first has to be seen as at the crossroads of strategy, finance and organizational theory; and secondly, optimization, demand forecast and customer behavior issues can be addressed. Building a transverse management methodology is a key prerequisite to generate organizational alignment and thus survive external events.

That is why we believe that a structured approach must be drawn: This article proposes a series of steps that would enlighten the feasibility study to support such a project. We therefore list a couple of steps or milestones that one should address when you coming with the idea of implementing Revenue Management.

Step 1: Be aware that you may find yourself in a difficult position

Due to the influence of capital markets and private equity (and the related expected returns), business today (and probably yesterday as well) tends to focus on high yield and short term payback, The investor follows the risk paradigm and expects a proportional (or at least not contrary) return / yield. Therefore, everyone can understand that an investor, who is endowing in a firm in capital need to finance projects, is experiencing a risk, especially if the investment is about implementing a new, challenging management technique!

From our experience and readings (see Talluri and Van Ryzin, The Theory and Practice of Revenue Management), it takes quite some time to implement Revenue Management; even more if it is the first time: the needs have to be properly defined and studied, the organization’s rules, design and processes have to be reengineered to support RM. This means that, whatever the size of the business, a transition time is needed to get from the current to the targeted /optimal situation. An implementation can take several months up to several years. 

This puts the manager in charge of the implementation in a difficult position: Investors could expect a “return” before the end of it, and will ask for an assessment of the first results of the newly implemented Revenue Management system. There is an inherent contradiction between a latent short-termism, and RM’s value creation which can take a bit of time before ramping up. This underlines the importance of sustainability.

Step 2: Build something called strategy, or at least, steer your organization. 

First of all, Revenue Management is not a secret formula, enabling managers to create growth and value, forever (neither is value creation in general by the way). We think that such a sustainable value creation is the coordinate action of an organization with aligned people, methodologies, and stakeholders, willing to make the move and bring the company to the next level. This implies the alignment on long run business objectives and changes together with a short run operational management. Making this change be part of a strategic positioning would have more success and meet expectations (Michael Porter,  What is strategy?, HBR Nov-Dec 1996) This whole is called “strategy”, and 2 companies out 3 lacks one – according to Henri Bouquin, Head of EMBA at Université Paris Dauphine, France in his book, Les fondamentaux du contrôle de gestion.)

Step 3: Try to assess a time period for Revenue Management. 

Revenue Management has currently no standard usage time (even if depreciation is a calculation made by accounting…but everyone knows how accounting can sometimes not represent reality!). This is a key as depreciation is based on utilization rate or time of the asset Obsolescence, from to our point of view, can only come from superior optimization and forecasting algorithms within the competition, preventing your company to reach all your usual revenue streams. To our opinion, the prerequisite to the kick-off of a project, before convincing any investor and being misled thereafter, is assessing timing and usage time. For example, usage time could follow the life cycle of the product or the foreseeable market macro-changes. This way, you can adapt your management to your activity. Basic idea, but robust in a globalized world!

Step 4: Assess revenue increase and value creation.

This will be the full content of an article to be published later in May

Step 5: Keep in mind your (high) fixed costs and the levers to keep Revenue in a good shape

Rule of thumb: Revenue Management will create positive results as long as the activity of your company is not affected by uncontrollable exterior factors (we’re pretty smart on this blog J). If the activity slows down, revenues may lower, and it will be quite critical to determine whether or not Revenue Management is generating superior value for the company. In this context, value is strongly needed by the organization which has, more than ever, to sell to high yield customers. This is when capacity adjustments have to come into play. Indeed so far, one of the hypotheses was a fixed capacity. . However companies can to take advantage of that and must have rescue plan that assess the opportunity cost of shutting down part of the capacity.

Even if Revenue Management works well in capacity constrained industries, it doesn’t mean that it should not be changed if needed. This is easy for some businesses like hotels and cruise lines for example, where you can scale down more or less rapidly (selling part of your assets) and try to diminish slightly your costs. Unfortunately, other businesses (parking lots, restaurants for example) have more difficulties to reduce their capacities due to limited levers. Indeed it is not easy to fire employees in restaurants in Europe (ok… in France!) to wait fewer tables for example. Anyhow, shutting half of a car park or of a restaurant off would not have any effect on reducing the costs, as opportunity costs remain for the whole occupied space.

Step 6: Have a look around.

Of course, your market is not revolving around you and key players could look at each other and find ways to set up alliances, leaving you behind, alone. This has happened recently in the airline industry: the three main alliances (Star Alliance, Skyteam, Oneworld) created JV to form oligopoly in some transatlantic markets. This leaves remote players like SAS, Finnair with low market shares. Their only alternative to keep the statu quo is low prices. This is for sure a more of a strategic subject, but RM is a topic for alliances (Can we align our pricing policy? Who will manage the inventory?).

Well, as an entrepreneur or a small business owner, you may not feel concerned with what is said above (even if we think that for every company size, there are markets and predators which will, as it is the goal of most corporations, grow!). We still believe distribution is a core lever for the successful implementation of revenue management. Indeed History shows that the first Global Distribution System (GDS) brought the first RM. Today, with the new techs, multi-channel distribution becomes easier than ever: Less complicated selling platforms have to be built (unlike GDS in the business travel industry. We are actively researching how could SMEs build their own distribution systems (based on a pool of companies, or one major) in order to secure the value chain and therefore increase overall chance to reach value creation expectations.

You might have noticed that in this article, value is not only addressed from a financial standpoint but also from an organizational and strategic point of view, as sustainability involves the whole company: This is our vision!

Despite the need for an overall view of business, numbers convince easily: We will go further in details for step 4 later this month.

See you soon!

Yoann and Julien

Building the pre-requisites to a Revenue Management System

Dear Reader,

Through the threads we started on various RM related group on the professional media LinkedIn, we wanted to know what the community of professionals would think of the application of Revenue Management principles (ie a “RM System” of a kind) to a wider range of companies (in terms of size and sector) (Linkedin group ). A lot of very interesting replies came up, and the bottom line is that many professionals think SMEs could implement RM, but that according to their experience, companies’ management only show a limited interest to complex RM systems:Cost of implementation, return on investment, software solutions cost, dedication of managers to run the system… However, some professionals think those trends are changing, and they take advantage of it to implement RM systems in many companies. In this blog, we also believe that companies can have a mixed approach: We think that they make some simple steps to trigger the optimization of their revenue, without being obliged to implement a complex IT infrastructure.

This feedback from the community made us step into the shoes of a business owner, and wonder if there are pre-requisites to the implementation of RM (whether it is a rule of thumbs applied on Excel as in our previous article, or an advanced RM system) in an organization. Beyond the generic term of perishability, let’s have a look at what the two main theorists, Kaylan T.Talluri and Garrett J. Van Ryzin, highlighted on the subject:

• Customer heterogeneity: Customers must have different buying decision criteria

• Demand variability : Demand has to be impacted by seasons (the customer flow is not homogeneous)

• Production inflexibility: You have limited and constant resources for sale available ( ex : Limited number of rooms in an hotel)

• Price as “non signal” of quality : Customers must not assess the value of the offered product based on the price (as per the luxury industry for example)

• Data and information system infrastructure: Knowing your customers, their habits, and how to make them access what you are selling are key success factors.

• Management culture: How is the company’s management open to implementing solutions to optimize the revenue stream? Do they believe this kind of preoccupation can go beyond the sales department?

Those six pre-requisites can be relatively hard to fulfill depending on your activity / sector / size, and rely on several sub-concepts. Ideally, assessing the elasticity of your demand for example, would require the measurement of the demand variability from a reliable data collection. However, there is a world between theory and being able to build a system which will face that in a corporation. A good way to bridge the gap is to rely on a simplified but easily manageable approach, as presented in our article on Peak Load management.

A multitude of SMEs fulfill the above pre-requisites, but - and that is understandable - with approximations. If many companies can identify their customers, they often display a limited knowledge: Limited number of surveys, quality of historical data, and lack of marketing integration…

At a larger scale, Revenue Management systems seem a priori to need rigor and precision in the setting of its parameters: Knowing that the pre-requisites match your business does not mean you can start a RM System. In the next articles, we will tackle those issues and try to determine what compliance level is needed for each pre-requisite, and how can simplified RM tools meet some smaller scale demand management issues.

RM aims, among many goals, at providing support for pricing decision and demand management. Fulfilling properly the pre-requisites is a first step; however there is a long way to reach this new management system. As explained on this previous article, it implies an evolution of the business model and of the organization.

We will develop a draft of an implementation process of a larger scale RM System in a further article.

How could I apply revenue management to my business ?

In his book, Revenue Management: Hard-Core Tactics for Market Domination, Robert G. Cross defines revenue management as “the application of disciplined tactics that predict consumer behavior at the micro-market level and optimize product availability and price to maximize growth”.

Most people associate RM with complicated pricing models, state of the art IT, and high-flying mathematicians. Needless to say, it helps. Revenue Management relies on a few basic principles. Everything is just a matter of implementation, in accordance with the sector, the organization and the size of the company: you don't need SAP to manage a hair salon; you don't need to be a Rube Goldberg machine to take the first steps towards the optimization of your revenue.

Indeed, Robert G. Cross summarizes revenue management with 7 core concepts:
•   Focus on price rather than costs when balancing supply and demand
•   Replace cost-based pricing with market-based pricing
•   Sell to segment micro-markets, not to mass markets
•   Save the products for the most valuable customers
•   Make decisions based on knowledge, not supposition
•   Exploit each product's value cycle
•   Continually re-evaluate your revenue opportunities

Principles
Three basic constraints shape the RM practice:
•   The ressources available for sale have to be in a fixed/limited amount
•   The ressources have to be "perishable": there should be a time limit after which the ressources loose their value
•   The different customers must be wiling to pay a different price for the same amount of ressource

If in your business, the costs are mainly made of fixed costs (ie, high % of fixed costs vs variable costs), then revenue management is a key factor to optimize your profit: as variable costs are rather low versus revenue, each increment in revenue will increase cost absorption, and impact directly the bottom line.

The goal is to maximize revenue for a given product, within a certain time horizon: the company should aim at providing each unit to the customer exctracting the highest price possible from the customer base. Ebay is a good illustration for this, and a simple way to encompass these principles for any product.

To trigger the purchase, Revenue Management uses two main leverages: price and inventory. In the price-based approach, the customer buys as soon as the price has decreased to her/his real or sensed expectations. As we will study in a later article, theaters could optimize their occupancy rates and then boost their sales by using this approach…

In opposition to this, Talluri and Van Ryzin, in their book The Theory and Practice of Revenue Management, highlighted the quantity based view, where the leverage used is the remaining inventory. As most applications of Revenue Management occurred in industries where the inventory is critical and highly perishable, the inventory approach is prevalent today.

Customer segmentation and pricing fences
It's obvious: know your customers.

What segments can you identify among your customers? On which criteria is this segmentation based? What price are the customers from distinct segments ready to pay for your product(s)? How are they sensitive to price fluctuations? What are their purchasing patterns over time?

You should be able to answer each of these questions, ideally with quantitative answers. The idea is to be able to segment customers on the basis of their willigness to pay, and to be able to charge different prices to different customer categories.

Therefore, customers should not be able to arbitrate between the different prices proposed for the same good. Indeed, the pricing has to be based on adequate and efficient fences, such as:
•   The time of purchase: as detailed in our previous article, the airline industry charge different fares, depending on the booking time.
•   The creation of a costless customer value: concert tickets are a good example. Certain tickets will give personal access to the perfomers before/after the concert, against a substantially higher price, and costing nearly nothing to the organizer.

Of course, this will depend largely on the product type, quantity and the opportunities for offer customization; but the focus has to be centered primarily on the customer.
 
Marketing management and ethics
Every move towards revenue optimization should be made in accordance with a company's marketing strategy.

As RM relies on price discrimination, it can stir up customer resistance, and harm the customer relationship. Long term customers can end up in the higher price range while expecting a well deserved discount/advantage. As the development of RM systems tended to weaken their customer base, the airline carriers answered by implementing the frequent flyer programs. Thus, RM practice has to be integrated within customer relationship management, has a tool to secure customer loyalty.

It also has to be consistant with the management of the company's image: in 2002, when Deutsche Bahn tried to implement RM on its "frequent loyalty card passengers" ( see article), it faced customer disaprovement and a declining number of passengers, and finally step back to fixed pricing.

In terms of princing, a common fear is that customer segmentation could be based upon unethical criteria. This has to be adressed through the practice in itself, and communicated consistantly.
 
Our blog
In the following articles, our goal is to illustrate these generic principles. For this purpose, we will study successful and unsuccessful RM practicies in various fields, discuss the potential application of RM principles within small and medium businesses, and try to develop simplified pricing and decision tools.