Practice article: Revenue Management fully integrated in the Electricity Supply Chain

Back from the RMP conference at Columbia University, we have been doing some thinking about the developments of this discipline and the potential opportunities for expansion.

Amid all the interesting subjects discussed during the conference – markdown pricing, social learning and RMP, cancellation and rebooking issues in travel industry, implementation cases – the issue presented during the plenary session was the most inspiring and representative of the opportunities RMP has created over the past few years. It demonstrated how these techniques have reshaped the electricity supply chain in the US (production, transmission and distribution).

The plenary session was chaired by Shmuel Oren, who is the Earl J. Isaac Professor in the Science and Analysis of Decision Making at the University of California at Berkeley, and served or still serve as consultant of many public utility authorities; his brilliant performance is available here (the closest to what was presented at the INFORMS RMP conference).

We let you, readers, have a look at this video, which will provide you with a clear vision of the organization of this market:

• How the US electricity market is organized from generation to consumption 
• How the capacity limits, and the transmission congestion lead to the need of interconnecting the generation zones – 3 in the US – and to the creation of financial transmission rights. This might be close to the concepts of physical and financial availability of seats in the airline industry, where physical availability represents the point of view of accepting a via point booking for one “leg”, and financial availability represents the impact of a booking on the whole network. 
• How the market uses the concepts of spot and forward buying of electricity at the macro level (see the status of contracts in RM based industries for other interpretation of the importance of the phenomenon) 
• How Europe is unfortunately far from this ideal world, where a wind power plant would never be able to supply more than its transmission right, and not able to buy rights from a next door fossil energy plant 
• How the market learnt from past errors (case of Enron which acted irrationally, buying more than the whole market was able to supply), and is now regulated (Financial markets could learn from it)

Pains and stakes of implementing Revenue Management and Pricing policies in the power market
Let’s focus on the part where Revenue Management is even more tangible: The distribution of electricity to households and businesses. Talluri and Van Ryzin introduced this area as a great opportunity for the implementation of RMP in the practice sections of “The Theory and Practice of Revenue Management” (Chap.10.7).

In our opinion, using RMP to manage electricity, along with congestion management techniques higher up in the electricity production and distribution chain would contribute to:

• Make production sustainable and enable the development and usage of green energies
• Forecast Demand on a very detailed level - households, businesses, factories - to match with generation
• Have an integrated chain
• Build common capacities for multiple distribution
• Manage the capacity constraint with multiple actors, to smoothen capacity needs

For example, in the US, the peaker plants (used to supply the grid during demand peaks) use non-renewable energies such as natural gas, diesel oil and jet fuel. Smoothening demand would limit peak loads, and would limit the use of such plants as a consequence.

In many countries, electricity distribution is already priced differently depending on the time of the day (min 18-20 of the video above). However, little evidence shows that this pricing enables displacing demand off a peak. This is the case in France for example with day/night pricing, but demand is always limited at night time, which does not make it the most effective lever... Segmenting the daytime could represent an opportunity.

The following figure is an overview of the situation in the US:

The wholesale and retail markets are quite heterogeneous:

• Electricity generation can follow deterministic (nuclear power plant) or stochastic (wind farm) demand, which brings difficulty 
• Transmission is key; over the past 15 years, RMP has been implemented and developed in this area 
• In the retail market, distribution is hard to address due to the complexity to forecast demand (high volume of data, first of its kind demand forecast for electricity supply market) and the difficulties to segment the market

Generation and distribution handled together
In 2002, McKinsey consultants, Justin A. Colledge & al., wrote “Power by the minute”, a paper on deregulation and opportunities for RMP to step in the B2C electricity distribution: “Once exposed to electricity prices that vary during the day, consumers are likely to alter their consumptions patterns, especially during critical peak period.”

The past couple of years have seen the emergence, in electricity distribution, of the implementation of smart meters worldwide. Smart meters aim at monitoring the consumption of electricity on the consumer side and bring data to distributors as well. This is basically the first step for distributors before implementing RMP and offering adapted plans or fares to their customers: The use of that information will enable them to consolidate consumption data and to forecast demand deterministically. Going from stochastic to deterministic modelling is a huge step; not only will it enable distributors to assess demand but it will also allow them to smoothen it.

We believe that two issues can be raised this last point:

• How can we adapt a deterministic demand distribution model so that it enables to forecast electricity generation from multiple sources? For example wind farms electricity production is hard to forecast, due to intrinsic stochastic behavior of production.
• How can we adapt wholesale pricing (which is very dynamic) to current end customer distribution (which is not dynamic yet)?

Recently, Adelman and Uckun investigated retail electricity pricing in the article “Dynamic electricity pricing for smart homes”. This article explores various options for understanding demand and controlling it. The following figure summarizes how dynamic pricing can be used to shift demand:

The toughest challenge is to reach maximum efficiency with a fully integrated chain: as retail demand is aggregated and escalated up to the production level, supply chain issues (such as the bull whip effect) raise.

In an ideal world, we would have power by the minute. Electricity would be priced at the minute for the customer, who would make the decision to consume or not (at least for some home appliances). In this world, transmission networks capacity would be rationalized, origin-destinations of the electric flows as well as production capacities would be optimized. Producers would therefore be able to forecast, anticipate, and to switch to sustainable energies whenever possible.

Critics and response
One may argue that people are not going to change the way they switch on or off the lights. Nevertheless, there are other appliances at home where adjustment on usage timing could be made; for example, people could choose to differ their use of air conditioners, washing machines, dishwasher and vacuum cleaners. According to the aforementioned McKinsey study, savings for US consumers (households and businesses) could be as high as $15 billion.

A recent study by the Brattle Group, “dynamic pricing of electricity and its discontent” advocates the ability of consumer to change behavior and act according to market supply and pricing. This excellent piece of writing dismantles the negative mythology which surrounds residential dynamic pricing. Even though their argument is aimed at convincing the institutions that regulate the US residential electricity market, the 7 myths they take down make this paper a case for dynamic pricing in general:

"Myth #1: Customers don’t respond to dynamic pricing
Myth #2: Customer response does not vary with dynamic pricing
Myth #3: Enabling technologies don’t boost demand response
Myth #4: Customer response does not persist over time
Myth #5: Dynamic pricing will hurt low-income customers
Myth #6: Customers have never encountered dynamic pricing
Myth #7: Customers don’t want dynamic pricing"

We urge you to take a take a look at this paper.

Another research published in 2009 by the Brattle Group demonstrate that smart metering coupled with dynamic pricing does represent a wonderful opportunity in the EU. "Unlocking the €53 Billion Savings from Smart Meters in the EU" show that the investments required to reach a 100% equipment rate in smart meters in the EU is €51bn. This would lead to improvements in the maintenance of the network (meters are easier to read, outages are detected instantly, theft is easier to control), and thus to savings amounting to €26bn to €41bn only. These operational savings are not sufficient to outweigh the costs. The Brattle Group demonstrates that implementing dynamic pricing could lead to additional savings estimated at €53bn: these savings derive uniquely from cutting the costs linked with the installation, use and maintenance of peak production capacity.

If the debate is clearly in favor of dynamic pricing from a financial and economic perspective, we believe that the attention should be drawn on change management. This may be due to our French origins, but our view is that in some places, changing habits is much more difficult than everywhere else. Change management would have to be particularly addressed if the EU decides to go down that road.

Here again, dynamic pricing represents the opportunity for one of these win-win situations that we love to see happen, and that got us to create this blog.

INFORMS Revenue Management and Pricing conference - some feedback!

Dear Readers,

Earlier this summer, Julien went to the INFORMS Revenue Management and Pricing conference at Columbia University. Held in NYC, this event “is the premier forum for both academics and practitioners who are active in research in the fields of pricing analytics and revenue management”. The objective was to get up to speed with the latest research, practicesand burning topics in the industry.

He was amazed to see how Revenue Management and Pricing (RMP) techniques are developed and widely used in the United States. Most of the conference participants originate from the US and this discipline seems far more advanced there than in Europe. There are business cases in many unconventional areas (e.g. Google, with its Ad Exchange is using RMP techniques to grow the online advertising pie in an unconventional way – more about that in an incoming article), and the markets have really understood the potential of the price dimension in the 4 Ps marketing mix.

We would like to share a few findings with you…

1) The prerequisites for RM revisited 
This conference enabled us to put this discipline in perspective; it also got us to rethink several ideas we had about pricing:

• Market power: it is commonly accepted that individual consumers represent a fragmented demand, which doesn’t have much bargain power when it comes to pricing. This statement doesn't hold in a context of "social learning", where information is shared, and expectations tend to converge.

• Market segmentation. For a while, we were wondering which came first: the chicken (pricing) or the egg (revenue management)? Well, for sure, pricing is not a sub-set of RMP (as well as inventory management is)- it goes along with it and is on a higher level of analysis. It has a strategic aspect that would lead RMP in the organization. Actually, proper market segmentation (and calculation of pricing break-even points) is probably the real pre-requisite to any price related activity. 

• Price as a signal: It tends to be accepted that RMP cannot be implemented in an organization where the price a signaling characteristic regarding the product. Research has gone further and presents the price as a signaling device of product availability (demand forecast vs. inventory available). On this regard, we are looking forward to the publication of "Markdown Management: Pricing as a Signaling Device", by Gad Allon (Northwestern University), AchalBassamboo (Northwestern University), Ramandeep Randhawa (University of Southern California). Adapting pricing to product availability is an issue that most companies are facing : Who has never wondered what is communicated by the price a good is sold (eg. Used items on ebay, amazon marketplace, craigslist etc)?

Above all, the concept of perishability remains: a product/service is lost when not sold due to a limited life span. Of course, some pre-requisites vary, and must be stabilized on a case by case basis.

2) A taxonomy of RM
Acknowledging RMP by sector is, we believe, not the right level of analysis. After having attended this conference, and thus analyzed the latest research, we believe that RMP could be classified into three core areas.

RMP focuses on the “Maximization of Revenue” through:

• A proper segmentation and an optimized pricing policy: This is a key component when willing to market you product differently to different groups (bundling questions, break-even point for segmentation, demand and promo management). This must be sufficient when no real binding constraint can be found 

• The management of a limited inventory: This is the origin of RMP 

• The management of a network’s congestion where capacity has a very limited life span, and could not be stocked: This is under implementation by Telcos, Energy providers … Stochastic demand analysis is at the heart of it. 

3) The power of social learning in RMP
As mentioned previously, strong social learning reshapes a market's forces.

A very interesting presentation dealt with the issue of whether the customers manage to get a rationale and can understand basic RMP concepts. Therefore, they could act upon it and compare the quality of products (don’t mix the comparability of products and their lookalike)

“Our model postulates a fairly simple learning mechanism. Given the number of past agents that purchased and of them the number of agents that liked the product, each agent forms an estimate of the quality sensitivity parameters (QSP) of the marginal agent that purchased and liked the product. The agent then compares this marginal QSP to his own QSP.” In "Monopoly Pricing in the Presence of Social Learning", by B.Ifrach, C.Maglaras, and M.Scarsini.

This presentation offers a vision of customer behavior and its impact on market actors. More to come in a separate article

4) The impact of research on RM practices
The RM industry is interesting in its ability to absorb state-of-the art research, and to always go further into details. Lately, this has resulted in an ability to:

• Build disruptive and even more robust RMP : several business case emerged for various new industries. Demand shocks management is one of them. 
• Use an industry minded research, with a focus on reality: Cancel and rebooking behavior and how to act upon 
• Build incremental innovation: Bundling services and its efficiency 
• Gather a growing number people from various horizons and nationalities 

5) RMP and value creation revisited
Boarder line subjects are lightly emerging and we are thrilled to see that coming.

Once again, through this blog, we are trying to explore how organizations can implement Revenue Management and Pricing techniques.

The first hurdle we have to overcome is the financial evaluation of a RMP project. Several options are available: i) The traditional NPV, ii) an NPV model associated with a Monte Carlo simulation (used by Hilton Hotels’ Revenue Management), iii) through an option-like valuation (This method, and the business case for RMP will be available later on this blog). Let’s not neglect the other aspects: the strategic fit, Finance and cash flow considerations, the existing IT infrastructure, People and the corporate culture, and the Marketing and Communication.

Implementing RMP should also mean bringing superior value to the organization. That is the article that we have initiated earlier and that we will keep on updating.

In short, this conference helped us realize how fast the Revenue Management and Pricing field is moving. In order to get a grasp of how innovative and far reaching RMP is, we will publish a couple of industry focused articles within the next few weeks.

Thanks for following us!

Julien & Yoann

Revenue Management: a fresh perspective from the field

Two months ago, we published a survey aimed at RM professionals, in order to add a practical perspective to our articles.

This survey had a relatively explorative goal – even though it had some closed-ended questions: We wanted to get professionals to put their own words on what they do.

It is not surprising that most of our respondents are currently working in the airline industry. Yet, we received contributions from the outdoor advertising, timeshare, hotel, and car rental industries.

We would like to thank all the respondents for their insights, and for their time. As we analyzed the results, we were glad to see certain issues that we had not completely addressed in the blog at that time - this will change soon.

The following are the main findings of our survey.

Organization – role in the company
All professionals believe that their role is crucial for their company’s success. The majority of them report directly to the top management, even if certain professionals have an extra hierarchical layer – sometimes, they report to the Revenue Management / Planning department.

As one of our respondents (obviously an airline RM professional) said: “The RM department should be the heart of the company, its main engine. It is the sector that assists in route planning, strategic planning and business strategies and marketing actions. Therefore, it should receive the best structure in the company.”

Pros and cons
Our respondents view Revenue Management as a sound, scientific and well justified approach to optimize revenue, and thus to boost the bottom line.

On the other hand, it seems that the main issue Revenue Management has to address is corporate culture. Top management does not always "trust" Revenue Managers, and does not always believe in RM’s potential. It can result in a poorly adapted organizational structure, and sloppy decision making process. In sufficiently large organizations, it appears that some Revenue Managers have trouble in getting credibility from other departments: The marketing department accuses them of neutralizing their efforts, whereas the sales department complains about removed responsibility.

Due to the same cultural issues, outsourcing Revenue Management does not seem completely feasible yet. As suggested, the data analysis part could be outsourced, while the interpretation part should stay within the company, close to the top management.

Metrics used / Analytics
Not surprisingly, most respondents declared that they use the following main structural variables:

• Revenue (price)
• Booking/reservation/inventory information (quantity) 
• Forecast data

The other indicators used include: competitors fares, sales channels, market changes, demand elasticity and costs.

Implementing Revenue Management
As one of the respondents summarizes it, “RM is far reaching”. Revenue Management is applicable to a wide scope of businesses, from the obvious to the not so obvious: Hotels, sales online in general, parking lots, hairdressers, supermarkets and retail as a whole.

If the pricing is dynamic in the airline industry, whether it should be uniform or dynamic when applied to other areas depends on the sector and the particular needs of the business.

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

We are back alive!

Dear Readers,

We have developed over the past month a growing appetite to know more about Revenue Management. Despite some weeks without posts (due to a heavy workload for both of us), we haven’t forgotten about RM and we still believe it is a great management technique: The only thing we want is to find out more, and publish a content that is as insightful as possible! 

Julien reached the end of his curriculum and had to hand over his thesis. Needless to mention that the core subject was Revenue Management, with the following approach: After a quick review of the basic concepts, he explores how RM creates value  and then demonstrates how decision processes are affected by RM.

We are going to publish on our blog some adapted extracts of this thesis, together with prospective articles (e.g. is there a critical size for RM to be implemented?)

The first of a series will be about the sustainability of the value creation allowed by RM in a company. We hope this will trigger reactions!

See you soon

Yoann and Julien

Revenue Manager: Make your voice loud!

Dear Readers and Revenue Managers,
One of our next topic on this blog will be focused on the job of Revenue Managers and Revenue Analysts.
We would like to share with the community the vision they have of Revenue Management and a feedback on their job.
.
Make your voice loud and participate in the survey "RM and Revenue Managers".

This survey is not limited to Revenue Managers, so please express yourself if you are in the field of Revenue Management.

This survey has absolutely no commercial purpose, and no data will be transmitted to third parties. This is very important to us, to be impartial and have no commitment towards third parties.

We are sure that your planning is already full, but if you don't mind taking 5-10 mn to answer our questions, we would be very grateful for it.

Thanks!

The ins and outs of penetration pricing

Contrary to price skimming, penetration pricing involves selling products at a lower price relative to direct competition. The underlying idea is to "penetrate" the market, i.e. gain a solid market share and build a base of loyal customers. From this base, prices are then progressively increased to reach the final price. 

We are surrounded by examples from the perishable goods industry. Let’s use California Kitchen frozen pizzas: from August to October, Yoann paid $4.99 for a pizza (he does not eat healthy) with his Ralph's card, versus an advertised regular price of $6.99. Then, from October to September, he paid $5.99, and received a $1 coupon per pizza purchased - the advertised regular price remained at $6.99. In January, he paid $5.99, but did not receive a coupon (he then stopped buying those pizzas). We can infer that California Kitchen will charge $6.99 a pizza relatively soon! 

Such a strategy is likely to be carried out successfully if the following elements are observed: 

• The company must be operating in a relatively elastic portion of the demand curve (so that the lower price result in a significant amount of additional sales) 
• The possibility of economies of scale. Just like revenue management in general, penetration pricing is justified by the ability to optimize capacity, and therefore lower unit production costs 
• As mentioned in previous articles, the corporation has to make sure that price is a "non-signal" of quality, in order to prevent a drop in sales! 
• The company must to make sure that its supply chain will support the additional sales. 

Admittedly, if the product sold is not differentiated enough from competition, then this strategy can trigger a price war, destroying any advantage that the corporation may get out of it. 

Customers’ loyalty is a key element in price penetration. As we can see on the graph below, the strategy takes advantage of a solid customer base built charging a low price (versus direct competition) to price-sensitive customers. The demand curb is bowing progressively (from t1 to t2, and t2 to t3), illustrating the effect of loyalty on demand - which becomes less price sensitive. The penetration strategy takes advantage of that situation, charging a higher price (in t2 and t3) to a less elastic demand. 

The following graph (below) offers a comparison. The company charges the exact same prices in t1, t2 and t3 as on the above graph. However, it does not benefit from a “loyalty effect”: The demand curve therefore remains the same through time. In this case, the company’s goal becomes maximizing revenue/profit from a given demand, and it does not have any incentive to purse this strategy. 

Freebie marketing (Complementary goods) 

Some corporations make a great use of penetration pricing, using this strategy to boost complementary products' sales. The main product is sold at a low price (often at a loss), in order to ensure a recurrent revenue stream from the associated consumables.

This business model where one item is almost given away in order to increase the sales of a complementary good, is known as freebie marketing. Freebie marketing is not new. As Alice Tisdale Hobart explains in Oil for the lamps of China: in order to expand to China, Standard Oil gave 8 millions of kerosene lamps away (or sold it at rock-bottom prices). Doing so, it created a demand for kerosene among Chinese customers, who would soon buy their supply from Standard Oil! 

Currently, two icons of freebie marketing (sometimes called the "razor/blades model") would be Gillette and HP. 

Competition is the main threat to freebie marketers. This strategy cannot success if cheaper alternatives to the complementary goods are available in the market; i.e., the company does not have a monopoly on these goods, which sometimes triggers legal issues. 

One may also question the intrinsic sustainability of such a strategy. Even though the business model sounds great on paper, customers’ behavior may be a threat. As customers may realize that they make a gain (vs their perceived-price) when they purchase the main product, they may purchase the main product repeatedly, instead of keeping it… We all tend to renew our phone subscription whenever we have the opportunity, so that we can get a new phone for free! 

Indeed, as far as electronics are concerned, freebie marketing tends to be inherently unsustainable. Indeed, when Lexmark and HP implemented it, new printers were expensive, and were kept for at least 5 years at the time. A decade later, as the price for printers dropped significantly, the results from this bound to be successful model started to dampen, as customers preferred purchasing a new printer to replacing their cartridge for nearly the same price…this reduced significantly printers’ useful life. Now, every time a new printer is sold, the manufacturer endures another negative-margin sale, and is deprived of the potential recurring revenue stream associated with the cartridge sales (as the older printer is not used anymore). 

Interestingly enough, Kodak’s strategic focus is now in the opposite direction, as their 2009 marketing campaign shows. 

Penetration pricing vs price skimming 

When entering a new market, corporations face this dilemma: Should they hunt market share or per unit profit? Should they adopt a penetration pricing strategy, or should they use price skimming? 

In a recent article, Hongju Liu explains that companies have incentives for both price skimming and penetration pricing. He takes the video games example, and analyses - based on pricing and strategic simulations - how the Nintendo 64 could have won the competition against the PS2. In reality, as mentioned previously, video game console manufacturers do use price skimming. 

However, according to Hongju Liu's simulations, in a market where companies have a first move advantage, and experience network effects, there is an incentive for penetration pricing. However, if companies face consumer heterogeneity, then they have an incentive to price skim. If penetration pricing leads to a faster diffusion of the product and provides a first move advantage, it does so at the expense of lower initial profits, of a longer recovery of sunk costs, and of the capture of each segment’s surplus. 

The issue of Internal Reference Price 

The IRP is a core factor in customers’ buying process. This issue has already been the object of an extensive literature. According to most scholars, in their buying process, customers build their IRP based on past prices and on the contextual reference prices of related products (similar products on the shelf, for example). 

Miao-Sheng Chen and Chaun-biau Chen, show in their article how the IRP can be used to influence consumer purchase behavior, and carry out an optimal price penetration strategy. Consumers perceive a gain if the price charged is below their IRP, and a loss otherwise. 

Then, the issue, is to find a reliable and costless technique for your company to measure customers' IRP for a new or existing product. Joel E. Urbany and Peter R. Dickson show in their article that the most efficient way to measure IRPs is to estimate it from actual market prices. They explain that even though most consumers have a relatively poor knowledge of market prices, the benefits of extended studies to infer IRP from consumers' price perceptions are not worth the costs. 

If measuring actual market prices does not provide the best estimate of the IRP, it does provide the most cost-efficient one, and the data collected can be completed launching various auctions on Ebay: the ending prices obtained provides a rather economical indication on how your product is perceived by customers.

The status of contracts in the RM-based industries: A bias to spot market, and to an optimal Revenue Management?

The issue of contracts in Revenue Management has not been studied by many scholars or corporations. It is however pregnant in this field. A 2005 white paper from the software company Ideas, now a SAS institute company, included an insightful paragraph on the subject. This also was one of the key elements of interest to Julien, when he was working with Carlson Wagonlit Travel, negotiating airline fares for large corporate contracts (not agency fares).

To fill planes, carriers have decided to build corporate contracts with negotiated fares per booking class, or even with capped fares, untying from the spot market (what is a spot market?). This situation may seem surprising: Have companies using RM lost faith in the market? Certainly not : According to the expected marginal revenue curve, the marginal revenue per unit decreases when the number of units sold increases:

We can therefore easily understand that this is an alternative to make sure that the plane, or the hotel, will be full (let’s remember that a day of sales can be not profitable if the expected demand is not realized). Note that graph presented above, is an abstract from an article by the decision technology team at American Airlines.

This graph implies that by adding more classes into the class nesting, chances of getting a high revenue for the marginal seat are higher. A traditional marginal revenue curve would look like this:

Corporate contracts are also subject to performance: This way, carriers or hotels make sure that by making an effort on the price, they are rewarded by a minimum number of seats or rooms sold. Contract performance and tracking have become key aspects over the years.

We can bring one simple interpretation from this practice: Corporations are risk averse, especially in terms of revenue, and they are not ready to let their RM system work alone and automatically.

This practice can also raise some doubts among outsiders regarding the efficiency of Revenue Management: If there is a customer for every product, at the right time and at the right price, why are companies using contracts in order to make sure they sell enough, as demand should meet the offer? We believe that there are two elements of explanation:

• There might be an excess in capacity, which should be adjusted as much as possible. Industries implementing RM have high fixed costs: There has to be high volumes to dilute those costs. Therefore, sunk in capacities can jeopardize profit
• Even with reliable and strong forecasts, markets are not in a situation of perfect competition

The white paper adds a very interesting reason:

• The ability, for companies, to meet special customers’ expectations in terms of fares. Some sound strategies can be built around that…We can further investigate on the subject if requested 

Please share your thoughts on the subject!
Why are those corporations willing to secure sales at lower and non-market price? How do they arbitrate between settling contracts and letting the spot market mechanism work? How can they earn economic profits (revenues > opportunity costs) out of the contract implementation? Is it recurrent?