Revenue management (RM) is the art and science of delivering the right product to the right customer at the optimal price and time. By analyzing price elasticity, experts in revenue management have developed sophisticated algorithms that dynamically adjust pricing based on demand patterns.
Originally created by PROS to optimize airline ticket pricing, airline revenue management has changed tremendously over the past decade and, driven by the Offer and Order industry initiative, is set for its next (r)evolution.
How do industries use revenue management?
Now back to what revenue management is. Today, revenue management concepts can apply to any industry that deals with limited capacity. The fundamentals of revenue management revolve around capturing the value of remaining capacity, particularly in situations where the capacity is constrained, and then combining that value with an understanding of the price elasticity of buyers. These two components combine to form the price that buyers should pay, with the goal of maximize revenue for sellers. The strategies associated with revenue management span across many industries including hotels, cruise lines, air cargo, rental cars, ocean freight, ride sharing apps, and others. Of course, the foundations of revenue management started in the airline industry. Many of these industries rely on fare/price designators to help with booking and downstream systems. A big next step in the revenue management field is the move to dynamic pricing science, an area PROS has been pioneering.
What are the two main drivers of revenue management?
When it comes to revenue management pricing solutions, there are many dynamic factors at play. However, there are two major variables that consistently influence revenue management: inventory (capacity) and price elasticity.
Capacity constraints
The first driver of revenue management is determining capacity constraints based on the remaining inventory. To accomplish this, the revenue management system is aware of how many seats, rooms, cars, etc. are left to purchase. In the typical RM industry, the remaining capacity has a fixed shelf life once the flight (or equivalent) departs. This means the window for capitalizing on the revenue opportunity is fixed and once it has passed, there is no way to recover. Based on this, the system relies on an accurate forecast of volume to understand how many people are expecting to use the remaining resources. For each of those passengers, the system must also understand how much they are worth, so you can assess which set of passengers is best to take.
Now that you are holding this information, you need to perform the optimization. In modern airline revenue management, the result of this optimization is a bid price. It’s the value of the next resource that is available. It isn’t the price that you will pay though. It’s the value the next passenger must be worth to take that next resource. In its simplest form, a bid price value of zero indicates that there is not enough demand to satisfy capacity. This doesn’t mean the price should be zero, of course.
Instead, it means that the pricing strategy for this entity should be based on price elasticity alone, not a capacity constraint consideration. If a bid price is greater than zero, then it means that there is a positive value associated with the next available resource. The larger the value, the more valuable next resource is. This value reflects the minimum threshold at which the next seat should be offered. While it may seem like a complicated concept, mathematically, it holds as an excellent way to represent the value of the next seat. As technology has evolved, the importance of the bid price has remained and refined. As you can see from the formulation, it requires an accurate forecast of volume and price elasticity to get high-quality bid prices.
Price Elasticity
The second key driver of revenue management is understanding and leveraging passenger price elasticity. This term, already mentioned earlier, is largely self-explanatory — it refers to the ability to assess how demand responds to changes in price for a specific product. At its core, this involves analyzing the relationship between price and demand, a concept rooted in the classic demand curve. Typically, as prices rise, demand falls. A robust revenue management system must grasp this dynamic to effectively capture value. Understanding this interplay between price and demand is essential to addressing the challenges of revenue management and optimizing profitability.
This is where high-quality forecasting comes into play. The revenue management system has a mechanism that predicts the volume component of the price/demand curve at various prices. Once the system understands this prediction, a simulation is possible that determines the optimal point at which revenue is maximized based on the relationship of price and demand.
In addition to the relationship of price and demand itself, is the proper segmentation of the passenger. This step is critical, as different segments of passengers will have different price elasticity. This is really where it becomes important to understand the behaviors of higher-paying demand, such as traveling on Monday mornings.
Once you have these two components in place, the system can generate the optimal price for a given passenger. In today’s world for most airlines, this means selecting the right fare/price designator, also called availability. But the future holds much more for these industries as they start to break away from these designators and focus on generating the optimal price directly. This is what is meant by dynamic pricing. We’re ready for the future today, so now is the time to join PROS and understand how your airline can be part of that journey.
PROS Revenue Management technology
PROS is an industry leader in revenue management technology. Not only does PROS identify key factors in optimizing revenue, but we also leverage over thirty years of data science, analytics and machine learning in a robust system that can predict market trends using advanced forecasting methodology.
Contact PROS to learn more about our latest RM innovations!
