Wednesday, August 29, 2012

American Airlines' and Delta’s Revenue Management Systems

Although I’ve referenced Harrah’s yield management system in a prior blog, the first yield management system was developed by American Airlines in the 1980’s with the support of the CEO Robert Crandall. As the Edelman Prize committee would later note, the system contributed $1.4 billion in profit over three years. How could any computer system generate half a billion dollars a year, and what methods did it use to achieve such a feat? And given such enormous gains, can any modern airline survive without such capabilities?

Methods & Philosophy of Revenue Management
I was inspired to write this blog after reading Revenue Management by Cross. Given his wide-ranging Revenue Management ('RM') work and the detail he provides on RM in the airline and car rental industries, I  tried to distill as much from that book as possible.
  • Use market-based pricing rather than cost-based pricing.
  • Use price to balance supply and demand.
    • Attract price sensitive customers to off-peak days and charge peak-day customers more.
    • Price to attract passengers on competitors' flights to empty seats on your flights.
    • Use innovative pricing strategies to earn some profit from "perishable products and opportunities” before spoilage.
    • Use price differentiation to smooth capital shortages resulting from "seasonal demand peaks”.
  • Microsegment your customers by every dimension possible.
    • “Market segmentation is the key to market-based pricing and revenue maximization.”
    • “Prevent people willing to pay higher prices from paying lower ones.”
    • Segment markets, forecast demand, optimize response.
    • Segment customers by “...their characteristics, including purchase patterns, perception of the product, and willingness to pay.” (Cross)
    • An RM system must account for “differences at the micromarket level, based on product type, day of week, and the individual location.” (Cross)
  • Forecasting
    • Forecast demand at every possible pre-spoilage time and re-forecast frequently.
    • RM systems should use dynamic forecasting at the micromarket level.
    • “The demand forecasting piece would support length-of-rent optimization at the same time it forecast arrival date activity. The optimization function would address overbooking and apply minimum length-of-rent parameters in inventory recommendations.”
    • “Often, we consider the possibility of reforecasting after every customer transaction. Studies indicate that the improvements in decision making from such a reforecast can increase a company’s revenues 1%-2%.“ (Cross)
    • Deliberately withhold inventory during price wars to sell more seats at the undiscounted price as competitors run out of inventory early.
Quantification of Benefits
  • Significant Revenue Driver: As Bob Crandall indicated, “We expect Yield Management to generate at least $500 million annually for the foreseeable future.”
  • Significant Revenue Driver: Delta’s initial foray into RM produced $300 million in incremental revenue with 56 people, which represented 50% of declared profits that year. (Cross)
  • Significant Revenue Driver: PanAm produced an incremental $70 million in revenues from the implementation of low level RM capabilities. (Cross)
  • Incremental Revenue: “Revenue gains of 3%-7% are often realized with relatively little incremental cost.” (Cross)
  • “American Airlines increased revenues 14.5% with 47.8% profit growth in 1985 despite a pilot strike.” (Cross)
  • Profitable market share growth: “The RM [advanced airlines] at the rollout of the Ultimate Super Save price war gained 15% of traffic and grew revenues 9% while the RM [laggard airlines] grew traffic 18% with 2% revenue growth.”
  • ROI Exceeding 200%: RM systems can generate ROI three times higher than that of the average IT system investment according to Erik Brynjofsson of MIT.

The most important take away from airlines' experience with RM systems is that RM IS microsegmentation. Secondly, where inventory management and pricing are not managed jointly, there will be opportunities for revenue improvement, profits and efficiency enhancement. Furthermore, RM systematizes pricing policies while optimizing opportunity and creating instantaneous decision making speed. It removes human bias from the equation, modularizes pricing knowledge, and facilitates employee training. It allows microsegmentation on hundreds of dimensions more than is possible with human pricing, and lets managers focus on customer service rather than pricing concerns.

It’s also enlightening that Wall Street penalized American Airlines when they implemented RM and began to steal market share from discount airlines. AMR stock fell more than 15% after advertising their new prices, which investors thought was the beginning of a ‘suicidal’ price war. American remained silent about what they were doing, and analysts were baffled when their quarterly earnings announcement showed spectacular revenue growth.

“THE SEVEN CORE CONCEPTS OF REVENUE MANAGEMENT:" Sell to microsegments. Reforecast often. Use fact based decision making. Use market-based pricing and not cost-based pricing. Use price rather than capital to balance supply and demand. Save product for your most valuable customers. “Exploit each product’s value cycle.”

“THE SEVEN UNCERTAINTIES:" Seasonality, spoilage, competitive pricing, market uncertainty, bundling/wholesaling, demand by market segment, opportunity perishability.


Revenue Management. By RobertCross. Published 1997, New York NY by Bantam Doubleday Dell Publishing Group.

“ROI Valuation: The IT Productivity Gap.” By Erik Brynjolfsson. July 2003.