Revenue Management
by Steve Marchant

Top management may be instrumental in determining corporate strategy and exercising cost control, but it is well worth focusing more closely on the revenue side of the profit equation

Many sectors, including transport, travel and telecoms, are concerned mainly with the sale of perishable goods and services. Firms in these industries can increase their profits significantly by applying the principles of revenue management. This is the term that is used to describe the process of achieving the maximum return. It requires information systems and pricing strategies to allocate the right type of capacity to the right customers at the right place at the right time. It also calls for a combination of market segmentation, inventory control, forecasting and pricing (Figure 1).

Revenue management started in the airline industry during the late 1970s after its deregulation in the US, when the established carriers were forced to protect their high-yield business from aggressive new competitors. It has been practised widely by airlines for 30 years, but it has been slow to spread to other sectors, despite the financial benefits it offers. It has now been adopted widely by hotel, cargo and car-hire businesses and, more recently, by tour operators.

Most industries are facing increasing price and margin pressure. Traditional solutions such as cost-cutting will always play a role, but on their own they are unlikely to create a lasting competitive advantage because companies will be following similar strategies and may take it in turns to be market leader, often with lower prices and profits. Revenue management can lead to a sustainable advantage - and this advantage is generally enhanced if your competitors choose the same route. It usually works best when a company's capacity is fixed or semi-variable and the revenue-earning potential of each unit of capacity is perishable.

Revenue management is a way of controlling price and capacity, which are generally (if not absolutely) known, and demand, which is far less well known. Accurate forecasting techniques are therefore required to predict future demand based on historical data and current sales trends. Advanced methods can be used to strip out the effects of price changes and capacity constraints.

The revenue improvement that is attainable increases with the precision of your forecasts, so it is important to use the most appropriate technique of the many that are available and to feed this with the most up-to-date and accurate information. Choosing a forecasting system is not straightforward and the one you choose depends on a range of factors, the key ones of which are:

• The buying behaviour of your customers;
• The historic sales and price data that is available to you;
• The data processing "window";
• The competitiveness of your market.

A forecasting system can generate a significant return on investment and is the logical first step for an organisation moving into revenue management, but this will not be fully effective unless it is harmonised with a profit optimisation system. The term "revenue management system" is generally used to cover this combination.

In essence, optimisation is the process of balancing supply and demand - profitably. A company can use a number of optimisation approaches, the best established being the "yield class" method. Yield classes sometimes exist in a business, even if they are not understood or referred to as such. Here, firms need to segment their inventory using criteria other than price - for example, by setting out differential terms, conditions and "extras", and then allocating their inventory to pre-determined yield-class "buckets" in the volumes determined by the forecast system for each bucket.

The age-old business problem is that of selling the right product to the right person at the right time for the right price. Anything else is either a lost customer or cannibalisation, both of which equate to a missed revenue opportunity. How many of us know how many of our customers would have paid more, or how many prospective customers went to a competitor after contacting us? How much revenue should we estimate has been missed? It is sure to be significant.

The introduction of a structured approach to revenue management gives firms the chance to minimise these missed opportunities and increase their returns. In essence, it involves tow steps - optimising the pricing structure and optimising price levels. Optimising the pricing structure will differentiate your products or services to match the differing needs of your customers. This builds effective barriers between your offerings to prevent cannibalisation and enable "upselling". Unsurprisingly, this ties in nicely with yield-class optimisation.

Optimising price levels is the process of determining the prices for each one of your products and services to maximise the revenue from your optimised pricing structure. An economist may tell you that this can be calculated from the price elasticity of demand. This is true - up to a point: different customers have different price elasticity, which can change over time and depend on their reasons for buying. To complicate matters further, many, if not all, customers will compare prices with those of your competitors.

The answer lies within your revenue management system. Here you have stacks of segmented data on how demand changes with price. Link this with your competitors' prices and you have the minimum amount of data needed to create and maintain an effective segmented price elasticity model. This model will enable you to:

• Optimise price levels;
• Evaluate new price decisions before implementing them;
• Assess the impact of your competitors' price changes and determine the best response.

These secondary benefits of revenue management systems are rarely exploited fully, yet they can deliver dramatic increases in profit through faster decision-making, more effective marketing, improved operational efficiency and increased productivity.

To ensure that you continue to get the best from your revenue management investment, you also need to establish correct performance monitoring supported buy periodic audits. These audits should address the system inputs, outputs and processes and also review how the valuable data and knowledge is used at different levels throughout an organisation.

Modern revenue management systems are now far more user-friendly, and Figure 2 shows the architecture of a typical system. Analysts and managers can be far more effective when they have a reliable reference tool that helps them to understand the relationship between historical and future sales volumes. A good system will produce structured exception reports on-line, allowing analysts to solve inventory problems and manage prices instead of wasting their time collating data.





Steve Marchant FCMA is Managing Director of Consultecom, a specialist revenue management solution provider in the United Kingdom. This article is contributed by CIMA, The Chartered Institute of Management Accountants, and it first appeared in Financial Management, CIMA’s monthly magazine for accountants in business.