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Do revenue management games always increase revenue?

By Ram Gopalan

Many big companies, e.g., airlines, hotels, rental car companies and cruise liners, implement sophisticated information technology solutions known variedly as revenue management (RM) systems or yield management (YM) systems. These systems incorporate smart pricing algorithms and can cost millions of dollars to implement. The worldview on these systems is Janus-faced – companies love them because they are supposed to increase revenue. However, customers often resent the practice because they may be forced to pay a higher price, especially when making a last-minute purchase. This article highlights an important marketing consideration that companies often overlook when implementing revenue management systems. Under some operating conditions, RM could actually end up costing companies revenue.

RM systems work in this manner: If you are an airline with 100 seats to sell, you may quickly sell up to 90 seats at a discounted price but hold 10 seats for last-minute buyers, usually business travelers, who are willing to pay a much higher price for the privilege of making their travel plans at the very last moment. Even if the 91st economy class traveler came along and clamored for a ticket, say three full weeks ahead of the travel date, RM systems will not allow further discounted bookings. RM works well only if the lost revenue from such denied discounted bookings can be made up for by the enhanced revenue from higher-fares generated from last-minute purchases.

Here’s the nub: RM also works best only when an omnipotent central distribution channel (e.g., the company itself) controls the pricing for all customer reservations. If companies divide sales effort between multiple channel partners in order to enhance distribution, RM systems may see some kinks. Airlines, for instance, use various marketing channels, selling direct to consumers or distributing tickets via travel agents or via multiple web-based intermediaries such as Travelocity.com or MakeMyTrip.com. Each of these entities usually determine their own pricing scheme independently in order to suit their specific business model. Firms implementing RM often forget this and fail to keep a close eye on what their channel partners are doing.

Here’s a story to close out. Recently, I held a reservation on Airline A, traveling from Philadelphia to Chennai (in India), connecting at an intermediate airport in Europe. Alas, bad weather intervened at the intermediate stop and my flight was cancelled. In fact, scores of flights were cancelled at this airport. Airline A was overwhelmed – call centers were bumping calls even as they arrived and lines at Philadelphia airport were snaking for miles. I was desperate to travel. If I waited for Airline A to re-book me on another flight, the process could take days. What was I to do?

At this critical moment, sheer desperation forced me to entertain some bizarre travel options. What if I simply cancelled my reservation with Airline A and tried to get a fresh booking with a different Airline B? Re-booking my itinerary on Airline A was super-hard, but total cancellation seemed easy enough. The only catch was, both Airlines A and B implemented RM systems. I checked the fares on their websites for travel within the next couple of days and nearly passed out from sticker-shock. Then I began exploring alternate distributors – most of them also implemented RM and had higher prices. But the prices varied significantly from distributor to distributor. After some effort, I found another distributor, a website that specializes in travel to India. They were selling tickets on Airline B for a high price, but a price point I could afford. I jumped and made my booking. And lived happily ever after.

For sure, Airline B made some money from my trip. But they would have made even more money off of me if they didn’t have to share a portion of the ticket price with a third-party distributor. Companies that implement RM have to strike a fine balance. Third-party distribution certainly enabled Airline B to reach more customers in this case, but because its RM system was not in sync with independent channel-partner prices, Airline B had to forego the opportunity to deal directly with the customer (and cut out the intermediary). But I will not complain about this at all. Airline B was competing in some sense with its own distributor for the customer’s business. As a result of this free market process, the customer won the battle in his desperate bid to complete his travel. And that is all we can ask for in the end!

Ram Gopalan (ram.gopalan@rutgers.edu) is a faculty member at the Rutgers School of Business-Camden.