Revenue Management

And seeing ignorance is the curse of God,

Knowledge the wing wherewith we fly to heaven.

Revenue Management is one the most important part of hotel’s operations. Research shows that it can increase revenues even by: 11 % (Cross, 1997, p. 3). What is then Revenue Management and how to use it to achieve such a growth?

Unfortunately, explaining RM is not simple. The most popular definitions presented below are vague and not truly represents the nature and idea of the RM, which is usually misunderstood with IT system. Moreover, the term Revenue Management does not also intuitively reflects the meaning of it. Therefore, the reason why I referred to Shakespeare in the beginning is my belief that RM relies on gathering information and transforming it into knowledge in order to make business decisions that will significantly increase revenues.

Moreover, RM might be identified with philosophy that there are ways to maximize revenue of the company, other than traditional and well established like cost-cutting. The RM also introduces a new relationship between customer – product – price. As a consequence one product can have different prices (depending on such factors as time, occupancy or special events) and customers accept those differences. However, RM is not limited to changes in prices and has also other ways to maximize revenue. When thinking about RM, it is good to remember the last time someone booked flight or hotel room and was irritated not because the price was so high but that he hadn’t booked it earlier. This feeling is a consequence of well-implemented RM in this company. The formal definitions below present different approaches to Revenue Management.

Revenue management is the application of disciplined tactics that predict consumer behavior at the micro-market level and that optimize product availability and price to maximize revenue growth.

(Cross, 1997, p. 3)

Revenue Management is an important tool for matching supply and demand by segmenting customers into different segments based on their willingness-to-pay and allocating scarce capacity to the different segments in a way that maximizes company’s revenues.

(El Haddad and Roper et al., 2008, p. 2011)

Both of those definitions emphasize customers, product and price. Therefore simple, intuitive but adequate seems to be definition developed by American Airlines (1987, p.22) and then expanded by Kimes (1989, p. 348):

Revenue Management is selling the right seats to the right customer at the right time at the right price

which can be easily use in other industries like lodging, rentals companies or broadcasting tv stations. There are even more definitions that describe the same process with the same desired outcome – increased revenue. But even if all of them were presented, it will be still not enough to fully understand the concept of Revenue Management, as most of them cannot be used as exclusive RM definition. To overcome this problem we will first focus on RM term and later on the way it is explained in the most popular RM books.

Before we can move to more detailed description it’s better to firstly focus on two components of the term Revenue Management. The revenue from financial perspective is the amount of money that a particular entity receives during a specific period. The revenue includes all costs and other expenses therefore it is a “top line” figure. In hotel operations revenue comes from sales of rooms and very often food and beverages. The management is organization and coordination of all activities in order to achieve certain objectives. In our case the objectives concern achieving certain level of revenue (or more often maximizing the revenue). The management is a complex process, which includes organizing planning, directing and controlling many of firm’s functions.

In literature the nature of Revenue Management is describe rather in practical than theoretical point of view. Therefore, instead of giving the assumptions or components of this concept, the idea is usually presented as collection of recommendations, typical areas of usage or by breaking myths built around the Revenue. Such an attitude will let people who are interested in Revenue Management to intuitively understand the process. This practical approach is extended to such a level, that it is the only way that Revenue Management is considered in academic and professional literature. Therefore, for purpose of this study, seven core concepts from the most popular RM book will be used. Those seven point due to Cross (1997), are keys to be able to answer following three questions: a) what is Revenue Management; b) when we can use it; c) how we can use it.

  1. RM is a tool for matching supply and demand as it was presented in the second definition. However, nowadays in highly competitive markets, it is really hard to find this perfect balance. Most companies use short-term tactics such as staffing up for peak periods and laying off afterwards to address the demand and lower the costs. However, it is often more costly than using pricing as lever to balance demand and supply, therefore short-term fluctuations should be addressed first with price, then with capacity.
  2. Products’ price is based usually on costs of production, selling, delivering and marketing. Although, customers’ willingness to buy them is based on their perceived value of the product vs actual price. If the prices exceed the expectation, customers would not be willing to buy the product or service. Although, customers’ behavior is extremely difficult to predict. Moreover, customer’s might expect price which will not give acceptable rate of return.
  3. Instead of selling to mass markets, firms need to segment market into micro-markets, based on customers’ needs and capabilities. However, customers’ preferences change over time. Therefore the goal of RM is to examine customer behavior at margin to determine the maximum revenue, that could be achieved in that particular micro-market at that time.
  4. The traditional approach “first come, first served” is fair business model for customers. However, very often the customers who are willing to pay the most are the last. In such case, it is necessary to save some of the products for those who are willing to pay more. It’s usually achieved by capacity control.
  5. The core idea of RM is make decisions based on knowledge not superstition. This specifically applies to forecasting customer behavior. Good forecasts reduce the uncertainty about future, and very good forecasts convert this uncertainty into probability. (Cross, 1997, p. 84) The straight – forward implication that better forecasts give higher revenue indicate the importance for constant improvement of forecasting mechanisms. Therefore the next part and empirical research will focus on critical comparison of those forecasting methods.
  6. The knowledge of customers’ behavior is not enough to make satisfying profits. It’s also important to understand and exploit the product’s value cycle. When both are combined, the right product is priced for the right customer.
  7. In nowadays markets, customer preferences change rapidly, therefore firms cannot apply one revenue strategy and stick to it regardless to situation in the market. In order to keep up with changing demand, revenue management system analyze huge amount of data, to continually reevaluate revenue opportunities.

Summary of those concepts could be one of the definitions presented in the beginning and indeed they seem to be adequate. The question which rise is whether airlines or huge hotels group invest millions of dollars in RM system to increase their revenues based on such simple concepts? The answer is yes, all advance and complicated software, databases and processes are based on those simple rules. To support this, it is good to look closer on myths that The American Hotel and Lodging Association developed on their annual conference. This will prove that Revenue Management is not a rocket science and can be used in a lot of situations and businesses.

  1. The first myth says that Revenue Management works only in good times. It’s certainly true that in times of high demand, there is bigger opportunity to maximize the use of demand, however, revenue management tools and techniques have their role when demand is low. It is related to systematic observations of bookings trends that will allow more informed decision to be made.
  2. The second myth says that Hotels must enjoy high levels of demand and occupancy to achieve benefits. It’s not true because there is always trade off between lower rates and higher demand. Sometimes lower occupancy on particular day will give more revenues than higher occupancy achieved by lower rates. Revenue Management optimizes this trade off by maximizing revenue.
  3. The third myth is that only few can afford automated solutions. As it might have been true in the past, the rapid technological development made RM systems way cheaper and more accessible.
  4. The fourth myth says that that it’s hard to measure the benefits that deploying a revenue management system may bring. As implementing any new system, also RM needs systematic and disciplined approach. Even if it is difficult to measure particular changes due to new system, there are ways to do it. But besides quantifiable benefits there are those less quantifiable like: improved access to data, sharper focus on activities that increase revenue and reductions in labor and there will be more time to make solutions, because less time will be wasted on manipulating data and creating manually reports.
  5. The last myth concerns the believe that Revenue Management works only in four- and five- star hotels, mostly because their bigger resources and ability to heavily invest in technology. However, not all RM systems are associated with huge investments and organizational changes in companies. It means that also smaller business can benefit from Revenue Management approach. Moreover, as following examples show some small businesses use revenue management unconsciously.

Revenue Management approaches can be divided into no-tech, low -tech and high-tech. No-tech are usually used in small firms, when owners observe the demand, and adjust prices to move demand from peak days to low-selling days. It is used in such a business as hairdressers, language schools, beauticians, coffee shops and small restaurants. Low-tech approach usually exists in businesses which have lots of customers in regular hours, such as cinemas, operas, entertainment park or small hotels. Demand in such businesses is strongly asymmetrical, it means that during weekends and evenings shows are sold out compare to middle of the day. To apply RM concepts is in this case, firm needs to find a group of price-sensitive customers, which can be moved from busy weekend days to middle of the week, by offering them discounts. However, tracking traffic and purchases require analysis of reservation or sales system, therefore such an approach is called low-tech. The last approach – high-tech – is visible when proper application of RM concepts require to analyze huge amount of data. In this webpage, I will focus on application of RM in big hotels, therefore it is approach will be between low and high tech. Both low and high tech approach to RM requires a structured flow of information and both system and RM team must be constantly notify of changing external and internal situation. The most complex and clear description of flow of information, outside impacts and entities which take part into decision analysis proposed Ivanov and Zhechev (2012, p.176).

Ivanov

As was mentioned before, there are several requirement for a business to fully benefit from the RM. The list was originally compiled by Kimes (1989), but I expanded it by ideas of Cross (1997) and Talluri (2004).

  1. Market can be divided into segments with different sensitivity to the price – customer heterogeneity.
  2. The overall capacity is relatively fixed, and it is expensive or impractical to expand it.
  3. There is a time dimension associated with service. Once that time passed, the inventory loses all value and we cannot use it again (e.g. certain flight or night in hotel).
  4. The marginal cost is relatively low compare to price of the service. It’s practical implication means that it is better to sell inventory with huge discounts than don’t sell it at all.
  5. There is a possibility to accept or reject booking request before the service or there is a possibility to quickly adjust prices to changing balance of supply and demand.
  6. There are peaks and valleys of demand, which can be predicted with a certain probability.
  7. There is a competition between individual and bulk purchasers.
  8. Price is not the signal of quality – it means that even if we pay different price for a hotel room or flight than others, it does not mean that we should expect different level of service.

Implementing Revenue Management system usually goes with huge investments, but looking at revenue alone would not be enough to appropriately evaluate improvement. The general idea of RM strategy would be described as charging different prices for the same service and parallely managing the capacity available. Result of such a strategy (and generally the impact of implementing RM system) is tracked by set of RM statistics.

The first and most simple measure is Average Daily Rate, which is calculated as:

Screen Shot 2014-05-27 at 22.03.42

The second most common statistic is Revenue per Available Room, which can reflect the whole hotel revenue quality. The Revenue per Available Room equation is as follows (Wei and Lee, 2009, pp. 856):

Screen Shot 2014-05-27 at 11.20.38

Form the earnings side, the most popular indicator is Return on equity:

Screen Shot 2014-05-27 at 11.21.31

Furthermore, Orkin (1988) proposed following method to calculate Yield Efficiency :

Screen Shot 2014-05-27 at 11.22.33

Hoogenboom on the other hand expanded Gross Operating Profit model:

Screen Shot 2014-05-27 at 11.37.57

where: Rev is the sum up of operational revenue, VC is sum of variable costs, FC is the sum of fixed costs;

into GOP Per Available Room:

Screen Shot 2014-05-27 at 11.39.39

where mar are margins, ADS is average daily spending, Occ is occupancy and FCPAR are fixed costs per available room. In both models is the number of possible sources of revenue and respective variable costs, is set of fixed costs categories (Hoogenboom, 2012). However, additionally to those financial measures, RM managers should take into considerations customer’s opinion, because it may greatly influence revenues in future. Therefore, additional attention should be place on quality of service (reliability, cleanliness, comfort, competences, availability, security) and resource utilization (productivity and efficiency) (Atkinson and Brown et al., 2001)

 


 

References:

  1. Cross, R. (1997) Revenue management. New York: Broadway Books.
  2. El Haddad, R., Roper, A. and Jones, P. (2008) The impact of revenue management decisions on customers attitudes and behaviours: A case study of a leading UK budget hotel chain. Vol. 6, pp. 2011
  3. Hoogenboom, E. (2012.) hospitalitynet.org. (online) Available at: http://www.hospitalitynet.org/file/152004871.pdf
  4. Ivanov, S. and Zhechev, V. (2012) Hotel revenue management-a critical literature review. Turizam, vol. 60, no. 2, pp. 175-197
  5. Kimes, S. (1989), Revenue Management: A Tool for Capacity-Constrained Service Firms, Journal of Operations Management, October
  6. Orkin, E. (1998) Wishful thinking and rocket science: The essential matter of calculating unconstrained demand for revenue management. The Cornell Hotel and Restaurant Administration Quarterly, vol. 39, no. 4, pp. 15-19
  7. Talluri, K. and Van Ryzin, G. (2004) The theory and practice of revenue management. Boston, Mass.: Kluwer Academic Publishers.
  8. Wei, W. and Lee, H. (2009) Hotel Revenue Management Theories and Applications. pp. 853-856
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