How Aviation Revenue Management Works

Within the modern international business world, while there are many competitive industries, very few business experts would dispute the fact that the airline industry is not only one of the most competitive, but also one of the most risky, featuring as many bankruptcies and failures as it does success stories. This complicated business model operates on several main principles; perhaps the most critical of these is the classic issue of profitability, which in the case of the airlines, is reached through the maximization of revenue from a given set of assets.

In this paper, revenue maximization will be discussed through the concepts of Yield Management and Revenue Management, and how these concepts can make significant contributions to the airline's bottom line. Examples will be used to further clarify these concepts.

Yield Management

Most businesses operate, at least in theory, on a set pricing structure, which of course takes into account the cost of the goods sold, additional expenses, and naturally a certain amount of profit which is enjoyed either by the owner of the firm in a proprietorship, or as value passed back to stockholders in the case of companies that are publicly owned, with shares being traded on one of the stock exchanges of the world. Strangely enough, however, the airline industry operates on a vastly different set of rules when it comes to pricing because of the nature of the competitive environment of the airline industry itself.

Airlines, in the most basic context, derive profit from several activities that are intended to add value to the investments that they make in people, equipment and capital. The activities include the obtaining of the aircraft used to transport passengers and/or freight, maintenance of the aircraft themselves, reservation systems, schedule/route planning, in-flight and after-flight services. All of these activities are intended to provide the service that customers pay for in the most efficient and safe way possible, the key being to make the customer understand the value of what is being offered and be willing to pay for it today and over the long term. As examples of the various services that are offered by the major airlines, passengers can opt to pay more for first class flights which include fancy meals and entertainment, freight haulers can pay extra for rapid delivery of goods, and the like. The bottom line is that every airline is concerned with efficient Yield Management.

Simply stated, Yield Management is a system of pricing that is supposed to yield the highest amount of revenue no matter the amount of individual fares that the airline sells at a given point (O'connor). This system is best described as a direct price/value ratio, meaning that the prices for the fares are highest when the fares are most valuable, along with the goal of the airlines to keep their planes as full as possible when they are flying from the proverbial point A to point B. This ratio bears closer explanation.

A price/value ratio in the airline business, further explained, means that airlines will command the highest price for their fares when those fares are most valuable, such as during peak holiday and business seasons when the passengers will pay the prices, even inflated, because the value that they place on air travel for the achievement of a given end-pleasure or business-far outweighs any objection in their mind to the inflated price they are facing. Yield management is driven to a large extent by the tried and true business practice of charging as high of a price as the market will bear; therefore, when planes are full of paying passengers, and these passengers are paying the highest possible price, the yield of the planes is maximized-that asset is generating a peak amount of return for the investment of flying the plane from one destination to another. Conversely, if demand for air travel is low at a given point, it is feasible that the customer will pay a lower fare because the demand for the airline ticket simply does not exist at that time. To overcome this shortage of passengers, airlines may even lower airfares at the last minute to realize last minute fares, thereby making a last-ditch attempt to maximize the yield that the aircraft will deliver for the assets that have to be devoted regardless of a plane's flight with one paying customer or one hundred. While this could in fact be a useful way to recoup an investment in the absence of any other viable alternative, it can also have its disadvantages. At a discounted fare, there is the possibility that the customer will cancel other higher priced flights on the same airline to pay less which in the long run harms the airline much more than the problem that was attempting to be corrected. There is also the distinct possibility that if the airline develops a reputation for discounting fares regularly, those who have the ability to delay air travel or schedule it flexibly may decline to pay higher fares in the future, which sets up a system of loss for the foreseeable future.

Yield Management was "born" in most parts of the world in the early to mid 1970s due to the occurrences of deregulation of the airline industries worldwide. Prior to this time, governments typically dictated to the industry exactly how much could be charged for an airline ticket which prevented the full operation of a free market system, as the airlines themselves lacked the ability to adjust price to meet demand, thus maximizing yield. One of the positive side effects of deregulation has been the ability for the airlines to try to gain the highest price that the consumer is willing to pay.

This is not to say that Yield Management will definitely result in massive profits and loads of incoming revenue. A tremendous challenge that the modern airlines are posed with in any market is the fact that operation of an airline is very capital intensive, which requires massive amounts of investment to realize a given yield. For example, it is not unusual for a commercial airliner to cost hundreds of millions of dollars to purchase, and that is only the beginning of the process, as the airliner must constantly be maintained, overhauled and flown full of paying passengers to yield any significant returns for an extended period of time. Technology, or more precisely the every changing nature of technology, also poses a challenge to proper Yield Management. Rapid developments in aviation technology require costly upgrades to existing equipment, and if the equipment is in fact too outdated to be upgraded, total replacement may have to take place, at a staggering cost. One of the main factors which defines how an airline grows and succeeds, or the opposite, is its ability to embrace new technology to continue to bring value to the customer and to ensure that the most cost effective and safe modes of air travel are being used. At the risk of stating the obvious, an airline which experiences accidents and service interruptions will quickly find themselves on the undesirable end of the public opinion; therefore, just as the investment in costly aircraft is mandatory, so too is the adaptation of the latest technology which not only makes sense from an operations position, but also from a customer relations position. Image can make or break any business, and something as competitive as the airlines is no exception.

Beyond technological improvements, more basic tactics have also been used by the airline industry to control costs and remain viable. One of the other tools at the disposal of the airlines to reach a desirable degree of Yield Management is to avoid excessive costs through the cancellation of services; if a given flight is deemed to have insufficient numbers of full fare paying customers, which would result in a loss for the airline, the most logical action to take, at least on the surface, is to cancel the flight outright. This action, however, carries with it its own unique consequences that will likely be farther reaching. If, for example, the cancellation of the flight causes some of the loyal airline customers to begin purchasing fares from competitors, that customer can be lost forever.

Two classic examples of the best and worst case scenarios in Aviation Yield Management can be seen in British Airways and American Value Jet respectively. British Airways, through its merger with US Airways, has formed a powerful airline that is now able to provide reliable, convenient travel between the United Kingdom and United States and vice versa. Because the airline offers a highly desirable service that is in demand by the consumer, high prices can be charged with few exceptions because the customer still values the service at the higher price. Therefore, British Airways has been able to maximize yield and retain market share. On the other hand, the now bankrupt Value Jet tried to maximize yield through low fares, which did sell seats on their flights but resulted in very little revenue for the airline. Because of a cash flow problem, behind the scenes, Value Jet neglected technological upgrades and necessary maintenance to aircraft in their fleet, resulting in a tragic crash several years ago which killed dozens of innocent people and ended the Value Jet company and concept. The point is that Yield Management is almost a science, whereby it must be balanced without neglecting key elements of operations which could save money but cost lives in the extreme cases.

In short, Yield Management protects the interests of the airline because it makes sure that planes are kept full of paying passengers, making each flight as profitable as it can be. This in turn leads to the maximization of revenue. Management of revenue, therefore, becomes important and deserves additional discussion.

Revenue Management

Earlier in this paper, it was stated that the airline industry is highly complex due to the extensive resources required to be a player in the industry and continued commitments that must be made to remain viable in the industry. Undoubtedly, one of the most important first steps in that process is the aforementioned Yield Management which keeps planes full and keeps revenue coming into the company coffers. Just as important is Revenue Management, or the process of ensuring that the best methods of generating revenue are being practiced.

One of the most complicated parts of Revenue Management is of course the actual choice of where to engage in operations; for the airlines, this means choosing where flights will take off from and travel to, how often these flights will take place, and if flights will be added or removed from the schedules. Also thrown into the mix is the allocation of maintenance, human resources, etc. Simple math shows that these factors create literally thousands of alternative courses of action, making it necessary for those in charge of Revenue Management to make these key decisions with the assistance of cutting edge technology, such as software applications which analyze all of the alternatives and assigns resources for the best management of revenue, taking out of the decision model the human tendency to "play it safe" or procrastinate. Proper decisions need to be made rapidly, and technology makes this possible.

The introduction of computer technology into Revenue Management has also added a great deal of value from another point of view, especially in the aviation industry. This industry ebbs and flows many times because of trends among customers; for example, it is obvious that the demand for air travel will be very high during traditional holiday and vacation seasons when travelers are less likely to argue about pricing and are more likely to simply pay whatever the price may be at that given time. Likewise, if a major event is taking place in a geographic location, such as a sporting event, demand to reach that point will be high; conversely, if a geographic location is hit by a natural disaster or act of war, few people will want or need to go there. All of these variables must be incorporated into decision models which represent the best possible options to pursue for revenue maximization. The human mind would be boggled by such complex decisions, but the computer models that exist for such purposes can make short work of such scenarios.

Revenue Management, through the utilization of modern technology and wise leadership, has the power to make much needed improvements to the product line of an airline. While most people would simply assume that the airlines have one product line, which is the offering of air travel, and that simply sending planes to major cities will result in paying fares and therefore revenue, the reality is far from this. In reality, airlines, as was stated earlier, have many variables to consider. Within that list of variables are the choices of whether to offer first class service on certain flights or not, whether flights will be offered in given locations, offerings of other amenities on flights, staffing and such. All of these key decisions will in the end result influence the amount of revenue that is derived from a given set of resources. If revenue is not flowing sufficiently, in a sense, there will not be adequate revenue available for the correct admininstration of Revenue Management itself. However, by the same token, if revenue is sufficient and wisely managed, it could be in ready supply which of course is a favorable situation for any business.

Revenue Management, in its best use, also has helped the aviation industry tremendously in the wasteful and costly practice of the overbooking of flights. In the past, to realize the most revenue, airlines commonly sold more seats than were available on a flight, based on the assumption that some people would cancel their reservations, choose a different flight, etc. However, this did not happen as often as was desirable, and in turn, airlines wasted huge financial resources in compensating passengers who were unable to take the desired flights. All of this also took the time of paid airline staff, translating into even more expense. When technology, joined with Revenue Management, made this practice less frequent, the financial benefits were quite substantial, advancing the cause of revenue maximization and moving the business end forward.

If in fact all of the right factors are in place, and the proper Revenue Management techniques are employed, it is feasible to assume that revenue will be maximized over the long term, keeping in mind that this management process must be constantly monitored and adjusted to keep the plan on course, so to speak. Another important differentiation to be made at this point is the key difference between revenue maximization and profit maximization.

It needs to be understood that there is a vast difference between revenue maximization and profit maximization, especially in the complex airline business. When an airline, as in the practice of yield maximization, offers excessively deep discounts, the discounts may lead to a large amount of revenue in the short term, but upon closer analysis, taking into the equation the costs involved in obtaining that revenue, a net loss may very well be the result. Thus is the paradoxical nature of the airline industry and one of the reasons that so many airlines quickly find themselves in dire financial straits when every indication was that all was well, usually due to the false impression that high revenues equal high profits.

The best example of successful Revenue Management perhaps comes from the pioneer of this practice in the airline industry, American Airlines. In the early 1960s, American found itself spinning out of control on the fiscal end; empty planes were flying to destinations where no one was waiting to board them, ticket pricing often was too low to cover costs, passengers could not get flights to where they wanted to go and the pilots themselves were often paid to sit idle while flights did not take off as they should. In short, resources were being mismanaged, resulting in mismanagement of revenue. To remedy this mismanagement, American introduced the Sabre computer system, which at that time was unheard of; this system effectively planned the use of all resources for effective management of revenue.

In Defense of Yield and Revenue Management

Lest anyone jump to the logical conclusion that the airline industry, because of the freedom afforded by deregulation and motivated by their interest in profits, has run amok and is taking advantage of consumers who have no choice but to pay the fares that are set, some words are in order in defense of the practices of Yield and Revenue Management.

Profit motives aside, the airlines do in fact serve the public interest; it is because of airlines' investments in material and human resources that the average person can travel from one place to another in a way that is far superior to any other mode of transportation in terms of time saved and convenience, and despite rumors to the contrary, in fact quite safely. This rapid transportation of people and goods improves the quality of life and efficiency of everyone, allowing business, political and interpersonal relationships to prosper as well as delivery of critical items when they are needed and where they are needed. Therefore, the airlines do in fact have every right to charge what they choose for their services, keeping in mind however that the consumer has the right to refuse to pay the set price. In this way, predatory pricing airlines will be forced out of the marketplace by the time tested forces of supply and demand.

The Future of Yield and Revenue Management

Up to this point in this paper, the concepts of Yield and Revenue Management have been presented and discussed from the viewpoints of their evolution and present state; however, it is also important to understand how the projected future of the aviation industry is likely to affect both of these concepts and shape how the industry evolves.

Industry experts generally agree that as the global economy becomes more complex and technology advances make air travel more common, the demand for air travel, even among those who are not conventionally considered to be air travelers is going to swell (Doganis). These "average" passengers will have a great deal of leverage in dictating to the industry what they are willing to pay for and what they do not consider to be valid value adds that are worth the money. Due to this customer controlled market, it is likely that such frills as first class seating will be abandoned by all but exclusive niche airlines so that lower fares for the typical airline can be passed on the consumers who demand them.

Conclusion

This paper has presented and discussed various aspects of the operations and financial dealings of the airline industry, and in the course of doing so, revealed other issues which drastically influence this vulnerable industry for better or for worse. The issues ultimately have led to several conclusions that need to be acknowledged in closing. First, every industry is vulnerable to circumstances beyond its control; while consumer behavior can be estimated to a given point, there are also areas that are unknown and uncontrollable. Therefore, as in all businesses, the airlines must effectively manage yield and revenue to remain solvent. Second, deregulation should not be used as an excuse to try to overcharge customers, as this will eventually hurt any airline that does so. Lastly, in closing, the entire industry, as in all industries, must continue to focus on value, convenience and safety, and continue to hear and heed the voice of the customer to remain relevant in a challenging and constantly evolving line of business.

References

Doganis, R. (2001). The Airline Business in the Twenty-First Century. London: Routledge.
Doganis, R. (2002). Flying off Course: The Economics of International Airlines. London: Routledge.
Juan, E. J. (1997, Winter). Aviation: The Politics and Economics of a Boom. Foreign Policy 141+.
O'connor, W. E. (2001). An Introduction to Airline Economics. Westport, CT: Praeger.
The Plane Truth about Airline Woes; It's Not Fallout from the 9/11 Attacks That Is Causing the Airline Industry to Crash, Aviation Experts Contend but Government Overregulation and Loose Bankruptcy Laws. (2004, March 29). Insight on the News 33.