Revenue Management:
Hard Core Tactics for Market Domination

Author: Robert Cross
Publisher: Broadway Books, 1997

Comments:

RM is a business and economic science that should change the way you view your business and manage the core issue of product, supply, demand and pricing.

Synopsis:

The marketplace is changing rapidly. Consumers are armed with an abundance of information about a universe of options. Information is ruling our lives. Intelligent sorting and filtering of growing stores of information is the challenge. Consumer markets are becoming more fragmented, disordered and chaotic. The growth of new products is proliferating, many of which are merely offshoots of old ones. The mass market is being superceded by amoeba markets, ones which constantly change shape and sub-divide. For instance, broadcasting in the television media industry is being superceded by narrowcasting.

Since the advent of corporations in the post Industrial Revolution, the world has seen a revolving door of “how-to” approaches. Each one has a long enough shelf life to absorb significant resources from the firms who jump on the temporal bandwagon. Cost-cutting strategy is a common reaction to changes in the external environment. But you can’t cost cut your way to prosperity. It is estimated that a 5% reduction in sales expenses will increase the bottom line by 3%; a 5% increase in sales volume will increase the bottom line by 20%; and a 5% increase in selling price will increase the bottom line by 50%. Thus, prosperity comes from real growth, which in turn comes from the marketplace. It is time to focus on the revenue side of the profit algorithm. Revenue Management (RM) seeks to maximize the revenue potential on every sale by understanding the demand for a company’s products at the micro level.

RM techniques were fostered in the airline industry. In that industry, “yield” is the amount of money earned per passenger airmile and “load” is the percentage of seats filled with paying customers. Total revenue is partially the product of these two, and the one is impacted by the other. Low fares mean more passengers, but not necessarily profitable ones. The key was to understand the micro aspects of that supply and demand interaction, and “mine” for more revenue at the margin. It was estimated that converting one seat on every flight from discount to full fare would yield $52M annually. The process was two-fold; first, to develop a sophisticated information system and second, to re-educate airline staff to be revenue controllers and commodity brokers instead of seat allocators.

This is simple supply and demand economics, from Adam Smith’s Wealth of Nations. Supply and demand economics is a macro-market equilibrium of price and quantity that sums from many micro-markets. There are some customers who attach more utility to your product and would pay more, but get to enjoy the lower price determined from the macro equilibrium. This gives them a “consumer surplus“, which is in effect a missed revenue opportunity for the company.

Economists would technically define RM as a means of allocative efficiency that maximizes economic wealth through dynamically forecasting the self-seeking activities of each individual consumer. RM says there is no average, macro customer to whom you must sell at an average price. The objective is to segment your market and sell to many sub-markets at different prices that they each accept.

Cross’ definition is the application of disciplined tactics that predict consumer behaviour at the micro-market level and optimize product availability and price to maximize revenue. RM ensures that the company sells the right product to the right customer at the right time for the right price. RM is more than a sophisticated IS department. It is an integrated set of business processes that brings together people and systems to understand the market and respond quickly to exploit opportunities. Its objective is to chart consumer preference at the margin to determine the most revenue obtainable from each micromarket at that moment in time. This requires forecasting customer behaviour, preferably with sophisticated techniques, not simply by-guess-and-by-golly. In turn, this requires understanding the value cycle of your product to time the availability of it.

Seven uncertainties need to be addressed to determine whether RM can work:

  1. Perishable products and opportunities
  2. Seasonal and other demand peaks
  3. Different value in different markets
  4. Product wastage
  5. Competition between individual and bulk purchasers
  6. Discounting to meet competition
  7. Rapidly changing circumstances

In many businesses, the product itself is not perishable per se, but the selling opportunity at full price is. This principle opens RM up to almost any business. For instance, Cross gave examples of RM in a one person hairdressing shop, a lemonade stand and to a city symphony society. The accommodation industry is another application. All could exploit the principle of selling the right product to the right customer at the right time for the right price. The exercise is to forecast the declining value of the product with more precision and price it accordingly. The degree of sophistication which you apply to this is a function of the value of the product and the speed of its perishability.

Seasonality can be observed across a day, a week a month or a year. Sometimes, varying production is the only way to address this, but sometimes, shifting demand through pricing is the answer. Sometimes the product is adapted to achieve the desired result, e.g. volume discounts in valleys, e.g. 2:1 or some other discount for consuming more of the product in its valley.

Some customers attach particular value to convenience while others may choose price.

RM defines product wastage as the expiration of a product value thanks to a cancelled sale. A cancellation fee is seldom excisable. Airlines and restaurants overbook to counteract this problem.

Discount tariff schedules frequently are mismanaged. The people on the firing line invariably offer a top discount regardless of the merit of the sale.

Nine steps to establish an RM program:

  1. Evaluate your market needs
  2. Evaluate your organization and processes
  3. Quantify the benefits: set targets for RM
  4. Enlist technology
  5. Implement forecasting
  6. Apply optimization
  7. Create teams
  8. Execute
  9. Evaluate progress to targets

Do not rush through the process without due care. Study the revenue generating processes; what drives it? Interview people on the firing line. Withdraw yourself one level from the product/service you sell to the customer need you are fulfilling: what is the customer really buying? How does your compensation system drive behaviour of sales people? Simulation software is increasingly available and affordable. Forecasting and optimization are the engine room of the Marketing function. You should draw upon at least a year of historical customer purchase history, ideally adjusted for seasonal and other cyclical patterns. Revenue maximization requires segmenting customers into the narrowest possible categories to understand their characteristics, including purchase patterns, value perceptions and willingness to pay. Optimization follows. You must match your product delivery to the customer preferences gleaned in your forecasting. Mismatching represents lost revenue opportunity.

As long as you notify the customer what your different products and prices are going to be at any moment in time and explain the benefits of the pricing differentials, you shouldn’t have any trouble converting your existing customers to RM.

Revenue Management should not be confused with Revenue Accounting. The former belongs in the Sales department; the latter in the Accounting/Admin department. Revenue managers need analytical ability, communications skills, problem-solving skills, authority and responsibility. People with marketing backgrounds often do not come with a strong quantitative background, although they may engage marketing research to tweak interest in their marketing initiatives.

In conclusion, the seven core concepts of revenue management are:

  1. Focus on price rather than costs when balancing supply and demand
  2. Replace cost-based pricing with market-based pricing
  3. Sell to segmented micromarkets, not to mass markets
  4. Save your products for your most valuable customers
  5. Make decisions based on knowledge, not supposition
  6. Exploit each product’s value cycle
  7. Continually reevaluate your revenue opportunities
Conventional Practice RM Practice
In times of seasonally high demand, increase your productive capacity, then decrease it when demand falls Address seasonal demand with price first, only then after with productive capacity
Set price to cover costs and desired profit margin Set prices consumers will pay and deliver products that you can deliver profitably
Equilibrium delivers the maximum revenue at the intersection of supply and demand in the mass market Different segments will pay different prices. Maximum revenue is found from engaging each sub-market
Sell your products on first come-first served basis Understand your micro markets and hold back product for higher paying customers
Pricing strategy is dictated periodically from on high Pricing strategy is dynamic and ongoing and needs to rest with workers in the trenches.

Visit the Profit Optimization Strategies Inc website for more information on revenue management.