REVENUE MANAGEMENT

Airline Regulation (1938-1978)

  • The Civil Aeronautics Board (CAB) set fares, routes, and schedules for all interstate air transport

  • Most major airlines favored this system due to guaranteed profits

  • Led to inefficiency and higher costs
    • Applications for new routes and fares often delayed or dismissed

Airline Deregulation (1978)

  • The administration of President Jimmy Carter passed the Airline Deregulation Act in 1978

  • The Act encouraged
    • More competition: 52 new airlines between 1980 and 2000
    • New air routes: saved passengers an estimated $10.3 billion each year in travel time
    • Lower fares: ticket prices are 40% lower today than they were in 1978
  • This led to more passengers
    • The number of air passengers increased from 207.5 million in 197.4 to 721.1 million in 2010

A competetitive Edge

  • More competition led to heavy losses by air carriers
    • Need to lower fares while meeting operating costs

  • 9 major carriers and more than 100 smaller airlines went bankrupt between 1978 and 2002

  • How did airlines compete?

Discount Fares

  • On January 17, 1985 American Airlines (AA) launched its Ultimate Super Saver fares to compete with PeopleExpress

  • Need to fill at least a minimum number of seats without selling every seat at discount prices
    • Sell enough seats to cover fixed operating costs
    • Sell remaining seats at higher rates to maximize revenues/profits

How Many Seats to Sell on Discount

  • Passengers have different valuations
    • Business people value flexibility (last-minute/refundable)
    • People seeking getaways value good deals (early birds)
  • Sell too many discounted seats
    • Not enough seats for high-paying passengers
  • Sell too few discounted seats
    • Empty seats at takeoff implying lost revenue
  • How should AA allocates its seat among customers to maximize its revenue

Simple Problem - JFK to LAX

Route

Route

Ticket Prices

Ticket Prices

166 Economy seats

166 Economy seats

Demand Forecasting

  • Demand for different prices can be forecasted using analytics tools, looking at historical data and incorporating models of human behavior
    • Time series methods
    • Linear regression
  • Forecasts could be erroneous
    • Need to assess sensitivity to forecast errors
  • We’ll assume that demand has been forecasted

Myopic Solution

  • How many discount seats to sell to maximize revenue

  • This seems simple, but what if we had 100 different flights?

Single Route Example

  • Problem: Find the optimal number of discounted seats and regular seats to sell to maximize revenue

Step 1: Decisions

  • What are our decisions?
    • Number of regular seats to sell - R
    • Number of discount seats to sell - D

Step 2: Objective

  • What is our objective?
    • Maximizing total airline revenue
    • Revenue from each type of seat is equal to the number of that type of seat sold times the seat price

\[max = 617R + 238D\]

Step 3: Constraints

  • AA cannot sell more seats than the capacity
    • Total number of seats sold cannot exceed capacity

\[R + D \leq 166\] * AA cannot sell more seats than the demand + Regular seats sold cannot exceed 100

\[R \leq 100\] + Discount seats sold cannot exceed 150

\[D \leq 150\]

Step 4 : Non-Negativity

  • AA cannot sell a negative number of seats

    \[R \geq 0 , D \geq 0\]

Problem Formulation

  • Maximize
    • Total airline revenue

    \[617R + 238D\]

  • Subject to
    • Seats sold cannot exceed capacity
    \[R + D \leq 166\]
    • Seats sold cannot exceed demand
    \[R \leq 100, D \leq 150\]
    • Seats sold cannot be negative

    \[R \geq 0, D \geq 0\]

Visualizing the Problem

Feasible Space

Marketing Decisions

  • Management is trying to figure out whether it would be beneficial to invest in marketing its fares

  • AA forecasts that its marketing effort is likely to attract one more unit of demand per $200 spent

Marketing Discount Fares

Marketing Decision

  • Management is trying to figure out whether it would be beneficial to invest in marketing its fares

  • AA forecasts that its marketing effort is likely to attract one more unit of demand per $200 spent

Capacity Allocation

  • Management is trying to figure out whether it would be beneficial to allocate a bigger aircraft for the 6 hour JFK - LAX leg

Aircraft Capacity

Capacity Allocation

  • Management is trying to figure out whether it would be beneficial to allocate a bigger aircraft for the 6 hour JFK - LAX leg

Connecting Flights

Step 1: Decisions

  • Number of regular seats to sell

\[R_{JFK-LAX} , R_{JFK-DFW} , R_{DFW-LAX}\] * Number of discount seats to sell

\[D_{JFK-LAX} , D_{JFK-DFW} , D_{DFW-LAX}\]

Step 2: Objective

  • Maximize total revenue

\[428R_{JFK-LAX} + 190D_{JFK-LAX} + 642R_{JFK-DFW} + 224D_{JFK-DFW} + 512R_{DFW-LAX} + 190D_{DFW-LAX}\]

Step 3: Constraints

  • AA cannot sell more seats than the aircraft capacity
    • First leg - JFK-DFW
    \[R_{JFK-LAX} + D_{JFK-LAX} + R_{JFK-DFW} + D_{JFK-DFW} \leq 166\]
    • Second leg - DFW-LAX
    \[R_{JFK-LAX} + D_{JFK-LAX} + R_{DFW-LAX} + D_{DFW-LAX} \leq 166\]
  • AA cannot sell more seats than the demand

\[R_{JFK-LAX} \leq 80 , D_{JFK-LAX} \leq 120\] \[R_{JFK-DFW} \leq 75 , D_{JFK-DFW} \leq 100\] \[R_{DFW-LAX} \leq 60 , D_{DFW-LAX} \leq 110\]

Step 4: Non-Negativity

  • AA cannot sell a negative number of seats

\[R_{JFK-LAX} \geq 0 , D_{JFK-LAX} \geq 0\] \[R_{JFK-DFW} \geq 0 , D_{JFK-DFW} \geq 0\] \[R_{DFW-LAX} \geq 0 , D_{DFW-LAX} \geq 0\]

The Competitive Strategy of AA

  • Selling the right seats to the right customers at the right prices

“Revenue management is the single most important technical development in transportation management since we entered the era of airline deregulation.” - Robert Crandall, former CEO of AA (~1985)

“We estimate that revenue management has generated $1.4 billion in incremental revenue in the last three years.” - Robert Crandall, former CEO of AA (~1985)

The Edge of Revenue Management

  • Sabre Holdings
    • Built revenue management system for AA
    • As of November 2012, ranked 133 among America’s largest private companies with $3.15 billion in sales
    • 400 airlines, 90,000 hotels, 30 car-rental companies
  • Today, companies prosper from revenue management
    • Delta airlines increased annual revenue by $300 million
    • Marriott hotels increased annual revenue by $100 million