Updated May 15, 2024
Yield management, now called revenue management, evolved out of the deregulation of the airline industry and the introduction of competition with low-cost fares in the early 1980s. The push was to find a way to optimize prices for services or products that has a fixed inventory or is perishable, such as seats on a plane.
Now, revenue management is critical to the financial success of many organizations, especially in the hospitality industries, where organizations need to manage pricing with a constrained supply over time and maximize revenue.
What is Yield Management?
Yield management is essentially an earlier term for revenue management and refers to the strategy or tactics used to manage the capacity assigned to different fare classes while maximizing revenue. To break that down, it’s a series of rules to determine how many units are in each fare class, and for how long. Typically, there are certain business environments when revenue management is applicable:
- The service or product is a fixed inventory and is perishable.
- Customers buy stock ahead of time
- There is a set of fare classes, and each fare class has a fixed price
- The availability of fare classes changes over time based on booking controls
Yield management techniques use customer segmentation and price tiers to drive profitability while limiting the number unsold inventory. For example, a hotel may reserve a certain number of rooms at a higher price tier for booking when the demand from business travelers is higher, since their price sensitivity may be lower. If the rooms are empty the day before, they may release them at a discount to capture any revenue from them.
In the earliest versions of yield management, incremental costs were not a primary consideration. Yield management was primarily being used by passenger airlines and fares were profitable. In the 1990s, the discount fares continued to decrease as compared to the incremental cost, until the difference was marginal in the early 2000s. Also, revenue management was being adopted by new industries, such as car rental companies, cruise lines and freight transportation, where incremental cost could be significant.
What is Revenue Management?
Revenue management evolved from a focus on maximizing revenue through optimizing fare class allocations to maximizing expected net contribution. The net contribution is the price plus revenue streams from ancillary products and services less the incremental cost of the commitment. This gives a more accurate picture of the profitability of the pricing structure and the total customer value. For example, a hotel may have the following incremental costs: commissions, distribution fees, room cleaning, and regular maintenance. The ancillary products or services could be minibar items and telephone fees.
A Practical Example of Revenue Management: Hotel Industry
The most common example of revenue management comes from the hotel management industry. The primary revenue source for hotels comes from room rates, and calculating revenue from bookings is a simple matter of multiplying price (room rate) and volume (number of rooms booked). Without yield or revenue management, the pricing structure for each hotel room would not have different classes, each with a number of rooms allocated to them and rules based on the demand curve for each class.
The earliest form of revenue management layered in an analysis of consumer behaviour, their needs and wants, and attempted to maximize the price each guest pays for their room while still filling as many rooms as possible. For example, the hotel may have two price rates for the same room on a Monday, one intended for tourists and the second for business travellers. The rooms would have a limit on the number sold at the lower rate, calculated by solving for the probability of being sold.
Revenue management uses the same analysis and tactics but also considers the costs associated with gaining bookings, as well as the other sources of revenue and related costs. For example, a hotel will pay for marketing and other customer acquisition strategies, meaning that the profit derived from each booking is not uniform. Solely maximizing price and volume ignores the fluctuations in profit, an omission that revenue management addresses. Furthermore, selling room service or providing laundry also brings in revenue (and profit) to the hotel. Revenue management looks at this whole ecosystem of hotel activities to ensure that the total customer value is maximized—not just revenue from rooms.
Revenue management now has a more comprehensive understanding of the value of pricing structure. It allows senior decision makers to make informed decisions to drive long-term growth.
Why is Revenue Management an Evolution?
Another way of seeing the evolution of yield management to revenue management is in the conflict between finance and sales. We commonly see the finance heads having issues with the lack of focus on profit from sales leaders in an organization. To some degree, they have it right; sacrificing profit to drive top-line growth is not strictly the best course of action. Neither is being solely focused on profit as we frequently see in the finance department. In the long term, the best course of action is to balance both top-line growth and profitability.
That in essence is the difference between the earliest forms of revenue management and the form most likely in practice today. In the early days, revenue management focused on driving top-line growth, the sales’ perspective in an organization. Now, revenue management equally evaluates top- and bottom-line growth, giving weight to both perspectives, finance and sales. Aside from being the more effective path to long-term, sustainable growth, revenue management also supports the alignment of finance and sales goals, avoiding some of the structural pitfalls faced by siloed organizations.
Pass the Buck: Why Are Sales Declining?
When the volume of sales is declining, how do you diagnose the issue? More times than not, the drop in volume results in a class blame game between sales and finance teams. Finance teams pin declining volume on sales and sales blames finance for the unrealistic margin hurdles. Without sales, there are fewer profit dollars, which affects every department negatively. On the other hand, only focusing on profit may lead to issues with sales volume. Revenue Management forces the two groups to balance objectives and understand drivers.
Mediation: Who gets to make the call when you have different goals?
Without aligned goals, it’s difficult to make decisions without conflicting outcomes. This disjointedness will require a more senior mediator (think President overseeing VPs) to decide which direction to take, which adds yet another layer to an already complicated decision-making process. Additionally, the further the decision-maker is from the product in question, the less qualified they are to make the deciding vote. To avoid this situation, it is important to establish a system that can inherently find balance.
Price Setting: How do you know if the price is right?
Price is a significant component in the success of an offer and, by extension, a business. Often, the goal is to find the maximum amount that the customer is willing to pay. However, if you are targeted on market share or sales, you may aim for a lower price to drive up volume, which results in lower profitability. A strong Revenue Management team will deliver a price strategy that maximizes profit and sales.
Better Decision Makers: Who sees the whole picture?
The best corporate decision-makers almost always act with the big-picture in mind. Whether it be the salesperson who used to be in finance, or the senior manager who has worked across multiple departments. Creating a P&L ownership culture makes everyone a better operator.
Questions to Ask Yourself: Improving Revenue Management
Moving from yield to revenue management is a necessity. To ensure your organization is moving in the right direction, begin by asking yourself a few of the following questions:
- Do we understand the differential cost associated with acquiring different classes of customers?
- Do we understand all revenue streams related to a customer and how they interrelate?
- Who are we targeting and why?
If you are not able to get clear questions to the above from across your organization, it’s more than likely you need to begin your revenue management journey.
ABOUT THE AUTHOR The Editorial Team at Revenue Management Labs is comprised of experts in pricing strategy, business transformation, and a broad range of industries. Each article is carefully reviewed for accuracy and clarity.
