Dynamic Pricing Schemes - Established Supplier Led Pricing - Yield Management

[Definition] [Short History] [Models] [A Simple Example] 

Definition

A Yield Management (also known as Revenue Management) based pricing strategy uses historic data and mathematical models to predict demand at future points in time. It then sets different prices at these different time points according to the predicted demand as well as varying prices according to the actual demand. It aims to stimulate demand when demand is low, and to maximise profits when demand is high. Overall, the aim is to increase profitability rather than simply increase utilisation.

Short History

The Price Man gives the origins of Yield Management as being generally attributed to the US airlines, following the industry's deregulation in 1978. American Airlines is widely reported to have been the first airlines in the market place with some sort of Yield Management system, though there are other references to Delta being first. Certainly both carriers had effective Yield Management systems very early, and many of the carriers that didn't make such investments are no longer around (Pan Am, Peoples Express). The seminal paper on the benefits of Yield Management is by Smith, Leimkuhler & Darrow (see references). Other industries have followed the airlines down a Yield Management path (hotels, car rentals, cruise lines, even golf courses).

Yield Management Models

It is particularly applicable where the supply side product or service is characterised as:

• capital intensive
• perishable.

and the demand side is characterised with:

• variability of demand
• variability of value

We can illustrate the above with two 2 x 2 models with example products and services:

Yield Management is most applicable for products and services situated in the High/High quadrant on both models. So this embraces the classic examples of a seat on an airplane, train, large sport event, etc.

Changing Consumers' Acceptance of Yield Management

Over time, a product's or supply's suitability for Yield Management may change. For example, a telephone call requires a capital intensive network which is perishable if not utilised. However, in recent years the consumer's value of a telephone call has changed. Once telephone calls were seen as expensive and some people would delay using the telephone until the cheaper rates after 1 pm or after 6 pm. Domestic international calls would be left to the week-end. Today, we don't hesitate to pick up the 'phone. In fact this month (June 2003), BT has eliminated national and local call price differentiation for many of its customers. Mobile calls, while still perceived as more expensive, are heading in the same direction. Other tariffs (e.g. dial-up internet calls) continue to stimulate demand in off-peak periods but have not yet been subject to Yield Management and dynamic pricing.

On the other hand, some products or supplies really ought to be subject to Yield Management and dynamic pricing. The UK Government is trying to change citizen's perception as to the value of road space. Roads are capital intensive and perishable if not utilised but at other times are inadequate to handle demand. In order to change driving habits road charging is being introduced. Currently only in central London, other schemes include a new toll motorway in the midlands. Different drivers will place different value as to the speed and convenience of using this toll motorway compared to the cheaper but more congested existing roads.

The Midland Expressway has announced the standard charge for car drivers will be £3 at launch. A minimum toll of 50p applies to all vehicles day or night. Interestingly, the new toll prices are based on the physical size of the vehicle, with light beams scanning and measuring vehicles as they approach a toll booth. For the future, one can foresee the possible use of Yield Management by using the overhead gantry displays to indicate the current price.

Easy Group maintain that consumers understand and accept that Easy companies use Yield Management.

Electricity Supply

Electricity supply, a highly capital industry, is moving to a Yield Management basis. Currently, in the UK, distributors bid for electricity from the suppliers and the distributors have a choice of buying in advance or taking their chances and biding close to the time of need, when they have a better appreciation of demand. However, consumers are continuing to pay the same for a unit of electricity although some large businesses are negotiating flexible supply terms. Whilst many consumers are used to the idea of lower tariffs for using electricity overnight (these consumers have a dual meter), variable day-time prices is probably currently a step too far.

But in time the acceptance and practicality of variable electricity pricing could change with internet enabled domestic appliances being under the control of the electricity distributors. So, for example, your washing machine uses low cost units but cannot be run at peak times. Maybe such appliances could display the current price to run the machine.

Computers

PCs and laptops are capital intensive items (a 1,000 PCs in a warehouse ties up £1m to £2m) and quickly date. Unfortunately, most buyers are not desperate and if need be will delay their purchase. IBM is predicting a shift to Business On Demand where-by business use computing power just like they use electricity, as and when needed. It is likely that a Yield Management pricing would suit this business model.

Services

Services are interesting. Take a call centre selling insurance or providing a help line. Call centres are capital intensive in buildings and computing equipment (e.g. running large CRM systems). Whilst the staff part of the supply can be made variable by having different numbers of staff on different shifts, once those staff are in place their use is perishable. Like telephone call charges, some companies use variable charging to smooth the peaks and troughs and to shift customers to self-service. However, yield management and dynamic pricing may be too advanced for most customers, as these capital costs are opaque to customers. They may perceive the company's taking advantage of them in their hour of need.

The ideal situation for the call centre is to have multi-skilled staff that can also handle back-office work in slack times, though call centres are reducing such work. Another tactic is to manage calls on a world-wide basis to smooth demands across countries (British Airways and Holiday Inn do this).

A Simple Example

Lets consider a cinema:

Whilst the above figure serve the following illustration, in reality UK cinemas have a typical utilisation (occupancy) of just 20%. A new cinema can only therefore be viable if it is built as a multiplex with the staff managing perhaps 6 to 10 screens showing 4 to 7 viewing a day. The capital costs may be spread over a longer period and money borrowed at lower rates. A quick investigation showed prices for a current release film varied from £2.50 to £5 in a provincial town to £4.50 to £7 in a large town in the prosperous hi-tech Thames Valley.

Many factors can influence the actual utilisation: poor weather, other entertainment events including television, political and economic events, etc.. And of course, over the 14 weekly sessions, some shows like Saturday evening may well have the cinema full whereas a sunny Monday afternoon may have zero attendees. As an example, if the overall utilisation drops to 40% then the cinema only takes £4,480 - a loss of £1,120 including expected profit, or a loss of £336 on the actual costs before profit.

Yield Management uses historic data to predict demand for each of the 14 session, taking into account the likely popularity of the film as well as special occasions such as public holidays and big sporting events. More immediate factors can also be factored in such as the weather forecast. The cinema can then set variable prices for each session and variable prices linked to how much in advance the tickets are booked - the earlier bookings having the lower prices. With the pre-bookings the cinema is better able to identify actual demand on a session by session, and therefore vary the price accordingly, plus it can obtains revenue even if the ticket holder decides not to attend.

Using some made-up data we can envisage a particular week having the following sales:

This scenario provides an income of £5,914 with the same overall utilisation as the fixed price model. Sensitivity analysis shows that profitability is only obtained by eliminating all lowest cost seats for the most popular sessions on Friday, Saturday and Sunday*.

Some questions remain:

• will consumers who turn up without bookings and pay more than £4.00 (i.e. the current average) ever come again?
• and if they do come, but pre-book, then the total income will still drop, so will prices have to rise over time?
• can some cinemas use Yield Management where there are other cinemas nearby who don't?

Note that EasyCinema is proposing seat prices of £0.20 to £5.00 and aiming for a utilisation of 50%.

Of course, other items can be factored in to the model such as sales of refreshments and programmes, though EasyCinema is banning food, presumably to save on cleaning costs. EasyCinema is also saving costs by selling tickets online and having automatic ticket barriers. One of the biggest issues with EasyCinema is that the film distributors are refusing to supply the chain with the latest releases.

*Some UK railway companies do this by not allowing cheap day tickets on Fridays and by making the other cheaper tickets only available if booked 14 days in advance (Super Apex).

Back to Established Supplier Led Pricing

External Resources
 

1. Malkani, Gautam, Cut-price gladiator goes to the cinema, Financial Times, 15 May 2003
2. Smith, Leimkuhler & Darrow, Yield Management at American Airlines), Interfaces, 1992, 2, pp8-31
3. Manning, Jon aka "The Price Man", private email, 15 May 2003
4. See the full list of resources for this web site for other related resources.

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