Demystifying Revenue Management - Three most common myths

Given its widespread adoption, revenue management (RM) approach is now an industry benchmark in airline, hospitality, and car rental industries for pricing. Over the past decade, revenue management approaches have gained popularity in other industries, most notably electricity (for dynamic pricing in conjunction with adoption of smart grids and smart meters), sports tickets (for pricing of both seasonal passes and individual game tickets), restaurant (for dynamic menu pricing to adjust for demand variations), and digital advertisements (for dynamic pricing of digital advertisement space in alignment with the demand across advertisers).

While there is a consensus on the potential offered by revenue management (RM) in achieving revenue goals, however in my interactions with business leaders across industries I have encountered few myths associated with RM approach. The three most common of these are:

• Myth 1: Revenue management increases the average price paid by customers 
• Myth 2: Revenue management is useful only in competitive markets 
• Myth 3: Revenue management systems reduce the significance of the role of the revenue managers

 In this and the next couple of articles, I will address these myths and separate facts from friction, so that business leaders can put their concerns at ease and make the best of the opportunities offered by RM.

Myth 1: Revenue management increases the average price paid by customers

Whenever the available inventory (of airline seats, hotel rooms, etc.) is greater than the demand at high price, revenue management will allocate a portion of the inventory for selling at low price. This maximizes the capacity utilization, and also brings down the average price paid by customers.

Revenue management dynamically allocates the available inventory for selling at different price points. As a result, if the future demand at high price points is lower than the inventory available, RM will allocate a part of the inventory for selling at lower price points, which will pull down the average price paid per customer.

For illustration, let’s consider an airline ticket pricing scenario for a flight on July 2^nd, 2015 from NYC to SFO, with 100 seats in the aircraft, which can be sold at the following four price points: $360, $440, $520, and $600. Assume that the airline starts accepting reservations from one year in advance, and the demand is uniform over the one year booking horizon. The total demand forecast over the year and the corresponding revenues at each of the price points in consideration are shown in Figure 1 below.

(Capacity = 100)

 

If the airline adopts an optimal single price policy for the July 2^nd flight, it will pick $440 because at this price its revenues are maximized at $37,840. However, notice that only 86% of the flight capacity is utilized at this price. If it prices at $360, it will fill-up all the seats, however it will generate only $36,000 in revenues.

If the airline adopts a simplistic revenue management approach, and for the first 237 days in the booking horizon (from July 2, 2014 to Feb 25, 2015) sells July 2^nd, 2015 flight tickets at $360, and for the balance 128 days (from Feb 26, 2015 to July 1, 2015) sells the tickets at $600, it can expect to sell 78 (=237/365*120) seats at $360, and 21 (=128/365*60) seats at $600. In this manner, for the July 2^nd, 2015 flight the airline can expect to generate revenues of $40,680 ($360*78 + $600*21).

In comparison to the optimal single price policy ($440), the RM approach here has contributed 7.5% higher revenues ($40,680 vs. $37,840), lead to a better flight capacity utilization (99% vs. 86%), and lowered the average price paid per customer from $440 to $411 (= $40,680 / 99).

Truly a win-win proposition!!

Pricing blunder, but a political masterstroke!

According to UNDP statistics, average daily water consumption per capita in India stands at ~130 liters. At an average household size of 4.51, monthly household water consumption in India is around 17,500 liters.

AAP's Delhi government recently announced 20,000 liters of FREE water per household per month for the residents of Delhi. This is almost 15% higher than the national average consumption.

The gift of FREE 20,000 liters of water per household per month on one side is certainly very appealing to the masses, but let's understand how harmful such a move is. There are essentially three issues to consider:

1. Natural resources are scarce, and world wide countries are focusing on ways to reduce their consumption. To control misuse of limited natural resources, governments should look at putting penalty on misuse. Giving a free allowance, which is 15% higher than the average usage is nothing but permission to waste.
2. When politicians win elections by a landslide on such promises, it will motivate other politicians to use same or similar approaches. Essentially making the entire system hollow. Such approaches are nothing but bribery and should be punishable under the court of law.
3. It's always easy to lower down the prices than to raise it. Giving away water for FREE is easy, but reversing this move would now be a nightmare for any political party now, including AAP.
4. When the entire focus is concentrated on giving away huge amount of water for FREE, essentially the focus is on quantity. The focus and efforts that are required to be put on quality will take a hit. People need both better quality and reasonable quantity of water. Lopsided approach is a lose-lose situation.

When people can afford to spend Rs. +50 for a bottle of beer, Rs. +30 for a bottle of Pepsi, and Rs. 200 for a spirited evening, what are we trying to do here Mr. AK?

Customer Service Best Practices - Wish Domino's Pizza gets this

Sequence of real events (Home Delivery Order number 250, dt. 19-12-2015 at Domino's, Siddhivinayak Residency, Kharghar, Navi Mumbai):

• 9:21:53 pm Pizza order is placed with Domino's
• 10:14 pm Customer calls up the store to check on the order status; is told that deliveries were getting delayed today, Store Associate says that although there is a delay, but a proper product will be delivered, requests customer to bear with the situation and customer agrees - while still on the call Pizza delivery boy shows up (finally)
• 10:18 pm Pizza delivery boy brings COLD pizzas to customer; note this is after almost an hour of placing the order (what happened to promising a proper product delivery, BTW this is not the  first time this is happening -- see the note below)
• 10:18 pm Customer while still on phone with the store associate tells him about COLD delivery, but instead the store associate says it's a) a normal delivery, b) pizza got cold because of the time that got spent in checking the pizza by the customer, c) uses different false names (Shantanu/Sandesh) for himself over the course of conversation (so much for customer service and credibility, not to forget the UBER incidence!)
• 10:19 pm Customer says 'thank you' to the delivery boy, refuses to take delivery (who wants to eat a COLD pizza)
• 10:20 pm Customer takes its family out to dinner elsewhere (matter is closed, what a waste of time in the first place in placing an order with Domino's)

Next day:

• 10:12 am Store Associate calls to inform that his name was used wrongly by another associate (it doesn't matter to the customer any more what name was used by who, stop wasting customer's time), and on the problem faced he says that they didn't tell last night to you but store would have been willing to send a proper pizza later in the night (willing, sure!! wait till eternity for you to do your work properly). Customer tells him he is not interested in discussing this matter any further.
• 10:49 am A person claiming to be District Manager (not sure after false identity episodes) calls up the customer and repeatedly mentions that you (customer) had faced a problem last night with Domino's delivery (yes, CUSTOMER ALREADY KNOWS IT FACED A PROBLEM LAST NIGHT WITH DOMINO'S, why are you wasting his time telling him this over and over again), and finally as a solution to the problem asks customer to place the order again today itself and this time he is personally willing to ensure that it'll be delivered on time (willing again!! why does he expect customer to go through the ORDEAL all over again). Customer tells him he is not interested in placing any order and for that matter dealing with Domino's, Domino's manager says that he offered a solution, but since customer has declined it, the matter is closed. For whatever it means, thank you finally the matter is CLOSED! 
• 2:02 pm But wait ... another call from another manager from Domino's. 

Please note:

• There is one consistency in the entire episode. The previous home delivery order with Domino's which was about 2 weeks ago, the exact same COLD and DELAYED delivery episode took place. (All the talk about customer service and learning from mistakes is a joke!)

Lessons for those who care about customers:

• At least don't make a poor service issue worse by calling up customer over and over again, when all you are interested in is only selling and not service
• If you have failed on service, accept it and fix it so that it doesn't repeat again in future

Private School Pricing -- Prospecting, Positioning, Pricing

Recently, my family relocated to Navi Mumbai, and we were searching for a private school for our son. I stumbled upon a very insightful pricing scenario...

After lots of R&D, we narrowed down our search for our son's school to two, lets call these schools as ABC and XYZ. Both of these schools follow same ICSE board curriculum, are located close to each other, and are very well known for their academic results, student placements in top undergraduate programs, comparable facilities available to students (both in terms of infrastructure -- e.g. swimming pool, football and basketball courts, auditorium, AC in every classroom, etc.; and also other extra curricular programs -- e.g. dance, karate, elocution, singing, etc.), as well as quality of faculty (and I learned from an acquaintance, who is a teacher at another private school, that both these schools pay comparable salaries to its teachers.)

The difference between these schools was in their annual FEE. School ABC was charging Rs. 24,000 for an academic year, while School XYZ was charging Rs. 70,000 for an academic year. When I investigated these schools further, I learnt that School ABC was having 54 students in every classroom, while School XYZ was having 30 students in every classroom. When I triangulated the numbers, I realized that at school ABC, student to teacher ratio was 36:1, while at school XYZ it was 15:1. In every other aspect, both these schools were at par.

How much, if at all, would be a fair premium for a better student to teacher ratio?

By having a better student teacher ratio, the cost of the academic program per student at school XYZ is certainly higher. One approach to pricing can be a cost plus approach. Costs are higher, therefore higher fee. The other way would be a value driven approach. Better student to teacher ratio can be viewed from a value aspect also, and can be translated into higher average time available per student with each teacher. The perceived value of the program, due to better student to teacher ratio is higher, therefore it is ok to charge a higher fee.

It might be a bit difficulty to quantify the differences in the delivered value at the two programs, but there seems to be a much stronger perceived value differentiation. As a result of which, different profile of customers will be attracted to the two programs, which is what I found at these schools as well. I also noticed that School XYZ was further highlighting the better student to teacher ratio in other aspects of school operations as well -- more space in canteen for students, spacious classroom with wider desks, larger closets for students to keep their belongings, etc.

If we do a little arithmetic, we will notice that School XYZ was actually making higher contribution margins vs. School ABC, as can be seen below (assuming all infrastructure and facilities charges are sunk costs):

School ABC
Number of students per class = 54
Number of division per class: 3
Number of classes (Junior Kindergarten to Class X): 12
Total number of students (N) = 54*3*12 = 1944
Number of teachers (T) = 54
Student to teacher ratio = 36 : 1
Average tuition fee (F) = Rs. 24,000
Annual gross revenue (A = F*N) = Rs. 46,656,000
Average teacher salary (B) = Rs. 4,00,000
Contribution margin (C = A - B*T) = 25,056,000

School XYZ
Number of students per class = 30
Number of division per class: 2
Number of classes (Junior Kindergarten to Class X): 12
Total number of students (N) = 30*2*12 = 720
Number of teachers (T) = 48
Student to teacher ratio = 15 : 1
Average tuition fee (F) = Rs. 70,000
Annual gross revenue (A = F*N) = Rs. 50,400,000
Average teacher salary (B) = Rs. 5,00,000
Contribution margin (C = A - B*T) = 26,400,000

Does it mean that School ABC is undercharging and it will be better off if it started charging Rs. 70,000 per student per year. I think the answer is NO. In this scenario, School XYZ positioned itself for high willingness to pay parents, and it turns out to be the case that there were just the right number of parents in the neighborhood that were capable of paying the higher fee and appreciate better student to teacher ratio. If the supply of seats at higher price programs increases, it will lead to a mismatch with demand. Such situations are not sustainable. There are sufficient number of parents who can only afford lower prices for school programs and there are enough of those to fill up all the seats available at ABC. A Robust pricing strategy integrates Prospecting, Positioning, Pricing. There are no magic optimal price numbers!

And now Price Match Guarantees at JCP

JCP recently announced a change in its pricing strategy, which now includes a price-match guarantee.

I see two basic issues in taking this approach:

> I don't know how much the customers will trust Price match guarantees, especially when the items you are dealing with are NOT "signpost" items. Certainly such guarantees work very well with competition, as you want to signal to your competition that any price reduction war by the competition will be matched. It's a clever strategy when you yourself don't want to go low price / price war route. But hey, here JCP is the company that is going the low price route.

> With Price Match guarantee, JCP is making a conscious choice of attracting price sensitive customers -- who rank very low on loyalty. The stores will have to rely on volumes, and PMG will probably assist towards it. But now the stores will get crowded with not so profit generating customers, and due to factors like "butt-brush" effect, the experience conscious customers will seek other avenues.

Some of the pricing experts have expressed that JCP's strategies are turnaround, courageous, revolutionary, decisive, etc.; certainly JCP's strategy is very bold - as it challenges some of the traditional wisdom. I am now very curiously looking forward to Q2 and Q3 results.

Making Your Prices Work Against You... CocoBerry!!

Day before y'day, I took my son to CocoBerry's outlet close to Juhu Beach. For the first time I noticed their menuboard carefully, and was left completely surprised by their prices.

 

CocoBerry is a Frozen Yogurt chain operating in India since 2009, and has about 40 outlets in 9 major cities. Along with Frozen Yogurt, they serve Smoothies, Sandwiches, Parfaits and Beverages. They were recently in news for having acquired more than 1 million Facebook fans.

Currently, CocoBerry has priced its Small size frozen yogurt serving at Rs. 58, Medium size at Rs. 122, and Large size at Rs. 197. I am sure on a per ounce basis, Large size must be the most attractive deal, followed by Medium and Small sizes. Given that the Large size is not over priced at Rs. 197 (less than $4), there should be many more customers buying Large size serving vis-a-vis the other sizes. However, this was not the case. I spent about 20 minutes at the outlet and during this time noticed that, out of the 12 customers who visited the outlet, every single customer ordered small size serving.

Sure my sample size is small, but I am sure their sales mix distribution will be way off than the industry, which runs around 40%: 40%: 20%. By pricing their Small size significantly lower than the Medium size (Medium size is more than 2x the Small size price; 3 digit vs. 2 digit pricing), they have created a big hurdle in the minds of the customers. Now the customers are not even bothered about comparing the sizes anymore, and see if there is any price per ounce benefit. CocoBerry doesn't even mention the sizes of the cups on the menuboard, so even if a customer wants to compare the prices he or she will have to ask the person at the counter!

Instead, if CocoBerry raises the price of its small size serving to 80, and drops the prices of medium and large sizes to 97 and 115 respectively (and maybe reduce the sizes of the medium and large size cups a bit), they will be able to get the customers to spend much more money with them, and see better revenues and profitability. 

Until then they are just making their prices work against them!!

Best Faculty Award, at the hands of Prithviraj Chavan, Chief Minister - Maharashtra