revenue & yield management

Hope this post helps some;

It is part of a uni assignement i done a while ago without the into and summaries. Should provide soem info for those who are short on reading material.

A long post of 3000 words so if your only buying VBA and other airline stocks based on technicals then read no further.


Regardless of whether an airline is a state owned non-profit flag carrier or full commercial enterprise the basic rules that govern the profitability and viability of all airlines depends on effective yield and revenue management and a critical assessment of its direct and indirect operating costs.

Operating Costs
For an existing airline or as part of the aircraft evaluation process management must first be able to define the costs which the airline will incur so that the basic accounting fundamentals can be applied. These costs are broken down into two broad groups known as Direct and Indirect operating costs. There is no hard and fast rule as to what cost fits into each category, other than to take the basic premise that indirect operating costs can be generally described as those that are not varied by the aircraft type involved.
Direct operating costs can consist of such broad categories as flight operations, maintenance and overhaul, depreciation and amortisation. These largely broad categories cover such aspects as salaries, insurance, spare parts, ground support equipment and administration.
Indirect operating costs fall into broad categories such as station and ground expenses, passenger services, ticketing and marketing. Such charges attributed to these include building and equipment leasing, handling fees and other service costs which are beyond the airlines control. (Doganis. R. 1985, p111)
The major variable in aviation unit cost is the instability in the costs of aviation fuel. During the early 70’s and followed by the early 80’s where periods of instability for oil production largely due to political issues originating in the Middle East. The same can be said most recently in the past 12-18 months which has seen an increase in the oil price of approximately 100% due to oil demand associated with the development and industrialisation of the emerging Chinese and Indian economies.
To put this into scale Emirates president Tim Clark revealed that every $10US increase in oil price would cut $500m US from revenue. To combat this increase he said that the airline was looking at cutting routes on less profitable segments and increasing fares where the market could bear it. He used the example that executives flying out of Houston Texas could have a large increase placed on their premium fares due to oil companies making such large profits at present. Alternatively he said that marginal routes would be wound back and they would increase services to markets that are more robust. (Creedy, S, The Australian, June 6, p38)
On a side note some long term benefit that can be taken from the oil crisis was pressure on manufacturing to make aircraft more fuel efficient.
It can then be noted that fuel which can form an approximate direct operating cost of 15% can cause much volatility to an airlines operating margin and bottom line, thereby reducing yield and revenue. Alternatively the largest portion in indirect operating costs can be attributed to sales and marketing which consumes similar levels of revenue, and a growing trend for increases attributed to general and administrative functions. (Doganis. R. 1985, p120)

Forecasting
With such demands and an array of costs including the high costs of lease or purchase of aircraft it necessarily follows that forecasting is an absolute vital function of management. Decisions for aircraft procurement, applying for new routes, employing and training more staff are strategic decisions which require long term forecasting as these functions form the basis of an airline. There are no hard and fast forecasting techniques that provide iron clad results. Instead airlines rely on a number of factors and indicators each of which provide varying accuracy, benefits and disadvantages to try and capture a probable solution, in short without forecasting a plan is not possible. (Doganis, R. 1985, p230)
Forecasting can be broken down into three main categories of time series projections, qualitative methods and casual models, the later which applies more basic logic to outside variables and data.
Qualitative methods;
• Executive Judgement. This method relies on the expertise of an executive or knowledgeable person within a particular field. Often the assessment is made based on prediction and judgement and also is used in conjunction with an assessment at the end of a more detailed forecasting method.
• Market Research. An adequate tool to be used where little previous data is available or thought unreliable. Generally in the form of surveys, the kind of questions will vary depending on the analysis involved. Questions ranging from transport to the airport, destination, hotel availability and level of service expected are typical questions employed to gauge a level of service or route frequency.
• Delphi Techniques. This method employees the use of the opinion of multiple experts in various fields to provide forecasts in future trends. These forecasts are then shown to the other industry experts who then provide comment in the form of support or argument until eventually a general consensus of opinion is achieved.
Time Series Projections are relatively simple and rely on previous data and statistical information and are reasonably accurate for short term trend information for forecasting traffic growth. Primarily based on the data and assumptions based on time, these projections prove overly simplistic when broader economic and socio economic issues which inherently or more long term cannot be factored. Management must then use executive judgement to help interpret the data based on those external factors. (Doganis. R, 1985, p244)
Casual Models such as regression analysis are used to trace back the origin of the income or behaviour of the target group. Comparisons of far yield to per capita income can be used in conjunction with Gravity models which provide the ability to forecast new routes based on GDP of a nation and the volume of traffic between two points. Casual models provide logical assumption and generally can form a reasonable assessment of short term for new routes and traffic growth. Casual modelling requires the availability of accurate historic data of a nation or population as well as air traffic data.
It is clear that no one forecasting tool can provide all the information required to form an opinion, rather, a mature approach based on economic forecasting, logic, mathematical assessment and critical judgement is the key to getting the right data mix. The size, timeframe and budgetary constraints of the airline will determine which forecasting tool will be used. It is critical then that management become familiar with the advantages and pit-falls of each forecasting tool so that proper judgement and the right decisions can be executed.

Pricing Structures
The ability for management to influence consumer choice and the setting of prices to maximise yield is within the airlines control. Yet there remain as in any other business the external factors which influence the viability of the airline. The primary factor is the cyclical changes in economic growth both in world GDP and in particular countries themselves. Growth or contraction whether business or leisure travel is reflected in the airlines Revenue per Kilometre (RPK). (Hutcheson. S. 1996, p174)
Amongst most businesses their exists a disincentive to short term planning, generally due to the fact of the cost of change and market share concerns. However, in the aviation industry which is cut on such fine revenue margins short term forecasting and planning play a pivotal role in staying ahead of the pack and increasing market share. Lower tariffs, frequent flier bonus points, attractive advertising and a lower end no-frills product tend to attract the price sensitive market that makes up an important part of the market fare and capacity of an aircraft on a selected route. (Gailloretto, L. 1988, p190)
A wide range of discounts is offered by full service carriers in most truly competitive market as well as those under a more rigidly regulated environment. The fares offered by full service airlines as part of a discount of a fully flexible fare will generally be part of limited period promotions. Alternatively the price structures offered by low fare carriers involve departure specific peak and off peak pricing where the fare increases or decreases with the time of the day. Few requirements or external restrictions are imposed on passengers such as a mandatory Saturday night stop over in certain ports or return bookings.
A particularly radical response by a few major airlines has been to introduce a low cost carrier brand to compete on price with the low-cost carriers that attract their price sensitive end of the market. This enables the parent operator to not have to compete on price but services, either by enhanced in-flight service levels, relaxation of ticket conditions and boosting customer loyalty programs for its already existing full service carrier. These do not necessarily impress the price elastic segments, but may have an impact further up the yield structure. (Holloway, S. 2003, p168)
Key examples of where Low Cost Carriers (LCC) competes with each other can be seen within Australia with Qantas subsidiary LCC Jetstar. Jetstar’s main rival in the Australia market is Virgin Blue which has 50 aircraft and the local market presence of Air Asia and its fleet of 70 aircraft. However, there also exist other smaller airlines that are trying to compete on secondary routes such as Tiger Airways. Tiger and its fleet of 5 aircraft is looking to expand to 8 in the near future by not competing with the bigger players and avoiding the highly competitive Sydney hub. The company is focusing mainly on Melbourne and Adelaide hubs to service destinations in Queensland, Tasmania, Perth, Darwin and Alice Springs.
Jetstar CEO Bruce Buchanan comments that LCC’s trying to compete in routes where they are the only existing carrier such as Tiger pose little threat, likewise Virgin’s complicated fare structure of “add-ons” such as baggage, excess baggage, meals and drinks losses appeal with some customers who prefer just to worry about the fare price rather than will they be hungry or actually only have carry on baggage only for that flight etc. (Thomas, G. October 3, 2008, p34)
Despite a return to normalised oil prices of the last two months, recessionary fears have created ideal conditions for LCC to grow and expand as business and consumers become more price sensitive. However, those carriers may find credit or finance harder to obtain and only true low cost carriers that have low costs should find robust opportunities rather than those competing on price alone which may see doors close if not mindful of their balance sheet. (Sadubin, D. October 3, 2008, p35)
It necessarily follows that those competing in the LCC market see some tactics being employed by full service carriers in various sectors of their cabin make up. Premium economy, business and first class facilities offered either at the terminal or on board such as bars, snack bars, in-flight entertainment are offset by advances in engine technology and weight reductions of aircraft all up weight.
Importantly airlines need to recognise the break even load factor as a picture of airline health for its base case finance model. The break even load factor is the point at which costs and revenues are equal. This is calculated by the level of expenses associated from direct and indirect operating costs compared to the total operating revenue for a given period. The break even load factor is then the first step in assessing the cost structure for airline pricing.


Yield
Having discussed the drivers of price, it should be considered that the yield is the real ability on which operating performance should be judged. Yield being the price per distance-weighted unit sold known as either Revenue Passenger Kilometre (RPK) or Revenue Tonne Kilometre (RTK)
Yield can be calculated across the entire spectrum of an airlines operations and network or can be concentrated on particular products for comparison i.e. business to first class yield system wide. Because yield is an average of revenue earned per unit of output sold, different airlines will have structures which reflect the different sources of their revenue for the different traffic and class mix. High yield passengers will often incur higher related expenditures generally due to space requirements than low yield passengers. These high yield passengers often compensate for themselves by paying higher fares, but during times of recession high yield traffic can often be dramatically reduced to airlines which can offer a similar product at a reduced price per unit. Alternatively low yield traffic offers unseen benefits such as traffic density on high traffic routes, this has a net effect of the airline being able to utilise larger aircraft, and this inturn lowers the trip cost due to larger aircraft generally running at lower total costs than smaller aircraft. Low yield traffic on high density routes also offers the benefits of a lower Available Seat Kilometre costs (ASK) that can be spread out over the network. (Holloway, S. 2003, p172)
Management’s biggest issue is capacity management. Overcapacity, spillage and spoilage will erode an airlines bottom line or result in revenue loss where seasonal demand is turned away.
Overcapacity exists when airlines have more available seats or aircraft on selected routes than demand. Often a result of poor aircraft selection or fleet management, this situation soon erodes an airlines bottom line.
Spoilage is a concept whereby the airline has seats fully booked but due to late cancellations or no-shows the flight leaves with available seats despite demand.
Alternatively spillage is when due to seasonal demand exceeds airline capacity and revenue is turned away to other airlines due to lack of capacity. Airlines competing in such destinations will often entice customers to travel at off-peak seasonal times with fare reductions or other offers so that the passenger distribution throughout the year is more even and lost revenue to other airlines is minimised.
Managing demand or traffic and output produced measured with output sold RTK and supply ASK are linked by load factor which is the percentage of output produced that has been sold. One way management attempt to accommodate rising demand is to accept a rising load factor. A high load factor however may eventually lead to “spillage” and in turn lost revenue either to a competitor, other scheduled services with-in that airline at a different time or alternative transport means based on service, price and customer expectations. (Holloway, S. 2003, p112)
Therefore it is an airlines passenger fare and rate structure combined with its traffic mix that drives system yield. Likewise a thorough understanding of competitors yield structures is critically important as mangers often have to make decisions based on imperfect forecasting data for their own business models.

Revenue Management
Revenue management is the practice of controlling the availability of seats for sale at different fares and subject to different conditions with the explicit purpose of maximising revenue. Revenue maximisation in the short term leads to end of year profits and shareholder returns in the medium term and therefore contributes to other long-term benefits such as finance availability and market perception for longevity.
An airlines operating performance is the result of not one factor alone, but a complex series of interactions between output decisions (ASK produced), costs arising from those decisions (unit cost per ASK), the volume of output that has been sold (RTK) and the yield earned from the output sold (revenue per RTK). Having scheduled a given level of output on each particular flight, direct and indirect costs can be averaged out over time and a tariff structure can be produced to determine the revenue for each flight leg. (Holloway, S. 2003, p521)
What differentiates an airline to most other industries even amongst other transport codes is “perishability’. Once a seat is produced or turned around on each leg it can not be sold more than once, and if not used it still incurs the cost of production. If a seat is not sold on a particular flight, then the rest of the passenger or occupied seats profit is eroded and is an immediate and irrecoverable loss. The degree or amount perishability that an airline may be exposed to is directly attributed to the socio-economic make-up of the target market, other competing airlines product ranges, pricing strategies and the size of the market. As airlines provide intermediary goods i.e. the decision to purchase a first class ticket is not due to a passenger wanting to fly first class as much as it is about getting from point A to point B (the objective) followed by the level of service. Therefore the decision to buy a seat on an airline is firstly driven by the need to travel and then price. (Hutcheson, S. 1996, p172)
Management need to firstly create demand via a fare structure which is consistent with the airlines marketing position and traffic mix. Price elasticity and time preference are ways in which airlines can control revenue management via booking classes and seat inventory control. The objective is to sell the right seat at the right time at the right price. The purpose of this is to get the right mix of revenue maximisation so that not too many low-yield fares are sold too early which thereby could sacrifice higher yield sales for bookings closer to departure. This practice on high volume routes would see airlines loose revenue due to spill. Alternatively rejecting low yield fares may tend to see aircraft depart with excess capacity at departure time.
In short an airline can not know every potential passengers maximum price they are willing to pay for a fare. Therefore a the price paid for low yield fares on the price inelastic markets combin3ed with those of the high yield price elastic markets must be mixed to ensure that the right amount of demand is created, spillage is avoided and high load factors resulting in increased revenue is achieved and the airline remain profitable. (Holloway, S. 2003, p535)
Revenue management is therefore the practice of charging different fares to different people in the same cabin.