Airline Economics – Revenue Management


Earlier we wrote a post about airline ticket prices. In this post we will take a look at the background of this airline pricing model, why it works like that and why it is a misunderstanding that the EU commissioner wants to crack down on airline websites for “unfair airline prices”.

The product

Let’s take a look at an example product, thus it will be easier to understand the theory. There is an airline that operates flights between Istanbul (IST) and Frankfurt (FRA). Its hub is Frankfurt, so it has connecting flights to the New York Kennedy Airport (JFK) US and Toronto (YYZ) Canada departing from Frankfurt. The core product we are going to talk about is the IST-FRA flight.

Costs and break even

As a profit oriented airline we would like to sell all our tickets and gain the highest revenue possible. Profitability means that the result of our operation is positive, so we have more income than cost on a certain product. So first we have to take a look at all our costs. It is not a simple process to calculate all the fixed (FC) and variable costs (VC) projected on a certain route, there are many airline who have never been able to do that, but without that it is impossible to calculate the profitability of a product. So let’s say that our total cost – FC+VC – in our case equals $50 per seat. So the break even is at $50 and if we would like to have a profit on the flight, we should sell seats for an average price that is higher than $50.

Customers

Now let’s take a look at the market. What do we know about the potential customers? We know that there are many-many Turkish people working and living in Germany. We know that their family often travels there to visit them. We also know that many of them go back to Turkey to open a business there, but they still keep on living in Germany. There is another segment: German businesses in Turkey, but also Istanbul is a fun leisure destination as well, with good weather and many things to see, so there will be Germans tourists travelling there. There are some Turkish families travelling to visit friends and family members also in the US and Canada.

Segmentation

The above mentioned types of passengers are our market segments. We have to examine them and find out more about their needs.

  • Family visitors will travel more around the holidays, so we can use higher prices then. They ususally stay more than a week, they have many baggages, they are sometimes elderly people not speaking langauges, so they might need some help around the airport.
  • Businessmen need higher level services, flexibility regarding refundability or changability of the ticket as their agenda might change during their journey.
  • Tourists will be price sensitive. They will easily choose Greece or Cyprus instead of Turkey if they cannot get cheap prices. They do not care about the flexibility of the fare rules.
  • People travelling onward to the US or Canada will buy tickets for the whole journey, so they will not care about the single price of an IST-FRA ticket.

Revenue and capacity management

So now comes the fun part. We have a plane we have to fill with people coming from our different  segments. We have to do it in a way to gain maximum profit possible from these people. For that we have to know how many people will potentially buy our tickets. We have historical data from previous years, so we have a forecast about that. And now have to start to play with the numbers.

The following picture shows a virtual plane with virtual capacity and virtual prices.

Virtual capacity of a flight

The orange numbers show an imagined price for a certain number of seats to be sold for our virtual flight. As you can see, we will sell more seats for a higher price than our $50 breakeven. If we are lucky enough and we can sell 100% of the seats, our flight will be profitable.

  • we will sell the lowest price tickets to tourists, but we will not allow then to refund or modify the ticket, this way we will make sure this income is there.
  • the middle range prices will be offered for family visitors and people travelling to JFK or YYZ. The higher middle prices like$99 or $120 will be applied in the case of passengers who would like to stay more than 2 weeks, they need flexibility on refunds and modification.
  • The highest price and a special service in the separate cabin classes will be used for business and first class travellers.

Of course real life always brings suprises and it might happen that we won’t be able to sell all the tickets. Therefore to keep revenue as high as possible, if we see that higher priced tickets are not selling, we simply close down the lower classes until we are sure, we will have enough income.

Summary

Naturally these are just the basics of revenue and capacity management and in real life there are many other circumstances to consider (e.g. competitors’ prices, seasinality of the travel industry, cultural or sport events, etc). But at least this short introduction gives you an insight why it is not easy to comply with the “Availability” rule of the EU as it is not just the lowest price that cannot be always available at an airline, it can be any of the classes that is closed and sold out.  Last week I saw a commercial abou a very cheap home beer tapping machine, so I thought it would be a nice Xmas gift to my brother, but by the time I called around all the shops, it was sold out. So shall I run to the EU commissioner about it?

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By Szafi
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3 Responses to “Airline Economics – Revenue Management”


  1. 1 caspar February 18, 2009 at 12:14 pm

    Well, what you describe is called price discrimination: Asking different prices from different groups of customers even if the marginal cost of each seat is the same. While this makes perfectly sense from an Airline’s point of view such pricing strategies can only be used if there is a lack of competition: Otherwise a competitor would offer a price somewhere above $50 to the guys you want to sell $200 tickets to.

    And a lack of competition is a reason for the EU commissioner to get involved.

  2. 2 balint01 February 18, 2009 at 3:05 pm

    Caspar, it’s not that straight forward. Even if there is competition, right before Christmas for example, the competitor’s plane will just as well be full and they will also charge $200 for their tickets – as they follow the same pricing logic. (This assumes that there is the right capactiy allocated to each routes, though.)
    It’s a simple market rule, if Airline A has a better service (schedule most importantly), people are willing to pay more to fly with them, so even when the $160 tickets are still available with Airline B, they will pay 200 to fly with Airline A.
    With the “Open Skies” in the EU, any other airline could fly any routes and enter the market if it looks monopolistic and another airline makes too much money. This is why low-cost airlines can still make money.

  3. 3 szafi February 18, 2009 at 9:01 pm

    Exactly. They can charge you $200 only if there is a demand for that price. Some airlines have routes that cannot make any profit at all, but their other routes might balance this loss.

    To be honest, this is nothing special. If you go to the bazaar, the old sales man will know by the way you look, how much money he can charge you for a golden ring. He knows how much you will spend in the end, so when you ask him, he might tell you a different price than another person, who arrives in a limo and who already wears a couple of golden jewellery. And if a poorer person will arrive in his shop, he will tell this guy to buy a golden-looking, but fake ring instead. This is exactly the same thing.


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