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An introduction to revenue management: exploring common techniques and the CPA's role.

Accountants are generally familiar with the ideas and techniques of cost management, but they are much less familiar with those of its logical counterpart, revenue management. Although this has been an active field of management practice for more than 25 years, it is seldom mentioned in the accounting literature. It is important to CPAs and the businesses they work for, because successful revenue management can increase revenues and profits. Moreover, CPAs have an important role to play in bringing financial analysis to bear on revenue management decisions.

What Is Revenue Management?

Revenue management is the selective use of pricing and other techniques to influence customer demand for a company's products and services in order to increase both total revenues and profits. Pricing and other revenue management techniques might initially appear to be primarily marketing decisions (to increase sales), but they are also important financial decisions because they focus on profits. Pricing strategies impact revenue generation and growth--and, ultimately, profitability. Accounting professionals have much to contribute in crafting and analyzing revenue management techniques.

Although revenue management is less familiar than cost management, it is no less important in managing an organization. The first step in improving profitability is generally to cut costs. But there are limits to this approach; at some point, excessive cost cutting adversely impacts customer service, employee morale, and prospects for future growth. A focus on revenue growth, on the other hand, might have a greater upside and greater prospects of sustainability. CPAs have an important role to play in analyzing revenue management strategies and balancing the use of revenue growth with the use of cost reduction.

The Origins of Revenue Management

Revenue management is usually considered to have originated in the airline industry, specifically American Airlines. In 1985, some of the first low-cost airlines, such as People Express, entered the market, featuring low fares and constituting a competitive threat to the established carriers that dominated air transport. American Airlines developed strategies to match these fares on a very selective basis (matching routes and times only), while preserving as much of its full-fare business as possible. Many customers preferred to fly on well-known carriers, rather than the relatively new and untested ones, thus opting for American's matching fares. This effort was successful, and these upstart airlines soon disappeared. But the pricing techniques survived because the airlines saw them as a way to build revenue by selling seats otherwise expected to be empty at a discount. Consequently, revenue management--formerly known as yield management--was born.

An airline seat was a type of perishable inventory--that is, once a flight departed, an empty seat could never be sold. The costs of an airline flight are nearly all fixed; thus anything gained by selling a seat that would otherwise be empty would be mostly profit. The challenge was to preserve the airline's normal full-price business, while gaining extra revenue by offering discounted prices to relatively few, discretionary travelers. "Building fences" around the lower rates restricted access to them. These rate fences imposed conditions on the lower fares, such as advance-purchase requirements, noncancelable and nonrefundable terms, and Saturday night stay-over requirements. These conditions were presumed to be unappealing to business travelers, whom airlines viewed as their main revenue source. Attracting some leisure fliers who would accept these conditions in return for lower prices was viewed as a viable way of selling what would otherwise be unused, perishable capacity. Moreover, because a flight's costs are substantially all fixed, some discounted passengers could be accommodated at virtually no added cost; this was seen as a profit-boosting strategy.

Other businesses that, like airlines, were characterized by heavy fixed costs, perishable service capacity, and some ability to forecast demand soon adopted comparable techniques. Revenue management expanded to hotels, restaurants, golf courses, cruise lines, car rental agencies, air cargo carriers, theaters, concert halls, and other businesses. The automobile industry also became a user of revenue management techniques, featuring rebates, low-cost financing, and similar inducements to build revenue and to sell its somewhat perishable (i.e., model-year) inventories.

Lessons from Early Application

Two industries that were early users of revenue management--airlines and automobile manufacturers--have had major profitability problems. Although this might seem to be an indictment of the usefulness of revenue management, it is not. Both industries lost sight of a key part of the definition of revenue management, which is to selectively use differential pricing and similar techniques. The airlines' rate fences gradually fell, and the growing ease of Internet price searching made it hard to restrict customers' access to lower fares. In the automobile industry, price concessions became the norm; one month's special offers might end, but consumers knew that new offers would come soon. Once an industry trains its customers to always expect low prices, it has a problem.

Revenue management techniques can build both revenues and profits, but if low prices become the norm, then profits, and perhaps even revenues, are likely to fall. How can today's businesses utilize revenue management for their benefit?

Evaluating Common Techniques

Several pricing techniques designed to increase total revenues are commonly used. The following sections discuss some considerations in evaluating these techniques.

Discounting. A temporary reduction in price, discounting is perhaps the most common pricing technique used to build revenue. Discounting is distinct from markdowns; the former implies that the price will return to normal levels after the discount period ends, whereas the latter implies that the price is permanently reduced until the merchandise has been sold.

The key to successful discounting is infrequency. When discounts occur too often, customers learn to wait for the next sale. Many kinds of businesses (e.g., auto dealers, furniture stores, mattress stores) seem to always have a sale going on; for them, the discount price becomes the normal price. Many years ago, Sears noticed that its appliance business was strong during sales but weak at other times. It attempted to change its pricing strategy to "everyday low prices," but this was unsuccessful. It had trained its customers too well in expecting that the next sale was not far away, and that they should wait for lower prices if they could. More recently, JCPenney also tried an everyday low-price strategy, but found it necessary to bring back sale pricing.

Currently, many discounts are circulated via social media websites, where one can purchase coupons for discounted goods and services, often at half price. Restaurants have been major players in this form of revenue management. Again, the message to customers is that a discount can always be found, and there is no need to pay full price. Discounts that are limited to use within a short time period have been especially troublesome because they often create an overflow of short-term demand that the business might be unable to service in its customary way, resulting in less-satisfied customers. Such practices might reduce revenue in the long term, rather than build it. An analysis of discounting should consider whether new customers are gained or whether the benefits go to existing customers who would have otherwise paid the normal price. If new customers are attracted by the discount, do they return as full-price customers in the future? If there is no sustainable increase in the customer base, it is likely that discounting, especially when offered frequently, is unprofitable.

Customer reward programs. These programs constitute a form of deferred discounting. Rather than getting an immediate price reduction, customers earn credits toward some future benefit, such as free goods and services, a cash refund, or other merchandise rewards. Not only do reward programs defer the discount; many rewards are never redeemed. From a customer's viewpoint, an infrequent but somewhat large reward may be preferable to regular but small price reductions. For example, when a credit card offers 1% back on purchases, a periodic check for the accumulated reward may be more appealing to customers than a 1% discount on each purchase would be. Similarly, an occasional free flight or free hotel stay might be more appealing than a small discount on each purchase. Furthermore, such programs are thought to promote continuing patronage.

Add-on fees. Adding extra fees to a base price enhances revenue, though it often leads to customer dissatisfaction. Airlines have trained their customers to expect low fares. Facing the resulting competitive difficulty of raising base fares, airlines have turned to a growing variety of add-on fees. Initially, these fees applied to basic services such as checked luggage, on-board food and drink, and ticket changes. Although they tended to generate customer ill will, most of the industry adopted them, and there was little effect on competition. More recently, airlines have initiated extra fees for value-added services, such as early boarding, preferred seating (e.g., aisles, exit rows), and extra leg room These fees have been better received because they allow the customer to choose something above and beyond the average experience.

Banks have also increased their use of add-on fees, as government regulation has limited some of their previous ability to use revenue management. Although customers have little choice when added fees are industry-wide, price reductions (discounts) are always better received by customers than extra charges.

Overbooking. Overbooking attempts to increase total revenue by promising more than the business can deliver, hoping that not all potential customers will take advantage. Airlines and hotels have been best known for this practice, but the concept can apply more broadly. A retailer that advertises a low price but has insufficient stock to meet demand, or a contractor who promises completion dates that are unlikely to be met, is practicing a type of overbooking. Although this strategy is designed to maximize short-term revenues, the cost of satisfying unfulfilled customers might exceed the benefits of the added revenue. An analysis of the cost of overbooking involves not just the accommodation to affected customers, but the loss of customer goodwill and potential future business.

Unlimited-use pricing. Unlimited-use pricing, sometimes called "all-you-can-eat" pricing, entails charging a fixed price for unlimited consumption within a period of time. Buffet-style restaurants; telephone, cable, and Internet providers; and amusement parks often practice this form of revenue management. Many theme parks, for example, charge a single admission fee that grants unlimited access to all its attractions during the day. This simplifies monitoring and billing for usage, and it attracts customers with a guaranteed price that is independent of utilization. If the distribution of demand can be reasonably well estimated so that a profitable price is set, this can be a useful strategy. In recent years, some Internet service and mobile phone providers have had to limit utilization for those customers who used increasing amounts of service for capacity-heavy applications, such as movie downloads.

Bundling and unbundling. A longstanding question in revenue management is whether to offer goods and services separately or in a package. Bundled goods and services are usually priced below the separate prices of the combined components. This is a form of discounting, but one that is contingent upon a customer buying the entire package. As such, it has reasonably good prospects for profitably enhancing total revenue, without the behavioral effects of standard discounting.

But customers sometimes resist having to buy things they don't want. One example is cable television service, which typically includes a large number of channels for a given rate. Some customers have argued for a la carte pricing and the ability to design their own package. Cable operators have resisted this for various reasons, including the added technical difficulty of giving different access to each customer, the likely decline in overall revenue, and the likely requirement of prohibitively high rates for little-watched channels. Some of the bundling occurs upstream, where content providers require cable operators to purchase a package of channels. Bundling is a way of cross-subsidizing less-popular channels.

Airlines are a classic example of using unbundling to increase revenue. Most airlines have moved from a single price for all services to extra charges for services such as reservation changes, early boarding, preferred seating, checked luggage, onboard meals and snacks, and personal comfort items (e.g., pillows, blankets, headphones). Just as many customers dislike having to buy bundled services, excessive unbundling has also been unpopular; however, as noted earlier, some value-added fees have been better received when priced separately.

"Free" goods and services. This has become a growing feature of revenue management. Though counterintuitive, providing something for free might actually stimulate revenue generation. Free information abounds on the Internet As has long been the case for radio and television broadcasters, third parties (i.e., advertisers) often support these free services.

Other forms of "free" can be part of a revenue management program. A company could provide something free with the expectation of earning revenue when the customer purchases other goods and services. For example, banks offer free credit cards, retailers offer coupons for a free item, and eating and drinking establishments offer free entertainment. Another technique is to offer a basic version of a product or service for free, with charges for upgrades. This approach, known as a "freemium," is often found in software, such as tax preparation, e-mail, and games. The freemium model has seen considerable success in recent years, as the initial free product serves to introduce it to the customer, who is then more likely to continue its use and to upgrade beyond the basic version.

Thus, "free" is a common revenue management tool for many companies. If the cost to provide the free element is modest, the potential revenue gains may be worthwhile.

Emerging Applications

New business models to generate revenue continue to emerge. A recent trend toward a "sharing economy" has expanded the opportunities for revenue from short-term rentals. Car rental by the hour is now found in areas where many people who do not own cars are concentrated, such as large cities or university campuses. Items such as fine art that were previously purchased are now available for rent. Even professional services are offered on short-term basis, such as a personal chef to prepare a single meal in one's home. Participation in the sharing economy is not limited to business entities. Individuals have become players as well, offering temporary use of space in their residences, power tools, automobiles, and the like, creating a changed competitive environment. Studies have noted a recent trend away from home buying in favor of renting, as well as a decline in car ownership. These trends might have important revenue implications for certain businesses.

Another emerging business model is the use of a mobile location, exemplified by the growing popularity of food trucks. This offers potential application to professional services and other personal service businesses. For some businesses, adopting mobile locations can be a revenue opportunity.

CPAs need to remain alert to such emerging business trends, which affect both revenue opportunities and threats for their clients.

Marginal Analysis and Its Limitations

Marginal analysis has long been a mainstay of managerial accounting theory and practice. Marginal analysis suggests that if the added revenue from a decision exceeds the added cost, the decision is desirable and profits should rise. Classic short-term decision problems, such as special orders, make-or-buy, and add-or-drop, are typically presented as applications of marginal analysis.

Early uses of revenue management were based on marginal analysis. Initial applications involved cases of perishable service capacity in a business where most costs were fixed, at least in the short term. Because variable costs were small in these applications, almost any action that increased revenue was considered beneficial.

Marginal analysis of revenue management decisions assumes that a large base of regular-price business exists and can be maintained, and that a few customers can be profitably added at lower prices to fill excess capacity. The earliest airline applications, seeking to attract additional leisure fliers while building rate fences around regular business passengers, sought to maintain that base of regular-price business. But history has shown that this strategy is usually unsuccessful; in the case of the airlines, the rate fences were ineffective or discontinued, and price discounting expanded to formerly full-price customers. Once this occurs, one can no longer ignore fixed costs.

Marginal analysis works only at the margin. Adding a few customers at reduced prices might not interfere with regular business, but the impact on profits will be small. When selective price reductions become widespread, the regular-price business is impaired, and the company can end up worse off. The key to profitable revenue management is that price concessions are infrequent and targeted at those who are not regular customers. Such conditions are hard to sustain.

Beyond Marginal Analysis

History has shown that marginal analysis alone is inadequate for a comprehensive evaluation of revenue management decisions. Rather than a single technique, a broader process of analysis is needed. The following considerations might be relevant when analyzing discounting or other price concessions as a means to increase total revenue:

* Is the business currently profitable? If not, there is insufficient volume and profit margin to cover fixed costs. Can price reductions increase volume enough, at a lower contribution margin, to make the business profitable on a long-term basis?

* If the business is currently profitable, would price reductions gain new customers or would they be primarily used by current customers (likely reducing revenues and profits)?

* If new customers are attracted, will they continue to patronize the business, or are they deal-seekers who will not return after one purchase?

* How will current customers react to special pricing offered only to new customers?

* If revenue management techniques are used frequently, will the business be training its customers to always expect lower prices or to wait for a frequently occurring sale?

* Can the company handle an increased influx of business? This has become an issue with many of the daily coupon deals promoted via social media. A big spike in demand sometimes resulted in sub-par service, making a poor impression on both new and continuing customers.

* If reduced pricing increasingly becomes the norm throughout the industry, can the business remain profitable?

Analysis of revenue management decisions also depends upon identifying the goal of employing revenue management techniques. Is the goal to increase sales to existing customers, improve retention of existing customers, gain new customers, or expand into new markets (e.g., geographical, customer segments, new products and services)?

The Relevance of Opportunity Cost

Opportunity cost is the profit forgone by making one particular decision rather than an alternative decision. A sale at a discounted price has a positive opportunity cost if the sale could otherwise have been made at a higher price, but zero opportunity cost if the sale would otherwise not have occurred at all.

Many applications of revenue management involve rapidly perishable service capacity characterized by high fixed costs and low variable costs. In such contexts, opportunity costs have often been treated as zero, in part because the time for other customers to materialize is short. But the opportunity cost is not zero if a large volume of discounted sales leads to the rejection of higher-priced business, or if customers usually willing to pay full price learn that they can secure a lower price with a little effort. When the long-term effects of price discounting are considered, opportunity costs might indeed prove to be significant.

Overbooking is sometimes used (especially by airlines and hotels) as a strategy to reduce opportunity cost. Although overbooking reduces the opportunity cost of unsold capacity, it substitutes a new opportunity cost (satisfying the displaced customer). When rapid perishability of service capacity is not present, opportunity cost is more likely to be positive, but a time dimension becomes a factor: is it better to sell now for a lower price, or sometime in the future for a higher price? Although opportunity costs are difficult to quantify, an analysis of the likely opportunity cost effect should accompany revenue management decisions.

Customer Reactions

An analysis of revenue management decisions is incomplete without consideration of likely customer reactions. Because most revenue management involves varying selling prices across customers or time, customer response will impact the long-term success of these decisions. Developing a sustainable, profitable customer base is more likely when customers perceive their suppliers as fair and trustworthy.

Fairness in pricing implies that the seller is not taking undue advantage of the buyer. As an extreme example, raising the price of air conditioners during a heat wave would likely be perceived as unfair by customers; the seller's costs have not changed, but the seller is exploiting a short-term buyer need. Customers usually perceive surcharges or add-on fees as less fair than discounts, even though the price differential in either case may be the same. Customers often judge fairness in comparison to what they expect to pay, which might be based on advertised prices, historical prices, competitors' prices, or other reference points.

Customer trust is a perception that the supplier has customers' interests at heart. Trust is enhanced when the basis for price differences is clear, when existing customers are not charged higher prices than new customers, and when the supplier offers customers an opportunity to save money by qualifying for lower prices.

Price differentiation among customers-the essence of most revenue management--entails many challenges for customer trust and perceptions of fairness. Some differentials are widely accepted, such as discounts potentially available to anyone willing to meet the conditions, such as early-bird dinner specials or discounts for holders of loyalty cards (available to anyone who signs up). Trust and fairness are also enhanced when pricing is trans parent and easy to understand, rather than complex and hidden, such as charges for medical services to private-pay versus insured patients.

Revenue management needs a long-term focus. The customer response to today's revenue management decisions will have either a positive or negative impact on future revenue generation; thus, every revenue management analysis needs to consider the customer's reaction.

The Role of the CPA

As previously mentioned, successful revenue management increases both revenues and profits; consequently, revenue management decisions are important financial decisions. With many techniques available to manage revenues, an analysis of their effects is essential. But this is not easy, because there is often a question of opportunity cost. What would have happened otherwise? Is the company better off than it would have been? Although these questions are difficult to answer, an imperfect analysis is better than no analysis.

Many consulting firms have arisen to offer revenue management services. Some specialize in a particular industry, such as hotels, whereas others are more broad-based. As these services are increasingly promoted, CPAs have a role to play in analyzing their merits for their clients and employers. Even if revenues are increased in the short term, will these added revenues be profitable? And what will be the long-term effects? Is the business likely to gain new customers? Will the business be gradually training its customers to routinely expect price concessions? Is a greater volume of business at lower prices and contribution margins a path to sustainable profitability?

Questions such as these are not easy to answer, and they require an astute analysis that needs to be more than a consideration of marginal revenue versus marginal cost. Developing a familiarity with revenue management techniques and an expertise in their analysis can be a value-added service for CPAs.

Ronald J. Huefner, CPA, CMA, PhD, is SUNY Distinguished Teaching Professor Emeritus at the State University of New York at Buffalo. He is also a member of The CPA Journal Editorial Board.
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Title Annotation:In Focus; certified public accountant
Author:Huefner, Ronald J.
Publication:The CPA Journal
Geographic Code:1USA
Date:Jun 1, 2014
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