White Paper

A Revenue Managers Guide to

Understanding Price Optimization
By Alex Dietz, Advisory Product Manager, IDeaS Executive Product Management

Revenue management has evolved into a very different science from what it was when airlines
first started using it in the mid-1970s. Today, revenue optimization is common throughout travel
and hospitality sub-industries including cruise lines, rental cars, hotels, ferries and passenger
railways. As the practice has expanded, the science behind revenue management has been
influenced by trends that invalidate important assumptions that were built into the original
models.

As analytic approaches to pricing have evolved, IDeaS Revenue Solutions and SAS often
hear the question: How is price optimization different from revenue management? Its a
simple question that has become increasingly difficult to answer largely due to the evolution
of revenue management practices and the definition of revenue management. As this paper
explains, the question itself reflects a mindset based on historical business practices.

Todays travel and hospitality marketplace encompasses aspects of both revenue management
and price optimization. To give customers the best possible results, it is recommended that
hotels take an analytical approach that takes into account both revenue management and
price optimization techniques.
 A Revenue Managers Guide to Understanding Price Optimization
What is Revenue Management?
To truly understand revenue management, its
important to start with todays definition and
review how it has changed over time. Wikipedia
defines revenue management as the application
of disciplined analytics that predict consumer
behavior at the micro-market level and optimize
product availability and price to maximize revenue
growth. This definition is very broad, but probably
well in line with the thinking of most travel revenue
managers and executives. Practitioners and industry
experts alike think of revenue management not as a
science but as a wide set of business practices with a
common goal. By this definition, price optimization is
no different from revenue management, and might
be better described as a specific methodology for
applying revenue management.
To get a better understanding of how price
optimization evolved from being a separate
discipline into being a tool in the
management toolbox, we need to
the development of revenue management
as a science.
What is Revenue Management
Science?
The application of mathematical
specifically to travel pricing - can be traced to
the mid-1970s. Before then, the use of analytics in
travel sales was limited to approaches surrounding
overbooking. But in the mid-70s after deregulation
of the US airline industry a number of airlines
introduced discounted fares that were sold into the
same compartment as the already-available full
fares. These new discounted fares generally required
significant advance purchase: 21 days.
The new discounts allowed the airlines to fill seats
that would have otherwise gone unused on low-
demand flights. But as a result, the airlines needed
a method to control the number of reservations
taken on these reduced fares when demand for
late-booking, full-fare passengers was expected
and when total demand from both discounted and
full fares would exceed capacity. Managing these
sales required airline systems inventory control
capabilities to evolve so that analysts could control
the number of discounted sales on a day-by-day
and flight-by-flight basis.
Next, the airlines formed yield management
groups. The yield managers role was to maximize
revenue on each flight by predicting the sale of
full-fare reservations and controlling the number
of discounted seats sold accordingly. The amount
of space to reserve for these future reservations
was (and still is) referred to as protection. As the
industry evolved this practice, airlines developed
increasingly complex fences (restrictions placed
on discounted fares) to distinguish these fares from
full fares (and each other.) The fences reduced
dilution (reduced revenue caused by a customer
purchasing a discounted fare that was not intended
for his market segment.) Airlines enhanced their
selling systems to enforce these restrictions as they
were developed and adapted.
Examples of fences include:
4 Advance reservations
4 Non-refundable fares
4 Minimum length of stay (including the infamous
revenue
explore Saturday night stay requirement)
4 Maximum length of stay
4 Day-of-week applicability
As this business process evolved, mathematicians
began to model the problem based on the manner
in which the business was being run at that time
models - (ca.1985.) Their goal was to find the mathematically
optimal protection levels that would maximize
revenue. The business had evolved to the point
where multiple protections would need to be
calculated for any given flight departure because
there were now many different discounted fares
available, each with a different value and customer
target segment. In effect, the mathematical
problem involved determining the maximum
number of each of these different discounted
products that should be sold to maximize revenue.
The early systems developed for this purpose were
known as yield management systems, and they
mark the beginning of revenue management as a
science.
The most involved yield management systems
attempted to account for complexity due to
the network effect: specifically, the problem of
forecasting demand for a specific segment (or
leg) of an itinerary, when many different kinds of
itineraries (all with different values to the airline) also
 A Revenue Managers Guide to Understanding Price Optimization

flowed over it. The question was critical to growing hub-and-spoke carriers where significant percentages of
passenger itineraries included a stop at the carriers hub.

What Has Changed?

The original formulations for revenue management science were based on how the airlines ran their
businesses. Fenced fare structures were critical components of this business model, because they clearly
separated different customer groups with distinctly different values. And, although these fences differed
across disparate customer groups, a key modeling assumption was that these different values were relatively
stable over time. (This assumption arose in part because of the fairly small computing power of older systems
compared to todays systems.) This assumption of stability allowed yield management systems to assume a
level of independence between customer groups.

For example, the systems assumed that a customer for a 21-day, non-refundable advance purchase (AP)
fare with a Saturday night stay requirement would not purchase a full fare if the 21-day AP fare was sold out
and that (similarly) a full-fare customer had no interest in that 21-day AP fare if it was available. In effect,
this assumption meant that each different fare type could be treated as a separate product which serviced
a separate market of customers, and which happened to utilize the same inventory unit (the airline seat) in
doing so.

What is Revenue Management & How did it Evolve?

Figure 1: How did revenue management get to where it is today?

Three important trends have emerged since these original methodologies were developed:

4 Low-cost airlines introduced simplified fare structures with fewer fares and significantly reduced fencing.
Today, these simplified fare structures dominate most air travel markets effectively invalidating the
assumption of demand independence made in revenue management models.

4 Revenue management has been introduced into markets where strict fences on rates or fares never
existed. Hotels, rental cars, cruise lines and others have rate or fare structures that do not contain strict
fences so the assumption of demand independence is again problematic.

4 Rates and fares in these simplified structures have become increasingly dynamic. Revenue managers now
frequently manage the price at which rates and fares are sold on a day-to-day basis.
 A Revenue Managers Guide to Understanding Price Optimization
These trends have taken travel and hospitality
practices far afield from the expectations of the
original revenue management scientists who
modeled the airline revenue management problem.
Of course, revenue management scientists have
tried to overcome the underlying limitations in
the original construct of the problem generally,
they have done this by introducing changes to
forecasting and optimization approaches that
allow for some measure of interdependence of
demand for different fares or rates. Consequently,
we see common references to sell up or buy
down probabilities associated with forecasting and
optimization in such systems.
There are also other business elements generally
required for the application of this original revenue
management approach:
4 Fixed available capacity capacity cannot be
increased to accommodate surplus demand.
4 Product perishability the product loses its value
to a customer after some point in time and
cannot be sold thereafter.
4 Advance reservations advance reservations are
accepted for the product.
These underlying assumptions continue to be valid
for travel companies, so they have not caused the
same types of concerns as the other trends.
Price Optimization
Price optimization approaches were developed to
suit industries whose characteristics dont match that
of the original revenue management approaches.
In these businesses, products are made available at
a single price to a broad market of customers. In this
broad market, each customer has a different ability
or willingness to pay, and the business can change
the products price over time. If the price is raised, it
begins to exceed the price that most customers are
willing to pay so demand decreases. If the price is
lowered, more customers are willing to pay for it
so demand increases. This is simple microeconomic
theory.
Using a price optimization approach, product
demand is estimated as a function of price. So the
price becomes the decision variable rather than
the protection value that is used in maximizing
revenues or margin. In businesses that use price
optimization, such as retail, there are no advance
reservations or separation by segment, so theres
no one to protect sales for. In addition, inventory
may not be constrained so theres no reason to
protect inventory, either. Since the market is not be
segmented by price, the question becomes what
is the optimal price to charge the overall market
to maximize return, accounting for the fact that
demand will change as the price changes?
Decision support solutions that utilize price
optimization approaches must estimate demand
and its sensitivity to price (i.e., price elasticity) for a
variety of products, from a variety of channels, and
anticipate how both demand and price sensitivity will
change over time. The calculation of price sensitivity
on a large-scale, automated basis introduces new
technical challenges that these solutions have had
to overcome much research has been invested in
this area over the last decade or so.
Revenue Management in the Future
The trends that have taken hold following the initial
development of revenue management methods
have undermined traditional revenue management
science, because they invalidate important
assumptions built into the models.
Consider the example of a roadside hotel. This
business meets the primary conditions of revenue
management (fixed capacity, perishable product
and advance reservations); but it probably does not
have clearly fenced segments. Rather, this business
chooses one of several possible rates to charge
on any given date, and that generally available
rate services the vast majority of its customers.
Once again, there is no independence of demand
between these rates they all have the same set of
characteristics, so the hotel guest will always select
the least expensive one.
These types of priceable products represent a
significant portion of todays travel and hospitality
market. Most travel and hospitality firms have such
a product, and for many of them, it is a significant
portion of their business. For priceable products, a
price optimization approach seems to be a good
fit for the business problem. Because with this
approach the selection of an optimal price is the
 A Revenue Managers Guide to Understanding Price Optimization

primary output of the model, and price elasticity is
directly modeled.
In the hospitality industry (including hotels and cruise
lines), priceable products make up a significant
portion of the market but not all products are
priceable. Many customers purchase rates and
fares that are controlled not through price, but
through availability. For example, many promotions
are managed this way, and some segments can be
both priced and managed via availability.
These changes cause much of the confusion
surrounding revenue management and
optimization approaches. In fact, todays travel
and hospitality marketplace has aspects of both
revenue management and price optimization
problems. Hybrid analytic approaches combining
aspects of both revenue management and price
optimization approaches are the best solution for
todays marketplace. The hybrid approach also
allows for market changes that will continue to take
place over time.
in the availability of yieldable products influences
decisions regarding the amount to charge for
priceable rates and fares. Revenue management
and price optimization the two must work together.
Conclusion
The major advantage of our hybrid approach is
that it models the problem as it exists and does
not require significant business shifts or related
technology changes to maximize revenues.
Optimizing yieldable and priceable products
together enables companies to develop pricing
price and inventory approaches that suit the needs
of their market, but are still supported by high-
performance analytical modeling. The approach
also offers flexibility in supporting new sales and
marketing approaches in the future.
Other hybrid approaches tackle pricing and yielding
as separate decisions first calculating optimal
protection levels, and then separately calculating
optimal pricing using the protections output from
the first step as input to that decision. At IDeaS,

How IDeaS & SAS are Different
SAS has developed modeling approaches that
allow for optimization of both priceable and
yieldable rates that are used in the IDeaS RMS
solution. These models can forecast demand for
both price-elastic, priceable fares, as well as those
that cannot be priced. Our optimization approach
calculates both optimal price (for priceable fares)
and optimal protection levels (for fares or rates that
must be managed via availability.)
Finally, and perhaps most importantly,
optimization approach treats pricing and availability
decisions as one integrated problem and makes
calculations accordingly. After all, changes in
price can affect demand, which affects optimal
protection for yieldable products. Similarly, changes
we have found that this approach of arbitrarily
breaking the problem into multiple steps results in
suboptimal results. And there are revenue benefits
to an approach that considers the entire business
model - resulting in superior revenue growth.
This is the future of revenue management and
price optimization: flexible, integrated models that
allow businesses to be modeled as they actually
exist. No more round pegs in square holes. No more
shoehorning our businesses into processes that
support analytics, or attempting to utilize analytics
our
that dont really fit our businesses. Let the analytics
come to the business.

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