Using Yield Management Pricing To Optimize Profitability

Yield management pricing is a revenue management concept which dynamically balances consumer demand with available inventory. It was pioneered for hotel and airline pricing. The concepts can be applied much more broadly across a range of industries.

Key Elements of Yield Management Pricing

A yield management based variable pricing strategy generally requires three conditions to be present:

Supplies of the product or service in question are limited and fixed
The product or service opportunity is perishable; after a specific time limit, the remaining inventory cannot be used
Different customers are willing to pay different prices for similar inventory

Hospitality industry and airline pricing is an excellent example of this. There is a relatively small difference in the operating cost between operating a full airliner and a partially loaded one. A airline seat is a good example of a perishable good – it can’t be stored and used later; the value of the unused seat is lost forever. Willingness to pay varies by market segment: students, families, and business passengers.

A revenue manager in the airline industry will organize their inventory to offer different price points and terms of service. These are intended to take advantage of consumer behavior patterns. Family vacation buyers are willing to buy far in advance but are price sensitive and rarely change flights. Business travelers are price-insensitive but book at the last minute and often need to adjust their plans.

Consumers will start shopping for an airline ticket up to several months before the flight, peaking in the final several weeks. Fares are posted with distribution channel partners (digital, travel agencies). There is also a risk of cancellations or shifts to another flight. Since most customer groups are rate sensitive, ticket prices are key factor in their decisions.

There is also a risk of overbooking, if expected cancellations do not occur. In addition to a financial penalty, this also can damage your reputation with the traveler. This affects future pricing, since customers will need a greater incentive (lower rate) to travel with you vs. a competitor.

A yield manager looks at the rate at which their inventory is selling across the different groups and makes changes to optimize revenue per seat. Since this process plays out over a series of months, you need good demand forecasting process to make the right pricing decision. You need to be able to look at the first several weeks of bookings and use your forecasting tool to estimate the impact of changing your prices. You need to be able to look at a period of high demand and evaluate if it was due to price or market conditions.

The yield management pricing model is especially important when the business in question has high fixed costs per execution and low variable costs. Yield management aims to use an understanding of consumer behavior to maximize total revenue generated from the (perishable) resource or event. This is accomplished by reserving inventory for customers willing to pay the highest net prices and using insights into price elasticity and buying preferences to optimize the revenue from the balance of the customer base based on their willingness to pay. For an industry with high fixed costs, most of the incremental revenue will drop straight to the bottom line.

Yield Management For New Products

Another application of this pricing strategy can be seen with new products. These concepts can be applied very broadly, in examples ranging from toys to fashion to new technology gadgets. By setting the initial price of a product at a relatively high level, you extract incremental revenue from those members of the target audience who are most willing to pay a premium for the latest and greatest gadget. As market awareness of the product matures, you can drop the price to the range of a broader set of potential consumers. Finally, as you approach the “end of life” for that particular item, widespread discounting occurs to clear out the last pieces of your inventory.

Within the technology space, this is a way to take advantage of the classic S-curve of technology adoption. the early adopters are frequently willing to pay a premium for access to the features offered by the new innovation. The majority of the market steps in once prices drop to a more reasonable level. Finally, as the next wave of innovations hit the market, the relative value of the product will drop further and you will likely need to implement greater discounts to move the final qualities out of the channel.

These same ideas can be applied in the B2B space for innovations, particularly capital goods, that significantly affect the productivity of a business. Setting a high price early into the release of the product allows you to harvest incremental revenue from the buyers with the strongest need to the item. As the market moves to embrace the item, you can discount your prices to bring other buyers into the fold. This pricing approach also gives you this opportunity to better align demand with available capacity or target occupancy; your early efforts will be constrained by limited production time as you ramp up the available capacity. It also provided you with incremental revenue early in the launch cycle to offset higher initial production costs (before economies of experience take hold) and reduce your reliance on external funding (which can be dilutive to founder equity).

Which suggests that revenue management strategy has a very significant role to play in even early stage businesses.

Yield Management for Customer Experiences

The principles of yield management can be applied to optimize incremental profit generated from optional upgrades and contingent pricing elements such as usage fees and penalties. In each of these cases the consumer decision opportunity becomes the unit of constrained supply and you set your pricing to maximize the total yield for these products. Since many of these items tend to be almost pure incremental revenue, the impact of these efforts is similar to the cases above.

Yield Management for Lean Manufacturing

While manufacturing has traditionally not been viewed as a traditional target for yield management strategies, the logic of these strategies can be applied to businesses operated under lean manufacturing principles. If we look at available production time as the constrained resource and view long term inventory buildup as undesirable, we actually wind up complying with the conditions required for yield management pricing:

Supplied of the item are finite – met; there are finite number of hours available in a production period
Inventory is perishable – met; if we do not allow long term inventory, we must sell available production time before it becomes available
Different customers willing to pay different prices – met, at multiple levels. Different customers pay different prices and generally different items would be produced at different rates. There is ample opportunity to optimize volume if you’re operating a job shop with spot buyers.

So under this model, you can look to apply yield management concepts to optimize the total return on the available time from your machines.

Yield Management Example for Service Businesses

A small garage or similar service business would satisfy the same tests:

Finite amount of available mechanic time on a given shift
Mechanic time is wasted if not used
Wide range of potential buyers and jobs, resulting in a wide range of effective revenue yield per hour

Furthermore, since most mechanics (like other employees) would prefer to work scheduled X hour shifts Y days per week, your labor cost for any small period is effectively fixed. You’re paying each of your mechanic staff $200 plus benefits to show up for work that day, regardless of how many jobs you complete. So any improvements in total revenue you can drive from effective yield management will drop straight to your bottom line.

Continuing the yield management example above, a small garage owner would probably agree:

You don’t make much on oil changes (unless you upsell additional services) but can do well on replacing tires and emergency repairs
Consumers are willing to endure premium prices for Saturday service, since they don’t need to take off work (unlike the week)
There’s a greater risk of unpaid idle time during the week (but you stay open in hopes of high margin emergency repair business)
Certain customers are more likely to upgrade to additional services in an oil change than others

While there are likely other rules here, a few ideas on how to optimize your total yield start to emerge:

Any discounting of oil changes to the general public should be restricted to off-peak periods (at least as a test)
Oil changes on Saturday require an appointment; new oil change appointments should be tightly restricted until after mid-day (at which point, you will have a good idea of your expected demand for higher margin services). As a courtesy, offer the customer a discount on Monday service and put their name on a will-call list for the afternoon if something opens up…. (an effort to preserve the lead and fill any gaps in the schedule)
If you have really good records, customers who routinely buy other high margin services as part of an oil change should be offered a preferred customer discount card and the ability to book oil changes on Saturday; another feel-good tactic and gives you a shot at high margin business…
Customers who are deterred from paying full price for larger repairs on Saturday should be offered a discount if you can do the repairs during the week; will increase your odds of booking higher margin per hour repair business…

Your mileage may vary, but this yield management example is a starting point for some testing to evaluate what customers respond to.

Implementing A Yield Management Technique

If you want to implement a dynamic pricing management system, you will generally need to automate your process. There are many revenue management software packages available, including ones specifically built for hotel revenue management, airline, or a service business. The hotel industry is a large and fragmented market for these services.

The yield management system will integrate your demand data, run forecasting models, set appropriate pricing by distribution channel and service class, and publish the results. You may also enter external data about market conditions. Automation also helps you efficiently publish multiple versions of your pricing, increasing your odds of connecting the right price with the right customer.

For a hotel manager, you would get room rate guidance for different tiers of inventory. The system would adjust this for available room inventory and occupancy percentage targets. You should be able to generate a KPI report to explain your yield management strategy to the hotel owner. Once approved, prices can be digitally transmitted to various selling partners.

Want to take a deeper dive into pricing? Check out some of our other work…

There’s also our guide to pricing terminology. If you’re looking for help trying to improve pricing for your business, we’re available as a pricing consultant.