An introduction of revenue management in airlines

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An introduction of revenue management in airlines

© All Rights Reserved

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MANAGEMENT

OMPETITIVE WWeapon

EAPON IN in

THEthe

AaCCompetitive

AIRLINE

BUSINESS

Airline

Business

Revenue Management,

a Competitive Weapon in the Airline Business

Airnguru, October 2016

What would we do, as revenue management practitioners(1)

, if we had a crystal ball? We would

probably like to answer questions like:

1.

2.

3.

4.

5.

6.

How much demand will we have for our premium product next weekend?

How much would demand change if we increase or decrease the prices by 10%?

What is our customers willingness to pay going to be for coach cabin in the afternoon

flight?

What will be our main competitors reaction to a 20% price reduction in this market?

How will the exchange rate fluctuate over the next month in this market in Asia?

etc

This guide provides a simple-to-read overview of the fundamental concepts, analytics and processes

that revenue management practitioners should engage in to provide value to their airlines.

With almost 14 years of previous experience in revenue management and pricing strategies in the

airline industry, Sergio Mendoza is cofounder and CEO at Airnguru, a cutting edge pricing intelligence

technology provider for airlines. He participated in the PODS-MIT Revenue Management Research

Consortium for 10 years and formed high performance teams in a diversity of core airline business

functions, leading transformational projects and innovation with high impact on profitability.

(1)

When we say revenue management analysts or revenue management practitioners we implicitly include pricing

analysts and practitioners. Pricing is a core part of revenue management.

I. INTRODUCTION

Uncertainty:

Knowing the future demand, the consumer reactions to future price changes, the future evolution of

exchange rates, etc, are among the wildest dreams of revenue management and pricing

practitioners, because anticipated knowledge of some of these future variables would allow them to

make perfect decisions in the present and succeed at their goals of maximizing airline revenues. But,

its just dreaming, normal people cant know the future; revenue management practitioners learned

to work with guesses, smart estimates or -professionally stated- forecasts.

The future is fundamentally stochastic, a result of underlying microscopic natural phenomena which

are essentially random, thanks to quantum mechanics. God actually plays dice! So, the bad news is

or customer behaviour exactly, there will always be a prediction

that we cannot predict demand

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error associated to forecasting. We may just analyze and predict demand probabilistically, within

certain confidence levels.

This is the first big challenge for revenue management and pricing analysts (and a permanent

frustration for commercial leaders).

Estimating the future demand involves a series of complex tasks. It requires segmenting the demand,

making reasonable hypothesis or estimates about exogenous variables (like the behaviour of

exchange rates, GDP, fluctuations of competitors supply, weather, special events, seasons, holidays,

competitors supply, prices and promotion, etc), incorporating and making assumptions about

parameters controlled by ourselves (like own supply, own prices, own promotion, etc), modelling of

the relationship between demand and all these variables and adjusting or training these models with

enough historical data for an adequate calibration.

The good news is that within the limitations imposed by its stochastic nature, the future can be, and

actually is, affected by our present decisions. In fact, we attempt to predict the future in order to

change that future, that is, in order to make decisions that will bend that future towards a more

convenient future.

Combinatorial complexity: demand is highly granular

On top of uncertainty, revenue management practitioners face the challenge of a big combinatorial

problem: multiple dimensions of deep granularity each, combining to produce millions of variables

for which we could take daily relevant decisions. For example, if we want to forecast the demand or

set the availability on a daily basis for each demand segment, for each future departure, for each

origin-destination, at each point of sale level, in an airline with 400 daily departures, published up to

365 days in advance, with two relevant origin-destinations per flight, two relevant markets (POS) per

origin-destination and two demand segments per market, we would need to compute around 1

million daily forecasts and make around 1 million daily availability decisions!

Thats why, in the airline business at least, the revenue management opportunity cannot be tackled

efficiently without the help of powerful technology.

What is Revenue Management?

Revenue management is a core business discipline that aims at maximizing the short term expected

profitability of assets, modelling and forecasting demand and optimizing prices and product

availability.

Revenue management integrates several fields or disciplines from economics and engineering,

including microeconomics, operations research (OR) and statistics and, in industries with high

transactional volumes (like the airline) it is enabled by the use of information technology.

In brick & mortar retail the assets are the stores (typically measured in surface units) and the

inventory (actually, the financial investment in inventory). In hospitality the assets are represented

by the rooms (or beds). In telco the asset is the bandwidth. In shipping the assets are the ships

capacities (measured in TEUs), etc.

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In the passenger airline business the assets are the airplanes that will fly a given itinerary, and

revenue management in this case aims at maximizing short term expected net revenues (which in

turn is equivalent to maximizing the expected profitability of the fleet that will fly a given itinerary).

The use of the term expected reflects the stochastic nature of the demand being modelled. It also

sets some expectations over the limitations of the revenue management discipline.

The effective practice of revenue management is sustained on a robust and systematic business

process to continuously execute some critical tasks, among which we highlight:

1.

2.

3.

4.

5.

Optimizing prices

Forecasting demand

Optimizing availability

Diagnosing and adjusting parameters, decisions and strategies

Note that airlines split the maximization of net revenues in two separate sub-optimizations:

optimization of prices (or pricing practice, step 2 in the diagram) and optimization of availability

(step 4). Thats how the airline industry typically works: it first defines a finite number of fare

products with their price levels and associated fare fences in order to optimally segment the demand

and then it optimizes the inventory (or seat availability) associated to each fare product and price

level. The advanced reader will note that this doesnt necessarily produce the mathematical

optimum of expected net revenues, however, this has proven to be a good heuristic to simplify an

overly complex optimization problem, given the technical, commercial, legal and sometimes political

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constraints that revenue management practitioners find when executing these optimization

processes.

Over 50% of the potential benefits of revenue management in the airline come from the

optimization of prices, ie the optimization of fare fences and price levels. In a segmented market (ie

a market that is used to the practice of fare products and fare fences) the benefits associated to

these components may represent from 15 to 20 percent points of net revenue, which is huge (in an

industry with such small margins). So, the quality of the airlines pricing practice determines whether

the airline makes or loses money. However, this is the most difficult and least systematized

component of revenue management.

The second most important contribution of revenue management comes from the optimization of

capacity or inventory allocation, ie determining how many seats to allocate to each fare product and

price level. The potential benefit of inventory allocation optimization may represent between 4 and 8

percent points of net revenues in a segmented market. The potential benefit could go above these

figures in low cost, un-fenced markets, but only partially compensating the detriment of unfencing

the market (ref: simulations of PODS-MIT). The optimization of capacity on a given fare structure is a

highly systematized component of revenue management: this, along with forecasting and

overbooking, are the core of what currently available revenue management systems do under the

supervision of revenue management analysts.

The third important contribution comes from forecasting. Simulations show that each 10 percent

points improvement in demand forecast quality may improve net revenue by 1 percent point (ref:

simulations and thesis of PODS-MIT). Again, given the small margins of the airline business, even this

extra 1 percent point contribution is huge and welcome. Forecasting is typically an integral

component of existing revenue management systems and it is a necessary input to the capacity

optimization component. Given the dynamics of the markets and the limitations of the currently

available systems (especially in the amount and diversity of data that they can handle), the

forecasting function of the system requires a lot of expert supervision. Our experience shows that

the effort of improving the forecast quality by the first 10 to 15 percent points is typically worth;

however, attempting to go further may be a much bigger effort so it should not be a priority for

revenue management teams given their high opportunity costs.

We highly recommend to keep the forecasting quality index as one of the permanent KPIs of the

revenue management process in order to control how healthy the system is running. However, not

only is it tricky to forecast, but also it is to correctly measure the forecast accuracy. Among other

complications, forecasts may suffer from self fulfilling prophecies: if you (erroneously or on

purpose) inhibit supply by keeping a fare product unavailable for a long time, the system has no way

to guess that there exists potential demand for that fare product; similarly, if demand in higher prices

is being diluted because of weak fare fencing in lower prices, the system will never experience the

real demand potential in higher prices and as a consequence it will not be able to correctly forecast

that demand. Currently available forecasting models cannot correctly forecast behaviours that they

havent seen in history, unless the users manually recalibrate them to do so. This produces high

supervision costs from revenue management teams. We expect that next generation of forecasters,

based on machine learning, may be able to automatically introduce controlled biases outside the

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boundaries of historic data in order to discover unseen behaviours and recalibrate the forecasts

accordingly.

Another relevant contribution of revenue management to the bottom line of the business comes

from overbooking. Overbooking is a way to compensate for booking or ticket cancellations that

otherwise produce empty seats. It is typically an integral component of currently available revenue

management systems. When load factors are high, overbooking may produce between one and two

percent points of extra net revenue to the bottom line of the business. There is an important

trade-off to the practice of overbooking: denied boardings. An overbooking policy requires a good

denied boarding policy, in order to minimize involuntary denied boardings and maintain the

overbooking policy effective without damaging the customer experience. Some countries prohibit

overbooking, some others have installed high penalties to airlines for denied boardings (which makes

overbooking less profitable), and some airlines have voluntarily decided not to overbook (typically

airlines with booking-less systems and with strict non-refund policies).

In low fare markets, where airlines have opted not to segment demand via fare fences, typically the

RASK (revenue per available seat kilometer, the metric for revenue generation efficiency) is

substantially lower than the one achieved in segmented markets with similar price levels. In low fare

markets there are fewer degrees of freedom for revenue management, so optimization is mainly

focused on capacity allocation.

The following graph summarizes estimates of the potential benefits of the different components of

revenue management on net revenues. These estimates (which may have a wide range, depending

on the particular airlines network configuration, load factors, percent of connecting traffic, market

position, etc) are based on simulations, on observed real cases and on the experience of the author.

More than 50% of the benefits of revenue management in the passenger airline business come from

segmentation via differential pricing and fare fences. On the other hand, availability optimization

may increase net revenues by 4 to 8 percent. Note that these figures are quite interdependent: for

instance, the impact of availability optimization substantially changes when fare fences are

eliminated. The estimate of the impact of reactive pricing here (1-3%) is the only estimate not based

on real observed or simulated data, however, we believe the figure is on the conservative side: we

assume that the airline establishes, documents, maintains and executes a consistent and systematic

reactive pricing policy; on the other hand, we know that the impact of a lousy reactive pricing

process may be disastrous in the short term and strategically detrimental in the long term.

Page 6

Introduction

In controlled markets, ie those markets or industries where prices for products and services arent a

free decision of the companies that sell those products or services, price levels are defined by the

authorities typically in order to protect consumers or to protect guilds and unions. Unless very well

informed economic criteria are used, prices defined by governments will introduce and maintain

severe distortions in the market:

(a) when the authorities objective is setting price caps to protect consumers, then they will

typically produce scarcity and black markets, because artificial price caps reduce or eliminate

suppliers margins, preventing producers from investing in capacity growth (capacity growth

would produce zero or negative returns on investment), at least while no innovation is

introduced that substantially changes the cost base; moreover, if the prices are fixed for long

times, they will make the products and services growingly attractive for consumers, because

inflation and economic growth reduce their relative price; in turn, growing amounts of

potential demand will be unfulfilled, growing scarcity will be suffered and black markets

incentivized; all these impacts get multiplied in high inflation contexts (the cases of Maduros

era in Venezuela and Kirchners era in Argentina clearly exemplify this phenomenon across

industries);

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(b) when authorities objective is setting price floors to protect guilds or unions (for example,

the price restrictions on the domestic airline industry in Argentina under the Kirchners,

whose purpose was to protect bus guilds that competed against airlines in inter-regional

passenger transportation), they restrain potential demand due to elasticity effects, they

restrain producers from stimulating demand via price and promotion, they inhibit the

introduction of low price business models and they inhibit the incentives for innovation.

This was the case of the airline industry until the late 70s in the United States. Airlines had grown

fat with full service, high single prices per market (one price per origin-destination) and loyal

customers. After the market was deregulated by the authorities in 1978, a significant growth in

capacity, demand and competition occurred, highly benefiting consumers and the economy. Revenue

management was born in the early 80s in the airline industry as a response from legacy airlines

(initiated by American Airlines) to the entrance of new competitors offering low fares for simple

service.

Pricing schemes & strategies

Deregulated markets have created pricing schemes and strategies with various levels of

sophistication. Among the various existing pricing paradigms, we highlight the following:

(a) Single price model in a steady state free market. This model is obsolete and sub-optimal.

On one hand, it does not reach all the market potential because it restrains price sensitive

customers whose willingness to pay is below the actual single price; on the other hand, the

single price model does not take advantage of consumer surplus because those customers

willing to pay a price above the actual single price keep the surplus for themselves.

Notwithstanding the above, if your business brings a disruptive technology or business model

advantage into an industry, you may reach the market with a single, easy to communicate,

very low price and succeed at gaining a big market share in a very short time, thus building

strong entry barriers before that industry becomes a steady state competitive industry again.

(b) In steady state markets, demand based (or willingness-to-pay based) differential pricing

offers a powerful way to sustain margins through demand and supply segmentation, using

fare fences and estimates of willingness-to pay (WTP) in order to stimulate demand and

obtain the consumer surplus for the supplier. Demand based pricing is the approach most

airlines attempt to use when doing revenue management. It is a tricky art & science to

determine WTP with precision, let alone its dynamic and multivariate nature. Given the high

churn rates of the airline demand due to large cross elasticities, WTP is affected by

competitors prices, so even market leaders should systematically monitor their competitors

price movements and consider reactive pricing policies to maintain their prices at optimum

levels.

(c) Value based pricing or also known as branding, will be key for longer term success of a

differential pricing paradigm. In this scheme, you elaborate a set of products or services, each

with a certain set of attributes that are easy to communicate and valued by the consumer,

and a price level. This paradigm will be necessary to fight against commoditization and to

make differential pricing sustainable and acceptable by consumers in a mature market. This

pricing scheme requires the use of sophisticated techniques, like conjoint analysis, in order to

consistently set the price levels across the set of products or services.

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(d) Through unbundling the supplier allows the consumer to purchase an extra service, gadget

or attribute that improves the base product or service that she/he is buying, for a marginal

extra cost. Unbundling generates some additional revenue for the supplier and a better

experience for the consumer. Usually these unbundled gadgets belong to more expensive

products/services upwards the value based ladder. Full unbundling allows consumers to

customize the product/service to their very specific needs, process known as

self-segmentation. As in the case of branding, consistently setting the price for an isolated

attribute (ie to avoid dilution or arbitrage) should be solved using a robust methodology like

a conjoint analysis.

(e) Suppliers use promotional pricing when they need to stimulate or accelerate demand and

get market awareness. Promotional pricing is a combination of price discount and publicity. If

advertising is not sufficiently intense the expected price elasticity of the demand will not be

fully perceived and the price discount will be dilutive (that is, the same consumers that would

have otherwise purchased for the normal price, will now be purchasing for a discounted

price).

(f) Price strategies described in b), c), d) and e) are typical examples of proactive pricing, where

the supplier proactively decides, optimizes and publishes its prices. In these cases the

supplier is typically a leader in the market, and other market participants are followers. In

opposition to this, in a market pricing scheme, the supplier is a follower, because it sets its

prices relative to its main competitors prices or relative to the market leader. In a market

pricing scheme the supplier will undercut or equal its competitors prices. This strategy is

justified when the suppliers product/service is inferior to its main competitors, when its

supply is limited though its product is comparable or when the market is of low relevance for

the supplier. Reactive pricing policies should be set by the supplier in order to be consistent

and systematic about its relative price positioning.

(g) Markup pricing is typical of industries with high marginal costs (for example, Retail). In this

case prices are set multiplying the marginal cost by a markup (a number larger than 1). This is

not the case of the airline industry. In the airline business the fleet (lease or depreciation

cost) and itineraries are fixed costs for the purposes of revenue management and the cost of

selling to and carrying an additional passenger is negligible compared to the fixed costs

(marginal costs typically represent in the order of 10% of total airline costs).

(h) Price based costs were pioneered by Intel (expressed in the famous Moores law). Ryanair is

the best example of a price based cost strategy in the airline industry. This strategy sets

frequent and aggressive price reduction goals that force the organization to implement cost

reduction initiatives, thus incentivizing continuous innovation to keep the business

sustainable.

Price optimization starts with the analysis and understanding of the underlying granular structure of

the demand. Demand is originated from a wide diversity of customers with a wide diversity of needs

and preferences. In the airline business we start by distinguishing among several macro demand

segments.

Page 9

To segment demand we need to perform the necessary analysis in order to identify variables that

help us group together customer instances with similar willingness-to-pay. These variables may be

associated with purchase and consumption behavior, like booking and/or ticket anticipation,

travelling period, point of sale, purchase channel, form of payment, etc. Segmentation has to be

performed for each origin-destination market. For example, the following table summarizes some

convenient demand segmentation variables identified for the three first segments of the chart

above:

Once segmentation of demand is achieved, segmentation of supply is built applying restrictions on

the segmentation variables. These restrictions will reflect the boundaries of the purchase and

consumption behavior of the various types of customer instances identified in the demand

segmentation process.

Page 10

In turn, each demand segment is offered an ad-hoc fare product built using fare fences. Fare

fences -or restrictions- like advanced purchase and length of stay (also called travelling period)

applied to the purchase and consumption behavior of ethnic and tourist fare products, reduce

revenue dilution from business customers which otherwise would buy the cheapest fare product

available. Prices for different demand segments are grouped or mapped into fare classes or

RBDs, represented by a single letter of the alphabet. Each RBD then is fenced using a set of fare

fences or restrictions that appeal to a given demand segment or group of demand segments with

similar WTP, but represent a strong inhibitor to demand segments with higher WTP, as can be seen

in the following example:

Business passengers that do not want to stay a Saturday night will buy RBDs Y or B. The classical

revenue management system protects seats for Y and B but maintains RBDs M and Q available

with a limited inventory (booking limit), without diluting revenue in higher price RBDs.

An underlying assumption in classic airline revenue management is that the demand segments get

perfectly separated in fare classes or RBDs, that is, fare fences function perfectly so that fare classes

contain independent demand.

Setting the optimal price levels

Lets assume we are dealing with a specific demand segment for which we have defined a product or

service. Lets also assume that we are market leaders. A market leader should not only be proactive

at defining the product or service offer, it should also optimize price levels (instead of just following

competitors). How are optimum prices set? Microeconomics works with hypothetical demand

curves, mathematical expressions (or functions) that relate the demands of products or services

(the dependent variables) to their prices (the independent variables). In reality demand curves are

unknown and, if they exist, they should be estimated or modeled from observed data. Observation

shows that demand for a suppliers specific product or service may depend on many more variables

than just the price of that specific product/service: it depends on prices of substitute

products/services (including potential substitute products/services offered by the same supplier), on

prices of complementary products/services (for example, a lower price of hotels in a given city could

increase demand for leisure air tickets to that city), time of the day, day of the week, day of the

month, month, season, special events, weather, GDP growth, exchange rates, advertising, available

stock (obviously no stock implies no demand but limited non zero stock may also have an inhibiting

impact on demand), etc.

Page 11

Lets discuss how the theory could be applied to some very simple (and thus likely unrealistic, thats

the tradeoff) cases, in order to exemplify the use of microeconomics and statistics concepts in

revenue management:

Assumptions: (a) demand dependent only on price of product/service offered, (b)

unlimited inventory, (c) two observations available and (d) zero marginal cost

Lets assume that we have unlimited inventory, that is whatever the price we set there will

always be stock (or seats) available.

Lets also assume that demand just depends on the price. Sadly, the simplest case isnt very

real: it is quite unlikely that demand depends just on the price, but, in some cases it may be a

good enough first approximation. In fact, if we are able to isolate the main independent

variables, for instance day of week and season, and just work with a constant value for

those, lets say Tuesday and high, we may be good enough just modeling demand for

Tuesdays of high season. Despite these efforts of isolating independent variables that explain

demand, we will always be left with a residual random fluctuation in the observed demand,

which is essential to its stochastic nature. So the demand curve really relates price with

expected demand, ceteris paribus.

Lets also assume that marginal cost is zero, so that optimal price is the price that maximizes

revenues (since net revenue and revenue are the same in this case).

This implies that demand (per unit time) doesnt change when price doesnt change. How

would we optimize the price of this product? Lets assume we have historical demand

observations with just two different prices (if we had always one price there would be no

way to estimate the demand curve, so, in this case, we better test changing the price and

measuring the new demand rate): at some point we had a price P1 which produced an

average demand per unit time of D1 and later we had a price P2 which produced an average

demand per unit time of D2 (at this point it is important to note that despite the assumptions

of our model, observed historical demand always behaves like a random variable, so we take

averages over several observed instances of D1 and D2).

With no more information available

the simplest assumption is setting the (expected) demand curve as a linear function of price:

D = D1 + (P P 1)

where

(D2 D1)

(P 2 P 1)

(III.2)

is the slope of the demand curve, which is related to the arc elasticity:

=

Page 12

P 1 D2D1

D1 ( P 2P 1 )

(III.1)

P1

D1

The arc elasticity of the demand to the price measured from point 1 represents the %

variation of the demand relative to D1 over the % variation of the price relative to P1.

Note that in this model and are negative constants, given the demand is linear with price

and given that it should decrease when price increases. If this were not the case when fitting

the observed data, it would mean that the assumptions of this simplified model would not be

true and the model would not be adequate (a typical case of inconsistency of our

assumptions is that of constrained inventory -to be discussed below-, where we may see

changes in prices with little or no impact on observed demand).

So, the optimum price P* is the price that maximizes revenue R (= PD):

P * = arg max R = P D

(III.3)

Replacing D for the demand function (III.1) and solving for the stationary point:

(P D)/P = 0

D + P *D/P = 0

D + P * = 0

2P * + D1 P 1 = 0

P * = 12(P 1 1D1) = 12P 1(1 1)

(III.4)

An arc elasticity at P1 of -1 will yield an optimum price P* = P1 ; an arc elasticity above -1 will

yield an optimum price above P1 and an arc elasticity below -1 (ie the demand is elastic) will

yield an optimum price below P1 (ie when demand is elastic it is convenient to reduce the

price in order to increase resulting revenue).

Replacing in III.1 we obtain the demand at the optimum price:

D* = 12(D1 P 1) = 12D1(1 )

(III.5)

1 (D P )2 = 1 P D ( 1)2

R* = 4

1

1

4 1 1

(III.6)

When there is a marginal cost c of serving one additional customer (which is most of the

times the case, at least in the airline business) the function to be maximized is not the

revenue R = PD, but the net revenue RN = (P-c)D, also called margin 1. The marginal cost c in

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the airline business covers marginal distribution costs, on-board marginal service costs,

marginal fuel cost (that is, the fuel cost of transporting one additional passenger and

luggage), etc; it may typically represents between 5% and 15% of the average price. Taking

into account the marginal cost, the optimum price may be expressed as:

P * = arg max RN = (P c)D

(III.7)

and solving for the stationary point of the right hand side term (using the same demand

curve III.1 ):

[(P c)D]/P = 0

D + (P * c)D/P = 0

D + (P * c) = 0

2P * + D1 (P 1 + c) = 0

P * = 12( P 1 1D1) + 12c = 12P 1(1 1 ) + 12c

(III.8)

A marginal cost of c increases the optimum price by c/2 relative to the optimum price of a

zero marginal cost scenario (in a linear demand function with unlimited inventory). It may be

counterintuitive that the adjustment in price necessary to compensate for marginal cost is

not the whole marginal cost; the explanation for this lies on the fact that the demand curve

has elasticity, so any increment in price will translate into a decrease in demand, affecting the

total revenue collected. One important lesson we get from this exercise is that fuel cost

increments in the airline business should not be wholly transferred into price increments (a

pricing practice typically performed by airlines via fuel surcharges), otherwise the airline

would deviate from the maximum net revenue potential by excessively inhibiting demand.

An arc elasticity at P1 of -1 will yield an optimum price of P 1 + 12c ; an arc elasticity above -1

The demand at the optimum price is:

1 D1 c

2P1

(III.9)

1 (D P + c )2 =

RN * = 4

1

1

P 1D1

c 2

4 ( 1 P 1 )

(III.10)

1 (D P )2 + 1 c 2 = 1 P D ( 1)2 ( c )2

R(P *) = 4

1

1

4 1 1

P

4

1

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(III.11)

which is smaller than the maximum revenue (obtained in III.6). In other words, we have to

sacrifice revenue in order to maximize net revenue. Just out of curiosity lets calculate, using

III.4 and III.5, the net revenue RN = (P-c)D resulting at the price that maximizes the revenue:

RN (P = arg max R) = [12(P 1 1D1) c]12(D1 P 1)

1 (D P )2 c (D P )

= 4

1

1

1

1

2

1 (D P + c )2 + 1 c2

= 4

1

1

4

and, using (III.10) for the first term on the right we find that the net revenue at the price that

maximizes the revenue is:

RN (P = arg max R) = RN * + 14c2 = RN * +

1 D1 c2

4P1

(III.12)

That is, the net revenue at the price that maximizes the revenue is smaller than the

maximum net revenue by 14c2 . So, another important lesson here is that in the case of non

zero marginal cost, if we optimized revenue instead of net revenue we would be diluting

D

potential margin at a rate of 14c2 = 14 P 1 c2 . How large could this dilution be? Lets

1

assume elasticities of long haul leisure air travel demand to be around -3 (typical leisure

demand elasticity), prices around 1.000 US$, demand at a rate of 200 passengers per day and

marginal cost at around 100 US$ per passenger, then dilution of potential margin would be

2

200

around 14 * 1000

* 3 * 100 US$/day = 1.500 US$/day .

Page 15

When airlines practice revenue management they constrain the inventory (setting booking

limits) in order to optimize revenue, as we are going to discuss later, so it is most likely the

case that historical demand observations for a given (fare) product are constrained or

truncated via booking limits (advanced purchase -AP- restrictions have a similar effect on

demand, but we consider APs to be fixed and part of the definition of the fare product).

Thus, given the stochastic behaviour of the demand, those demand observations that would

otherwise be greater than the booking limit (BL) produce a value equal to BL, and as a

consequence, the resulting mean observed demand D will be lower than the unconstrained

expected demand D. For example, assuming that the demand distributes Poisson with mean

D, the mean observed demand will be given by:

BL1

D = eD

k=0

Dk

k!

k + eD

k=BL

Dk

k!

BL = D eD

k=BL

Dk

k!

(k BL) < D

(III.13)

This inequality suggests us that in order to optimize prices in the constrained demand case

we have no choice but to take into account the stochastic nature of the demand and, as a

consequence, de-truncate the observed demand data first, otherwise we will be

underestimating the real demand.

A side note on the choice of Poisson distribution: the booking curves slope (ie the

rate at which bookings for a specific flight get created or confirmed) for a future flight

instance varies over time till departure, but, it may be regarded as a collection of

booking rates that remain constant during certain intervals of time. Given this

observation and disregarding group bookings (since they arrive in bulk), the booking

count of each of these time intervals could be modelled as a Poisson random

variable, so, the total demand resulting from the evolution of the booking curve till

departure date would distributes as the sum of independent Poisson variables, which

is also a Poisson variable.

Looking at observed historical demand for several instances of the same fare product we may

find several types of behavior associated to the same stochastic process: (1) Non constrained

demand, i.e. demand which was freely expressed, it never hit the inventory limit of the RBD

(or booking limit BL) associated to the fare product being optimized and even the AP did not

affect the evolution of the booking curve; (2) demand is not constrained by booking limit but

it is constrained by the AP (evidenced by the booking curve reaching the AP with a positive

slope) and (3) demand was effectively constrained by the booking limit.

Page 16

One way to de-truncate the observed demand -which is necessary to unveil the real demandwould be to measure the % of type (3) cases (that accumulate at the Peak B in Fig.5), which,

assuming a Poisson distribution of mean D and a reasonable number of historical

observations, should be given by:

BL1

% of type (3) cases P rob {Demand BL} = 1 P rob {Demand < BL} = 1 eD

k=0

Dk

k!

From this expression we can fit the mean D of the unconstrained demand.

Another, maybe simpler de-truncation method is finding the peak of the observed demand

distribution below the booking limit (ie Peak A in Fig.5 above), as long as it exists, and

relate that to D. Using discrete calculus to compute the maximum of a Poisson distribution

k

of mean D, that is, the maximum of the discrete function P (D, k) = eD Dk! (where k takes

integer values equal or greater than zero), we get two conditions for the optimum value of k,

k* :

P (D, k*) > P (D, k* 1) and P (D, k* + 1) P (D, k*)

Dk1 D

(k1)! ( k

1) > 0 and

Dk ( D

k! k+1

1) 0

D (k*, k* + 1]

(III.14)

Page 17

That is, the mean demand D (which doesnt have to be an integer number) lies between the

booking count that maximizes the Poisson function and that number plus 1. So, in this

method D could be fit by setting

D k* + 12

(III.15)

These simple de-truncation methods fail when the % of type (3) cases is too high (because

the uncertainty of the estimator gets too high), when the Peak A is non-existent (i.e. when k*

falls above BL) or when the curve has two or more peaks below BL (in which case another

proxy could be proposed for D).

If the Peak A lies above BL it means that the demand is highly constrained. In this case we

have space for safely increasing price generating extra net revenue, since the expected

observed demand will not diminish noticeably. We could keep increasing price until we reach

a reasonably low % of type (3) data or until Peak A appears below BL, to de-truncate the

observed demand. As in cases 1 and 2, we need at least two price vs de-truncated demand

points in order to fit a linear demand curve D = D(P) and later proceed to optimize price.

If we succeeded in estimating the de-truncated demand function D, in order to now compute

the optimum price, ie the price that will maximize the expected net revenue when inventory

is constrained, we shall first rewrite the optimization function (III.7) in stochastic form:

= (P c)( D eD

k=BL

Page 18

Dk

k!

(k BL) )

(III.16)

Solving III.16 implies solving for P the following equation (we use III.1 to relate D and P):

D = 0

< RN > = D + (P c)D

with

D D

= 1 g(D, BL)

and

BL

D1 (P 1 c)

So,

BL1

D

(BL + 2D)g + (2 eD(BL1)!

)D = 0

(III.17)

which can be solved numerically for D, and from D* we obtain P * = 1(D* D1) + P 1

Reactive Pricing

A robust reactive pricing process improves airlines competitive position because it makes its reactive

pricing policies more consistent, it increases its efficiency and reduces pricing errors and time to

market, generating in the long term an extra contribution to the bottom line. Some basic rules to

follow in order to maintain an adequate reactive pricing include:

1. Assure competitivity of bottom fares

Fare Levels

Page 19

Fare Restrictions

In all distribution channels

In availability of inventory

Competitivity of the bottom fare not necessarily means maintaining exactly the same price

level as the relevant competitor or the market leader, but a consistent difference, based on

the difference in value. Sometimes leading players dont let followers undercut their bottom

prices, even if the followers product is worse, so whenever the follower undercuts them

they timely react always matching the price, which could trigger a price war in the market.

2. Maintain the reactive pricing policies and the price match rules

Keep them updated

Keep them consistent

3. Monitor the competition

4. Minimize Time-To-Market

Long reactive pricing time-to-market encourages competitors to make aggressive

proactive moves, leading to market share and revenue losses

Proactive Pricing

An effective proactive pricing process ensures a good revenue share in the market (even above QSI),

enhancing profitability. Some basic rules for a robust reactive pricing process include:

1. Definition of desired price competitive position.

2. Definition of balanced price differences between fare products.

3. Definition of f are fences that effectively segment the demand, but taking into account the

competitive situation and the desired competitive position.

4. Implementation of promotional activities that stimulate demand in depressed markets or

low load factor flights.

5. Periodic review of price mapping to RBDs, price levels and fare restrictions to always ensure

a good revenue generation.

It is convenient to classify the different origin-destination markets and routes of the airline for the

purpose of defining the right pricing strategies, for which we could use the following dimensions:

1) Leisure vs business market

Typically a market with less than 40% business traffic may be classified as a leisure market and

vice-versa.

2) Load factor

A route (or a group of route flights) with an average load factor of 80% or more is a high load

factor route (or group of route flights).

Page 20

A route (or a group of route flights) with an average load factor of 70% or less is a low load factor

route (or group of route flights).

3) Dominance

If the airline is the carrier with the highest market share (MS) in a market, then the airline is the

dominant carrier in that market.

4) Industry evolution

Markets that are growing in size vs markets that are decreasing in size.

5) Low Fare vs Full Service markets

Markets with dominant airlines that use Low Fare models vs markets where dominant airlines use

Full Service models.

6) Haul

Markets could also be classified by haul (long haul, mid haul and short haul markets) so that some

fare rule templates (especially for secondary fare rules) may be defined and applied efficiently in

each scenario.

Forecasts have two fundamental objectives in the airline commercial processes:

1. Determine the optimum stock/availability

Usually business customers buy very late, just a few days before departure, so, for example,

if we knew with some certainty that 5 business passengers will buy 3 days before departure,

wouldnt we keep those or some of those seats protected for them from being sold to leisure

customers who buy much earlier but are willing to pay much less?

2. Prepare for future performance

When the airline systematically forecasts expected demand, fares, margins, etc, with enough

anticipation, it will be able to make better commercial and strategic decisions that will

improve the expected performance and increase expected profitability.

Using as much of the available relevant information as possible, forecasts play critical roles in the

decision making processes. They should be an essential part of weekly route performance reviews.

Thanks to forecasts, managers and executives can drive the business looking through the

windshield, as opposed to looking through the rear-view mirror. The business should forecast the

future in order to change that future, in order to make now the right decisions that will bend that

future into the desired future.

Forecast quality is an issue, but up to a certain point. A 10% improvement of demand forecast errors

induces a 1% increase in net revenues (as simulated by PODS-MIT), but the effort of pursuing a

second 10% improvement may not be worth. Maintaining forecast errors under control is a high

Page 21

opportunity cost task and we believe there is still much to improve by revenue management system

providers in this regard.

Forecasts should reflect the expected reality given all the available relevant information and given

the actions that have already been implemented and the decisions that have already been taken.

This is a relevant issue because revenue management systems typically have access to a very limited

diversity of variables (typically just incumbent airlines itineraries, flown passengers and bookings), so

they are blind in several dimensions, causing their forecasts to be slow at reacting to new external or

internal conditions in the market. By manually intervening the forecasts using additional information

not automatically available to the revenue management system, the pricing and revenue

management analysts should carefully adjust them, in order to accelerate the reaction of the system

and timely capture the revenue opportunities.

Differential pricing enables the airline to compound its revenues with an optimum mixture of prices.

With differential pricing the airline aims at capturing the highest willingness-to-pay (WTP) customers,

from the top to the bottom prices, till the airplane is full. This allows the airline to maximize the

revenue collected for the flight.

Inventory or capacity optimization, like the optimization of fare fences, may be regarded as a way to

segment supply. If the airplanes had no capacity constraint, supply segmentation via fare fences

could be enough to optimize revenue. However, given that the airplanes have fixed total capacity,

selling to too many customers at low fares will produce a displacement of customers willing to pay

higher fares, that is, some high WTP customers will not find available seats to buy, so the airline will

not be collecting the maximum revenue it could potentially collect and it wouldnt be satisfying the

expectations of some business customers who would have liked to fly with the airline. This is

Page 22

especially critical when high WTP demand manifests itself closer to departure than low WTP demand

(which is typically the case in most markets).

The optimal execution of the differential pricing strategy requires then that the airline protects seats

for higher WTP customers against the demand from lower WTP customers. However, since demand

is stochastic, determining the right number of seats to protect for higher WTP consumers requires

fitting a probability distribution for the demand (or a stochastic demand forecast). Based on this

probability distribution the airline has to perform a calculation of the trade-off between an additional

seat protected for a high fare and the same seat sold to a lower fare customer.

Expected Marginal Seat Revenue (EMSR)

The Expected Marginal Seat Revenue (EMSR) was proposed by Peter Belobaba in the 80s. EMSR

became a fundamental revenue management concept and is used at the core of most revenue

optimization systems in the airline industry. As its name suggests, the EMSR corresponds to the extra

expected revenue generated by an extra seat allocated (the marginal seat) to a given RBD (or

fareclass). ER(n), the expected revenue produced from n seats allocated to a given RBD, is obtained

by multiplying the price P corresponding to that RBD times the expected number of seats to be

sold. Given there is an upper limit of n seats to be sold, the whole probability of selling n or more

seats contributes to the scenario of selling exactly n seats. So, ER(n) can be computed as:

n1

i=1

i=n

(IV.1)

Where Pr(D=i) is the probability that the demand D for seats equals i (with i an integer that can

take values from zero to infinite). How does ER(n) change if we allocate one less seat in this RBD?

Using the formula above the expected revenue for (n-1) allocated seats would be:

Page 23

n2

i=1

i=n1

And, subtracting the two expressions we obtain the EMSR(n), the expected marginal revenue of the

nth

allocated seat

EMSR(n) ER(n) ER(n 1)

i=n

That is

i=n

(IV.2)

So, EMSR(n) is the price times the probability of selling the nth

seat as the last seat allocated or

protected at that price.

Optimizing seat allocation, general algorithm (leg based revenue management)

Lets now solve the seat allocation optimization problem for a flight (this problem is know as leg

based revenue management), assuming the airplane has a total capacity of C seats and that we have

a fare structure of just two prices P1 (higher price) and P2 (lower price). We aim at maximizing the

the higher price (and

expected revenue of the flight ER(n) as a function of the protection level n for

Max{n integer

[0,C]}

(IV.3)

Where ERi(n) is the expected revenue associated to price Pi when a maximum of n seats are allocated

to it. Given that the probability of selling a first seat allocated to P1 is close to 1 and that P1 > P2, the

ER(n) starts at zero as a rapidly increasing function of n. If the optimum n lies within the range [0, C]

then it should comply with the condition that increasing it by 1 will reduce the value of the objective

function ER(n), so the optimum value of n, lets call it N1, is the maximum protection level for which

the expected revenue increases:

N 1 = Max {n : ER(n) ER(n 1)}

(IV.4)

Using (IV.3) in (IV.4) and replacing the resulting terms by the definition of EMSR (see (2)) yields the

following expression, which is the condition for optimality:

N 1 = Max{n : EMSR1(n) EMSR2(C n + 1) }

(IV.5)

(EMSRk(n)

stands

for the EMSR of the nth

seat allocated to the price Pk ). In case of three prices, we

first compute N1+2 , the aggregated protection of the two higher prices (using the aggregated

probability distribution of the two higher prices and the corresponding expected price) and then we

perform a new two price protection optimization using expression (IV.5) where we replace C for N1+2

to compute N1 . So, expression (IV.5) can be used recursively for any number of price levels in order to

perform a general optimization of protection levels.

Page 24

Let us now work an example. Lets assume we have just three price levels (I will omit $

symbols) P1 = 1000, P2 = 700 and P3 = 500 and that demand for each price level distributes

Poisson with means 5, 15 and 30 respectively (I will defy the typical use of Normal

distributions, not just to be different, but also because Poisson may be a better

approximation to reality when demands are small integer numbers). Lets assume the

airplane cabin has a total capacity C = 25. The graph and table below show the EMSRs of all

prices, including the EMSR of the compounded demand for prices 1 and 2 (the sum of two

independent Poisson variables distributes Poisson with mean equal to the sum of the

means), as functions of n (the number of protected seats for each price), as well as

required for the optimality condition (IV.5). We clearly see that the condition

EMSR3(C-n+1)

(IV.5) applied to the compounded demand for prices 1 and 2 is satisfied for n=18, because

EMSR1+2(n = 18) = 544.8 EMSR3(25 n + 1 = 8) = 500

and

EMSR 1+2(n + 1 = 19) = 479.4 < EMSR3(25 n 1 + 1 = 7) = 500

Page 25

Now that we have 18 seats protected for the compounded demand of prices P1 and P2 we

apply again condition (IV.5), now with C = 18, to get the protection for P1 , which, from the

EMSR table above (by comparing the second and last lines) we see it equals 5 (given that

> EMSR2(18-5+1)=446

and EMSR1(6)=384

< EMSR2(18-6+1)=513).

EMSR1(5)=560

Once we have calculated all the protection levels for higher compound prices and for the top

price, we shall proceed to compute the booking limits, ie the maximum number of bookings

that will be allowed at each price level. The booking limit for the top price should be set

equal to the capacity of the airplane, since we wouldnt reject anybody willing to pay the top

price (many airlines, in order to compensate for no shows, allow overbookings, so the

booking limit of the top price could slightly surpass the capacity of the airplane). The booking

limit for the second price equals the booking limit of the top price minus the protection

required for the top price, that is 25-5=20. The booking limit of the third price equals the

booking limit of the top price minus the protection of the combined 1+2 prices (ie 25 - 18 =

7), and so on. In summary, we get the following protection levels and booking limits:

Littlewood rule

Typically lower price demand is much bigger (ie 2 >>

1 ) and it arrives earlier than the higher price

EMSR2(m) = P 2 P r2(i) P 2

i=m

(IV.6)

for m such that 1< m << 2. That is, the first m seats of the lower price P2 have all a similar EMSR,

which can be approximated to P2. As we saw in the example above, one key feature of EMRS(n) is

that it is monotonically decreasing in n, because the higher the number of seats protected, the lower

the probability that the last seat protected will be sold. So, if we start increasing the protection level

for price P1 , at some point the EMSR of the last seat protected for P1 will be smaller than the EMSRs

of any of the first m seats that could be protected for the next lower price P2. At that point, we

should stop increasing the protection level of P1 in order not to displace higher expected value

customers. That is, there exists an n = N1 so that

N 1 = M ax {n : EMSR1(n) P 2}

Page 26

(IV.7)

and N1 represents the optimum protection level for P1 from its next lower price P2. This is known as

the Littlewood rule. What Littlewood is basically assuming is that the demand of the next m seats

(for a sufficiently large m) at the lower price is certain. When the expected demand at the lower price

is a small number or as the airplane fills in with bookings, Littlewood rule may cease to be a good

approximation.

EMSRa & EMSRb optimization algorithms

The EMSRa algorithm, first introduced by Peter Belobaba in 1984, calculates the protections using

Littlewood rule for each higher price against a given lower price and then adds up the resulting

protections to determine the total number of seats to protect for all those higher prices from the

selected lower price; this calculation is then repeated for each of the lower prices from the bottom of

the fare structure up to the second highest price.

Using the same data of the previous example we can compute the protection levels and booking

limits resulting with the EMSRa algorithm as follows:

First compute protections for P1 and P2 from P3 using Littlewoods rule. From the EMSR table

= 560 >= P3 and

above we get that protections for P1 from P3 equal 5, given that the EMSR1(5)

= 384 < P3. Similarly, we get 13 for P2 from P3, which gives a total number of seats to

EMSR1(6)

protect from P3 equal

P1 from P2 reading the table above, which gives a total of 4. Thus, the booking limit for P1 is

the capacity of the airplane, 25; the booking limit for P2 is 25 minus the protection for P1 , that

is 25-4 = 21 and the booking limit for P3 is 25 minus the protection for P1+2, that is 25-18 =7:

The EMSRb algorithm, proposed by Belobaba as an improvement to the EMSRa algorithm, instead of

adding up the protections of higher prices against the selected lower price, it applies the Littlewood

condition to the aggregated probability distribution (along with the corresponding expected price)

of the higher prices against the selected low price. EMSRb is a better approximation than EMSRa

because it computes the real EMSR of an additional seat protected for the higher prices as a whole,

from the corresponding lower price.

Using the same data of the previous examples we can compute the protection levels and

booking limits resulting with the EMSRb algorithm as follows:

First compute protections for P1+2 from P3 using Littlewoods rule on the EMSR1+2 of the

aggregated demand of the higher prices. From the EMSR table above we get that protection

for P1+2 from P3 equals 18 (which in this example is the same as in EMSRa, but it shouldnt

necessarily be the same in all cases). Then compute the protection of P1 against P2, which is 4.

Having calculated the protection levels the procedure for getting the booking limits is exactly

as in EMSRa, so we get the following results:

Page 27

Note that in this very simple example EMSRa and EMSRb produced exactly the same output (which,

as we noted, will not always be the case), however, both protect one seat less than the general

optimization algorithm in P1 (4 vs 5 seats, respectively). This is a consequence of Littlewood

approximation, which is used in EMSRa and EMSRb, because it overestimates the EMSRs of lower

prices.

The allocation optimization concepts and algorithms discussed here are typically used in leg based

revenue management, that is, in the optimization of seat allocations for independent flights.

Network Optimization

Also known as Origin-Destination or O&D revenue management, network optimization sets the

availability of seats for the different price levels (or fare products) of all the flights of a network,

aiming at the maximum expected net revenue of the whole flight network, as opposed to a specific

flight (which is the case of leg based revenue management).

Several algorithms have been developed to compute the optimum network availabilities, among

which we highlight Dynamic Programming. These algorithms are computationally intensive and

currently they require heuristic approximations in order to converge in a reasonable time at a

reasonable cost.

The concept of Bid Price has been introduced in network optimization to control inventory in a

more granular and dynamic way. Bid prices reflect the opportunity costs of all the available seats in

all the flight legs of the network. Bid prices are frequently recomputed and informed to the

reservation system of the airline, so that new bookings are confirmed in an itinerary only if the price

being offered or paid by the customer is at least equal or greater than the sum of the bid prices of

the seats being taken by the booking.

Network optimization adds an estimated 1.5% - 2% extra net revenue to the bottom line of the

business over leg optimization in a relatively connected high load factor network (ie a network with

at least 40% connecting traffic and 80% average load factor).

Although from a business point of view network optimization makes more sense than leg

optimization, from a system and from an organizational point of view O&D optimization is a highly

complex process, much more complex than leg optimization, so it should be no surprize that it

requires more team and more supervision than leg optimization.

Hybrid Models

Finally, there is a third generation of algorithms that deal with seat allocation optimization in low fare

markets, that is, in markets with fare structures that have weak or no fare fences. These are called

the hybrid models or low fare models. These models aim at recovering part of the diluted

Page 28

revenue by estimating the diluted demand and adjusting booking limits of lower prices RBDs

accordingly.

Given the way prices and inventory interact (unavoidably linked through the demand function), and

given the highly tactical nature of revenue management, pricing management and capacity

management functions should both report to one role (typically the Route Manager) responsible for

the maximization of the route RASK (revenue per available seat kilometer). Some airlines keep these

functions separate with no joint tactical accountability for the route RASK, which is suboptimal.

Pricing strategies affect capacity strategies and vice-versa. In fact, when demand and load factors are

high, the emphasis of the revenue management process should go to capacity optimization,

especially to avoid displacing high yield customers. When load factors are low, the emphasis should

go to the fare structure optimization, especially to avoid dilution of high yield customers and

stimulate low yield demand.

A robust revenue management process is sustained on skilled and motivated teams managing

adequate systems and making timely decisions based on the right information. The revenue

management process requires dashboards, KPIs, accountabilities and ownerships clearly defined.

CONCLUSIONS

Revenue management teams empowered by the right technological platforms and systematically

leading robust commercial processes may provide substantial value to the airline business,

converting revenue management into a strategic weapon and a competitive advantage.

The effectiveness of revenue management in a business with high combinatorial complexity like the

airline business discipline will is far from stagnant, we envision years of interesting applied research

and new developments that will help the best practicing airlines maintain a profit advantage.

Page 29

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