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An introduction to revenue management: Exploring common techniques

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 In
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2 JUNE 2014 / THE CPA JOURNAL

An Introduction to
Revenue Management
Exploring Common Techniques and the CPA’s Role
Ronald J. Huefner

A
ccountants 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 men-
tioned in the accounting literature. It is important to CPAs and the busi-
nesses 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 influ-
ence 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 ini-
tially 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 profession-
als 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 gen-

JUNE 2014 / THE CPA JOURNAL 3

erally 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 sustain-
ability. 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 con-
sidered 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 mar-
ket, featuring low fares and constituting a
competitive threat to the established carri-
ers 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 sur-
vived because the airlines saw them as a
way to build revenue by selling seats oth-
erwise expected to be empty at a dis-
count. Consequently, revenue manage-
ment—formerly known as yield manage-
ment—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 most-
ly profit. The challenge was to preserve the
airline’s normal full-price business, while
gaining extra revenue by offering dis-
counted prices to relatively few, discre-
tionary 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 nonre-
fundable 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 con-
4 JUNE 2014 / THE CPA JOURNAL
ditions 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 discount-
ed passengers could be accommodated at
virtually no added cost; this was seen as a
profit-boosting strategy.
Other businesses that, like the airlines,
were characterized by heavy fixed costs,
perishable service capacity, and some abil-
ity to forecast demand soon adopted com-
parable techniques. Revenue management
expanded to hotels, restaurants, golf cours-
es, 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 perish-
able (i.e., model-year) inventories.
Lessons from Early Application
Two industries that were early users of
revenue management—airlines and auto-
mobile manufacturers—have had major
profitability problems. Although this may
seem to be an indictment of the useful-
ness 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
price searching via the Internet made it
hard to restrict customers’ access to lower
fares. In the automobile industry, price con-
cessions 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 con-
siderations in evaluating these techniques.
Discounting. A temporary reduction in
price, discounting is perhaps the most
common pricing technique used to build rev-
enue. Discounting is distinct from mark-
downs; 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 nor-
mal price. Many years ago, Sears noticed
that its appliance business was strong dur-
ing sales but weak at other times. It
attempted to change its pricing strategy to
“everyday low prices,” but this was unsuc-
cessful. 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 circulat-
ed 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 ser-
vice 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 oth-
erwise paid the normal price. If new cus-
tomers 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 dis-
counting, especially when offered fre-
quently, is unprofitable.
Customer reward programs. These pro-
grams constitute a form of deferred dis-
counting. 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 may 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 cus-
tomers have little choice when added fees
are industry-wide, price reductions (dis-
counts) are always better received by cus-
tomers 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 advan-
tage. 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 cus-
tomers might exceed the benefits of the
JUNE 2014 / THE CPA JOURNAL
added revenue. An analysis of the cost of
overbooking involves not just the accom-
modation 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, 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 monitor-
ing and billing for usage, and it attracts cus-
tomers with a guaranteed price that is inde-
pendent 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 long-
standing question in revenue management
is whether to offer goods and services sep-
arately or in a package. Bundled goods and
services are usually priced below the sep-
arate 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 reason-
ably good prospects for profitably
enhancing total revenue, without the behav-
ioral effects of standard discounting.
But customers sometimes resist having
to buy things they don’t want. One exam-
ple is cable television service, which typ-
ically includes a large number of chan-
nels for a given rate. Some customers have
argued for a la carte pricing and the abil-
ity to design their own package. Cable
operators have resisted this for various rea-
sons, including the added technical diffi-
culty of giving different access to each cus-
tomer, the likely decline in overall revenue,
and the likely requirement of prohibitive-
ly high rates for little-watched channels.
Some of the bundling occurs upstream,
where content providers require cable oper-
ators 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 air-
lines 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., pil-
lows, blankets, headphones). Just as many
customers dislike having to buy bundled ser-
vices, 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 man-
agement. 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 broadcast-
ers, third parties (i.e., advertisers) often sup-
port these free services.
Other forms of “free” can be part of a
revenue management program. A compa-
ny could provide something free with the
expectation of earning revenue when the
customer purchases other goods and ser-
vices. For example, banks offer free cred-
it cards, retailers offer coupons for a free
item, and eating and drinking establish-
ments 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 consider-
able success in recent years, as the initial
free product serves to introduce it to the
customer, who is then more likely to con-
tinue its use and to upgrade beyond the
basic version
Thus, “free” is a common revenue man-
agement tool for many companies. If the
cost to provide the free element is mod-
est, the potential revenue gains may be
worthwhile.
Emerging Applications
New business models to generate rev-
enue continue to emerge. A recent trend
toward a “sharing economy” has expand-
ed the opportunities for revenue from short-
term rentals. Car rental by the hour is
now found in areas where many non–car
owners are concentrated, such as large
cities or university campuses. Items such
as fine art that were previously purchased
are now available for rent. Even profes-
5
sional 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 busi-
ness entities. Individuals have become
players as well, offering temporary use of
space in their residences, power tools, auto-
mobiles, and the like, creating a changed
competitive environment. Studies have
noted a recent trend away from home buy-
ing 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 emerg-
ing business trends, which affect both revenue
opportunities and threats for their clients.
Marginal Analysis and Its Limitations
Marginal analysis has long been a main-
stay 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 spe-
cial 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 applica-
tions involved cases of perishable service
capacity in a business where most costs were
fixed, at least in the short term. Because vari-
able costs were small in these applications,
almost any action that increased revenue was
considered beneficial.
Marginal analysis of revenue manage-
ment 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 inef-
fective or discontinued, and price dis-
6 JUNE 2014 / THE CPA JOURNAL
counting expanded to formerly full-price
customers. Once this occurs, one can no
longer ignore fixed costs.
Marginal analysis works only at the mar-
gin. Adding a few customers at reduced
prices might not interfere with regular busi-
ness, but the impact on profits will be
small. When selective price reductions
become widespread, the regular-price busi-
ness is impaired, and the company can end
up worse off. The key to profitable rev-
enue 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 analy-
sis alone is inadequate for a comprehen-
sive evaluation of revenue management
decisions. Rather than a single technique,
a broader process of analysis is needed.
The following considerations might be rel-
evant when analyzing discounting or other
price concessions as a means to increase
total revenue:
n Is the business currently profitable? If
not, there is insufficient volume and prof-
it 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?
n If the business is currently profitable,
would price reductions gain new customers
or would they be primarily used by cur-
rent customers (likely reducing revenues
and profits)?
n If new customers are attracted, will they
continue to patronize the business, or are
they deal-seekers who will not return
after one purchase?
n How will current customers react to spe-
cial pricing offered only to new customers?
n 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?
n 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.
n 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 cus-
tomers, improve retention of existing cus-
tomers, gain new customers, or expand into
new markets (e.g., geographical, customer seg-
ments, 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 dis-
counted price has a positive opportunity
cost if the sale could otherwise have been
made at a higher price, but zero opportu-
nity cost if the sale would otherwise not
have occurred at all.
Many applications of revenue manage-
ment 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 vol-
ume 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 (espe-
cially by airlines and hotels) as a strategy
to reduce opportunity cost. Although over-
booking reduces the opportunity cost of
unsold capacity, it substitutes a new oppor-
tunity cost (satisfying the displaced cus-
tomer). 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 man-
agement decisions.
Customer Reactions
An analysis of revenue management
decisions is incomplete without consider-
ation of likely customer reactions. Because
most revenue management involves vary-
ing 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 sell-
er 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 per-
ceive surcharges or add-on fees as less fair
than discounts, even though the price dif-
ferential in either case may be the same.
Customers often judge fairness in com-
parison to what they expect to pay, which
might be based on advertised prices, his-
torical 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 suppli-
er offers customers an opportunity to save
money by qualifying for lower prices.
Price differentiation among customers—
the essence of most revenue manage-
ment—entails many challenges for cus-
tomer 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 rev-
enue management increases both revenues
and profits; consequently, revenue man-
agement decisions are important financial
decisions. With many techniques available
to manage revenues, an analysis of their
JUNE 2014 / THE CPA JOURNAL
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effects is essential. But this is not easy,
because there is often a question of
opportunity cost. What would have hap-
pened otherwise? Is the company better off
than it would have been? Although these
questions are difficult to answer, an imper-
fect 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 increas-
ingly 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 analy-
sis that needs to be more than a consider-
ation of marginal revenue versus marginal
cost. Developing a familiarity with revenue
management techniques and an expertise
in their analysis can be a value-added ser-
vice for CPAs. q
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.
7