A 'New' Tool For Manufacturers

Dec. 21, 2004
Revenue management, now a staple in many service industries, also can aid manufacturers.
Suppose your company's market goes south. To keep the top line intact, employees busy, and machines humming, you could discount your prices, or accept some of the lower-margin orders that you normally pass. It might work, but how can you make sure that you won't be mired in cut-rate business when the market bounces back? Or you may be ready to bid on a long-term contract with a potential client that you've been eyeing for years. The lower your price, the more likely you'll win the business. On the other hand, you'll also make less money. How can you decide on the rate you'll charge? The discipline of revenue management (sometimes referred to as yield management) can help. Straddling the fields of operations research, economics, finance, and marketing, revenue management takes a disciplined approach to forecasting demand for products or services, figuring out how to most efficiently provide them, and using price as a lever to influence demand and generate as much revenue as possible. Robert G. Cross, in Revenue Management: Hard-Core Tactics for Market Domination (1997, Broadway Books), describes revenue management as "the art and science of predicting real-time customer demand at the micromarket level and optimizing the price and availability of products." (Cross is chairman of Mountain View, Calif.-based Talus Solutions Inc., a provider of revenue-management applications.) Although revenue management is most heavily entrenched in service industries, experts say the principles behind it work in manufacturing companies as well. If a company has the ability to adjust its prices to influence and meet demand, revenue management applies, says Garrett J. van Ryzin, associate professor of management science and operations management with the graduate school of business at Columbia University, New York. In the future, revenue management is likely to become even more relevant in manufacturing. For one thing, many manufacturers are moving to just-in-time production schedules, which limits their ability to use inventory as a buffer against swings in demand. "Revenue management is an additional tool to handle variability in manufacturing," says Lawrence Robinson, associate professor of operations management at Cornell University, Ithaca, N.Y. At the same time, more manufacturers are working with products that become obsolete at an almost dizzying pace. Revenue management's focus on forecasting demand and utilizing capacity can help in getting the most from perishable inventory. If you travel regularly, you're probably already familiar with the principles behind revenue management. You know that the price you paid for your plane ticket may be very different from what the person sitting next to you paid, and that the travelers a row behind you may have handed over yet another amount. Such pricing differences aren't just to make life confusing for you or the travel agents. They're a result of airlines' efforts to generate as much revenue as they can by finding the optimal mix of customers -- from those who pay a premium to book at the last minute to the thriftier souls who reserve tickets weeks ahead in order to pay less. Of course, the notion of reserving capacity for clients who are willing to fork over big bucks has been around for a while, as has the idea of offering price breaks for scheduling ahead. What's new with revenue management is the rigor with which decisions about demand, pricing, and capacity allocation are made and the explicit linking of these three functions. The revenue-management system at St. Paul-based Northwest Airlines, for example, reviews demand and inventory for each fare class on every flight in order to optimally allocate seats. In the process it chugs through some 14 million forecasts nightly. It was in the airline industry in the late 1970s that the field of revenue management took off. Deregulation hit, and the established carriers had to find a way -- quickly -- to compete with low-cost upstarts such as People's Express. Before then, planes routinely flew with a fair number of empty seats. "You want premium buyers to cover costs and get profits," says Richard C. Larson, professor of operations research at the Massachusetts Institute of Technology, Cambridge. "Then, for the rest you sell (as long as you sell above marginal costs) you'll make dollars that you wouldn't make otherwise." Today, almost every airline practices revenue management, along with many hotel chains and car-rental operations. A number of other service firms, such as broadcasting and delivery companies, also have hopped aboard the bandwagon. The growing popularity isn't surprising, when you listen to the claims made about revenue management. Most airlines measure the contributions of their revenue-management systems to their top lines in the hundreds of millions of dollars. And, because costs don't go up proportionately (instead, price is used to meet and influence demand), the impact on the bottom line can be tremendous. There's no reason why manufacturers can't adopt (or adapt) these techniques. Some elements of revenue management, such as capacity planning and demand forecasting, already are familiar territory for most. One automaker reportedly has begun implementing a revenue-management system, but declines to talk about it. For many companies, revenue management simply means handling in a more data-driven fashion what management already is doing to manage pricing and availability. "It's a very scientific application of the laws of supply and demand," says Graham Parker, vice president of PROS Strategic Systems, Houston, a provider of revenue-management systems. Revenue management encompasses three broad activities: forecasting demand, utilizing capacity, and adjusting prices to best meet -- and influence -- demand, says Doug Gray, a Tampa-based industry consultant. A credible demand forecast acts as the foundation of a revenue-management application. "If the prediction has a great deal of uncertainty, the benefits of revenue management start to fall off," says Barry Smith, senior vice president of Sabre Inc., Southlake, Tex. To effectively predict demand, a company must segment its market as finely as possible and look both at business that it has won, as well as the business it has lost, says Bob Phillips, president of Talus. "You want to find out the price responsiveness for different segments of customers." Dallas-based Omni Hotels has 40-some hotels around the country, with an average of 400 rooms per hotel. The company's revenue-management system, which is from Talus, provides detailed information on demand at each hotel. For example, the system breaks down demand fluctuations by date of arrival and length of stay, says Milton Godwin, corporate director of revenue management, who works at Omni's Omaha reservation center. That information is combined with yet more data on variations in demand by day of the week and season of the year, going back over the previous year. The system then factors in the latest trends in demand during the previous several weeks at the hotel. Having this level of detail about demand helps the company set its sales strategy. "It lets us know when to be patient and wait because it will happen. Or it tells us it doesn't look like it will happen, so let's sell more," says Godwin. That's important, says Godwin, because it's hard for directors of sales to be patient. For example, they panic when they see that there aren't any reservations eight to nine months out. However, if the system can show that the hotel is likely to pick up high-margin business in the interim, it's easier to wait. Omni has been using revenue-management concepts for several years, with good results. The company measures performance with a calculation called revenue per available room, which factors in both occupancy rates and room prices. The measure increased more than 5% between 1997 and 1998, most of which flowed directly to the bottom line, says Godwin. In addition to getting a handle on demand, a company should figure out how to best allocate capacity. Just as the airlines began courting price-sensitive consumers to fill up their planes in the early 1980s, Unimark Group, based in Bartonville, Tex., has found additional business to complement its core. Unimark -- founded in 1991 with 1998 sales of $90 million -- produces and distributes freshly cut fruit under the SunFresh label to grocery stores around the U.S. During the last several years, the company also has sought out accounts in the private-label and food-service sectors. Although margins are lower, the business provides the volume needed to keep Unimark's factories running and employees on the job, says CEO Soren Bjorn. "The branded side of the business will make the company profitable and healthy, because we have equity in the brand," says Bjorn. "The other keeps our factories running and covers overhead." When Unimark's only business was its branded fruit products, the company's plants and employees worked just several months out of the year. SunFresh fruit is cut by hand, and workers quickly lose their cutting skills when they're off the job. Bjorn and his management team needed to find markets that would complement the SunFresh line. In addition to the commercial-food business, Unimark began producing and distributing what's known as "cell sacs." These are segments of unripened grapefruit that are used to add texture and eye-appeal in drinks and yogurts sold in Asian countries. Pricing, the third element in revenue management, was largely responsible for United Parcel Service of America Inc.'s (UPS) interest in the strategy, says Mark Rudel, corporate marketing manager with the Atlanta-based company. "About six or seven years ago, the marketing group at UPS saw that we were getting into a more complex marketplace from a pricing point of view. As the years went by, a higher percent of customers were not paying list rate, but were negotiating individually." UPS had to become smarter about the types of agreements it entered into and fine-tune its ability to forecast demand and manage different price points. The challenge when a company vies for corporate accounts, as UPS does, is "finding the price at which the probability of winning the account, multiplied by the contribution [to profit] of the account is maximized," says Talus' Phillips. UPS' revenue-management system, a Talus system that was implemented last summer, analyses a number of factors about its customers. That includes their size, the length of their relationship with UPS, the type of packages they ship (because UPS charges by weight, small, heavy packages are more profitable than large, lightweight ones), and the distances the packages travel. The system is expected to add several percentage points to UPS' top line, now just under $25 billion, and help balance the need to grow with the need to keep a healthy bottom line, says Rudel. "It raised the bar and made us smarter." Even as revenue management becomes more widely applied, its use raises some issues. The idea of charging different prices for what appears to be the same product can raise hackles, as most airline executives know only too well. "There's the idea that revenue management is gouging," says Sabre's Smith. Closer examination reveals that this isn't the case; the ability to reserve a seat on a plane (or a slot on an assembly line) at the last minute is a service that providers certainly can charge for. At this point, it's hard to say if manufacturers will experience the strong returns from revenue management that other industries have. For one thing, they already have implemented some of the concepts, such as capacity planning. In addition, differing cost structures between industries will impact returns. For instance, when more costs are variable (that is, they go up as volume goes up), the profit generated by adding lower-priced business isn't going to be as great as it is in industries (such as the airlines) where fixed costs are a larger portion of the total, points out Bill Congdon, general manager of Texas Instrument Inc.'s precision-products business unit in Attleboro, Mass. Perhaps the issue of biggest concern for manufacturers is simply the fact that revenue management has yet to be implemented to any degree outside the service sector, and unforeseen hitches are likely to crop up. However, that's not to say the concepts can't apply. PROS' Parker says, "Anywhere supply is constrained and demand is elastic, revenue management makes sense."
Core concepts of revenue management
In Revenue Management: Hard-Core Tactics for Market Domination, (1997, Broadway Books), Robert Cross suggests seven core concepts for revenue management: 1. Focus on price rather than costs when balancing supply and demand. 2.. Replace cost-based pricing with market-based pricing. 3. Sell to segmented micro-markets, not to mass markets. 4. Save your products for your most valuable customers. 5. Make decisions based on knowledge, not supposition. 6. Exploit each product's value cycle. 7. Continually reevaluate your revenue opportunities.
When revenue management makes sense
Garrett van Ryzin, professor of management science and operations management in the graduate school of business at Columbia University, says several conditions indicate that revenue management could be profitable: 1. You have limited short-run capacity. 2. Marginal costs are low. 3. Demand varies (over time). 4. Pricing is flexible. 5. You can control how you allocate supply. 6. You're able to obtain data on historical demand.

Popular Sponsored Recommendations

Voice your opinion!

To join the conversation, and become an exclusive member of IndustryWeek, create an account today!