American Airlines Dynamic Pricing

EXECUTIVE SUMMARY Revenue management is a proven technique to help service industries maximize revenue. It involves management of inventory and distribution channels and prices to maximize profits over the long run. Simply stating the technique involves selling the right product to the right customer at the right time at the right price. The following are the primary activities involved: demand data collection, demand modeling, demand forecasting, pricing optimization, and system implementation and distribution. Though individual airlines in the States are not owned by the government, it effectively controlled their performance until the late 1970s by setting a single price for each route and decreeing which of many carriers could operate where, but from the late 1970s on, the government relaxed the rules. American Airlines (AA) was the first to use basic revenue management techniques, offering dynamic pricing in shape of discounted fares to passengers who booked early, incentivizing customers by reserving seats for higher paying customers, and overbooking seats in the knowledge that some passengers would cancel at the last moment and that others would fail to show up. AA pioneered the revenue management system and reaped the rewards of being one of the first movers in that direction. By using the methods mentioned earlier American Airlines claims to have been able to generate as much as $500 million a year in additional profits from 1980s onward.

The methods used and the steps taken highlight the simple use of basic microeconomics principles in that dynamic pricing helps reduce the consumer surplus and deadweight loss and at the same time increases the firm’s profits. Using dynamic pricing (and coupling with yield management) AA decreased demand variability in that the customers understood that the earlier they book the better price they will get. The questions American Airlines asked itself were: How many seats to make available at each of the listed fares, depending on time of year, time of week, remaining seats available, remaining time until departure, what contracts and prices to provide to corporations, how many seats to make available to consolidators and travel agents (if at all), and at what prices, how much capacity to make available to cargo shippers and freight forwarders, and at what prices. The same techniques can (and have been) applied in many other sectors like hotel industry, Ocean cargo industry, car ental industry, restaurant industry, manufacturing industry, retail industry and many others where the goods are perishable and opportunity costs exist including even golf courses and entertainment industry (ticket pricing, advertisement slots etc). Analysis 1. What are AA’s major strategic & tactical Decisions American Airlines (AA) faces intense competitive threat as airline deregulation had opened the market to new entrants; the deregulation has also allowed airlines to change their fares and route structure at will. AA executives have to make major strategic and tactical decision to thwart these competitive threats and maintain AA leadership as airline of choice. * Cost Containment – AA has to keep it cost in control, acquire new fuel efficient aircraft, maintain its labor and pilots productivity and reduce its aircraft maintenance costs. * Route Structure – The evolution of hub-and-spoke model of airlines operation required AA executives to decide on optimal routes, aircraft size, fares and terminal allocation. Marketing – AA executives have to find out the optimal way of using AMR’s SABRE reservation system and leverage bit to seek competitive advantage. SABRE system as Quantitative Decision Support System AMR’s SABRE ticket distribution system has information regarding 35% of all airlines reservation in United States wealth of ticketing and routing data that can be leveraged by AA to understand where it stands with respect to the competition. AA can utilize data mining on SABRE system thus converting it into a quantitative tool that can help AA support its strategic and tactical decisions. AA can use route and faire optimization to arrive at its short and long term pricing strategy. 2. Should AA counter Continental’s $159 west coast fare with a relatively unrestricted fare on the non-stop Chicago-west coast flight? American Airlines should actively take measures to meet its breakeven passenger load factor of 56. 0% in September and October, although these measures may not necessarily include countering Continental’s $159 west-coast fare with $10-$20 premiums and high restrictions. Firstly, it may not be a sound strategy for American Airlines to compete with Continental on its core strength: pricing. More specifically, Continental’s post-Chapter 11 reorganization and low-cost structure provides the airline with a non-replicable competitive cost advantage over American Airlines.

American Airlines may need to cut its margins steeply in order to compete with Continental’s low prices. Should American Airlines choose to pursue countermeasures against Continental, however, the company should determine the most cost-effective way of lowering prices.

For example, the company should recognize that lowering prices in July and August, months in which their breakeven passenger load factor minimum is already met, is unnecessary. Therefore, the company’s focus should turn to the months of September and October, in which the current load factors are 1. 4% and 0. 8% lower than the company’s breakeven point. American Airlines should also recognize that the average full-coach O&D passenger totals actually increases in the months of September and October to 7,389. 5, up from 7,056. 5 in the months of July and August. It is reasonable to conclude that American’s inability to meet its breakeven point is not attributable to its inability to sell Full Coach tickets, but more a reflection of its Discount Fare ticket sales. Assuming that $10-$20 premiums over the company’s expenses are achieved, its new margins over its current operating expenses per available passenger seat mile of 7. 59 cents would be $10/2,132. 92 = $0. 004 per mile, $15/2,132. 92 = $0. 007 per mile, and $20/2,132. 92 = $0. 01 per mile (there are 2,132. 92 miles between Chicago and San Francisco). If the company cuts its margins to this extent, and is still able to earn $7. 60 per mile over the operating expenses of $7. 59 per mile ($20 premium), it may be able to capture 100% of Continental’s market share in September and October (11. 3% and 11. %). With a total market size of (7095+57261)*100/26. 1 = 246,574 tickets in September, and (57261-7095)/57261 = 87. 6% of tickets being Discount Fare tickets, stealing 100% of Continental’s market share in discount tickets would subsequently increase the American’s Discount Fare ticket sales by 9. 9%, or 24,407 tickets. Similarly, with a total market size of (7684+59724)*100/26. 4 = 255,333 tickets In October, and (59724-7684)/59724 = 87. 1% of tickets being Discount Fare tickets, stealing 100% of Continental’s market share in discount tickets would subsequently increase the American’s Discount Fare ticket sales by 9. 8%, or 24,908 tickets. Assuming linear relationships, a difference of 20,000 tickets reflects approximately a difference of 16% of load factor – i. e. an incremental 1% difference in load factor can be attributed to selling only 1,250 more tickets. In conclusion, it seems unnecessary for American to reduce its prices this steeply in capturing Continental’s entire Discount Fare ticket market share, when it needs only to increase its load factors by 1. 4% and 0. 8% in September and October. In order to meet its breakeven load factor, the company should sell another 1. *1250 = 1750 in September and another 0. 8*1250 = 1000 in October.

Because there are 180 seats on a Boeing 737, and subsequently, (7095+57261)/180 = 357 flights in September and (7684+59724)/180 = 374 flights in October, 5 and 3 additional tickets need to be sold in September and October, respectively, in order to meet its breakeven load minimum. Assuming linear relationships again, American Airlines can generate additional sales of 11. 66-7. 59 = 24,407/4. 07 = 5996 tickets per cent of revenue yield lowered in September and 24,908/4. 07 = 6119 tickets per cent of revenue yield lowered in October. In order to achieve its objective of 56. 0% breakeven passenger load factor, the company should, therefore, lower its revenue yield per passenger mile to 11. 66 – 0. 29 = 11. 37 cents and 11. 66 – 0. 17 = 11. 49 cents in September and October. Including Full Coach ticket prices, the airline should ultimately lower the average fare from $248. 70 to $242. 51 in September, and $245. 07 in October. American Airlines may still consider pursuing other options in meeting its breakeven passenger load factor, which do not compete with other airline companies’ core strengths. For example, because United’s core strength originates in its successful flight scheduling, competing with United on another aspect of the business, such as pricing for non-stop flights, may provide American Airlines with a unique advantage, and allow the company to meet its breakeven passenger load factor. 3. What additional information should Santoni collect on a response to Eastern’s pricing decision ? New York-San Juan is critical to AA revenue as it is the largest market in terms of revenue passenger per miles. Performance in this sector ill significantly impact AA’s overall revenue, profits, cost per passenger mile and Load Factor. In order to competitively respond to Eastern Airlines offer and make data driven informed decision AA should further investigate the following areas 1. Overall Market Size: The number of passenger travelling between New York and San Juan will impact the decision on number of flights and schedule for this sector to capture even greater market share. We also need to understand the factors that could increase the overall market in this segment. 2. Weekends and weekdays Travelers: The segmentation of the passenger will enable AA to offer different pricing structure to attract each type of customer leading to increased revenue and load factor. 3. Market segmentation: Categorize the passengers based on following criteria- a. Traveler Category: Business, Leisure, Local This segmentation of the travelers will influence the scheduling appropriate to the season and travel trends.

For example, significant number of business travelers will lead to fairly constant demand throughout the year. Otherwise, for passengers fall in the leisure category the demand would be higher in the summer than during other parts of the year. Further, the number of passengers that prefer to buy a one way unrestricted ticket would influence our pricing. b. O&D versus those originating from other destinations: This segmentation would affect our decision because if there are significant numbers of O&D travelers then we may focus more on the NY-SJU sector otherwise we can focus on providing connecting flights, treating San Juan as a transfer hub or devising alliance with local carriers. This would help us differentiate from other carrier as AA can provide a more comprehensive flight package and enable us to charge tickets at premium. 4. Relative market share of the major players in this sector: This would help AA to devising pricing or scheduling schemes to gaining more market share based on our relative market share. 5. Current Schedule of flight by Eastern Airlines in this market: The scheduling of flights depends on the number of aircrafts operated by the carrier in the region. Moreover, the connecting flights for passenger continuing for destinations beyond San Juan will impact the choice of carriers. 6. AA’s load factor in this sector: This would influence our decision of dropping the price of seats to attract more leisure passengers in case the load factor is below the industry average. Else if we have a high load factor then AA can increase the service in this sector to pick up even greater market share. 4. Yield Management The cost of underestimate full-fare passenger is $400 ($499-$99) per passenger and the cost of overestimate full-fare passenger is $99 per empty seat. Since the cost of turning down a full-fare passenger is much higher than the cost of turning down a discount-fare passenger, the airlines should set a high initial authorization level for the full-fare bucket, which is 30 in this example, and then adjust the levels later to reflect the differences between forecasted and actual demand. The total revenue peaks when the actual demand of full-seat passenger equals the forecasted demand. It goes down by $400 when there is 1 more actual demand and by $99 when there is 1 less.

Estimated # of full-rate demand| Actual # of full-rate demand| 27| 28| 29| 30| 26| 20,300| 20,300| 20,300| 20,300| 27| 20,700| 20,700| 20,700| 20,700| 28| 20,601| 21,100| 21,100| 21,100| 29| 20,502| 21,001| 21,500| 21,500| 30| 20,403| 20,902| 21,401| 21,900| 31| 20,304| 20,803| 21,302| 21,801| Demand| 10| 11| 12| 15| 20| 25| 30| TotalRevenue| 13,900| 14,300| 14,700| 15,900| 17,900| 19,900| 21,900| AverageRevenue| 9,666| 10,115| 10,559| 11,862| 13,932| 15,879| 17,700| Risk and Contingency Developing and implementing information systems and processes indispensably bear several types of risks. The enhanced automation of pricing and yield management brings market-related risks, operational risks, and financial risks to American Airlines (AA). Market-related Risks The fact that market demand is uncertain naturally causes risks in the processes of demand modeling, demand forecasting, and pricing optimization. The demand variability is critical challenge for AA in developing profit maximizing revenue management system and the yield management system. Moreover, concerning the pricing activity, the primary uncertainty lies in the demand for different fare types (full- and discount-fare seats) which is affected by economic fluctuation, changes in consumer lifestyle trends, etc. It’s also expected that the level of those risks could be intensified by unexpected economic, political, social events such as economic distress and outbreak of wars. However, these risks are unavoidable and could be minimized through extensive demand data collection and continuous improvement of modeling and systems over time. Regarding the marketing strategy of AA, the cost leadership may not be an unique competitive advantage of AA in the long-run since it could be copied by its competitors. As a result, the strategic and tactical decisions should be made to strengthen both its cost leadership and quality of services. Operational/Financial Risks The revenue management system and the yield management system are exposed to system failure risk, information security risk, and integrity risk. In integrating several different information systems and internal and external databases, these risks increase.

However, risks will be rationally mitigated through the IT governance policy of AA’s Information Systems Department and the minimum level of risks should be accepted by AA in order to maximize profits. In a financial standpoint, system development, implementation, and maintenance activities require enormous investment and costs. If expected financial benefits are not met, it could fail to generate positive operating cash flow from the investment activities.

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