Profiting with Yield Pricing

by James T. Berger, December 2005

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Increasing numbers of companies are taking elements of “yield pricing” or “yield management,” a pricing strategy originally developed for perishable service sector products and adapting this strategy to new uses.

Yield management as been used since the mid-80s in the lodging industries and in airline ticketing. The key variables are: (1) the perishable nature of the product, and (2) different levels of demand from different customer categories or segments. Common example are a motel reducing its room rate at the end of the day when it’s unlikely to be able to rent its rooms at its normal rate. Or, when a airline facing a half empty plane will cuts its ticket prices to try to fill the empty seats.

With yield management the increase of usage (i.e. motel rooms or airline seats) have no or little variable cost. Thus, it costs the motel no more to operate at 100 percent of capacity than at 50 percent. The same with the airplane. There is no additional cost for filling all the seats versus filling half the seats.

Yield management systems attempt to understand, anticipate and react to consumer behavior in order to maximize revenue. Those using yield management pricing strategies periodically review transactions for goods or services already supplied and for good and services to be supplied in the future. They may also review information (including statistics) about known future events (such as holidays) or unexpected past events (such as terrorist attacks). They also may review competitive pricing information, seasonal patterns and other pertinent factors that affect sales. The models attempt to forecast total demand for all products/services they provide, by market segment and by price point. Since total demand normally exceeds what the particular firm can produce in that period, the models attempt to optimize the firm’s output to maximize revenue.

The optimization attempts to answer the question: “Given our operating constraints, what is the best mix or products and/or services for us to produce and sell in the period to generate the highest revenue production?”

Yield management was first developed in the mid-1980s by the newly deregulated airline industry. But going beyond air transportation and lodging, examples of yield management are abundantly found elsewhere. For example:

Seasonal Products. Take for example products indigenous to winter such as snow-blowers or products indigenous to the warmer months such as lawnmowers and air conditioners. Let’s assume the producers of these products are producing them 12 months a year. Generally, the first attractive pricing is the “pre-season” sale, which is generally a result of the manufacturer using seasonal pricing to PUSH the products through the distribution channels and each channel member passes on the lower price. The manufacturer of the seasonal product is generally sitting on large inventories that it wants to convert to cash. In the midst of the season – after the first snowstorm – pricing will reach its highest point. Then, after the season is over, pricing will fall as retailers attempt to clear out their winter inventory and begin with their pre-season lawnmower sale.

Unexpected past events. The September 11 terrorist attacks, using hindsight, would have been an excellent proving ground for yield management. The lodging, airline transportation, car rental and other travel-related industries fell into a severe depression as people were suddenly fearful of travel. What eventually evolved was extremely low prices as the travel industry attempted to use price to assuage customer fears. In the future, reaction time will most likely be much quicker.

Life Cycle and Adoption Curve Dynamics. In industries where the product life cycle is relatively short (such as fashion) yield pricing has been used for years. The new styles come out and they are priced at a premium. Here the demand from innovators and early adopters (approximately 16% of the market) is high while supplies are low — thus the high prices. As supply catches up with demand, prices will fall to the normal level as the early majority (approximately 34 percent of the market). Finally, when the style has run its course or the early majority has finishing buying, the still-in-style product goes on sales and is purchased at a small discount by the late majority (34 percent of the market). Then, at the end of life cycle when the style has been replaced by a new style, pricing goes down to liquidation levels and the remaining surpluses are absorbed by the “laggards” (approximately 16% of the market.)

Here are some specific examples of how yield management is used in specific industries and by specific companies:

In the November, 2005, Harvard Business Review, there is an article by Harvard Marketing Professor John H. Roberts entitled “Defensive Marketing: How a Strong Incumbent Can Protect its Position.” This article focuses on the Australian telecommunications industry where a company called Telstra enjoyed a virtual monopoly when the industry was regulated. When the Australian telephone industry was deregulated in the late 1990s, a powerful new competitor, Optus, entered the marketplace. Optus was a joint venture financed by the U.S. company, Bell South, and the British company, Cable and Wireless. Telstra adopted a defensive strategy to combat the Optus threat. One of the battlegrounds was pricing. Roberts writes that research revealed that Telstra’s customers, although likely to respond favorably to Optus’s low prices, didn’t view Telstra’s prices as a strong incentive to stay with the company—possibly because a Telstra price decrease would only raise questions in the consumers’ minds about why the company hadn’t dropped its prices before it had competition.

To combat the competitive threat, Telstra adopted a hybrid form of yield pricing. Roberts explains: “…Telstra adopted a parity strategy, in which it created strategically chosen, but quite limited, points of price superiority over Optus. That is, while on the average Optus offered lower prices, Telstra’s prices were lower on some routes and at certain times of day. This meant that the lower priced carrier for a given customer depended on that individual’s specific calling pattern – a muddled situation in which consumers were less likely to take the big step in switching phone companies on the basis of price.”

A much simpler example is the neighborhood bakery. Early in the ot morning when the baked goods are hot and fresh, the bakery has the opportunity to charge a premium price for that market segment that desires fresh-baked goods. Once that segment has bought, the bakery could lower its prices for its normal, walk-in customers. Late in the day – before closing – it could put its remaining goods on sale to move them out in preparation for tomorrow’s products.

The Christmas retail shopping season would be an excellent proving ground for yield management. Every year it seems there is one or two products where the demand is so high supply can’t keep up. This trend started a number of years ago with the Cabbage Patch dolls and as been evidence more recently with the “Tickle Me Elmo” dolls, the Play Station 2, IBox and Xbox, etc. It’s almost become a marketing badge where if the product can be obtained, it’s assumed that it is not that wonderful. Invariably, after the holidays, the supply catches up with the demand and there are ample quantities on the shelves.

What if the marketer of the “hot” product adopted yield pricing and charged a premium price for the product. Then, those who really wanted it could buy it and those who were willing to wait could buy it after the holidays at the normal list price. If you wanted it badly enough you’d pay the higher price.

Yield management opportunities are available everywhere. Smart marketers will see the yield pricing relationship with their own products and services and adopt creative strategies to maximize profits.

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Author
James T. Berger, Managing Editor of The Wiglaf Journal, specializes in both finance and marketing and has spent a number in both the investor relations field as well as an account manager and officer at several Chicago advertising agencies.

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