The most important theme coming out of United’s investor day last week was that it admits something that everyone else has known for years: it has a real revenue problem. Considering the network and assets it has, it should be making more money. A lot of things are going to fix that issue, including initiatives we’ve already discussed like better scheduling of connecting hubs and the introduction of Basic Economy. But there are behind-the-scenes changes in the revenue management system that are going to yield big improvements as well. Scott Kirby opened up the black box and explained in surprising detail some of the issues United faces. Today I’m going to translate some of that into English.
Alright, so maybe that’s not fair. Scott actually did a pretty good job of talking about the issues in plain-speak, and I’d encourage you to listen to the investor day presentation. Once you get it started, flip to slide 42 and the audio will skip ahead as well. It’s slide 43 that starts to explain what’s going on. Or you can just flip through without commentary here.
This slide sums up the four primary issues:
In short, the overall problem is that United’s revenue management system is nearly 20 years old. Since it was built, a lot of things have changed in the world of pricing/demand as well as in technology. So there are issues that need to be fixed. The last 3 issues here are pretty straightforward, so I’m going to focus on the first one, the independence of demand, or lack thereof.
This sounds like a revolutionary war cry of some sort, but it’s really referring to how pricing structures have changed over time. First, I need to explain how revenue management systems work. Airlines file fares which book into so-called “buckets” which are represented by letters. We’re going to use a very simplified example here to make it easier to explain.
For United, let’s pretend it has only three buckets in coach (there are far more). The coach bucket with the highest fares is Y, and that’s followed by B, and M in descending order. These letters mean nothing. They’re just ways for United to determine how many seats it wants to sell at each fare.
Let’s say there are 100 seats to be sold on a particular flight from, say, Los Angeles to Denver. There are three fares in the market:
|Y||$250 one way||
Demand forecasts show that there will be 25 people who are willing to pay for a Y seat, 50 who will pay for a B seat, and 75 who will pay for an M seat on this particular flight. Since United has only 100 seats to sell, it can’t take everyone. So it will work to maximize revenue, selling as many of the high fare seats as it can.
Buckets are “nested” meaning that anything available in B will also be available in Y. (After all, if more people want to buy the top fare than forecasted, hooray.) That means every seat, all 100, will be available in Y. Then 75 seats will be made available in B (reserving 25 that can only be sold in Y). That means only 25 will be allocated to M class.
These fares are all pretty unique, and the people who are truly price sensitive will only go for the cheapest fare. Meanwhile the business traveler who needs flexibility and can’t stay overnight or book far in advance will buy the most expensive fare. This is what United is calling “independence of demand.”
It’s also roughly how things used to work when Orion was built 20 years ago. It’s NOT how things work anymore. The increase in low cost carrier competition has led to an erosion of fare rules on a much greater scale than back in the 1990s. Now you see a fare structure more like this.
|Y||$250 one way||
|B||$125 one way||
|M||$50 one way||
Again, this is a highly-simplified model. But now what you find is fewer fences to wall off the different fares. In many markets, roundtrip requirements have disappeared entirely, let alone the Saturday night stay. And instead of having one fare with unique advance purchase requirements, you could have multiple fares with the same rules. How do you determine demand?
The reality is that there is no reason anyone would ever buy the Y fare unless United made it so that the B fare was unavailable. And while there are still differences between the B and M fare, the roundtrip requirement is gone and the advance purchase has shrunk. Overlap of demand for the different fares increases. And this is where Orion stumbles.
Let’s just focus on the Y and B buckets here for this piece. Orion will look at historical demand in each bucket to guess demand for our example flight. Let’s say that Orion is looking at 100 flights in its history for this particular forecast.
If on 50 of those flights (half the time) the B bucket is open, that means demand for the Y fare is zero, even though the Y bucket is also open. With identical fare rules, you would never buy the more expensive Y fare as long as the B fare was available. On the other 50 flights, the B bucket is closed (probably due to manual intervention from an analyst – more than 2/3 of flights are handled this way at United), and demand for the Y fare is 20 people on each of those flights.
Selling 20 Y seats on 50 flights (with none sold on the other 50) means United sold a total of 1,000 Y fares. Divided by the 100 flights and we have an average of 10 per flight. That means Orion will assume there will be demand for 10 Y seats on our flight, because it doesn’t realize there would have been demand for Y fares on the other flights, if only the B bucket had been closed.
And that is the issue with the disappearance of the independence of demand. This forecasting algorithm wasn’t an issue when fares had greater fences separating themselves, but now it is a huge problem. The system underestimates demand for higher fares.
To make it worse, this causes what United is calling “spiral down.” When the system underestimates demand in Y, it holds back fewer seats to be sold in that bucket (10 instead of 20 in our case). And then it underestimates demand off the new, already too low estimate. The system effectively shrinks expected demand for the highest fares closer and closer to zero.
In practice, this means United is holding back fewer seats to be sold at higher fares and leaving lower buckets open for longer. That may be why you can get a cheap fare at the last minute even though you’re willing to pay more. Now United is going to fix this issue (in the next year or two), and that means there will be fewer seats available at the lowest fares and more at the highest fares.
By United’s estimates, these changes (not just fixing the problem of the lack of independence of demand, but all four) will be worth $100m in 2017 and upwards of $900m by 2020. That is, of course, if United’s forecasts are right….
For more reading, check out United’s presentation beginning on page 43 of this deck.