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Best practices in pricing and price optimization

publication date: Jan 25, 2015
author/source: Chris Anderson, HSMAI

Best practices in pricing and price optimization


By Chris K. Anderson
HotelNewsNow.com columnist

While pricing can be a great strategic lever for service firms, simple non-tactical decreases in posted prices are bound to encourage competitive reaction and provide a classic illustration of the
Prisoner’s Dilemma.

An examination of industry pricing during our last two economic downturns indicates we as an industry still have lessons to learn.

A look at U.S. average-daily-rate and demand declines (as summarized in Figure 1 below) shows that during the 2001/2002 downturn hotels quickly responded to weakening demand with price decreases. In 2007 and 2008, suppliers responded slower, but once prices started to decrease there was a race to the bottom as prices declined faster and further.

There are some simple best practices that can help hoteliers better respond when demand weakens and truly optimize their revenue when demand is strong:
• Make the price-change contribution positive;
• assess the implications when reacting to a competitive reaction;
• think like marketers;
• manage discounts strategically;
• leverage easy-to-implement and targeted approaches to generate demand; and
• use online travel agencies for strategic marketing.

Make the price-change contribution positive
For most suppliers, demand as a function of room price is relatively inelastic as the room expense is only a portion of the travel experience and does not necessarily increase the propensity to travel. A decrease in posted prices is quickly matched by competition (whether logical or not), resulting in short-term market share quickly dissipating.

When contemplating a price change, firms need to first assess the required demand response to make the price-change contribution positive. For example, consider Figure 2 where a firm is contemplating decreasing prices from P1 to P2. The firm would have sold Q1 at P1. By lowering prices to P2, they forgo the contribution outlined in area A [(P1-P2)* Q1] while they receive new contribution defined by B [(Q2-Q1)*(P2-VC)]. The price change will be contribution-positive as long as B>A. The price change breaks even if A=B.

We can express this break-even change in demand as:

where CM is the firm’s original contribution margin (P1-VC) and delta P is P1-P2.

If you don’t think you can achieve the required break-even demand increase, then don’t decrease prices. (This works the same if considering a price increase.) The fundamental issue firms fail to consider when making price changes is that all consumers pay (or don’t pay) the new price—even those who would have paid more had prices not been decreased.

Assess the implications when reacting to a competitive reaction
Calculations are even simpler if you contemplate reacting to a competitive reaction. If your competition has decreased prices, you are bound to suffer. The question is: Which is worse? Following them down (in essence selling the same at lower prices) or holding prices and selling less at higher prices? The break-even formulas simplify to:

Unfortunately, many firms never assess the implications of competitor price changes and simply follow them down, largely because they don’t want to reward the competitor.

We can generalize pricing changes with a few basic concepts:

1. Decrease prices (either proactively or reactively following a competitor’s price reduction) in price-sensitive (elastic) segments:

2. Raise prices (or follow a competitor’s price increase) in non-price sensitive (inelastic) segments:

The key term here is segments, indicating firms should not universally price dynamically but rather target price changes at specific market segments, as only targeted price changes will generate enough incremental demand to compensate for rate dilution.

Think like marketers
Increasingly, revenue managers need to think like marketers—making sure their price changes and promotions are targeted at price-sensitive customers. As illustrated with the break-even analysis, if pricing actions are not properly segmented or targeted, they can result in dilution of profits instead of creating incremental demand.

Manage discounts strategically
Today’s online world has made it easy for customers to compare rates both across hotels and across distribution channels and has moved/forced hotels to maintain price parity across channels. The ease of price comparisons requires you to offer discounts in a private fashion. Private (or opaque) discounts allow discounts to be presented to price-sensitive customers while maintaining higher prices on regular posted price channels. Private discounts are often offered on opaque online travel agents like Priceline’s Name-Your-Own-Price channel or on Hotwire.com.  Both Hotwire and Priceline hide the name of the property until after the purchase, allowing the service provider to reach price-sensitive (non-brand-loyal consumers) while simultaneously reaching brand-loyal customers at higher prices.

Bundling is another method of offering private discounts whereby the hotel room is bundled with other hotel services (e.g., spa and food and beverage) with the hotel guest paying a (reduced) package price. More recently, membership selling or flash sales have become increasing popular. Membership selling, unlike posted-price-online selling, involves offers being sent to qualified members of a program. Individual hotels or airlines have performed these actions in the past by sending fliers or emails to registered customers in their databases. These membership selling groups (TravelZoo, JetSetter, LivingSocial, Groupon, etc.) are contacting their members on the supplier’s behalf often with dramatically reduced rates.  

Chris Anderson

A supplier needs to monitor these programs extensively. If these customers are not properly qualified (segmented), then these sales might in fact not be incremental and might be diluting firm profits (you would have sold to some fraction of them regardless—and at higher prices).

Leverage easy-to-implement and targeted approaches to generate demand
Today’s online advertising world offers numerous ways to market to individual customers whether via your customer relationship marketing system (where you are using your database of past customers and their travel patterns to create specific offers), with email offers, or through an online search engine (e.g. Google, Yahoo! or Bing) where you can pay for very specific exposure of your ads with links to special reduced prices.

Search engine marketing or search engine optimization refer to the use of search engines as marketing vehicles. Many consumers first research their potential travel destinations or hotels at a search engine prior to other travel sites. Ensuring your hotel has prime placement at the search engine will undoubtedly drive more demand further down the search funnel. Figure 5 is a display of a Google search on “hotels in red wing.” This search stems from a project with the St. James Hotel in Red Wing, Minnesota. As you can see, the search nets the hotel’s URL high on the list, with their pay-per-click ad fifth down the list of ads on the right hand side.

When looking at this first page result we see both direct competitors to the St. James being listed (e.g., American Inn), as well as the OTAs (using PPC). Search engine marketing will increasingly become an important aspect of all revenue management activities at a property as it provides an easy to implement and targeted approach to generating demand.

Use OTAs for strategic marketing
As we have seen in both recent economic downturns, many hotels have opted to use OTAs as a means to reach price-sensitive consumers. A recent study by Continental Airlines (“The impact of the Internet on airline fares: The Internet Price Effect”) illustrates that while average fares have dropped as consumers have moved online to shop and purchase travel, they are actually choosing to purchase in off-peak periods with lower prices and smoothing out demand. One could conclude that prices are not decreasing, but rather these online channels are reaching price-sensitive consumers that might not have otherwise purchased. 

A related experimental study (“The Billboard Effect: Online Travel Agent Impact on Non-OTA Reservation Volume”) showed that not only do OTAs generate incremental reservations at the OTA, they also significantly increase reservation volume at non-OTA channels (hotel’s own website, call center, traditional travel agent, etc.). The study found that an approximate lift of 20% in reservations is obtained by listing on OTAs like Expedia, Orbitz or Travelocity. Together, these two studies illustrate the strategic role of OTAs in generating reservations for many hotels.

As a note of caution, hotels must use these OTAs strategically—ensuring they are using these channels only when price-sensitive customers are shopping. Provide rooms, and potentially deals, to the OTA when the majority of reservations for the discount segment are booking but then remove these deals once the full price segment is in the market. Look at the OTA as a marketing expense targeted to price-sensitive consumers, using the OTA if you think it’s the most efficient use of your marketing dollars.

Generally speaking, OTAs are relatively consistent in the products and services they offer consumers. What differentiates each is their ability to market to consumers and drive traffic to the specific OTA.

Given the general move towards rate parity, the use of OTAs does not in itself provide an effective method of customer segmentation as customers see the same prices regardless of shopping/purchasing channel. The OTA does provide segmentation opportunities if suppliers understand the types of customers “in the market” at various days before arrival and engage the OTAs appropriately.

For example if customers are researching travel early in the booking cycle (30 DBAs or greater), then they are probably price-focused leisure travelers. As a result, the supplier might want to engage in sponsored placement or banner adds to capture the consumer’s eye or engage in strikethrough pricing to indicate the presence of promotions. For customers shopping even earlier, the supplier might wish to participate with an OTA’s opaque packaging rate and provide a somewhat hidden discount given an air/hotel bundle. Conversely, for shopping dates closer to arrival, customers are more likely to be less price-sensitive. Given rate parity (and the need to offer similar rates at brand.com to more brand-loyal customers), suppliers should be less active in promotional activities at the OTA—perhaps attracting customers with value adds (e.g., parking, free breakfast, etc.) in an attempt to add value and still maintain decent page sort at the OTA.

Ultimately, you should view OTAs and their associated elevated fees or commissions as a marketing vehicle. For many smaller properties, the OTAs represent an efficient use of marketing dollars to generate incremental demand, whereas larger properties or properties within a brand might have other opportunities to stimulate demand.

Special Note: This topic will be explored in more detail on 22 November as part of the 10-part 2011 Revenue Management Webinar Series. The related webinar is titled “What Are the Best Practices in Pricing and Price Optimization?"


Want to Learn More?
This topic will be addressed as part of the 10-part
2011 Revenue Management Webinar Series produced by the HSMAI University in partnership with HotelNewsNow and STR, and sponsored by IDeaS. Each month a webinar covers one aspect of cutting edge revenue management in today's economy in conjunction with articles written by members of the HSMAI Revenue Management Advisory Board. If you’re not able to attend a live program, archives are available. Also, some of these and other timely revenue management topics were the focus of the HSMAI Revenue Optimization Conference on June 20, 2011.  Presentation recordings are now available in the ROC 365 Conference Archive.

About the Author
Chris K. Anderson is an associate professor at the Cornell School of Hotel Administration.  His main research focus is on revenue management and service pricing.  He actively works with industry, across numerous industry types, in the application and development of revenue management, having worked with a variety of hotels, airlines, rental car and tour companies as well as numerous consumer packaged goods and financial services firms.  Anderson’s research has been funded by numerous governmental agencies and industrial partners.  He serves on the editorial board of the Journal of Revenue and Pricing Management and is the regional editor for the International Journal of Revenue Management.  At the Hotel School he teaches courses in revenue management, data driven analytics and service operations management.  Chris is a member of HSMAI’s Revenue Management Advisory Board.

The opinions expressed in this column do not necessarily reflect the opinions of HotelNewsNow.com or its parent company, Smith Travel Research and its affiliated companies. Columnists published on this site are given the freedom to express views that may be controversial, but our goal is to provoke thought and constructive discussion within our reader community. Please feel free to comment or contact an editor with any questions or concerns.

About the HSMAI Revenue Management Advisory Board
The Revenue Management Advisory Board leverages insights, emerging trends, and industry innovations to guide the development of products and programs that optimize revenue for hotels.

Members include:
• Chris K. Anderson, Ph.D., Professor, Cornell University
• Christopher Crenshaw, CRME, Vice President, Marketing Intelligence, Loews Hotels
• Kathleen Cullen, CRME, Corporate Director of Revenue Strategies, Heritage Hotels and Resorts
• Sloan Dean, CRME, Vice President of Sales & Marketing, Interstate Hotels & Resorts
• Jon Eliot, CRME, CHA
• Tammy Farley, Principal, The Rainmaker Group
• Fred Heintz, CRME, Director of Group Strategy, Marriott & Renaissance Hotels of New York City
• Jay Hubbs, Director Hotel Supplier Relations, Expedia Partner Services Group / Hotwire
• Burl Hutchison, CRME, Manager of Revenue Optimization, Sabre Hospitality Solutions
• Warren T. Jahn, Jr., Ph.D., Manager, Revenue Systems Training AMER, IHG
• Klaus Kohlmayr, Senior Director, Consulting, IDeaS Revenue Optimization
• Orly Ripmaster, CRME, Senior Analyst, STR Analytics
• Scott Roby, CRME, Vice President, Revenue Management, Evolution Hospitality
• Chinmai Sharma, Vice President, Revenue Management, Wyndham Hotel Group
• Susan Spencer, Market Director - N. America, ChannelRUSH
• Trevor Stuart-Hill, CRME, President, Revenue Matters
• Paul Wood, CRME, CHBA, Vice President of Revenue Management, Greenwood Hospitality Group

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