Date:
September-02-05
Magazine:
International Rental News
Editor:
Mr Murray Pollok (Email: murray.pollok@khl.com)

Yield Management

NOTE

This the first of a two-part article on yield management, by Lucy Peterson, that appeared in the July-August issue of European Rental News (ERN). The second part will be published in the September issue of ERN.

INTRODUCTION

Yield management has become an essential pricing tool in the airline and hotel businesses, among others. Is it now time for the equipment rental industry to exploit the technique? Lucy M Peterson reports for ERN, in the first of a two-part article.

Say 'yield management' and most people think of American Airlines. The company's groundbreaking introduction of yield pricing in the airline industry is the stuff business legends are made of. When deregulation converged with electronic data distribution in the 1980s, a window of opportunity opened — and American flew a figurative 747 straight through it. Furthermore, most of the seats were taken.

What filled those seats was a profit concept called yield management, a scientific way to manage near-term supply against forecasted demand (see box story). American Airlines had the vision to define its 'supply' as perishable units of time and place, and the technology to make educated guesses at demand. The concept was revolutionary enough to shift pricing power back to American and away from new competitors with low operating costs, such as People Express. In theory, it was nothing short of inspired.

It looked impressive in practice as well. American quickly gained margin using yield management pricing. Hard on its heels Delta followed suit, while companies that were slow to invest in the technology saw their profits evaporate.

As People Express founder and former CEO Donald Burr conceded post-bankruptcy, “We were a vibrant, profitable company from 1981 to 1985, and then we tipped right over into losing $50 millions a month. We were still the same company. What changed was American's ability to do widespread yield management … There was nothing left to defend us.”

Since then, yield management has become an indispensable tactic of all airlines in the struggle to preserve market share and profitability. Other business sectors have followed suit in the US, the UK and Europe, most notably the hotel industry.

Why not equipment rental?

In the business of equipment rental, sophisticated yield management qualifies as the 'blind date' of revenue optimisation — it sounds good, but the chemistry is still a question mark. Certainly there are empirical similarities with other time-perishable industries. Cruise, rail, vehicle rental, golf, film and concert ticket enterprises, for example, have all successfully adopted versions of the airline and hospitality models. Can it translate to equipment rental?

The answer is complex and open to debate. In the US, a few rental companies have tiptoed around variable pricing for more than a decade. But the practice never grew legs, in part because there was no reliable way to predict near-term demand. Many small rental firms still use 'line of sight' discounting based on the amount of equipment sitting in the yard at 8 am. Larger operations are intrigued by yield management, but worry about losing control of inventory and margins. The risk is obvious, the return still unproven.

There are serious technological considerations as well. To accurately predict supply and demand, yield management software relies on customer transaction data, seasonality and other historical predictors of future behavior. In theory, this information is cross-referenced with external data such as competitive pricing patterns and active building permits.

The good news is that sufficient internal data is already captured by rental business systems in the normal course of transactions. But the necessary related technologies have been slow in coming. The rental industry in the US has historically been viewed as a small, relatively unsophisticated vertical market with complex needs, making it a weak candidate for IT capital investment.

Now the climate is changing, and there may be reasons to try yield management sooner rather than later. Demand for equipment is improving in the competitive US marketplace, and rental companies may find it imprudent or impossible to cut their cost base. Industry eyes are on pricing.

Some upsides for rental

The hotel industry, while obviously not equipment rental, similarly sells perishable hours and operates with a high fixed cost structure. In the late 1990s, US hotels discovered that a 1% increase on investment to increase room capacity yielded a 2,3% increase in operating profit, on average. But a 1 percent increase in room rental rates yielded an 11,1% increase in profit, and a 1% decrease in rates resulted in an 11,1% decrease in operating results.

On paper, the concept is simple: non-utilized inventory can be priced to produce revenue, and small changes in the top line should magnify the bottom line. Sometimes the top line changes aren't so small – with airlines, for example, the total revenue benefit is between 6% and 10%, according to most analysts.

The high end of this range is a feasible goal for equipment rental businesses, according to Tom Struttmann, chief executive officer of Yield Dynamics, Inc, a California-based company offering yield management solutions to the rental industry. Together with Steve Small, chairman and chief technology officer, Mr Struttmann offers YieldWizard, a suite of technology tools based on similar architecture that Mr Small developed for the multi-family apartment industry. YieldWizard is currently being piloted with an eight-store Caterpillar dealer in the States.

“In the pilot, we've seen something like a 10% improvement in top line revenues,” says Mr Struttmann. “That's a huge number. It may not be that huge in every company, but just by tightening up some of the discipline, the leverage is pretty high. You can do all kinds of other things, take costs out…but nothing [else] is going to produce this kind of a jolt.”

The system differentiates between what it terms Gross Effective Rent and Base Effective Rent. Gross Effective Rent is the rent charged to a customer over the term of the rental plus the total of all concessions, divided by the number of days or hours in the rental term. Gross Effective Rent represents the actual revenue that is likely to be received from a piece of equipment.

By contrast, Base Effective Rent is used to understand the average revenue you can expect from a specific equipment class. It is derived from the Gross Effective Rent as adjusted by the effect of all attributes and any short-term rental charge. Attributes can be positive or negative – manufacturer enhancements that command a premium, for example, or extensive machine hours that reduce a rate. Attributes are stripped away to arrive at a 'normalized rent' that facilitates statistical forecasting and trend analysis.

Understanding these numbers, says Mr Small, is as important to yield management as the technological tools. “If you think you can take a black box and throw it [into your business] and have better pricing, you'll be very disappointed. It's about the process. The tools will give you better insight into what's going on, but you still have to have the processes in place to take advantage of them.”

YieldWizard uses algorithms to forecast customer demand and adjust pricing after analyzing current and predicted time utilization. The company also offers customer and trend analysis, and equipment acquisition and disposition analysis “to rebalance the portfolio and make more efficient use of capital,” says Mr Small.

One case for yield management can be made at street level in large operations, where branch personnel may feel compelled to get the deal at any cost. Industry consultant Dan Kaplan wrote of Hertz's experience in 1992 when the company began to move from entrepreneurial-type pricing based largely on local intuition to narrow bands of tightly controlled variable pricing. “Although managerial initiative in pricing seems to work well on the upside [of market demand],” he wrote, “it does not work effectively on the downside. The managers start disbelieving all they know as the competition begins to cut prices.” (Service Success; 1994)

That experience was echoed recently in the US, where the equipment rental industry is just now starting to emerge from a deep decline in demand. Rates suffered as companies fought for share. Now the challenge is to rebuild a profitable industry pricing structure without diminishing what the US customer sees as the main reason to rent construction equipment — namely that all things considered, it is less expensive to rent equipment than to own it.

And here is where serious questions about yield pricing emerge. To increase rates while remaining competitive, rental companies must stay away from commodity selling. To reinforce the economic value of rental over purchase, the industry must set some general expectations of price/value for renting a specific type of equipment, because there are fairly rigid price/value expectations for buying it. Are these two conditions compatible with yield management?

The concluding part to this article, in the September issue of European Rental News, will seek to answer that question by examining some specific risks and opportunities of yield management as applied to equipment rental.

=== SIDEBAR ===

What is yield management?

Simply stated, yield management is the management of revenue to produce the most profit. Prices on perishable goods – which are available units of time in the equipment rental business - are adjusted up or down in response to forecasted demand. Computers typically control this process.

Yield management also dictates that a certain amount of supply be held in reserve to satisfy last-minute demand. The idea of reserve is important because it incorporates the goal of customer satisfaction. The reserve is set, not to restrict utilisation, but to achieve utilisation more profitably than would be possible otherwise. In the ideal world of yield management, your good customer runs into your shop at the last minute, finds the compressor he needs, and happily pays top rate for it. Everybody wins.

The most famous examples of yield management come from the place where it all began – the airline industry. Say you plan to travel to Paris on Saturday, having purchased your fare last month. Few people on your airplane will have paid a fare equal to yours. Travelers who bought their tickets closer to departure may have paid a premium – or they may have received a discount.

Furthermore, there is no steady trend: a fare may flip numerous times between premium and discount depending on demand, reserve levels, and changes in external events. If the exact same set of customer behaviors occurs next month, the results can be completely different.

The idea of non-fixed pricing can be troubling to consumers but attractive to business. Yield management doesn't dismiss the idea that the customer is king. But it suggests that the seller could be king as well.

* Test your understanding of yield management at:

http://web.mit.edu/urban_or_book/www/animated-eg/ym/

THE AUTHOR

Lucy Peterson is president and owner of Balboni Associates Inc, a longstanding US supplier of consultancy and market communication services to rental and related industries. Lucy is also president of Balboni Associates’ press distribution subsidiary, IndustryWire.net. She can be contacted on: lpeterson@balboniassociates.com