Question

Explain using an example of how a company earnings management and justify it by conservatism?

Answer 1

A Definition Of Yield Management.

A yield management system which can also be referred to as revenue management is a system that attempts to
understand anticipate and then react to consumer behaviour in order to maximise revenue/profit

In a nutshell, yield management can be defined as selling a product or service to the right customer, at the right time, and at the right price.1Yield management strategies can be applied to virtually any type of business that:

• Has a fixed number of products to sell. Examples include hotel rooms, airline or bus seats, or rental cars.
• The product’s value is time-constrained, meaning that after a certain date or amount of time, the product loses value.
• Different customers are willing to pay different prices for the same product or number of products.1

Now, before your head starts spinning, let’s break it down as to how yield management pricing applies to your small or independent hotel (and itdoes apply, whether your hotel has ten rooms or ten thousand).

• Your facility has a finite number of rooms.
• Once all the rooms are rented for the night (whether the hotel is full or not), you’ve hit the revenue ceiling for that night. As another example, your facility could be further limited by season, such as a summer beach destination or a winter ski mecca.
• Customers who book far in advance generally expect to pay a lower price than those who book on impulse, close to their desired check-in date.

As another example of value constraint, let’s say you offer a two-night package deal for two for Valentine’s Day. Restrictions could include offering only a certain number of rooms under that package, or requiring that the package be booked by a certain deadline, after which it is no longer offered.
Another common strategy is to offer a special rate on mul1ti-night stays, but only if the stay includes a Saturday.
Additionally, your hotel could be hosting a business conference and you are offering a special room rate for registered conference attendees. Those who book extra nights outside the specified conference dates are charged the regular room rate for those nights.

How Does Yield Management Work?

To achieve maximum revenue/profit, a yield management system needs to have an understanding of what has happened before and what is happening now; using this historical data to predict what may then happen in the future. So the yield management system will periodically review transactions that have occurred between the consumer and the hotel.
Other external information is then fed into the yield management system and this can include statistical data, events such as public holidays, competitor price information, seasonal buying patterns, etc. A predictive modeller then attempts to forecast the total demand within a specific period for the services on offer by market segment and price point.

In simple terms yield management tries to answer the question "Given our operating constraints, what is the best mix of services for us to sell within a particular timeframe, so that we generate the highest revenue?"

The process of yield management optimisation helps an organisation to adjust its prices so that they meet the total demand characteristics of its markets. In order to maximise the revenue, prices can be determined by

• Service
• Group of services
• Market (consumer type or geographical)
• A combination of the above

Yield management models are most effective where the service being supplied is characterised as:

• Capital intensive
• Perishable (revenue is lost if the product/service is not sold by a particular point in time)

and the demand side is characterised with:

• Variability of demand
• Variability of value

APPROPRIATE SITUATIONS FOR EFFECTIVE YIELD MANAGEMENT APPLICATION

Yield management is very well suited for service firms. We will review a few characteristics that make yield management efficient.

Relatively Fixed Capacity

The reason for this characteristic is very simple. If capacity were flexible, there would be no need for a tradeoff. If airlines could add or remove seats or aircraft at will, there would be no reason to try to manage capacity. Unfortunately, the plane cannot be enlarged, the only flexibility allowed is to schedule the passenger on a later flight.

Ability to Segment Markets

Since one of the purposes of yield management is to smooth the distribution of passengers, to be effective, the airline must be able to segment its market into different passenger categories. Keeping in mind that we seek a tradeoff between maximum load factor and highest paying passengers, a very good example is the comparison between the time-sensitive business person and the price-sensitive customer. One is willing to pay a higher fare in exchange for flexibility (open return, cancellation option, schedule change, etc.) the other is willing to give-up some flexibility for the sake of a cheaper ticket (stay overnight Saturday, not come back on Labor Day - which is a peak day). Such a strategy allows airlines

Perishable Inventory

In the airline industry, plane seats are referred to as inventory. In fact, it is the available Amaterial" for Aproduction@ (the flight itself). If the plane leaves the gate with empty seats, this inventory cannot be stored and is lost. If an airline can minimize the inventory spoilage, then it will operate much more efficiently. Since yield management determines the load level to try to maximize revenue, we see why businesses that deal with perishable inventory can benefit from such a technique. Note the analogy with unoccupied hotel rooms or unrented cars at a car rental agency. Product Sold in Advance If all tickets were sold at once, the right tradeoff would be a fixed figure and would not take advantage of customer behavior. Since customer demand level patterns vary continually over time, it makes sense to also try to find the best tradeoff over time. Airplane fares change all the time, some on an hourly basis others on a weekly basis. The tradeoffs occur when a manager is faced with the option of accepting an early reservation from a customer who wants low price, or waiting to see if a higher paying customer will show up. Fluctuating Demand Yield management is a tool that can be used to smooth the demand pattern. In peak season, the airline can increase its revenues by increasing the fare on its tickets and in low season, it can increase capacity utilization by offering low prices. Past years data will offer the manager a way to forecast when these peek and low seasons occur. Demand fluctuates seasonally (peak season in the summer and low season in the fall) and also gradually (there is an increase in the demand for reservation until a few days prior departure).

Low Marginal Sales Costs and High Capacity Change Costs

We have already talked about fixed capacity, but it is not enough in this case. In order for yield management to work optimally, additional capacity should be expensive to acquire. In this situation, the cost of a plane is high, moreover, the lag between the order and delivery is significant. On the other hand, the cost of an additional passenger should be low (in fact, airlines have very high fixed costs), such as the negligible cost of drinks and food for a customer. In fact, if there were low capacity change costs, it would be easy to adapt quickly by storing a few airplanes Ain reserve@.

THE PROBLEM

By now, we know that yield management in the airline industry has similar objectives to inventory control for manufacturing companies. The yield management problem is best described as a non-linear, stochastic, mixed-integer mathematical program that requires data such as passenger demand pattern, cancellations, group reservations, cargo load, and other estimates. Solving this problem would require approximately 250 million decision variables! For the sake of feasibility and time, this problem has been reduced to three smaller ones: overbooking, discount allocation and traffic management

Discount Allocation

If all passengers on a flight were paying the same price, overbooking would be the panacea of yield management. Unfortunately, as illustrated by the story in the introduction, this is rarely the case. In this section, we will discuss discount allocation, the process of determining the number of discount fares to offer on a flight. The ratio of discount vs. full fares (called buckets) is not fixed during the reservation period and is moved appropriately as the departure date approaches. It varies on the basis of forecast (American Airlines uses exponential smoothing), past experience and special events. Here again, the opportunity cost of selling a discounted ticket instead of a full fare one has to be measured in order to make the best decision possible. Let's illustrate this concept with an example using the single inventory model. For the sake of the example, we only consider a one-time decision of the number of full-fare seats to reserve

Example

Lately, in order to stimulate demand for its Mexican routes, United Airways has decides to offer a

special non-refundable, non-exchangeable, one-month advance-purchased ticket on its ChicagoCancun
route for only $450 instead of the regular $650 round-trip fare. The DC-10 used by United
Airways has a capacity of 150 passengers in tourist class. Past data analysis showed that the
demand for full-fare tickets follow a normal distribution with mean of 60 and a standard deviation
of 15. Let=s use CU for the overage cost, that is the cost associated with reserving too few seats at
full fare; CO for the overage (or shortage) cost, that is the cost associated with reserving too many
seats at full fare. CU is the lost opportunity of an additional $200 which is the difference between
the full and the discounted fare. CO = $450 because we assume the extra seats reserved for fullfare
passengers could only have been sold at a discount.
Using the critical fractile model, we get:

Where f is the demand for full-fare tickets and x the number of seats
reserved for full-fare passengers. The critical fractile value P(f<x)=
200/(200+450)=0.31. From the Normal distribution table, we find
that the corresponding z is -0.50. We then calculate the number of full-fare seats to reserve = µ +
zσ = 60 + (-0.50) (15) = 53

Use by industry

There are three essential conditions for yield management to be applicable:

• That there is a fixed amount of resources available for sale.
• That the resources sold are perishable (there is a time limit to selling the resources, after which they cease to be of value).
• That different customers are willing to pay a different price for using the same amount of resources.

If the resources available are not fixed or not perishable, the problem is limited to logistics, i.e. inventory or production management. If all customers would pay the same price for using the same amount of resources, the challenge would perhaps be limited to selling as quickly as possible, e.g. if there are costs for holding inventory.

Yield management is of especially high relevance in cases where the constant costs are relatively high compared to the variable costs. The less variable cost there is, the more the additional revenue earned will contribute to the overall profit. This is because it focuses on maximizing expected marginal revenue for a given operation and planning horizon. It optimizes resource utilization by ensuring inventory availability to customers with the highest expected net revenue contribution and extracting the greatest level of ‘willingness to pay’ from the entire customer base. Yield management practitioners typically claim 3% to 7% incremental revenue gains. In many industries this can equate to over 100% increase in profits.

Yield management has significantly altered the travel and hospitality industry since its inception in the mid-1980s. It requires analysts with detailed market knowledge and advanced computing systems who implement sophisticated mathematical techniques to analyze market behavior and capture revenue opportunities. It has evolved from the system airlines invented as a response to deregulation and quickly spread to hotels, car rental firms, cruise lines, media, telecommunications and energy to name a few. Its effectiveness in generating incremental revenues from an existing operation and customer base has made it particularly attractive to business leaders that prefer to generate return from revenue growth and enhanced capability rather than downsizing and cost cutting.

Airlines

The passenger airline case, capacity is regarded as fixed because changing what aircraft flies a certain service based on the demand is the exception rather than the rule. When the aircraft departs, the unsold seats cannot generate any revenue and thus can be said to have perished, or have spoiled. Airlines use specialized software to monitor how seats are reserved and react accordingly. There are various inventory controls such as a nested inventory system. For example, airlines can offer discounts on low-demand flights, where the flight will likely not sell-out. The converse, selling more-expensive seats when there is excess demand, managing off demand.

Another way of capturing varying willingness to pay is to attempt market segmentation. A firm may repackage its basic inventory into different products to this end. In the passenger airline case this means implementing purchase restrictions, length of stay requirements and requiring fees for changing or canceling tickets.

The airline needs to keep a specific number of seats in reserve to cater to the probable demand for high-fare seats. This process can be managed by inventory controls or by managing the fare rules such as the AP restrictions. (30ap, 21ap, 14ap, 7ap, 0ap/walk up) The price of each seat varies directly with the number of seats reserved, that is, the fewer seats that are reserved for a particular category, the lower the price of each seat. This will continue until the price of seat in the premium class equals that of those in the concession class. Depending on this, a floor price (lower price) for the next seat to be sold is set.

Hotels

Hotels use this system in largely the same way, to calculate the rates, rooms and restrictions on sales in order to best maximize their return. These systems measure constrained and unconstrained demand along with pace to gauge which restrictions to implement, e.g. length of stay, non-refundable rate, or close to arrival. Yield management teams in the hotel industry have evolved tremendously over the last 10 years and in this global economy targeting the right distribution channels, controlling costs, and having the right market mix plays an important role in yield management. Yield management in hotels is selling rooms and services at the right price, at the right time, to the right people.

Rental

In the rental car industry, yield management deals with the sale of optional insurance, damage waivers and vehicle upgrades. It accounts for a major portion of the rental company's profitability, and is monitored on a daily basis. In the equipment rental industry, yield management is a method to manage rental rates against capacity (available fleet) and demand

Intercity buses

Yield management has moved into the bus industry with companies such as Megabus (United Kingdom), Megabus (North America), BoltBus, and easyBus, which run low-cost networks in the United Kingdom and parts of the United States, and more recently, nakedbus.com and Intercape, which have networks in New Zealand and South Africa. Now operating and developed in Chile by SARCAN, a Chilean company that provides revenue and yield management systems focused on this industry, with the company Turbus as principal customer. Finnish low-cost inter-city bus service OnniBus, as well as Polish PolskiBus, bases its revenue flow on yield management.

Multifamily housing

In the multi-family residential industry, yield optimization is focused on producing supply and demand forecasts to determine rent recommendations for profit optimization. However, the use of the yield optimization systems is fairly new to the industry in the late 1990s, with Archstone Smith pioneering its use.^[5] The multifamily industry currently has two providers of yield management systems, the LRO (Lease Rent Options) Revenue Management System from Rainmaker, and the YieldStar Asset Optimization System from RealPage. There are new providers that have entered the market and provide extended capabilities in a much more simplified workflow. Chief among the new vendors is Property Solutions International with its PricingPortal product.