We continue our educational revenue management series by expanding on the topic of inventory controls. In this article we’ll explain what a bid price is and how it is used as a pricing tool.
It might be useful to read our other articles, such as:
- What is the Difference Between Origin & Destination and Leg/Segment Inventory Controls?
- O&D, Leg, or Hybrid? Balancing Revenue Management Sophistication and Complexity
- Fare Classes and Buckets: What They are & How Pricing Strategies are Changing
Understanding Bid Price
In economics, the opportunity cost of an activity is the expected value we give up when we take one action in lieu of another. In the airline revenue management context, we assume capacity is fixed, so each seat on a plane that is sold has an opportunity cost equal to the revenue the airline could capture if it still had that seat for sale in the future. This opportunity cost is referred to as the “bid price” in the RM context.
The Bid Price is the expected future revenue lost if we give a seat away for free
- The bid price changes anytime we sell a seat, and when expected future revenue changes.
- The bid price defines the minimum revenue we should accept when selling a seat.
- It is the same for everyone that could buy a given seat.
- It is zero when we have excess capacity.
- The bid price decreases with additional seats remaining.
The bid price is a separate concept from the fare that the airline should charge for the flight. The fare charged needs to be at least as high as the bid price, but the optimal fare to charge can vary depending on the market conditions.
Since the bid price expresses the change in expected future revenue with one additional seat, if we add up the bid prices for all the seats in the cabin, it equals the expected remaining revenue for this cabin.
To better understand bid price, let’s look at an example of a single flight over time. On this example of a single cabin on one flight, we can model out the expected remaining revenue for each possible combination of remaining seats (let’s assume this flight has 100 seats that can be sold total). These “expected revenue curves” would be the output of our forecast and optimization process for the flight.
"The bid price is a separate concept from the fare that the airline should charge for the flight. The fare charged needs to be at least as high as the bid price, but the optimal fare to charge can vary depending on the market conditions."
We can take the number of seats we’ve sold in the cabin up to this point and subtract that from 100 (the capacity) to find our current seats available for sale. For example, if we’ve sold 60 seats already, (i.e. 40 left to sell) and we have 45 days to departure, we can expect to capture approximately $39,200 of revenue between now and departure.
However, if we have only 5 days to departure and 40 seats left to sell, we might expect only to capture $5,700 with those seats.
Now, if we instead had already sold 85 seats (15 left to sell), at 45 days to departure we would expect to capture only $21,000 of revenue between now and departure. if we have 15 seats to sell, but just 5 days to sell them, my expected revenue-to-come is still $5,700.
In essence, with 45 days to departure, having sold 25 additional seats in the past had an opportunity cost of $18,200 of revenue that we now can’t capture in the future. However, with only 5 days remaining for sale, those same 25 seats had no opportunity cost at all; I’m no worse having already sold them to other customers.
To understand the opportunity cost of each seat sold at each point in time we should look instead at the change in expected future revenue per seat sold.
With this metric (i.e. the bid price), we have a good understanding of whether or not we should sell any given seat at each point in time based on whether or not we will be better off for having sold it.
If the bid price is the future revenue lost from selling a seat, then essentially:
- If revenue from selling seat ≥ bid price: We are better off. We should make the sale.
- If revenue from selling seat < bid price: We would be better not to sell this seat until later at a higher price.
Modeling these tradeoffs in capturing revenue now by selling tickets versus understanding the future opportunity cost of that capacity is an essential component to revenue management. However – this concept of the “future-revenue-value-of-capacity” has invaluable applications across the broader commercial airline.
Bid Price Drives Better Business Decisions
The power of the bid price in the commercial airline context is that, since it communicates the opportunity cost of capacity, it can serve as an interpretable coordinating tool across departments to drive better business decisions.
- Network Planners can use bid price to understand the value of spilled demand to reallocate capacity, or find more optimal fleeting close to departure where flights with lots of seats remaining at $0 bid price can be traded with other departures where the bid price is high (therefore allowing the airline to capitalize on additional revenue opportunity).
- The scheduling team can use current bid prices to estimate the revenue impact of any given schedule change or capacity reallocation to help weigh tradeoffs.
- The sales team and group desk can quote prices with a full understanding of the revenue to be displaced when a group takes a large portion of capacity, or if the existing revenue is displaced by a new corporate contract.
- The pricing and marketing teams can measure promotions net of the displaced revenue that would have been captured regardless, allowing future promotions to be designed to maximize incremental revenue.
- The inventory team can set an optimal overbooking strategy by understanding the incremental revenue value of allowing an additional booking versus the expected DB cost, rather than trying to minimize spoilage without understanding the time-dependent value of that spoiled capacity.
- Fleet purchase and LOPA decisions can be heavily informed by understanding the incremental revenue capture of the additional capacity applied over the historical network.
- The loyalty and credit card programs of an airline must understand the “costs” incurred by displacing paying passengers – bid prices give a strong indication of this cost and how it's distributed across the network.
- Bid price is a critical ingredient in determining optimal dynamic prices and dynamic offers.
Here we provided a high-level introduction to bid price as a concept. We’ll continue this series on inventory controls, diving deeper into how airlines apply this concept. Next, we will look at the relationship between bid price and protection levels, which will be explained in the following piece.