1. Supply Chain Management
SYST 4050 Slides
Supply Chain Management
Lecture 25
Chapter 3

2. Semester Outline Tuesday April 20 Chap 15
SYST 4050 Slides
Semester Outline
Tuesday April 20 Chap 15
Thursday April 22 Simulation Game briefing
Tuesday April 27 Review, buffer
Thursday April 29 Simulation Game
Chapter 3

3. Outline Today Homework 7 Thursday Chapter 15 Online today
SYST 4050 Slides
Outline
Today
Chapter 15
Sections 1, 2
Homework 7
Online today
Due Thursday April 29 before class
Homework submitted before April 29 will be graded and returned on April 29
Thursday
Simulation game briefing
Chapter 3

4. What is Revenue Management?
SYST 4050 Slides
What is Revenue Management?
Revenue management is the practice of differential pricing to increase supply chain profits
A strategy that adjusts prices based on product availability, customer demand, and remaining duration of the sales season will result in higher supply chain profits
Chapter 3

5. What is Revenue Management?
SYST 4050 Slides
What is Revenue Management?
Revenue management is the practice of differential pricing to increase supply chain profits
A strategy that adjusts prices based on product availability, customer demand, and remaining duration of the sales season will result in higher supply chain profits
Revenue management, also called yield management, and sometimes smart pricing, is a technique to optimize revenue from a fixed, but perishable inventory
RM: Matching supply to demand when supply is fixed
Chapter 3

6. Revenue Management Revenue Management: Maps capacity into demand
SYST 4050 Slides
Revenue Management
The classical newsvendor problem is one of optimally choosing a level of capacity to respond to a known demand distribution. This can be interpreted as taking an operations view of the firm since the distribution of demand is given and the task is to marshal appropriate capacity to meet it. In many firms, however, capacity is relatively more difficult to adjust than demand (the time required to install new capacity). Consequently, one is tempted to ask the inverse question: Given a level of installed capacity, what is the optimal demand distribution to cultivate? This is more of a marketing view of the firm, since demand management is the key question being addressed. We call this the inverse newsvendor problem. The traditional newsvendor problem maps demand into capacity, whereas the inverse newsvendor problem maps capacity into demand.
The inverse newsvendor problem is one of optimally choosing a demand distribution with fixed capacity.
Revenue Management: Maps capacity into demand
Newsvendor problem: Maps demand into capacity
Chapter 3

7. What is Revenue Management?
SYST 4050 Slides
What is Revenue Management?
Revenue management, also called yield management, and sometimes smart pricing, is a technique to optimize revenue from a fixed, but perishable inventory
Is revenue management possible for…
Airline tickets
Cruise travel
Restaurants
Hospitals
LTL trucking companies
Apartment rental
Incoming MBA class
Vending machines
Chapter 3

8. Revenue Management and Vending Machines
SYST 4050 Slides
Revenue Management and Vending Machines
Coca-Cola announces that it is considering vending machines that will boost prices during hot weather.
“Coca-Cola is a product whose utility varies from moment to moment. In a final summer championship, when people meet in a stadium to enjoy themselves, the utility of a chilled Coca-Cola is very high. So it is fair it should be more expensive. The machine will simply make this process automatic.”
Douglas Ivester, Chairman and CEO
Chapter 3

9. Conditions for Revenue Management
SYST 4050 Slides
Conditions for Revenue Management
The value of the product varies in different market segments
Airline seats: leisure versus business travel
The product is highly perishable or product waste occurs
Fashion and seasonal apparel
High tech products
Demand has seasonal and other peaks
Cruise travel
The product is sold both in bulk and on the spot market
Owner of warehouse who can decide whether to lease the entire warehouse through long-term contracts or save a portion of the warehouse for use in the spot market
Chapter 3

10. Why Revenue Management?
SYST 4050 Slides
Why Revenue Management?
Success stories
American Airlines increased annual revenue by over $1 billion through revenue management
Marriott hotels increased annual revenue with $100 million through revenue management
National Car Rental was saved from liquidation through revenue management
Canadian Broadcasting Corporation increased revenue with $1 million per week
Chapter 3

11. Choose the fare that maximizes the area (revenue) of the rectangle
SYST 4050 Slides
Airfare example q
Choose the fare that maximizes the area (revenue) of the rectangle
1000
800
600
400
200
200
400
600
800
1000 p
Chapter 3

12. Choose the fare that maximizes the area (revenue) of the rectangle
SYST 4050 Slides
Airfare example q
Choose the fare that maximizes the area (revenue) of the rectangle
1000
Unaccommodated demand
800
Maximum revenue = 500*500 = $250,000
600
An airline that can extract a higher price from the business traveler compared to the leisure traveler will always do better than an airline that charges the same price to all travelers
400
Consumer surplus
200
200
400
600
800
1000 p
Chapter 3

13. SYST 4050 Slides
Airfare example q
Choose the fare that maximizes the SUM of areas of the rectangles
1000
800
Economy class
Maximum revenue = 333*( ) = $333,000
600
400
Business class
200
200
400
600
800
1000 p
Chapter 3

14. SYST 4050 Slides
Airfare example q
Choose the fare that maximizes the SUM of areas of the rectangles
1000
Economy class
800
Maximum revenue = 200*( ) = $400,000
Economy plus class
600
Business class
400
First class
200
200
400
600
800
1000 p
Chapter 3

15. Perfect price discrimination
SYST 4050 Slides
Airfare example q
Perfect price discrimination
1000
Charging a different price to a different buyer for the same product without any true cost differential to justify the different price
800
Maximum revenue = $500,000
600
400
200
200
400
600
800
1000 p
Chapter 3

16. Is Revenue Management Price Discrimination?
SYST 4050 Slides
Is Revenue Management Price Discrimination?
The same product sold at different times for different prices is not necessarily price discrimination, because at different times...
The production or distribution costs may be different
Inventory costs were incurred to keep the product in stock until a later time
Consumers value products differently at different points in time
The product value may change over time, such as perishable or maturing or seasonal products, fashion goods, antiques.
Interest is earned if product is sold at an earlier time
Locking sales in early reduces uncertainty
Price discrimination: Charging a different price to a different buyer for the same product without any true cost differential to justify the different price
Chapter 3

17. Revenue Management for Multiple Customer Segments
SYST 4050 Slides
Revenue Management for Multiple Customer Segments
If a supplier serves multiple customer segments with a fixed asset, the supplier can improve revenues by setting different prices for each segment
What price to charge each segment?
How to allocate limited capacity among the segments?
Prices must be set with barriers such that the segment willing to pay more is not able to pay the lower price
Chapter 3

18. SYST 4050 Slides
Revenue Management
Hotels, airlines, opera houses hope this tool will help them maximize sales and profits
“The real beneficiary of revenue management has been the consumer”
Clearly, customers for which revenue management has decreased the cost of air travel, have benefited from revenue management. Could customers for which revenue management has increased the cost of air travel, also have benefited from revenue management?
Chapter 3

19. What is Revenue Management?
SYST 4050 Slides
What is Revenue Management? q q
1000
1000
800
800
600
600
400
400
200
200
200
400
600
800
1000
200
400
600
800
1000 p p
Chapter 3

20. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
A contract manufacturer has identified two customers segments for its production capacity—one willing to place an order more than one week in advance and the other willing to pay a higher price as long as it can provide less than a week’s notice for production. The customers that are unwilling to commit in advance are less price sensitive and have a demand curve d1 = 5,000 – 20p1. Customers willing to commit in advance are more price sensitive and have a demand curve of d2 = 5,000 – 40p2. Production cost is c = $10 per unit. What price should the contract manufacturer charge each segment if its goal is to maximize profits?
Chapter 3

21. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
c = 10
d1 = 5,000 – 20p1
Chapter 3

22. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
c = 10
Profit
d1 = 5,000 – 20p1
p - c
Chapter 3

23. Pricing Multiple Segments
SYST 4050 Slides
Pricing Multiple Segments
Assume that the demand curve for segment i is given by
di = Ai – Bipi
The goal of the supplier is to price so as to maximize profits
Max (pi – c)(Ai – Bipi)
Profit
Chapter 3

24. Pricing Multiple Segments
SYST 4050 Slides
Pricing Multiple Segments
The optimal price for segment i is given by
pi = Ai/2Bi + c/2
Chapter 3

25. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
For segment 1:
pi = Ai/2Bi + c/2 pi = 5,000/(2*20) + 10/ = $130
Profit (pi – 10)(5,000 – 20pi) = (130 – 10)(5,000 – 20*130) = $288,000
For segment 2:
pi = Ai/2Bi + c/2 pi = 5,000/(2*40) + 10/ = $67.50
Profit (pi – 10)(5,000 – 40pi) = (67.5 – 10)(5,000 – 40*67.5) = $127,650
Total profit $415,650
Chapter 3

26. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
If total capacity is limited to 4,000 units, what should the contract manufacturer charge each segment?
For segment 1: p1 = $130
Demand d1 = (5,000 – 20p1) = 2,400
For segment 2: p2 = $67.50
Demand d2 = (5,000 – 40p2) = 2,300
Total demand = 2, ,300 = 4,700
Total demand exceeds production capacity of 4,000
Chapter 3

27. Pricing Multiple Segments
SYST 4050 Slides
Pricing Multiple Segments
The goal of the supplier is to price so as to maximize profits
Max ∑ki=1 (pi – c)(Ai – Bipi)
Subject to: ∑ki=1(Ai – Bipi)  Q pi  0
Maximize profits
Production capacity
Price
Chapter 3

28. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
If the contract manufacturer were to charge a single price over both segments, what should it be?
d1 = 5,000 – 20p1
d2 = 5,000 – 40p2
d = (5,000 – 20p) + (5,000 – 40p) = 10,000 – 60p
Chapter 3

29. Example 15-1: Pricing to multiple segments
SYST 4050 Slides
Example 15-1: Pricing to multiple segments
For segment 1 and 2:
p = Ai/2Bi + c/2 p = 10,000/(2*60) + 10/ = $83.33
Max (p – c)(A – Bp) Max (p – 10)(10,000 – 60p) = (83.33 – 10)(10,000 – 60*83.33) = $366,650
Differential pricing raises profit from $366,650 to $415,650
Chapter 3

30. Revenue Management for Multiple Customer Segments
SYST 4050 Slides
Revenue Management for Multiple Customer Segments
If a supplier serves multiple customer segments with a fixed asset, the supplier can improve revenues by setting different prices for each segment
What price to charge each segment?
How to allocate limited capacity among the segments?
What if demand is uncertain?
Chapter 3

31. The Park Hyatt Philadelphia
SYST 4050 Slides
The Park Hyatt Philadelphia
118 King/Queen rooms.
Hyatt offers a pL= $128 (low fare) targeting leisure travelers.
Regular fare is pH= $181 (high fare) targeting business travelers.
Demand for low fare rooms is abundant.
Let DH be uncertain demand for high fare rooms.
Assume demand for the high fare (business) occurs only within a few days of the actual stay
How much capacity should Hyatt save for the higher priced segment?
Chapter 3

32. Allocating Capacity to a Segment Under Uncertainty
SYST 4050 Slides
Allocating Capacity to a Segment Under Uncertainty
Basic tradeoff between committing to an order from a lower-price buyer or waiting for a high-price buyer to arrive later on
Spoilage occurs when the capacity reserved for higher-price buyers is wasted because demand from the higher-price segment does not materialize
Spill occurs if higher-price buyers have to be turned away because the capacity has already been committed to lower-price buyers
Chapter 3

33. Allocating Capacity to a Segment Under Uncertainty
SYST 4050 Slides
Allocating Capacity to a Segment Under Uncertainty
Expected revenue = sales probability x sales price
Never sell a unit of capacity for less than the expected revenue
$128  $ = 1.0 x 181
$128  $ = 0.9 x 181
$128  $ = 0.8 x 181
$128  $ = 0.7 x 181
Chapter 3

34. Allocating Capacity to a Segment Under Uncertainty
SYST 4050 Slides
Allocating Capacity to a Segment Under Uncertainty
$ = 0.7 x 181
Expected revenue = sales probability x sales price
RH(CH) = Prob(demand from higher-price segment > CH) x pH
Never sell a unit of capacity for less than the expected revenue
Chapter 3

35. Allocating Capacity to a Segment Under Uncertainty
SYST 4050 Slides
Allocating Capacity to a Segment Under Uncertainty
$128  $ = 0.7 x 181
Expected revenue = sales probability x sales price
RH(CH) = Prob(demand from higher-price segment > CH) x pH
Never sell a unit of capacity for less than the expected revenue
pL = Prob(demand from higher-price segment > CH) x pH
Prob(demand from higher-price segment > CH) = pL/pH
Chapter 3

36. Allocating Capacity to a Segment Under Uncertainty
SYST 4050 Slides
Allocating Capacity to a Segment Under Uncertainty
Prob(demand from higher-price segment > CH) = pL/pH
Prob(demand from higher-price segment  CH) = 1 – pL/pH
CH = F-1(1 – pL/pH, DH, H)
Prob CH
1 – pL/pH
pL/pH
Chapter 3

37. Example: Allocating Capacity to a Segment Under Uncertainty
SYST 4050 Slides
Example: Allocating Capacity to a Segment Under Uncertainty
Assume that demand for rooms at the high rate is normally distributed with mean 102 and standard deviation Also assume that the high rate is 181 dollars and low rate (discount rate) is 128 dollars
Determine probability that expected marginal revenue of higher rate class will exceed marginal revenue of lower rate class
pL = 128
pH = 181
1 – pL/pH = 1 – 128/181 =
Convert that probability into the number of rooms
NORMINV(1 – pL/pH, DH, H) = NORMINV(0.2928, 102, 20.8) = 91
Hence, 91 rooms should be reserved for the high rate class
Chapter 3

38. Example 15-2 Allocating Capacity to Multiple Segments
SYST 4050 Slides
Example 15-2 Allocating Capacity to Multiple Segments
ToFrom Trucking serves two customer segments. One segment (A) is willing to pay $3.50 per cubic feet but wants to commit with only 24 hours notice. The other segment (B) is willing to pay only $2.00, but is willing to commit to a shipment with up to one week notice. With two weeks to go, demand for segment A is forecast to be normally distributed, with a mean of 3,000 cubic feet and a standard deviation of 1,000. How much of the available capacity should be reserved for segment A?
Chapter 3

39. Example 15-2 Allocating Capacity to Multiple Segments
SYST 4050 Slides
Example 15-2 Allocating Capacity to Multiple Segments
Revenue from segment A
pA =
Revenue from segment B
pB =
Mean demand for segment A
DA =
Standard deviation of demand for segment A
A =
Capacity to be reserved for segment A
CA =
$3.50
$2.00
3,000
1,000
F-1(1 – pB/pA, DH, H) = F-1(0.4286,3000,1000) = 2,820
Chapter 3

40. Example 15-2 Allocating Capacity to Multiple Segments
SYST 4050 Slides
Example 15-2 Allocating Capacity to Multiple Segments
ToFrom Trucking serves two customer segments. One segment (A) is willing to pay $3.50 per cubic feet but wants to commit with only 24 hours notice. The other segment (B) is willing to pay only $2.00, but is willing to commit to a shipment with up to one week notice. With two weeks to go, demand for segment A is forecast to be normally distributed, with a mean of 3,000 cubic feet and a standard deviation of 1,000. How much of the available capacity should be reserved for segment A?
How should ToFrom change it decision if segment A is willing to pay $5 per cubic foot?
Chapter 3

41. Example 15-2 Allocating Capacity to Multiple Segments
SYST 4050 Slides
Example 15-2 Allocating Capacity to Multiple Segments
Revenue from segment A
pA =
Revenue from segment B
pB =
Mean demand for segment A
DA =
Standard deviation of demand for segment A
A =
Capacity to be reserved for segment A
CA =
$5.00
$2.00
3,000
1,000
F-1(1 – pB/pA, DH, H) = F-1(0.6, 3000, 1000) = 3,253
Chapter 3