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© 2007 Pearson Education 15-1 Chapter 15 Pricing and Revenue Management in the Supply Chain Supply Chain Management (3rd Edition)
© 2007 Pearson Education 15-2 Outline uThe Role of Revenue Management in the Supply Chain uRevenue Management for Multiple Customer Segments uRevenue Management for Perishable Assets uRevenue Management for Seasonable Demand uRevenue Management for Bulk and Spot Customers uUsing Revenue Management in Practice uSummary of Learning Objectives
© 2007 Pearson Education 15-3 The Role of Revenue Management in the Supply Chain uRevenue management is the use of pricing to increase the profit generated from a limited supply of supply chain assets uSupply assets exist in two forms: capacity and inventory uRevenue management may also be defined as the use of differential pricing based on customer segment, time of use, and product or capacity availability to increase supply chain profits uMost common example is probably in airline pricing
© 2007 Pearson Education 15-4 Conditions Under Which Revenue Management Has the Greatest Effect uThe value of the product varies in different market segments (Example: airline seats) uThe product is highly perishable or product waste occurs (Example: fashion and seasonal apparel) uDemand has seasonal and other peaks (Example: products ordered at Amazon.com) uThe product is sold both in bulk and on the spot market (Example: 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)
© 2007 Pearson Education 15-5 Revenue Management for Multiple Customer Segments uIf a supplier serves multiple customer segments with a fixed asset, the supplier can improve revenues by setting different prices for each segment uPrices must be set with barriers such that the segment willing to pay more is not able to pay the lower price uThe amount of the asset reserved for the higher price segment is such that the expected marginal revenue from the higher priced segment equals the price of the lower price segment
© 2007 Pearson Education 15-6 Revenue Management for Multiple Customer Segments p L = the price charged to the lower price segment p H = the price charged to the higher price segment D H = mean demand for the higher price segment H = standard deviation of demand for the higher price segment C H = capacity reserved for the higher price segment R H (C H ) = expected marginal revenue from reserving more capacity = Probability(demand from higher price segment > C H ) x p H R H (C H ) = p L Probability(demand from higher price segment > C H ) = p L / p H C H = F -1 (1- p L /p H, D H, H ) = NORMINV(1- p L /p H, D H, H )
© 2007 Pearson Education 15-7 Example 15.2: ToFrom Trucking Revenue from segment A = p A = $3.50 per cubic ft Revenue from segment B = p B = $3.50 per cubic ft Mean demand for segment A = D A = 3,000 cubic ft Std dev of segment A demand = A = 1,000 cubic ft C A = NORMINV(1- p B /p A, D A, A ) = NORMINV(1- (2.00/3.50), 3000, 1000) = 2,820 cubic ft If pA increases to $5.00 per cubic foot, then C A = NORMINV(1- p B /p A, D A, A ) = NORMINV(1- (2.00/5.00), 3000, 1000) = 3,253 cubic ft
© 2007 Pearson Education 15-8 Revenue Management for Perishable Assets uAny asset that loses value over time is perishable uExamples: high-tech products such as computers and cell phones, high fashion apparel, underutilized capacity, fruits and vegetables uTwo basic approaches: –Vary price over time to maximize expected revenue –Overbook sales of the asset to account for cancellations
© 2007 Pearson Education 15-9 Revenue Management for Perishable Assets uOverbooking or overselling of a supply chain asset is valuable if order cancellations occur and the asset is perishable uThe level of overbooking is based on the trade-off between the cost of wasting the asset if too many cancellations lead to unused assets and the cost of arranging a backup if too few cancellations lead to committed orders being larger than the available capacity
© 2007 Pearson Education 15-10 Revenue Management for Perishable Assets p = price at which each unit of the asset is sold c = cost of using or producing each unit of the asset b = cost per unit at which a backup can be used in the case of asset shortage C w = p – c = marginal cost of wasted capacity C s = b – c = marginal cost of a capacity shortage O* = optimal overbooking level s* = Probability(cancellations < O*) = C w / (C w + C s )
© 2007 Pearson Education 15-11 Revenue Management for Perishable Assets If the distribution of cancellations is known to be normal with mean c and standard deviation c then O* = F -1 (s*, c, c ) = NORMINV(s*, c, c ) If the distribution of cancellations is known only as a function of the booking level (capacity L + overbooking O) to have a mean of (L+O) and std deviation of (L+O), the optimal overbooking level is the solution to the following equation: O= F -1 (s*, L+O), (L+O)) = NORMINV(s*, L+O), (L+O))
© 2007 Pearson Education 15-12 Example 15.5 Cost of wasted capacity = C w = $10 per dress Cost of capacity shortage = C s = $5 per dress s* = C w / (C w + C s ) = 10/(10+5) = 0.667 c = 800; c = 400 O* = NORMINV(s*, c, c ) = NORMINV(0.667,800,400) = 973 If the mean is 15% of the booking level and the coefficient of variation is 0.5, then the optimal overbooking level is the solution of the following equation: O = NORMINV(0.667,0.15(5000+O),0.075(5000+O)) Using Excel Solver, O* = 1,115
© 2007 Pearson Education 15-13 Revenue Management for Seasonal Demand uSeasonal peaks of demand are common in many supply chains uExamples: Most retailers achieve a large portion of total annual demand in December (Amazon.com) uOff-peak discounting can shift demand from peak to non-peak periods uCharge higher price during peak periods and a lower price during off-peak periods
© 2007 Pearson Education 15-14 Revenue Management for Bulk and Spot Customers uMost consumers of production, warehousing, and transportation assets in a supply chain face the problem of constructing a portfolio of long-term bulk contracts and short-term spot market contracts uThe basic decision is the size of the bulk contract uThe fundamental trade-off is between wasting a portion of the low-cost bulk contract and paying more for the asset on the spot market uGiven that both the spot market price and the purchaser’s need for the asset are uncertain, a decision tree approach as discussed in Chapter 6 should be used to evaluate the amount of long-term bulk contract to sign
© 2007 Pearson Education 15-15 Revenue Management for Bulk and Spot Customers For the simple case where the spot market price is known but demand is uncertain, a formula can be used c B = bulk rate c S = spot market price Q* = optimal amount of the asset to be purchased in bulk p* = probability that the demand for the asset does not exceed Q* Marginal cost of purchasing another unit in bulk is c B. The expected marginal cost of not purchasing another unit in bulk and then purchasing it in the spot market is (1-p*)c S.
© 2007 Pearson Education 15-16 Revenue Management for Bulk and Spot Customers If the optimal amount of the asset is purchased in bulk, the marginal cost of the bulk purchase should equal the expected marginal cost of the spot market purchase, or c B = (1-p*)c S Solving for p* yields p* = (c S – c B ) / c S If demand is normal with mean and std deviation , the optimal amount Q* to be purchased in bulk is Q* = F -1 (p*, , ) = NORMINV(p*, , )
© 2007 Pearson Education 15-17 Example 15.6 Bulk contract cost = c B = $10,000 per million units Spot market cost = c S = $12,500 per million units = 10 million units = 4 million units p* = (c S – c B ) / c S = (12,500 – 10,000) / 12,500 = 0.2 Q* = NORMINV(p*, , ) = NORMINV(0.2,10,4) = 6.63 The manufacturer should sign a long-term bulk contract for 6.63 million units per month and purchase any transportation capacity beyond that on the spot market
© 2007 Pearson Education 15-18 Using Revenue Management in Practice uEvaluate your market carefully uQuantify the benefits of revenue management uImplement a forecasting process uApply optimization to obtain the revenue management decision uInvolve both sales and operations uUnderstand and inform the customer uIntegrate supply planning with revenue management
© 2007 Pearson Education 15-19 Summary of Learning Objectives uWhat is the role of revenue management in a supply chain? uUnder what conditions are revenue management tactics effective? uWhat are the trade-offs that must be considered when making revenue management decisions?
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