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Dynamic Pricing and Yield Management

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1 Dynamic Pricing and Yield Management
Yossi Sheffi Professor, MIT ESD.260J/1.260J/15.770J What you are is clear – the only issue is price⋯

2 What you are is clear – the only issue is price…

3 Outline Airline revenue management The essence of price discrimination
Revenue management in TL trucking

4 Yield/Revenue Management
Objective:maximize revenue (minimize lost revenue / opportunity costs) “Science of squeezing every possible dollar from customers” Integrated management of capacity and pricing

5 Revenue Management Example: Airline
# of Seats 100 $1,000 Price

6 Revenue Management Example: Airline

7 Revenue Management Example: Airline

8 Revenue Management Example: Airline

9 Revenue Management Example: Airline

10 Two Challenges: How do we make sure that the people who are willing to pay $750 will not buy the $250 ticket? How do we make sure that we have enough seats for those willing to pay $750?

11 Two Answers: Create artificial hurdles:
 Advance purchase: 21 days, 14 days, 7days  Use limitations: Saturday night stay, non-refundable tickets Restrict the number of seats sold at the low price  This requires a forecast of future booking by higher-paying customers and the discipline to forgo a “bird-in-hand.” Note 1: airlines do not change prices dynamically; they actually change capacity (classes) dynamically Note 2: freight can also displace passengers when RM is really optimized

12 Why is This Important? American Airlines saved over $1.4B between “I believe that yield management is the single most important technical development in transportation management “  Robert Crandall, CEO AMR

13 Markdowns Markdowns are one of the main levers that retailers have to influence results in-season. As such, it can be a very powerful driver of performance. Markdown Opportunity: • Markdowns may represent more than 30% of total sales • Short-cycle product can represent up to 80% of a retailer’s assortment • In some segments, short-cyce products may represent a smaller percentage of the assortment but still have a significant impact on gross margin (up to 40%) Goals / Trends: • Movement to more Localized pricing decisions • Growing realization of the true cost of left-over inventory • Greater emphasis on inventory productivity as store base growth slows

14 Sales Rate-Based Discounting
After initial sales rate (r0= i0/t0) Required sales rate: r1=i10-t1) %r required: (r1/ r0)-1 Divide by ε Get the % price change required

15 Price Discrimination First degree: willingness to pay (rare)
RR in late 1800-s, asking shippers for their income statement so they could determine their ability to pay College financial aid Taxes Second degree: artificial hurdles but open Buying process (coupons, advance purchase…) Cost to serve (volume discounts, risk adjustments, "set up" costs in travel industry…) Distribution channels (Internet, outlets, etc.) Markdowns (timing of purchase, product age, selection, etc.) Value of product (in many rail movements; regeltarifklassen) Commodity type (part of tariffs; in many rail movements) Use limitations (e.g., "final sale") Bundling ("menu" vs. "a-la-cart") Time of use (e.g., peak hour, congestion pricing)

16 Price Discrimination First degree: willingness to pay (rare)
Second degree: artificial hurdles but open Third degree: based on external factors Geography (neighborhood, state) Gender (women's clothing) Age (senior/student discounts) Profession/affiliation (small/large business business; educational,medical…)

17 3rd Degree Discrimination
Online shopping: Dell Computer

18 Specific Example Dimension® 8200 Series, Pentium® 4 Processor at 1.7 GHz 128MB PC800 RDRAM New Dell® Enhanced QuietKey Keyboard Video Ready w/o Monitor 32MB NVIDIA GeForce2 MX 4X AGP Graphics Card with TV-Out 40GB Ultra ATA/100 Hard Drive 3.5 in Floppy Drive MicrosoftR Windows® Millennium with WinXP Home Upgrade Coupon MS IntelliMouse® 10/100 PCI Fast Ethernet NIC 56K Teephony Modem for Wndows-Sound Option 48X Max Variable CD-ROM Integrated Audio with Soundblaster Pro/16 Compatibility Harman Kardon HK-395 Speakers Upgrade to Microsoft® Office Small Business w/EducateU 3 Year Ltd. Warranty, 3 Year At Home Service, Lifetime 24x7 Phone Support

19 Specific Example User Base Price Home $1,378 Small business $1,238
Large business $1,338 Student $1,327 University $1,427

20 When Does YM Work? Administration Product Discipline !
Economic conditions Demand (LT with signaling; Governme conference Segme No arbitrage Administration A Product High fix Perishability Discipline !

21 Marketing Most schemes are based on 2nd degree discrimination – seems more fair (choice is available) Positioning the message: discounts are more acceptable than price increases, even if the result is the same Avoid gauging "Profiteering" is not acceptable Use open communications Some forms of 3rd degree discrimination are illegal, but many are acceptable: student/senior citizen discounts profession/use (Dell)

22 Carrier Portfolio of Pricing
Dynamic pricing with spot market shippers Dynamic pricing with contracted shippers Long-term fixed-rate contracts LT fixed rate contracts with capacity commitments

23 Rev. Management in TL Trucking
Little opportunity during bid response No monopoly power Exceptions: good service history coupled with client strategy geared towards service Value-added services Only opportunity in real-time (spot) market There are limited opportunities for local/temporary monopolies: Responses to shipper "dialing for diesels” Requests along "power lanes"

24 Rev. Management in TL Trucking
Remember the twin challenges: How do we make sure that the people who are willing to pay $750 will not buy the $250 ticket? How do we make sure that we have enough seats for those willing to pay $750? Comes down to one question: Should we take this load? Should capacity be committed to a particular load/shipper/contract?, or should we wait for a better-paying load? Depends on the forecast…

25 Strategic Decisions Set the Limits for Tactical Decisions
Size of fleet Market focus – regions, industries, equipment Relationships with O/Os, 3PLs Percent of business under long-term contract Long-term contract rates Bid-response strategies Capacity commitments Seasonal Pricing Demand booking and solicitation Dynamic pricing Proactive empty repositioning Driver assignment

26 System Contribution of a Load
Regional potential: the expected contribution of a truck in a region. P(A) - Potential of region A D(A-B) - Direct cost for moving a truck from A to B R(A-B) - Revenue for the move from A to B

27 System Contribution of a Load
S(A-B) = R(A-B) -D(A-B) + P(B) -P(A) Direct contribution System impact P(B) -the value of one more truck at region B P(A) -the value of one less truck at region A Order acceptance: Take a load only if S(A-B) > 0 Take the load with the highest S(A-B)

28 Analysis of Movements Head haul: S(A-B) = R(A-B) -D(A-B) + P(B) -P(A)
Back haul:

29 YM in Manufacturing Reserve capacity to the highest paying customer
Tie the pricing to the capacity commitment Use pricing to manage component supply (in BTO)

30 Final Observations RM involves the entire enterprise
Customer service Sales Reservations Scheduling RM can be used to increase profits and serve customers better Bring in those who otherwise would not use the service Provide higher LOS to those who pay a lot by giving them more frequent service, higher probability of service, etc. Increase utilization by smoothing demand patterns The essence of RM is the judicious management of capacity and pricing simultaneously The trick: reserve capacity to the highest paying customers

31 Any Questions?

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