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Demand and Revenue Management
Anton J. Kleywegt
April 2, 2008
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Revenue Management
What is Revenue Management Why do Revenue Management Pricing Optimization Demand Modeling and Forecasting
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What is Revenue Management
Management of inventory, distribution channels and prices to maximize profit over the long run
Selling the right product to the right customer at the right time at the right price
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What is Revenue Management
Revenue Management involves the following activities Demand data collection Demand modeling Demand forecasting Pricing optimization System implementation and
distribution
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What is Revenue Management
Airline industry How many seats to make available at each of the listed
fares, depending on the OD pair, time of year, time of week, remaining seats available, remaining time until departure
What contracts and prices to provide to corporations How many seats to make available to consolidators and
travel agents (if at all), and at what prices How much capacity to make available to cargo shippers
and freight forwarders, and at what prices
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What is Revenue Management
Hotel industry How much to charge for a room depending on
the location, type of room, time of year, time of week, duration of stay
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What is Revenue Management
Ocean cargo industry Which types of contracts to enter into with
shippers How much capacity to commit to each shipper Which contract prices to have for each shipper How to vary prices as a function of direction of
trade, commodity, and time of year
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What is Revenue Management
Car rental industry How much to charge for a rental car depending
on the class of car, time of year, time of week, duration of rent
Restaurant industry How much to charge for lunch vs dinner
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What is Revenue Management Manufacturing industry
Make-to-stock: dynamic pricing of inventory Make-to-order: dynamic pricing of orders, how
much discount to give for orders in advance Make-to-stock and make-to-order: prices of
advance orders vs prices of inventory
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What is Revenue Management Retail industry Example: fashion apparel industry
Products in fashion for a single season Retailer wants to sell available inventory for
maximum profit Prices higher at start of season Retailer has to decide when to mark prices
down, and by how much
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What is Revenue Management Entertainment ticket pricing Example: opera houses let their ticket prices depend on
The performance The reviews received so far Location of seat in opera house Day of the week of the performance Time of the day of the performance Time of performance in the season Remaining time until the performance Number of remaining seats available
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What is Revenue Management Golf courses
Variable pricing: Choose prices to vary by time of day day of week season of year
Round duration control control tee-time interval control uncertainty in arrival time control uncertainty in duration
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Hospital Contract Case Study
Major customers of hospitals Insurance companies Medicare Medicaid Individuals
Hospital contracts with major customers Discount-off-listed-charges contracts Per-diem contracts Case-rate contracts Capitation contracts
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Hospital Contract Case Study
Example of setting per-diem rates
ICU Patient Length of Stay
0%2%4%6%8%10%12%14%16%
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Number of Days
% o
f P
ati
en
ts
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Hospital Contract Case Study
Example of setting per-diem rates Observe that most patients stay for only a few
days, although a few patients make the average length of stay quite high
Stratified per-diem rates Charge more per day to patients who stay for only a
few days Results
Higher average revenue Lower standard deviation of revenue
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Hospital Contract Case Study
Higher average revenue clearly beneficial to the hospital
Lower standard deviation of revenue Beneficial to the hospital?
Yes. More predictable revenue Beneficial to the insurance company?
Yes. More predictable costs
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What is Revenue Management
Overbooking may be part of revenue management Overbooking important practice in many
industries that use reservations, and where cancellations or no-shows may occur airlines hotels car rental cruise lines restaurants contractors (construction etc)
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What is Revenue Management
Overbooking Important trade-off between opportunity cost of unused
resources if cancellations or no-shows cause resources to be wasted, and cost of oversales
In 1960’s, Simon and Vickrey proposed the use of auctions to allocate airline seats in case of oversales
Airlines rejected idea for many years Nowadays, reverse Dutch auctions are widely used to
allocate airline seats in case of oversales, and seem to be widely accepted
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What is Revenue Management
Dynamic pricing and the bullwhip effect Dynamic pricing can increase demand
variability The case of Campbell Soup
Wild swings in demand and in shipments of chicken noodle soup from the manufacturer to distributors and retail stores
Increase in production, storage and logistics costs Frequent stockouts resulting in lost sales
The culprit: Trade promotions!
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What is Revenue Management
Dynamic pricing and the bullwhip effect Dynamic pricing can be used to decrease demand
variability Peak load pricing: lower prices during off-peak times,
higher prices during peak times Airlines Hotels Golf courses Electricity wholesale market Oil/gasoline?
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What is Revenue Management
Revenue Management may involve price discrimination, but it does not have to
P=130-QUnit cost = 10Firm’s profits under single price:(130-Q-10)QP
qMC=10
130
130
60
70
Consumer surplus=1800
Deadweight loss=1800
Firm profits=3600
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Price Discrimination (continued)P=130-QUnit cost = 10What if the firmcould segmentthe market and charge two different prices?
P
q
MC=10
130
130
80
90
Consumer surplus=1600
Deadweight loss=800
Firm profits=4800
50
40
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Price Discrimination (continued)
P
q
MC=10
130
130
80
110 Consumer surplus=1000
Deadweight loss=200
Firm profits=6000
90
40
70
50
30
20 60 100
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Price Discrimination (continued)
Perfect pricediscrimination
P
q
MC=10
130
130
Consumer surplus=0Deadweight loss=0Firm profits=7200
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What is Revenue Management 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 the product value may change over time, such as perishable or
maturing or seasonal products, fashion goods, antiques. the remaining inventory may be different interest is earned if product is sold at an earlier time consumers value products differently at different points in time locking sales in early reduces uncertainty
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What is Revenue Management
It is not spam
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Fairness and Legal Issues
Depending on the industry, there may be legal obstacles to revenue management
Examples Regulated prices of utilities (this is changing) Prices in airline industry were regulated until 1978 -
price and quantity changes had to be approved by CAB Pricing in ocean cargo industry was regulated until
1999 - carriers had to provide all shippers with the same essential contract terms
Spot market pricing in ocean cargo industry is still regulated - 30 days notice required for price increases
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Fairness and Legal Issues
Golf course examples Kimes and Wirtz survey results (1 = extremely
fair, 7 = extremely unfair) Time-of-day pricing: 3.41 Varying price (for example, as function of bookings
on hand): 6.16 Two-for-one coupons for off-peak use: 1.80 Time-of-booking pricing: 5.12 Reservation fee/Charge for no-shows: 3.19 Tee-time interval pricing: 3.95
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Fairness and Legal Issues
Amazon.com example Fall 2000, Amazon conducted experiment to try to
determine price sensitivity of demand for DVDs Discounts between 20% and 40% offered randomly Customers who visited amazon.com multiple times
noticed changing prices Furious response by customers and press, suspecting
Amazon varied price by demographics Why are varying airline prices accepted by most, and
not varying DVD prices?
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Why do Revenue Management
Success stories American Airlines increased annual revenue with $500
million through revenue management Delta Airlines increased annual revenue with $300 million
through revenue management Marriott hotels increased annual revenue with $100 million
through revenue management National Car Rental was saved from liquidation with
revenue management Canadian Broadcasting Corporation increased revenue with
$1 million per week
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Why do Revenue Management
Increasing competition Fewer restriction on international trade More efficient international transportation Low cost foreign competitors Competitors use revenue management Use revenue management to stay on top
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Demand Forecasting
The first law of forecasting: The forecast is always wrong
Sources of forecast error: Modeling error Parameter error Measurement error
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It is very important to understand and model customer behavior accurately
Incorrect models of customer behavior can lead not only to suboptimal prices, but can lead to the systematic deterioration of models, prices, and profits over time – the spiral-down effect
Demand Modeling
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Spiral-down effect in airline revenue management For many years, airlines have used following simple
model of customer behavior Some time before departure, customer requests a ticket in a
particular fare class Airline accepts or rejects the request
Above model describes the way airline reservations systems work
However, it does not accurately describe the way customers behave
Demand Modeling
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Spiral-down effect in airline revenue management Low fare tickets and high fare tickets Airlines set aside chosen number of seats for
high fare tickets Airlines use observed sales to estimate the
supposed “demand for high fare tickets”
Demand Modeling
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Spiral-down effect in airline revenue management Spiral-down effect:
Airline allows some low fare sales Some flexible customers (not modeled by the airlines) willing to
buy high fare if that is the only option, now buy low fare tickets Airlines observe more low fare sales and less high fare sales –
decrease their estimate of “high fare demand” Airlines set aside fewer seats for high fare tickets, and allow
more low fare sales More customers buy low fare tickets, and the spiral down
continues Spiral-down effect is the consequence of an incorrect
model of customer behavior
Demand Modeling
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Forecasting methods Judgmental methods Statistical forecasting methods
Demand Forecasting
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Judgmental forecasting methods “Expert” opinion Questionable: See the articles
Armstrong, J.S., “How Expert Are the Experts?”, Inc, pp.15-16, 1981
Armstrong, J.S., “The Seer-Sucker Theory: The Value of Experts in Forecasting”, Technology Review, pp.16-24, 1980
Consensus methods, such as Delphi technique
Demand Forecasting
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Statistical forecasting methods Non-causal methods
Exponential smoothing Time series methods
Causal methods Linear regression Nonlinear regression Discrete choice models (logit, probit, etc)
Whatever the method, the basic approach is to find systematic behavior in data that one has reason to believe will continue in the future
Demand Forecasting
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Forecasting software surveys: Yurkiewicz, J., “Forecasting: Predicting Your Needs”, OR/MS
Today, volume 31, number 6, pp. 44-52, December 2004, <http://lionhrtpub.com/orms/surveys/FSS/fss-fr.html>.
Swain, J. J., “Desktop Statistics Software: Serious Tools for Decision Making”, OR/MS Today, volume 26, number 5, pp. 50-61, October 1999.
Swain, J. J., “Looking for Meaning in an Uncertain World”, OR/MS Today, volume 28, number 5, pp. 48-49, October 2001.
Swain, J. J., “2005 Statistical Software Products Survey: Essential Tools of the Trade”, OR/MS Today, volume 32, number 1, pp. 42-51, February 2005, <http://lionhrtpub.com/orms/surveys/sa/sa-survey.html>.
Demand Forecasting
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Questions?