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The Role of RM in SCsRevenue management is the use of pricing to increase the profit generated from alimited supply of supply chain assets SCs are about matching demand and capacity Prices affect demands

Yield management similar to RM but deals more with quantities rather than pricesSupply assets exist in two forms Capacity: expiring Inventory: often preserved

Revenue management may also be defined as offering different prices based oncustomer segment, time of use and product or capacity availability to increasesupply chain profitsMost commonly known example is probably in airline ticket pricing Pricing according to customer segmentation at any time Pricing according to reading days for any customer segment

Reading days : Number of days until departure

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Conditions for RM to Work

The value of the product varies in different market segments Airline seats: Leisure vs. Business travel Films: Movie theater goers, DVD buyers, Cheap movie theater goers, TV watchers.

The product is highly perishable or product waste occurs Fashion and seasonal apparel High tech products

Demand has seasonal and other peaks Products ordered at Amazon.com, peaking in December Supply Chain textbook orders peaking in August and January.

The product is sold both in bulk and on the spot market O wner 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 Truck capacities for a transportation company

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RM 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

Must figure out customer segmentsPrices must be set with b arriers such that the segment willing to

pay more is not able to pay the lower price Barriers : Time, location, prestige, inconvenience, extra service

In the case of time barrier, The amount of the asset reserved for the higher price segment is such that

quantities below are equal the expected marginal revenue from the higher priced segment the price of the lower price segment

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Customer Segmentation by extra serviceExample: Cruise ship

A cruise ship with C= 400 identical cabinsWhat is the price to maximize revenue?

Price

No. Seats

2000

1000

P =2000-2Q

D emand Curve

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Example: Cruise ship

Price

No. seatsQ 1

=400

P 1 =1200

Q 2 =200

P 2 =1600Revenue=1600(200) + 1200(400-200)=560,000

ff er additional services todiff erentiate products and pricing

Increase revenue more?

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Barrier: T ime which implies Customer SegmentRM for Multiple Customer Segments

pL = the price charged to the lower price segment pH = the price charged to the higher price segmentDH = mean demand for the higher price segment

WH = standard deviation of demand for the higher price segmentCH = capacity reserved for the higher price segmentR H(CH) = expected marginal revenue from reserving more capacity

= Prob(Demand from higher price segment > C H) x p H

O ptimality by equivalance of marginal revenues: R H(CH) = p Lwhich leads to

Prob(Demand from higher price segment > C H) = p L / pH

CH = F-1

(1- p L/pH, DH,WH) = Norminv(1- p L/pH, DH,WH)

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Example 15.1: ToFrom Trucking

Revenue from segment A = p A = $3.50 per cubic ftRevenue from segment B = p B = $2 .00 per cubic ftMean demand for segment A = D A = 3,000 cubic ft

Std dev of segment A demand = WA = 1,000 cubic ftCA = Norminv(1- p B/pA, DA,WA)

= Norminv(1- ( 2 .00 /3.50), 3000 , 1000 )= 2 ,8 2 0 cubic ft

If pA increases to $5. 00 per cubic foot, thenCA = Norminv(1- p B/pA, DA,WA)

= Norminv(1- ( 2 .00 /5.00 ), 3000 , 1000 )= 3,2 53 cubic ft

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2

Two questions:

What happens to the capacity reserved for the high paying segment, when the high paying segmentstarts paying about the low paying segment? How much does the high paying segment value quick

service?

We never consider the distribution of the demand for low paying segment when computing the reservedcapacity for the high paying segment. Can this becorrect, why?

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RM in the Service Industries

Airline Industry uses RM the most.Evidence of airline revenue increases of 4 to 6 percent: With effectively no increase in flight operating costs

RM allows for tactical matching of demand vs. supply: Booking limits can direct low-fare demand to empty flights Protect seats for highest fare passengers on forecast full flights

Hotel, Restaurant, Car rental, O verseas shipping, Cruise

travel, Transportation capacity providers, Computationcapacity providers (computer farms) and sometimesHealth care industries show similarities to airline industryin using RM.

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What are the barriers among customer segmentsin the airline industry?

L eisure

Travelers

BusinessTravelers

No

Offer

No

D emand

Sensitivityto

P rice

Sensitivity t o D urati o nSensitivity t o Flexibility

High L ow

L ow

High

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A RM ModelExpected Revenue = Expected Revenue from Business Class +Expected Revenue from Leisure ClassAssume demand distribution for the business class is known andthe demand for leisure class is C

L B r QC dx x f Qdx x xf r Q )()()()( 0

!

g

0)](1[)(

!! L B r Q F r dQQd

Marginal revenue of business class = Marginal revenue of leisure class

B

L B

r r r

Q F !)( * SL: Service Level

capacityirplane passenger,isurerevenue/le passenger,sinessrevenue/bu !!! L B r r

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Example: Airline seat classes

There are only two price classes Leisure: (f 2 ) $100 per ticket Business: (f1) $ 2 50 per ticket

Total available capacity= 8 0 seatsDistribution of demand for business class is knownAssume enough demand for the leisure class

H ow many seats t o all o cate t o the business class t o maximize expected revenue?

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Business Class Demand Distribution

0%

20%

40%

60%

80%

100%

Business Class Seat Allocation

P r o

b a b

i l i t y

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

P robabilitycd f

P robability 5% 11% 28% 22% 18% 10% 6%

cd f 5% 16% 44% 66% 84% 94% 100

0 5 10 15 20 25 30

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8

Identifying O ptimal Allocation

0%

20%

40%

60%

80%

100%

Bus i ss l ss t ll ti

r

i l i t

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

P r ilitf

P r ilit 5% 11% 28% 22% 18% 10% 6%

cd f 5% 16% 44% 66% 84% 94% 100

0 5 10 15 20 25 30

SL= 0.60SL= 0.60

Opt imal Alloca t ion Qu an t it y = 15

No te:r B: 2 50,r L: 100

SL = (r B - r L )/ r B= (2 50-100 )/2 50 = 60%

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9

Expected Revenue

Expected Revenue

8000

8688

92389438 9363

9063

8638

78008000

8200

8400

86008800

900092009400

9600

0 5 10 15 20 25 30 35

Business Class

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O ptimality Condition

Marginal Revenue Business

0

50

100

150

200

250

0 5 10 15 20 25 30 35

MarginalRevenue

L eisure

Optimality C o nditi o n : Choose the number of seats for the business class such that marginal revenue from business class isthe same as the marginal revenue from the leisure class.

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RM for Perishable Assets

Any asset that loses value over time is perishableExamples: high-tech products such as computers and cell

phones, high fashion apparel, underutilized capacity, fruits andvegetablesTwo basic approaches: Dynamic Pricing: Vary price over time to maximize expected revenue O verbooking: O verbook sales of the asset to account for cancellations

Airlines use the overbooking most Passengers are offloaded to other routes O ffloaded passengers are given flight coupons This practice is legal

Dynamic pricing belongs to RM while overbooking can be said to morewithin the domain of Yield management.

But concepts are more important than the names!

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O verbooking or overselling of a supply chain asset is valuable if order cancellations occur and the asset is perishable

The level of overbooking is based on the trade-off between the costof wasting the asset if too many cancellations lead to unused assets( s poilage ) and the cost of arranging a backup ( offload ) if too fewcancellations lead to committed orders being larger than theavailable capacitySpoilage and offload are actually terms used in the airline industry

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p = price at which each unit of the asset is soldc = 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 shortageCw = p c = marginal cost of wasted capacity = O verage costCs = b c = marginal cost of a capacity shortage = Underage costO * = optimal overbooking level

P (D emand=Capacity)= C o / (C u + C o )

P (Order cancellati o ns < O *) = C o / (C u + C o )

s* := P r o bability( o rder cancellati o ns < O*) = C w / (C w + C s)

Beware:T

his is the newsvendor formula in disguise.

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If the distribution of cancellations is known to be normal withmean Qc and standard deviation Wc then

O * = F -1(s*, Qc, Wc) = Norminv(s*, Qc, Wc)

If the distribution of cancellations is known only as a function of the booking level (capacity L + overbooking O ) to have a meanof Q(L+O ) and std deviation of W(L+O ), the optimal

overbooking level is the solution to the following equation:O * = F -1(s*,Q L+O ),W(L+O ))

= Norminv(s*, Q L+O ),W(L+O ))

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Example 15. 2Cost of wasted capacity = C w = $10 per dressCost of capacity shortage = C s = $5 per dresss* = C w / (Cw + C s) = 10/(10+5) = 0.667

Qc =8

00; W

c = 400O * = Norminv(s*, Qc,Wc)= Norminv( 0.667 ,8 00 ,400 ) = 9 73

If the mean is 15 % of the booking level and the coefficient of variation is 0.5, then the optimal overbooking level is thesolution of the following equation:

O * = Norminv( 0.667 ,0.15(5 000 +O * ),0.07 5(5000 +O * ))Using Excel Solver, O * = 1,115

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RM for Seasonal Demand

Seasonal peaks of demand are common in many SCs\ Most retailers achieve a large portion of total annual demand in

December

Amazon.comO ff-peak discounting can shift demand from peak to non-

peak periodsCharge higher price during peak periods and a lower price

during off-peak periodsRead Section 9 .3: Managing Demand [with discounts] of the textbook.

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RM for Bulk and Spot CustomersMost consumers of production, warehousing, and transportationassets in a supply chain face the problem of constructing a

portfolio of long-term bulk contracts and short-term spot marketcontracts

Long-term contracts for low cost Short-term contracts for flexibilityThe basic decision is the size of the bulk contractThe fundamental trade-off is between wasting a portion of the low-cost bulk contract and paying more for the asset on the spot market

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RM for Bulk and Spot Customers

For the simple case where the spot market price is known butdemand is uncertain, a formula can be used

cB = bulk rate

cS = spot market priceQ* = 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.

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Revenue Management for Bulk and Spot Customers

If the optimal amount of the asset is purchased in bulk, themarginal cost of the bulk purchase should equal the expectedmarginal cost of the spot market purchase, or c B = (1-p*)c S

Solving for p* yields p* = (c S cB) / c S

If demand is normal with mean Q and std deviation W, the optimal

amount Q* to be purchased in bulk isQ* = F -1(p*, Q,W) = Norminv(p*, Q,W)

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Example 15. 3: Buying transportation capacityto bring goods from China

Bulk contract cost = c B = $1 0,000 per million unitsSpot market cost = c S = $1 2 ,500 per million unitsDemand for transportation: Q = 10 million units

W= 4 million units p* = (c S cB) / cS = (1 2 ,500 10,000 ) / 12 ,500 = 0.2Q* = Norminv(p*, Q,W) = Norminv( 0.2 ,10,4) = 6.63The manufacturer should sign a long-term bulk contract for 6.63

million units per month and purchase any transportationcapacity beyond that on the spot market

If the demand is exactly 1 0 million units without any variability,how much long-term bulk contract with the transporter?

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Using RM in Practice

Evaluate your market carefully Understand customer requirements for services and products Price, flexibility (time, specs), value-added services, etc. Based on requirements identify customer segments (groups) Differentiate products/services and their pricing according to

customer segments Dell: Same product is sold at a different price to different consumers

(private/small or large business/government/academia/health care) Price of the same product for the same industry varies

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Using RM in Practice

Quantify the benefits of revenue managementImplement a forecasting process

Apply optimization to obtain the revenue managementdecisionInvolve both sales and operationsUnderstand and inform the customer

Integrate supply planning with revenue management

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Summary of Learning O bjectives

What is the role of revenue management in asupply chain?Under what conditions are revenue managementtactics effective?What are the trade-offs that must be consideredwhen making revenue management decisions?

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Smart Pricing Through Rebates

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Rebate Examples

Nikon Coolpix digital camera is sold either on-lineor in stores for $ 600 . the manufacturer provides arebate of $1 00 independently of where the camerais purchased.

Sharp VL-WD 2 55U digital camcorder is sold for

about $5 00 at retail or virtual stores. Sharp provides a rebate to the customer of $1 00 independently of where the product is purchased.

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Mail-in-Rebate

What is the manufacturer trying to achieve withthe rebate? Why the manufacturer and not the retailer?

Should the manufacturer reduce the wholesale price instead of the rebate?

Are there other strategies that can be used toachieve the same effect?

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Example

A Retailer and amanufacturer. Retailer faces customer

demand. Retailer orders from

manufacturer.

S elling P rice=?

Wholesale P rice=$ 900

Retailer Manu f acturer

Variable P roduction Cost=$ 200

Demand

Price

10000

2000

P =2000-0.22Q

D emandCurve

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Example

Retailer profit=(P R -PM)(1/0.22 )(2 ,000 - PR )

Manufacturer profit=(P M-CM) (1/ 0.22 )(2 ,000 - PR )

Retailer takes P M=$9 00 Sets P R =$1450 to maximize (P R -9 00 ) (1/ 0.22 )(2 ,000 - PR ) Q = (1/ 0.22 )(2 ,000 1,450) = 2 ,500 units Retailer Profit = (1, 450-9 00 )2 ,500 = $1, 37 5,000

Manufacturer takes CM=variable cost Manufacturer profit=( 9 00 -2 00 )2 ,500 = $1, 750,000

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Retailer Expected Profit (No Rebate)

0

200,000

400,000

600,000

800,000

1,000 ,000

1,200 ,000

1,400 ,000

1,600 ,000

5 00 1 ,0 00 1 ,5 00 2 ,0 00 2 ,50 0 3 ,00 0 3 ,50 0 3 ,65 4 4 ,11 0 4 ,56 7 4 ,547

Order

R e

t a i l e r

E x p e c

t e d

P r o

f i t

$1,37 5,000

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Manufacturer Profit (No Rebate)

0

1 000 000

2 000 000

3 000 000

4 000 000

5 000 000

6 000 000

5 0 0

10 0 0

15 0 0

20 0 0

25 0 0

30 0 0

35 0 0

36 5

4

41 1 0

45 6 7

45 4 7

49 6

1

53 7

4

57 8 8

62 0

1

66 1

4

70 2 8

74 4

1

78 5 5

r de r

M a n u a c

t u r e r

P r o

i t

$1,750,000

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Example: Customer Mail-in Rebate

What happens with $1 00 customer mail-in rebate? Note that it is a discount for the customer so the demand should

go up!!! Q = (1/0.22 ) [2 ,000 (PR -Rebate)] = (1/ 0.22 ) [2 ,000 (1450-100 )] =

2 9 54

Retailer Profit = (1, 450-9 00 )2 ,9 55 = $1, 62 5,2 50 Manufacturer profit=( 9 00 -2 00 -100 )2 ,9 55 = $1, 773 ,000

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Retailer Expected Profit ($1 00 Rebate)

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,110 4,567 4,547 4,961

O rder

R e

t a i l e r

E x p e c

t e d P r o

f i t

$1,62 5,2 50

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Manufacturer Profit ($1 00 Rebate)

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

1 , 0 0 0

1 , 5 0 0

2 , 0 0 0

2 , 5 0 0

3 , 0 0 0

3 , 5 0 0

4 , 0 0 0

4 , 1 1 0

4 , 5 6 7

4 , 5 4 7

4 , 9 6 1

5 , 3 7 4

5 , 7 8 8

6 , 2 0 1

6 , 6 1 4

7 , 0 2 8

7 , 4 4 1

7 , 8 5 5

8 , 2 6 8

O rder

a n u

f a c

t u r e r

P r o

f i t

$1,773 ,000

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Example: Wholesale discount

What happens with $1 00 wholesale discount to retailer?

Retailer takes P M=$8 00

Sets P R =$1400 to maximize (P R -8 00 ) (1/ 0.22 )(2 ,000 - PR ) Q = (1/ 0.22 )(2 ,000 1,400 ) = 2 ,72 7 units Retailer Profit = (1, 400 -8 00 )2 ,72 7 = $1, 499 ,8 50

Manufacturer takes P R =$8 00 and CM=variable cost Manufacturer profit=( 8 00 -2 00 )2 ,72 7 = $1, 499 ,8 50

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Example: Global O ptimization

What happens if manufacturer sells directly or optimizesfor the whole system globally? Manufacturer sets P R =$1,1 00 to maximize (P M -2 00 )

(1/0.22 )(2 ,000 - PM

) Q = (1/ 0.22 )(2 ,000 1,100 ) = 4,09 1 units Manufacturer profit=(11 00 -2 00 ) 4,09 1 = $ 3,68 1,9 00

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Strategy Comparison

Strategy Retailer Manufacturer Total

No Rebate 1,370,096 1,750,000 3,120,096 With Rebate ($100) 1,625,250 1,773,000 3,398,250 Reduce Wholesale P ($100) 1,499,850 1,499,850 2,999,700 Global Optimization 3,681,900

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Managerial Insights

Mail in Rebate allows supply chain partners tomove away from sequential strategies towardglo bal o ptimizati o n

Provides retailers with upside incentive

Mail in Rebate o utperf o rms wholesale pricediscount for manufacturer

O ther advantages of rebates: Not all customers will remember to mail them in Gives manufacturer better control of pricing

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Smart Pricing

Customized Pricing Revenue Management Techniques

Distinguish between customers according to their price

sensitivity Influence retailer pricing strategies Move supply chain partners toward global optimization

Dynamic Pricing Changing prices over time without necessarily

distinguishing between different customers Find the optimal trade-off between high price and low

demand versus low price and high demand

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When does Dynamic Pricing Provide Significant ProfitBenefit?

Limited CapacityDemand VariabilitySeasonality in Demand PatternShort Planning Horizon

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The Internet makes Smart Pricing Possible

Low Menu CostLow Buyer Search CostVisibility To the back-end of the supply chain allows to

coordinate pricing, production and distribution

Customer Segmentation

Difficult in conventional stores and easier on theInternet

Testing Capability

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A Word of Caution

Amazon.com experimented with dynamic pricing customers responded negatively

Coca-Cola distributors rebelled against a seasonal pricing scheme

O paque fares (priceline.com, hotwire.com) Determining the correct mix of opaque and regular

fares is difficult.

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