Supply Chain Management

1
Supply Chain Management

• Lecture 25

2
Semester Outline

• Tuesday April 20 Chap 15
• Thursday April 22 Simulation Game briefing
• Tuesday April 27 Review, buffer
• Thursday April 29 Simulation Game

3
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

4
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

5
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

6
Revenue Management
Revenue ManagementMaps capacity into demand
Newsvendor problemMaps demand into capacity
7
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

8
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
9
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

10
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

11
Airfare example
q
Choose the fare that maximizes the area (revenue)
of the rectangle
1000
800
600
400
200
p
1000
800
600
400
200
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Airfare example
q
Choose the fare that maximizes the area (revenue)
of the rectangle
Unaccommodated demand
1000
800
Maximum revenue 500500 250,000
600
400
Consumer surplus
200
1000
800
600
400
200
p
13
Airfare example
q
Choose the fare that maximizes the SUM of areas
of the rectangles
1000
800
Economy class
Maximum revenue 333(333 667) 333,000
600
400
Business class
200
1000
800
600
400
200
p
14
Airfare example
q
Choose the fare that maximizes the SUM of areas
of the rectangles
1000
Economy class
800
Maximum revenue 200(800600400200)
400,000
Economy plus class
600
Business class
400
First class
200
1000
800
600
400
200
p
15
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
1000
800
600
400
200
p
16
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

17
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
18
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?
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What is Revenue Management?
q
q
1000
1000
800
800
600
600
400
400
200
200
1000
800
600
400
200
1000
800
600
400
200
p
p
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Example 15-1 Pricing to multiple segments

• A contract manufacturer has identified two
  customers segments for its production
  capacityone 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 weeks 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?

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Example 15-1 Pricing to multiple segments
d1 5,000 20p1
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Example 15-1 Pricing to multiple segments
d1 5,000 20p1
Profit
p - c
23
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
24
Pricing Multiple Segments

• The optimal price for segment i is given by
• pi Ai/2Bi c/2

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Example 15-1 Pricing to multiple segments

• For segment 1
• pi Ai/2Bi c/2 pi 5,000/(220) 10/2
  130
• Profit (pi 10)(5,000 20pi) (130
  10)(5,000 20130) 288,000
• For segment 2
• pi Ai/2Bi c/2 pi 5,000/(240) 10/2
  67.50
• Profit (pi 10)(5,000 40pi) (67.5
  10)(5,000 4067.5) 127,650

Total profit 415,650
26
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 2,400 2,300 4,700

Total demand exceeds production capacity of 4,000
27
Pricing Multiple Segments

• The goal of the supplier is to price so as to
  maximize profits
• Max ?ki1 (pi c)(Ai Bipi)
• Subject to?ki1(Ai Bipi) ? Qpi ? 0

Maximize profits
Production capacity
Price
28
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
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Example 15-1 Pricing to multiple segments

• For segment 1 and 2
• p Ai/2Bi c/2 p 10,000/(260) 10/2
  83.33
• Max (p c)(A Bp) Max (p 10)(10,000 60p)
  (83.33 10)(10,000 6083.33)
  366,650

Differential pricing raises profit from 366,650
to 415,650
30
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?
31
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?
32
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

33
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 ? 181.00 1.0 x 181
128 ? 162.90 0.9 x 181
128 ? 144.80 0.8 x 181
128 ? 126.70 0.7 x 181
34
Allocating Capacity to a Segment Under Uncertainty
126.70 0.7 x 181
Expected revenue sales probability x sales price
RH(CH) Prob(demand from higher-price segment gt
CH) x pH
Never sell a unit of capacity for less than the
expected revenue
35
Allocating Capacity to a Segment Under Uncertainty
128 ? 126.70 0.7 x 181
Expected revenue sales probability x sales price
RH(CH) Prob(demand from higher-price segment gt
CH) x pH
Never sell a unit of capacity for less than the
expected revenue
36
Allocating Capacity to a Segment Under Uncertainty
Prob(demand from higher-price segment ? CH) 1
pL/pH
CH F-1(1 pL/pH, DH, ?H)
CH
pL/pH
1 pL/pH
37
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 20.8. 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 0.2928
• 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
38
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?

39
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
40
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?
41
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