Demand and Revenue Management

Anton J. Kleywegt
April 2, 2008

Revenue Management

What is Revenue Management Why do Revenue Management Pricing Optimization Demand Modeling and Forecasting

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

What is Revenue Management

Revenue Management involves the following activities

Demand data collection Demand modeling Demand forecasting Pricing optimization System implementation and distribution

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

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

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 How much to charge for lunch vs dinner

Restaurant industry

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

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 control tee-time interval control uncertainty in arrival time control uncertainty in duration
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Round duration control

Hospital Contract Case Study

Major customers of hospitals

Insurance companies Medicare Medicaid Individuals Discount-off-listed-charges contracts Per-diem contracts Case-rate contracts Capitation contracts
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Hospital contracts with major customers

Hospital Contract Case Study

Example of setting per-diem rates

ICU Patient Length of Stay
16% 14% 12% 10% 8% 6% 4% 2% 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14
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% of Patients

Number of Days

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 1960s, 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

130

Revenue Management may involve price discrimination, but it does not have to
P=130-Q Consumer surplus=1800 Unit cost = 10 Firms profits under single price: Firm profits=3600 (130-Q-10)Q
Deadweight loss=1800

70

60

130

MC=10 q
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Price Discrimination (continued)

130
Consumer surplus=1600

90 P
Firm profits=4800

P=130-Q Unit cost = 10 What if the firm could segment the market and charge two different prices?

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Deadweight loss=800

MC=10 40
80 130 q
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Price Discrimination (continued)

130 110 P 90 70 50 30
Firm profits=6000
Deadweight loss=200 Consumer surplus=1000

MC=10

20 40 60 80 100

130

q
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Price Discrimination (continued)

130

Perfect price discrimination

Consumer surplus=0 Deadweight loss=0 Firm profits=7200

MC=10

130

q
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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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Demand Modeling

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
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Demand Modeling

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
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Demand Modeling

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

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Demand Modeling

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 47

Demand Forecasting

Forecasting methods

Judgmental methods Statistical forecasting methods

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Demand Forecasting

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

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Demand Forecasting

Statistical forecasting methods

Non-causal methods

Exponential smoothing Time series methods Linear regression Nonlinear regression Discrete choice models (logit, probit, etc)

Causal methods

Whatever the method, the basic approach is to find systematic behavior in data that one has reason to believe will continue in the future
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Demand Forecasting

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/fssfr.html>. Swain, J. J., Desktop Statistics Software: Serious Tools for Decision Making, OR/MS Today, volume 26, number 5, pp. 5061, 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. 4251, February 2005, <http://lionhrtpub.com/orms/surveys/sa/sasurvey.html>.
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Questions?

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