Pricing and Revenue Management in Supply Chains PDF

Here's the conversion of the provided document into a structured markdown format: # Chapter 16: Pricing and Revenue Management in a Supply Chain **Learning Objectives:** After reading this chapter, you will be able to: * **16.1** Understand the role of revenue management in a supply chain. *...

Here's the conversion of the provided document into a structured markdown format: # Chapter 16: Pricing and Revenue Management in a Supply Chain **Learning Objectives:** After reading this chapter, you will be able to: * **16.1** Understand the role of revenue management in a supply chain. * **16.2** Identify how differential pricing can help increase profits when serving multiple customer segments. * **16.3** Describe how dynamic pricing and overbooking can help increase profits from perishable assets. * **16.4** Discuss how peak pricing and off-peak discounts can help increase profits when demand is seasonal. * **16.5** Describe how both buyers and sellers can combine long-term contracts and spot purchases to increase profits when demand is uncertain. * **16.6** Understand the potential negative consequences of revenue management in practice. Given that most supply chain assets are fixed but demand fluctuates, the matching of supply and demand is a constant challenge. In this chapter, we discuss how managers may use pricing as a lever to better match supply and demand and grow revenue derived from supply chain assets. ## 16.1 Understand the Role of Revenue Management in a Supply Chain The Role of Pricing and Revenue Management in a Supply Chain In Chapter 9, we discussed how short-term price promotions can be an effective tool to more profitably meet seasonal demand. In this chapter, we further build on the idea of using pricing as an important lever to increase supply chain profits by better matching supply and demand, especially when there are multiple customer types willing to pay different prices (based on attributes such as response time) for an asset. *Revenue Management* is the use of pricing to increase the supply chain surplus and profit generated from a limited availability of supply chain assets. Supply chain assets exist in two forms—capacity and inventory. Capacity assets in the supply chain exist for production, transportation, and storage. Inventory assets exist throughout the supply chain and are carried to improve product availability. In the presence of multiple customer types, revenue management aims to grow profits by selling the right asset to the right customer at the right price. Besides varying capacity and inventory, revenue management suggests varying price to grow profits by better matching supply and demand. An excellent discussion of revenue management techniques in theory and practice can be found in Talluri and Van Ryzin (2004) and Phillips (2005). Consider a trucking company that owns ten trucks. One approach that the firm can take is to set a fixed price for its services and use advertising to spur demand if surplus capacity is available. If demand is higher than anticipated, the trucking company can react by purchasing more trucks. Using revenue management, however, the firm could do much more as long as there are customers whose willingness to pay varies with some dimension of the service, such as response time. One approach is to charge a lower price to customers willing to commit their orders far in advance and a higher price to customers looking for transportation capacity at the last minute. Another approach is to charge a lower price to customers with long-term contracts and a higher price to customers looking to purchase capacity at the last minute. A third approach is to charge a higher price during periods of high demand and lower prices during periods of low demand. Each instance where differential prices are used is likely to result in higher profits than charging a fixed price and adjusting available capacity. The capacity decision cannot easily be reversed but prices can easily be changed. Similarly, an apparel retailer who adjusts prices based on product availability, customer demand, and remaining duration of the sales season will make higher profits than a retailer who fixes price for the entire duration of the sales season. All these revenue management strategies use differential pricing as a critical lever to maximize earnings. Revenue management may also be defined as the use of differential pricing based on customer segment, time of use, and product or capacity availability to increase supply chain surplus and profits. The impact of revenue management on supply chain performance can be significant. One of the most often cited examples is the successful use of revenue management by American Airlines to counter—and finally defeat—PeopleExpress in the mid-1980s. PeopleExpress started in Newark, New Jersey, and offered fares that were 50 to 80 percent lower than those of other carriers. At first, the other airlines ignored PeopleExpress because they were not interested in the low-fare market segment. By 1983, however, PeopleExpress was flying 40 aircraft and achieving load factors of more than 74 percent. PeopleExpress and other new entrants were making significant inroads into the turf of existing airlines. The existing airlines could not compete by cutting prices to the level of PeopleExpress because they had higher operating costs. American Airlines was the first to come up with an effective countermeasure using revenue management. Rather than lower the price of all its seats, American lowered prices of a portion of the seats to prices at or below those of PeopleExpress. The number of low-price seats was larger on flights that were likely to have empty seats, which would otherwise have produced no revenue. This strategy allowed American to attract customers who valued the low prices without losing revenue from customers who were willing to pay more. Soon, other airlines, such as United, followed suit, attracting many of PeopleExpress's passengers. This was sufficient to drive down load factors for PeopleExpress to below 50 percent, a level at which the airline could not survive. Before the end of 1986, PeopleExpress collapsed. American Airlines succeeded primarily because it used differential pricing to lower prices for a fraction of the seats and attract passengers who would otherwise have flown PeopleExpress. American did not lower prices for the fraction of seats used by business travelers who were not flying with PeopleExpress. Targeted differential pricing is at the heart of successful revenue management. Revenue management has a significant impact on supply chain profitability when one or more of the following four conditions exist: 1. The value of the product varies in different market segments. 2. The product is highly perishable or product wastage occurs. 3. Demand has seasonal and other peaks. 4. The product is sold both in bulk and on the spot market. Airline seats are a good example of a product whose value varies by market segment. A business traveler is willing to pay a higher fare for a flight that matches his or her schedule. In contrast, a leisure traveler will often alter his or her schedule to get a lower fare. An airline that can extract a higher price from the business traveler (by offering an appropriate schedule) compared to the leisure traveler will always do better than an airline that charges the same price to all travelers. Similar ideas can be applied in the context of hotel rooms and car rentals, for which there is a significant difference between the business traveler and the leisure traveler. Fashion and seasonal apparel are examples of highly perishable products because they lose value over time. Customers typically value high-fashion apparel more at the start of the season because they want to be the first people seen wearing it. By the end of the season, customers are willing to buy the product only if it is deeply discounted. Similarly, production, storage, and transportation capacity loses all value if it is not used at a given time because the lost capacity cannot be recovered. If a truck is not used for a day, its transportation capacity for that day is gone forever without producing revenue. Thus, all capacity is also a highly perishable asset. The goal of revenue management in such a setting is to adjust the price over time to maximize the profit obtained from the available inventory or capacity. Demand for hotel rooms in many tourist destinations shows a highly seasonal pattern. For example, resorts in Phuket, Thailand, charge a significantly lower rate during the off-season summer months compared with the peak winter months. Such a pricing pattern allows them to attract customers with some time flexibility during the lower-cost summer months, leaving the winter capacity for customers who are willing to pay more to enjoy Phuket in the winter. Some commuter railroads use a similar strategy to deal with the distinct peaks in passenger travel, charging higher fares during peak periods and lower fares for off-peak travel. It is important to keep in mind that differential pricing for peak and off-peak periods increases profits in a manner that is consistent with customer priorities. In the absence of peak pricing, peak periods, being the most desirable, would have excess demand, whereas off-peak periods would have significant idle capacity. With differential pricing, customers who really value the peak period pay the higher price, whereas those that are not time constrained shift to the off-peak period to take advantage of lower prices. The outcome of such a move is a higher supply chain surplus with higher profits for the firm and utilization of assets by customers that is consistent with their needs. Every product and every unit of capacity can be sold both in bulk and in the spot market. For example, the owner of a warehouse must decide whether to lease the entire warehouse to customers willing to sign long-term contracts or to save a portion of the warehouse for use in the spot market. The long-term contract is more secure but typically fetches a lower average price than the unpredictable spot market. Revenue management increases profits by finding the right portfolio of long-term and spot-market customers. Revenue management can be a powerful tool for every owner of assets in a supply chain. Many successful examples of the use of revenue management are from the travel and hospitality industry and include airlines, car rentals, and hotels. American Airlines has stated that revenue management techniques increase its revenues by more than $1 billion each year. Revenue management techniques at Marriott raise annual revenues by more than $100 million. Revenue management can have a similar impact on all stages of a supply chain that satisfy one or more of the four conditions identified earlier. In the following sections, we discuss various situations in which revenue management is effective and the techniques used in each case. **Summary of Learning Objective 1** Revenue management uses differential pricing to better match supply and demand and increase supply chain profits. Traditionally, firms have changed the availability of assets to match supply and demand. Revenue management aims to reduce any supply/demand imbalance by using pricing as a lever. A big advantage of using revenue management is that a change in pricing is much easier to reverse compared with an investment in supply chain assets. When it is used properly, revenue management increases firm profits while leaving service sensitive customers more satisfied through greater asset availability and price sensitive customers more satisfied with lower prices. Revenue management is most effective in a supply chain when the value of the product varies by market segment, the product is highly perishable, product demand is seasonal, or the product is sold both in bulk and on the spot market. **Test Your Understanding** * **16.1.1 Pricing can be used to:** * [ ] change available supply. * [ ] reduce supply chain costs. * [ ] influence demand if customers are price sensitive. * [ ] all of the above * **16.1.2 Revenue management has a significant impact on supply chain profitability if:** * [ ] demand is stable and predictable. * [ ] the value of the product does not change regardless of market. * [ ] the product has a long shelf life. * [ ] the product is sold both in bulk and on the spot market. ## 16.2 Identify how differential pricing can help increase profits when serving multiple customer segments. **Differential Pricing for Multiple Customer Segments** A classic example of a market with multiple customer segments is the airline industry, in which business travelers are willing to pay a higher fare to travel on a specific schedule, whereas leisure travelers are willing to shift their schedules to take advantage of lower fares. Many similar instances arise in a supply chain. Consider ToFrom, a trucking firm that has purchased six trucks, with a total capacity of 6,000 cubic feet, to use for transport between Chicago and St. Louis. The monthly lease charge, driver, and maintenance expense is $1,500 per truck, resulting in a total monthly cost of $9,000. Market research has indicated that the demand curve on this route for trucking capacity is: $d = 10,000 - 2,000p$ where *d* is the demand across all segments and *p* is the transport cost per cubic foot. A price of \$2 per cubic foot results in a demand of 6,000 cubic feet (all customers willing to pay \$2 or more), revenue of \$12,000, and a profit of \$3,000, whereas a price of \$3.50 per cubic foot results in a demand of 3,000 (only customers willing to pay \$3.50 or more), revenue of \$10,500, and a profit of \$1,500. The real question is whether the 3,000 cubic feet of demand at a price of \$3.50 can be separated from the 3,000 additional cubic feet of demand generated at a price of \$2 per cubic foot. If ToFrom assumes that all demand comes from a single segment and cannot be separated, the optimal price is \$2.50 per cubic foot, resulting in a demand of 5,000 cubic feet and revenue of \$12,500 However, if ToFrom can differentiate the segment that buys 3,000 cubic feet at \$3.50 from the segment that buys 3,000 cubic feet only at \$2.00, the firm can use revenue management to improve revenues and profits. ToFrom should charge \$3.50 for the segment willing to pay that price and \$2.00 for the 3,000 cubic feet that sells only at the lower price. The firm thus extracts revenue of \$10,500 from the segment willing to pay \$3.50 and revenue of \$6,000 from the segment willing to pay only \$2.00 per cubic foot, for total revenue of \$16,500. In the presence of different segments that have different values for trucking capacity, revenue management increases the revenue from \$12,500 to \$16,500 and results in a significant improvement in profits. In theory, the concept of differential pricing increases total profits for a firm. Two fundamental issues, however, must be handled in practice. First, how can the firm differentiate between the two segments and structure its pricing to make one segment pay more than the other? Second, how can the firm control demand so the lower-paying segment does not use the entire availability of the asset? To differentiate between the various segments, the firm must separate the segments along product or service attributes that the segments value differently. For example, business travelers on an airline want to book at the last minute and change their schedules if necessary. Leisure travelers, on the other hand, are willing to book far in advance and adjust the duration of their stays. Plans for business travelers are also subject to change. Thus, advance booking and a penalty for changes on the lower fare separate the leisure traveler from the business traveler. For a transportation provider such as ToFrom, the segments can be differentiated based on how far in advance a customer is willing to commit and pay for the transportation capacity. Similar separation can also occur for production- and storage-related assets in a supply chain. Separating segments based on how far in advance an order arrives typically results in customers seeking lower prices arriving earlier and customers willing to pay higher prices arriving later. For example, leisure travelers are willing to purchase a cheaper ticket far in advance of a flight. Given that future demand of business travelers is uncertain, the airline must decide how much of the available capacity to allocate to leisure travelers and how much to save for business travelers. As a result, a firm using revenue management across multiple segments must solve the following two problems: 1. What price should it charge for each segment? 2. How should it allocate limited capacity among the segments? **Pricing to Multiple Segments** Let us start by considering the simple scenario in which the firm has identified criteria on which it can separate the various customer segments. One such criterion may be an airline requiring a Saturday night stayover. Another might be a trucking company separating customers based on the advance notice with which they are willing to commit to a shipment. The firm now wishes to identify the appropriate price for each segment. Consider a supplier (of product or some other supply chain function) that has identified *k* distinct customer segments that can be separated. Assume that the demand curve for segment *i* is given by (we assume linear demand curves to simplify the analysis): $d_i = A_i - B_i p_i$ The supplier has a cost *c* of production per unit and must decide on the price *pᵢ* to charge each segment; *dᵢ* is the resulting demand from segment *i*. The goal of the supplier is to price so as to maximize its profits. The pricing problem can be formulated as follows: $Max \sum_{i=1}^k (p_i-c)(A_i-B_ip_i)$ Without a capacity constraint, the problem separates by segment, and for segment *i*, the supplier attempts to maximize: $(p_i - c)(A_i - B_ip_i)$ The optimal price for each segment *i* is given by: If the available capacity is constrained by *Q*, the optimal prices are obtained by solving: subject to: $\sum_{i=1}^k (A_i - B_ip_i) \leq Q$ $A_i - B_ip_i\geq 0$ for $ i = 1, \ldots, k$ Both formulations are simple enough to be solved in Excel ### Example 16-1: Pricing to Multiple Segments A contract manufacturer has identified two customer segments for its production capacity—one 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 one week’s notice for production. The customers that are unwilling to commit in advance are less price sensitive and have a demand curve $d_1 = 5,000 - 20p_1$. Customers willing to commit in advance are more price sensitive and have a demand curve of $d_2 = 5,000 - 40p_2$. Production cost is $c = \$10$ per unit. What price should the contract manufacturer charge each segment if its goal is to maximize profits? If the contract manufacturer were to charge a single price over both segments, what should it be? How much increase in profits does differential pricing provide? If total production capacity is limited to 4,000 units, what should the contract manufacturer charge each segment? **Analysis:** Without capacity constraints, the differential prices to be charged each segment are given by Equation 16.1. We thus obtain: $p_1 = \frac{5000}{2*20} + \frac{10}{2} = 125 + 5 = $130$ and $p_2 = \frac{5000}{2*40} + \frac{10}{2} = 62.50 + 5 = $67.40$ The demand from the two segments is given by: $d_1 = 5,000 - (20 * 130) = 2,400 $ and $d_2 = 5,000 - (40 * 67.5) = 2,300 $ The total Profit is: Total profit = $(130 * 2,400) + (67.5 * 2,300) - (10 * 4,700) = \$420,250 $ If the contract manufacturer charges the same price $p$ to both segments it is attempting to maximize: $(p-10)(5,000-20p)+(p-10)(5,000-40p) = (p-10)(10,000-60p)$ The optimal price in this case is given by: $p=\frac{10,000}{2*60} + \frac{10}{2} = $88.33$ The demand from the two segments is given by: $d_1 = 5,000 - 20*88.33 = 3,233.40 $ and $ d_2 = 5,000 - 40*88.33 = 1,466.80 $ The total Profit is: Total Profit = $(88.33 - 10) * (3,233.40 + 1,466.80) = \$368,167$ Differential pricing thus raises the profits by more than \$50,000 relative to offering a fixed price. Observe that differential pricing charges the more price sensitive segment less than the fixed price and the less price sensitive segment more than the fixed price. Now, let us consider the case in which total production capacity is limited to 4,000 units. The optimal differential price results in demand that exceeds total production capacity. Thus, we resort to the formulation in Equation 16.2 and solve: $Max(p_1 - 10)(5,000 - 20p_1) + (p_2 - 10)(5,000 - 40p_2)$ subject to: $(5,000 - 20p_1) + (5,000 - 40p_2) <= 4,000$ $(5,000 - 20p_1), (5,000 - 40p_2) >= 0$ The results of the constrained optimization are shown in Figure 16-3. The contract manufacturer charges the two segments \$141.7 and \$79.2 per units of capacity respectively. Observe that the limited capacity lead the contract manufacturer to charge a higher price to each of the two segments relative to when there was no capacity limit. The methodology we have described has two important assumption that are unlikely to hold in practice. The first assumption is that no one from the higher- price segment decide to shift to the lower-price segment after prices are announced. In other words, we have assumed that the attribute such as lead time used to separate the segment works for all practical purposes. In practice, this is unlikely to be the case. Our second assumption is that once prices are decided, customer demand is predictable. In practice, future is uncertain. **Allocating Capacity to Segments Under Uncertainty** In most instances of differential pricing, demand from the segment paying the lower price arises earlier in the time than demand from the segment paying the higher price. It is also often the case that there is enough demand from the lower-price segment to use up the entire available capacity. For example, leisure travelers tend to book a cheaper ticket far in advance. Given that, the quantity of demand from future business traveler is uncertain so that the optimal amount available should be given to the leisure traveler is uncertain. As result, a firm using revenue- management across multiple segments must solve the following two problems. If there are more than two customer segments, the same philosophy can be used to obtain a set of nested reservation. The quantity C1 reserved for the highest- segment should be such that the set of An important point to observe that the use of differential pricing increases the level of the high- segments. Capacity is being solved for Customers who arrive late because of the set. Thus, effective use of revenue management increases firm profits and improves service for a small limited a low prices to segments. ### Example 16-2 Allocating Capacity to Uncertain Demand from Multiple Segments ToFrom Trucking serves to segments of customer. One segment is (A) willing to is willing Two weeks to forecast. How ToFrom willing **Analysis:** In this case, we have Revenue from, $P_A = $3.50 Revenue from $P_B = $2.00 for $D_A = $3,000.00 $S_A = $1,000.00 16.4, The capacity be is given $C = norminv(1-\frac{(P_B)}{(P_A)}, D_A , S_A)$ = 1-20.0/3.50 Thus ToFrom truck when $752 $8.50, The capacity should be increased to $A= A1 norminv(3/PA SA)$ Ideally, the demand forecast for all customer segments should be revised and a new reservation quantity calculated each time a customer order is processed. In practice, such a procedure is difficult to implement. It is more practical to revise the forecast and the reservation quantity after a period of time over which either the forecast demand or the forecast accuracy has changed by a significant amount. Another approach to differential pricing is to create different versions of a product targeted at different segments. Publishers introduce new books from best-selling authors as hardcover editions and charge a higher price. The same books are introduced later as paperback editions at a lower price. The two versions are used to charge a higher price to the segment that wants to read the book as soon as it is introduced while providing a low priced alternative later to customers who are price sensitive. Different versions can also be created by bundling different options and services with the same basic product. Automobile manufacturers create high-end, mid-level, and low-end versions of the most popular models based on the options provided. This policy allows them to charge differential prices to different segments for the same core product. Many contact lens manufacturers sell the same lens with a one-week, one-month, and six-month warranty. In this instance, the same product with different services in the form of warranty is used to charge differential prices. To use differential pricing successfully when serving multiple customer segments, a firm must use the following tactics effectively: * Separate segments effectively on some service dimension (e.g. response time) * Charge different prices based on the value assigned by each segment * Forecast demand at the segment level * Save appropriate amount of the asset for the late arriving high-price segments Freight railroads and trucking firms have not used revenue management with multiple segments effectively. Airlines, in contrast, have been much more effective in using this approach. A major hindrance for railroads is the lack of scheduled freight trains. Without scheduled trains, it is hard to separate the higher-price and lower-price segments. To take advantage of revenue management opportunities, owners of transportation assets in the supply chain must offer some scheduled services as a mechanism for separating the higher-price and lower-price segments. Without scheduled services, it is difficult to separate customers that are willing to commit early from those that want to use the service at the last minute. **Summary of Learning Objective 2** If a supplier revenue setting is to charging or The segment must higher price times Given The of such the the equals the segments. **Test Your Understanding** * **16.2.1** The use of differential pricing should: * [ ] decrease total profits for a firm. * [ ] increase total profits for a firm. * [ ] increase capacity for a firm. * [ ] decrease capacity utilization for a firm. * **16.2.2** The basic trade-off to be considered by the supplier with production capacity is between: * [ ] committing to an order from a higher-price buyer or waiting for a lower-price buyer to arrive later on. * [ ] allowing the market to be controlled by price or capacity. * [ ] committing to an order from a lower-price buyer or waiting for a higher-price buyer to arrive later on. * [ ] having marketing or operations establish the constraints within which orders are accepted. ## 16.3 Describe how dynamic pricing and overbooking can help increase profits from perishable assets. **Dynamic Pricing and Overbooking for Perishable Assets** Any asset that loses value over time is perishable. Clearly, fruits, vegetables, and pharmaceuticals are perishable, but this list also includes products such as computers and cell phones that lose value as new models are introduced. High-fashion apparel is perishable because it cannot be sold at full price once the season is past. Perishable assets also include all forms of production, transportation, and storage capacity that are wasted if not fully utilized. Unused capacity from the past has no value. Thus, all unused capacity is equivalent to perished capacity. For example, unused capacity of a truck is perishable and cannot be saved for another day. A well-known example of revenue management in retailing of apparel was the original Filene's Basement in Boston. Merchandise was first sold at the main store at full price. Leftover merchandise was moved to the basement and its price reduced incrementally over a 35-day period until it sold. Any unsold merchandise was then given away to charity. Today, most department stores progressively discount merchandise over the sales season and then sell any remaining inventory to an outlet store, which follows a similar pricing strategy. Another example of revenue management for a perishable asset is the use of overbooking by the airline industry. An airplane seat loses all value once the plane takes off. Given that people often do not show up for a flight even when they have a reservation, airlines sell more reservations than the capacity of the plane, to maximize expected revenue. The following are two revenue management tactics used for perishable assets: 1. Vary price dynamically over time to maximize expected revenue. 2. Overbook sales of the asset to account for cancellations. **Dynamic Pricing** Dynamic pricing, the tactic of varying price over time, is suitable for assets such as fashion apparel that have a clear date beyond which they lose much of their value. The success of dynamic pricing also requires the presence of different customer segments, with some willing to pay a higher price for the product. Apparel designed for the winter does