# Revenue Management in the Supply Chain

George Easaw, Ph.D., Xavier Institute of Management and En'ship Electronic City, Ph II, Hosur Road, Bangalore 100. <geasaw@gmail.com>

Supply Chain assets

Capacity assets
Production  Transportation and  Storage

Inventory assets
Carried throughout the supply chain  Improves product availability

What is Revenue Management ?
Increasing the supply chain surplus by the use of differential pricing based on Customer segment  Time of use  Product or capacity availability

Different Revenue Management Models

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Differential pricing model for multiple customer segments Perishable assets model Seasonal demand model Bulk and spot customer model

Single Period Stochastic Inventory Control Model – Newsboy model

Assumptions
Single item, stochastic demand during the period  Decision taken at the beginning of the period  Items get obsolete after one period

Costs attached to the Newsboy model
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Purchase cost, c Selling price, p Salvage cost, s Cost of overstocking, C_o = c - s Cost of understocking, C_u = p – c

Other notations
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CSL* - optimal cycle service level O* - corresponding optimal order size CSL = probability( demand during period <= O*.

Formulation of newsboy model
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At CSL*, the marginal cost of purchasing an additional unit is zero ie. an additional unit at O*, sells with a prob. of (1-CSL*) resulting in benefit of (p-c). The additional unit does not sell with a probability of CSL* and results in a loss of (c-s). (1-CSL*).(p-c)=CSL*.(c-s) CSL* = probability(customer demand <= O*) = (p-c) / ((p-c) + (c-s)) = C_u / (C_u + C_o)

Newspaper boy , c = Rs2.00, p = Rs3.00, s = Rs 0.75. The daily demand and freq. of occurrence in number of days is shown below for 20 days < 10 – 2 days 11 – 3 days 12 – 4 days 13 – 4 days 14 – 3 days 15 - 2 days 16 – 1 day >17 – 1 day. Find the optimal order quantity of newspapers for the newsboy to optimise his earnings..

Issues in RM model for multiple customer segments
 How to differentiate the different segments and

structure the pricing so that one pays more than the other ?  How to control demand so that the lower paying segment does not fully utilise the entire availability of asset ?

How to differentiate customers ?
 Create barriers by identifying product or service

attributes that the segments value differently.
 Offer products at different prices  Offer products at different points of time

RM model for multiple customer segments – basic trade-off

Spoilage – capacity reserved for higher price segment wasted, as demand does not materialise Spill – higher price customers are turned away as capacity is reserved for lower price segment Decision is to commit the capacity to higher price buyers so as to minimise the expected cost of spoilage and spill.

Formulation
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P_h – price charged to the high priced segment C_h – capacity allotted to the high priced segment – THE DECISION VARIABLE P_l – price charged to the low priced segment C_l – capacity allotted to the low priced segment Let high priced demand be normally distributed with mean D_h and standard deviation sigma_h

Contd..

Expected marginal revenue from reserving more capacity for high priced segment = R_h(C_h) = probability(demand from high price segment > C_h) . P_h Current marginal revenue from lower priced segment = P_l Capacity C_h should be decided in such a way that expected marginal revenue from high priced segment = the current marginal revenue from lower price segment

ie. prob(demand from high priced segment > C_h) . P_h = P_l prob(demand from high priced segment > C_h) = P_l/P_h ie. prob(demand from high priced segment <= C_h) = 1 – (P_l/P_h) Using spreadsheet program like Excel or Openoffice calc, C_h is got by giving the formula = norminv((1-P_l/P_h), D_h,sigma_h) in any cell.

Nested Reservations

The quantity C_h reserved for the high priced segment is computed by keeping the expected marginal revenue from the highest priced segment equal to the next highest priced segment The quantity (C_h + C_m) reserved for the two highest priced segments is such that the expected marginal revenue from the two highest priced segments equals the price of the third highest priced segment.

RM model for perishable assets

The tactics adopted for perishable assets are
Varying price over time to maximise expected revenue – effective differential pricing over time increases the level of product availability for the customer willing to pay full price, increasing revenue.  Overbooking sales of the asset to account for cancellation

Tradeoffs & Objective – Overbooking RM model

Loss of revenue from wasted capacity because of excessive cancellations Reduction in margin by using an expensive backup as there is shortage of capacity because of few cancellations. Objective is to maximise profits by minimising cost of wasted capacity and cost of capacity shortage

Model formulation
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c – the cost of producing unit asset p - price of selling each unit of asset b – cost of the unit backup resource Marginal cost of wasted capacity, C_w = p-c Marginal cost of capacity shortage, C_s = b-p O* - optimal overbooking level s* - prob. Cancellations <= O*

Contd..

As per the newsboy model formulation, the optimal overbooking level, s*, prob. (cancell. <= O*) = C_w/(C_w + C_s) If cancellations are known to have mean of mhu_c and std. dev sigma_c, inserting =norminv(s*,mhu_c,sigma_c) in the spreadsheet program gives the optimal number of overbookings, O*.

RM for Seasonal Demand

The tactic employed is to charge a higher price during the peak period and lower price during off-peak periods, resulting in a demand shift from peak to off-peak periods The discount given during off-peak period is more than offset by the decrease in cost due to a smaller peak and increase in revenue during offpeak period. Eg. Hotels, transportation systems.

A company arranges with a transporter to carry the Chinese imports he gets at the port in Chennai to Bangalore. The bulk rate is Rs. 10,000/1000 cft and the spot rate for transportation is Rs. 14,000 /1000 cft. The demand for items imported at Chennai port is normally distributed with a mean of 10,000 cft with a std dev of 3,000 cft. What volume should be contracted at the bulk rate and what volume at spot rate? If the demand changes to 15,000 cft with std dev of 3000 cft, what is the new quantity at bulk rate?

RM model for bulk and spot customers

Long term bulk contract – fixed low price but can get wasted if not utilised Spot market offers a higher price but never gets wasted. Tradeoff is deciding the amount of long term bulk shipping contracts to sign

Formulation
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C_b – bulk rate in the market C_s – spot rate in the market Q* - optimal amount of asset purchased in bulk p* - probability(demand for asset <= Q*) Marginal cost of purchasing another unit in bulk = C_b Expected marginal cost of not purchasing another unit in bulk and then purchasing it in the spot market is (1-p*).C_s

Contd ..
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(1-p*).C_s = C_b p* = (C_s – C_b)/ C_s If bulk demand is distributed normally with mean mhu_b and std deviation sigma_b, norminv(p*, mhu_b,sigma_b) gives the optimal bulk quantity to be purchased.

References:
Chopra and Meindl, Supply Chain Management, 3 e, Pearson Education  Simchi Levi et al, Design and Analysis of Supply Chains, 2e, Tata McGraw Hill.

Research Issues in RM

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Applying Optimization models to Revenue Management Integrating supply chain planning with revenue management Implementing effective forecasting processes Quantifying the benefits of revenue management