BT2403: Service Operations Management

Wang Jianfu

Revenue Management
Session 11
 Agenda
• Revenue Management
– Protection levels
– Overbooking
– Advance Selling
 Revenue Management
• What is Revenue / Yield Management
– Technique to maximize revenue by matching fixed supply
with uncertain demand

• Examples
– Airlines – how many seats to allocate to different types of
travelers, or how many seats to overbook the flight by?
– Hotels – how many hotel rooms to save for later?
– Movie – How many tickets should be sold in advance?

• Solutions based on exact same logic and reasoning as

Newsvendor problem
 Significance of Revenue Management
Avoiding Bankruptcy
Some US Airline Industry Observations
• Since deregulation (1978), 137 carriers have filed
for bankruptcy.
• From ‘95-’99 (the industry’s best 5 years ever)
airlines earned 3.5 cents on each dollar of sales:
– The US average for all industries is around 6 cents.
– From ‘90-’99 the industry earned 1 cent per $ of sales.
➢ Carriers typically fill 72.4% of seats and have a break-even
load of 70.4%.
 Significance of Revenue Management
Wide Applicability
Many industries have relatively fixed supply.
• Travel industries (fixed number of seats,
rooms, cars, etc)
• Advertising time (limited number of time
slots)
• Telecommunications bandwidth
• Size of the MBA program
• Doctor’s availability for appointments
 Technique #1:
Booking Limits and Protection
Levels
Airline Pricing for a Coach Seat
Traditional Fixed Price
Distribution of willingness to pay?
Price
Demand Curve

Consumer Surplus

Seats Available

P*

Quantity

Q*

Total Revenue = PQ
What is the highest revenue?
11-8
Airline Pricing for a Coach Seat Multiple
Pricing Using Yield Management

Price
Total Revenue = P1Q1 + (Q2-Q1)P2 + (Q3-Q2)P3
Demand Curve

Consumer Surplus

P1

P2 Seats Available

P3

Quantity

Q1 Q2 Q3

Full Advanced Internet

Coach Purchase Special
11-9
 Service Characteristics that make
Technique #1 Appropriate
• The same unit of capacity (e.g., airline seat) can be used to
deliver services to different customer segments (e.g., business
and leisure customers) at different prices.
• Perishable capacity (it cannot be stored) and limited capacity
(all possible customers cannot always be served).
• Capacity is sold in advance of demand.
• There is an opportunity to segment customers (so that
different prices can be charged) and different segments are
willing to pay different prices.
• It is not illegal or morally irresponsible to discriminate among
customers.
 Hotel Protection Level Problem
• A Hotel with 118 standard rooms offered to leisure
and business travelers.
• Two fares:
– $159 Discount fare (advanced purchase
requirements, restrictive cancellations) – Leisure
Traveler.
– $225 Regular fare – Business Traveler.
• Consider, a day, 30 days from now. The hotel knows
(assumes) that all rooms can be sold easily at a price
of $159, but it wants to maximize REVPAR (Revenue
Per Available Room)
• Could allow booking on FCFS basis, but business
travelers normally book later, so lost opportunity.
Booking Limit & Protection Level
• The booking limit is the number of rooms you are willing to sell
in a fare class or lower.
• The protection level is the number of rooms you reserve for a
fare class or higher. Let Q be the protection level for the high fare
class.
• Since there are only two fare classes, the booking limit on the low
fare class is capacity – Q = 118 – Q:
– You will sell no more than 118-Q low fare rooms because you
are protecting (or reserving) Q rooms for high fare customers.
 Too Much versus Too Little
• This problem is similar to the newsvendor
problem or an inventory problem for a
seasonal item.
• Underage and overage cost.
• Cost of underage = 225-159 = Cu
• Cost of overage = 159 = Co
• Optimal solution (using marginal analysis)
• Compute the critical fractile:
Cu/ (Cu+Co) = (225-159)/225 = 0.2933
 Optimal Protection Level
• FORMULA: The optimal protection level is the largest
value of Q* satisfying
∗
𝐶𝑢
𝑃 𝐷<𝑄 ≤
𝐶𝑢 + 𝐶𝑜

where D is the uncertain high fare demand

• Valid for both continuous and discrete demand
distributions. For continuous distribution, the “less than”
sign reduces to equality.
 The Problem (continued)
• Suppose high fare demand is D, a random variable that follows a
Poisson distribution with average = 27.3, i.e. Prob[D ≤ Q] = F(Q).

Cumulative Expected Lost Cumulative Expected Lost

Q Probability F(Q) demand L(Q) Q Probability F(Q) demand L(Q)

10 0.01% 17.30 20 9.20% 7.45

11 0.04% 16.30 21 13.14% 6.55
12 0.09% 15.30 22 18.02% 5.68
13 0.19% 14.30 23 23.81% 4.86
14 0.39% 13.30 24 30.40% 4.10
15 0.77% 12.31 25 37.60% 3.40
16 1.40% 11.31 26 45.16% 2.78
17 2.42% 10.33 27 52.80% 2.23
18 3.96% 9.35 28 60.25% 1.76
19 6.18% 8.39 29 67.26% 1.36
 The Problem (continued)
• Recall the computed critical fractile.
𝐶𝑢 𝑟ℎ − 𝑟𝑙 225 − 159 66
= = = = 0.2933
𝐶𝑢 + 𝐶𝑜 𝑟ℎ 225 225
• From the table
– P(D<24) = P(D<23) = F(23) = 23.81%
– P(D<25) = P(D<24) = F(24) = 30.40%
• Answer: 24 rooms should be protected for high
fare customers.
• Equivalently, a booking limit of 118 – 24 = 94
rooms should be applied to low fare
reservations.
 Other Calculations
• How many high-fare customers will be refused a reservation?

• How many high-fare customers will be accommodated?

• How many rooms will remain empty?

• What is the expected revenue?

Benefit of Revenue Management
• REVPAR with RM
=
• REVPAR if all rooms prices at 225
=
• REVPAR if all rooms priced at 159
=
 Practical Extensions /
Considerations
• In practice, there are multiple fare classes and length of
stay (LOS or Duration Control for hotel), and multiple
segments (for airlines).
• So there needs to be booking limits set for different classes.
• Another approach used is Bid Price. All fares which are
higher bid prices, are accepted for booking.
• This is less flexible than booking limit for each class. But
bid prices can be adjusted dynamically after each booking,
in which case both approaches are similar.
• For multiple segments, assign a bid price to each segment.
A fare is accepted if it exceeds the sum of the bid prices on
the segments it uses.
 Revenue Mgt. Example: Airplane
Booking
• You have to manage the seat allocation of passengers for a
flight from Sydney to Singapore with 250 seats
– Your passengers either buy the ticket in advance
– Or, wait till the last minute
– You charge two rates:
• Advance booking: Tourist Airfare
• Late booking: Business Airfare
• Suppose you can easily get 250 advance reservations, and
fill up your airplane. Should you give all the seats to
advance customers?
– Why?
– How many seats should be set aside for last-minute
customers?
– What information do you need?
 Revenue Mgt. Example: Airplane
Booking
• Number of Business Travelers is normally distributed
with mean 50 and standard deviation 10
– Tourist Airfare: $100
– Business Airfare: $750

Solution:
cu = _________
co = _________

(z) = _________
z = _________
The Airline should reserve _______ seats for the Business Travelers.
 Revenue Mgt. Example:
Hotel Reservation
• You manage a hotel with 200 rooms in Singapore
– Your guests either book a room in advance
– Or, wait till the last minute
– You charge two rates:
• Advance booking: Bargain rate
• Late booking: Premium rate
• Suppose you can easily get 200 advance reservations, and fill up
your hotel. Should you fill up rooms with advance customers?
– Why?
– How many rooms should be set aside for last-minute
customers?
– What information do you need?
 Revenue Mgt. Example:
Hotel Reservation
• Assume
– Number of last minute customers is normally distributed with
mean 75 and standard deviation 25, ~N(75,25)
– Advance booking: $80/night
– Late booking: $150/night

Solution:
cu = _________
co = _________

(z) = _________
z = _________
The hotel should reserve _______ rooms for last-minute
customers.
Technique #2:
Overbooking
 The Ugly Truth: cancellations and no-shows

• Approximately 50% of reservations get cancelled at some

point in time.
• In many cases (car rentals, hotels, full fare airline
passengers) there is no penalty for cancellations. Some
customers do not show up even if there is a penalty.
• Problem:
– the company may fail to fill the seat (room, car) if a customer
does not show up.
– This is a problem even if the customer does not receive a refund.
• Solution:
– sell more seats (rooms, cars) than capacity.
• Danger:
– some customers may have to be denied a seat even though they
have a confirmed reservation.
 Hotel Overbooking Problem
• A Hotel with 118 standard rooms offered to customers.
• The hotel knows (assumes) that all rooms can be sold easily at a
price of $159.
• The forecast for the number of customers that do not show up (
X ) is Poisson with mean 8.5.
• The cost of denying a room to the customer with a confirmed
reservation is $350 in ill-will and penalties.
• How many rooms ( Q ) should be overbooked (sold in excess of
capacity)?
 Overbooking Solution
Newsvendor setup: Single decision when Poisson distribution with mean 8.5
the number of no-shows is uncertain. Q F (Q ) Q F (Q )
• Saving underage cost: if X > Q 0 0.0002 10 0.7634
1 0.0019 11 0.8487
(insufficient number of rooms 2 0.0093 12 0.9091
overbooked) then we could have sold X- 3 0.0301 13 0.9486
Q more rooms. Cu = 159 4 0.0744 14 0.9726
5 0.1496 15 0.9862
• Overage cost: if X < Q (too many rooms 6 0.2562 16 0.9934
overbooked) then we deny rooms to Q - 7 0.3856 17 0.9970
X customers. Co = $350 8 0.5231 18 0.9987
9 0.6530 19 0.9995
• Marginal analysis:
1 − 𝑃 𝑋 < 𝑄 𝐶𝑢 − 𝑃 𝑋 < 𝑄 𝐶𝑜 ≥ 0
• Optimal overbooking level:
𝐶𝑢 159
𝑃 𝑋<𝑄 ≤ = = 0.3124
𝐶𝑢 +𝐶𝑜 159+350
 Revenue Mgt. Example:
Flight Overbooking
• Suppose you cannot charge latecomers a different
rate because of a city ordinance that prohibits
charging different prices for the same service
• You can easily get 200 reservations, and fill up
your flight
• But, you are afraid that some people with
reservations may not show up
• How many reservations should you take?
– More than 200?
– How many more?
• What information do you need?
 Revenue Mgt. Example:
Flight Overbooking
• Assume
– Number of no-shows is normally distributed with mean 5 and
standard deviation 3, ~N(5,3)
– Normal rate: $80/seat
– Cost of every overbooking: $200/seat

Solution:
cu = _________
co = _________

(z) = _________
z = _________
The flight should take _______ reservations.
 More on Overbooking
and Differential Pricing
• Booking limits and protection levels for different fare
classes are adjusted based on the overbooking limit.
• Initially it was not perceived as fair. But like new
technologies, customer acceptance has increased over the
last ten years.
• Cornell survey found that even in golf facilities or
restaurants, customers are willing to accept differential
fares based on time of day, weekend/weekday,
lunch/dinner, but not based on table location.
• Also, more positive acceptance, if the difference is
presented as a discount rather than a premium.
Technique #3:
Advance Selling
 Advance Selling
• A practice wherein buyers make purchase commitments
before the time of service delivery in exchange for some
benefit (e.g. price discount, guaranteed future capacity)
• Revenue increase is due neither to price discrimination
nor better capacity allocation.
• Main characteristic is buyer uncertainty about their
future valuation of the service.
 The Problem
(No Capacity Constraints)
• A 60-person capacity skating rink has 50 potential
customers during weekdays, and must decide how
to price its tickets (with skate rental).
• Each potential skater is uncertain about his
valuation of the service, represented by the
amount he is willing to pay (WTP).
• WTP depends on his consumption state, which
depends on his mood, fatigue, company, etc.
• Suppose he is 50-50 likely to be in a favorable or
an unfavorable state, with WTP of $12 and $7,
respectively. Cost to serve a customer is $2.
• How to price the tickets?
 The Problem (cont’d)
• No capacity constraints during weekdays.
• Three options
– Spot sell at $12
• Earn 25 x (12 – 2) = $250
– Spot sell at $7
• Earn 50 x (7 – 2) = $250 (coincidence!)
– Advance sell at (12 + 7)/2 = $9.50
• Earn 50 x (9.5 – 2) = $375
• Note: Customers are willing to buy at $9.50
because of uncertainty in their valuation.
 Some explanations
• Service quality is constant, but value of service to
buyers may vary, depending on their consumption
state at the time of delivery
• Buyer uncertainty creates symmetry between seller
and buyer.
• Once buyer knows, seller is at a disadvantage in
setting spot price.
• Allows advance sales to buyers who would be in
unfavorable states later and would not purchase
under a spot-selling strategy. However,
unprofitable if buyers value service less than its
cost.
 The Problem Extended
(With Capacity Constraints)
• 100 potential customers on weekends, but
can only serve 60 customers
• Reconsider the three options:
– Spot sell at $12
• Earn 50 x (12 – 2) = $500
– Spot sell at $7
• Earn 60 x (7 – 2) = $300
– Advance sell at $9.50
• Earn 60 x (9.50 – 2) = $450
• Clearly, capacity constraints reduces
effectiveness of advance selling.
 Limited Advance Selling
A Combination Strategy
• Advance sell 20 tickets at $9.50, spot sell remaining 60 –
20 = 40 tickets at $12.
– Earn 20 x (9.50 – 2) + 40 x (12 – 2) = $550.
– Increase profits by 10% from spot selling at $12.
• How to determine number of tickets (x) to advance sell?
– (#customers – x)(prob of favorable) = capacity – x
– E.g. (100 – x)/2 = 60 – x -> x = 20 tickets.
 Role of Technology
in Advance Selling
• Enabling Technologies
– Internet web sites
– Electronic tickets
– Smart cards
• Benefits of Technology
– Less arbitrage
– Lower transaction costs
– More complex service packages
– More information about buyer and demand over
time