Demand and Revenue Management

Anton J. Kleywegt

April 2, 2008

1
Revenue Management
 What is Revenue Management
 Why do Revenue Management
 Pricing Optimization
 Demand Modeling and Forecasting

2
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

3
What is Revenue Management
 Revenue Management involves the
following activities
 Demand data collection
 Demand modeling
 Demand forecasting
 Pricing optimization
 System implementation and distribution

4
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

5
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

6
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

7
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
 Restaurant industry
 How much to charge for lunch vs dinner

8
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

9
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

10
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
11
What is Revenue Management
 Golf courses
 Variable pricing: Choose prices to vary by
 time of day
 day of week
 season of year
 Round duration control
 control tee-time interval
 control uncertainty in arrival time
 control uncertainty in duration

12
Hospital Contract Case Study
 Major customers of hospitals
 Insurance companies
 Medicare
 Medicaid
 Individuals
 Hospital contracts with major customers
 Discount-off-listed-charges contracts
 Per-diem contracts
 Case-rate contracts
 Capitation contracts

13
Hospital Contract Case Study
 Example of setting per-diem rates

ICU Patient Length of Stay

16%
14%
% of Patients

12%
10%
8%
6%
4%
2%
0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Number of Days
14
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

15
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

16
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)

17
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 1960’s, 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

18
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!

19
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?

20
 What is Revenue Management
 Revenue Management may involve price
discrimination, but it does not have to
130
P=130-Q
Consumer surplus=1800 Unit cost = 10
Firm’s profits
under single price:
P 70
Firm profits=3600 (130-Q-10)Q

Deadweight loss=1800
MC=10
q
60 130 21
 Price Discrimination (continued)
P=130-Q
130 Unit cost = 10
What if the firm
Consumer surplus=1600 could segment
the market and
90 charge two
different prices?
P Firm profits=4800
50 Deadweight loss=800

MC=10
q
40 80 130 22
 Price Discrimination (continued)

130

110 Consumer surplus=1000

90
P
70 Firm profits=6000

50 Deadweight loss=200
30
MC=10
q
20 40 60 80 100 130 23
 Price Discrimination (continued)
Perfect price
130
discrimination

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

MC=10
q
130 24
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

25
What is Revenue Management
 It is not spam

26
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
27
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

28
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?

29
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
30
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

31
Demand Forecasting
 The first law of forecasting: The
forecast is always wrong
 Sources of forecast error:
 Modeling error
 Parameter error
 Measurement error

40
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

44
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

45
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”

46
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

48
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

49
Demand Forecasting
 Statistical forecasting methods
 Non-causal methods
 Exponential smoothing
 Time series methods
 Causal methods
 Linear regression
 Nonlinear regression
 Discrete choice models (logit, probit, etc)
 Whatever the method, the basic approach is to find
systematic behavior in data that one has reason to
believe will continue in the future

50
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/fss-
fr.html>.
 Swain, J. J., “Desktop Statistics Software: Serious Tools for
Decision Making”, OR/MS Today, volume 26, number 5, pp. 50-
61, 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. 42-
51, February 2005,
<http://lionhrtpub.com/orms/surveys/sa/sa-
survey.html>.
51
Questions?

54