Introduction To PRM (S20)

LECTURE 1
INTRODUCTION TO PRM
Outline
 Introduction to Revenue Management (RM)
 What is RM?
 Applications of RM
 RM Problems and decisions
 Introduction to Pricing
MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

What is Revenue Management?
 Began in the airline industry

◼ $1000 Y class product: can be purchased at any time, no
restrictions, fully refundable
◼ $200 Q class product: Requires 3 week advanced
purchase, penalties for changing ticket after purchase
 Question: How much inventory to make available in

each class at each point in the sales cycle?

 Many people may have noticed that the same seat on the
same aircraft is sold for different prices.
 For example, a “usual” fare on a flight can be sold in the

range of $200 to $500 at different times prior to departure
 It is not because of different classes like economy, business

and first class. The range of $200 to $500 is for a single seat
in the economy class.

 It is more desired to sell the same ticket at the highest

price
 Demand is stochastic
 A bunch of customers with high w.t.p will probably try to

book the flight close to departure, like business travelers
 Other customers (leisure travelers) book flight too early in

order to get lower prices

 Given a request to book a flight with lower price:
 Accept: the risk of displacement with higher price demand that

could be requested in future prior to departure
 Reject: risk of not having that much demand for higher prices we
expect in future
 In general, the question arises how the given capacity should be

assigned to products (i. e. fares and passengers) such that the
total revenue (profit, contribution margin, . . . ) is maximized.

 RM has been a large success in airlines, hotels and

other companies and is nowadays considered to
be a key component of capacity management in
many industries.

 RM:
 By thoroughly understanding customer’ value function
and behavior
 Creating and managing service/product packages for

different market segments
◼ Combination of attributes such as price, features, purchase
restrictions, distribution channels
 To maximize revenue

 “Revenue management has been credited with $500 and

$300 million of increased revenue and earnings by US
Airlines and Delta Airlines, Respectively” (Boyd, 1998).
 Cross (1997) reports that revenue management helps

Marriott Hotel to gain $100 million additional annual
revenue

Alias of RM:
 yield management (the traditional airline term)
 pricing analytics and revenue management
 pricing and revenue optimization
 revenue process optimization
 demand management
 demand-chain management

The Applications of RM
 Airlines, hotels and rental car industries: 3 major traditional

applications of RM
 Similar characteristics:
 All of their products are perishable
 Demand for their products vary significantly over time
 Large fixed costs while variable costs are small in the

short run

RM Application Areas
Traditional Non-Traditional
 Airline  Energy
 Hotel  Broadcast
 Extended Stay Hotel  Healthcare
 Car/Apartment Rental  Manufacturing
 Rail  Apparel
 Tour Operators  Restaurants
 Cargo  Golf
 Cruise  Internet service
 Others

Major revenue management problems
 Pricing
 Auctions
 Capacity control (or inventory control)
 Overbooking
 Forecasting.
 Joint problems

Pricing
 The objective of pricing is to answer these questions:
 How to determine the price for various customer

groups?
 How to vary prices over time to maximize revenues or
profits?
 The first question is whether it is possible for a company to

use pricing strategies to maximize revenues.

RM vs SCM
Field SCM RM
Concerns Supply decisions Demand decisions
Objective Minimizing costs Maximizing revenues

RM Decisions
 Structural Decisions
 Price Decisions
 Quantity Decisions

RM Decisions: Structural
 Selling format (posted prices, negotiations or auctions)
 Segmentation or differentiation mechanisms
 Terms of trade to offer (volume discounts and cancellation or

refund options)
 How to bundle products

 …

RM Decisions: Price
 How to set posted prices, individual-offer prices, or reserve

prices (in auctions)
 How to price across product categories
 How to price over time
 How to markdown over the product lifetime

 …

RM Decisions: Quantity
 Whether to accept or reject an offer to buy
 How to allocate output or capacity to different segments,

products or channels
 When to withhold a product from the market and sale at

later points in time
 …

Revenue Management Aspects
 Price based RM:

◼ Dynamic pricing
◼ Auctions
 Quantity based RM:

◼ Single Resource Capacity Control
◼ Network Management
◼ Overbooking

PART 2: INTRODUCTION TO
PRICING
Outline
 List price vs Pocket price
 Traditional approaches to pricing
 Pricing and Revenue Optimization (PRO)
 Pricing Strategy
 Researches in Pricing
 The role of data and statistical analysis in pricing

Introduction
❑ Pricing is the only marketing variable that brings revenues

to a firm.
❑ A key business question: what do I charge?
❑ How to price a product? A most difficult and challenging

business question
❑ Willingness to pay of consumers: usually unclear even for
existing products not just for new product

List price vs Pocket price
 List price: The price posted by the firm as the

original price of the good/service
 Pocket price: The price that actually customers pay

from their pocket to get the good/service

Distribution of Pocket Price for a CPG company
CPG: Consumer Package Goods
 9% of consumers receive more than 40% discount

 16% of consumers receive 35% up to 40% discount
30
PERCENT OF TOTAL VOLUME
25
20
15
10
0
>40 35 30 25 20 15 10 5 List
price
DISCOUNT TO LIST PRICE (%)
Source: Figure courtesy of Mike Reopel of A. T. Kearney

Distribution of Pocket Price for a CPG company
 Findings from the distribution of pocket price:

 The good is not an essential good and consumers are expecting a
wide range of price
 Only 3% of consumers buy at list price
 Is obtaining the list price a critical decision?

Traditional Approaches to Pricing
 Pricing to maximize revenue should consider the following

inputs:
 Costs
 Customers (Demand)
 Competition
 Traditional pricing approaches usually consider one of

these inputs

Traditional Approaches to Pricing
Approach Based on Ignores Liked by

Competition,
Cost-Plus Costs Accounting
Customers
Market based Competition Costs, Customers Sales
Value based Customers Cost, Competition Marketing

Cost-Plus Pricing
 Pros:
 Still one of the popular pricing methods
 Super easy: Just add the preferred profit to the finished cost
 Cons:
 Does not consider the market situation
 Does not support price differentiation
 Example:
 Food is marked up three times
 Drinks four times
 Internet service providers use this method in pricing some products
 If all competitors have same cost structure then cost-plus could be

applicable and will insure the price stability and will be beneficial for all
competitors

Market-Based Pricing
 Price is obtained based on market situation
 Usually used by small or new companies to penetrate the market

or if there is a market leader
 Example: A small cola brand might set its price based on the price of
Coca-Cola
 Used for commodities: there is no other alternative
 Price of key competitors is monitored and considering the

position of the company among the key competitors price is
adjusted

Value-based Pricing
 Different prices for different segments
 Personalized pricing: each customer may be charged with

different price
 Example:
 Mortgage interest rate
 Consulting services
 Challenges:
 Estimation of customer’s value
 Competition: customers have other options
 Arbitrage and Cannibalization

Pricing Strategy
❑ Pricing Strategy: the approach on setting and changing the

price
❑ Example: Fashion goods
❑ Optimal strategy: Price skimming
❑ Any pricing strategy has two parts:

❑ Price structure
❑ Price level
❑ Focus of this course: price level: what is the number and

where does it come from?

Pricing strategy
❑ Pricing effect:
❑ Revenue
Pricing
❑ Contribution Structure
❑ Customer acquisition
❑ Customer retention Pricing
Strategy
❑ Market share
❑ Brand image Pricing
❑ … Level
Effect
Assessment

Common Pricing Strategies
 Price skimming  Image pricing

 Penetration pricing  Premium pricing
 Parity (matching) pricing  Periodic or random
 Low-Price supplier discounts
 Complementary product  Geographic pricing
pricing  Internet pricing
 Price bundling  …
 Price signaling

Pricing research
❑ Qualitative Research: ❑ Quantitative Research:

❑ Focus group ❑ Observational
❑ In-depth interviews ❑ Experimental
❑ Expert opinion ❑ Consists of data analysis and
❑ Management judgement statistical modeling
❑ Focus is on opinion based and ❑ Data analysis:
unscientific ❑ Correlations, patterns, trends
❑ Does not rely on data ❑ Building a model
❑ Statistical models:
❑ Based on experimental data to
explore preferences, behaviors,
…

Quantitative research in pricing: Pricing Analytics
❑ Quantitative research in pricing

Theory Foundation
Establishes the underlying
principles for research
Statistical Model
Data Analysis
(Predictive Analytics)
(Descriptive Analytics)
Estimates: elasticities, Price
Supports a statistical model
response function, effects, …
Prescriptive Analytics
Obtains price level and its changes
over time

Pricing Analytics: Pricing and Revenue Optimization
(PRO)
The goal of pricing and revenue optimization is to provide the

right price,
• for every product
• to every customer segment
• through every channel
and to update those prices over time in response to
changing market conditions.

The PRO process

Appendix: Role of statistical model
 Estimating the key parameters of the model
 The model: a statement of relationships we expect to learn

from the data
 Without a model: searching (mining) for relationships seem
possible: unsupervised learning
 Using a statistical model: Supervised learning
 Structured (supervised) learning is better in pricing analysis

since we are looking for a particular quantity measures like
elasticity to be able price a product

Appendix: Role of statistical model
 Mechanistic model vs Statistical model
 Mechanistic model: the value of Y is exactly known based on

values of X
 𝑌 = 𝑓(𝑋)
 𝑌 = 𝛽0 + 𝛽1 𝑋
 𝑌 = 𝛽0 + 𝛽1 𝑋1 + ⋯ + 𝛽𝑛 𝑋𝑛
 Statistical model: random variables and statistical relationship

between variables
 𝑌 = 𝛽0 + 𝛽1 𝑋 + 𝜖, where, 𝜖: stochastic or random variable

Introduction To PRM (S20)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Introduction To PRM (S20)

Uploaded by

Copyright:

Available Formats

LECTURE 1

 RM Problems and decisions

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Began in the airline industry

 Question: How much inventory to make available in

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 For example, a “usual” fare on a flight can be sold in the

 It is not because of different classes like economy, business

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 It is more desired to sell the same ticket at the highest

 A bunch of customers with high w.t.p will probably try to

 Other customers (leisure travelers) book flight too early in

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Given a request to book a flight with lower price:

 Accept: the risk of displacement with higher price demand that

 In general, the question arises how the given capacity should be

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 RM has been a large success in airlines, hotels and

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Creating and managing service/product packages for

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 “Revenue management has been credited with $500 and

 Cross (1997) reports that revenue management helps

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 pricing analytics and revenue management

 pricing and revenue optimization

 revenue process optimization

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Airlines, hotels and rental car industries: 3 major traditional

 Demand for their products vary significantly over time

 Large fixed costs while variable costs are small in the

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 The objective of pricing is to answer these questions:

 How to determine the price for various customer

 The first question is whether it is possible for a company to

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Selling format (posted prices, negotiations or auctions)

 Segmentation or differentiation mechanisms

 Terms of trade to offer (volume discounts and cancellation or

 How to bundle products

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 How to set posted prices, individual-offer prices, or reserve

 How to price across product categories

 How to price over time

 How to markdown over the product lifetime

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Whether to accept or reject an offer to buy

 How to allocate output or capacity to different segments,

 When to withhold a product from the market and sale at

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 Price based RM:

 Quantity based RM:

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

❑ Pricing is the only marketing variable that brings revenues

❑ A key business question: what do I charge?

❑ How to price a product? A most difficult and challenging

MSCI 700 (S20) Pricing and Revenue Management H. Shavandi

 List price: The price posted by the firm as the