Demand and Revenue Management

1. Demand and Revenue Management Anton J. Kleywegt April 2, 2008

2. Revenue Management • What is Revenue Management • Why do Revenue Management • Pricing Optimization • Demand Modeling and Forecasting

3. 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

4. What is Revenue Management • Revenue Management involves the following activities • Demand data collection • Demand modeling • Demand forecasting • Pricing optimization • System implementation and distribution

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. Hospital Contract Case Study • Example of setting per-diem rates

15. 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

16. 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

17. 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)

18. 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

19. 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!

20. 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?

21. Consumer surplus=1800 70 Firm profits=3600 Deadweight loss=1800 60 What is Revenue Management • Revenue Management may involve price discrimination, but it does not have to 130 P=130-Q Unit cost = 10 Firm’s profits under single price: (130-Q-10)Q P MC=10 q 130

22. Price Discrimination (continued) P=130-Q Unit cost = 10 What if the firm could segment the market and charge two different prices? 130 Consumer surplus=1600 90 P Firm profits=4800 50 Deadweight loss=800 MC=10 q 130 80 40

23. Price Discrimination (continued) 130 110 Consumer surplus=1000 90 P 70 Firm profits=6000 50 Deadweight loss=200 30 MC=10 q 40 130 80 100 60 20

24. Price Discrimination (continued) Perfect price discrimination 130 Consumer surplus=0 Deadweight loss=0 Firm profits=7200 P MC=10 q 130

25. 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

26. What is Revenue Management • It is not spam

27. 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

28. 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

29. 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?

30. 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

31. 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

32. Demand Forecasting • The first law of forecasting: The forecast is always wrong • Sources of forecast error: • Modeling error • Parameter error • Measurement error

33. 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

34. 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

35. 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”

36. 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

37. Demand Forecasting • Forecasting methods • Judgmental methods • Statistical forecasting methods

38. 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

39. 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

40. 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>.

41. Questions?