Operations management

1. Operations management Session 17: Introduction to Revenue Management and Decision Trees

2. Previous Class Operations Management

3. Today’s Class • Introduction to Revenue Management • Decision-making under uncertainty • Decision Trees • Simulation Game Explanation Operations Management

4. $ Reducing Cost Increasing Revenue Profits RM: A Basic Business Need • What are the basic ways to improve profits? Revenue Management Operations Management

5. market segmentation pricing Revenue Management capacity control forecasting optimization overbooking Operations Management

6. Revenue Management Definitions ‘Selling the right seats to the right customers at the right prices and the right time.’ (American Airlines 1987) (Squeezing as many dollars as possible out of the customers) ‘Integrated control and management of price and capacity (availability) in a way that maximizes company profitability.’ Operations Management

7. Revenue Management History • RM was ‘invented’ by major US carriers after airline deregulation in the late 1970’s to compete with new low cost carriers • Matching of low prices was not an alternative because of higher cost structure • American Airline’s ‘super saver fares’ (1975) have been first capacity controlled discounted fares • RM allowed the carriers to protect their high-yield sector while simultaneously competing with new airlines in the low-yield sector • From art to science: By now, there are sophisticated RM tools and no airline can survive without some form of RM • Other industries followed - hotel, car rental, cruise lines etc. Operations Management

8. Revenue Management • How the optimization in Revenue Management might differ from what we have already learned (like linear programming)? Operations Management

9. Capacity Investment-1 • New-Fashion buys dyed yarns and makes fashionable dress. The company knows with certainty that red will be the color of the year and the demand for a red gown is 2,000 units per month for the next 5 months. • The company can invest in a new production line with advanced technology. The capacity of the new line is 2,000 units per month. • The cost of this line is $1,000,000. • The production cost per unit is $130. Operations Management

10. Capacity Investment-1 • Alternative: The company can also convert an obsolete line with traditional technology. The capacity of the production line is also 2,000 units per month. • The cost of this conversion is $500,000. • The production cost per unit is $200. • Each red gowns are sold for $300 each. Operations Management

11. Capacity Investment-1 • Which technology should the company chose? • Clearly the new technology is preferable. -1,000,000+5*2,000*170=0.7M New Traditional -500,000+5*2,000*100=0.5M Operations Management

12. Capacity Investment-2 • New-Fashion company is concerned that orange instead of red being the color of year. • The CEO of the company prefers to assume that the demand for the red gowns will be: • 2,000 per month (probability 0.6) • 0 (probability 0.4, market will demand 2000 orange gowns) • Given this information… Operations Management

13. Capacity Investment-2 -1,000,000+5*2,000*170=0.7M red -1,000,000+0=-1M orange New -500,000+5*2,000*100=0.5M red Traditional -500,000+0=-0.5M orange Operations Management

14. Capacity Investment-2 • The optimal decision is to invest in the traditional technology. • Intuitively, the traditional technology is preferred when the demand is uncertain because it has a lower upfront cost, but higher variable cost of production. Lesson: Lower upfront costs are preferred when there is more variability. Operations Management

15. Decision Tree • A tool to come up strategy under uncertain environments Decision Scenario Operations Management

16. Capacity Investment-3 • A smart consultant realized that a technology can delay the dye process and enable the company dye finished gowns after they know the color of the year. • The technology introduces an additional $30 cost of dyeing for each unit produced. • What should the company do? Operations Management

17. Capacity Investment-3 w/o dye delayed with dye delayed Operations Management

18. Observations • We observe that delay dyeing to collect more information is beneficial. Operations Management

19. More Observations • We also observe that if the company delays dyeing it is optimal to invest in the new technology. While if it decides to not wait, it is optimal for the company to invest in the traditional technology. Why? The new technology costs more, but has lower production costs. Therefore, once we know demand is high, we prefer to make a higher initial upfront investment but have a lower marginal production cost. • Postpone differentiation and flexibility is desirable • Sometime, waiting and collecting information is worthwhile Operations Management

20. What did we learn? • How to use a decision tree to evaluate alternatives. • Let’s see another example in a different context. Operations Management

21. Decision Trees • A new drug must pass through three stages of clinical trials before it can be brought to market. • Phase 1: Safety is evaluated on a small group. • Phase 2: The effectiveness of the drug is evaluated on a large group. • Phase 3: Randomized controlled trials are performed on even larger groups. Comparison is against a “gold standard” treatment. • (Phase 4: Post-launch safety surveillance.) When should we contract for production capacity? Operations Management

22. Decision Trees • Suppose we desire to introduce a new hypertension drug to market. • We have completed phase 1 and 2 trials successfully. • We assess a 90% probability of completing phase 3 successfully (and therefore gaining FDA approval). • We assume demand for the drug will be 5 million people in the next year. • A one-year drug supply for a single person should net us a $50 profit. Operations Management

23. Decision Trees • We have the option of contracting for manufacturing capacity now for $150 million. • We expect the cost of manufacturing capacity to increase if we wait until we know the results of our Phase 3 trial. • What is the minimum expected cost of delaying manufacturing such that it is beneficial for us to wait to contract for manufacturing capacity? Operations Management

24. Decision Trees approved $50×5-$150 =$100 million contract now 0.9 not approved -$150 million 0.1 contract later 0.9× (50×5-P) million 0.9×100-0.1×150=75>0.9× (50×5-P), 83.33 > 250-P or P>166.67 in order that contracting now is more profitable. Operations Management

25. Decision Trees We valued the flexibility of being able to wait until there is no more uncertainty. Operations Management

26. Decision Trees • Now suppose we have only completed Phase 1, and that we assess the probability of completing phase 2 to be 50%. • We still assess the probability of completing Phase 3 to be 90%. • We again have the option to contract now at $150 million or to contract later (after either completing phase 2 or 3). Operations Management

27. Decision Trees pass phase 3 $100 million 0.9 pass phase 2 do not pass now 0.5 -$150 million $75 million 0.1 -37.5 million do not pass -$150 million 0.5 later It does not make sense to contract now. Operations Management

28. What did we learn? • Decision trees • How to value the option of delaying decisions to collect information • Next class, we will study revenue management tools based on decision trees • Still upcoming … simulation game explanation. Operations Management

29. Next Session • Homework 4 due. • Game report 1 due. Operations Management