Chapter 16

Chapter 16
Supply Chain Management: Strategy, Planning, and Operation, 5/e Authors: Sunil Chopra, Peter Meindl and D. V. Kalra
Copyright 2013 Dorling
Pricing and Revenue Management in a Supply Chain
Learning Objectives
Understand the role of revenue management in a supply chain Identify conditions under which revenue management tactics can be effective
Describe trade-offs that must be considered when making revenue management decisions
The Role of Pricing and Revenue Management in the Supply Chain

Revenue management is the use of pricing to increase the profit
generated from a limited supply of supply chain assets Supply assets exist in two forms capacity and inventory Revenue management may also be defined as the use of differential pricing based on customer segment, time of use, and product or capacity availability to increase supply chain profits
The Role of Pricing and Revenue Management in the Supply Chain

Revenue management has a significant impact on supply chain exist The value of the product varies in different market segments The product is highly perishable or product waste occurs Demand has seasonal and other peaks The product is sold both in bulk and on the spot market
profitability when one or more of the following four conditions
Pricing and Revenue Management for Multiple Customer Segments

Differential pricing increases total profits for a firm Two fundamental issues must be handled in practice How can the firm differentiate between the two segments and structure its pricing to make one segment pay more than the other? How can the firm control demand such that the lower-paying segment does not utilize the entire availability of the asset?
Figure 16-1
Figure 16-2
Pricing to Multiple Segments
Demand curve for segment i = di = Ai Bi pi

Ai c Optimal price = pi = + 2Bi 2
Supplier maximizes pi c Ai Bi pi
)(
For capacity constrained by Q

k
Max pi c Ai Bi pi
Subject to
i=1
)(
( A B p ) Q
i i i i=1
Ai Bi pi 0 for i =1 ,...,k
Customers unwilling to commit d1 = 5,000 20 p 1 c = $10

5,000 10 + = 125 + 5 = $130 2 20 2 5,000 10 p2 = + = 62.5 + 5 = $67.5 2 40 2 p= 1
Customer willing to commit d2 = 5,000 40 p 1
d1 = 5,000 20 130 = 2,400 and d2 = 5,000 40 67.5 = 2,300

Total profit = 130 2,400 + 67.5 2,300 10 4,700 = $420,250
Same price to both segments

( p 10) ( 5,000 20 p) + ( p 10) ( 5,000 40 p) = ( p 10) ( 10,000 60 p)

10,000 10 Optimal price p = + = $88.33 2 60 2
d1 = 5,000 20 88.33 = 3,233.40 d2 = 5,000 40 88.33 = 1 ,466.80
Total profit = 88.3310 3,233.40 +1 ,466.80 = $368,166.67

) (
Total production capacity is limited to 4,000 units
Max p 10 5,000 20 p + p2 10 5,000 40 p2 1 1

Subject to
( 5,000 20 p ) + ( 5,000 40 p ) 4,000 ( 5,000 20 p ) ,( 5,000 40 p ) 0

1 2 1 2
)(
) (
)(
Figure 16-3
Allocating Capacity to a Segment Under Uncertainty

Basic trade-off is between committing to an order from a lowerSpoilage Spill
price buyer or waiting for a higher-price buyer to arrive
RH CH = Prob(demand from higher-price segment > CH ) pH Prob(demand from higher-price segment > CH ) = pL / pH CH = F 1 1 pL / pH , DH , H = NORMINV 1 pL / pH , DH , H
( )
Allocating Capacity to a Segment Under Uncertainty

Effective use of revenue management increases firm profits and
improves service for the more valuable customer segment Create different versions of a product targeted at different segments Tactics for multiple customer segments Price based on the value assigned by each segment Use different prices for each segment Forecast at the segment level
Allocating Capacity to Multiple Segments
CA = NORMINV 1 pB / pA, DA, A = 2,820 cubic feet
( ) = NORMINV ( 1 2.00 / 3.50,3,000,1 ,000)
CA = NORMINV 1 2.00 / 5.00,3,000,1 ,000 = 3,253 cubic feet
Revenue from segment A, pA = $3.50 per cubic foot Revenue from segment B, pB = $2.00 per cubic foot Mean demand for segment A, DA = 3,000 cubic feet Standard deviation of demand for A, A = 1,000 cubic feet
Pricing and Revenue Management for Perishable Assets

Any asset that loses value over time is perishable Two basic approaches Vary price dynamically over time to maximize expected revenue Overbook sales of the asset to account for cancellations
Dynamic Pricing
Demand for period i = di = Ai Bi pi
Max pi Ai Bi pi
Subject to
i=1
( A B p ) Q
i i i i=1
Ai Bi pi 0 for i = 1 ,...,k
Effective differential pricing increases the level of product availability for the consumer willing to pay full price and total profits for the retailer
Dynamic Pricing
d1 = 300 p1, d2 = 300 1.3p2, and d3 = 300 1.8p3
Maxp 300 p + p2 300 1.3 p2 + p3 300 1.8 p3 1 1
Subject to
( 300 p ) + ( 300 1.3 p ) + ( 300 1.8 p ) 400

1 2 3
300 p ,300 1.3 p2 ,300 1.8 p3 0 1

Effective differential pricing increases the level of product availability for the consumer willing to pay full price and total profits for the retailer
Dynamic Pricing
Figure 16-4
Dynamic Pricing
Figure 16-5
Evaluating Quantity with Dynamic Pricing
d1 = 300 p1, d2 = 300 1.3p2, and d3 = 300 1.8p3
Maxp 300 p + p2 300 1.3 p2 + p3 300 1.8 p3 100Q 1 1

Subject to
( 300 p ) + ( 300 1.3 p ) + ( 300 1.8 p ) Q

1 2 3
300 p ,300 1.3 p2 ,300 1.8 p3 ,Q 0 1
Evaluating Quantity with Dynamic Pricing
Figure 16-6
Overbooking
Basic trade-off is between having wasted capacity because of because of few cancellations requiring expensive backup
excessive cancellations or having a shortage of capacity
Cw s* = Prob cancellations O * = Cw + Cs
O = F 1 s*, L + O , L + O = NORMINV s*, L + O , L + O
O* = F 1 s*, c, c = NORMINV s*, c, c
) (
))
) (
))
Overbooking
Cost of wasted capacity, Cw = $10 per dress Cost of capacity shortage, Cs = $5 per dress
Cw 10 s* = = = 0.667 Cw + Cs 10 + 5
O* = NORMINV s*, c, c = NORMINV 0.667,800,400 = 973 O = NORMINV 0.667,0.15, 5000 + O ,0.075 5000 +O O* = 1 ,115
))
Pricing and Revenue Management for Seasonal Demand

Seasonal peaks of demand common in many supply chains Off-peak discounting can shift demand from peak to non-peak periods Charge higher price during peak periods and a lower price during off-peak periods Increases profits for the owner of assets, decreases the price paid by a fraction of customers, and brings in new customers during the off-peak discount period
Pricing and Revenue Management for Bulk and Spot Contracts

Problems constructing a portfolio of long-term bulk contracts and
short-term spot market contracts Decide what fraction of the asset to sell in bulk and what fraction of the asset to save for the spot market The amount reserved for the spot market should be such that the expected marginal revenue from the spot market equals the current revenue from a bulk sale
Pricing and Revenue Management for Bulk and Spot Contracts
Q* = F 1 p*, , = NORMINV p*, ,
cS cB Optimal value p* = cS
Long-Term Bulk Contracts versus the Spot Market

Bulk contract cost, cB = $10,000 per million units Spot market cost, cS = $12,500 per million units
cS cB 12,500 10,000 p* = = = 0.2 cS 12,500
Q* = NORMINV p*, , = NORMINV 0.2,10,4 = 6.63
Using Pricing and Revenue Management in Practice

Evaluate your market carefully Quantify the benefits of revenue management Implement a forecasting process Keep it simple Involve both sales and operations Understand and inform the customer Integrate supply planning with revenue management
Summary of Learning Objectives
Understand the role of revenue management in a supply chain Identify conditions under which revenue management tactics can be effective Describe trade-offs that must be considered when making revenue management decisions

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Pricing and Revenue Management in a Supply Chain

The Role of Pricing and Revenue Management in the Supply Chain

The Role of Pricing and Revenue Management in the Supply Chain

profitability when one or more of the following four conditions

Pricing and Revenue Management for Multiple Customer Segments

Pricing and Revenue Management for Multiple Customer Segments

Copyright 2013 Dorling

Pricing and Revenue Management for Multiple Customer Segments

Copyright 2013 Dorling

Pricing to Multiple Segments

Demand curve for segment i = di = Ai Bi pi

For capacity constrained by Q

Pricing to Multiple Segments

Customers unwilling to commit d1 = 5,000 20 p 1 c = $10

Customer willing to commit d2 = 5,000 40 p 1

d1 = 5,000 20 130 = 2,400 and d2 = 5,000 40 67.5 = 2,300

Pricing to Multiple Segments

Same price to both segments

( p 10) ( 5,000 20 p) + ( p 10) ( 5,000 40 p) = ( p 10) ( 10,000 60 p)

Total profit = 88.3310 3,233.40 +1 ,466.80 = $368,166.67

Pricing to Multiple Segments

Total production capacity is limited to 4,000 units

Max p 10 5,000 20 p + p2 10 5,000 40 p2 1 1

( 5,000 20 p ) + ( 5,000 40 p ) 4,000 ( 5,000 20 p ) ,( 5,000 40 p ) 0

Copyright 2013 Dorling

Pricing to Multiple Segments

Copyright 2013 Dorling

Allocating Capacity to a Segment Under Uncertainty

price buyer or waiting for a higher-price buyer to arrive

Allocating Capacity to a Segment Under Uncertainty

Allocating Capacity to Multiple Segments

CA = NORMINV 1 pB / pA, DA, A = 2,820 cubic feet

( ) = NORMINV ( 1 2.00 / 3.50,3,000,1 ,000)

CA = NORMINV 1 2.00 / 5.00,3,000,1 ,000 = 3,253 cubic feet

Copyright 2013 Dorling

Pricing and Revenue Management for Perishable Assets

Demand for period i = di = Ai Bi pi

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d1 = 300 p1, d2 = 300 1.3p2, and d3 = 300 1.8p3

Maxp 300 p + p2 300 1.3 p2 + p3 300 1.8 p3 1 1

( 300 p ) + ( 300 1.3 p ) + ( 300 1.8 p ) 400

300 p ,300 1.3 p2 ,300 1.8 p3 0 1

Copyright 2013 Dorling

Copyright 2013 Dorling

Copyright 2013 Dorling

Evaluating Quantity with Dynamic Pricing

d1 = 300 p1, d2 = 300 1.3p2, and d3 = 300 1.8p3

Maxp 300 p + p2 300 1.3 p2 + p3 300 1.8 p3 100Q 1 1

( 300 p ) + ( 300 1.3 p ) + ( 300 1.8 p ) Q

300 p ,300 1.3 p2 ,300 1.8 p3 ,Q 0 1

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Evaluating Quantity with Dynamic Pricing

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excessive cancellations or having a shortage of capacity

O = F 1 s*, L + O , L + O = NORMINV s*, L + O , L + O

O* = F 1 s*, c, c = NORMINV s*, c, c

Pricing and Revenue Management for Seasonal Demand

Pricing and Revenue Management for Bulk and Spot Contracts

Pricing and Revenue Management for Bulk and Spot Contracts

Q* = F 1 p*, , = NORMINV p*, ,

Copyright 2013 Dorling

Long-Term Bulk Contracts versus the Spot Market

O = F 1 s, L + O , L + O = NORMINV s, L + O , L + O

O* = F 1 s, c, c = NORMINV s, c, c

Q* = F 1 p, , = NORMINV p, ,