REVENUE MANAGEMENT &

DYNAMIC PRICING

OVERBOOKING

Prof. Preetam Basu

IIM Calcutta
Overbooking
 The practice by which a seller with constrained capacity sells
more than his available capacity in the expectation that no
shows/cancellations will bring the number of reservations
actually used below maximum occupancy.

 Protect against unanticipated no-shows and cancellations

 Airlines estimate 20% of the reservations result in either

cancellations or no-shows

 Overbooking becomes critical without which sellers not only

lose potential revenue but also incur costs for maintenance and
support for unused capacity
Historical Background
 In the early days of commercial aviation in the US, airlines
adopted the policy that a customer with a reservation could
cancel at any time before departure without paying a penalty
and for no-shows the full face value of the ticket could be used
for a future flight

 How many passengers should be allowed to book?

 If bookings were limited to the capacity of flight many fully-booked
flights would have to fly with empty seats
 “10% of sold-out flights would be empty if they are booked upto
capacity”---American Airlines
What about customers who are denied
boardings?
 Voluntary denied boardings: Overbooked airline asks for
volunteers to be bumped in return for compensation (e.g.: voucher
for future travel)

 Involuntary denied boardings: Overbooked airline picks customers

to bump.

 Airline research shows that voluntary denied boardings are not

only happy but are often eager to get bumped in return for
compensation

 Involuntary denied boardings rate are less than1 per 10,000

passengers
When is overbooking applicable?
 Capacity is constrained and perishable and bookings
are accepted for future use

 Customers are allowed to cancel or not show

 The cost of denying service to a customer with a

booking is relatively low.

 Amount of capacity that will be available is uncertain

 “Gapping” in television broadcasting
Overbooking in different industries

Industry Importance of Treatment of overbooked customers

overbooking
Passenger airlines Very High Compensation and rebooking on a
different flight
Hotels High Re-accomodation at other hotels
Rental cars High Wait or redirect to other centers of
the same chain
Made to order Medium Backorder or delay delivery
manufacturing
Cruise lines Low Typically do not overbook
Sporting events, concerts Very Low Nonrefundable tickets with no
and shows overbooking
Overbooking Policies
 Deterministic heuristic: calculates a booking limit based only
on capacity and expected no-show rate

 Risk-based policies: estimates the costs of denied service and

weighs them against the potential revenue

 Service-level policies: involves managing to a specific service

level

 Hybrid policies: combines risk-based limits with service-level

considerations
Basic Overbooking Model
 A seller plans to accept bookings for a fixed capacity C.
 The seller sets a booking limit b before any bookings arrive
 The seller accepts bookings as long as total bookings are less than b. Once
the limit is reached he stops accepting bookings.
 At the time of service customers arrive. Booked customers who arrive are
called shows and those to fail to show are called no-shows
 Each show pays a price of p
 The seller can accommodate C of the shows. If the number of shows is less
than or equal to C, they are all accommodated. If the number of shows
exceed C, exactly C shows will be served and the rest will be denied
service. Shows that are denied service are each paid denied service-
compensation of D>p.
 We will later extend the basic model to cancellations, multifare classes and
partially refundable prices
Deterministic Heuristic
 Example: A hotel has observed historically that its
show rate is 85% . The hotel has 250 rooms. What
should be the overbooking limit?

 250/0.85=294

bC/
Risk-based Policies
 Booking limit is set by balancing the expected cost of denied
service with the potential additional contribution from more
sales

 Denied service cost includes:

 The direct cost of compensation to the bumped customer
 The provision cost of meals and lodging
 The reaccommodation cost of a customer denied service
 The ill-will cost from denying service
The Risk-based Objective Function
 Denote the number of passengers who show up at a departure
by s
 The number of shows is a random variable that depends on the
booking limit and the total demand for bookings
 Each show pays price p
 If shows exceed capacity C, then the seller must deny service
to s-C customers. Each customer denied service results in a cost
D
 The expected net revenue is then:

E[ R]  pE[s]  DE[( s  C )  ]
Simple Risk-based Booking Limit
 Assume the number of no-shows is independent of
the number of total bookings

 Define F(d) as the probability that the total number

of bookings requests is less than or equal to d

 Define G(x) as the probability that the number of

no-shows will be less than or equal to x

 Draw a decision tree to see what happens if the

booking limit is increased from b to b+1
Simple Risk-Based Model
x<=b-C
p-D
G(b-C)
d>b

1-F(b) 1-G(b-C) x > b-C

p
bb+1

F(b)
d <=b
0

 Total booking limit decision tree for a simple risk-based model

 Optimality Condition

E[ R | b  1]  E[ R | b]  [1  F (b)]{G (b  C )( p  D) 
[1  G (b  C )] p}  F (b)0
 [1  F (b)][ p  G (b  C ) D]

As long as G(b-C)<p/D keep increasing the booking limit

Simple Risk-based Booking Limit Algorithm

 Initialize b=C
 If p/D<=G(b-C), stop. The current value of b is
optimal
 If p/D>G(b-C), set b=b+1 and go to step 2

 The optimal booking limit in the simple risk-based

model is the smallest value of b for which
p/D<=G(b-C)
Example: Simple Risk-based Booking
Limit
 Consider a flight with 100 seats, a fare of $120 and
a denied boarding cost of $300. No-shows follow a
Binomial(0.42,20) distribution. Find the simple risk-
based booking limit and the corresponding net
revenue.
Relation to the newsvendor model
 Solution to the newsvendor model requires ordering an
amount of inventory Y* such that:
F(Y*)=U/(U+O)
where U is the underage and O is the overage cost

 Underage cost in our case is the opportunity cost of an

empty seat, that is, p

 Overage cost is the net denied boarding cost, that is, D-p

 Critical ratio is p/D

G(b-C)=p/D
Service-Level Policies
 Determine the highest overbooking limit that does not cause
denied service incidents to exceed management specified
levels

 Reasons why some companies follow service-level policies

rather than risk-based ones:
 Denied service cost is difficult to quantify
 Service-level policies are easy to understand
 Service level policies give comfort that denied-service levels will be
in line with those experienced by competitors
Service-Level Policy (1)
 Limit the fraction of booked customers denied
service
 An airline might set a policy that the fraction of
bookings that result in denied service should be
approximately 1 in 10,000


E[(( s | b)  C ) ]  0.0001E[( s | b)]
Service-Level Policy (2)
 Number of denied service incidents should be some
specified fraction of customers served

E[(( s | b)  C )  ]  qE[min(( s | b), C )]

 q is the target denied-service fraction

 E[min((s|b),C)] is expected sales given a booking
limit of b
Hybrid Policies
 Most airlines, hotels and rental car companies use
hybrid polices under which they calculate booking
limits based on both risk-based and service level
polices and then use the minimum of the two limits

 Combines the economic advantage of trading off

costs and benefits and still ensure that the service
levels are within acceptable bounds
Example:
 An airline is using the deterministic heuristic to calculate
dynamic booking limits. The flight has 120 seats and an
average no-show rate of 13%. Twenty days before departure
the expected cancellation rate is 60%. What would be the
booking limit?

 Answer: 345 = 120/{(1-0.6)*0.87}

 Dynamic Booking Limits (Cont’d)
Bookings

No-show
Capacity Booking limit
pad
Bookings

A B
Departure
Time

 Bookings tend to firm towards departure

 Booking limit tends to be high early on when the actual bookings are low
 Booking limits require frequent updating as departure approaches as the number
of bookings increase and cancellations decrease
Measuring Overbooking
 Load factor is an utter failure as a measure of overbooking
policy….Why??

 Any booking policy that increases load factor is likely to result

in an increase in denied bookings and vice-versa

 Overbooking policies are measured by:

 Spoilage rate: the number of empty seats at departure for which
bookings were denied, expressed as fraction of total seats
 Denied boarding rate: the number of denied boardings expressed
as a fraction of total seats
Measuring Overbooking (Cont’d)
 Performance needs to be evaluated against targets for
both the spoilage and denied-boarding rate

 Does a denied-boarding rate of 1% compared to 2%

indicate better performance?
 If the lower denied-boarding rate was achieved at the cost
of a higher spoilage rate: Overbooking policy was
conservative and lost profitable opportunities to fill
additional seats
Portfolio of Airline Revenue Management
Metrics
 Denied-boarding & Spoilage rates: to measure the
effectiveness of overbooking and capacity
allocation policies

 Revenue per available seat mile (RASM): to measure

overall effectiveness and to compare performance
to that of other airlines

 Revenue opportunity metrics (ROM): to measure

effectiveness of revenue management system