Demand and Revenue Management

Anton J. Kleywegt
April 2, 2008

Revenue Management

What is Revenue Management

Why do Revenue Management
Pricing Optimization
Demand Modeling and Forecasting

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

What is Revenue Management

Revenue Management involves the

following activities

Demand data collection

Demand modeling
Demand forecasting
Pricing optimization
System implementation and distribution

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
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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

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

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

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

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
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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
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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
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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
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Hospital Contract Case Study

Example of setting per-diem rates
ICU Patient Length of Stay
% of Patients

16%
14%
12%
10%
8%
6%
4%
2%
0%
1

9 10 11 12 13 14

Number of Days
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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
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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

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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)
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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 1960s, 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
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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!

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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?
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What is Revenue Management

130

70

Revenue Management may involve price

discrimination, but it does not have to
P=130-Q
Consumer surplus=1800
Unit cost = 10
Firms profits
under single price:
Firm profits=3600 (130-Q-10)Q
Deadweight loss=1800

60

130

MC=10
q
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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
40

80

130

q
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Price Discrimination (continued)

130
110
P

Consumer surplus=1000

90
70

Firm profits=6000

50

Deadweight loss=200

30

MC=10

20 40 60 80 100

130

q
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Price Discrimination (continued)

Perfect price
discrimination

130

Consumer surplus=0
Deadweight loss=0
Firm profits=7200

MC=10

130

q
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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
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What is Revenue Management

It is not spam

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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
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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
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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?
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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
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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

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Demand Forecasting

The first law of forecasting: The

forecast is always wrong
Sources of forecast error:

Modeling error
Parameter error
Measurement error

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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
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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
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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

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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
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Demand Forecasting

Forecasting methods

Judgmental methods
Statistical forecasting methods

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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

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Demand Forecasting

Statistical forecasting methods

Non-causal methods

Causal methods

Exponential smoothing
Time series 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
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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/fssfr.html>.
Swain, J. J., Desktop Statistics Software: Serious Tools for
Decision Making, OR/MS Today, volume 26, number 5, pp. 5061, 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. 4251, February 2005,
<http://lionhrtpub.com/orms/surveys/sa/sasurvey.html>.
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Questions?

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