Revenue Management

in the Supply Chain

George Easaw, Ph.D.,

Xavier Institute of Management and En'ship

Electronic City, Ph II, Hosur Road,
Bangalore 100. <geasaw@gmail.com>
 Supply Chain assets
 Capacity assets
 Production
 Transportation and

 Storage

 Inventory assets
 Carried throughout the supply chain
 Improves product availability
What is Revenue Management ?

Increasing the supply chain surplus by the use of

differential pricing based on

 Customer segment
 Time of use

 Product or capacity availability

 Different Revenue Management
Models
 Differential pricing model for multiple customer
segments
 Perishable assets model
 Seasonal demand model
 Bulk and spot customer model
 Single Period Stochastic
Inventory Control Model –
Newsboy model
 Assumptions
 Single item, stochastic demand during the period
 Decision taken at the beginning of the period

 Items get obsolete after one period

 Costs attached to the Newsboy
model
 Purchase cost, c
 Selling price, p
 Salvage cost, s
 Cost of overstocking, C_o = c - s
 Cost of understocking, C_u = p – c
 Other notations

 CSL* - optimal cycle service level

 O* - corresponding optimal order size
 CSL = probability( demand during period <=
O*.
 Formulation of newsboy model
 At CSL*, the marginal cost of purchasing an
additional unit is zero
 ie. an additional unit at O*, sells with a prob.
of (1-CSL*) resulting in benefit of (p-c).
 The additional unit does not sell with a
probability of CSL* and results in a loss of
(c-s).
 (1-CSL*).(p-c)=CSL*.(c-s)
 CSL* = probability(customer demand <= O*)
= (p-c) / ((p-c) + (c-s)) = C_u / (C_u + C_o)
 Newspaper boy , c = Rs2.00, p = Rs3.00, s = Rs
0.75. The daily demand and freq. of occurrence
in number of days is shown below for 20 days
< 10 – 2 days
11 – 3 days
12 – 4 days
13 – 4 days
14 – 3 days
15 - 2 days
16 – 1 day
>17 – 1 day.
Find the optimal order quantity of newspapers
for the newsboy to optimise his earnings..
 Issues in RM model for multiple
customer segments

 How to differentiate the different segments and

structure the pricing so that one pays more than
the other ?
 How to control demand so that the lower
paying segment does not fully utilise the entire
availability of asset ?
How to differentiate customers ?

 Create barriers by identifying product or service

attributes that the segments value differently.
 Offer products at different prices

 Offer products at different points of time

RM model for multiple customer
segments – basic trade-off
 Spoilage – capacity reserved for higher price
segment wasted, as demand does not materialise
 Spill – higher price customers are turned away
as capacity is reserved for lower price segment
 Decision is to commit the capacity to higher
price buyers so as to minimise the expected cost
of spoilage and spill.
 Formulation
 P_h – price charged to the high priced segment
 C_h – capacity allotted to the high priced
segment – THE DECISION VARIABLE
 P_l – price charged to the low priced segment
 C_l – capacity allotted to the low priced
segment
 Let high priced demand be normally distributed
with mean D_h and standard deviation sigma_h
 Contd..
 Expected marginal revenue from reserving
more capacity for high priced segment =
R_h(C_h) = probability(demand from high
price segment > C_h) . P_h
 Current marginal revenue from lower priced
segment = P_l
 Capacity C_h should be decided in such a
way that expected marginal revenue from
high priced segment = the current marginal
revenue from lower price segment
 ie. prob(demand from high priced segment >
C_h) . P_h = P_l
 prob(demand from high priced segment >
C_h) = P_l/P_h
 ie. prob(demand from high priced segment <=
C_h) = 1 – (P_l/P_h)

Using spreadsheet program like Excel or

Openoffice calc, C_h is got by giving the
formula = norminv((1-P_l/P_h),
D_h,sigma_h) in any cell.
 Nested Reservations
 The quantity C_h reserved for the high priced
segment is computed by keeping the expected
marginal revenue from the highest priced
segment equal to the next highest priced
segment
 The quantity (C_h + C_m) reserved for the two
highest priced segments is such that the
expected marginal revenue from the two
highest priced segments equals the price of the
third highest priced segment.
 RM model for perishable assets
 The tactics adopted for perishable assets are
 Varying price over time to maximise expected
revenue – effective differential pricing over time
increases the level of product availability for the
customer willing to pay full price, increasing
revenue.
 Overbooking sales of the asset to account for
cancellation
 Tradeoffs & Objective –
Overbooking RM model
 Loss of revenue from wasted capacity because
of excessive cancellations
 Reduction in margin by using an expensive
backup as there is shortage of capacity because
of few cancellations.
 Objective is to maximise profits by minimising
cost of wasted capacity and cost of capacity
shortage
 Model formulation
 c – the cost of producing unit asset
 p - price of selling each unit of asset
 b – cost of the unit backup resource
 Marginal cost of wasted capacity, C_w = p-c
 Marginal cost of capacity shortage, C_s = b-p
 O* - optimal overbooking level
 s* - prob. Cancellations <= O*
 Contd..
 As per the newsboy model formulation, the
optimal overbooking level, s*, prob.
(cancell. <= O*) = C_w/(C_w + C_s)
 If cancellations are known to have mean of
mhu_c and std. dev sigma_c, inserting
=norminv(s*,mhu_c,sigma_c) in the
spreadsheet program gives the optimal number
of overbookings, O*.
 RM for Seasonal Demand
 The tactic employed is to charge a higher price
during the peak period and lower price during
off-peak periods, resulting in a demand shift
from peak to off-peak periods
 The discount given during off-peak period is
more than offset by the decrease in cost due to
a smaller peak and increase in revenue during
offpeak period. Eg. Hotels, transportation
systems.
 A company arranges with a transporter to carry
the Chinese imports he gets at the port in
Chennai to Bangalore. The bulk rate is Rs.
10,000/1000 cft and the spot rate for
transportation is Rs. 14,000 /1000 cft. The
demand for items imported at Chennai port is
normally distributed with a mean of 10,000 cft
with a std dev of 3,000 cft. What volume
should be contracted at the bulk rate and what
volume at spot rate? If the demand changes to
15,000 cft with std dev of 3000 cft, what is the
new quantity at bulk rate?
 RM model for bulk and spot
customers
 Long term bulk contract – fixed low price but
can get wasted if not utilised
 Spot market offers a higher price but never gets
wasted.
 Tradeoff is deciding the amount of long term
bulk shipping contracts to sign
 Formulation
 C_b – bulk rate in the market
 C_s – spot rate in the market
 Q* - optimal amount of asset purchased in bulk
 p* - probability(demand for asset <= Q*)
 Marginal cost of purchasing another unit in
bulk = C_b
 Expected marginal cost of not purchasing
another unit in bulk and then purchasing it in
the spot market is (1-p*).C_s
 Contd ..
 (1-p*).C_s = C_b
 p* = (C_s – C_b)/ C_s
 If bulk demand is distributed normally with
mean mhu_b and std deviation sigma_b,
norminv(p*, mhu_b,sigma_b) gives the
optimal bulk quantity to be purchased.
 References:
 Chopra and Meindl, Supply Chain Management, 3
e, Pearson Education
 Simchi Levi et al, Design and Analysis of Supply
Chains, 2e, Tata McGraw Hill.
 Research Issues in RM
 Applying Optimization models to Revenue
Management
 Integrating supply chain planning with revenue
management
 Implementing effective forecasting processes
 Quantifying the benefits of revenue
management