1

Demand and Revenue Management

Anton J. Kleywegt
April 2, 2008
2
Revenue Management
at is Revenue Management
y do Revenue Management
Pricing Optimization
Demand Modeling and Forecasting
3
at is Revenue Management
Management oI inventory, distribution cannels
and prices to maximize proIit over te long run
Selling te rigt product to te rigt customer at
te rigt time at te rigt price
4
at is Revenue Management
Revenue Nanagement involves the
following activities
Demand data collection
Demand modeling
Demand forecasting
Pricing optimization
System implementation and distribution

at is Revenue Management
Airline industry
How many seats to make available at eac oI te listed
Iares, depending on te OD pair, time oI year, time oI
week, remaining seats available, remaining time until
departure
at contracts and prices to provide to corporations
How many seats to make available to consolidators and
travel agents (iI at all), and at wat prices
How muc capacity to make available to cargo sippers
and Ireigt Iorwarders, and at wat prices

at is Revenue Management
Hotel industry
How muc to carge Ior a room depending on
te location, type oI room, time oI year, time oI
week, duration oI stay

at is Revenue Management
Ocean cargo industry
ic types oI contracts to enter into wit
sippers
How muc capacity to commit to eac sipper
ic contract prices to ave Ior eac sipper
How to vary prices as a Iunction oI direction oI
trade, commodity, and time oI year

at is Revenue Management
ar rental industry
How muc to carge Ior a rental car depending
on te class oI car, time oI year, time oI week,
duration oI rent
Restaurant industry
How muc to carge Ior lunc vs dinner

at is Revenue Management
ManuIacturing industry
Make-to-stock: dynamic pricing oI inventory
Make-to-order: dynamic pricing oI orders, ow
muc discount to give Ior orders in advance
Make-to-stock and make-to-order: prices oI
advance orders vs prices oI inventory
10
at is Revenue Management
Retail industry
Example: Iasion apparel industry
Products in Iasion Ior a single season
Retailer wants to sell available inventory Ior
maximum proIit
Prices iger at start oI season
Retailer as to decide wen to mark prices
down, and by ow muc
11
at is Revenue Management
Entertainment ticket pricing
Example: opera ouses let teir ticket prices
depend on
Te perIormance
Te reviews received so Iar
Location oI seat in opera ouse
Day oI te week oI te perIormance
Time oI te day oI te perIormance
Time oI perIormance in te season
Remaining time until te perIormance
Number oI remaining seats available
12
at is Revenue Management
olI courses
Variable pricing: oose prices to vary by
time oI day
day oI week
season oI year
Round duration control
control tee-time interval
control uncertainty in arrival time
control uncertainty in duration
13
Hospital ontract ase Study
Major customers oI ospitals
Insurance companies
Medicare
Medicaid
Individuals
Hospital contracts wit major customers
Discount-oII-listed-carges contracts
Per-diem contracts
ase-rate contracts
apitation contracts
14
Hospital ontract ase Study
Example oI setting per-diem rates
ICU Patient Length of Stay
0%
2%
4%
6%
8%
10%
12%
14%
16%
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Number of Days
%

o
f

P
a
t
i
e
n
t
s
1
Hospital ontract ase Study
Example oI setting per-diem rates
Observe tat most patients stay Ior only a Iew
days, altoug a Iew patients make te average
lengt oI stay quite ig
StratiIied per-diem rates
arge more per day to patients wo stay Ior only a
Iew days
Results
Higer average revenue
Lower standard deviation oI revenue
1
Hospital ontract ase Study
Higer average revenue clearly beneIicial to
te ospital
Lower standard deviation oI revenue
BeneIicial to te ospital?
Yes. More predictable revenue
BeneIicial to te insurance company?
Yes. More predictable costs
1
at is Revenue Management
Overbooking may be part oI revenue management
Overbooking important practice in many
industries tat use reservations, and were
cancellations or no-sows may occur
airlines
otels
car rental
cruise lines
restaurants
contractors (construction etc)
1
at is Revenue Management
Overbooking
Important trade-oII between opportunity cost oI unused
resources iI cancellations or no-sows cause resources
to be wasted, and cost oI oversales
In 1960`s, Simon and Vickrey proposed te use oI
auctions to allocate airline seats in case oI oversales
Airlines rejected idea Ior many years
Nowadays, reverse Dutc auctions are widely used to
allocate airline seats in case oI oversales, and seem to
be widely accepted
1
at is Revenue Management
Dynamic pricing and te bullwip eIIect
Dynamic pricing can increase demand
variability
Te case oI ampbell Soup
ild swings in demand and in sipments oI cicken
noodle soup Irom te manuIacturer to distributors
and retail stores
Increase in production, storage and logistics costs
Frequent stockouts resulting in lost sales
Te culprit: Trade promotions!
20
at is Revenue Management
Dynamic pricing and te bullwip eIIect
Dynamic pricing can be used to decrease demand
variability
Peak load pricing: lower prices during oII-peak times,
iger prices during peak times
Airlines
Hotels
olI courses
Electricity wolesale market
Oil/gasoline?
21
at is Revenue Management
Revenue Management may involve price
discrimination, but it does not ave to
P=130Q
Unit cost = 10
Firm's profits
under single price:
(130Q10)Q
P
q
NC=10
130
130
0
0
onsumer surplus1800
Deadweigt loss1800
Firm proIits3600
22
Price Discrimination (continued)
P=130Q
Unit cost = 10
What if the firm
could segment
the market and
charge two
different prices?
P
q
NC=10
130
130
0
0
onsumer surplus1600
Deadweigt loss800
Firm proIits4800
0
40
23
Price Discrimination (continued)
P
q
NC=10
130
130
0
110
onsumer surplus1000
Deadweigt loss200
Firm proIits6000
0
40
0
0
30
20 0 100
24
Price Discrimination (continued)
Perfect price
discrimination
P
q
NC=10
130
130
onsumer surplus0
Deadweigt loss0
Firm proIits7200
2
at is Revenue Management
Te same product sold at diIIerent times Ior diIIerent
prices is not necessarily price discrimination, because at
diIIerent times...
te production or distribution costs may be diIIerent
inventory costs were incurred to keep te product in stock until a
later time
te product value may cange over time, suc as perisable or
maturing or seasonal products, Iasion goods, antiques.
te remaining inventory may be diIIerent
interest is earned iI product is sold at an earlier time
consumers value products diIIerently at diIIerent points in time
locking sales in early reduces uncertainty
2
at is Revenue Management
It is not spam
2
Fairness and Legal Issues
Depending on te industry, tere may be legal
obstacles to revenue management
Examples
Regulated prices oI utilities (tis is canging)
Prices in airline industry were regulated until 1978 -
price and quantity canges ad to be approved by AB
Pricing in ocean cargo industry was regulated until
1999 - carriers ad to provide all sippers wit te
same essential contract terms
Spot market pricing in ocean cargo industry is still
regulated - 30 days notice required Ior price increases
2
Fairness and Legal Issues
olI course examples
Kimes and irtz survey results (1 extremely
Iair, 7 extremely unIair)
Time-oI-day pricing: 3.41
Varying price (Ior example, as Iunction oI bookings
on and): 6.16
Two-Ior-one coupons Ior oII-peak use: 1.80
Time-oI-booking pricing: 5.12
Reservation Iee/arge Ior no-sows: 3.19
Tee-time interval pricing: 3.95
2
Fairness and Legal Issues
Amazon.com example
Fall 2000, Amazon conducted experiment to try to
determine price sensitivity oI demand Ior DVDs
Discounts between 20 and 40 oIIered randomly
ustomers wo visited amazon.com multiple times
noticed canging prices
Furious response by customers and press, suspecting
Amazon varied price by demograpics
y are varying airline prices accepted by most, and
not varying DVD prices?
30
y do Revenue Management
Success stories
American Airlines increased annual revenue wit $500
million troug revenue management
Delta Airlines increased annual revenue wit $300
million troug revenue management
Marriott otels increased annual revenue wit $100
million troug revenue management
National ar Rental was saved Irom liquidation wit
revenue management
anadian Broadcasting orporation increased revenue
wit $1 million per week
31
y do Revenue Management
Increasing competition
Fewer restriction on international trade
More eIIicient international transportation
Low cost Ioreign competitors
ompetitors use revenue management
Use revenue management to stay on top
32
y do Revenue Management
At many companies, little costcutting juice can easily be
extracted from operations. Pricing is therefore one of the few
untapped levers to boost earnings, and companies that start
now will be in a good position to profit fully from the next
upturn. - NcKinsey Quarterly, 2003
33
Revenue Management Optimization
ontrol Metods
Resource Bucket ontrol Metods
Bid Price ontrol Metods
Dynamic Programming
SoItware
34
Revenue Management Optimization
ontrol Metods/Optimization Metods
Static Dynamic
Deterministic
Stochastic
Leg Based
OD based
3
Revenue Management Optimization
Resource Bucket ontrol Metods
II supply oI diIIerent products are related, Ior example
iI diIIerent products use sared resources or capacity,
ten revenue management sould not be done
separately Ior te diIIerent products
Also iI demand Ior products are related, Ior example
complementary goods or substitutes
Examples
Airlines: Itineraries wit diIIerent origin-destination
pairs sare te same Iligt legs (resource)
Hotels and rental cars: Multiple day bookings sare
capacity
3
Revenue Management Optimization
Bid price metods
Simple single-stage deterministic LP model
Input:
Lines oI Iligt (LOF)
Te Iligts (legs/segments) eac LOF traverses (Iligt-LOF
incidence matrix A)
Fares I
1
,I
2
,.,I
k
Ior eac LOF
Demand D
j
Ior eac LOF-Iare combination j (not well-deIined
notion)
apacity Q
i
oI eac Iligt (leg/segment) i
Primal decision variables:
x
j
number oI seats allocated to LOF-Iare combination j
3
Revenue Management Optimization
Dynamic programming
State oI process: current bookings/seats available Ior eac Iligt,
competitor inIormation
Transitions: take place troug bookings and cancellations
Decisions: wic prices/Iares are quoted wen booking requests
are received
Policy: decision Ior eac state x and time t
Objective: determine optimal policy
Value Iunction: expected value V(x,t) as Iunction oI state x and
time t
Solving problem involves computing optimal value Iunction
V*(x,t)
Anoter beneIit: Optimal policy very simple:
accept booking request iI Iare ~ V*(x,t) - V*(x-1,t)
3
Revenue Management Optimization
Optimization SoItware Surveys
Fourer, R., 'Linear Programming, OR/MS Today, volume 32,
number 3, pp. 46-55, June 2005,
<http://lionhrtpub.com/orms/surveys/LP/LP-
survey.html.
Nas, S. ., 'Nonlinear Programming, OR/MS Today, volume 25,
number 3, pp. 36-45, June 1998,
<http://lionhrtpub.com/orms/surveys/nlp/nlp.
html.
rossman, T.A., 'Spreadseet Add-Ins Ior OR/MS, OR/MS
Today, volume 29, number 4, pp. 46-51, August 2002,
<http://lionhrtpub.com/orms/surveys/SSA/SSA.
html.
3
Revenue Management Optimization
Decision Support SoItware Surveys
Aksoy, Y. and Derbez, A., 'SoItware Survey: Supply ain Management, OR/MS
Today, volume 30, number 3, pp. 34-41, June 2003,
http://lionhrtpub.com/orms/surveys/scm/scmsurvey.html>.
Buede, D., 'Decision Analysis SoItware Survey: Aiding Insigt IV, OR/MS Today,
volume 25, number 4, pp. 56-64, August 1998.
Hall, R., 'Veicle Routing SoItware Survey: On te Road to Recovery, OR/MS
Today, volume 31, number 3, pp. 40-49, June 2004,
<http://lionhrtpub.com/orms/surveys/Vehicle_Routing/vrss
.html.
Maxwell, D.T., 'Decision Analysis: Aiding Insigt VII, OR/MS Today, volume 31,
number 5, pp. 44-55, October 2004,
<http://lionhrtpub.com/orms/surveys/das/das.html.
Swain, J. J., ''aming' Reality: Biennial survey oI discrete-event simulation
soItware tools, OR/MS Today, volume 32, number 6, pp. 44-55, December 2005,
<http://lionhrtpub.com/orms/surveys/Simulation/Simulatio
n.html.
Swain, J. J., 'Power Tools Ior Visualization and Decision-Making, OR/MS Today,
volume 28, number 1, pp. 52-53, February 2001.
40
Demand Forecasting
'he first law of forecasting: 'he
forecast is always wrong
Sources of forecast error:
Nodeling error
Parameter error
Neasurement error
41
Demand Forecasting
Nodeling error
'he basic form of the demand model is wrong
Example
Suppose we want to forecast demand d as a function of
price p
'he true demand function is d = exp(32p) / (1 + exp(3
2p))
We try to estimate a linear demand model d = a - bp,
with parameters a and b that are estimated with data
No matter what values we estimate for a and b, the
estimated model is wrong - modeling error
42
Demand Forecasting
Parameter error
'he basic form of the demand model is correct,
but we do not know the correct values of the
parameters
Example
'he true demand function is d = exp(32p) / (1 + exp(3
2p))
We try to estimate a demand model d = exp(abp) / (1
+ exp(abp)), with parameters a and b that are
estimated with data
!f we estimate a=3 and b=2 (for example, with good
data and a good statistical technique), then the
estimated model is correct
43
Demand Forecasting
Neasurement error
'he basic form of the demand model is correct,
but we do not know the correct values of the
parameters, and data errors make it impossible to
use statistical techniques to estimate the
parameter values
Example
'he true demand function is d = exp(32p) / (1 + exp(3
2p))
We try to estimate a demand model d = exp(abp) / (1
+ exp(abp)), with parameters a and b that are
estimated with data
Because of bad data, we estimate a=4 and b=1
44
It is very important to understand and model
customer beavior accurately
Incorrect models oI customer beavior can
lead not only to suboptimal prices, but can
lead to te systematic deterioration oI
models, prices, and proIits over time te
spiral-down eIIect
Demand Modeling
4
Spiral-down eIIect in airline revenue management
For many years, airlines ave used Iollowing simple
model oI customer beavior
Some time beIore departure, customer requests a ticket in a
particular Iare class
Airline accepts or rejects te request
Above model describes te way airline reservations
systems work
However, it does not accurately describe te way
customers beave
Demand Modeling
4
Spiral-down eIIect in airline revenue
management
Low Iare tickets and ig Iare tickets
Airlines set aside cosen number oI seats Ior
ig Iare tickets
Airlines use observed sales to estimate te
supposed 'demand Ior ig Iare tickets
Demand Modeling
4
Spiral-down eIIect in airline revenue management
Spiral-down eIIect:
Airline allows some low Iare sales
Some Ilexible customers (not modeled by te airlines) willing
to buy ig Iare iI tat is te only option, now buy low Iare
tickets
Airlines observe more low Iare sales and less ig Iare sales
decrease teir estimate oI 'ig Iare demand
Airlines set aside Iewer seats Ior ig Iare tickets, and allow
more low Iare sales
More customers buy low Iare tickets, and te spiral down
continues
Spiral-down eIIect is te consequence oI an incorrect
model oI customer beavior
Demand Modeling
4
Forecasting metods
Judgmental metods
Statistical Iorecasting metods
Demand Forecasting
4
Judgmental Iorecasting metods
'Expert opinion
Questionable: See te articles
Armstrong, J.S., 'How Expert Are te Experts?,
3., pp.15-16, 1981
Armstrong, J.S., 'Te Seer-Sucker Teory: Te
Value oI Experts in Forecasting, Te.3ology
Review, pp.16-24, 1980
onsensus metods, suc as Delpi tecnique
Demand Forecasting
0
Statistical Iorecasting metods
Non-causal metods
Exponential smooting
Time series metods
ausal metods
Linear regression
Nonlinear regression
Discrete coice models (logit, probit, etc)
atever te metod, te basic approac is to Iind
systematic beavior in data tat one as reason to
believe will continue in te Iuture
Demand Forecasting
1
Forecasting soItware 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/fss-
fr.html.
Swain, J. J., 'Desktop Statistics SoItware: Serious Tools Ior
Decision Making, OR/MS Today, volume 26, number 5, pp. 50-
61, October 1999.
Swain, J. J., 'Looking Ior Meaning in an Uncertain orld,
OR/MS Today, volume 28, number 5, pp. 48-49, October 2001.
Swain, J. J., '2005 Statistical SoItware Products Survey: Essential
Tools oI te Trade, OR/MS Today, volume 32, number 1, pp. 42-
51, February 2005,
<http://lionhrtpub.com/orms/surveys/sa/sa-
survey.html.
Demand Forecasting
2
Revenue Management Implementation
Business case: assessment of
Revenue opportunity
Development and support personnel needs
Development cost
Naintenance cost
Hardware
Software
DBNS
Forecasting
Optimization
!nterfaces
3
Revenue Management Implementation
Distribution system
Communication network hardware
!nterfaces with revenue managers
!nterfaces with customers
Nanagement of customer awareness
and customer perceptions
Nanagement of organizational change
4
Questions?