Revenue Management / Yield Management Matching supply to demand when supply is fixed

Examples of fixed supply:

Application of the Newsvendor to:
• Booking Limits
• Overbooking
Fall 2009
– Travel industries (fixed number of seats, rooms, cars, etc).
– Advertising time (limited number of time slots).
– Telecommunications bandwidth.
– Size of the MBA program.
– Doctor’s availability for appointments.
• Revenue management is a solution:
– If adjusting supply is impossible – adjust the demand!
– Segment customers into high willingness to pay and low
willingness to pay.
– Limit the number of tickets sold at a low price, i.e., control the
average price by changing the mix of customers.
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Revenue management and margin arithmetic Booking Limits – An Example

• Small changes in revenue can have a big impact on profit, especially for
high gross margin and low net profit % industries:
An aircraft has 100 seats, and there are two types of
Percentage change in profit for different gross margins, revenue increases
and net profits as a percentage of revenue. fares: full ($500) and discount ($100). Although there
is unlimited demand for the discount fare, demand for
Net profit % = 2% Net profit % = 6%
full fare is estimated to be equally likely anywhere
Revenue increase Revenue increase
Gross Gross between 11 and 30. How many seats should be
margin 1% 2% 5% 8% margin 1% 2% 5% 8%
100% 50% 100% 250% 400% 100% 17% 33% 83% 133% protected for full-fare passengers?
90% 45% 90% 225% 360% 90% 15% 30% 75% 120%
75% 38% 75% 188% 300% 75% 13% 25% 63% 100%
50% 25% 50% 125% 200% 50% 8% 17% 42% 67%
25% 13% 25% 63% 100% 25% 4% 8% 21% 33%
15% 8% 15% 38% 60% 15% 3% 5% 13% 20%

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Yield management decisions The connection to the newsvendor

• The booking limit is the number of airline seats you are willing to sell in a
fare class or lower. • A single decision is made before uncertain demand is realized.
• The protection level is the number of airline seats you reserve for a fare class
• There is an overage cost:
or higher.
• Let Q be the protection level for the high fare class. – If D < Q then you protected too many seats (you over protected) ...
• Q is in effect while you sell low fare tickets. – … so some seats are empty which could have been sold to a low fare
• With two fare classes, the booking limit on the low fare class is 100 – Q: traveler.
– You will sell no more than 100 – Q low fare seats because you are
protecting (or reserving) Q seats for high fare customers. • There is an underage cost:
0 100 – If D > Q then you protected too few seats (you under protected) …
– … so some seats could have been sold at the high fare instead of the
low fare.
Sell no more than the low Q seats protected for • Choose Q to balance the overage and underage costs.
fare booking limit, 100 - Q high fare customers
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 Discount Seat Allocation Discount Seat Allocation
Protected too few seats;
loose additional margin
Demand of full Cu 400
fare customers
of full fare customers = = 0.8 Interpretation ?
Cu = 500 – 100 = 400 Cu + C0 500
Demand Probability Cumulative
11 0.05 0.05
Demand 12 0.05 0.10
Shortage 13 0.05 0.15
.
.
Excess
Flight takes 25 0.05 0.75
Batch size
decision off 26 0.05 0.80
27 0.05 0.85
Protected too many seats;
Seats reserved for loose margin 28 0.05 0.90
FULL fare customers of low fare customers 29 0.05 0.95
30 0.05 1.00
Co = 100
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The solution Related calculations

• On average, how many high-fare customers will be refused a reservation?

“Protect 26 seats” for full-fare customers – Expected lost sales = 0.05*1 + …+ 0.05* 4 = 0.5

• On average, how many high-fare customers will be accommodated?

# of seats available at discount fare: – Expected sales = Expected demand – Lost sales = 20.5 – 0.5 = 20
100-26=74 • On average, how many seats will remain empty?
– Expected left over inventory = Q – Expected sales = 26 - 20 = 6

• What is the expected revenue?

– $500 * Exp. sales + $100 * Booking limit (100-26) =$17,400.
– Note: without yield management worst case scenario is $100 x 100 =
$10,000.

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Revenue management challenges … Discount Seat Allocation

• Demand forecasting.
– Wealth of information from reservation systems but there is seasonality, special Three Fare classes: Full, Medium, Low Fare
events, changing fares and truncation of demand data.
• More than 2 fare classes Nested Control
• Dynamic decisions.
• Variable capacity:
– Different aircrafts, ability to move rental cars around.
• Group reservations.
• Multi-leg passengers/multi-day reservations for cars and hotels: 100 Deep Discount Fare,
seats Medium Fare & Full
– Not all customers using a given piece of capacity (a seat on a flight leg, a room Medium Fare
for one night) are equally valuable. Fare
& Full Fare
• How to construct good “fences” to differentiate among customers?
– One-way vs round-trip tickets. No. of seats
– Saturday-night stay requirement. Protected for
– Non-refundability.
Full fare
– Advanced purchase requirements.
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 Ugly reality: cancellations and no-shows

• Approximately 50% of reservations get cancelled

at some point in time.
Revenue Management: • In many cases (car rentals, hotels, full fare airline
passengers) there is no penalty for cancellations.
• Problem:
Overbooking – the company may fail to fill the seat (room,
car) if the passenger cancels at the very last
minute or does not show up.
• Solution: sell more seats etc. than capacity
• Danger:
– some customers may have to be denied a seat
even though they have a confirmed
reservation.
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An example “Overbooking” problem Solving the Overbooking Problem

Marty Ford is an operations analyst for Piedmont Commuter Airlines (PCA). Sold too many seats /
# of passengers Demand > Capacity
Marty was asked to determine how many reservations PCA should book on Flight
who show up
343, a flight from a small regional airport to a major hub. Historical data show Cu = 155 – 85 = 70
that PCA frequently has seats left, if it accepts only 19 reservations (the plane’s
capacity). Industry statistics show that for every ticket sold for a commuter flight,
a 0.10 probability exists that the ticket holder will not be on the flight. Demand
PCA sells nonrefundable tickets for Flight 343 for $85 per seat. Thus, every Shortage
empty seat on this flight represents an opportunity cost, because the seat could
have be filled by another passenger paying $85. On the other hand, if PCA
overbooks and more than 19 passengers show up, some of them will have to be Excess
bumped to the next available flight. To compensate for the inconvenience of Batch size Flight takes
being bumped, PCA gives these passengers meal, and sometimes hotel, vouchers decision off
and a coupon for a free flight. Overall, it costs PCA an average of $155 for each
passenger who gets bumped. Sold too few seats /
# of seats to sell Demand < Capacity
Marty wants to determine whether PCA can increase profits by overbooking this
flight and, if so, how many reservations should be accepted to produce the Co = 85
maximum
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“Newsvendor Solution” Environments suitable for revenue management

Cu 70 • The same unit of capacity (e.g., airline seat) can be used to deliver
= = 0.45 Interpretation ?
Cu + Co 70 + 85 services to different customer segments (e.g., business and leisure
customers) at different prices.
Prob. (Demand ≤ 19) ≥ 0.45
• High gross margins (so that the variable cost of additional sales is low).
Passenger show-up prob. = 0.9
If you accept N reservations, distribution of total # of passengers who show-up: • Perishable capacity (it cannot be stored) and limited capacity (all
possible customers cannot always be served).
BINOMIAL (N,0.9)
• Capacity is sold in advance of demand.
N Cumulative Prob. = BINOMDIST (19, N, 0.9, TRUE)
• There is an opportunity to segment customers (so that different prices
19 1.00
can be charged) and different segments are willing to pay different
20 0.878
prices.
21 0.635
22 0.379 • It is not illegal or morally irresponsible to discriminate among
customers.
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 Revenue management summary Class Overview

• Yield management and overbooking give demand flexibility where supply • Process Analysis
flexibility is not possible. – Capacity calculations
– Capacity calculations with setup times
• The Newsvendor model can be used: • Effect of Variability
– Single decision in the face of uncertainty. – Queue length
– Underage and overage penalties. – Little’s Law
• Effect of Setup Costs
• These are powerful tools to improve revenue:
– Optimal Batch size (EOQ)
– American Airlines estimated a benefit of $1.5B over 3 years. – Setup cost and holding costs
– National Car Rental faced liquidation in 1993 but improved via yield
• Betting on Uncertain demand – the Newsvendor Model
management techniques.
– Critical ratio – target service level
– Delta Airlines credits yield management with $300M in additional
– Performance measures (Service level, fillrate, expected profits, …)
revenue annually (about 2% of year 2000 revenue.)
– Application in contract agreements
– Application in Revenue Management
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Class Overview Final Exam: Dec. 1st 1pm – 4 pm

• Uncertain Demand with Multiple Periods • Review Session (going over old exam): Thursday, 26.11., 4:20pm
– Continuous Review • What is on the test?
– Periodic Review – Mix of quantitative and qualitative questions (75% - 25%)
– Look at practice problems / old exam
• Supply Chain Strategies • What can I use during the test?
– Quick response – Your own calculator – You may NOT use cell phones as calculators & you
may NOT share calculators!
– Various forms of risk pooling (location pooling, lead time pooling,
– Same formula sheet and tables provided in class – distributed with the exam.
standardization, delayed differentiation, …)
• What to do during test?
• Supply Chain Coordination – Show CALCULATIONS – otherwise NO full credit even for correct answers
– Causes and effects of bullwhip effect – Skip a question you do not know how to approach – and come back to it at the
end, if you have time.
– VMI – Attempt all question, even if you are not sure. I will give partial credit!
– Contractual agreements to coordinate SC • What if I have a question during the exam?
– I will be at the exam room during the test to answer questions. Since there are
several rooms, I will go back and forth between them.

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One last request…

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Thanks for your participation …

… and good luck in the final !

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