Chapter -3

Pricing and Revenue Management

LEARNING OBJECTIVES

After reading this chapter, you will be able to

1. Understand the role of revenue management in a supply chain.

2. Identify conditions under which revenue management tactics can be

effective.

3. Describe trade-offs that must be considered when making revenue

management decisions.
 Pricing
Pricing is a process of fixing the value that a manufacturer will receive in
the exchange of services and goods.

Setting a price for a product or service can be a challenge, as many

variables factor into determination of a price.

Costs
Costs are anything that contributes to the expense of the product or
service provided by a business.

Profit
P = Revenue – Cost

Revenue is defined as the total amount of money a business receives

from sales and investments.

R = Price x Quantity
Costs are typically broken down into two categories

 Fixed Costs

 Variable Costs
 Pricing refers to how companies should set and
adjust their prices in order to maximize profitability
 Revenue Management
Supply chain assets are fixed but demand fluctuates, the matching of supply and
demand is a constant challenge.

Revenue management is the use of pricing to increase the supply chain surplus
and profit generated from a limited availability of supply chain assets.

Supply chain assets exist in two forms-

• Capacity
• Inventory
Capacity assets in the supply chain exist for production, transportation, and
storage. Inventory assets exist throughout the supply chain and are carried to
improve product availability.
Revenue Management Process
Revenue Management Process
 RM for Multiple Customer Segments

Consider a trucking firm that has purchased six trucks, with a total
capacity of 6,000 cubic feet, to use for transport between Chicago and
St. Louis. The monthly lease charge, driver, and maintenance expense
is $1,500 per truck. Market research has indicated that the demand
curve for trucking capacity is
d = 10,000 - 2,000p
 RM for Multiple Customer Segments

The presence of multiple customer types, revenue management aims to grow profits
by selling the right asset to the right customer at the right price.
P1: A contract manufacturer has identified two customer
segments for its production capacity— one willing to place
an order more than one week in advance and the other
willing to pay a higher price as long as it can provide less
than one week’s notice for production. The customers that
are unwilling to commit in advance are less price sensitive
and have a demand curve d1 = 5,000 - 20p1. Customers
willing to commit in advance are more price sensitive and
have a demand curve of d2 = 5,000 - 40p1. Production cost
is c = $10 per unit. What price should the contract
manufacturer charge each segment if its goal is to
maximize profits? If the contract manufacturer were to
charge a single price over both segments, what should it
be? How much increase in profits does differential pricing
provide?
P2: EBike, an electronic bicycle manufacturer, has identified
two customer segments, one is willing to pay a higher price for a
customized bicycle and the other one is more price sensitive and
is willing to pay for standard bicycles. Demand curve for the
customers willing to pay for customized bicycles is d1 = 11,000 -
25p1. Demand curve for the more price sensitive customers is d2
= 11,000 - 45p2. Assume production cost for each bicycle
(standard and customized) is c = $160 per unit.

1. What price should eBike charge each segment if its goal is to

maximize profits?
2. If eBike was to charge a single price over both segments, what
should it be?
3. How much increase in profits does differential pricing provide?
Allocating Capacity to a Segment Under
Uncertainty
Example 3: Allocating Capacity to a Segment Under Uncertainty
Trucking company serves two segments of customers. One segment
(A) is willing to pay $3.50 per cubic foot but wants to commit to a
shipment with only 24 hours notice. The other segment (B) is willing
to pay only $2.00 per cubic foot and is willing to commit to a
shipment with up to one-week notice. With two weeks to go, demand
for segment A is forecast to be normally distributed, with a mean of
3,000 cubic feet and a standard deviation of 1,000.

• How much of the available capacity should be reserved for segment

A?

• How should change its decision if segment A is willing to pay $5

per cubic foot?
Example 4

Demand for hotel rooms at the high rate is normally distributed with
mean 102 and standard deviation 20.8. Also assume that the high rate
is 181 dollars and low rate (discount rate) is 128 dollars.

• How much of the available capacity should be reserved for higher

rate?

1 – pL/pH = 1 – 128/181 = 0.2928

Convert that probability into the number of rooms

NORMINV(1 – pL/pH, DH, H) = NORMINV(0.2928, 102, 20.8) = 91

Example 5

A small warehouse has 100,000 square feet of capacity. The manager at the
warehouse is in the process of signing contracts for storage space with customers.
The contract has charged a fee of $3 per square foot based on actual usage. The
warehouse guarantees the contracted amount even if it has to arrange for extra
space at a price of $6 per square foot. The manager believes that customers are
unlikely to use the full contracted amount at all times. Thus, he is thinking of
signing contracts that exceed 100,000 square feet. He forecasts that unused space
will be normally distributed, with a mean of 20,000 square feet and a standard
deviation of 10,000 square feet.

What is the total size of the contracts he should sign?

Capacity reserved for higher segment =NORMINV(1-3/6,20000,10000)

= 20000 square feet

Total size of the contract he should sign =100000+20000 =120000 square feet
 Overbooking is the practice of
selling more bookings or goods than
can be accommodated.

Overbooking is often one part of a

Overbooking business strategy that can lead to
optimal or full occupancy.

underage cost: is the cost incurred

per unit of unmet demand
overage cost: is the cost incurred
per unit of unused inventory
Overbooking
The production capacity available from the supplier is 5,000 dresses, and it makes
$10 for each dress. The supplier is currently taking orders from retailers and must
decide on how many orders to commit to at this time. If it has orders that exceed
capacity, it has to arrange for backup capacity, which results in a loss of $5 per dress.
Retailers have been known to cancel their orders near the winter season as they have
better visibility in to expected demand. How many orders should the supplier accept
if cancellations are normally distributed, with a mean of 800 and a standard
deviation of 400? How many orders should the supplier accept if cancellations are
normally distributed?

In this case, the supplier should overbook by 973 dresses and take orders for a total of 5,973
dresses.
Example
Blue Air lines primarily targets two segments of customers, business travellers and economy
travellers. It is currently operating at different regions of the country. However, the traffic in
Delhi-Mumbai route happens to be maximum. The airline wants to maximize its revenue in
this route from both categories of travellers. The airline charges Rs 6000 from business
travelers and Rs2500 from economy travellers for a single seat. The capacity of an aircraft is
150. The authorities of the airlines are concerned with finding out as to how many seats are to
be kept reserved for business travellers. It has maintained some past data relating to the
demand of seats for business travellers. The airlines has further estimated that the demand for
business travellers is likely to follow a normal distribution, with mean demand and standard
deviation of demand being 40 and 15, respectively.

a. What will be the optimum level of service to be provided to the passengers?

b. How many seats should be kept reserved for business travellers?

Example
Blue Airlines follows the practice of overbooking of seats in order to maximize the
generation of revenues from its customers The capacity of the aircraft is 150 The airlines
charges an average of Rs 4000 from its customers on the Mumbai Delhi route Because of
the policy of overbooking, sometimes the airlines has to face shortage of seats Whenever it
faces shortage of seats, it accommodates the passengers in another airline, which charges Rs
6000 from Blue Airlines for providing seats at short notice The airlines has kept past data in
respect of last minute cancellations It is found that the number of cancellations
approximately follows a normal distribution, with a mean of 18 and a standard deviation of
6.

a. What will be the optimum level of service to be provided to the passengers?

b. How many seats should be kept reserved for business travellers?

Example

Super Airlines decided to charge Rs2000 for leisure travellers (who are expected to
book 14 days ahead of the scheduled flight day) and Rs5000 for business travellers.
With price of Rs2000 for leisure travellers, demand is more than 180. At price of
Rs5000, demand for business travellers is likely to follow normal distribution with
mean demand being 60 seats with standard deviation of demand.

a. What will be the optimum level of service to be provided to the passengers?

b. How many seats should be kept reserved for business travellers?

c. How many seats should be kept reserved for leisure travellers?

Example 7