12
Pricing and Revenue
Management
Supply Chain Management_Janat Shah
Learning Objectives
 What is revenue management?
 Why do firms offer differential prices to different market segments?
 What are the conditions under which revenue management can be
practised in an effective way?
 How do firms make optimal pricing decision in the context of
revenue management?
 Why does the fashion industry offer markdown pricing during the
end of the season?
Supply Chain Management_Janat Shah
Revenue Management
 The traditional approach involves hierarchical decision making
 Marketing function makes decisions on pricing and other marketing variables
and supply chain function makes relevant supply chain decisions .
 In limited supply situation , it is important to make integrated decisions where
pricing decisions in particular and overall marketing decisions in general should
factor in limited supply availability.
 Supply is limited by the available capacity in perishable products or service
situations. Since one can not store perishable products and services, the
capacity of plane or a hotel or a truck restricts the supply position in these
businesses.
 Supply is limited by available inventory in long lead time supply situations.
The ability to handle demand is constrained by the fact that the supplier needs a
long lead-time and, within that period the firm has to manage with the
inventory available at hand.
 Under conditions of limited supply, the bulk of the capacity and supply-related
costs have already been incurred and consequently revenue management
attempts to make optimal pricing decision so that the firm can generate the
highest possible revenue so as to generate the highest possible profit.
Supply Chain Management_Janat Shah
Optimal Pricing Decision:
Single Customer segment
 Linear demand curve
D= a- b p
D= demand and p = price and a & b are parameters of demand curve
 Pricing : No capacity constraint , zero variable cost
P* = a/2b & Revenue* = a 2/4b
P* & Revenue* = optimal price & Revenue respectively
 Pricing under capacity constraint
P* = (a – capacity)/b
 Pricing in a situation involving significant variable cost
P* = ( a+bc) /2 b where c= variable cost
Supply Chain Management_Janat Shah
Demand and Revenue Curve
Demand = 160- 20* price
Revenue = 160* Price - 20 * Price 2
Supply Chain Management_Janat Shah
Revenue Management for Multiple Customer
Segments
 Required conditions for Applicability of Revenue Management
 Capacity is perishable
 One can not store unused airline seat or unused hotel room
 The same unit of capacity can be used to deliver product or
service to different submarkets having their own demand curves
with differing price elasticity.
 Leisure and Business traveller would use identical seat/room
 Using appropriate booking rules firm can create a fence among
the relevant submarkets.
 Leisure Traveller is willing to book early and does not mind
no cancellation policy while Business traveller would book
close to the travel date and would value flexibility of
cancelling at last minute
Supply Chain Management_Janat Shah
Demand Curve for Multiple
Customer Segments
Demand = 160 -20 p if price > 4
Demand = 400- 80p if price ≤ 4
Supply Chain Management_Janat Shah
Impact of Different Price Schedule on
Revenue Under Capacity Constraints
How to determine optimal prices ? : Optimization model
Supply Chain Management_Janat Shah
Pricing Under Capacity Constraint for Multiple
Segments: Demand Deterministic: Optimization Model
 (a
Maximize
i
 bi Pi ) * Pi
i
Subject to
 (a
i
 bi Pi ) * Pi
≤ Capacity
i
( ai - bi Pi ) ≥ 0 for i= 1.. n
i= 1.. n represent n market segments

(ai
 bi P
i )
i
Supply Chain Management_Janat Shah
Revenue Management under Uncertain
Demand and Limited-capacity Situations
Capacity allocation under multiple segments
 Low price segment has unlimited demand ( at least more than
capacity ) & High price segment has uncertain demand
 Low price segment demand/booking is observed before the High
price segment demand is realised
 Capacity for price segment needs to be reserved by placing limit on
low price booking.
 Illustrations
 Business segment versus leisure segment in travel and hotel
industry: Prices are high in Leisure segment but demand is
uncertain. Prices are low in leisure market but demand is
high ( usually more than capacity)
 Forward versus spot market in business to business markets
where capacity : Spot market is les price sensitive but
demand is uncertain. Prices are low in Forward market but
demand is high ( usually more than capacity)
Supply Chain Management_Janat Shah
Capacity Allocation Among Multiple
Segments: Airlines and Hotels
 Let Pb be a price charged to the business traveller and Pl the price
charged to the leisure traveller.
 Cost of understocking = Pb - Pl
Cost of overstocking = Pl
 Optimal Service Level =
(CU  100) / (CU + CO ) = (Pb - Pl )*100/( Pb - Pl + Pl )

= (Pb - Pl )*100/ Pb
 Optimum protection level for the high-price segment = Mean
demand for the high-price segment+ k  Standard deviation of the
demand for high price
 Where k = service factor for optimal service level
Supply Chain Management_Janat Shah
Capacity allocation among Multiple segments
: Airline industry - Illustration

Super Airlines case : The seating capacity of each aircraft is 180
seats.
 Super Airlines decided to charge Rs 2000 for leisure travellers
(who are expected to book 14 days ahead of the scheduled flight
day) and Rs 5000 for business travellers.
 With price of Rs 2000 for leisure travellers, demand is more than
180.
 At price of Rs 5000, demand for business travellers is likely to
follow normal distribution with mean demand being 60 seats
with standard deviation of demand being 20 seats.
 Optimal booking limit for low-price fares:
CU = Pb - Pl = 5000- 2000= 3000 & CO = Pl = 2000
Optimal Service Level = 3000*100/ (3000+2000) = 60%
service level of 60% means k ≈0.25
= 60 + 0.25*20 = 65
High-price protection level for business travelers = 65 seats
Booking limit for low price fares = 180-65 = 115 seats.
Supply Chain Management_Janat Shah
Capacity Allocation Among Multiple
Segments: Forward-versus-spot Market
 Forward price is Pf and spot price is Ps
 Cost of understocking = Ps - Pf
Cost of overstocking = Pf
 Optimal Service Level =
(CU  100) / (CU + CO ) = (Ps - Pf )*100/( Ps - Pf + Pf )
= (Ps - Pf)*100/ Ps
 Optimum protection level for the spot market segment = Mean
demand for the spot market segment+ k  Standard deviation of the
demand for spot market segment
 Where k = service factor for optimal service level
Supply Chain Management_Janat Shah
Capacity Allocation Among Multiple
Segments: Forward-versus-spot Market
Warehousing firm Case : Firm has a warehouse in Gurgaon and a the
firm rents out capacity for a month as a unit of time. It has physical
warehousing space for storing 50000 MT of goods and is trying to
decide on how much capacity to reserve for spot market customers for a
coming December month.
 Forward market : Unlimited demand , market prices are Rs. 150 per
MT
 spot markets prices are 200 per MT. Demand for warehousing
capacity in spot market in December follows normal distribution
with mean demand being 10000 MT with standard deviation of
demand being 3000 MT.
 Ps = 200 & Pf = 150
Cost of understocking = Ps - Pf = 50 & Cost of overstocking = Pf = 150
Optimal Service Level = 50*100/200 = 25% → k= - 0.7
Optimum reserve capacity for spot market = 10000 -0.7 * 3000 = 7900
MT

Supply Chain Management_Janat Shah
Overbooking : Revenue Management for
Handling Booking Cancellations
 Overbooking is the practice of booking seats/rooms in excess of the actual
seats available in flights or rooms available in hotel.
 Whenever there are chances of cancellations (at the last hour) or no-shows
(customer not showing up), if airlines/hotels does not do overbooking, it will
end up with a lot of unused capacit
 Optimum overbooking
p= price for the unit of capacity sold
b = net cost incurred in making backup arrangements in case the firm is not
able to provide the booked unit of capacity to the customer.
Cost of understocking* = p
Cost of overstocking* = b
Optimal Service Level = p*100/(p+b)
Optimum number of over-bookings = Mean cancellations + k  Standard
deviation of cancellations where k = service factor for optimum service level
* Stocking refers to excess bookings ( Bookings above capacity )done by
Airline/hotel
Supply Chain Management_Janat Shah
Overbooking: Illustration
 Bangalore Hotel has 100 deluxe rooms and has observed in the past
that cancellations at the last minute (including no shows) follow a
normal distribution with mean of 15 and standard deviation of 5.
 The hotel charges room rent of Rs. 2600 per day from all its
customers. Because of overbooking policy, whenever Bangalore
Hotel faces shortage of rooms it accommodates the customers in
another hotel in the neighbourhood which charges Rs; 4000 to
Bangalore Hotel for providing rooms at short notice.
 Optimum Overbookings:
C u = P= 2600 and C o = b= 4000 -2600 = 1400.
Optimal Service Level = 2600 *100/ (2600 +1400) = 65 % → k ≈
0.4
Optimum number of over-bookings = Mean cancellations + k 
Standard deviation of cancellations where k = service factor
So optimum number of over-bookings = 15 + 0.4 * 5 = 17
Supply Chain Management_Janat Shah
Revenue Management for Inventory Assets
 In short life cycle product Demand over season is highly uncertain
But usually order for entire season is placed before the start of
season
 Standard Practice: If Seasonal demand < Order, excess stock is
salvaged at the end of season
 Markdown Management: Forecast is updated based on demand
observed during initial part of the season and if Updated Demand <
Inventory, Prices are reduced ( marked down) so as to Maximise
revenue over the Season .
Supply Chain Management_Janat Shah
Markdown Management: Illustration
 Season consist of Four periods and demand is updated at the end of
period1 & entire requirement for the season is ordered in advance
 Updated Demand = 150 units per period
 Opening stock at the beginning of period 2 = 694 units, Base price=
500 Rs./Unit, Salvage Value at the end of season= Rs. 30/unit
 Possible Markdown options:
Markdown
Demand Increase
0%
0%
20%
30%
40%
70%
 Markup not allowed
Supply Chain Management_Janat Shah
Markdown Management:
Impact of Markdown Options on Revenue
Supply Chain Management_Janat Shah
Markdown Management:
Impact of Markdown on Sales and Revenue
Markdown
Option
Period-2
Sales(Units)
Period-3
Period-4
Period-2
Period-3
Tot-Rev
Period-4
1
0
0
0
150
150
150
232320
2
0
0
20
150
150
195
233970
3
0
0
40
150
150
255
230670
4
0
20
20
150
195
195
235620
5
0
20
40
150
195
255
232320
6
0
40
40
150
255
255
229020
7
20
20
20
195
195
195
237270
8
20
20
40
195
195
255
233970
9
20
40
40
195
255
244
227700
10
40
40
40
255
255
184
208200
Supply Chain Management_Janat Shah
Innovative Pricing
 Firm can offer differential prices to customers even in a situation where there
are no capacity constraints.
 Use of Rebate coupons by P &G
 Use of Happy hours by Pubs & Restaurants
 Differential prices charged by Amazon.com
 Brand loyal customers ( customers who do not search over net for
price comparisons) were charged prices
 Coca-cola experimented with idea of changing prices at smart kisoks
based on season and temperature and based on location of Kiosk.
 Higher prices charged on hotter day, Kiosks located close to football
field would charge higher prices on the day of the match
 Firm should ensure that differential pricing schemes are not perceived as
unfair practices by customers
 Amazon.com and Coca Cola discontinued differential pricing schemes
when they found that customers perceived theses practices as “unfair”
 Extreme case of differential pricing would involve customized pricing where
each customer is charged different prices based on his utility and willingness
to pay.
Supply Chain Management_Janat Shah
Summary-I
 In a situation where capacity is perishable, the bulk of the capacity
and supply-related costs have already been incurred, revenue
management attempts to make optimal pricing decision so that a firm
can Maximize both the revenue, and by extension, the profit.
 Revenue management can be practiced where the same unit of
capacity can be used to deliver product or service to different
submarkets having their own demand curves with differing price
elasticity.
 Firm should be able to come up with innovative way of separating
different submarkets so that firm can offer differential pricing
schemes. Using different booking conditions, firm should be able to
create a fence between various submarkets.
Supply Chain Management_Janat Shah
Summary-II
 As different submarkets book capacity at different point in time,
firm has to a priory allocate capacity to various submarkets. In
uncertain demand situations firm faces a delicate decision regarding
how much capacity to reserve for high fare paying customers who
usually book capacity at later point in time. Given uncertainty in
demand, while reserving capacity for high fare paying customers
firm has to balance cost of over-reserving versus cost underreserving.
 Firm can use ideas of revenue management in any industry ( not
restricted to case of perishable capacity context) by applying
innovative pricing scheme like customised pricing so as to increase
revenues and profits.
Supply Chain Management_Janat Shah