Chapter 13 Smart Pricing SCM SCM 13.1 Introduction Implicit assumption so far has been that demand cannot be influenced In reality, this is not true Demand level changes can be made through: Advertising, displays, and promotional tools Pricing 13-2 Dell’s Pricing Strategy Product price different based on type of customer Product price varies over time Prices of options offered also vary over time 13-3 Other Examples IBM is investigating software that will allow it to adjust prices according to demand Nikon Coolpix Digital Camera sold for about $600. Manufacturer provides a rebate of $100 independently of where the camera is purchased Boise Cascade Office Products sells many products on-line Prices for the 12,000 items ordered most frequently on-line might change as often as daily 13-4 Different Pricing Objectives 13-5 Questions Related to Pricing What are these companies doing? Why does Dell charge a different price for different consumers? At different times? If Dell can do it, can it work for other companies? What is the impact of the mail-in rebate? Shouldn’t Nikon and Sharp just reduce the wholesale price paid by the retailers instead of asking the consumer to mail in the coupon? What is wrong with a traditional fixed-price policy? 13-6 Issue Matching supply with demand How the supply process can be better managed to match demand OR How demand can be adjusted to match supply The various techniques to achieve the later are known as Revenue Management (Yield Management) 13-7 Revenue Management Revenue management is the practice of differential pricing to increase supply chain profits A strategy that adjusts prices based on product availability, customer demand, and remaining duration of the sales season will result in higher supply chain profits 13-8 Revenue Management Revenue management, also called yield management, and sometimes smart pricing, is a technique to optimize revenue from a fixed, but perishable inventory. Is revenue management possible for… Airline tickets Cruise travel Restaurants Hospitals LTL trucking companies Apartment rental Incoming MBA class Vending machines Revenue Management: Maps capacity into demand Newsvendor problem: Maps demand into capacity 13-9 Revenue Management and Vending Machines Coca-Cola announces that it is considering vending machines that will boost prices during hot weather. “Coca-Cola is a product whose utility varies from moment to moment. In a final summer championship, when people meet in a stadium to enjoy themselves, the utility of a chilled Coca-Cola is very high. So it is fair it should be more expensive. The machine will simply make this process automatic.” Douglas Ivester, Chairman and CEO 13-10 Revenue Management Principles All companies trying to boost profit by using what are know as smart pricing or revenue management techniques Techniques first pioneered by the airline, hotel, and rental car industries. Airline industry Revenue management has increased revenue significantly American Airlines’ estimates of annual incremental revenue of $1 billion through revenue management 13-11 Other success stories Marriott hotels increased annual revenue with $100 million through revenue management National Car Rental was saved from liquidation through revenue management Canadian Broadcasting Corporation increased revenue with $1 million per week 13-12 Conditions for Revenue Management The value of the product varies in different market segments The product is highly perishable or product waste occurs Fashion and seasonal apparel High tech products Demand has seasonal and other peaks Airline seats: leisure versus business travel Cruise travel The product is sold both in bulk and on the spot market Owner of warehouse who can decide whether to lease the entire warehouse through long-term contracts or save a portion of the warehouse for use in the spot market 13-13 Airfare example q 1000 800 Choose the fare that maximizes the area (revenue) of the rectangle 600 400 200 200 400 600 800 1000 p 13-14 Airfare example q 1000 800 Choose the fare that Unaccommodated maximizes the area demand (revenue) of the rectangle 600 Maximum revenue 400 = 500*500 = $250,000 200 Consumer surplus 200 400 600 800 1000 p 13-15 Airfare example q 1000 Choose the fare that maximizes the SUM of areas of the rectangles 800 Economy class Maximum revenue 600 400 = 333*(333 + 667) = $333,000 Business class 200 200 400 600 800 1000 p 13-16 Airfare example q 1000 Choose the fare that maximizes the SUM of areas Economy class of the rectangles 800 Economy plus class Maximum revenue 600 400 200 = 200*(800+600+400+200) Business class = $400,000 First class 200 400 600 800 1000 p 13-17 Airfare example q 1000 800 600 Perfect price discrimination Charging a different price to a different buyer for the same product without any true cost differential to justify the different price Maximum revenue = $500,000 400 200 200 400 600 800 1000 p 13-18 13.2 Price and Demand All things being equal Demand for a product will typically go up as the product’s price goes down Certain products more or less sensitive to price changes In general the property holds Downward-sloping demand curve 13-19 Manager’s Issue What is the optimal price at which revenue is maximized? Need to characterize the relationship between pricing and demand for each product Utilize this characterization to determine the optimal price for each product May involve many complexities Vast quantities of data may need to be analyzed Competitors’ behavior may need to be captured Many firms do manage to at least approximate this relationship. 13-20 Example – Single Product Management estimates the relationship between demand, D, and price, p D = 1,000 - 0.5p When the p=$1,600, D=200 When the p=$1,200, D=400 13-21 Price vs Revenue Table Price Demand Revenue $250 875 $218,750 $500 750 $375,000 $750 625 $468,750 $1,000 500 $500,000 $1,250 375 $468,750 $1,500 250 $375,000 Maximum Revenue = $500,000 when price = $1,000 13-22 Demand-Price Curve FIGURE 13-1: Price/Demand curve for Example 13-1 13-23 13.3 Markdowns Assumption in example: demand is deterministic based on price Realistic picture Demand is random At the end of a selling season, there may be remaining inventory Firms frequently employ a markdown or sale to dispose excess inventory Think about demand from the customer’s perspective: Each customer has a maximum price that he or she is willing to pay for the product Reservation price 13-24 Markdown Concept When the p=$1,200, D=400 400 customers have a reservation price at or above $1200 When the price is below their reservation price, they will buy The lower the price, the more customers with a reservation price at or above that price Sell product to customers whose reservation prices were below the original price, but above the sale price. Traditionally, retailers have tried to avoid markdowns Evidence of mistakes in purchasing, pricing, or marketing Low reservation price customers seen as: less desirable or profitable, useful to get rid of the excess inventory 13-25 13.4 Price Differentiation Customers who are willing to buy at sales price were different than the customers who were willing to buy at original price In fashion, some customers are very fashion conscious Other customers are value-conscious Eager to buy at the start of the selling season Willing to pay more to have fashionable items first Willing to wait until the end of the sales season Unwilling to pay the same high prices as the fashionable customers Different customers charged different prices can result in higher revenue 13-26 Price Differentiation Example According to the demand–price curve, the retailer charges many customers who are willing to pay a higher price only $1000 About 200 customers willing to pay $1,600 About 100 willing to pay $1,800 By charging a single price, management is leaving a large amount of money on the table 13-27 Multi-tiered Pricing Strategy Money left on the table = (2,000 - 1,000) • 500/2 = 250,000 Consider a differential or customized pricing strategy Consider a two-price strategy in which the firm introduces two prices, $1,600 and $1,000. Tailors pricing to different market segments At a p=$1,600, there is demand for 200 items At a p= $1,000, there is demand for 500 items Total revenue in this case is 1,600 • 200 + 1,000 • (500 - 200) = 620,000 $120,000 more than in the single-tier strategy A three-tier pricing strategy can do even better At p=$1,800, D=100; p=$1,600, D=200; p=$1,000, D=500 Total revenue equals 1,800 • 100 + 1,600 • (200 - 100) + 1,000 • (500 - 200) = 640,000 $20,000 more than in two-tier strategy 13-28 Three-Tier Pricing Strategy FIGURE 13-3: Three-Tier Pricing Strategy 13-29 13.5 Revenue Management Selling the right inventory unit to the right type of customer, at the right time, and for the right price Integrates pricing and inventory strategies to influence market demand, Provides controls for companies to improve the bottom line Revenue management techniques have been traditionally applied in the airline, hotel, and rental car industries Common characteristics of such industries: existence of perishable products fluctuating demand fixed capacity of the system segmentation of the market based on sensitivity to price or service time products sold in advance 13-30 History of Revenue Management Pioneered by American Airlines in the 1980s As a counter to new airlines like PeopleExpress Techniques employed differentiated pricing Widely successful PeopleExpress went out of business Other airlines started adopting Hotels and rental companies adopted later 13-31 Customer Segments in Airline Industry Leisure travelers Highly sensitive to price Not generally sensitive to the duration of the trip Willing to book non-refundable tickets far ahead of time Business travelers Not particularly price-sensitive Highly sensitive to trip duration Need high flexibility to adjust their travel plans as needed 13-32 Customer Differentiation in the Airline Industry FIGURE 13-4: Customer differentiation in the airline industry 13-33 Differential Pricing “Build fences” to prevent business travelers from moving from the top-left box to the bottomright box Require weekend stays and early booking The more fare classes, the more fences required Other factors: How many of each type of ticket to offer? How much to price for each ticket 13-34 Revenue Management Systems Market Segmentation For a specific time and flight (origin to destination), Different products designed and priced to target different market segments Products feature different restrictions Booking Control Non-refundable Available up to 21 days before the flight. Allocates available seats to fare classes Setting limits on the number of seats that can be allocated to lower fare classes Requires: Sophisticated algorithms Basic criterion: Equal marginal revenues in each class 13-35 Optimal Allocation of Flights Leisure fare is $100 per ticket Business fare is $250 per ticket 80 seats on the plane Company can sell as many seats as they make available at the leisure fare Business fare is random 13-36 Demand Distribution for Business Fares FIGURE 13-5: Demand distribution for Example 13-4 13-37 Marginal Revenues of the Two Classes FIGURE 13-6: Marginal revenue of leisure and business class for Example 13-4 13-38 Marginal Revenues Determine expected revenue for each number of allocated seats Determine expected marginal revenue of business class Marginal revenue associated with leisure class seats revenue associated with allocating one additional seat can also be calculated this decreases as the number of allocated seats increases unlimited demand for seats implies marginal revenue is constant Marginal revenue of the two is equal at 18 seats 18 seats should be allocated to business class 13-39 Complexities of the Real Systems Variety of flight classes Different hierarchies of classes More complex demand information Network management A flight can be part of many ultimate origin-destination pairs System needs to account for this by allocating seats to particular flights Prices change over time Flight may be expensive on some days and times If a plane is not filling up, the airline might increase the allocation of lower price fares to that flight over time 13-40 13.6 Smart Pricing Fundamental Approaches to Smart Pricing Differential Pricing Charging different prices to different customers Dynamic pricing Charging different prices over time 13-41 Differential Pricing Charge different customers different prices according to their price sensitivity Dell does this by distinguishing between private consumers, small or large businesses, government agencies, and health care providers Difficult to do in many cases 13-42 Differential Pricing Strategies Group Pricing Channel Pricing Discounts to specific groups of customers very common in many industries Senior citizen discounts at diners, software discounts to universities, student discounts at movie theaters, “ladies night” at bars Works only when there is a correlation between group members and price sensitivity Charging different prices for the same product sold through different channels Different prices on web sites vs. retail stores Works only if customers who use different channels have different price sensitivities Regional Pricing Exploiting different price sensitivities at different locations Beer is much more expensive in a typical stadium than in a bar 13-43 Differential Pricing Strategies Time-based Differentiation Similar products differentiated based on time Amazon.com charges different rates for different delivery times A technique for segmenting price sensitive customers and customers who are more delivery time sensitive. Dell charges different prices for repair contracts that complete repairs in different amounts of time (overnight vs. within a week) Product Versioning Offer slightly different products in order to differentiate price sensitivities May take the form of branding. Store brand vs Generic brand Additional features added to products at the higher end of the line High end buyers are inclined to buy the higher end products in the line Pay significantly more than the lower end products Cost very little more to manufacture. 13-44 Differential Pricing Strategies Coupons and Rebates Distinguish between customers that place a high value on time or flexibility Those who are willing to spend the time to get a lower price by using a coupon or submitting a rebate form Mail-in rebates at the point of sale Adds a significant hurdle to the buying process Customers willing to pay the higher price will not necessarily send the coupon Do not incorporate fences Require a more detailed analysis. 13-45 Rebates No rebate Each retailer decides on the price and the amount to order from the manufacturer to maximize its profit. Retailer needs to find a price and an order quantity so as to maximize its expected profit Manufacturer would like the retailer to order as much as possible @ the wholesale price Mail-in-rebates manufacturer influences customer demand provides an upside incentive to the retailer to increase its order quantity Retailer’s profit increases Increase in demand forces the retailer to order more from the manufacturer. Optimal order quantity: Compensates for the rebate/ Implies an increase in the manufacturer’s expected profit. 13-46 Why Not Discount the Wholesale Price? Rebate strategy implies not every consumer will mail the coupon to the manufacturer. If the manufacturer merely reduces the wholesale price, the retailer may keep the discount and not transfer it to the customers. Even if the retailer uses the discounted wholesale price to optimize its pricing and ordering decisions, and even if every consumer mails back the rebate, the mail-in rebate strategy is a better strategy for the manufacturer – WHY? 13-47 Mail-in Rebate Strategy Better Assume retailer orders the same amount in both strategies Order quantity < realized demand the two strategies provide the manufacturer with exactly the same profit Order quantity > realized demand Manufacturer’s profit with rebate is larger than its profit under discounted wholesale price 13-48 Dynamic Pricing Retailers change price at the end of the season to get rid of excess inventory Manufacturers change price during the season to distinguish between low and high reservation price customers Use pricing to affect demand 13-49 Dynamic Pricing Better than FixedPrice Strategy Dynamic Pricing may increase profit by 2-6% Significant in industries with low margins Retail industry Computers industry 13-50 Conditions under which Dynamic Pricing Is Superior Available capacity Demand variability Benefit of dynamic pricing increases as the degree of demand uncertainty increases Seasonality in demand pattern Smaller the production capacity relative to average demand, the larger the benefit from dynamic pricing Benefit of dynamic pricing increases as the level of demand seasonality increases Length of the planning horizon Longer the planning horizon, the smaller the benefit from dynamic pricing 13-51 13.7 Impact of the Internet Many approaches of smart pricing made more practical by internet and e-commerce Menu cost cost that retailers incur when changing the posted price Much lower on the Internet than in the off-line world Updating of prices possible on a daily basis Lower buyer search price cost that buyers incur when looking for a product forces competition between sellers leads to a focus on smart pricing strategies 13-52 Impact of the Internet Visibility Customer segmentation to the back-end of the supply chain makes it possible to coordinate pricing, inventory, and production information has facilitated growth of smart pricing using buyers’ historical data is possible on the Internet very difficult in conventional stores Testing capability Internet can be used to test pricing strategies in real time On-line seller may test a higher price on a small group of the site visitors Use those data to determine a pricing strategy 13-53 13.8 Caveats Must avoid the appearance of unfair treatment of customers Amazon.com’s failed experimented with a pricing strategy in which customers were paying different amounts for the same DVD based on demographics or the browser used Coke’s development of a soda machine that would measure the outside temperature, and increase prices as the temperature increased On-line sites Priceline and Hotwire.com provide: an outlet for last-minute, unsold seats and hotel rooms opaque fares “Protects” the published fares promoted by the airlines and hotels themselves When many published fares are about as good as the opaque fares, it is harder to attract customers to the Priceline and Hotwire sites 13-54 SUMMARY Pricing and promotion can be used to influence the level of demand. Traditionally, fashion retailers have used price markdowns to sell off excess inventory at the end of the season. Mid-1980’s: airline executives began to use a set of more sophisticated approaches to manipulating demand. Revenue management has two goals Variety of techniques Differentiate demand Use pricing to adjust aggregate demand Differential pricing Dynamic pricing Made more effective by the Internet and e-business Caveat that customer should not be unfairly treated 13-55 Thank You 13-56 What is Revenue Management? 1000 q 1000 800 800 600 600 400 400 200 200 200 400 600 800 1000 p q 200 400 600 800 1000 p 13-57 Example 15-1: Pricing to multiple segments A contract manufacturer has identified two customers 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 a 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 – 40p2. Production cost is c = $10 per unit. What price should the contract manufacturer charge each segment if its goal is to maximize profits? 13-58 Example 15-1: Pricing to multiple segments c = 10 6000 Demand 5000 4000 d1 = 5,000 – 20p1 3000 2000 1000 0 0 50 100 150 200 250 300 Price 13-59 Example 15-1: Pricing to multiple segments 6000 c = 10 Demand 5000 4000 3000 2000 d1 = 5,000 – 20p1 Profit 1000 0 0 50 100 p-c 150 200 250 300 Price 13-60 Pricing Multiple Segments Assume that the demand curve for segment i is given by di = Ai – Bipi The goal of the supplier is to price so as to maximize profits 6000 Max (pi – c)(Ai – Bipi) 5000 Demand 4000 3000 2000 Profit 1000 0 0 50 100 150 200 250 300 Price 13-61 Pricing Multiple Segments The optimal price for segment i is given by pi = Ai/2Bi + c/2 13-62 Example 15-1: Pricing to multiple segments For segment 1: pi = Ai/2Bi + c/2 Profit pi = 5,000/(2*20) + 10/2 = $130 (pi – 10)(5,000 – 20pi) = (130 – 10)(5,000 – 20*130) = $288,000 For segment 2: pi = Ai/2Bi + c/2 Profit pi = 5,000/(2*40) + 10/2 = $67.50 (pi – 10)(5,000 – 40pi) = (67.5 – 10)(5,000 – 40*67.5) = $127,650 Total profit $415,650 13-63 Example 15-1: Pricing to multiple segments If total capacity is limited to 4,000 units, what should the contract manufacturer charge each segment? For segment 1: p1 = $130 Demand For segment 2: p2 = $67.50 Demand d1 = (5,000 – 20p1) = 2,400 d2 = (5,000 – 40p2) = 2,300 Total demand = 2,400 + 2,300 = 4,700 Total demand exceeds production capacity of 4,000 13-64 Pricing Multiple Segments The goal of the supplier is to price so as to maximize profits Max ∑ki=1 (pi – c)(Ai – Bipi) Maximize profits Subject to: Production capacity ∑ki=1(Ai – Bipi) Q Price pi 0 c Q Segment 1 2 Total 10 4000 Price 141.666666651042 79.1666666744792 Demand =5000-20*B4 =5000-40*B5 =C4+C5 Profit =(B4-B1)*(5000-20*B4) =(B5-B1)*(5000-40*B5) =D4+D5 13-65 Example 15-1: Pricing to multiple segments If the contract manufacturer were to charge a single price over both segments, what should it be? 6000 6000 5000 5000 4000 4000 Demand Demand 3000 2000 3000 2000 1000 1000 0 0 0 50 100 150 200 250 300 Price d1 = 5,000 – 20p1 0 50 100 150 200 250 300 Price d2 = 5,000 – 40p2 d = (5,000 – 20p) + (5,000 – 40p) = 10,000 – 60p 13-66 Example 15-1: Pricing to multiple segments For segment 1 and 2: p = Ai/2Bi + c/2 Max (p – c)(A – Bp) p = 10,000/(2*60) + 10/2 = $83.33 Max (p – 10)(10,000 – 60p) = (83.33 – 10)(10,000 – 60*83.33) = $366,650 Differential pricing raises profit from $366,650 to $415,650 13-67 Revenue Management for Multiple Customer Segments If a supplier serves multiple customer segments with a fixed asset, the supplier can improve revenues by setting different prices for each segment What price to charge each segment? How to allocate limited capacity among the segments? What if demand is uncertain? 13-68 The Park Hyatt Philadelphia 118 King/Queen rooms. Hyatt offers a pL= $128 (low fare) targeting leisure travelers. Regular fare is pH= $181 (high fare) targeting business travelers. Demand for low fare rooms is abundant. Let DH be uncertain demand for high fare rooms. Assume demand for the high fare (business) occurs only within a few days of the actual stay How much capacity should Hyatt save for the higher priced segment? 13-69 Allocating Capacity to a Segment Under Uncertainty Basic tradeoff between committing to an order from a lower-price buyer or waiting for a high-price buyer to arrive later on Spoilage occurs when the capacity reserved for higher-price buyers is wasted because demand from the higher-price segment does not materialize Spill occurs if higher-price buyers have to be turned away because the capacity has already been committed to lower-price buyers 13-70 Allocating Capacity to a Segment Under Uncertainty Never sell a unit of capacity for less than the expected revenue Expected revenue = sales probability x sales price $128 $181.00 = 1.0 x 181 $128 $162.90 = 0.9 x 181 $128 $144.80 = 0.8 x 181 $128 $126.70 = 0.7 x 181 13-71 Allocating Capacity to a Segment Under Uncertainty $126.70 = 0.7 x 181 Expected revenue = sales probability x sales price RH(CH) = Prob(demand from higher-price segment > CH) x pH Never sell a unit of capacity for less than the expected revenue 13-72 Allocating Capacity to a Segment Under Uncertainty $128 $126.70 = 0.7 x 181 Expected revenue = sales probability x sales price RH(CH) = Prob(demand from higher-price segment > CH) x pH Never sell a unit of capacity for less than the expected revenue pL = Prob(demand from higher-price segment > CH) x pH Prob(demand from higher-price segment > CH) = pL/pH 13-73 Allocating Capacity to a Segment Under Uncertainty Prob(demand from higher-price segment > CH) = pL/pH Prob(demand from higher-price segment CH) = 1 – pL/pH CH = F-1(1 – pL/pH, DH, H) Prob 1 – pL/pH CH pL/pH 13-74 Example: Allocating Capacity to a Segment Under Uncertainty Assume that demand for 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 Determine probability that expected marginal revenue of higher rate class will exceed marginal revenue of lower rate class pL = 128 pH = 181 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 Hence, 91 rooms should be reserved for the high rate class 13-75 Example 15-2 Allocating Capacity to Multiple Segments ToFrom Trucking serves two customer segments. One segment (A) is willing to pay $3.50 per cubic feet but wants to commit with only 24 hours notice. The other segment (B) is willing to pay only $2.00, but 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? 13-76 Example 15-2 Allocating Capacity to Multiple Segments Revenue from segment A pA = $3.50 Revenue from segment B pB = $2.00 Mean demand for segment A DA = 3,000 Standard deviation of demand for segment A A = Capacity to be reserved for segment A CA = F-1(1 – pB/pA, DH, H) = F-1(0.4286,3000,1000) = 2,820 1,000 13-77 Example 15-2 Allocating Capacity to Multiple Segments ToFrom Trucking serves two customer segments. One segment (A) is willing to pay $3.50 per cubic feet but wants to commit with only 24 hours notice. The other segment (B) is willing to pay only $2.00, but 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 To From change it decision if segment A is willing to pay $5 per cubic foot? 13-78 Example 15-2 Allocating Capacity to Multiple Segments Revenue from segment A pA = $5.00 Revenue from segment B pB = $2.00 Mean demand for segment A DA = 3,000 Standard deviation of demand for segment A A = Capacity to be reserved for segment A CA = F-1(1 – pB/pA, DH, H) = F-1(0.6, 3000, 1000) = 3,253 1,000 13-79