Pricing and

revenue
management
Lu Chen
Shanghai Jiao Tong University
Contents
q The role of pricing and revenue management in the
supply chain
q Pricing and revenue management for multiple
customer segments
q Pricing and revenue management for perishable
assets
q Pricing and revenue management for seasonal
demand/bulk and spot contracts

2
The role of pricing and revenue
management in a supply chain
q Pricing is an important lever to increase supply chain
profit by better matching supply and demand.
q Revenue management is the use of pricing to
increase the profit generated from a limited supply
of supply chain assets.
q Supply chain assets: capacity and inventory
q Revenue management: the use of differential pricing
based on customer segment, time of use, and
product or capacity availability to increase supply
chain surplus.

“Science of squeezing every possible dollar from customers”

3
Traditional approaches of pricing
q Cost-plus pricing calculates prices based on costs
plus a standard margin.
q Market-based pricing determines prices based on
competitors’ actions.
q Often applied by smaller players in situations where there is a
clear market leader to compare prices to.
q Value-based pricing sets prices based on estimates of
how customers value the product.
q The approach focuses on customer value as the key driver of the
price.

4
Cost-plus pricing
q The technique is very simple: determine the cost of the product
and add a certain percentage to determine the price.
q The surchage often reflects a fixed cost plus a required return
on capital.
q E.g. in the restaurant industry:
q – food is marked up three times,
– beer is marked up four times, and
– liquor is marked up six times.

q Shortage?
q The company is guaranteed to gain the profit margin if all
competitors have similar cost structures.
q Complete ignore the market

5
Dimensions of pricing and revenue
optimization (PRO) cube

e l
a nn
C h
Customer type
Product

6
4 conditions where revenue
management is crucial
q The value of the product varies in different market
segments (airline seats).
q The product is highly perishable or product wastage
occurs (fashion and seasonal apparel).
q Demand has seasonal and other peaks (hotel
booking).
q The product is sold both in bulk and on the spot
market (warehouse lease).

7
Segmentation and marketing
strategies
No. of segments Segmentation Strategy Marketing Strategy
Zero Undifferentiated strategy Mass marketing: no segmentation
Niche marketing: focus efforts on a
One Focus strategy
small, tightly defined target market
Mass customization: focus efforts on
Two or more Differentiated strategy
multiple, tightly defined segments
Hyper-segmentation One-to-one marketing: customize the
Thousands
strategy offer for each individual customer

q Some typical bases for market segmentations include:

8
Contents
q The role of pricing and revenue management in the
supply chain
q Pricing and revenue management for multiple
customer segments
q Pricing and revenue management for perishable
assets
q Pricing and revenue management for seasonal
demand/bulk and spot contracts

9
An example of airline tickets
Demand of Seats

100

$1,000 Price

10
An example of airline tickets
Demand of Seats

100
Revenue = $25,000

50

$500 $1,000 Price

11
An example of airline tickets
Demand of Seats

100
Revenue = $31,250

50

25

$500 $750 $1,000 Price

12
An example of airline tickets
Demand of Seats

100
Revenue = $37,500
75

50

25

$250 $500 $750 $1,000 Price

13
Maximum revenue
Demand of Seats

100
Revenue = $50,000
75

50

25

$250 $500 $750 $1,000 Price

14
Challenges?
q How to make sure that the people who are willing to
pay $750 will not buy the $250 ticket?
q How to make sure that there are enough seats for
those who willing to pay $750?

15
Price discrimination
q First degree: willingness to pay (rare)
q Taxes
q Second degree: artificial hurdles
§ Buying process (coupons, advance purchase…)
§ Cost to serve (volume discounts…)
§ Distribution channels (Internet, outlets, etc.)
§ Markdowns (timing of purchase, product age, selection, etc.)
§ Time of use (e.g., peak hour, congestion pricing)
q Third degree: based on external factors
§ Geography (neighborhood, state)
§ Gender (women's clothing)
§ Age (senior/student discounts)
§ Profession/affiliation (small/large business business; educational,
medical…)
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Another approach to differential
pricing
q To create different versions of product targeted at
different segments.
q Publishers use two different versions of new books at different
prices.
q Automobile manufactures create a high-end, a mid-level, and a
low-end version of the most popular models based on the options
provided.
q Many home appliance manufactures sell their products with
different length of warranty.

17
Important issues
q What price to charge each segment?
q How to allocate limited capacity among the
segments?

18
Pricing to multiple segments
q Assume the demand curve for segment i is:

q The goal of the supplier is to price so as to maximize

its profits:

q For segment i, the supplier attempts to maximize:

q The optimal price for each segment is:

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With a capacity constraint

Subject to:

for

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An important assumption
q Once prices are decided, customer demand is
predictable.

q What if the demand from different segment is

uncertain?

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Allocating capacity to segment under
uncertainty
q Demand from the segment paying the lower price
arises earlier than demand from the segment paying
the higher price.
q The supplier must limit the amount of capacity
committed to lower-price buyers.

q How much capacity to save for the higher-price

segment?

22
Basic trade-off
q Production capacity → an order from a lower-price buyer
→ waiting for a buyer to arrive

q Two risks:
q Spoilage: the capacity reserved for higher-price buyers is
wasted because demand does not materialize.
q Spill: higher-price buyers have to be turned away because
the capacity has been committed to lower-price buyers.

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Expected revenue for 2 customer
segments
pL price charged to the lower-price segment
pH price charged to the higher-price segment
DH average demand for the higher-price segment
sH standard deviation of the demand for the higher
-price segment

What to determine?
CH capacity reserved for the higher-price segment

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The quantity reserved for the higher-
price segment
The expected marginal revenue RH (CH) from reserving more capacity
is:
RH (CH) = Prob (demand from higher-price segment > CH) ´ pH

The marginal revenue from the lower-price segment is:

RH (CH) = pL

Prob (demand from higher-price segment > CH) = pL/pH

CH = F –1 (1 – pL / pH , DH , σ H ) = NORMINV (1 – pL / pH , DH , σ H )

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There are more than 2 customer
segments
q The expected marginal revenue from the highest-
price segment equals the price of the next-highest-
priced segment.
q …… same philosophy

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ToFrom Trucking – an example
q ToFrom Trucking serves two segments of customers:
q Segment A is willing to pay $3.50 per cubic foot but wants to
commit to a shipment with only 24 hours notice.
q Segment B is willing to pay $2.00 per cubic foot and is willing to
commit to a shipment with up to one week notice.
q Mean demand for segment A, DA 3,000 cubic feet
q Standard deviation of demand for segment A, σ A 1,000 cubic
feet

q How much of the capacity should be reserved for

segment A?

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Innovative Pricing
q Firm can offer differential prices to customers even in a situation where
there are no capacity constraints.
q Use of Rebate coupons for women’s clothes
q Use of Happy hours by Pubs & Restaurants
q Differential prices charged by Amazon
q Different prices for Coca-cola at kiosks based on season, temperature and
location.
q Extreme case of differential pricing would involve customized pricing
where each customer is charged different prices based on his utility and
willingness to pay.

q Firm should ensure that differential pricing schemes are not perceived as
unfair practices by customers.
q Wiliness to pay ≠ happiness to pay

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Contents
q The role of pricing and revenue management in the
supply chain
q Pricing and revenue management for multiple
customer segments
q Pricing and revenue management for perishable
assets
q Pricing and revenue management for seasonal
demand/bulk and spot contracts

29
Perishable assets
q Any asset that loses value over time.
q Fruits, vegetables, and pharmaceuticals
q Computers and cell phones that lose value as new models are
introduced.
q High-fashion apparel
q Production, transportation, and storage capacity that is wasted if
not fully utilized.

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An example in retailing of apparel –
Filene’s Basement
q Merchandise was first sold at the main store at full
price.
q Leftover merchandise was moved to the basement
and its price reduced incrementally over a 35-day
period until it sold.
q Any unsold merchandise was then given away to
charity.

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Two tactics for perishable assets
q Vary price dynamically over time to maximize
expected revenue
q Overbook sales of the asset to account for
cancellations

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Dynamic pricing
q To vary price effectively over time for a perishable
asset, the asset owner must be able to:
q Estimate the value of the asset over time, and
q Forecast the impact of price on customer demand effectively

q Effective differential pricing over time generally

increases:
q The level of product availability for the consumer willing to pay
full price, and
q Total profits for the retailer

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A simple methodology for dynamic
pricing
q The seller has a specified quantity Q of a single
product at the start of the season.
q The seller divided the selling season into k periods
and forecasted the demand for each period.

q The dynamic pricing problem can be formulated as:

for 34
An example
q A retailer has purchased 400 ski parkas before winter
at a cost of $100 each.
q The season lasts 3 months. The demand in each
month is d1 = 300 – p1, d2 = 300 – 1.3p2, d3 = 300 – 1.8p3.
q How should the retailer vary the price of the parkas
over the 3 months to maximize revenue?

Quantity at beginning of season

Period Price Demand Revenue

Total
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Evaluating quantity with dynamic
pricing
q If the order quantity Q is a decision, then how many
units the retailer should purchase at the beginning
of the season? How should the products be priced
over the three months of the season to maximize
profits?

36
Dynamic pricing is more complicated
in reality
q Demand is unpredictable
q Customers behave strategically in that they may
decide to delay their purchase if they know that
prices will drop over time.

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Overbooking
q The tactic of overbook is suitable in any situation in
which customers are able to cancel orders and the
value of assets drops significantly after a deadline.
q Airline seats
q Items designed specially for holidays
q Production capacity

q Airline industry:
q Business / leisure split 50/50
q Very high investment and fixed costs
q Low variable cost
q Empty seats: nil incremental cost
q On average 15% of confirmed passengers don’t show up for a flight
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Cost analysis
q The cost of wasted capacity: the margin that would
have been generated if the capacity had been used for
production.
q The cost of a capacity shortage: the loss per unit that
results from having to go to a backup source.

q The goal: to maximize supply chain profits.

q Trade-off: having wasted capacity (or inventory) vs

having a shortage of capacity (or inventory)

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Set overbooking level
p selling price of each product
c unit cost
b the cost per unit at which a backup can be used
CW p – c, marginal cost of having wasted capacity
CS b – p, marginal cost of have a capacity shortage
O* the optimal overbooking level
s* Prob (cancellations ≤ O*), the probability that
cancellations will be less than or equal to O*
CW
s* = Pr(cancellations £ O*) =
CW + CS

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An example
q Consider an apparel supplier that is talking orders for dresses
with a Charismas motif. The production capacity is 5,000
dresses. It makes $10 for each dress sold.
q The supplier is taking orders from retailers. If it has orders that
exceed capacity, it has to arrange for backup capacity that
results in a loss of $5 per dress.
q Retailers cancel their orders near winter as they have better
visibility into expected demand.
q Decision to make: How many orders should the supplier accept
if cancellations are normally distributed, with a mean of 800
and a standard deviation of 400?

41
Contents
q The role of pricing and revenue management in the
supply chain
q Pricing and revenue management for multiple
customer segments
q Pricing and revenue management for perishable
assets
q Pricing and revenue management for seasonal
demand/bulk and spot contracts

42
Seasonal peaks of demand
q Off-peak discounting is an effective method of
shifting demand from the peak to the off-peak
period.
q Charge higher price during peak periods and a lower
price during off-peak periods.
q Amazon offers free shipping for orders that are placed in
November, in order to reduce the December peak.
q Marriott offers lower rates during the weekend to encourage
families to use the hotel during that time.
q Increases profits for the owner of assets, decreases
the price paid by a fraction of customers, and brings
in new customers during the off-peak discount
period.
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Bulk and spot contracts
q Most firms faces a market in which some customers
purchase in bulk at a discount and others buy single
units or small lots at a higher price.
q Warehousing capacity
q Decide what fraction of the asset to sell in bulk and
what fraction of the asset to save for the spot market.
q The amount reserved for the spot market should be
such that:
the current revenue from a bulk sale
the expected marginal revenue from the spot market

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Optimal value for bulk contract
cS spot market price
cB bulk contract price
Q* optimal value for bulk contract
p* Prob (Demand ≤ Q*)

cS – c B
Optimal value p* =
cS

Q* = F –1 p*, µ,σ = NORMINV p*, µ,σ

( ) ( )
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Exercise
q Felgas, a manufacturer of felt gaskets, has a
production capacity of 1,000 units per day. The firm
sells production capacity for $5 per unit. At this price,
all production capacity gets booked about one week
in advance. Some customers said that they would be
willing to pay $10 per unit if Felgas had capacity on
the last day.
q Assuming that demand for high-price segment is
normally distributed N ~ (250, 100).
q How much production capacity should Felgas reserve
for the last day?

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