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Dynamic Pricing and Yield Management

Yossi SheffiProfessor, MIT

ESD.260J/1.260J/15.770J

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What you are is clear – the only issue is price…

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Outline

Airline revenue management

The essence of price discrimination

Revenue management in TL trucking

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Yield/Revenue Management

Objective:maximize revenue (minimize lost revenue / opportunity costs)

“Science of squeezing every possible dollar from customers”

Integrated management of capacity and pricing

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Revenue Management Example: Airline

100

$1,000 Price

# of Seats

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Revenue Management Example: Airline

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Revenue Management Example: Airline

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Revenue Management Example: Airline

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Revenue Management Example: Airline

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Two Challenges:

How do we make sure that the people who are willing to pay $750 will not buy the $250 ticket?How do we make sure that we have enough seats for those willing to pay $750?

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Two Answers:

Create artificial hurdles: Advance purchase: 21 days, 14 days, 7days Use limitations: Saturday night stay, non-refundable

tickets Restrict the number of seats sold at the low price This requires a forecast of future booking by higher-

paying customers and the discipline to forgo a “bird-in-hand.”

Note 1: airlines do not change prices dynamically; they actually change capacity (classes) dynamically

Note 2: freight can also displace passengers when RM is really optimized

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Why is This Important?

American Airlines saved over $1.4B between 1989-1992“I believe that yield management is the single most important technical development in transportation management . . . “

Robert Crandall, CEO AMR

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MarkdownsMarkdowns are one of the main levers that retailers have to influence results in-season. As such, it can be a very powerful driver of performance.

Markdown Opportunity: • Markdowns may represent more than 30% of total sales • Short-cycle product can represent up to 80% of a retailer’s assortment • In some segments, short-cyce products may represent a smaller percentage of the assortment but still have a significant impact on gross margin (up to 40%)

• Goals / Trends: • Movement to more Localized pricing decisions • Growing realization of the true cost of left-over inventory • Greater emphasis on inventory productivity as store base growth slows

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Sales Rate-Based Discounting

After initial sales rate (r0= i0/t0)Required sales rate: r1=i10-t1)%r required: (r1/ r0)-1Divide by εGet the % price change required

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Price DiscriminationFirst degree: willingness to pay (rare)

RR in late 1800-s, asking shippers for their income statement so they could determine their ability to pay

College financial aid Taxes

Second degree: artificial hurdles but open Buying process (coupons, advance purchase…) Cost to serve (volume discounts, risk adjustments, "set

up" costs in travel industry…) Distribution channels (Internet, outlets, etc.) Markdowns (timing of purchase, product age, selection,

etc.) Value of product (in many rail movements;

regeltarifklassen) Commodity type (part of tariffs; in many rail movements) Use limitations (e.g., "final sale") Bundling ("menu" vs. "a-la-cart") Time of use (e.g., peak hour, congestion pricing)

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Price DiscriminationFirst degree: willingness to pay (rare)Second degree: artificial hurdles but openThird 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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3rd Degree Discrimination

Online shopping: Dell Computer

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Specific ExampleDimension® 8200 Series, Pentium® 4 Processor at 1.7 GHz128MB PC800 RDRAMNew Dell® Enhanced QuietKey KeyboardVideo Ready w/o Monitor32MB NVIDIA GeForce2 MX 4X AGP Graphics Card with TV-Out40GB Ultra ATA/100 Hard Drive3.5 in Floppy DriveMicrosoftR Windows® Millennium with WinXP Home Upgrade CouponMS IntelliMouse®10/100 PCI Fast Ethernet NIC56K Teephony Modem for Wndows-Sound Option48X Max Variable CD-ROMIntegrated Audio with Soundblaster Pro/16 CompatibilityHarman Kardon HK-395 SpeakersUpgrade to Microsoft® Office Small Business w/EducateU3 Year Ltd. Warranty, 3 Year At Home Service, Lifetime 24x7 Phone Support

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Specific Example

UserBase Price

Home $1,378Small business

$1,238

Large business

$1,338

Student $1,327University $1,427

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When Does YM Work?

Economic conditions Demand (LT with signaling; Governme conference Segme No arbitrage

Administration A A

Product High fix Perishability

Discipline !

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Marketing

Most schemes are based on 2nd degree discrimination – seems more fair (choice is available)Positioning the message: discounts are more acceptable than price increases, even if the result is the sameAvoid gauging"Profiteering" is not acceptableUse open communicationsSome forms of 3rd degree discrimination are illegal, but many are acceptable:

student/senior citizen discounts profession/use (Dell)

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Carrier Portfolio of PricingDynamic pricing with spot market shippers

Dynamic pricing with contracted shippers

Long-term fixed-rate contracts

LT fixed rate contracts with capacity commitments

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Rev. Management in TL Trucking

Little opportunity during bid response No monopoly power Exceptions: good service history coupled with

client strategy geared towards service Value-added services

Only opportunity in real-time (spot) market There are limited opportunities for

local/temporary monopolies:• Responses to shipper "dialing for diesels”• Requests along "power lanes"

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Rev. Management in TL Trucking

Remember the twin challenges: How do we make sure that the people who

are willing to pay $750 will not buy the $250 ticket?

How do we make sure that we have enough seats for those willing to pay $750?

Comes down to one question: Should we take this load?

Should capacity be committed to a particular load/shipper/contract?, or should we wait for a better-paying load?

Depends on the forecast…

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Strategic Decisions Set the Limits for Tactical Decisions

• Size of fleet• Market focus – regions, industries, equipment• Relationships with O/Os, 3PLs

• Percent of business under long-term contract• Long-term contract rates• Bid-response strategies• Capacity commitments• Seasonal Pricing

• Demand booking and solicitation• Dynamic pricing• Proactive empty repositioning• Driver assignment

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System Contribution of a Load

Regional potential: the expected contribution of a truck in a region.P(A) - Potential of region AD(A-B) - Direct cost for moving a truck from A to BR(A-B) - Revenue for the move from A to B

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System Contribution of a Load

S(A-B) = R(A-B) -D(A-B) + P(B) -P(A)

Direct contribution System impact

P(B) -the value of one more truck at region BP(A) -the value of one less truck at region A

Order acceptance:- Take a load only if S(A-B) > 0- Take the load with the highest S(A-B)

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Analysis of Movements

Head haul:S(A-B) = R(A-B) -D(A-B) + P(B) -P(A)

Back haul:S(A-B) = R(A-B) -D(A-B) + P(B) -P(A)

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YM in Manufacturing

Reserve capacity to the highest paying customerTie the pricing to the capacity commitmentUse pricing to manage component supply (in BTO)

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Final ObservationsRM involves the entire enterprise

Customer service Sales Reservations Scheduling

RM can be used to increase profits and serve customers better

Bring in those who otherwise would not use the service Provide higher LOS to those who pay a lot by giving

them more frequent service, higher probability of service, etc.

Increase utilization by smoothing demand patterns

The essence of RM is the judicious management of capacity and pricing simultaneously

The trick: reserve capacity to the highest paying customers

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Any Questions?