Operations management
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Operations management. Session 17: Introduction to Revenue Management and Decision Trees. Previous Class. Today’s Class. Introduction to Revenue Management Decision-making under uncertainty Decision Trees Simulation Game Explanation. $. Reducing Cost. Increasing Revenue. Profits.

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Operations management

Operations management

Session 17: Introduction to Revenue Management and Decision Trees


Previous class

Previous Class

Operations Management


Today s class

Today’s Class

  • Introduction to Revenue Management

  • Decision-making under uncertainty

    • Decision Trees

  • Simulation Game Explanation

Operations Management


Rm a basic business need

$

Reducing Cost

Increasing Revenue

Profits

RM: A Basic Business Need

  • What are the basic ways to improve profits?

Revenue Management

Operations Management


Revenue management

market

segmentation

pricing

Revenue Management

capacity

control

forecasting

optimization

overbooking

Operations Management


Revenue management definitions

Revenue Management Definitions

‘Selling the right seats to the right customers at the right prices and the right time.’ (American Airlines 1987)

(Squeezing as many dollars as possible out of the customers)

‘Integrated control and management of price and capacity (availability) in a way that maximizes company profitability.’

Operations Management


Revenue management history

Revenue Management History

  • RM was ‘invented’ by major US carriers after airline deregulation in the late 1970’s to compete with new low cost carriers

  • Matching of low prices was not an alternative because of higher cost structure

  • American Airline’s ‘super saver fares’ (1975) have been first capacity controlled discounted fares

  • RM allowed the carriers to protect their high-yield sector while simultaneously competing with new airlines in the low-yield sector

  • From art to science: By now, there are sophisticated RM tools and no airline can survive without some form of RM

  • Other industries followed - hotel, car rental, cruise lines etc.

Operations Management


Revenue management1

Revenue Management

  • How the optimization in Revenue Management might differ from what we have already learned (like linear programming)?

Operations Management


Capacity investment 1

Capacity Investment-1

  • New-Fashion buys dyed yarns and makes fashionable dress. The company knows with certainty that red will be the color of the year and the demand for a red gown is 2,000 units per month for the next 5 months.

  • The company can invest in a new production line with advanced technology. The capacity of the new line is 2,000 units per month.

    • The cost of this line is $1,000,000.

    • The production cost per unit is $130.

Operations Management


Capacity investment 11

Capacity Investment-1

  • Alternative: The company can also convert an obsolete line with traditional technology. The capacity of the production line is also 2,000 units per month.

    • The cost of this conversion is $500,000.

    • The production cost per unit is $200.

  • Each red gowns are sold for $300 each.

  • Operations Management


    Capacity investment 12

    Capacity Investment-1

    • Which technology should the company chose?

    • Clearly the new technology is preferable.

    -1,000,000+5*2,000*170=0.7M

    New

    Traditional

    -500,000+5*2,000*100=0.5M

    Operations Management


    Capacity investment 2

    Capacity Investment-2

    • New-Fashion company is concerned that orange instead of red being the color of year.

    • The CEO of the company prefers to assume that the demand for the red gowns will be:

      • 2,000 per month (probability 0.6)

      • 0 (probability 0.4, market will demand 2000 orange gowns)

  • Given this information…

  • Operations Management


    Capacity investment 21

    Capacity Investment-2

    -1,000,000+5*2,000*170=0.7M

    red

    -1,000,000+0=-1M

    orange

    New

    -500,000+5*2,000*100=0.5M

    red

    Traditional

    -500,000+0=-0.5M

    orange

    Operations Management


    Capacity investment 22

    Capacity Investment-2

    • The optimal decision is to invest in the traditional technology.

    • Intuitively, the traditional technology is preferred when the demand is uncertain because it has a lower upfront cost, but higher variable cost of production.

      Lesson: Lower upfront costs are preferred when there is more variability.

    Operations Management


    Decision tree

    Decision Tree

    • A tool to come up strategy under uncertain environments

    Decision

    Scenario

    Operations Management


    Capacity investment 3

    Capacity Investment-3

    • A smart consultant realized that a technology can delay the dye process and enable the company dye finished gowns after they know the color of the year.

    • The technology introduces an additional $30 cost of dyeing for each unit produced.

    • What should the company do?

    Operations Management


    Capacity investment 31

    Capacity Investment-3

    w/o dye

    delayed

    with dye delayed

    Operations Management


    Observations

    Observations

    • We observe that delay dyeing to collect more information is beneficial.

    Operations Management


    More observations

    More Observations

    • We also observe that if the company delays dyeing it is optimal to invest in the new technology. While if it decides to not wait, it is optimal for the company to invest in the traditional technology. Why?

      The new technology costs more, but has lower production costs. Therefore, once we know demand is high, we prefer to make a higher initial upfront investment but have a lower marginal production cost.

    • Postpone differentiation and flexibility is desirable

    • Sometime, waiting and collecting information is worthwhile

    Operations Management


    What did we learn

    What did we learn?

    • How to use a decision tree to evaluate alternatives.

    • Let’s see another example in a different context.

    Operations Management


    Decision trees

    Decision Trees

    • A new drug must pass through three stages of clinical trials before it can be brought to market.

      • Phase 1: Safety is evaluated on a small group.

      • Phase 2: The effectiveness of the drug is evaluated on a large group.

      • Phase 3: Randomized controlled trials are performed on even larger groups. Comparison is against a “gold standard” treatment.

      • (Phase 4: Post-launch safety surveillance.)

    When should we contract for production capacity?

    Operations Management


    Decision trees1

    Decision Trees

    • Suppose we desire to introduce a new hypertension drug to market.

    • We have completed phase 1 and 2 trials successfully.

    • We assess a 90% probability of completing phase 3 successfully (and therefore gaining FDA approval).

    • We assume demand for the drug will be 5 million people in the next year.

    • A one-year drug supply for a single person should net us a $50 profit.

    Operations Management


    Decision trees2

    Decision Trees

    • We have the option of contracting for manufacturing capacity now for $150 million.

    • We expect the cost of manufacturing capacity to increase if we wait until we know the results of our Phase 3 trial.

    • What is the minimum expected cost of delaying manufacturing such that it is beneficial for us to wait to contract for manufacturing capacity?

    Operations Management


    Decision trees3

    Decision Trees

    approved

    $50×5-$150

    =$100 million

    contract now

    0.9

    not approved

    -$150 million

    0.1

    contract later

    0.9× (50×5-P) million

    0.9×100-0.1×150=75>0.9× (50×5-P),

    83.33 > 250-P

    or P>166.67 in order that contracting now is more profitable.

    Operations Management


    Decision trees4

    Decision Trees

    We valued the flexibility of being able to

    wait until there is no more uncertainty.

    Operations Management


    Decision trees5

    Decision Trees

    • Now suppose we have only completed Phase 1, and that we assess the probability of completing phase 2 to be 50%.

    • We still assess the probability of completing Phase 3 to be 90%.

    • We again have the option to contract now at $150 million or to contract later (after either completing phase 2 or 3).

    Operations Management


    Decision trees6

    Decision Trees

    pass phase 3

    $100 million

    0.9

    pass phase 2

    do not pass

    now

    0.5

    -$150 million

    $75

    million

    0.1

    -37.5

    million

    do not pass

    -$150 million

    0.5

    later

    It does not make sense to contract now.

    Operations Management


    What did we learn1

    What did we learn?

    • Decision trees

    • How to value the option of delaying decisions to collect information

    • Next class, we will study revenue management tools based on decision trees

    • Still upcoming … simulation game explanation.

    Operations Management


    Next session

    Next Session

    • Homework 4 due.

    • Game report 1 due.

    Operations Management


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