Dynamic Pricing and Yield Management

1. Dynamic Pricing and Yield Management Yossi Sheffi Professor, MIT ESD.260J/1.260J/15.770J

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

3. Outline • Airline revenue management • The essence of price discrimination • Revenue management in TL trucking

4. 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

5. Revenue Management Example: Airline # of Seats 100 $1,000 Price

6. Revenue Management Example: Airline

7. Revenue Management Example: Airline

8. Revenue Management Example: Airline

9. Revenue Management Example: Airline

10. 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?

11. 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

12. 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

13. Markdowns Markdowns 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

14. Sales Rate-Based Discounting • After initial sales rate (r0= i0/t0) • Required sales rate: r1=i10-t1) • %r required: (r1/ r0)-1 • Divide by ε • Get the % price change required

15. Price Discrimination • First 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)

16. Price Discrimination • First degree: willingness to pay (rare) • Second degree: artificial hurdles but open • 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…)

17. 3rd Degree Discrimination • Online shopping: Dell Computer

18. Specific Example Dimension® 8200 Series, Pentium® 4 Processor at 1.7 GHz 128MB PC800 RDRAM New Dell® Enhanced QuietKey Keyboard Video Ready w/o Monitor 32MB NVIDIA GeForce2 MX 4X AGP Graphics Card with TV-Out 40GB Ultra ATA/100 Hard Drive 3.5 in Floppy Drive MicrosoftR Windows® Millennium with WinXP Home Upgrade Coupon MS IntelliMouse® 10/100 PCI Fast Ethernet NIC 56K Teephony Modem for Wndows-Sound Option 48X Max Variable CD-ROM Integrated Audio with Soundblaster Pro/16 Compatibility Harman Kardon HK-395 Speakers Upgrade to Microsoft® Office Small Business w/EducateU 3 Year Ltd. Warranty, 3 Year At Home Service, Lifetime 24x7 Phone Support

19. Specific Example

20. When Does YM Work? • Economic conditions • Demand (LT with signaling; Governme conference • Segme • No arbitrage • Administration • A • A • Product • High fix • Perishability • Discipline !

21. 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 same • Avoid gauging • "Profiteering" is not acceptable • Use open communications • Some forms of 3rd degree discrimination are illegal, but many are acceptable: • student/senior citizen discounts • profession/use (Dell)

22. Carrier Portfolio of Pricing Dynamic pricing with spot market shippers Dynamic pricing with contracted shippers Long-term fixed-rate contracts LT fixed rate contracts with capacity commitments

23. 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"

24. 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…

25. 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

26. System Contribution of a Load • Regional potential: the expected contribution of a truck in a region. • P(A) - Potential of region A • D(A-B) - Direct cost for moving a truck from A to B • R(A-B) - Revenue for the move from A to B

27. 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 B • P(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)

28. 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)

29. YM in Manufacturing • Reserve capacity to the highest paying customer • Tie the pricing to the capacity commitment • Use pricing to manage component supply (in BTO)

30. Final Observations • RM 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

31. Any Questions?