The Role of Pricing and Revenue Management in a Supply Chain

In Chapter 9, we discussed how short-term price promotions could be an effective tool to more profitably meet seasonal demand. In this chapter, we further build on the idea of using pricing as an important lever to increase supply chain profits by better matching supply and demand, espe­cially when there are multiple customer types willing to pay different prices (based on attributes such as response time) for an asset. Revenue management is the use of pricing to increase the supply chain surplus and profit generated from a limited availability of supply chain assets. Sup­ply chain assets exist in two forms—capacity and inventory. Capacity assets in the supply chain exist for production, transportation, and storage. Inventory assets exist throughout the supply chain and are carried to improve product availability. In the presence of multiple customer types, revenue management aims to grow profits by selling the right asset to the right customer at the right price. Besides varying capacity and inventory, revenue management suggests varying price to grow profits by better matching supply and demand. An excellent discussion of revenue man­agement techniques in theory and practice can be found in Talluri and Van Ryzin (2004) and Phillips (2005).

Consider a trucking company that owns ten trucks. One approach that the firm can take is to set a fixed price for its services and use advertising to spur demand if surplus capacity is available. Using revenue management, however, the firm could do much more as long as there are customers whose willingness to pay varies with some dimension of the service, such as response time. One approach is to charge a lower price to customers willing to commit their orders far in advance and a higher price to customers looking for transportation capacity at the last minute. Another approach is to charge a lower price to customers with long-term contracts and a higher price to customers looking to purchase capacity at the last minute. A third approach is to charge a higher price during periods of high demand and lower prices during periods of low demand. Consider a retailer that purchases seasonal apparel for sale. 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 than a strategy that fixes prices for the duration of the sales season.

All these revenue management strategies use differential pricing as a critical lever to maxi­mize earnings. Revenue management may also be defined as the use of differential pricing based on customer segment, time of use, and product or capacity availability to increase supply chain surplus and profits. The impact of revenue management on supply chain performance can be significant. One of the most often cited examples is the successful use of revenue management by American Airlines to counter—and finally defeat—PeopleExpress in the mid-1980s. PeopleExpress started in Newark, New Jersey, and offered fares that were 50 to 80 percent lower than those of other car­riers. At first, the other airlines ignored PeopleExpress because they were not interested in the low- fare market segment. By 1983, however, PeopleExpress was flying 40 aircraft and achieving load factors of more than 74 percent. PeopleExpress and other new entrants were making significant inroads into the turf of existing airlines. The existing airlines could not compete by cutting prices to the level of PeopleExpress because they had higher operating costs. American Airlines was the first to come up with an effective countermeasure using revenue management. Rather than lower the price of all its seats, American lowered prices of a portion of the seats to prices at or below those of PeopleExpress. The number of low-price seats was larger on flights that were likely to have empty seats, which would otherwise have produced no revenue. This strategy allowed American to attract customers who valued the low prices without losing revenue from customers who were willing to pay more. Soon, other airlines, such as United, followed suit, attracting many of PeopleExpress’s passengers. This was sufficient to drive down load factors for PeopleExpress to below 50 percent, a level at which the airline could not survive. Before the end of 1986, PeopleExpress collapsed.

American Airlines succeeded primarily because it used differential pricing to lower prices for a fraction of the seats and attract passengers who would otherwise have flown PeopleExpress. American did not lower prices for the fraction of seats used by business travelers who were not flying with PeopleExpress. Targeted differential pricing is at the heart of successful revenue management.

Revenue management adjusts the pricing and available supply of assets and has a signifi­cant impact on supply chain profitability when one or more of the following four conditions exist:

1. The value of the product varies in different market segments.
2. The product is highly perishable or product wastage occurs.
3. Demand has seasonal and other peaks.
4. The product is sold both in bulk and on the spot market.

Airline seats are a good example of a product whose value varies by market segment. A business traveler is willing to pay a higher fare for a flight that matches his or her schedule. In contrast, a leisure traveler will often alter his or her schedule to get a lower fare. An airline that can extract a higher price from the business traveler compared to the leisure traveler will always do better than an airline that charges the same price to all travelers. Similar ideas can be applied in the context of hotel rooms and car rentals, for which there is a significant difference between the business traveler and the leisure traveler.

Fashion and seasonal apparel are examples of highly perishable products because they lose value over time. Customers typically value high-fashion apparel more at the start of the season because they want to be the first people seen wearing it. By the end of the season, customers are willing to buy the product only if it is deeply discounted. Similarly, production, storage, and transportation capacity loses all value if it is not used at a given time because the lost capacity cannot be recovered. If a truck is not used for a day, its transportation capacity for that day is gone forever without producing revenue. Thus, all capacity is also a highly perishable asset. The goal of revenue management in such a setting is to adjust the price over time to maximize the profit obtained from the available inventory or capacity.

Demand for hotel rooms in many tourist destinations shows a highly seasonal pattern. For example, resorts in Phuket, Thailand, charge a significantly lower rate during the off-season summer months compared with the peak winter months. Such a pricing pattern allows them to attract customers with some time flexibility during the lower-cost summer months, leaving the winter capacity for customers who are willing to pay more to enjoy Phuket in the winter. Some commuter railroads use a similar strategy to deal with the distinct peaks in passenger travel, charging higher fares during peak periods and lower fares for off-peak travel. It is important to keep in mind that differential pricing for peak and off-peak periods increases profits in a manner that is consistent with customer priorities. In the absence of peak pricing, peak periods, being the most desirable, would have excess demand, whereas off-peak periods would have significant idle capacity. With differential pricing, customers who really value the peak period would pay the higher price, whereas those that were not time constrained would shift to the off-peak period to take advantage of lower prices. The outcome of such a move is a higher supply chain surplus with higher profits for the firm and a utilization of assets by customers that is consistent with their needs.

Every product and every unit of capacity can be sold both in bulk and in the spot market. For example, the owner of a warehouse must decide whether to lease the entire warehouse to customers willing to sign long-term contracts or to save a portion of the warehouse for use in the spot market. The long-term contract is more secure but typically fetches a lower average price than the unpredictable spot market. Revenue management increases profits by finding the right portfolio of long-term and spot-market customers.

Revenue management can be a powerful tool for every owner of assets in a supply chain. Most successful examples of the use of revenue management are from the travel and hospitality industry and include airlines, car rentals, and hotels. American Airlines has stated that revenue management techniques increase its revenues by more than $1 billion each year. Revenue man­agement techniques at Marriott raise annual revenues by more than $100 million. Revenue man­agement can have a similar impact on all stages of a supply chain that satisfy one or more of the four conditions identified earlier.

In the following sections, we discuss various situations in which revenue management is effective and the techniques used in each case.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.