Demand Management

Session 17
April 12th, 2018
Measuring Forecast Accuracy
You are a marketing analyst for McDonalds and have the following sales forecasts ($M)
using two methods.

Month Actual Demand Method 1 Forecast Method 2 Forecast

1 110 100 130

2 140 70 100
3 140 150 180
4 160 110 150
5 210 230 250

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Two Methods

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Measuring Forecast Accuracy
Forecast error is the difference between the actual value and the
predicted value
• Error = Actual – Forecast

Mean absolute deviation (MAD)

• MAD = ∑|Actual – Forecast| / n

Tracking signal
• Ratio of cumulative error and MAD
• TS = ∑(Actual – Forecast) / MAD

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Method 1: Tracking signal

Month Actual Forecast Error ∑|Error| MAD ∑(Error) TS

1 100 60

2 100 130

3 200 200

4 200 270

5 400 340

Error = Actual – Forecast MAD = ∑|Error| / n TS = ∑(Error) / MAD

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Method 2: Tracking signal

Month Actual Forecast Error ∑|Error| MAD ∑(Error) TS

1 100 100 0 0 0 0 0.00

2 100 100 0 0 0 0 0.00

3 200 150 50 50 16.7 50 3.00

4 200 200 0 50 12.5 50 4.00

5 400 250 150 200 40 200 5.00

Error = Actual – Forecast MAD = ∑|Error| / n TS = ∑(Error) / MAD

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Interpreting Tracking Signals
Method 2

3
2 Actual exceeds forecast
Tracking Signal

1
0
-1 Actual is less than forecast
Method 1
-2
-3
0 1 2 3 4 5
Month

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Revenue Management

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Outline

• How are prices set?

• Origins of revenue management

o Capacity-based
o Price-based

• Revenue management with capacity controls

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Prices

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The Demand Curve
As price increases, demand decreases.

Suppose we have a capacity of 100 tons of oil, how should we sell it to

maximize our profit?

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Uniform Pricing

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Differential Pricing

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What is Revenue Management?
• Revenue Managemement (RM) was first developed in airline industry
in 1980
• It is the practice of maximizing revenue by optimizing product
availability (capacity) and price
• Evolution of RM
Capacity-based RM Price-based RM
• Widely used in airlines, • Markdown pricing in
hotels, and car rental retailing
industries • Dynamic pricing in e-
• Fixed and perishable commerce
resources • Surge pricing by Uber
• …

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Why Revenue Management?

Revenues 1000

COGS 800

Gross Margin 200

Other Expenses 150

Net Margin 50

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Why Revenue Management?
+2%
Revenues 1020

COGS 800

Gross Margin 220

Other Expenses 150

+40%
Net Margin 70

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Price—Most Effective Profit Lever

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Segmentation of customers
Different Customer Classes (Price-differentiation)
• Group discount, coupons
• Airline ticket restrictions: ticket issuing date, minimum stay,
maximum stay, refundability requirements
• Shipping: Same-day express, second-day shipping

Time-Based Differentiation (Dynamic/inter-temporal pricing)

• Time-value of products for customers

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Prices Differ for Customer Segmentations

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Price Trend—Airline Pricing

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Price Trend—Fashion Products

A Namin, BT Ratchford, GP Soysal, An empirical analysis of demand variations and markdown policies for
fashion retailers, Journal of Retailing and Consumer Services 38, 126-136
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Current Industry Practice
Airlines Hotel
Video: Marriott

Media &
Car rental
broadcasting

Retailing
Gas pipelines

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How Revenue Management Works Today?
• Revenue management decision support system
o A comprehensive computer system to maximize revenue for capacity-
constrained services using reservation systems, overbooking, and
partitioning demand

Selling the right product… n Airplane seats

n Hotel rooms

to the right customer n Business travel

n Leisure

for the right time n Same day purchase

n 2 months in advance

at the right price n Full fare

n Discount rate

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An Example with Two Classes
Two classes of passengers
• Leisure: Very price sensitive and buy their tickets in advance
• Business: Price insensitive and buy at the last minute

Business Strategy:
• Offer two fare classes f1 > f2
• Passengers that buy before a specific threshold pay f2,
otherwise they pay f1.

y1
y1: Protection level for
high-value or business y2
travelers y3

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An Example with Two Classes (cont’d)
• An airline has started to sell tickets for the flight from Hong Kong to
London on May 29.
• Capacity = 335 seats.
• Two Fare Classes: y1
• Full Fare: f1 = $7950 y2

• Discount Fare: f2 = $5250 y3

• Two Customer Classes:

• Business: Book at last minute. Demand is DB=Normal (25,5)
• Leisure: Book far in advance. The demand of leisure customers is ample and the
discount tickets are expected to sell out.
• Question: How should y1 be decided?

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Marginal Analysis
Revenue
No – protect 20 seats only
$5250

DB>20
Increase protection Sold at full
level y1 from 20 to 21?
Price later $7950
Yes – protect 21
seats

DB ≤ 20
Not sold by
May 29

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An Example with Two Classes (cont’d)
Use Newsvendor Formula
o Overage Cost (reserved too many seats for business customers)
Co = f2 = $5250
o Underage Cost (reserved too few seats for business customers)
Cu = f1 - f2 = $7950 - $5250 = $2700
Protection Level (for business customers):
Cu 2700
Prob(D B <= y1 ) = = » 0.339
Cu + Co 2700 + 5250
Þ z* » -0.41 (from Standard Normal Table)
Þ y1 = 25 + 5 * (-0.41) » 23 seats
Booking limit = Capacity – protection level

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Parallel with Newsvendor model
Revenue management with capacity Newsvendor
controls
Decision: protection level for high fare Decision: order quantity

Uncertain demand: Demand for high fare Uncertain demand: Demand for
tickets newspapers

Overstocking cost = discounted fare Overstocking cost = purchase cost –

salvage value

Understocking cost = full fare – discounted Understocking cost = retail selling price –
fare purchase cost

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RM: Capacity control
• In general, there are more than 2 fare classes, with
f1 > f2 > f3 > · · · · > fn

• The previous solution can be extended to multiple fare classes, where now the
controls are given by a nested structure of booking limits, where each class has
access to the capacity of lower classes

Booking limit, class 2

Booking
Booking limit, class 3
limit,
class 1 Booking limit, class 4

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Common RM Tactics: Overbooking

Suppose there are 100 seats on a flight from Hong

Kong to Singapore.

The number of people who book tickets but do not

show up: Normally distributed with mean of 20 and
standard deviation of 10.

Air ticket fare = $105

How many reservations should the airline take?

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Treatment of Overbooked Passengers
• Volunteers
o First seek customers willing to take a later flight in return for
compensation.
• Involuntary denied boardings
o Travel arrangement with a different flight or with another airline
o Compensation depending on the arrival time (may include meal
and lodging)

• Cost
o Direct cost of the compensation
o Travel arrangement cost
o The ill-will cost

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Optimal Overbooking Level

Use marginal analysis to derive the optimal overbooking decision:

Cu = Cost of underestimating no-shows

(when actual no-shows ≥ # of overbooked customers)
Co = Cost of overestimating no-shows
(when actual no-shows < # of overbooked customers)

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Optimal Overbooking Level

• Air ticket price = $105

• Compensation for each passenger denied boarding

• Arrangement for travel on another airline: $200
• Free air ticket: $105
• ill-will cost: $100

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Marginal Analysis
n Cost of overbooking a passenger = $405 (if he/she shows up)
Revenue
no
0

Increase the no. of

overbooking from 10 to
11? #No show > 10
$105
yes

$105 - $405 = $-
#No show ≤ 10 300

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Rephrasing the Problem into Newsvendor Model
• How many seats should the airline overbook for this flight?
o Overage cost (too many seats overbooked)
• Co = $405 - $105 = $300
o Underage cost (too little seats overbooked)
• Cu = $105
• Optimal level of overbooking (X) satisfies
Cu 105
Pr Demand≤X = = =0.259
Cu +Co 105+300
• Since Demand is N(20, 102),
X∗ =20+10z∗ = 13.5
where z∗ =norminv 0.259, 10, 102 =−0.65 or use the standard normal
table
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Using z-table

!" = −!%&"

!'.)*+ =
− !'.,-% = −'. .*

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Summary
Revenue management with capacity Newsvendor
controls with single product
Decision: protection level for high fare Decision: order quantity

Uncertain demand: Demand for high fare Uncertain demand: Demand for
tickets newspapers

Overstocking cost = discounted fare Overstocking cost = purchase cost –

salvage value

Understocking cost = full fare – discounted Understocking cost = retail selling price –

fare purchase cost

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