DSC4213 Analytical Tools for

Consulting

Session 3 Retailer Price

Optimization

Prof. WANG Tong

Dept. of Decision Sciences
NUS Business School
 Last time …

• Estimate N by observing real-time sales

• If N is large (N>133), set p = $60 all the time (total sales = 15*N > 2000)

• If N is small (N<76), set p = $48 all the time (total sales = 26.15N < 2000)

• More complicated markdown strategies are needed for a moderate N

(76 < N < 133)
– Never reduce the price to $36!

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 2

 Competition Time

• Competition ID: DSC4213H2 (you need to type it, case sensititve)

• 20 minutes

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 3

 Markdown Strategies

• Inventory-clearance strategy (T* strategy)

• Linear Programming formulation and solution

• A stochastic perspective

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 Inventory Clearance Strategy – One-cut

• Objective: to clear all the 2000 units at the end of the season
• Can cut price once (say from $60 to $54)
• Suppose market size is given (say N=125), no uncertainty over time
• When to cut?

Inventory

2000
P = 60
Weekly Demand = 125

P = 54
Weekly Demand = 125*1.3

0 5 10 T* 15 Time (week)

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 5

 Inventory Clearance Strategy – One-cut

• Optimal markdown time T* satisfies

2000 = N R(60) T* + N R(54) (T-T*)
• Plug in N=125, R(60) = 1, R(54) = 1.3, T=15 => T*=11.7

Inventory

2000

0 5 10 T* 15 Time (week)

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 Inventory Clearance Strategy – One-cut

• Find the T* for other price levels

$60 -> $54 $60 -> $48 $60 -> $36

Market Size (N) T* Profit T* Profit T* Profit
125 11.7 116750 13.6 116473 14.4 115324

T* (54) T* (48) T* (36) 15 Time (week)

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 Inventory Clearance Strategy – One-cut

• Also we can try different market size N

N=150:
One-Cut: $60 -> $54 One-Cut: $60 -> $48 One-Cut: $60 -> $36
Market Size (N) T* Effective T* Profit T* Effective T* Profit T* Effective T* Profit
150 20.6 13.3 120000 17.3 13.3 120000 15.9 13.3 120000
Inventory

P = 60
2000 Weekly Demand = 150

P = 54
Weekly Demand = 150*1.3

0 5 10 15 T* Time (week)

Effective
T*

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 8

 Inventory Clearance Strategy – One-cut

• Also we can try different market size N

N=50: One-Cut: $60 -> $54 One-Cut: $60 -> $48 One-Cut: $60 -> $36
Market Size (N) T* Effective T* Profit T* Effective T* Profit T* Effective T* Profit
50 -68.3 1.0 78140 -18.8 1.0 79764 1.0 1.0 73240
Inventory
P = 60
2000 Weekly Demand = 50

P = 48
Weekly Demand = 50*1.79

T* 0 5 10 15 Time
Effective T* (week)
=1

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 9

 Inventory Clearance Strategy – One-cut

• Also we can try different market size N

One-Cut: $60 -> One-Cut: $60 -> One-Cut: $60 ->

$54 $48 $36
Optimal
Market Effective Effective Effective Price
Size (N) T* T* Profit T* T* Profit T* T* Profit cut level
150 20.6 13.3 120000 17.3 13.3 120000 15.9 13.3 120000 -
140 17.4 14.3 120000 16.0 14.3 120000 15.4 14.3 120000 -
130 13.7 13.7 118700 14.5 14.5 118589 14.8 14.8 118130 54
125 11.7 11.7 116750 13.6 13.6 116473 14.4 14.4 115324 54
120 9.4 9.4 114800 12.7 12.7 114357 14.1 14.1 112518 54
110 4.4 4.4 110900 10.7 10.7 110124 13.2 13.2 106907 54
100 -1.7 1.0 106280 8.2 8.2 105892 12.2 12.2 101296 54
90 -9.1 1.0 100652 5.2 5.2 101659 11.0 11.0 95685 48
80 -18.3 1.0 95024 1.5 1.5 97427 9.4 9.4 90074 48
70 -30.2 1.0 89396 -3.3 1.0 91670 7.4 7.4 84463 48
60 -46.1 1.0 83768 -9.8 1.0 85717 4.8 4.8 78851 48
50 -68.3 1.0 78140 -18.8 1.0 79764 1.0 1.0 73240 48

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 10

 Inventory Clearance Strategy – Multi-cut

• What about mark down more than once ($60 -> $54 -> $48 -> $36)?

Inventory

2000

P=
60

P = 54

P = 48
P = 36
0
T1* T2* T3* 15 Time (week)

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 Linear Programming --- Formulation

• Decision variables?

• Objective function?

• Constraints?

2000

0 15
T1* T2* T3*

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 Linear Programming --- Formulation

• Decision variables:

X60 = # of effective weeks the item is sold at price $60

X54 = # of effective weeks the item is sold at price $54
X48 = # of effective weeks the item is sold at price $48
X36 = # of effective weeks the item is sold at price $36

• Objective function:

Revenue = Sales Revenue + Salvage Revenue

Sales Rev. = 60*X60*N*R(60) + 54*X54*N*R(54) + 48*X48*N*R(48) + 36*X36*N*R(36)

Salvage Rev. = 25*(2000 – Sales)

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 13

 Linear Programming --- Formulation

• Constraints:
– Capacity constraint: sales ≤ inventory

Sales = X60*N*R(60) + X54*N*R(54) + X48*N*R(48) + X36*N*R(36) ≤ 2000

– Time constraint: total effective weeks at all prices ≤ the selling season

X60 + X54 + X48 + X36 ≤ 15

– Full price in week 1:

X60 ≥ 1

– Non-negativity: X60 , X54 , X48 , X36 ≥ 0

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 Linear Programming --- Solution

Retailer Linear Programming Worksheet

Market Size…….................................... 125

Number of weeks remaining…….…… 15
Initial quantity on hand.......................... 2000
Salvage value........................................ 25

Price levels...................... 60 54 48 36
R(P)…….......................... 1 1.3 1.74 2.79
Avg. weekly demand....... 125 162.5 217.5 348.8
Total
No. of weeks 11.7 3.3 0.0 0.0 15 weeks
Units sold 1458.3 541.7 0.0 0.0 2000 sales
Units salvaged 0.00 salvaged

Revenue from sales 116,750

Revenue from salvage 0
Total revenue $116,750

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 15

 Linear Programming --- Solution
Retailer Linear Program Results

Number of weeks at each price level: Number Total

N $60 $54 $48 $36 salvaged Revenue
150 13.3 0.0 0.0 0.0 0 $120,000
1 140 14.3 0.0 0.0 0.0 0 $120,000
130 13.7 1.3 0.0 0.0 0 $118,700
125 11.7 3.3 0.0 0.0 0 $116,750
2 120 9.4 5.6 0.0 0.0 0 $114,800
110 4.4 10.6 0.0 0.0 0 $110,900
100 1.0 12.2 1.8 0.0 0 $106,702
3 90 1.0 7.1 6.9 0.0 0 $102,086
80 1.0 0.8 13.2 0.0 0 $97,471
70 1.0 0.0 14.0 0.0 225 $91,670
4 60 1.0 0.0 14.0 0.0 478 $85,717
50 1.0 0.0 14.0 0.0 732 $79,764
0. $36 is never used
1. Very high N (>140), fix price at $60 all the time
2. High N (100 ~ 140), one-cut inventory clearance
3. Low N (70 ~ 100), multi-cut inventory clearance
4. Very low N (<70), mark down to $48 asap (not all units can be sold)

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 A Stochastic Perspective

• LP Solution is optimal if market size is deterministic and known, but this is

not the case in the Retailer game …
– Early sales observations are not reliable
– Weekly uncerntainty

• Problems of the static and deterministic strategies

– Cannot utilize the real-time sales information
– Does not take uncertainty into account

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 17

 Dynamic Adjustment Strategy

• Dynamic adjustment: to incorporate realized sales/demand information

• Observation: the nested structure of the problem

• Dynamic Adjustment Strategy:

1. Solve the LP based on historical demand information and 1st week sales
2. Implement the solution for one week
3. Observe more sales
4. Update the demand estimate
5. Re-solve the LP for the remaining sub-problem
6. Repeat “Implement-Observe-Update-Solve” each week

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 18

 Dynamic Adjustment Strategy

• A positive demo of dynamic adjustment strategy (0.37% diff.)

LP with Dynamic Adjustments LP Sub-problem
Observed Solutio
Week Inventory Price Sales Revenue N Estimate Market Size Time Initial Inventory n Actual Revenue Diff
1 2000 60 168 10080 168 168 $104,496 0.37%
2 1832 60 66 3960 66 117 168 14 1832 10.9 0.0 0.0 0.0
3 1766 60 73 4380 73 102 117 13 1766 6.1 6.9 0.0 0.0
4 1693 54 112 6048 86 98 102 12 1693 0.0 9.9 2.1 0.0
5 1581 54 78 4212 60 91 98 11 1581 7.0 4.0 0.0
6 1503 54 112 6048 86 90 91 10 1503 1.9 8.1 0.0
7 1391 54 146 7884 112 93 90 9 1391 0.5 8.5 0.0
8 1245 54 131 7074 101 94 93 8 1245 1.3 6.7 0.0
9 1114 54 132 7128 101 95 94 7 1114 0.8 6.2 0.0
10 982 54 91 4914 70 92 95 6 982 0.2 5.8 0.0
11 891 48 193 9264 111 94 92 5 891 5.0 0.0
12 698 48 155 7440 89 94 94 4 698
13 543 48 161 7728 92 93 94 3 543
14 382 48 261 12528 150 97 93 2 382
15 121 48 121 5808 69 96 97 1 121

• Compared to T* strategy (4.3%) and static LP (1.46%)!

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 19

 Dynamic Adjustment Strategy

• A negative demo of dynamic adjustment strategy (4.86% diff.)

LP with Dynamic Adjustments LP Sub-problem
Observed Solutio
Week Inventory Price Sales Revenue N Estimate Market Size Time Initial Inventory n Actual Revenue Diff
1 2000 60 85 5100 85 85 $97,428 4.86%
2 1915 54 68 3672 52 69 85 14 1915 0.0 4.3 9.7 0.0
3 1847 48 210 10080 120 86 69 13 1847 0.0 0.0 13.0 0.0
4 1637 48 177 8496 102 90 86 12 1637
5 1460 48 183 8784 105 93 90 11 1460
6 1277 48 142 6816 81 91 93 10 1277
7 1135 48 271 13008 155 100 91 9 1135
8 864 48 101 4848 58 95 100 8 864
9 763 48 175 8400 100 95 95 7 763
10 588 48 182 8736 104 96 95 6 588
11 406 48 233 11184 134 100 96 5 406
12 173 48 111 5328 64 97 100 4 173
13 62 48 62 2976 36 92 97 3 62
14 0 #N/A #N/A 92 2 0
15 #N/A #N/A #N/A 1 0

• Compared to T* (3.27%) and static LP (1.88%)!

• What’s wrong here???

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 Deal with the Uncertainty

• Advanced forecast updating procedures (e.g., Bayesian learning)

– Improve the demand estimate
– Acquire the info about the magnitude of the uncertainty

• Better strategies that take into account the irrecoverability of price cuts
– Otherwise be conservative (rely on human interference)

• Better strategies that incorporate the effect of uncertainty

– Stochastic dynamic programming models

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 Summary of the Retailer Game

• Data analysis
– Isolate price response and market size
– Identify strategies for extreme situations
• Rule out “dominated” prices ($36)
• Highest price ($60) if demand is extremely high
• “Optimal” price ($48) if demand is extremely low

• Static and deterministic strategies

– Inventory clearance: good for moderate-high demand
– LP: multi-cut for moderate-low demand

• Dynamic adjustment to incorporate real-time sales data

• More sophisticated strategies to deal with uncertainty

– Otherwise be conservative with price cut: later is better than earlier

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 Implementation Issues

• Accept the risk of unsold inventory

– Convince yourself and your sales people and accountants!!

• Decision support tool

– requires good data (GIGO)
– and good people

• Customer’s perception and response

– Segmentation by early/late is always difficult
– Evolving customer behavior

Aug 2016 DSC4213 Session 3 - Prof. WANG Tong 23

 Next time …

• Logit model setup

• MLE (Maximum Likelihood Estimation) for the logit model

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