SCM - Pricing & Revenue
Pricing is a factor that gears up profits in supply chain through an appropriate match of supply and demand. Revenue management can be defined as the application of pricing to increase the profit produced from a limited supply of supply chain assets.
Ideas from revenue management recommend that a company should first use pricing to maintain balance between the supply and demand and should think of further investing or eliminating assets only after the balance is maintained.
The assets in supply chain are present in two forms, namely capacity and Inventory
Capacity assets in the supply chain are present for manufacturing, shipment, and storage while inventory assets are present within the supply chain and are carried to develop and improvise product availability.
Thus, we can further define revenue management as the application of differential pricing on the basis of customer segment, time of use and product or capacity availability to increment supply chain surplus.
Revenue management plays a major role in supply chain and has a share of credit in the profitability of supply chain when one or more of the following conditions exist −
- The product value differs in different market segments.
- The product is highly perishable or product tends to be defective.
- Demand has seasonal and other peaks.
- The product is sold both in bulk and the spot market.
The strategy of revenue management has been successfully applied in many streams that we often tend to use but it is never noticed. For example, the finest real life application of revenue management can be seen in the airline, railway, hotel and resort, cruise ship, healthcare, printing and publishing.
RM for Multiple Customer Segments
In the concept of revenue management, we need to take care of two fundamental issues. The first one is how to distinguish between two segments and design their pricing to make one segment pay more than the other. Secondly, how to control the demand so that the lower price segment does not use the complete asset that is available.
To gain completely from revenue management, the manufacturer needs to minimize the volume of capacity devoted to lower price segment even if enough demand is available from the lower price segment to utilize the complete volume. Here, the general trade-off is in between placing an order from a lower price or waiting for a high price to arrive later on.
These types of situations invite risks like spoilage and spill. Spoilage appears when volumes of goods are wasted due to demand from high rate that does not materialize. Similarly, spill appears if higher rate segments need to be rejected due to the commitment of volume goods given to the lower price segment.
To reduce the cost of spoilage and spill, the manufacturer can apply the formula given below to segments. Let us assume that the anticipated demand for the higher price segment is generally distributed with mean of DH and standard deviation of σ H
CH = F-1(1-PL/PH, DH, σH) = NORMINV(1-PL/PH, DH, σH)
CH = reserve capacity for higher price segment
PL = the price for lower segment
PH = the price for higher segment
An important point to note here is the application of differential pricing that increments the level of asset availability for the high price segment. A different approach that is applicable for differential pricing is to build multiple versions of product that focus on different segments. We can understand this concept with the help of a real life application of managing revenue for multiple customer segments, that is, the airlines.
RM for Perishable Assets
Any asset that loses its value in due course of time is considered as a perishable item, for example, all fruits, vegetables and pharmaceuticals. We can also include computers, cell phones, fashion apparels, etc.; whatever loses its value after the launch of new model is considered as perishable.
We use two approaches for perishable assets in the revenue management. These approaches are −
- Fluctuate cost over time to maximize expected revenue.
- Overbook sales of the assets to cope or deal with cancellations.
The first approach is highly recommended for goods like fashion apparels that have a precise date across which they lose a lot of their value; for example, apparel designed for particular season doesn’t have much value in the end of the season. The manufacturer should try using effective pricing strategy and predict the effect of rate on customer demand to increase total profit. Here the general trade-off is to demand high price initially and allow the remaining products to be sold later at lower price. The alternate method may be charging lower price initially, selling more products early in the season and then leaving fewer products to be sold at a discount.
The second approach is very fruitful here. There are occurrences where the clients are able to cancel placed orders and the value of asset lowers significantly after the deadline.
RM for Seasonal Demands
One of the major applications of revenue management can be seen in the seasonal demand. Here we see a demand shift from the peak to the off-peak duration; hence a better balance can be maintained between supply and demand. It also generates higher overall profit.
The commonly used effective and efficient revenue management approach to cope with seasonal demand is to demand higher price during peak time duration and a lower price during off-peak time duration. This approach leads to transferring demand from peak to off-peak period.
Companies offer discounts and other value-added services to motivate and allure customers to move their demand to off-peak period. The best suited example is Amazon.com. Amazon has a peak period in December, as it brings short-term volume that is expensive and reduces the profit margin. It tempts customers through various discounts and free shipping for orders that are placed in the month of November.
This approach of reducing and increasing the price according to the demand of customers in the peak season generates a higher profit for various companies just like it does for Amazon.com.
RM for Bulk and Spot Demands
When we talk about managing revenue for bulk and spot demand, the basic trade-off is somewhat congruent to that of revenue management for multiple customer segments.
The company has to make a decision regarding the quantity of asset to be booked for spot market, which is higher price. The booked quantity will depend upon the differences in order between the spot market and the bulk sale, along with the distribution of demand from the spot market.
There is a similar situation for the client who tends to make the buying decision for production, warehousing and transportation assets. Here the basic tradeoff is between signing on long-term bulk agreement with a fixed, lower price that can be wasted if not used and buying in the spot market with higher price that can never be wasted. The basic decision to be made here is the size of the bulk contract.
A formula that can be applied to achieve optimal amount of the asset to be purchased in bulk is given below. If demand is normal with mean µ and standard deviation σ, the optimal amount Q* to be purchased in bulk is −
Q* = F-1(P*, μ, σ) = NORMINV(P*, μ, σ)
P* = probability demand for the asset doesn’t exceed Q*
Q* = the optimal amount of the asset to be purchased in bulk
The amount of bulk purchase increases if either the spot market price increases or the bulk price decreases.
We can now conclude that revenue management is nothing but application of differential pricing on the basis of customer segments, time of use, and product or capacity availability to increase supply chain profit. It comprises marketing, finance, and operation functions to maximize the net profit earned.