Lectures 19 & 20 – Supply Chain Management (SCM)

Pricing & Revenue Management in a Supply chain:

Dr Arijit De
The University of Manchester
Email: [email protected]
Pricing and Revenue Management in
a Supply Chain
Pricing and Revenue Management in a Supply Chain

• Role of pricing and revenue management in the supply

chain

• Pricing and Revenue Management for a single customer

Segments and multiple customer segments

• Pricing for different market segments

 Role of Pricing and Revenue Management in the
Supply Chain

Revenue management has a significant impact on supply chain

profitability when one or more of the following conditions exist

• The value of the product varies in different market segments

(Example: airline seats).

• Demand has seasonal and other peaks (Example: Christmas gifts)

 More examples on Conditions for Revenue
Management
Seasonal demand:
• Products ordered at Amazon.com peaks around Christmas time
(December)
• Supply chain textbook orders peaking in August and January (start of the
session)

Products is sold both in bulk and on the spot market

• Warehouse owner can decide whether to lease the entire warehouse
for long-terms contracts or save a portion of the warehouse for use in
the spot market.
 Choosing the right price is not an easy job –
Case Study
• Consider an example of airplane, A320 having 200 seats operating between
Paris and London.
• The ticket price is current $400 and 120 tickets are sold by the time of
departure.
• Now, as a manager it is essential to increase the profit and for that the
revenue need to be estimated which is $400 multiplied by 120 giving $48,000.
• The capacity of the flight is 200 and only 120 tickets or only 60% tickets are
sold. The plane is nearly half-empty.
• As the operating cost can’t be lowered, so the only way to increase the profit
is by increasing the revenue.
• How can you achieve it? By adjusting the ticket price. Whether by increasing
or decreasing the ticket price.
 Why not decrease the ticket price?

• Decreasing the ticket price should allow the sell of more tickets, and therefore
fill up the plane. Let’s have a look at what would happen if the ticket price is
set to $250
• At a lower price, more number of people buys tickets, and 200 seats are sold
quickly. The plane is now full and the revenue is $50,000 which is $250
multiplied by 200.
• So, by decreasing the ticket price the revenue has increased by 4.16%, but is
that the best solution?
 Why not increase the ticket price?

• Increasing the price might be a good idea. If same number of tickets are sold,
then it should increase the profit. Let’s see what happens when you set the
ticket price as $550.
• The number of passenger willing to pay $550 is much lower than the number
of passengers paying $400, and the airline ends up selling only 100 tickets for
the flight.
• Only 50% of the tickets are sold and the revenue becomes $550 multiplied by
100 giving $55000.
• So, the revenue has increased by 14.58%. But, there are still empty seats and
we can still look for some better pricing strategies.
 Analyzing different customer segments

• Some of the travelers are willing to pay more than other for the same flight. Some are
willing to pay $550, others $400 and some of the passengers will pay no more than
$250.
• The travelers are divided into 3 separate groups each paying different prices. The first
group of customers comprising of 100 passengers who are willing to pay $550, so we
can allow them to pay $550. The revenue for the first group is $55,000
• There were 120 passengers who were willing to pay $400 and among them 100
passengers have already paid $550. So, there are still 20 customers who are willing to
pay $400.
• The second group of customers are 20 passengers who pays $400 each and therefore
the revenue for the second group is $8000 and the plane is still not full.
 Analyzing different customer segments

• The remaining 80 seats in the aircraft are filled by customers who are willing to pay
only $250. The third group of customers pays $250 each and the revenue generated
from the third group is $20,000.
• It is $55,000 for the first group plus $8,000 for the second group of 20 people, and
$20,000 for the remaining group of people (80 passengers) who are very happy with
the discounted price.
• The outcome is rewarding for the airline: the aircraft is full, and the total revenue is
€83,000. This is about 50.9% more than the best solution of €55,000 obtained by
considering single price strategy.
Pricing and Revenue Management for Customer
Segment

The demand varies with price.

Demand is given in units and price in
dollars.
Demand function,
d = 10000 – 2000 p When the price of one unit is $2.50,
the demand becomes 5000 units.

d = 10000 – (2000*2.50) = 5000

Pricing and Revenue Management for Customer
Segment

When the price of one unit is $3.50, the

demand becomes 3000 units.

d = 10000 – (2000*3.50) = 3000

Demand function,
d = 10000 – 2000 p Although, when the price of one unit is
changed to $2, the demand becomes
6000 units,
d = 10000 – (2000*2) = 6000

So, lowering the price attracted new

segment of customer and as a result the
demand of the product went up.
 Pricing and Revenue Management for Customer
Segment

• 1st Case: When the price of one unit is as $3.50, the demand becomes 3000 units. So, the revenue earned is
$10,500. As, Revenue = Price * Demand

• 2nd Case: When the price of one unit is changed to $2, the demand becomes 6000 units. So the revenue generated
in this case is $12000.

• Now, profit in both the cases depends on the production cost, or Profit = Revenue – Production cost

• So, supposedly, if the cost of production of one unit is $1, then the Profit in 1st case = 10,500 – (3000*1) = $7500,
and Profit in 2nd case = 12000 – (6000*1) = $6000

• Therefore, by lowering the price, new customer segment was attracted as the demand went up but the profit was
reduced compared to the earlier case.

• So, it is always essential to devise certain pricing strategy which will help in achieving more profitability
 Pricing and Revenue Management for Customer
Segment

• 1st Case: When the price of one unit is as $3.50, the demand becomes 3000 units. So, the revenue earned is
$10,500. As, Revenue = Price * Demand

• 2nd Case: When the price of one unit is changed to $2, the demand becomes 6000 units. So the revenue generated
in this case is $12000.

• Now, profit in both the cases depends on the production cost, or Profit = Revenue – Production cost

• So, supposedly, if the cost of production of one unit is $1, then the Profit in 1st case = 10,500 – (3000*1) = $7500,
and Profit in 2nd case = 12000 – (6000*1) = $6000

• Therefore, by lowering the price, new customer segment was attracted as the demand went up but the profit was
reduced compared to the earlier case.

• So, it is always essential to devise certain pricing strategy which will help in achieving more profitability
 The Optimal Price
• Assuming the cost of each unit of product is c = $1, and p is the price of the product,

• (p – c) × (10000 – 2000 p) = (p – 1) × (10000 – 2000 p)

Total profit earned = (Price -cost)*(Total
demand met)
= – 2000p2 + 12000 p - 10000 Where demand function is (10000 – 2000 p)

Profit Function

• Analytically, p* = - 12000/(- 2000 × 2) = 3

• When p = $3, profit = – (2000 ×3 ×3) + (12000 × 3) – 10000

= – 18000 + 36000 – 10000 = $8000
 Generic Formula – The Optimal Price
Profit Function

Max (p – c) (A – Bp)
𝐴 𝐶
• The optimal price: 𝑝 = + Remember this formula, if
possible note it down
2𝐵 2

How do we got this formula???? By solving it Analytically

Profit = (p – c) (A – Bp) = Ap – Bp2 – AC + BCp
Differentiating the Profit function D with respect to p (price),
𝑑𝐷 𝑑2 𝐷
= 𝐴 − 2𝐵𝑝 + 𝐵𝑐. Now, again differentiating, = −2𝐵 < 0
𝑑𝑝 𝑑𝑝2
So there lies a maximum point on Profit function D,
𝑑𝐷 𝑑𝐷
So, by making = 0, we can obtain the value of p, = 0 or 𝐴 − 2𝐵𝑝 + 𝐵𝑐 = 0
𝑑𝑝 𝑑𝑝
𝐴 𝐶
𝑜𝑟, 𝑝 = +
2𝐵 2
 Pricing for different market segments:
Examples

• An airline provides three different seats: economy class, business class

and first class
• A car manufacturing such as Volkswagen has different brands, e.g., Audi,
VW, Skoda. Each brand also has different types of cars, e.g, SUV, Sedan,
Hatchbacks, MPV
• A builder builds different types of houses, e.g., detached, semi-detached,
terrace with different sized rooms and gardens
• A furniture manufacture produces various types of sofas with different
leather, fabric, and size
 Pricing and Revenue Management for
Multiple Market Segments
• There exist different market segments or customer segments for similar
products
• Offering different prices based on various customer segment increases
the total profits for a firm
• Two fundamental issues must be handled in practice
– How can the firm differentiate between the two segments and
structure its pricing to maximize the overall profit?
– How can the firm control demand such that the lower-paying segment
does not utilize the entire availability of the asset?
 Pricing and Revenue Management –
Example
• A contract manufacturer has identified two customer segments for its production
capacity – one willing to place an order more than one week in advance and the
other willing to pay a higher price as long as it can provide less than one week's
notice for production.

• The customers that are unwilling to commit in advance are less price sensitive and
have a demand curve 𝑑1 = 5000 − 20𝑝1 . Customers willing to commit in advance
are more price sensitive and have a demand curve of 𝑑2 = 5000 − 40𝑝2 .
Production cost is c = $10 per unit.
 Pricing and Revenue Management –
Example
1. What price should the contract manufacturer charge each segment if its
goal is to maximize profits? Determine the profit as well
2. If the contract manufacturer were to charge a single price over both
segments, what should it be? Also compute the profit
3. How much increase in profits does differential pricing (offering different
prices based on various customer segment) provide?
4. If total production capacity is limited to 4,000 units, what should the
contract manufacturer charge each segment?
 1. What price should the contract manufacturer charge
each segment if its goal is to maximize profits? Determine
the profit as well
 Pricing to Multiple Segments
𝑝1 = Price per unit of product in
For customer segment 1 (customer unwilling to segment 1
commit), 𝑑1 = 5000 − 20𝑝1 𝑑1 = demand of product in segment 1
For customer segment 2 (customer willing to that can be met
commit), 𝑑2 = 5000 − 40𝑝2 𝑝2 = Price per unit of product in
This formula we had
obtained by solving segment 2
Cost of production of one unit, c = $10 profit function optimally
𝑑2 = demand of product in segment 2
that can be met
𝐴1 𝑐 5000 10
𝑝1 = + = + = 125 + 5 = $130
2𝐵1 2 2×20 2
𝐴2 𝑐 5000 10
𝑝2 = + = + = 62.5 + 5 = $67.5
2𝐵2 2 2×40 2
𝑑1 = 5000 − 20𝑝1 = 5000 − 20 × 130 = 2400
𝑑2 = 5000 − 40𝑝2 = 5000 − 40 × 67.5 = 2300
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 = 130 × 2400 + 67.5 × 2300 − 10 × 4700 = $420,250
2. If the contract manufacturer were to charge a single price
over both segments, what should it be? Also compute the
profit
 Pricing to Multiple Segments

Same price to both segments or to both customer demands

𝑝 − 10 5000 − 20𝑝 + 𝑝 − 10 5000 − 40𝑝 = (𝑝 − 10)(10000 − 60𝑝)
This formula for
𝐴 𝑐 10000 10 determining optimal price
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝑝𝑟𝑖𝑐𝑒, 𝑝 = + = + = $88.33
2𝐵 2 2 × 60 2
Percent increase in profit by
𝑑1 = 5000 − 20𝑝 = 5000 − 20 × 88.3 = 3233.40
introducing differential pricing,
𝑑2 = 5000 − 40𝑝 = 5000 − 40 × 88.33 = 1466.80
420250−368166.67
= × 100 = 14.146%
368166.67

𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 = 88.33 − 10 × 3233.40 + 1466.80

= $368,166.67
 Pricing to Multiple Segments

3. How much increase in profits does differential pricing

(offering different prices based on various customer
segment) provide?

Percent increase in profit by introducing differential

pricing,
420250−368166.67
= × 100 = 14.146%
368166.67
4. If total production capacity is limited to 4,000 units, what
should the contract manufacturer charge each segment?
 Pricing to Multiple Segments

Total production capacity is limited to 4,000 units

𝑀𝑎𝑥𝑖𝑚𝑖𝑧𝑒 𝑝1 − 10 5000 − 20𝑝1 + (𝑝2 − 10)(5000 − 40𝑝2 )

Proft from selling to Profit from selling to

customer segment 1 customer segment 2
𝐶𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡𝑠,

Total demand satisfied should be less

5000 − 20𝑝1 + (5000 − 40𝑝2 ) ≤ 4000 than the maximum production capacity

5000 − 20𝑝1 ≥ 0 5000 − 40𝑝2 ≥ 0

Demand satisfied for Demand satisfied for
customer segment 1 should customer segment 2 should
be more than or equal to zero be more than or equal to zero
 Conclusion

• Role of pricing and revenue management in the supply chain

• Pricing and Revenue Management for a single and multiple customer

segments (different demand functions)

• Pricing for different market segments (Pricing strategy)

• Determined the optimal price for examples of pricing on multiple

segments
 Reading List

▪ Supply Chain Management: Strategy, Planning and Operation Sunil Chopra and D V Kalra, 7e,
Pearson Publications

▪ Designing and Managing the Supply Chain: Concepts, Strategies, and Case Studies by: David
Simchi-Levi, Philip Kaminsky and Edith Simchi-Levi . Third Edition 2008, Tata McGraw-Hill
Publishing Co. Ltd., New Delhi
Thank You