Module:6

Sourcing, Transporting and

Pricing of Products

Dr. JAYAKRISHNA KANDASAMY

Professor, School of Mechanical Engineering
VIT University
[email protected]
9894968596

www.vit.ac.in
 Module:6 Sourcing, Transporting and Pricing of Products
Module:6 Sourcing, Transporting and Pricing of Products Hours: 7 CO 5
Part I Evaluate different
Sourcing decisions in supply chain transportation modes and
pricing strategies
Part II
Transportation in the supply chain – transportation infrastructure – suppliers of
transport services – transportation modes and trade-offs

Part III
Pricing and revenue management in the supply chain.

Learning Objectives of this Module – Part I

• Understand factors that affect the decision to outsource a supply chain function.

2
Prof. Jayakrishna Kandasamy - VIT University
 Sourcing decisions in supply chain

• Purchasing, also procurement, is the process by which companies acquire raw materials, components, products,
services, or other resources from suppliers to execute their operations

• Sourcing – entire set of business processes required to purchase goods and services

• Outsourcing – supply chain function being performed by a third party

 Sourcing decisions in supply chain

• Outsourcing questions

▪ Will the third party increase the supply chain surplus relative to performing the activity in-house?

▪ To what extent do risks grow upon outsourcing?

▪ Are there strategic reasons to outsource?

 Benefits of Effective Sourcing Decisions

• Higher quality and lower cost

• Better economies of scale

• Reduced the overall cost of purchasing

• Design collaboration resulting in easier manufacturing and distribution, lower overall costs

• Facilitate coordination with the supplier and improve forecasting and planning, lower inventories, improved
matching of supply and demand

• Appropriate sharing of risk and benefits can result in higher profits for both the supplier and the buyer

• Lower purchase price through the use of auctions

 In-House or Outsource?

• Decisions based on supply chain surplus and risk incurred

• Third parties increase surplus through

▪ Capacity aggregation
▪ Inventory aggregation
▪ Transportation aggregation by transportation
intermediaries
▪ Transportation aggregation by storage intermediaries
▪ Warehousing aggregation
▪ Procurement aggregation
▪ Information aggregation
▪ Receivables aggregation
▪ Relationship aggregation
▪ Lower costs and higher quality
 Module:6 Sourcing, Transporting and Pricing of Products
Module:6 Sourcing, Transporting and Pricing of Products Hours: 7 CO 5
Part I Evaluate different
Sourcing decisions in supply chain transportation modes and
pricing strategies
Part II
Transportation in the supply chain – transportation infrastructure – suppliers of
transport services – transportation modes and trade-offs

Part III
Pricing and revenue management in the supply chain.

Learning Objectives of this Module – Part II

• Understand the role of transportation in a supply chain
• Evaluate the strengths and weaknesses of different modes of transportation
• Discuss the role of infrastructure and policies in transportation
• Identify the relative strengths and weaknesses of various transportation network design options
• Identify trade-offs that shippers need to consider when designing a transportation network

7
Prof. Jayakrishna Kandasamy - VIT University
 The Role of Transportation in a Supply Chain

• Movement of product from one location to another

• Products rarely produced and consumed in the same location

• Significant cost component

• Shipper requires the movement of the product

• Carrier moves or transports the product

 Modes of Transportation and Their Performance Characteristics

• Air

• Package carriers

• Truck

• Rail

• Water

• Pipeline

• Intermodal
 Modes of Transportation and Their Performance Characteristics

Freight Value Added to

Freight Value Freight Tons
Ton-Miles GNP
Mode ($ billions) (billions)
(millions) ($ billions)
in 2002 in 2002
in 2002 in 2009
Air (includes
563 6 13 61.9
truck and air)
Truck 9,075 11,712 1,515 113.1
Rail 392 1,979 1,372 30.8
Water 673 1,668 485 14.3
Pipeline 896 3,529 688 12.0
Multimodal 1,121 229 233
 Air

• Cost components

1. Fixed infrastructure and equipment

2. Labor and fuel

3. Variable depending on passenger/cargo

• Key issues

• Location/number of hubs

• Fleet assignment

• Maintenance schedules

• Crew scheduling

• Prices and availability

 Package Carriers

• Small packages up to about 150 pounds

• Expensive

• Rapid and reliable delivery

• Small and time-sensitive shipments

• Provide other value-added services

• Consolidation of shipments a key factor

 Truck

• Significant fraction of the goods moved

• Truckload (TL)

• Low fixed cost

• Imbalance between flows

• Less than truckload (LTL)

• Small lots

• Hub and spoke system

• May take longer than TL

 Rail

• Move commodities over large distances

• High fixed costs in equipment and facilities

• Scheduled to maximize utilization

• Transportation time can be long

• Trains ‘built’ not scheduled

 Water

• Limited to certain geographic areas

• Ocean, inland waterway system, coastal waters

• Very large loads at very low cost

• Slowest

• Dominant in global trade

• Containers
 Pipeline

• High fixed cost

• Primarily for crude petroleum, refined petroleum products, natural gas

• Best for large and stable flows

• Pricing structure encourages use for predictable component of demand

 Intermodal

• Use of more than one mode of transportation to move a shipment

• Grown considerably with increased use of containers

• May be the only option for global trade

• More convenient for shippers – one entity

• Key issue – exchange of information to facilitate transfer between different modes

 Transportation Infrastructure and Policies

• Governments generally take full responsibility or play a significant role in building and managing infrastructure
elements

• Without a monopoly, deregulation, and market forces help create an effective industry structure

• Pricing should reflect the marginal impact on the cost to society

Transportation Infrastructure and Policies
 Design Options for a Transportation Network

When designing a transportation network

1. Should transportation be direct or through an intermediate site?

2. Should the intermediate site stock product or only serve as a cross-docking location?

3. Should each delivery route supply a single destination or multiple destinations (milk run)?
Direct Shipment Network to Single Destination
Direct Shipment Network with Milk Runs
All Shipments via Intermediate Distribution Center with Storage
 All Shipments via Intermediate Transit Point with Storage

• Suppliers send their shipments to a central distribution center

• Stored until needed by buyers

• Shipped to each buyer location

 All Shipments via Intermediate Transit Point with Cross-Docking

• Suppliers send their shipments to an intermediate transit point

• They are cross-docked and sent to buyer locations without storing them
Shipping via DC Using Milk Runs
 Tailored Network

Network Structure Pros Cons

Direct shipping No intermediate warehouse High inventories (due to large

Simple to coordinate lot size)
Direct shipping with Lower transportation costs for small lots Lower Increased coordination
milk runs inventories complexity
All shipments via central DC Lower inbound transportation cost through Increased inventory cost
with inventory storage consolidation Increased handling at DC
All shipments via central DC Low inventory requirement Increased coordination
with cross-dock Lower transportation cost through complexity
consolidation
Shipping via DC using Lower outbound transportation cost for small Further increase in
milk runs lots coordination complexity
Tailored network Transportation choice best matches needs of Highest coordination
individual product and store complexity
 Selecting a Transportation Network

• Eight stores, four supply sources

• Truck capacity = 40,000 units
• Cost $1,000 per load, $100 per delivery
• Holding cost = $0.20/year
 Selecting a Transportation Network

Annual sales = 960,000/store Direct shipping

Batch size shipped from each

supplier to each store = 40,000 units
Number of shipments/yr from
each supplier to each store = 960,000/40,000 = 24
Annual trucking cost
for direct network = 24 x 1,100 x 4 x 8 = $844,800
Average inventory at each
store for each product = 40,000/2 = 20,000 units
Annual inventory cost
for direct network = 20,000 x 0.2 x 4 x 8 = $128,000
Total annual cost of
direct network = $844,800 + $128,000 = $972,800
 Selecting a Transportation Network

Annual sales = 960,000/store Milk runs

Batch size shipped from each

supplier to each store = 40,000/2 = 20,000 units
Number of shipments/yr from
each supplier to each store = 960,000/20,000 = 48
Transportation cost per shipment
per store (two stores/truck) = 1,000/2 + 100 = $600
Annual trucking cost
for direct network = 48 x 600 x 4 x 8 = $921,600
Average inventory at each
store for each product = 20,000/2 = 10,000 units
Annual inventory cost
for direct network = 10,000 x 0.2 x 4 x 8 = $64,000
Total annual cost of
direct network = $921,600 + $64,000 = $985,600
 Selecting a Transportation Network

Annual sales = 120,000/store Direct shipping

Batch size shipped from each

supplier to each store = 40,000 units
Number of shipments/yr from
each supplier to each store = 120,000/40,000 = 3
Annual trucking cost
for direct network = 3 x 1,100 x 4 x 8 = $105,600
Average inventory at each
store for each product = 40,000/2 = 20,000 units
Annual inventory cost
for direct network = 20,000 x 0.2 x 4 x 8 = $128,000
Total annual cost of
direct network = $105,600 + $128,000 = $233,600
 Selecting a Transportation Network

Annual sales = 120,000/store Milk runs

Batch size shipped from each

supplier to each store = 40,000/4 = 10,000 units
Number of shipments/yr from
each supplier to each store = 120,000/10,000 = 12
Transportation cost per shipment
per store (four stores/truck) = 1,000/4 + 100 = $350
Annual trucking cost
for direct network = 12 x 350 x 4 x 8 = $134,400
Average inventory at each
store for each product = 10,000/2 = 5,000 units
Annual inventory cost
for direct network = 5,000 x 0.2 x 4 x 8 = $32,000
Total annual cost of
direct network = $134,400 + $32,000 = $166,400
 Mumbai Dabbawalas

• Lunchbox delivery system

• Factors facilitating success

1. Low uncertainty of demand
2. Temporal aggregation of demand
3. Use of transportation resources when they are
underutilized

Dabbawalas: How India's 130-year-old food

delivery system works
https://www.youtube.com/watch?v=KDD32skx-zM

https://streamlynacademy.com/blog/mumbai-dabbawala-case-study/
 Trade-offs in Transportation Design

• Transportation and inventory cost trade-off

• Choice of transportation mode

• Inventory aggregation

• Transportation cost and responsiveness trade-off

 Trade-offs in Transportation Design

Cycle Safety In-Transit Transportation Transportation

Mode
Inventory Inventory Cost Cost Time
Rail 5 5 5 2 5

TL 4 4 4 3 3

LTL 3 3 3 4 4

Package 1 1 1 6 1

Air 2 2 2 5 2

Water 6 6 6 1 6
 Trade-offs When Selecting Transportation Mode

Demand = 120,000 motors, Cost = $120/motor,

Weight = 10 lbs/motor, Lot size = 3,000,

Safety stock = 50% ddlt

Range of Quantity
Carrier Shipping Cost ($/cwt)
Shipped (cwt)
AM Railroad 200+ 6.50
Northeast Trucking 100+ 7.50
Golden Freightways 50–150 8.00
Golden Freightways 150–250 6.00
Golden Freightways 250+ 4.00
 Trade-offs When Selecting Transportation Mode

Cycle inventory = Q/2 = 2,000/2 = 1,000 motors

Safety inventory = L/2 days of demand

= (6/2)(120,000/365) = 986 motors

In-transit inventory = 120,000(5/365) = 1,644 motors

Total average inventory = 1,000 + 986 + 1,644

= 3,630 motors

Annual holding cost using AM Rail = 3,630 x $30 = $108,900

Annual transportation cost using AM Rail = 120,000 x 0.65 = $78,000

The total annual cost for inventory and transportation using AM Rail = $186,900
 Trade-offs When Selecting Transportation Mode

Transpor-
Lot Size Cycle Safety In-Transit Inventory
Alternative tation Total Cost
(Motors) Inventory Inventory Inventory Cost
Cost
AM Rail 2,000 $78,000 1,000 986 1,644 $108,900 $186,900

Northeast 1,000 $90,000 500 658 986 $64,320 $154,320

Golden 500 $96,000 250 658 986 $56,820 $152,820

Golden 1,500 $96,000 750 658 986 $71,820 $167,820

Golden 2,500 $86,400 1,250 658 986 $86,820 $173,220

Golden 3,000 $80,000 1,500 658 986 $94,320 $174,320

Golden 4,000 $72,000 2,000 658 986 $109,320 $181,320

(old proposal)
Golden 4,000 $67,000 2,000 658 986 $109,320 $176,820
(new proposal)
 Inventory Aggregation

• Can significantly reduce safety inventories

• Transportation costs generally increase

• Use

• When inventory and facility costs form a large fraction of a supply chain’s total costs

• For products with a large value-to-weight ratio

• For products with high demand uncertainty

 Tradeoffs When Aggregating Inventory

HighVal – weekly demand μH = 2, σH = 5, weight = 0.1 lbs, cost = $200

LowVal – weekly demand μL = 20, σL = 5, weight = 0.04 lbs, cost = $30

CSL = 0.997, holding cost = 25%, L = 1 week, T = 4 weeks

UPS lead time = 1 week, $0.66 + 0.26x

FedEx lead time = overnight, $5.53 + 0.53x

• Option A. Keep the current structure but replenish inventory once a week rather than once every four weeks

• Option B. Eliminate inventories in the territories, aggregate all inventories in a finished-goods warehouse at
Madison, and replenish the warehouse once a week
 Tradeoffs When Aggregating Inventory

1. HighMed inventory costs (current scenario, HighVal)

Average lot size, QH = expected demand during T weeks

= T m H = 4 ´ 2 = 8 units
Safety inventory, ssH = F –1(CSL) ´ s T +L = F –1(CSL) ´ T + L ´ s H
= F –1(0.997) ´ 4 +1´ 5 = 30.7 units
Total HighVal inventory = QH / 2 + ssH = (8 / 2) + 30.7 = 34.7 units

All 24 territories, HighVal inventory = 24 x 34.7 = 832.8 units

 Tradeoffs When Aggregating Inventory

1. HighMed inventory costs (current scenario, LowVal)

Average lot size, QL = expected demand during T weeks

= T m H = 4 ´ 20 = 80 units
Safety inventory, ssL = F –1(CSL) ´ s T +L = F –1(CSL) ´ T + L ´ s L
= F –1(0.997) ´ 4 +1´ 5 = 30.7 units
Total LowVal inventory = QL / 2 + ssL = (80 / 2) + 30.7 = 70.7 units

All 24 territories, LowVal inventory = 24 x 70.7 = 1696.8 units

 Tradeoffs When Aggregating Inventory

Annual inventory holding cost for HighMed

= (average HighVal inventory x $200 + average LowVal inventory x $30) x 0.25

= (832.8 x $200 + 169.8 x $30) x 0.25

= $54,366 ($54,395 without rounding)

 Tradeoffs When Aggregating Inventory

2. HighMed transportation cost (current scenario)

Average weight of each replenishment order

= 0.1QH + 0.04QL = 0.1 x 8 + 0.04 x 80 = 4 pounds

Shipping cost per replenishment order

= $0.66 + 0.26 x 4 = $1.70

Annual transportation cost = $1.70 x 13 x 24 = $530

3. HighMed total cost (current scenario)

Annual inventory and transportation cost at HighMed

= inventory cost + transportation cost

= $54,366 + $530 = $54,896

 Tradeoffs When Aggregating Inventory

Current Scenario Option A Option B

Number of stocking locations 24 24 1
Reorder interval 4 weeks 1 week 1 week
HighVal cycle inventory 96 units 24 units 24 units
HighVal safety inventory 737.3 units 466.3 units 95.2 units
HighVal inventory 833.3 units 490.3 units 119.2 units
LowVal cycle inventory 960 units 240 units 240 units
LowVal safety inventory 737.3 units 466.3 units 95.2 units
LowVal inventory 1,697.3 units 706.3 units 335.2 units
Annual inventory cost $54,395 $29,813 $8,473
Shipment type Replenishment Replenishment Customer order
Shipment size 8 HighVal + 80 LowVal 2 HighVal + 20 LowVal 1 HighVal + 10 LowVal
Shipment weight 4 lbs. 1 lb. 0.5 lb.
Annual transport cost $530 $1,148 $14,464
Total annual cost $54,926 $30,961 $22,938
 Tradeoffs When Aggregating Inventory

Average weight of each customer order = 0.1 x 0.5 + 0.04 x 5 = 0.25 pounds

Shipping cost per customer order = $5.53 + 0.53 x 0.25 = $5.66

Number of customer orders per territory per week = 4

Total customer orders per year = 4 x 24 x 52 = 4,992

Annual transportation cost = 4,992 x $5.66 = $28,255

Total annual cost = inventory cost + transportation cost

= $8,474 + $28,255

= $36,729
Tradeoffs When Aggregating Inventory

Aggregate Disaggregate
Transport cost Low High
Demand uncertainty High Low
Holding cost High Low
Customer order size Large Small
 Trade-off Between Transportation Cost and Customer Responsiveness

• Closely linked to degree of responsiveness

• High responsiveness, high transportation costs
• Decreased responsiveness, lower transportation costs

• Temporal aggregation – combining orders across time

 Trade-off Between Transportation Cost and Customer Responsiveness

Steel shipments LTL = $100 + 0.01x

Monday Tuesday Wednesday Thursday Friday Saturday Sunday

Week 1 19,970 17,470 11,316 26,192 20,263 8,381 25,377
Week 2 39,171 2,158 20,633 23,370 24,100 19,603 18,442
 Trade-off Between Transportation Cost and Customer Responsiveness
Two-Day Response Three-Day Response Four-Day Response
Quantity Quantity Quantity
Day Demand Cost ($) Cost ($) Cost ($)
Shipped Shipped Shipped
1 19,970 19,970 299.70 0 0
2 17,470 17,470 274.70 37,440 474.40 0
3 11,316 11,316 213.16 0 48,756 586.56
4 26,192 26,192 361.92 37,508 475.08 0
5 20,263 20,263 302.63 0 0
6 8,381 8,381 183.81 28,644 386.44 54,836 648.36
7 25,377 25,377 353.77 0 0
8 39,171 39,171 491.71 64,548 745.48 0
9 2,158 2,158 121.58 0 66,706 767.06
10 20,633 20,633 306.33 22,791 327.91 0
11 23,370 23,370 333.70 0 0
12 24,100 24,100 341.00 47,70 574.70 68,103 781.03
13 19,603 19,603 296.03 0 0
14 18,442 18,442 284.42 38,045 480.45 38,045 480.45
$4,164.46 $3,464.46 $3,264.46
 Tailored Transportation

• The use of different transportation networks and modes based on customer and product characteristics

• Factors affecting tailoring

• Customer density and distance

• Customer size

• Transportation cost based on total route distance

• Delivery cost based on number of deliveries

• Product demand and value

 Tailored Transportation

Short Distance Medium Distance Long Distance

High density Private fleet with milk runs Cross-dock with Cross-dock with
milk runs milk runs
Medium density Third-party milk runs LTL carrier LTL or package carrier

Low density Third-party milk runs or LTL or package carrier Package carrier
LTL carrier
 Tailored Transportation

Product Type High Value Low Value

High demand Disaggregate cycle inventory. Aggregate Disaggregate all inventories and use
safety inventory. Inexpensive mode of inexpensive mode of transportation for
transportation for replenishing cycle replenishment.
inventory and fast mode when using safety
inventory.
Low demand Aggregate all inventories. If needed, use Aggregate only safety inventory. Use
fast mode of transportation for filling inexpensive mode of transportation for
customer orders. replenishing cycle inventory.
 Module:6 Sourcing, Transporting and Pricing of Products
Module:6 Sourcing, Transporting and Pricing of Products Hours: 7 CO 5
Part I Evaluate different
Sourcing decisions in supply chain transportation modes and
pricing strategies
Part II
Transportation in the supply chain – transportation infrastructure – suppliers of
transport services – transportation modes and trade-offs

Part III
Pricing and revenue management in the supply chain.

Learning Objectives of this Module – Part III

• Understand the role of revenue management in a supply chain
• Identify conditions under which revenue management tactics can be effective
• Describe trade-offs that must be considered when making revenue management decisions

54
Prof. Jayakrishna Kandasamy - VIT University
 The Role of Pricing and Revenue Management in the Supply Chain

• Revenue management is the use of pricing to increase the profit generated from a limited supply of supply chain
assets

• Supply assets exist in two forms – capacity and inventory

• 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 profits
 The 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 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

 Pricing and Revenue Management for Multiple Customer Segments

• Differential pricing increases 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 make one segment pay
more than the other?

• 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 for Multiple Customer Segments

d = 10,000 – 2,000p
Pricing and Revenue Management for Multiple Customer Segments

d = 10,000 – 2,000p
Pricing to Multiple Segments

Demand curve for segment i = di = Ai – Bi pi

(
Supplier maximizes pi – c Ai – Bi pi )( )
Ai c
Optimal price = pi = +
2Bi 2

For capacity constrained by Q

k

( )(
Maxå pi – c Ai – Bi pi )
i=1
Subject to
k

å( A – B p ) £ Q
i i i
i=1

Ai – Bi pi ³ 0 for i = 1,...,k
Pricing to Multiple Segments

Customers unwilling to commit d1 = 5,000 – 20 p1

Customer willing to commit d2 = 5,000 – 40 p1
c = $10
5,000 10
p1 = + = 125+5 = $130
2´20 2
5,000 10
p2 = + = 62.5+5 = $67.50
2´ 40 2

d1 = 5,000 – (20´130) = 2,400 and d2 = 5,000 – (40´67.5) = 2,300

Total profit = (130´2,400)+(67.5´2,300) – (10´ 4,700) = $420,250

Pricing to Multiple Segments

Same price to both segments

( p – 10) (5,000 – 20 p) + ( p – 10) (5,000 – 40 p)

= ( p – 10) (10,000 – 60 p)

10,000 10
Optimal price p = + = $88.33
2 ´ 60 2
d1 = 5,000 – 20 ´ 88.33 = 3,233.40
d2 = 5,000 – 40 ´ 88.33 = 1,466.80

( ) ( )
Total profit = 88.33-10 ´ 3,233.40+1,466.80 = $368,166.67
Pricing to Multiple Segments

Total production capacity is limited to 4,000 units

( )( ) (
Max p1 – 10 5,000 – 20 p1 + p2 – 10 5,000 – 40 p2 )( )

Subject to

(5,000 – 20 p ) + (5,000 – 40 p ) £ 4,000

1 2

(5,000 – 20 p ) ,(5,000 – 40 p ) ³ 0
1 2
Pricing to Multiple Segments
 Allocating Capacity to a Segment Under Uncertainty

• Basic trade-off is between committing to an order from a lower-price buyer or waiting for a higher-price buyer to
arrive

• Spoilage

• Spill

( )
RH C H = Prob(demand from higher-price segment > C H ) ´ pH
Prob(demand from higher-price segment > C H ) = pL / pH
( ) (
C H = F –1 1– pL / pH , DH ,s H = NORMINV 1– pL / pH , DH ,s H )
 Allocating Capacity to a Segment Under Uncertainty

• Effective use of revenue management increases firm profits and improves service for the more valuable customer
segment

• Create different versions of a product targeted at different segments

• Tactics for multiple customer segments

• Price based on the value assigned by each segment

• Use different prices for each segment

• Forecast at the segment level

 Allocating Capacity to Multiple Segments

Revenue from segment A, pA = $3.50 per cubic foot

Revenue from segment B, pB = $2.00 per cubic foot
Mean demand for segment A, DA = 3,000 cubic feet
Standard deviation of demand for A, sA = 1,000 cubic feet

( )
C A = NORMINV 1– pB / pA , DA,s A
= NORMINV (1– 2.00 / 3.50,3,000,1,000)
= 2,820 cubic feet

(
C A = NORMINV 1– 2.00 / 5.00,3,000,1,000 )
= 3,253 cubic feet
 Pricing and Revenue Management for Perishable Assets

• Any asset that loses value over time is perishable

• Two basic approaches

1. Vary price dynamically over time to maximize expected revenue, dynamic pricing

2. Overbook sales of the asset to account for cancellations

 Dynamic Pricing

• Effective differential pricing generally increases the level of product availability for the consumer willing to pay full
price and total profits for the retailer

Demand for period i = di = Ai – Bi pi

k

(
Maxå pi Ai – Bi pi )
i=1
Subject to
k

å( A – B p ) £ Q
i i i
i=1

Ai – Bi pi ³ 0 for i = 1,...,k
 Dynamic Pricing

• Effective differential pricing generally increases the level of product availability for the consumer willing to pay
full price and total profits for the retailer

d1 = 300 – p1, d2 = 300 – 1.3p2, and d3 = 300 – 1.8p3

( ) (
Maxp1 300 – p1 + p2 300 – 1.3 p2 + p3 300 – 1.8 p3 ) ( )
Subject to

(300 – p ) + (300 – 1.3 p ) + (300 – 1.8 p ) £ 400

1 2 3

300 – p1,300 – 1.3 p2 ,300 – 1.8 p3 ³ 0

Dynamic Pricing
Dynamic Pricing
Evaluating Quantity with Dynamic Pricing

d1 = 300 – p1, d2 = 300 – 1.3p2, and d3 = 300 – 1.8p3

( ) ( ) (
Maxp1 300 – p1 + p2 300 – 1.3 p2 + p3 300 – 1.8 p3 – 100Q )
Subject to

(300 – p ) + (300 – 1.3 p ) + (300 – 1.8 p ) £ Q

1 2 3

300 – p1,300 – 1.3 p2 ,300 – 1.8 p3 ,Q ³ 0

Evaluating Quantity with Dynamic Pricing
 Overbooking

Basic trade-off is between having wasted capacity because of excessive cancellations or having a shortage of capacity

because of few cancellations requiring expensive backup

Cw
(
s* = Prob cancellations £ O * =
Cw + C s
)
( )
O* = F –1 s*, mc ,s c = NORMINV s*, mc ,s c ( )
( ) ( ) (
O = F –1 éës*, m L +O ,s L +O ùû = NORMINV éës*, m L +O ,s L +O ùû ) ( )
 Overbooking

Cost of wasted capacity, Cw = $10 per dress

Cost of capacity shortage, Cs = $5 per dress

Cw 10
s* = = = 0.667
Cw + Cs 10 + 5

( ) (
O* = NORMINV s*, mc ,s c = NORMINV 0.667,800,400 = 973)
O = NORMINV éë0.667,0.15,(5000 +O ) ,0.075 (5000 +O )ùû
O* = 1,115
 Pricing and Revenue Management for Seasonal Demand

• Seasonal peaks of demand common in many supply chains

• Off-peak discounting can shift demand from peak to non-peak periods

• Charge higher price during peak periods and a lower price during off-peak periods

• Increases profits for the owner of assets, decreases the price paid by a fraction of customers, and brings in new
customers during the off-peak discount period
 Pricing and Revenue Management for Bulk and Spot Contracts

• Problems constructing a portfolio of long-term bulk contracts and short-term spot market contracts

• Decide what fraction of the asset to sell in bulk and what fraction of the asset to save for the spot market

• The amount reserved for the spot market should be such that the expected marginal revenue from the spot market
equals the current revenue from a bulk sale
Pricing and Revenue Management for Bulk and Spot Contracts

cS – c B
Optimal value p* =
cS

( ) (
Q* = F –1 p*, m,s = NORMINV p*, m,s )
Long-Term Bulk Contracts versus the Spot Market

Bulk contract cost, cB = $10,000 per million units

Spot market cost, cS = $12,500 per million units

cS – cB 12,500 – 10,000
p* = = = 0.2
cS 12,500
( )
Q* = NORMINV p*, m,s = NORMINV 0.2,10,4 = 6.63 ( )
 Using Pricing and Revenue Management in Practice

1. Evaluate your market carefully

2. Quantify the benefits of revenue management

3. Implement a forecasting process

4. Keep it simple

5. Involve both sales and operations

6. Understand and inform the customer

7. Integrate supply planning with revenue management

 Key Point

✓ A third party may be able to provide sustainable growth of the surplus by aggregating to a higher level than the firm itself.
The growth in surplus comes from aggregating capacity, inventory, inbound or out-bound transportation, warehousing,
procurement, information, receivables, or relationships to a level that the firm cannot achieve on its own. A growth in
surplus may also occur if the third party has lower costs or higher quality because of specialization or learning.

✓ Transportation infrastructures often require government ownership or regulation because of their inherently monopolistic
nature. In the absence of a monopoly, deregulation, and market forces help create an effective industry structure. When the
infrastructure is publicly owned, it is important to price usage to reflect the marginal impact on the cost to society. If this is
not done, overuse and congestion result because the cost borne by a user is less than the user’s marginal impact on total
cost.

✓ When selecting a mode of transportation, managers must account for unit costs and cycle, safety, and in-transit inventory
costs that result from using each mode. Modes with high transportation costs can be justified if they result in significantly
lower inventory costs.
 Key Point
✓ Inventory aggregation decisions must account for inventory and transportation costs. Inventory aggregation decreases supply
chain costs if the product has a high value-to-weight ratio, high demand uncertainty, low transportation cost, and customer orders
are large. If a product has a low value-to-weight ratio, low demand uncertainty, large transportation cost, or small customer
orders, inventory aggregation may increase supply chain costs.

✓ Temporal aggregation of demand results in a reduction of transportation costs because it entails larger shipments and reduces the
variation in shipment sizes from one shipment to the next. It does, however, hurt customer response time. The marginal benefit of
temporal aggregation declines as the time window over which aggregation takes place increases.

✓ Tailoring transportation based on customer density and distance, customer size, or product demand and value allows a supply
chain to achieve appropriate responsiveness and low cost.

✓ If a supplier serves multiple customer segments with a fixed asset, it can improve revenues by setting different prices for each
segment. Prices must be set with barriers such that the segment willing to pay more is not able to pay the lower price. The amount
of the asset reserved for the higher-price segment is such that the expected marginal revenue from the higher-price segment
equals the price to the lower-price segment.
 Key Point
✓ Dynamic pricing can be a powerful tool to increase profits if the customers’ sensitivity to price changes in the course of the
season. This is often the case for fashion products, for which customers are less price sensitive early in the season but become
more price sensitive toward the end of the season. Dynamic pricing should, however, carefully consider strategic behavior by
customers who may anticipate future price drops and delay their purchase. With strategic customers it may be better to have a
fixed price or reduce the quantity offered.

✓ Overbooking or overselling of a supply chain asset is a valuable tactic if order cancellations occur and the asset is perishable.
The level of overbooking is based on the trade-off between the cost of wasting the asset if too many cancellations lead to
unused assets and the cost of arranging a backup if too few cancellations lead to committed orders being larger than the
available capacity.

✓ Most consumers of production, warehousing, and transportation assets in a supply chain face the problem of constructing a
portfolio of long-term bulk contracts and spot market purchasing. The basic decision is the size of the bulk contract. The
fundamental trade-off is between wasting a portion of a low-cost bulk contract and paying more for the asset on the spot
market.