Operations management
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Operations management Session 17: Introduction to Revenue Management and Decision Trees
description
Operations management. Session 17: Introduction to Revenue Management and Decision Trees. Previous Class. Today’s Class. Introduction to Revenue Management Decision-making under uncertainty Decision Trees Simulation Game Explanation. $. Reducing Cost. Increasing Revenue. Profits. - PowerPoint PPT Presentation
Transcript of Operations management
Operations management
Session 17: Introduction to Revenue Management and Decision Trees
Session 17 Operations Management 2
Previous Class
Session 17 Operations Management 3
Today’s Class
Introduction to Revenue Management
Decision-making under uncertainty Decision Trees
Simulation Game Explanation
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RM: A Basic Business Need
What are the basic ways to improve profits?
ProfitsProfits$Red
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g C
ost
Incr
easi
ng R
even
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Revenue Management
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Revenue Management
forecastingcapacitycontrol
overbooking
optimizationmarketsegmentation
pricing
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‘Selling the right seats to the right customers at the right prices and the right time.’ (American Airlines 1987)
Revenue Management Definitions
(Squeezing as many dollars as possible out of the customers)
‘Integrated control and management of price and capacity (availability) in a way that maximizes company profitability.’
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Revenue Management History
RM was ‘invented’ by major US carriers after airline deregulation in the late 1970’s to compete with new low cost carriers
Matching of low prices was not an alternative because of higher cost structure
American Airline’s ‘super saver fares’ (1975) have been first capacity controlled discounted fares
RM allowed the carriers to protect their high-yield sector while simultaneously competing with new airlines in the low-yield sector
From art to science: By now, there are sophisticated RM tools and no airline can survive without some form of RM
Other industries followed - hotel, car rental, cruise lines etc.
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Revenue Management
How the optimization in Revenue Management might differ from what we have already learned (like linear programming)?
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Capacity Investment-1
New-Fashion buys dyed yarns and makes fashionable dress. The company knows with certainty that red will be the color of the year and the demand for a red gown is 2,000 units per month for the next 5 months.
The company can invest in a new production line with advanced technology. The capacity of the new line is 2,000 units per month.
The cost of this line is $1,000,000. The production cost per unit is $130.
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Capacity Investment-1
Alternative: The company can also convert an obsolete line with traditional technology. The capacity of the production line is also 2,000 units per month.
The cost of this conversion is $500,000. The production cost per unit is $200.
Each red gowns are sold for $300 each.
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Capacity Investment-1
Which technology should the company chose?
Clearly the new technology is preferable.
New-1,000,000+5*2,000*170=0.7M
Traditional -500,000+5*2,000*100=0.5M
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Capacity Investment-2
New-Fashion company is concerned that orange instead of red being the color of year.
The CEO of the company prefers to assume that the demand for the red gowns will be:
2,000 per month (probability 0.6) 0 (probability 0.4, market will demand 2000 orange
gowns) Given this information…
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Capacity Investment-2
New
Traditional
red
orange
red
orange
-1,000,000+5*2,000*170=0.7M
-1,000,000+0=-1M
-500,000+5*2,000*100=0.5M
-500,000+0=-0.5M
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Capacity Investment-2
The optimal decision is to invest in the traditional technology.
Intuitively, the traditional technology is preferred when the demand is uncertain because it has a lower upfront cost, but higher variable cost of production.
Lesson: Lower upfront costs are preferred when there is more variability.
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Decision Tree
A tool to come up strategy under uncertain environments
Decision
Scenario
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Capacity Investment-3
A smart consultant realized that a technology can delay the dye process and enable the company dye finished gowns after they know the color of the year.
The technology introduces an additional $30 cost of dyeing for each unit produced.
What should the company do?
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Capacity Investment-3
w/o dyedelayed
with dye delayed
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Observations
We observe that delay dyeing to collect more information is beneficial.
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More Observations
We also observe that if the company delays dyeing it is optimal to invest in the new technology. While if it decides to not wait, it is optimal for the company to invest in the traditional technology. Why?
The new technology costs more, but has lower production costs. Therefore, once we know demand is high, we prefer to make a higher initial upfront investment but have a lower marginal production cost.
Postpone differentiation and flexibility is desirable Sometime, waiting and collecting information is
worthwhile
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What did we learn?
How to use a decision tree to evaluate alternatives.
Let’s see another example in a different context.
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Decision Trees
A new drug must pass through three stages of clinical trials before it can be brought to market.
Phase 1: Safety is evaluated on a small group. Phase 2: The effectiveness of the drug is evaluated on a
large group. Phase 3: Randomized controlled trials are performed on
even larger groups. Comparison is against a “gold standard” treatment.
(Phase 4: Post-launch safety surveillance.)When should we contract for production capacity?
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Decision Trees
Suppose we desire to introduce a new hypertension drug to market.
We have completed phase 1 and 2 trials successfully. We assess a 90% probability of completing phase 3
successfully (and therefore gaining FDA approval). We assume demand for the drug will be 5 million
people in the next year. A one-year drug supply for a single person should net
us a $50 profit.
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Decision Trees
We have the option of contracting for manufacturing capacity now for $150 million.
We expect the cost of manufacturing capacity to increase if we wait until we know the results of our Phase 3 trial.
What is the minimum expected cost of delaying manufacturing such that it is beneficial for us to wait to contract for manufacturing capacity?
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Decision Trees
contract now
contract later
approved
not approved0.9
0.1
$50×5-$150=$100 million
-$150 million
0.9× (50×5-P) million
0.9×100-0.1×150=75>0.9× (50×5-P),83.33 > 250-P or P>166.67 in order that contracting now is more profitable.
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Decision Trees
We valued the flexibility of being able to wait until there is no more uncertainty.
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Decision Trees
Now suppose we have only completed Phase 1, and that we assess the probability of completing phase 2 to be 50%.
We still assess the probability of completing Phase 3 to be 90%.
We again have the option to contract now at $150 million or to contract later (after either completing phase 2 or 3).
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Decision Trees
later
nowpass phase 2
do not pass
pass phase 3
do not pass
$100 million
-$150 million
-$150 million
0.9
0.10.5
0.5
$75 million
-37.5 million
It does not make sense to contract now.
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What did we learn?
Decision trees How to value the option of delaying
decisions to collect information Next class, we will study revenue
management tools based on decision trees Still upcoming … simulation game
explanation.
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Next Session
Homework 4 due. Game report 1 due.
