Cashing in on E-Commerce
The value of operations research soars as the digital economy takes wing
By Arthur Geoffrion
If operations research has been important to the offline economy for the last half century as amply demonstrated by other articles in this issue it is destined to be still more valuable to the digital economy as businesses rethink their basic value propositions and in some cases seek to reinvent themselves. This is especially true in such areas as supply chain management, dynamic pricing/yield management and Internet marketing, which are the focus of this article.
Supply Chain Management. The distinction between tangible goods like cars and computers, and (digitizable) information goods like magazines and music, comes up constantly in the e-business context. When completely digitized, information goods incur essentially no production cost after the first unit, no transportation cost and no inventory cost. Tangible goods do not enjoy these magical qualities, and require supply chains whose combined annual costs are approaching $1 trillion in the U.S.
Based on forecasts by Forrester Research, Inc. for North America in 2004 , about two-thirds of projected business-to-consumer (B2C) e-commerce revenues ($204 billion) and four-fifths of projected business-to-business (B2B) revenues ($3.25 trillion) will be in tangible goods rather than in information goods. Hence, supply chains are destined to play a monumentally important role in the digital economy. Their great importance is already plain, as the business press has been proclaiming emphatically since about mid-1999. This guarantees a major role for operations research, since a half-century of experience teaches that supply chain excellence is very difficult to achieve without quantitative modeling.
Planning and scheduling are the most fruitful areas for OR to improve supply chains. Planning includes deciding which plants to have and what major equipment they should contain, which products to produce where, how many warehouses to have of which type, and what size fleet to have. Scheduling includes deciding when and what to produce, store and move. Success stories in both planning and scheduling at Hewlett-Packard , IBM , Sears  and hundreds of other companies big and small are plentiful, and have been well documented in this magazine as well as Interfaces, the practice-oriented journal of the Institute for Operations Research and the Management Sciences (INFORMS).
Without sound planning and scheduling, even excellent execution will cost more than necessary and will not provide desired service levels. This was the sad experience of many firms that implemented ERP (Enterprise Resource Planning) for, in reality, there was essentially no P in ERP. Now there is a brisk demand for supplemental APS (Advanced Planning and Scheduling) software, and all the ERP vendors are scrambling to incorporate better planning and scheduling into their products, along with Internet-enabled connectivity. The universal objective is enterprise-wide "optimization," a term that to many is all but synonymous with operations research.
Although everyone wants "optimal" plans and schedules, most planning and scheduling software currently available from APS and ERP vendors produces solutions that may be workable but only faintly approximate being truly optimal. Over time, supply chain management will migrate to software solutions that incorporate better operations research technology. Competition among e-businesses, exacerbated by the rapid emergence of e-markets and associated opportunities to reconfigure supply chains dynamically, will hasten this migration.
Dynamic Pricing and Yield Management. You have limited and perishable capacity seats on an airplane, time on an expensive manufacturing line, hotel rooms, communication bandwidth, etc. and you want to gain the most revenue possible from this capacity. A ship that sails with an empty stateroom, idle manufacturing capacity or an empty theater seat are wasted revenue opportunities. The closer to the time when capacity will expire (e.g., a sailing date), the more inclined you are to discount from the usual price structure, or perhaps, on the contrary, to raise prices for desperate last-minute buyers. But by how much and when?
This kind of question, which requires highly technical analysis, gives rise to the closely related OR subfields of yield management, revenue management and dynamic pricing. The results have been spectacular. For example, yield management has generated "almost $1 billion of incremental annual revenue" at American Airlines according to Tom Cook, former president of The Sabre Group, Inc.  (See related article The Sabre Story [page 46]). This figure exceeds the airline's total operating earnings most years. In another dramatic example, National Car Rental executives credited revenue management for saving the car rental company from liquidation and returning it to profitability . The sophisticated analytical methods responsible for such successes are propagating rapidly beyond the airline industry that gave birth to them.
The advent of the digital economy is making dynamic pricing-type questions ever more important. One reason is that communication with customers is so much better thanks to e-mail and the Web. These technologies create the opportunity to change prices globally and instantly at little or no cost as drop-dead dates for capacity commitment approach. At the same time, they facilitate rapid customer responses to price changes and quick response to that feedback. This is true not only for B2C e-commerce, but also for B2B. For example, yield management systems are now being integrated with core business processes by online leaders in last-minute travel deals, natural gas trading, tickets and other industries .
Dynamic pricing and yield management are destined to play a crucial role in online auctions and e-markets, presently the most explosively expanding part of e-business. Business processes incorporating these ideas can be designed properly only with the help of analytical methods.
Internet Marketing. Marketing science is one of the most important OR subfields for success in B2C, and to some extent in B2B as well. Many familiar topics take on a new dimension with the advent of the Web. For example, understanding online consumer behavior and price sensitivity becomes one of the keys to successful e-tailing. Channel conflict is now of great concern to manufacturers adding a direct Internet channel. The Web is a new medium for new product diffusion and brand building. And, at last, the technology is at hand to enable one-to-one marketing for many kinds of customers.
Other marketing topics arise for the first time, such as how to mine clickstream data and Web logs for information that can help refine Website designs and online marketing tactics, how to dynamically optimize the choice of ads to be served from ad inventory each time a Web page is requested, and how to design a "clicks and mortar" strategy.
The business media often treat all Web marketing topics indiscriminately as novel phenomena without historical precedent. But in fact, many well-known theories and techniques of marketing science, sometimes combined with other OR techniques, can be adapted to good effect . Quantitative analysts who study such issues, often called Internet Marketing specialists, are becoming increasingly influential in e-business [9,10].
Why OR Is So Valuable
We have looked briefly at supply chain management, dynamic pricing/yield management and Internet marketing. Space permitting, it would be easy to establish the key role of operations research in such other areas as the telecommunications infrastructure for e-business (especially hardware manufacturing and network planning, operations and management) and online financial services (such as prepayment modeling for equity-backed loans and services pricing) . (See related stories on Level 3 [page 38] and Merrill Lynch [page 48].)
Why is OR playing a key role in bringing the emerging digital economy to life, and in helping e-businesses compete effectively in this economy?
There are at least six answers to this question, and they are not the ones most commonly given in the context of the offline economy. Each springs from an attribute of the digital economy:
1. OR excels at squeezing value out of data, which is being created in ever-increasing abundance by e-businesses. Think of Web log data, clickstream data, mobile scanner data, ERP data, process data stashed in data warehouses, customer data collected for personalized marketing programs, etc. Statistics and data analysis, including data mining, are core competencies of operations research. Coupling these with decision technology enables organizations to make sense of the data flood and turn it into actionable knowledge.
2. OR copes well with complexity because it is congenitally analytical in approach. Analysis literally means breaking up a complex whole into its component parts just what is needed to cope with an e-business revolution that is exacerbating organizational complexity by demanding more alliances, more inter-company focus, and better integration of business processes of all types.
3. OR has good tools for managing risk and coping with uncertainty. That's what statistics, decision analysis and probabilistic modeling are all about. The pace of business and technological change is now so rapid that the past is a poor guide to the present, let alone the future. The successful business practices of the past are often rendered obsolete, along with experienced-based business intuition. In this situation, it is prudent to invoke model-based approaches to decision-making that quantify risk explicitly.
4. OR is perhaps the most reliable way known to achieve a truly deep understanding of many kinds of business issues. One of the characteristics of the digital economy is a greater management premium put on deep understanding. Knowledge is increasingly recognized as a key competitive asset, and there is widespread interest in methods for knowledge discovery, knowledge management and protecting intellectual capital. It can be argued that no phenomenon, even man-made ones like business processes, is really understood until it can be measured and modeled. OR is the branch of knowledge that specializes in the scientific analysis of business issues and processes, with the eventual goal of understanding them deeply. To illustrate, IBM recently won a major INFORMS-sponsored award for achieving a model-based understanding of their inventories sufficiently deep to enable them to capture more than $750 million in savings during a single year .
5. OR has plenty of experience performing virtual "experiments" that study business issues without risking damage to a company's assets or financial performance. This trick is performed with the help of models, mathematics and computer simulation, and is increasingly valuable in a business era where intuition-busting novelty is the order of the day and the consequences of failures can be multiplied many times by the global reach of the Web.
6. OR thrives in situations where the same kind of decision must be made very quickly (perhaps in real time, as in many Web applications) and repeatedly, for it can furnish decision technology that can be embedded in the information systems and e-business software that implement business processes. E-business is fundamentally about automating business processes and coupling these to Internet (often Web) interfaces with other companies or customers. Many decisions that used to be made manually are being converted to full-automatic even home equity loans. Doing this to good economic effect, and in a way that satisfies other companies and customers, usually requires decision technology as well as information technology. Rules of thumb that work well even 99 percent of the time can generate huge economic penalties and dissatisfaction when used on a high-traffic Website. The solution is to install solid decision technology wherever possible.
As a professional society, INFORMS recognizes and embraces the growing importance of the digital economy. For example, Interfaces will publish a special issue on e-business applications of operations research later this year, and follow it with a regular Forum on the same theme. Other INFORMS journals have published or will publish special issues on applicable research relating to e-business, and a new special interest section of INFORMS on e-commerce has just been born. INFORMS will hold a conference for OR practitioners in May 2001. The meeting theme: "Optimizing the Extended Enterprise in the New Economy." (See related article on page 72.) All this adds up to INFORMS as a fertile source of information and expertise increasingly aligned with today's e-business challenges.
Arthur Geoffrion is the James A. Collins Professor of Management at UCLA's Anderson School. After working for many years on optimization and its applications to supply chain management and other areas, and then on the foundations of computer-based modeling environments, his current interests focus on e-business. He is a member of the National Academy of Engineering and a recent president of INFORMS.
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