1 ganesh iyer product line design and price customization part 1: decision process and optimization...

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Product Line Design and Price CustomizationPart 1:

Decision Process and Optimization Methodology

XMBA 206.1Summer 2008

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Examples of Versioning

Turbo tax http://www.turbotax.com/

Statistical Software Packages http://www.systat.com/store/

Adobe http://www.adobe.com/products/main.html

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Microsoft Office: Product Line (Versioning) in Action

Office 2000Developer

Office 2000Premium

Office 2000Professional

Office 2000Small Business

Office 2000Standard

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Palm Pilot: Product-line in Action

Palmm505Color$449

Palmm500$399

Palm VIIx$399

Palm IIIxe$179

Palm m100$129

Palm Vx$299

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Cambridge Software Corporation (CSC)

If CSC offers only one version of Modeler, which version should it

offer? At what price?

Should the firm offer more than one version of Modeler? If so, which versions should it offer? At what prices?

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Cost, Demand, and Willingness-to-Pay Estimates

"Student" "Commerical" "Industrial"

Product Development Cost $100,000 $200,000 $500,000

Variable Cost Per Unit $15 $25 $35

Market Segment Size Segment Willingness to PayDev. Cost (Per Unit)

Large, Multidivisional 5,000 $150,000 $150 $1,200 $2,500 Corporations

Corporate R&D and 2,000 $100,000 $100 $1,000 $2,000 University Laboratories

Consultants and 20,000 $200,000 $200 $300 $600 Professional Companies

Small Buisnesses 15,000 $200,000 $175 $225 $300

Students 500,000 $300,000 $50 $60 $100

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Product Line Pricing: Optimization Methodology and Decision Process

Key Principle: Backwards Induction Optimization Procedure (Decision Tree)

Two Step Decision Process = Backwards Induction

Stage 2Pricing and Targeting

Stage 1Product Choice

BackwardsInduction

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Decision ProcessStage 2: Pricing and Targeting for a given product

Suppose CSC introduces “student” version, what is the optimal price?

Relevant Costs» What are the relevant costs at this stage of decision making?

– segment development cost– variable cost (per unit)

» Is product completion cost a relevant cost at this stage?

Economic Trade-off: » unit contribution-margin vs. volume (# segments served).» choose the price which gives the maximum total contribution.» Total Contribution = Unit Price Volume - Segment Dev. Cost(s).

Can the optimal price of CSC be different from $ 50, $ 100, $ 150, $ 175 or $ 200?

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Student version

Table 1: Contribution Analysis for Modeler “Student” Version

Price Segments Served

Unit Contribution

Seg. Dev. Costs

Demand Total Contribution

(‘000s) $ 200 Consultants $ 185 $ 200,000 20,000 $ 3,500 $ 175 Consultants

Small Bus. $ 160 $ 400,000 35,000 $ 5,200

$ 150 Consultants Small Bus. Large Corp.

$ 135 $ 550,000 40,000 $ 4,850

$ 100 Consultants Small Bus. Large Corp. R&D, U Lab.

$ 85 $ 650,000 42,000 $ 2,920

$ 50 Consultants Small Bus. Large Corp. R&D, U Lab. Students

$ 35/$ 15*** $ 950,000 542,000 $ 8,020

*** CSC sells to student segment through college book stores which get 40 % commission so that

CSC nets only 60 % of the sale price of $ 50.

Above would imply that optimal price for “student” version is $ 50 at which all the 5 segments

are served and the Total Contribution from this version is $ 8,020,000.

If this version is chosen then the Net contribution after Product development costs is

8,020,000 – 100,000 = 7,920,000.

But is this really the case

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Single-version Case: Fixed Cost Trap

Segment Size 5,000 2,000 20,000 15,000 500,000

Segment Dev. Cost $150,000 $100,000 $200,000 $200,000 $300,000

"Student" $100,000; $15

$200 $185 $3,500,000 $3,400,000$175 $160 $3,000,000 $2,200,000 $5,100,000$150 $135 $525,000 $2,500,000 $1,825,000 $4,750,000$100 $85 $275,000 $70,000 $1,500,000 $1,075,000 $2,820,000$50 $35 $25,000 ($30,000) $500,000 $325,000 $7,200,000 $7,950,000

$15

Key Learning: Look out for Fixed Cost traps in decision making.

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Total Contribution Analysis for all products

Derive the Total Contribution if CSC instead offered “commercial” or “industrial” version » Backwards induction Management has already figured out its optimal

pricing policies in these contingencies.

Table 2: Contribution Analysis For “Commercial” and “Industrial” versions

Version Optimal Price Segments Served Total Contribution “Commercial” $ 225 Consultants

Small Bus. Large Corp. R&D,U Lab.

$ 7,750,000

“Industrial” $ 600 Consultants Large Corp. R&D,U Lab.

$ 14, 805,000

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Step 2: Product ChoiceNet contribution analysis

Choose the version which gives the maximum Net Contribution » What becomes relevant at this stage?

Product Development cost» Student = 100,000

» Commercial = 200,000

» Industrial = 500,000Table 3: Optimal Choice of Versions

Version Optimal Price Segments Served Net Total Contribution

“Student” $ 50 Consultants Small Bus. Large Corp. R&D,U Lab. Students

$ 7,950,000

“Commercial” $ 225 Large Corp. R&D,U Lab. Consultants Small Bus.

$ 7,550,000

“Industrial” $ 600 Large Corp. R&D,U Lab. Consultants

$ 14, 305,000

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Optimal Single Product

Optimal Single product design means 3 interrelated decisions» Product = Industrial

» Price = $ 600.

» Targeting = 3 high-end segments viz. Large Corp., Labs and Consultants segments.

This is where pricing, product design and segmentation come together.

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Recap…two-stage process.

Stage 2Pricing and Targeting

Stage 1Product Choice

BackwardsInduction

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Single-version Case

Unit Large, Corporate R&D Consultants and Small Students TOTAL NETContribution Multidivisional and University Professional Businesses CONTRIBUTION

Corporations Laboratories CompaniesSegment Size 5,000 2,000 20,000 15,000 500,000

Segment Dev. Cost $150,000 $100,000 $200,000 $200,000 $300,000

"Student" $100,000; $15

$200 $185 $3,500,000 $3,400,000$175 $160 $3,000,000 $2,200,000 $5,100,000$150 $135 $525,000 $2,500,000 $1,825,000 $4,750,000$100 $85 $275,000 $70,000 $1,500,000 $1,075,000 $2,820,000$50 $35 $25,000 ($30,000) $500,000 $325,000 $7,200,000 $7,950,000

$15"Commerical" $200,000; $25

$1,200 $1,175 $5,725,000 $5,525,000$1,000 $975 $4,725,000 $1,850,000 $6,375,000$300 $275 $1,225,000 $450,000 $5,300,000 $6,775,000$225 $200 $850,000 $300,000 $3,800,000 $2,800,000 $7,550,000$60 $35 $25,000 ($30,000) $500,000 $325,000 $5,200,000 $5,850,000

"Industrial" $500,000; $35

$2,500 $2,465 $12,175,000 $11,675,000$2,000 $1,965 $9,675,000 $3,830,000 $13,005,000$600 $565 $2,675,000 $1,030,000 $11,100,000 $14,305,000$300 $265 $1,175,000 $430,000 $5,100,000 $3,775,000 $9,980,000$100 $65 $175,000 $30,000 $1,100,000 $775,000 $12,200,000 $13,780,000

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Product Line

In the single-version case CSC ignores the largest segment = students = 500,000. Why?» Negative price effect (reduction in unit contribution) outweighed the

positive volume effect (demand expansion).

Is there some other way to include the Students segment? » Offer 2 versions with Students segment buying one version and other

segments buying the other version?

Two possible options: (1) “Industrial” + “Commercial” versions or “Industrial” + “Student” versions.

Consider “Industrial” and ‘Student” version why? » In the single-version case, if CSC were to introduce “Commercial”

version, it would have ignored the “students” segment.

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Qualitative Benefits of selling to studentsCatch ‘em young

Pricing to lock consumers in youth» Apple

» Gaming

» WSJ student edition

» Pharmaceutical firms and medical interns.

What are the advantages?» Loyalty through consumer investments in learning

» Sell upgrades in future.

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Two Products: Pricing and Targeting

How will you price the student version?» Price_Student = $50.

Can you charge $ 600 for the Industrial version as in the single product case?» What are the considerations?

Considerations that are different in the pricing of 2 products compared to one product?» No purchase of high quality product does not mean zero purchase.

Table 4: Consumer Surplus with “Industrial” version @ $600 and “Student” version @ $50

“Student” version “Industrial” version

Large Corp $100 (= $150 - $50) $1900 (=$2500-$600)

Labs $ 50 (=$100 - $50) $1400 (=$2000-$600)

Consultants $ 150 (=$200 - $50) $ 0 (=$600-$600)

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Pricing the Industrial Version Key Principle: Self-Selection/Cannibalization

Table 5: Maximum Price for “industrial” version consistent with consumer “self-selection”

Surplus from Maximum Price for “Student” version “Industrial” version

Large Corp $100 $2400 (=$2500-$100)

Labs $ 50 $1950 (=$2000-$50)

Consultants $ 150 $450 (=$600-$150)

Maximum Price for = Willingness-to-pay (EV) - Surplus from“Industrial” version for “Industrial” version “Student”

version

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Contribution of the Industrial Version

Table 6: Revised Contribution Analysis for Modeler “Industrial” Version

Price Segments Served

Unit Contribution

Seg. Dev. Costs

Demand Total Contribution

(‘000s) $ 2400 Large Corp. $ 2365 $ 150,000 5,000 $ 11,675 $ 1950 Large Corp.

R&D, ULab. $ 1915 $ 250,000 7,000 $ 13,155

$ 450 Large Corp. R&D, U Lab. Consultants

$ 415 $ 450,000 27,000 $ 10,755

• Optimal price of “Industrial” version = $ 1950

• Optimal targeting is the 2 high-end segments (Large Corp. and Labs).

• Net Contribution from “Industrial” version is $12,655,000.

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Contribution of the Student Version

Other 3 segments buy the Student version.

Table 7: Revised Contribution Analysis for Modeler “Student” Version

Demand Unit Contribution Total Contribution (Net of Seg. Dev. Cost) Consultants 20,000 $ 35 $ 500,000

Small Business 15,000 $ 35 $ 325,000

Students 500,000 $ 15 $ 7,200,000

Less:

Product Completion Cost $ 100,000

Net Total Contribution: $ 7, 925, 000

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Product Line Design and Pricing: Summary

CSC introduced two versions– Industrial at $1950– Student at $50

This allowed Cambridge to increase profit from $14,305,000 to $20,580,000 (plus $6,275,000).

In addition, students are served leading to greater future potential as they move to commercial and industrial employment.

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Product Line Design

Part 2: Strategic and Managerial Considerations

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Product Line Strategy Pros & Cons

There are economic benefits to a product line pricing strategy using several products, but these benefits must be weighed against the costs

1. Management complexity and coordination.2. Potential consumer confusion = Diverse product line means less

focused positioning

There are questions that cannot be answered by numbers alone “What do the people in the firm really want?”

1. How does your sales force react to selling too many versions?

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Different ways to create product lines

Design to accentuate the needs of different groups of customers. Emphasizing customer differences allows you to extract, through the product line versions, a higher fraction of the total value you create.

Features to emphasize differences: » Speed of Operation – Mathematical software» Support -- Software with & w/o documentation. Minitab» Capability -- 7 versions of Kurzweil’s voice recognition software

differentiated on range & type of vocabulary

Need not be physical features» Time (Delay): PAWW Financial Network -- $50/month for real-time

quote & $8.95/month for 20-minute delayed quote

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How to Implement Product Lines

Identify the best features to distinguish the different versions of the product/service

Need to determine which features will be highly valuable to some customers but of little value to others.

Goal: Create the “right” # of versions -- targeted at the “right”

customer segments by setting the “right” prices.

Strategic Issue -- Cannibalization: Will the high-end customers buy the higher priced version? How to dissuade them from buying the lower priced version?

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How to Prevent Cannibalization?

How did we do it in the Cambridge case?

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Preventing Cannibalization: Disabling Attributes

Intel sells 486DX chip for $1000.

Intel disables the math coprocessor of the DX chip and makes the SX chip (thus incurring a cost of $50).

Intel sells the 486SX chip for $800!

So Intel sells a damaged product that actually costs more to make for a lower price.

What is going on here?

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Product Line Design: Disabling Attributes

Problem facing Intel when it introduced 486 chip (two types of early adopters):

E, G (50% of each type), E is willing to pay more and performs lots of math calculations

Res. Price Buyer Revenues

$1000 E $1000

$800 E & G $1600

What should Intel price the 486?

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Disabling Attributes

If Intel can charge different prices to different users

» $800 to G» $1000 to E

» Total: $1800

Price discrimination can earn the seller an extra 200!

But there is a caveat……..

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Disabling Attributes

The seller wants to charge G less than E for the same 486 chip.

At the same time, the seller has to prevent E from buying the product meant for G. What does the seller do?

The seller disables the math coprocessor for G!» Actually incurs a cost of doing so (say $10)

» But makes $200 extra from E.

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Controlling CannibalizationTwo Methods

Potential Cannibalization: If the low-end version is “too

attractive”, it may attract some customers who would other wise

pay a premium for the high-end version

Method #1: Cut the price of your high-end version to ensure that your high-value customers buy the high end version.

Method #2: Damage your low-end version “enough” to make it unattractive to the high-end segment

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Learning: Optimal Product Line Design and Pricing

Point #1: Identify the attributes/features that are highly valued by some customer segments yet of little importance to other customer segments

Point #2: Greater the differences among the customers in their intensity of preference for the differentiating attribute, the wider is the product line.

Point # 3: Find the best way to reduce cannibalization.

Qualitative Issues while selecting # of Versions: Costs of complexity can be large. Consumers may get confused if the positioning of the different versions is

not distinct. Salesforce buy-in.

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Sequential versus Simultaneous Product Launch

In reality, firms can choose to introduce the different versions sequentially? If you chose to introduce the versions sequentially, what is the order of sequential introduction? Why?

What factors would you consider while deciding whether to introduce the versions simultaneously versus sequentially?