Product Line Design and Price Customization Part 1: Decision Process and Optimization Methodology XMBA 206.1 Summer 2008

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

Microsoft Office: Product Line (Versioning) in Action Premium Office 2000 Professional Office 2000 Developer Office 2000 Standard Office 2000 Small Business

Palm Pilot: Product-line in Action Palm VIIx $399 Palm Vx $299 Palm IIIxe $179 Palmm505 Color $449 Palmm500 $399 Palm m100 $129

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?

Cost, Demand, and Willingness-to-Pay Estimates

Product Line Pricing: Optimization Methodology and Decision Process Key Principle: Backwards Induction Optimization Procedure (Decision Tree) Two Step Decision Process = Backwards Induction Stage 2 Pricing and Targeting Stage 1 Product Choice Backwards Induction

Decision Process Stage 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?

Student version

Single-version Case: Fixed Cost Trap Key Learning: Look out for Fixed Cost traps in decision making.

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.

Step 2: Product Choice Net 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 = 500,000

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.

Recap…two-stage process. Pricing and Targeting Stage 1 Product Choice Backwards Induction

Single-version Case

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.

Qualitative Benefits of selling to students Catch ‘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.

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.

Pricing the Industrial Version Key Principle: Self-Selection/Cannibalization Maximum Price for = Willingness-to-pay (EV) - Surplus from “Industrial” version for “Industrial” version “Student” version

Contribution of the Industrial Version 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.

Contribution of the Student Version Other 3 segments buy the Student version.

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.

Product Line Design Part 2: Strategic and Managerial Considerations

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 Management complexity and coordination. 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?” How does your sales force react to selling too many versions?

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

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?

How to Prevent Cannibalization? How did we do it in the Cambridge case?

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?

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?

Disabling Attributes $800 to G $1000 to E Total: $1800 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……..

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.

Controlling Cannibalization Two 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

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.

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?