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Product Line Design and Price Customization

Part 1:
Decision Process and Optimization Methodology
XMBA 206.1
Summer 2008

Ganesh Iyer

Examples of Versioning

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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

Office 2000
Developer

Office 2000
Premium

Office 2000
Small Business
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Office 2000
Professional

Office 2000
Standard
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Palm Pilot: Product-line in Action

Palmm505 Palmm500 Palm VIIx


$399
Color
$399
$449

Palm Vx
$299

Palm IIIxe
$179

Palm m100
$129
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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

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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 1
Product Choice
Backwards
Induction

Stage 2
Pricing and Targeting

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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?

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Student version

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Single-version Case: Fixed Cost Trap

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.

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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

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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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Recaptwo-stage process.

Stage 1
Product Choice
Backwards
Induction

Stage 2
Pricing and Targeting

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Single-version Case

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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 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.

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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.

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Pricing the Industrial Version


Key Principle: Self-Selection/Cannibalization
Maximum Price for
Industrial version

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Willingness-to-pay (EV) for Industrial version


version

Surplus from
Student

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Contribution of the Industrial Version

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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

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Other 3 segments buy the Student version.

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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 Kurzweils 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?

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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
$1000
$800

Buyer
E
E&G

Revenues
$1000
$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 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

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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?

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