CAMBRIDGE SOFTWARE CORPORATION: QUANTITATIVE ANALYSIS Learning Objectives: Benefits of product variety Factors limiting product variety Strategic

gic considerations in product-line pricing III. Quantitative Analysis: We will first consider the product-line design and pricing decisions for the case when CSC can offer only one version. In this case, the product-line design only involves selecting the right version to offer. Note further that targeting/positioning decision is synonymous with pricing decision in this case because the price selected by CSC completely determines which of the potential 5 segments will actually buy the version introduced by CSC. In the second part of this document, we consider the multi-version case.

(a) Single-Version Case: Decisions Rule: Choose the version which gives the highest contribution margin Options: (i) Student version; (ii) Commercial version; (iii) Industrial version

Optimization Procedure (Managerial Logic): The managerial logic involved in this case can be represented by the following decision tree:

Student

Commercial

Industrial

Large Corp

Labs

Consultants

Small Business

Students

In the decision tree, there are two levels of decisions/optimizations. The first level involves selection of the model to introduce. The second level decision is the targeting/positioning/pricing decision. In the figure above, Consultants refers to the fact that targeting includes Consultants and more high-end segments (i.e. Large Corporations and labs). Note that with any decision tree analysis, to reach a conclusion, we have to work backwards. The managerial thought process involves the following steps:

Step 1: Suppose CSC introduces student version, what is the optimal price? What are the relevant costs at this stage of decision making?

segment development cost variable cost (per unit)

Why is product completion cost NOT a relevant cost at this stage? Because, CSC management has already (hypothetically) committed itself to producing student version. As such, it is a sunk cost because irrespective of the # of segments served, CSC has to incur it if this version is introduced at all. Economic Trade-off: unit contribution-margin vs. volume (# segments served); choose the unit price which gives the maximum total contribution Total Contribution = Unit Price Volume - Segment Dev. Cost(s) NOTE: Since CSC introduces only one version, individual consumers have only two options: to buy or not to buy the version given CSCs price and their willingness-topay (economic value). Can the optimal price of CSC be different from $ 50, $ 100, $ 150, $ 175 or $ 200? (These are the willingness-to-pay of the 5 segments for student version.)

Table 1: Contribution Analysis for Modeler Student Version Price $ 200 $ 175 $ 150 $ 100 Segments Served Consultants Consultants Small Bus. Consultants Small Bus. Large Corp. Consultants Small Bus. Large Corp. R&D, U Lab. Consultants Small Bus. Large Corp. R&D, U Lab. Students Unit Contribution $ 185 $ 160 $ 135 $ 85 Seg. Dev. Costs $ 200,000 $ 400,000 $ 550,000 $ 650,000 Demand 20,000 35,000 40,000 42,000 Total Contribution (000s) $ 3,500 $ 5,200 $ 4,850 $ 2,920

$ 50

$ 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. The 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.

Step 2: Derive the Total Contribution IF CSC instead offered commercial or industrial version (Note: CSC management has already figured out its optimal pricing policies in these contingencies.) Table 2: Results From Contribution Analysis For Commercial and Industrial versions Version Commercial Optimal Price $ 225 Segments Served Consultants Small Bus. Large Corp. R&D,U Lab. Consultants Large Corp. R&D,U Lab. Total Contribution $ 7,750,000

Industrial

$ 600

$ 14, 805,000

Step 3: Choose the versions which gives the maximum Net Total Contribution (net of estimated product (version) completion cost). Why is product completion cost a relevant cost at this decision stage? e.g. CSC should choose student version if Optimal TCstudent - $ 100,000 > Optimal TCcommercial - $ 200,000 and Optimal TCstudent - $ 100,000 > Optimal TCindustrial - $ 500,000 Table 3:Optimal Choice of Versions Version Student Optimal Price $ 50 Segments Served Consultants Small Bus. Large Corp. R&D,U Lab. Students Large Corp. R&D,U Lab. Consultants Small Bus. Large Corp. R&D,U Lab. Consultants Net Total Contribution $ 7,920,000

Commercial

$ 225

$ 7,550,000

Industrial

$ 600

$ 14, 305,000

CSC should offer the Industrial version in the single-version case. The

optimal targeting/positing involves serving the three high-end segments viz. Large Corp., Labs and Consultants segments. With this product line design and targeting, the optimal price is $ 600.

(b)

Multi-Version case:

Note that in the single-version case, CSC chooses to introduce the Industrial version and serve only the 3 high-end segments. Even though Students segments (@ 500,000) is by far the largest segment, CSC chose to ignore it because the negative price effect (reduction in unit contribution) outweighed the positive volume effect (demand expansion). Is there some other way to include the Students segment? What about offering 2 versions of Modeler, with Students segments buying one version and other segments buying the other version? Now, for 2-version case, there are two options: (1) Industrial and Commercial versions; and, (2) ) Industrial and Student versions. We will consider the second option i.e. Industrial and Student versions first because of the following considerations: The logic for including a second version is to include the large students segment. Now, observe that in the single-version case, if CSC were to introduce Commercial version, it would have ignored the students segment because the incremental contribution (net of segment development cost) was negative at $ 1,730,000. How should one approach the problem of optimal targeting/pricing, given that CSC is introducing Industrial and Student versions? To ensure that Students segment buys the Student version, it must be priced at $50. What about the price of the Industrial version? Recall that in the singleversion case, the optimal price was $ 600 and the target segments were Large Corp., Labs and Consultants. Would these segments still buy the Industrial version at $ 600 given that they can buy Student version as well (i.e. CSC can not restrict these consumers from buying Student version)?1 Below are the consumer surplus (i.e. willingness-to-pay minus price) for the two versions of the 3 high-end segments (recall that, in the single-version case, if
Note that in same cases, firms can and do prevent sale e.g. special student and senior citizen discount is available only to these specific segments by requiring student ID or proof-of-age
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CSC were to introduce Industrial version, optimal targeting excluded the Small Business segment): Table 4: Consumer Surplus with Industrial version @ $600 and Student version @ $50 Student version Large Corp Labs Consultants $100 (= $150 - $50) $ 50 (=$100 - $50) $ 150 (=$200 - $50) Industrial version $1900 (=$2500-$600) $1400 (=$2000-$600) $ 0 (=$600-$600)

From Table 4, it is clear that while Large Corp and Labs will continue to buy Industrial segment, Consultants segment will switch to Student version because they get more surplus with that version. What price should CSC charge for Industrial version, given that Student version is priced @ $ 50? Clearly, $ 600 is not optimal anymore because at this price, Consultants are not buying the Industrial version. Recall that in the single-version case, CSC reduced the price of Industrial version up to $ 600 (willingness-to-pay for industrial version for Consultants segment) because the positive volume effect offset the negative price effect up to the Consultants segment. Any further reduction was suboptimal. What about a price of $ 450 for Industrial version? Note that at this price, the Consultants are indifferent between the two version. This changes the contribution from the Consultants segment and the conclusion from our earlier Contribution Analysis (Table 2) that Industrial version should target Consultants segment is no longer valid. Another thing to note at this point is that in the singleversion case, if Consultant did not buy the Industrial version, unit sales of 20,000 (segment size) was lost. In the 2-version case, however, these consumers can now buy the low-end Student version and so sales is not lost altogether.

To answer the question of optimal pricing for Industrial version, we first compute the Maximum Price that these 3 segments will pay for Industrial version, given that they have the option of buying Student version @ $ 50. We use the following formula: Maximum Price for Industrial version = Willingness-to-pay (EV) for Industrial version Surplus from Student version

Table 5: Maximum Price for industrial version consistent with consumer self-selection Surplus from Student version Large Corp Labs Consultants $100 $ 50 $ 150 Maximum Price for Industrial version $2400 (=$2500-$100) $1950 (=$2000-$50) $450 (=$600-$150)

With these effective willingness-to-pay for Industrial version (which is different from EV), the total contribution analysis for Industrial segment yields: Table 6: Revised Contribution Analysis for Modeler Industrial Version Price $ 2400 $ 1950 $ 450 Segments Served Large Corp. Large Corp. R&D, ULab. Large Corp. R&D, U Lab. Consultants Unit Contribution $ 2365 $ 1915 $ 415 Seg. Dev. Costs $ 150,000 $ 250,000 $ 450,000 Demand 5,000 7,000 27,000 Total Contribution (000s) $ 11,675 $ 13,155 $ 10,755

The optimal price of Industrial version is $ 1950 and the optimal

targeting/positing for this high-end version is the 2 high-end segments viz. Large Corp. and Labs. Net Contribution from Industrial version is $12,655,000.

The other 3 segments buy Student version generating a net contribution

(net of product completion cost) from this version of: Table 7: Revised Contribution Analysis for Modeler Student Version Demand Consultants Small Business 325,000 Students Less: Product Completion Cost Net Total Contribution: $ 100,000 $ 7, 925, 000 500,000 $ 15 $ 7,200,000 20,000 15,000 Unit Contribution $ 35 $ 35 Total Contribution (Net of Seg. Dev. Cost) $ 500,000 $

By offering two versions, Cambridge software earns a total net contribution of $20,580,000, an increase of $6,275,000 versus the optimal single product offering.

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