From: Hugh Whalen <HWHA@UNB.CA>
Subject: Re: Bundling and the price of NT
Organization: The University of New Brunswick
Date: Wed, 14 Oct 1992 23:19:18 GMT

In article <1992Oct14.172222.24245@mksol.dseg.ti.com> mccall@mksol.dseg.ti.com (fred j mccall 575-3539) writes:
>In <13OCT92.14357384.0207@UNBVM1.CSD.UNB.CA> HWHA@UNB.CA (Hugh Whalen) writes:
>
>>First I'd like to state that I teach in the *business* faculty. And
>>no, I'm not a "marketroid." (Is this proper flame terminology? I'm new
>>at this. :-))
>
>>In a previous post someone (Pete Skelly, I believe?) argued:
>
>>> Let X be the cost of development per unit sold
>>> Let Y be the price per unit per unit sold
>
>>> To make a profit, X < Y
>
>>>More to the point, Y is not necessarily based on the
>>>value of X, more than it should be more than X to make a profit. Y is
>>>based on what the market will pay for the product. Simple economics.
>
>>Pete is *almost* right here.
>
>>Those challenging Pete are arguing that including networking will
>>increase the cost of NT because we must now consider the cost of
>>developingnetworking in the pricing decision. As Fred McCall says:
>
>>> Because you have increased your value of X above (that floor price
>>> below which there is no profit in selling the thing) because now
>>> some proportion of the network stuff costs must be included in X.
>
>>Good point but  *wrong*.
>
>Well, it's wrong if you're not concerned about staying in business.

I'm glad to see that the people on the net are no brighter than
our students. :) :) (multiple smilies for the humour impaired)

>
>>The development costs of the product are IRRELEVANT in the pricing
>>decision. Yes I said irrelevant and I meant it. These development
>>costs are known as sunk costs. You have spent the money, you cannot
>>unspend it and if you consider the sunk costs you may make the
>>incorrect decision. This is one of the harder things for our students
>>to learn because it is counter intuitive. Nonetheless it is true. An
>>example will illustrate my point.
>
>Any pricing decision which doesn't cover the sunk costs will
>eventually lead to a sunk business.  Yes, when it comes to a
>sell/don't sell decision you are correct, but for initial pricing you
>damned well better take those sunk costs into account, since you had
>to pay them and the idea behind developing a product is to make money
>producing and selling it.
>

Agreed. And you *must* take into account this when you are considering
building the system in the first place. However that was then this is
now. Now that the development is finished your objective is *not* to
cover the costs but to generate as much revenue as possible from the
product you have. These are *not equivalent*. You cannot change the
past. You must deal with the world as it is. The fact is that you
have spent a lot of money developing a product but that is history.
Nothing can change this. This money is gone, .... forever. You must
move on to other things. What you must consider now is that you have
something .... a product. All that matters is how much you can sell
the product for. Customers do not *care* what you paid for it. They
only care what it is worth to them. You should be focused on what
the product can generate in terms of revenue not what it cost. Focusing
on the costs can hurt your judgement. It is conceptually wrong.

>>Let's say you are developing a new operating system. This system cost
>>$10,000,000 to develop. Marketing and production costs will be $30 per
>>unit sold. If you can sell 50,000 units at $100 each should you do
>>this?
>
>Of course you should.  Given the choice between selling the 50,000 and
>not selling it, the answer is obvious.  However, given the choice
>between selling 50,000 units at $100 each and 70,000 units at $50
>each, which one would YOU do?  And if you have the option of setting

The proper way to look at this is profit on the $100 sales is $70 per
unit or 50,000 times $70 = $3,500,000. Profit on the $50 sale is $20
per unit or 70,000 times $20 =$1,400,000. Clearly it is better to sell
the OS for $100 per unit.

>the price in such a way as to recover sunk costs as opposed to pricing
>it lower and NOT covering sunk costs, which one are you going to do?
>

I will repeat this one more time. THE PROPER STRATEGY IS TO MAXIMIZE
REVENUE MINUS THE VARIABLE COSTS SUCH AS PRODUCTION, MARKETING AND
SUPPORT. SINCE THE DEVELOPMENT COSTS ARE A CONSTANT THIS STRATEGY
WILL PRODUCE MAXIMUM PROFITS (OR MINIMUM LOSS). YOU ARE CONSIDERING
SOMETHING WHICH IS IRRELEVANT TO THE DECISION.

>>If you accept Fred's arguement the answer would appear to be no
>>because you would loose money. This is because the unit cost is $230
>>($30 production and marketing and $10,000,000/50,000 units or $200 per
>>unit in development costs)and the selling price is only $100. You
>>would lose $130 per unit and should therefore not sell the product.
>>This analysis is deeply flawed because it includes the development
>>costs.
>
>No, this analysis is flawed because you're talking about a sell/don't
>sell decision and we're talking about setting the initial price.
>

The same arguements hold. See the above explanation.

>>The proper analysis is: Selling price is $100 per unit and the
>>variable costs are $30. Each sale would increase your profit by $70
>>and selling 50,000 units would increase your profit by $3,500,000.
>>Therefore you should sell the OS.
>
>>Another way of looking at this is:
>
>>Sell the OS:
>> Revenue: 50,000 times $100       = $  5,000,000
>> Expenses:
>> Production and marketing              1,500,000
>> Development costs                    10,000,000
>> LOSS                               $  6,500,000
>
>>Do not sell the OS:
>> Revenue                   $0
>> Expenses:
>> Development costs       10,000,000
>> LOSS                   $10,000,000
>
>>As a $6,500,000 loss is better than a $10,000,000 loss you are better
>>off to sell the product.
>
>>I know .... a profit is better still but sometimes this is not
>>possible. The point is this: The proper way to analyse this problem is
>>to look at revenue and variable costs (such as production, marketing,
>>after sales support, etc.) and to ignore the sunk costs (i.e., the
>>development costs).
>
>Sorry, but that's 'after the fact' reasoning and doesn't take into
>account things like ongoing maintenance costs (which will likely be
>higher if you sell more units, but not linear), etc.  According to
>your reasoning, some 30% of the cost of producing and maintaining a

If you read what I said you will note that I included these costs.
They are $30 per unit.

>software product just sort of miraculously 'disappears'.  If you don't
>take getting your sunk costs back when you look at your pricing
>decisions, you are going to have a bankrupt business in one hell of a

They didn't disapear. They are merely irrelevant. Not the same thing
at all.

>hurry.  And if you can arbitrarily set prices such that that doesn't
>matter, then you should probably be regulated in the first place.
>

The issue of regulation is also irrelevant to this discussion of
pricing.

>>Since the costs of developing NT and networking are sunk costs (the
>>money has already been spent) Microsoft should ignore these costs. If
>>they are smart business people (and I believe they are) they will
>>instead attempt to maximize revenue and minimize variable costs.
>
>The money HASN'T already been spent, or they would be delivering NT
>this week.  The decision at this point must be that they think they
>can recover the remaining 6 months or so of costs in the price they
>plan on charging.  In fact, when they started the perception had to be
>that they could recover what WOULD become sunk costs in the price of
>the product or the decision to produce the product doesn't make sense
>in the first place.
>

I'm sure the vast majority of it has been spent. It's been in
development for what .... three years or longer.

>>How will bundling networking with NT affect revenue and costs? Well,
>>my speculation would be that it would probably reduce variable costs.
>>It is cheaper to produce and market one product than 2.
>
>It would reduce variable costs IN THOSE CASES WHERE THEY WOULD HAVE
>HAD TO PROVIDE NETWORKING SEPARATELY.  The other thing it does is let
>them justify a higher price, since it "includes the networking".  So

Huh? Sorry I don't understand.

>even by YOUR argument, putting the networking in all copies is going
>to cost the people who don't need it money, and probably more than
>just the marginal per/unit developmental costs of the networking.  So,

No!!!! My arguement is that it may or may not increase the cost to
the end user but does not necessarily do so because of the fact
that development costs are higher. The pricing is based primarily
on other things. We would only know this if we could read the
minds of the people at Microsoft. They will consider many things
in their pricing decision. ONE OF THE THINGS THEY SHOULD NOT CONSIDER
ACCORDING TO CURRENT ACCOUNTING (BUSINESS?) THEORY IS THE SUNK
COSTS.

>under your manner of thinking, it is WORSE for the consumer if the
>networking is bundled than it is under my way of thinking.
>

No!!! This is a complete misrepresentation of what I have said.


>>There are many other considerations in deciding the price of a
>>product. For example, a company might be willing to make a smaller
>>profit in order to increase market share as this is an important
>>business objective. A product may be strategic and the company may be
>>willing to shave profitability in order for it to succeed as it helps
>>other parts of our business. Example: if Microsoft sells NT apps it
>>may be willing to make less profit on NT if it can make more profit on
>>the apps.
>
>They may, in fact, even be willing to take a loss for a period of time
>in order to drive producers who don't have sufficiently cheap pockets
>right out of the market.  However, even though all the losses up to
>some point in time will count as 'sunk costs', that business must have
>some means in mind for recovering them in the future, or things like
>reducing profit in exchange for market penetration simply don't make
>sense (since the other guy can do the same and you're right back where
>you started, except at a lower price -- which is why I stated that in

You are correct here. Businesses do not *want* to do this. They
would all prefer monopolies and stable markets. Unfortunately
they have to deal with competition. This forces them to do
things which while not in their best interests are in the best
interests of consumers. Businessmen hate it. Consumers love it.
It's free enterprise ... the market at work.


>a competetive environment prices will tend toward the minimum of
>variable costs + share of amortized fixed costs + share of 'sunk
>costs' for each unit they expect to sell -- and the more units they
>expect to sell, the less regard they can give to anything except
>variable costs).
>
>>In summary, the bundling of networks may or may not increase the cost
>>of the product. Nobody (at least nobody outside of Microsoft) *knows*
>>how this bundling affects the price. I suspect that it will have very
>>little effect.
>
>I think it's pretty plain that no matter whose reasoning you use, the
>inclusion of networking will increase the price paid by people who
>would not have needed networking and decrease the price paid by those

Yes it's plain. It's plain wrong. :) :)


>who would have needed networking anyway.  This is how decisions like
>this get made (at least in businesses that turn a profit over the long
>term) -- bundling decisions are made based on what you expect your
>market mix to be with each type of bundling.
>
>--
>"Insisting on perfect safety is for people who don't have the balls to live
> in the real world."   -- Mary Shafer, NASA Ames Dryden
>------------------------------------------------------------------------------
>Fred.McCall@dseg.ti.com - I don't speak for others and they don't speak for me.
>.
>.

Hugh Whalen                |Questions are the important thing. Answers
Faculty of Administration  |are less important. Learning to ask good
University of New Brunswick|questions is the heart of intelligence.
                           |Learning the answer .... well answers are
                           |for students. Questions are for thinkers.
                           |               -- Roger C. Schank



DISCLAIMER: Neither UNB nor I care what the other thinks.

                       .