From: mccall@mksol.dseg.ti.com (fred j mccall 575-3539)
Newsgroups: comp.os.os2.advocacy
Subject: Re: Bundling and the price of NT
Date: 14 Oct 92 17:22:22 GMT
Article-I.D.: mksol.1992Oct14.172222.24245
Organization: Texas Instruments Inc

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. 

>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.

>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 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?

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

>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.

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

>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
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
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.
Newsgroups: comp.os.os2.advocacy