From: Hugh Whalen <HWHA@UNB.CA>
Subject: Bundling and the price of NT
Organization: The University of New Brunswick
Date: Tue, 13 Oct 1992 17:17:37 GMT

I have been reading the thread on the cost of bundling networks with
OS/2 vs NT and would like to add my $.02 worth.

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*.

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.

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?

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.

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).

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.

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.

Whether or not bundling will increase revenue is more complicated. It
is based on estimates made by the marketing people of the number of
copies they can sell at a particular price, both bundled and
unbundled. This may result in including more bundled features without
increasing costs. Look at word processing to see how different
companies have made different decisions. Microsoft includes a grammar
checker with Word for Windows. WordPerfect does not (at least the last
time I looked at it). I believe that the suggested price is the same
for both. Microsoft is using this feature to sell more programs and
obviously believes that they are getting more revenue by bundling.

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.

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.


Hugh Whalen
Faculty of Administration
University of New Brunswick

Disclaimer: In all probablity UNB does not know these are my opinions.
If they knew, they probably wouldn't care. If they did care they would
probably disagree. If they did disagree, I wouldn't care that they
did. :) :)



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