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Business Journal 4


Open Posted By: nikiedward Date: 27/08/2020 Academic Level: High School Paper Type: Report Writing

 

Refer to the attached link for article (http://www.businessinsider.com/how-target-gets-you-to-spend-more-money-in-store-2018-4#partnerships-and-unique-products-5)  and perform the following:

 (a) summarize the article


 (b) discuss the article applying at least two of the assigned readings- See attached-and the relevant concepts covered powerpoint- see attached.


 Topic is Differentiation and Positioning.


 Maximum-Three double spaced pages in MS Word form.  Please cite which articles used in the paper.


Category: Accounting & Finance Subjects: Finance Deadline: 24 Hours Budget: $60 - $90 Pages: 2-3 Pages (Short Assignment)

Attachment 1

Spring 2018

Lecture 7

ECO 526: Business Strategy

Plan

• De Beers Case Discussion

• Differentiation and Strategic Positioning: Conceptual issues

Differentiation and Strategic Positioning

 Differentiation allows firms to maintain prices above marginal costs, even with high/intense competition

• Differentiation and positioning keys

• Exploit opportunities (find “gaps”)

• Identify meaningful segments

• Mitigate strength of industry forces

• Consider costs (entrenchment, commitments, complexity, cannibalization)

• Establish a defensible/durable position

• Differentiation mechanisms

• Horizontal (variety)

• Vertical (quality)

V = v - |xB – xA| * t

V: Willingness to pay for the actual product offering

v: Willingness to pay for the product with ideal characteristics |xB – xA|: Difference between ideal and actual product characteristics

t: Marginal disutility from consuming a non-ideal product (“transp. cost”)

Horizontal Differentiation

• Products differ by their location in the Product Space

• Preferences are represented by consumer’s location

• Consumer Heterogeneity: Different consumers have different

locations and ‘costs’ for consuming a remote product

v : Willingness to pay for ideal cup of coffee

xB & xA : Ideal and actual locations of the coffee shop

t : Transportation cost / loss from having to travel for coffee

Ex: Geographic Differentiation; Coffee Shops

Suppose that the city is laid out on a single, mile long street

• 100 consumers live in the town and their homes

are uniformly distributed along this street

• Each consumer has v = $5 and t = $1/mile

Also assume that all coffee shops are identical, except for

where they locate in the city, and that the marginal cost of

producing a cup of coffee (c) is $1

Given these conditions, where should the shops locate?

Recall: Consumers will select the product with a higher (V - P)

Coffee Shops…

Equilibrium 1 – “Go where the demand is”

v - |xB – xA|*t for each product…

→ P =

- Hotelling’s Principle

- Profits?

Hotelling Example: Gas Stations in Bay Area

Coffee Shops…

Equilibrium 2 – Strategic Positioning / Differentiation

• Optimal (Monopolistic) Location

• Given location, what prices maximize profits?

• The usual economics tradeoff

• Price

• Quantity demanded

Coffee Shops – Differentiated Equilibrium

• Solving for optimal price yields (see posted Appendix)

P* = t + c =

• Profits?

• Lowering price just below your competitor’s price no longer captures the whole market

• Drawback: Earn less revenue from ‘loyal’ customers

• Benefit: Capture some customers from competitor

• Contrary to non-differentiation, the benefit of cutting prices is lower because of the proximity (loyalty) of some customers to the other product  Softer price competition

• Max differentiation is desirable, but there may be constraints to differentiation (or an allure of going where the demand is)

Coffee Shops: Conclusion

• Spatial model applies to any horizontal-type differentiation

• Distance and location are metaphors for consumers’ preferences and product attributes

• Extensions

• Many firms

• Cost (product and transportation) heterogeneity

• Asymmetric consumer distributions

Basic Model: V = θ*s θ = “Units of quality” in the product s = $/unit consumer is willing to pay for quality

Vertical Differentiation

• Vertical Differentiation — Products differ in actual quality

• Assume consumers have identical preference orderings

• Consumer Heterogeneity — Different individuals have

varying amounts that they are willing to pay for quality

θ = # of stars that the motel receives

s = $ that consumer is willing to pay for each ⋆ worth of quality

Example: Motels (Mazzeo, 2002)

• Possible values for V:

Suppose: Two consumers — Sal has s = 16, Bob has s = 20

Motels’ costs increase in the number of stars —

For simplicity assume C = $10 per ⋆

Stars (θ) Sal (s=16) Bob (s=20)

1 V = 16 V = 20

2 V = 32 V = 40

3 V = 48 V = 60

Motels…

• Given these preferences, how should two competing motels position their products?

• Key: Consumers choose product with higher (V-P)

• Nash Equilibrium 1: No quality differentiation

• E.g., both motels offer ⋆⋆ (V-P) is identical for the two products P = Profit =

Motels…

• Nash Equilibrium 2: Quality differentiation

• E.g., Motel X Offers ⋆⋆⋆, Motel Y Offers ⋆

• Equilibrium prices and profits?

• Motel X Charges P = → Bob stays at Motel X

→ (P-C) =

• Motel Y Charges P = → Sal stays at Motel Y

→ (P-C) =

Motels – Evidence

• Price and Quality (# of stars) data collected for 1,800+ motels located nearby 492 separate rural interstate highway exits

• Motels classified into two categories (low and high) based on the number of stars assigned by AAA

• Econometric model related a motel’s price to (a) number of competitors at the exit, (b) whether the competitors were same quality or different quality than the motel in question, and other control variables

• Main Finding: The presence of a same-quality competitor lowered the observed motel price, but the presence of a different-quality competitor did not

Differentiation and Positioning: Implications

Higher prices can be maintained when

– Identify segments that exploit what is good and avoid what

is bad about the industry (understand industry forces)

– Bring right capabilities to this segment and invest to defend

your position and preempt competition (“consonance”)

– Optimal positioning allows you to earn a price premium

– Transportation costs/consumer preferences are stronger

– Product is closer to the ideal of many consumers

– Differentiation between competing products is greater

Differentiation and Positioning: Segmentation

Examples :

Segments of an industry are groups of buyers with a

strong and specific set of preferences

– Buyer segments: Consider subsets of consumers with

alternative/underserved preferences

– Channel segments: Distribution to distinct customers

– Product segments: Focus on actual differences in attributes

– Geographic segments: Based on physical location

Golden Rule of Differentiation: Segments with more consumers and fewer firms will be the most profitable

Differentiation and Positioning - Examples

– Product segments: Actual differences in attributes

Whole Foods

Retail supermarket that focuses on high quality, natural, and

organic foods and products. Prices are correspondingly higher,

but customers interested in these offerings are willing to pay…

Differentiation and Positioning - Examples…

The New York Mets

Targeting the Hispanic market for baseball fans in

New York City by emphasizing the signing of prominent

Latino players – particularly important, given….

– Buyer segments: Consider subsets of consumers

Differentiation and Positioning – Examples…

Kmart’s retail stores in Bridgehampton, NY, and

Exmore, VA

None or little direct competition in the area –

Despite Kmart’s hard times, these particular stores

continued to perform well…

– Geographic segments:

Differentiation and Positioning – Examples…

– Channel segments: Distribution to distinct customers

Mail distribution channel softened direct

competition, and attracted a higher

income, growing customer base; but…

as technology changed…

Next Session

 Enterprise-Rent-A-Car discussion

 Dynamics, Growth, and Sustainability – Conceptual issues

 Check D2L/syllabus for readings

Attachment 2

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 1/13

Hello Visitor. You get to see one FREE ARTICLE. To enjoy more articles like this one sign in, or create an account.

Designing the Right Product Offerings

Magazine: Fall 2007 • Research Feature • October 01, 2007 • Reading Time: 24 min 

David S. Evans and Karen L. Webster

Companies create product versions from multiple components. The big challenge is how to take the available components and combine them into the product versions and product lines that will maximize profits.

Businesses are constantly making decisions about which products and services will attract customers. In an

era driven by the mantra of “give customers what they want,” some businesses feel compelled to offer many

different versions of their products. This trend is relatively new. For years, blue jeans came in only one

shade of blue and in only one style, but now they are available in a dizzying array of styles and colors. Yet

some companies continue to stick to a single version of their products, making alterations only when

technology impacts what they can provide or when competition shifts. Music publishers, for example, after

decades of providing mainly bundles of songs on compact discs or records, have, in recent years, made

individual songs available as well — thanks to technological changes that have made distribution over the

Internet less costly to them and more efficient for consumers.

How can companies design products and product lines to maximize their profits? Out of all the potential

configurations available, how should companies decide which ones to offer? We have developed a

framework for balancing the costs of developing and offering a rich line of products and services against

customer demand for additional choice. (See “About the Research.”) Our methodology allows managers to

make informed decisions about product­offering architecture: which features to include in the product,

which variations to include in a product line, and how the goods should evolve with technology and

competition. In particular, our approach highlights how costs influence the design of the most profitable

offering. Thus, it departs from the standard product­success metrics, such as revenue and market share,

which are the primary focus of most of the work on product bundling.

2

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 2/13

About the Research

This article is based on empirical and theoretical research concerning the use of tying and bundling

strategies. Our framework is drawn from field research on products in the payment, software and media

industries, and analysis of business models and pricing in diverse industries, as well as theoretical work

on the costs and revenues from bundling and versioning. David S. Evans, working jointly with Professor

Michael Salinger of Boston University’s finance and economics department, studied the role of cost in

determining profit­maximizing bundles. The research demonstrated the role of fixed costs in determining

when it is optimal for a business to satisfy demand by offering individual components, only the bundled

components, or tying one component to an optional one. Primary and secondary empirical research on

the use of product bundles in the automobile, pharmaceutical and retail electronics industries helped

validate that theory and demonstrate the role of fixed and marginal costs in practical business settings.

This research is based partly on in­store visits to CVS and Radio Shack stores to assess products and

prices. In addition, the authors have conducted research into the structure of products in a number of

multi­sided industries, including software platforms, advertising­supported media and payment cards.

The ABCs of Product Architecture

By conceptualizing products as being built from components, product architecture helps companies narrow

the field of possible features and combine them into the product version or versions that maximize profits.

Sometimes, this means developing both a basic product and other versions that come bundled with state­

of­the­art features (for example, mobile phones that can play videos from the Internet).

Companies make product­offering architecture decisions in response to market and technological forces as

well as shifts in business models. In the automobile industry, for example, carmakers must decide which

features to include in their base products, which ones to make available as options and what to leave to

aftermarket suppliers. Prior to World War II, automakers did not offer air conditioning on any of their

models, but they gradually made it available on selected models in response to growing consumer

demand. Now, most car models in the United States come with air conditioning as standard equipment,

even though some consumers, such as people living in colder climates, use it infrequently and would rather

not have it at all. Until recently, navigation systems were strictly an aftermarket product.

To understand why companies commit themselves to product configurations that may not meet the needs

of customers, one must first understand what drives consumer choice at any point in time. To illustrate

what product architects face, let us consider a simple case where companies can create product versions

from two distinct components, which we represent with a square and a triangle. Each shape represents a

distinct product that could be sold as a stand­alone version or combined to make something more

appealing to the end customer. The square could represent the base product (for example, a credit card),

while the triangle could be a possible upgrade option (such as concierge services for premium cardholders).

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 3/13

Alternatively, the square and triangle might represent two products that could be sold separately — for

example, a hotel room and access to high­speed Internet — but could also be combined into a package

(hotel guests getting “free” high­speed Internet connections in their rooms).

Using the two components, it is possible, when the components could in principle be sold separately, to

offer three distinct products: a triangle product, a square product or a combination that consists of, say, the

square with a triangle on top. Indeed, adding the triangle to the square creates another version of the

product. It may be that by combining components, the producer creates added value for consumers who

want both features and derive convenience from being able to get them together. The bundle is therefore

more valuable than the sum of its components.

Companies have the ability to fashion five distinct types of products from the three different products

(square, triangle and square plus triangle) that can be built from the two components (the square and the

triangle). (See “Spectrum of Product Offerings Using Two Features.”)

SPECTRUM OF PRODUCT OFFERINGS USING TWO FEATURES

Spectrum of Product Offerings Using Two Features

Companies can fashion different types of product offerings from the same set of basic components.

A la carte offering

With a la carte, companies can treat different product features individually, allowing consumers to create

the product version that suits their needs best. Sony Corp., for example, produces both televisions and

DVDs. This allows consumers to bundle the two products on their own if they choose.

Specialization offering

Companies use specialization when they realize economies from providing one basic product feature that

customers want or that customers can combine with other features. For example, MAXjet Airways Inc.

offers only business­class service and Southwest Airlines Co. offers only coach.

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 4/13

All-in-one offering

The all­in­one product combines all the different product features, removing the customer’s ability to order

items separately. For example, newspaper publishers don’t allow you to buy the daily paper without the

sports or classified sections, even if you never read them.

Basic/premium offering

The basic/premium product strategy permits companies to offer both a basic product and a premium

version that includes some additional features; however, consumers can’t “unbundle” the basic product to

get the features they want. For example, cable customers generally can’t get ESPN without also receiving a

basic cable package that includes standard channels.

“Have-it-your-way” offering

These offerings are not mutually exclusive, and some companies offer an array of possibilities. Microsoft

Corp., for example, sells the complete Office software suite, but it also lets customers buy the individual

software programs separately and several versions of the Office suite with different features. Cable

companies offer many different combinations of channels — from basic to super­premium — in addition to

providing bundles that include high­speed Internet and voice over IP phone services.

Depending on the nature of the product, the number of alternative products increases exponentially with

the number of features. For example, three distinct product features can be combined into 125 distinct

products by varying the composition of the bundles offered to customers. Practically speaking, many

product features can’t be sold separately (for example, pockets for jeans) which reduces the number of

combinations in practice. Nevertheless, in many real­world settings the number of offerings increases with

the number of features available. (See “The Mathematics of Product Offerings.”)

THE MATHEMATICS OF PRODUCT OFFERINGS

The Mathematics of Product Offerings

The potential number of alternative product versions increases exponentially with the number of

components.

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 5/13

The mathematics of the potential combinations has two important implications. First, companies won’t find

it profitable to provide all the products that they could make from the components available to them. And

second, as a consequence, consumers generally can’t get all of the product versions that they might choose

in a perfect world. Our method for designing product offerings gives managers a tool for isolating the most

profitable product lines from all possible combinations while evaluating the inherent trade­offs between the costs and benefits to both consumers and companies alike. (See “Rules of Thumb for Product

Architecture.ȁ)

Rules of Thumb for Product Architecture

Guidelines for creating product configurations that satisfy most consumers and provide healthy ROI:

When should you consider an all­in­one product strategy?

There is little demand for other combinations of these features relative to the cost of offering them. For example, demand for an iPod that can’t upload songs from CDs but can play only songs downloaded from the iTunes store is apt to be small.

The marginal cost of including components is low relative to the additional customers that are pulled in. Adding Spike TV to the lineup of cable channels costs little, but may be popular with young males that advertisers aim to reach.

The cost of combining features is more than offset by the ability to reach a larger audience. Most computer users do not routinely use all of the features in their word-processing programs, such as the ability to index a document, but almost everyone uses several features they care about.

When should you consider “basic/premium” offerings?

There is sufficient demand for a product configuration relative to the cost of offering it. Enough people want crunchy peanut butter for most major makers to offer both crunchy and smooth varieties.

Different product offerings facilitate segmenting customers. At close to $145,000, the Mercedes-Benz S600 has limited appeal, but the high price some customers will pay more than offsets the additional production cost.

When should you consider adopting an a la carte strategy?

There is little demand for combining features, consumers can do this themselves very easily, and demand is so heterogeneous that it would require offering many choices. Selling a combination of jeans and cowboy boots might appeal to some customers, but most would prefer to buy them separately.

The fixed or marginal costs of combining features are prohibitive relative to demand. Restaurants might find it easier to offer a set menu paired with wine but most patrons like to order food and wine a la carte.

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 6/13

When should you weigh expanding product offerings and adding new features?

Costs and technology change in ways that reduce the fixed costs of offering separate products. Internet distribution lowers the cost of providing digital media such as songs separately.

Competition changes demand conditions. When a competitor introduces a new product version, it may siphon demand from other versions. While there may be continued advantages in offering specialized products, consider matching the competitor’s product or introducing a superior feature set of your own.

The Role of Cost in Configuring the Most Profitable Product Offering

Maximizing long­term profits requires assessing the cost of making offerings available to consumers and

the anticipated level of consumer demand. First, let us consider costs.

From the perspective of the company, the decision to offer a product and how it is designed generally

affects both the fixed costs (the costs the business incurs regardless of how many units it sells) and the

marginal costs (the costs the company incurs for each additional unit sold).

Fixed Costs

When a company offers multiple products, the fixed costs typically relate to the packaging and retail shelf

space required for each. An advantage of an all­in­one offering is that the fixed costs of a single product will

almost certainly be less than providing two separate products a la carte. A newspaper, for example,

economizes on printing and distribution costs by offering a single print edition.

Marginal Costs

The effect of product bundling on marginal costs is more complex. Adding product features can result in

interdependencies among product and service components that may lead to higher design costs and

sometimes even costly service calls or product recalls. Such costs tend to be greater for complex durable

goods and professional services than for information­based ones. For example, adding a higher­resolution

camera to a mobile telephone or a business­strategy consulting practice to an accounting firm is more costly

than adding a new home and garden section to a newspaper.

In some cases, however, integrating separate components can reduce marginal costs. Consider the example

of over­the­counter medications. Rather than making one tablet to treat headaches and another to treat

colds, it is cheaper to produce a combined tablet that relieves the symptoms of both because the costs of the

chemical ingredients are only a small fraction of the total cost. The marginal cost of the combined tablet is

less than the sum of the marginal costs for the two tablets. Companies should carefully assess the effect of product combinations on their marginal costs. They may be surprised at the additional costs of producing

things together, or they may uncover ways to economize on packaging and other costs.

3/29/2015 Designing the Right Product Offerings | MIT Sloan Management Review

http://sloanreview.mit.edu/article/designing­the­right­product­offerings/ 7/13

Information­based products — in particular, software and media — are different from most other goods in

that it is possible to add another component to the product with little or no effect on marginal cost. Adding

another song to a CD costs virtually nothing so long as there is space on the disc. Likewise, when Apple Inc.

adds another software feature to its iPodiTunes platform, the cost is minimal.

Technological change and organizational improvements enable manufacturers to manage the fixed and

variable costs of their products more effectively. Lean manufacturing techniques, including just­in­time

inventory methods, allow companies to reduce their costs while customizing their products. Dell Inc.’s

business model, for example, combines both low cost and choice. However, choice generally comes at a

cost, and businesses ultimately face a trade­off between presenting consumers more choice and offering

consumers lower prices as a result of reduced costs.

Product architects need to expand their definition of fixed and marginal costs beyond those that they

typically track and account for. They must consider costs across the entire supply chain because these will

ultimately affect the costs they need to recover. These include so­called complexity costs resulting from the

impact of multiple product versions on management and production time, which ultimately drive up the

cost of the product. Although some of these may be hard to quantify, they are often too significant to

ignore.

Tapping Consumer Demand: Aligning Price and Preference

Consumers will usually say that they want to get the version of the product that is “right for them.”

However, their appetites for different features vary, and they also have differing abilities to pay for

premium versions. This heterogeneous demand tends to support a have­it­your­way or a la carte strategy as

a way to give consumers as much choice as possible.

In many situations, however, consumers reject choice in part because of the higher costs. They find they

can realize savings in both time and effort when product features are combined (as in the headache and

cold pill or smart phones that provide e­mail capabilities). Downloadable music enables people to buy

individual songs, but some consumers still prefer buying the bundles of songs the artists and music

publishers put together; it saves time, reduces risk and improves efficiency overall. (See “The Music

Industry: A Case Study.”)

The Music Industry: A Case Study

The recorded­music business illustrates the principles behind product­offering architecture and how the

optimal offering changes based on technology, consumer demand and competition. In the mid­2000s,

music publishers faced serious business issues about whether to make their songs available online as well

as through physical media such as CDs, and also whether to make songs available online individually, in

bundles or both. Technological change — the emergence of the Internet, increased broadband penetration

and capacity, and increased piracy through illegal downloads — had dramatically changed the costs and

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benefits of their established product line.

During the 1950s, popular songs had been sold as singles, mainly on 45­rpm records. Singles dominated

the market until the Beatles released “Sergeant Pepper’s Lonely Hearts Club Band” as an album in 1967.

Since then, popular music has been distributed primarily as collections of songs, usually 10 to 20. The

publishers and artists selected the best songs for the album; songs that did not make the cut were either

held for the next album or not distributed at all.

The all­in­one offering was efficient for several reasons.i The cost of pressing and distributing recordings

was fixed, and releasing singles and smaller collections would have required retailers to stock more

products. Albums allowed music publishers to generate additional revenues from people who really just

wanted one or two songs and who would buy them that way if they could. The business question was

whether the net incremental revenues of releasing different versions of an album, with different numbers

and selections of songs, would outweigh the incremental costs of producing and selling them. For more

than 35 years, music publishers believed the answer was no.

The Internet and related phenomena (including the spread of fast broadband and Apple Inc.’s immensely

popular iPod­iTunes combo) changed both the cost and the demand sides of the equation. On the cost

side, the Internet made it much cheaper to distribute music and, in particular, to distribute individual

songs. On the demand side, as downloading music has become easier, people are more eager to do it.

Identifying the optimal product architecture for the new digital era, however, requires a thorough analysis

of demand and costs. The fact that it is possible to make individual songs available digitally does not

necessarily mean that music publishers should not offer digital bundles. Some people may still prefer

having someone aggregate content because it is easier and less time intensive than doing it themselves.

Moreover, music publishers may be able to realize higher profits by using bundles to segment consumer

demand. However, there is also the chance that the Internet will disintermediate the role music

publishers have played in choosing song lists. Rather than looking to music publishers, consumers may be

just as happy to let other experts recommend bundles. What’s more, the increased popularity of iPods and

other digital music devices may draw people away from whole CDs and playlists to selecting from massive

libraries of songs.

One can determine the relative importance of these offsetting effects by using standard statistical survey

techniques such as conditional logic or conjoint analysis studies, in which individuals are presented with

alternative choices at various prices and are asked to express their preferences. This methodology will

help companies find the optimal bundling strategies based on consumer demand.

From the music industry’s standpoint, two other major considerations are piracy and cannibalization.

Music publishers were attracted to digital downloading based on the hope that more legal downloads of

individual songs would reduce the demand for illegal ones, even though digital downloads result in less

demand for physically distributed recorded music. The additional profits from reduced piracy are greater

than the lost profits from cannibalization of physical media.ii Music publishers will eventually face the

same decision for CDs and audiotapes as they did for prior music formats. As new distribution

mechanisms become more popular, music publishers and other content providers will need to compare

the cost of making a format available against the incremental revenue it is expected to bring in.

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i. Technically, the publishers follow a limited, and/or strategy since they typically released a hit single as

well as the album.

ii. A.J. Padilla, “Music in the Digital Era: Using Econometrics to Model the Music Business: 2004­2009”

(presentation at Abbey Road to EMI Group, London, July 1, 2004),

www.lecgcp.com/ec/forum/index.aspx?class=”footnote” name=72.

In choosing among the five possible product alternatives, companies must weigh the costs of alternative

product lines against the expected demand and the costs for exploiting this demand. There are two key

consumer­demand strategies companies can use to assess the willingness of consumers to pay for different

versions of products against the profit­maximizing potential of them: aggregation and segmentation.

AGGREGATION.

Aggregation is especially important for information­based products because it is cheap to add features to

generate extra demand. Consider a family’s decision to subscribe toThe New York Times. The woman may

be interested in national news and the arts sections. The man may be drawn to the business section and

articles about science. Their 16­year­old son may like having access to the newspaper’s online database for

homework research. None of the family members would be willing to pay $9.30 a week individually. But

the combination of features makes it an attractive household investment.

Aggregation is related to the law of large numbers, which informs how the universe of potential customers

values different aspects of a product. For example, whenThe New York Times combines numerous features in its paper, chances are that some set of those features will appeal to consumers who will then pay the full

subscription price. There are, of course, significant fixed costs in creating the basic product, but the

incremental cost of adding features or distributing those additional features to consumers is low.

Companies generally use aggregation strategies by making an all­in­one product. As a result, consumers

often end up getting features they don’t care about. Some may find this irritating, but more often the

benefits of ignoring the features they don’t want far outweighs the costs of either doing without the item or

paying more to eliminate the annoying feature. Consumers generally benefit from aggregation because it

keeps their costs low and allows producers to realize scale economies that are passed on in the form of

lower prices. For example, ifThe New York Times had to distribute each section separately, the company would no longer have scale economies; it would probably have to raise prices (not that they wouldn’t raise

prices anyway) or eliminate sections.

SEGMENTATION.

Companies often design products based on how much demand they envision from a certain customer

segment. Services enterprises often use this approach as well. It creates an opportunity for companies to

charge a premium to customer groups that want a particular package, and then to price the no­frills version

of the product more aggressively. For this approach to be effective, there must be a predictable correlation

between features and demand; for example, you need to know that price­sensitive airline travelers will not

pay extra for in­flight meals. That is a major reason why companies develop “basic/premium” products —

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providing a basic package to price­sensitive customers and a higher­price, feature­rich package to those less

sensitive to price. A have­it­your­way product can also be used to segment demand by charging different

prices for different alternatives.

This last point raises an important aspect of product design. Businesses can deliver great value to particular

segments of consumers by adding features to a product. Often it does not cost much to do so, but it can

permit higher markups — and therefore higher profits. Many studies show that U.S. automakers realize

much higher margins on their luxury models than on their base models.

Identifying the Best Product Line

What ultimately matters to product architects is who will buy, what they will buy and how much they will

pay. That is more complicated than it seems on the surface, especially when the goal is to maximize profits

rather than revenues. Our approach to product­offering architecture can provide much needed insight.

STEP 1: MODEL DEMAND AND PRICING FOR ALTERNATIVE OFFERINGS.

For each possible product line, the company must determine what prices to charge consumers by

examining the cost­benefit of different aggregation and segmentation strategies with an eye toward

achieving optimal demand and maximum profit. Once managers decide which strategy (aggregation or

segmentation) will yield optimal demand and determine how much to charge, they can forecast revenues

from each product in the product line and from the product line as a whole. For example, they can compare

a basic/premium product as part of a segmentation strategy to an all­in­one offering as part of an

aggregation strategy.

In making these decisions, managers have to keep two things in mind. First, offering a new version of a

product can cannibalize sales from the original; for example, some customers who previously bought the

bundle may opt to buy only one feature. Second, giving consumers an additional choice — for example, a

no­frills automobile — may persuade consumers who didn’t want the all­in­one alternative to purchase a

less complete version. These market­expansion effects (where more consumers are attracted by the

product­line extensions) also account for differences between the revenues that can be realized with

different products. The alternative products, although possible to deliver, could also have negative

implications for the overall fixed and variable costs.

STEP 2: WEIGH COSTS AGAINST REVENUES.

Naturally, the best product is the one that generates the highest profit after taking cost, demand and pricing

strategies into account. Designing products, however, becomes vastly more difficult as the number of

possible alternatives increases. Product architecture helps companies focus only on the subset of offerings

likely to be most profitable, starting with whether there is enough demand to warrant the fixed costs of

making a product available at all.

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It stands to reason that companies should compare the fixed cost of offering a product against the demand

for it. It does not make business sense to produce many products when there isn’t enough demand for

them, although sometimes lack of demand does not become apparent until after the product is introduced.

Other times, the fact that there is enough demand to warrant a particular product configuration only

becomes clear after the company weighs the cost of offering the product against the incremental demand

for it. For example, many carmakers have concluded that it is expensive to offer too many car models with

different options and have scaled back the number of choices in order to reduce costs. It is easy to see from

these considerations why it is profitable for businesses to offer only a fraction of the products (defined by

the combination of components) they could make. Even relatively modest fixed costs would encourage producers to restrict the number of products to those for which there is significant demand.

Technological change can alter these trade­offs. For example, Internet distribution has made it cheaper for

software companies to distribute multiple versions of mass­market software without having to incur costs

in packaging each version separately and taking up scarce shelf space with multiple versions. The ability to

miniaturize components also makes feature­rich versions of products more appealing to consumers. Since a

camera on a mobile phone takes up little space, consumers who don’t care about this feature can easily

ignore it. According to the “long tail theory,” Internet­related innovations have made it cheaper to serve

narrow niches of consumers with specialized products. This may be true in part, although it overlooks the

fact that aggregation strategies have also become cheaper.

Designing products in response to competitive threats also affects these trade­offs. Managers might infer

that when competitors offer more product variety they are doing it because it is profitable. And it may be.

However, the fixed costs of offering more products may limit the number of businesses that can profitably

serve customers. In fact, matching the competition may be a money­losing proposition. The most profitable

strategy may be to specialize in a small number of offerings to larger consumer groups, letting boutiques

focus on the niches.

OUR APPROACH TO PRODUCT­OFFERING architecture provides a framework for helping businesses

create products and product lines that maximize their long­term profits. It is based on the premise that

there are both costs and benefits associated with choice. There are costs for consumers because they need to

acquire information, make decisions, take risks and incur other transactions costs. There are costs for

companies because they need to maintain additional production capabilities, design more packaging and

pay for additional shelf space. By definition, offering many different features requires more resources,

resulting in higher costs and opportunities for higher prices and profit.

But choice also provides important benefits. Consumers value some choice, although the degree varies by

product and circumstance. Businesses value it, too, because it allows them to segment their markets and

charge higher prices. The most profitable product lines are those that balance the benefits and costs for

both consumers and businesses.

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Copyright © Massachusetts Institute of Technology, 1977­2015. All rights reserved.

REFERENCES (13)

1.  For a summary, see D.S. Evans and M. Salinger, “The Role of Cost in Determining When Firms Offer Bundles,” Journal of Industrial Economics, in press. See also D.S. Evans and M. Salinger, “Why Do Firms Bundle and Tie? Evidence from Competitive Markets and Implications for Tying Law,” Yale Journal on Regulation 22, no. 1 (Winter 2005): 38–89.

2.  W.J. Adams & J.L. Yellen, “Commodity Bundling and the Burden of Monopoly,” Quarterly Journal of Economics 90, no. 3 (August 1976): 475–498; R. Schmalensee, “Gaussian Demand and Commodity Bundling,” Journal of Business 57, no. 1 (January 1984): S211–30; and R.P. McAfee, J. McMillan, and M.D. Whinston, “Multiproduct Monopoly, Commodity Bundling, and Correlation of Values,” The Quarterly Journal of Economics 104, no. 2 (May 1989): 371– 383.

3.  See http://web.archive.org/web/19990423055451/vintagecars.tqn.com/library/weekly/aa050898.htm.

4.  Let n be the number of features and v be the number of product versions, then v=2n­1. Thus, with three features it is possible to construct seven different product versions, and with four features it is possible to construct 15.

5.  Let o be the number of product offerings. Then o=2v­1 = 2(2n­1)­1.

6.  Y. Bakos and E. Brynjolfsson, “Bundling Information Goods: Pricing, Profits, and Efficiency,” Management Science 45, no. 12 (December 1999): 1613– 1630.

7.  Evans, “Why Do Firms Bundle and Tie?” supra, note 1, for a summary of the evidence that automobile companies incur significant costs as a result of offering numerous different products.

8.  B. Schwartz, “The Paradox of Choice: Why More Is Less” (New York: HarperCollins, 2004).

9.  Bakos, “Bundling Information Goods,” supra, note 6.

10.  See http://homedelivery.nytimes.com

11.  Companies can also use an all­in­one offering to implement a block­booking strategy — named after a 1963 paper by that name by Nobel prize­winning economist George Stigler — that enables companies to obtain a greater portion of consumers’ willingness to pay for products. Stigler demonstrated this strategy by examining the economics of movie distribution. Suppose that theater 1 is willing to pay $8,000 and theater 2 is willing to pay $7,000 for movie A; and that theater 1 is willing to pay $2,500 and theater 2 is willing to pay $3,000 for movie B. If the movie distributor charged a single price to the two distributors, it would charge $7,000 and $2,500 to attract both theaters; the distributor would collect $9,500 from each for a total of $19,000. But consider how much the theaters would pay for both movies: Theater 1 would pay $10,500 and theater 2 would pay $10,000. Thus, if the distributor charged each $10,000 for the bundle — block­booked the movies — it would collect $20,000 and therefore make more money.

12.  S. Berry, J. Levinsohn and A. Pakes, “Automobile Prices in Market Equilibrium,” Econometrica 63, no. 4 (July 1995): 841–890.

13.  An extensive discussion of the long tail theory can be found in C. Anderson, “The Long Tail: Why the Future of Business Is Selling Less of More” (New York: Hyperion, 2006). The long tail theory posits that the Internet allows a large number of people access to a wide variety of items, which creates new, albeit in some cases small, profitable markets for goods and services.

ABOUT THE AUTHORS

David S. Evans is the founder of Market Platform Dynamics, a management consulting company based in Cambridge, Massachusetts, and coauthor of “Invisible Engines: How Software Platforms Drive Innovation and Transform Industries” (MIT Press, 2006).Karen L. Webster is president of Market Platform Dynamics. Comment on this article or contact the authors through [email protected]

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