Chapter 11

Versioning

The Role of Versioning in Expanding the Market Through Self-Cannibalization with Substitute Products

Agenda

• What is versioning? How is versioning different from bundling or add-on pricing?

• Are production cost savings the only reason to offer versions rather than individual products?

• How do different psychological effects influence prices within a versioning structure?

• How should discounts be managed when a firm is versioning?

Versioning

• Versioning is an alternative price segmentation to add-ons– Like add-ons, versioning attempts to price segment customers

according to their willingness to pay for marginal improvements in attributes, features, and benefits

– Unlike add-ons, the only route to gain additional features is to purchase the next higher value product in the product line-up

• In versioning, different variations of a similar product are In versioning, different variations of a similar product are sold simultaneouslysold simultaneously– Products vary between the feature deprived to the feature

enhanced– Some versions offer more features or benefits – Others offer fewer features and benefits

Versioning Tradeoffs

• In Versioning, the company is marketing its own substitute products, each of which cannibalizes sales from the other versions.

• Whether versioning improves profits or harms profits depends on the tradeoffs between the market expansion for the firm by offering alternative versions and the loss of higher value sales through the sale of lower value versions.

Versioning Examples

• Retailers – Consumable or durable consumer products– Store brand laundry detergent, Gain, and Tide

• Manufacturers – Black & Decker coffee makers that vary according to brewing capacity,

exterior finish, programmability, thermal carafe, and the ability to brew espresso along with the regular cup of Joe

• Information goods– Financial service products: American Express Green, Gold, and

Platinum cards – Software: QuickBooks Simple Start, Pro, and Premier

• Infrastructure– Road fees in EZPass, cash, non-highway

• Commodities– Different grades of purity in polyethylene

Versioning Structures

• The product is sold in two or more versions, where some versions are benefit deprived and others are benefit enhanced

• Single dominant dimension of product improvement

• Pricing Challenge: The price of an enhanced version can be greater than, less than, or equal to the sum price of its additive parts

• P(A+B) (>=<) PA + PB

AmEx• Versions simultaneously increase

customer benefits and prices– Each of the Green, Gold, and

Platinum cards enables a cashless purchase of goods and includes the Membership Rewards loyalty program

– Customers demanding a higher level of service or access to special events must upgrade to the Gold or Platinum versions

– Only the Platinum card includes travel privileges such as customer instant access to airlines airport clubs

Card Features Price

Green Membership Rewards $95

Gold Membership Rewards Gold EventsPurchase ProtectionGlobal Assist Hotline

$125

Platinum Membership Rewards By Invitation Only EventsPurchase ProtectionGlobal Assist HotlineTravel Privileges

$450

Versions

• Because versioning restricts choice over add-on pricing, this strategy may be less profitable.

• Versioning may deliver cost savings for the firm

Good-Better-Best Segmentation

• The “good” product is priced lowest and has the fewest features and benefits

– In an extreme form, it is a version stripped of all but the most essential features required to compete within the product category

– The entry-level product is feature deprived, providing the minimal functionality to satisfy customers

• The “best” product is priced the highest and has the most features and benefits

– In an extreme form, it is loaded with bells-and-whistles to satisfy even the most demanding customer of the product category

– The top-level product is feature enhanced, providing further functionality to meet the demands of a more discriminating clientele

• Between the extremes lies the “better” product– Priced in the middle and loaded with a medium level of features

and benefits

• As products progress from good to better and best, the price increases and the benefits provided increase proportionately

• Some customers are willing to pay more than others

• The willingness to pay and the benefits demanded may follow a normal distribution,

Per

ceiv

ed P

rice

Perceived Benefits

Good

Best

Better

Demanded Utility is Dispersed

Versioning Customer Segmentation

Perceived Benefits

Heterogeneity in Demanded Utility

• Pricing strategy must be based how customers differ in the benefits sought and willingness to pay

• Implementing a versioning strategy requires an understanding of the heterogeneity in benefits demanded

– Which features are used to enhance a product and which are used to deprive a product

– The entry-level version must deliver sufficient functionality to satisfy a portion of the markets needs, but not all

– Feature enhanced versions must satisfy the demands of more utility sensitive segments

Per

ceiv

ed

Pri

ce

Perceived Benefits

Good

Best

Better

– With information based products, a common approach is to design and develop the full-featured product, then remove features to create other versions within the product line up

Heterogeneity in Demanded Utility• The map of perceived benefits to

perceived price also indicates a key limitation of a pure good-better-best version strategies– Good-better-best approach

assumes that benefits can be added in a monotonically increasing manner, such that the highest priced version has significantly more features than the lower priced version

– It also assumes that customer heterogeneity in benefits sought is mono-dimensional, and moreover the heterogeneity in willingness to pay varies with the heterogeneity in benefits sought

Per

ceiv

ed

Pri

ce

Perceived Benefits

Good

Best

Better

When should we do versioning?

• In markets, where customer heterogeneity in benefits demanded will correlate with willingness to pay, versioning is optimum.

• In markets where customer heterogeneity in benefits demanded does not correlate with their willingness to pay, versioning cannot take a good-better-best approach.

Contribution Margins in Versions

• From a profitability perspective, a company should not add $1 in marginal cost to a product unless the company can increase the price by more than $1, holding all else constant– Most companies have the largest

margins on their feature enhanced versions

– For example: with infrastructure or intellectual property based goods, the marginal cost to reproduce is constant for all versions, hence margins are directly driven by the price a company can charge for a version

CMA < CMTotal

Manage Segments Carefully

• It is often tempting for companies to try to shift all customers to the feature enhanced version

• Companies must balance their focus on higher margin customers alone with the potential negative consequences of neglecting the bottom– Leaves room at the bottom of the market for a low-

feature, low margin product to be produced by a competitor, giving them a foothold into the industry

– Seeking to make all customers purchase the higher version neglects the profit potential of charging more for the higher version and shifting more customers into the “middle”.

#1 Tradeoff – Form of Customer Heterogeneity

Nokia 6103

Charger Adaptor

Mobile Charger 1

Travel Charger 1

Connectivity Adaptor

Car Kit

Audio Adaptor

Wireless Headset

Mobile Charger 2

Travel Charger 3

Travel Charger 2

Traveling Customer

Upgrading Customer

Per

ceiv

ed

Pri

ce

Perceived Benefits

Good

Best

Better

Demanded Utility

VersioningSingle Dimension of Utility Demand Heterogeneity

Add-onsMultiple Dimensions of Utility Demand Heterogeneity

Influence of Marginal Cost

• If the sum marginal cost of producing product A and B (VA, VB) is greater than the marginal cost of producing Total product which has the functionality and benefits of product A an B (VTotal < VA + VB), then …

• the manufacturer will achieve greater profit with a versioning strategy over an add-on strategy providing the volume of transactions is sufficient to overcome the incremental fixed costs (manufacturing, branding, etc.), and …

Marginal Cost and Versioning

• The marginal cost argument has been used in many situations to defend versioning over add-on price structures– Hard disc drive manufacturers find it less

expensive to produce a single hard disc drive with twice the storage capacity than to produce two individual hard disc drives

– Software manufacturers face near zero reproduction costs with non-zero marginal packaging, selling, and installation costs, and therefore would reap higher profits through versioning over add-on price strategies

Prospect Theory

• Everybody like gains, not pains

• Prospect theory indicates that customers generally prefer one large pain rather than two smaller pains to the same total larger pain.

• Therefore versioning dominates over itemized pricing ( adding pains)

Extreme Aversion

• Psychological aversion to Extremes

• Given good-better-best options, customers tend to select the “better”

• Not necessarily because the “better” option delivers the best utility for the price paid, but partially because consumers are simply averse to buying either the lowest or highest quality product

• WHY?

Extreme Aversion Arises from Loss Aversion

• In comparison to a reference point, consumers are more averse to losses away from that reference point than they are seeking gains above that reference point– (wait for prospect theory)

• Loss Aversion and Choice of Middle– Middle version has the smallest loss of functionality

from higher-utility good– Middle version has the smallest loss in cash

(payment) in comparison to the lowest-priced good– Hence, middle version is chosen

Number Effect• How many versions is too many?• From a profit maximization point of view, we have

to acknowledge that each version comes with its own costs– Even if the marginal costs to produce different

versions were zero, the marketing costs of defining, developing, and promoting an infinite number of separate versions would soon become prohibitive

• With too many versions, customers have a difficulty in making tradeoffs to identify the product that is most likely to satisfy their desire for utility and a low price– Confusion can lead to delayed purchases, depressing

overall demand, or require increased expenditures on consultative selling and market communications to overcome the confusion

Range Effect

• Some research has indicated that wide price ranges between the highest-quality version and lowest-quality version negatively affect perceptions of value and thus dampen demand

– Prices at restaurants typically land within a factor of 2 of each other

Loss Aversion and Order Bias

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NIS at $69

NAV at $39

N360 at $79

NIS at $69

NAV at $39

N360 at $79

DescendingAscending

• Loss aversion: In comparison to a reference point, consumers are more averse to losses than they are seeking of gains to that reference point

• On average, consumers tend to select a higher priced product when presented in descending order rather than ascending order

Order Bias

• Research has shown that presenting products in the descending order (highest to lowest) tends to encourage customers to select a higher priced product on average than presenting the products in the ascending order.

• When individual products within a versioning lineup are discounted, the price differences between the products will change.

• Changing price differentials between versions can affect customer choices.

• Divergent Price differential– The base product will be

discounted more than the enhanced version, thus the price difference between the versions increases

• Convergent Price Differential– The base product will be

discounted less than the enhanced version, and thus the price difference between the versions decreases

Divergent Price to Value

ListPrice

InvoicePrice

Net Price

Convergent Price to Value

Constant Price to Value

Pric

e P

aid

Discounting

Summary

• In versioning, different variations of a similar product are sold simultaneously. Some versions offer more features or benefits, while others offer fewer features and benefits.

• Versioning strategies often follow a good-better-best progression.

• Versioning strategies have often been defended from a marginal cost standpoint. If the sum marginal cost of producing independent products is greater than the marginal cost of producing a product that delivers the same benefits, then the manufacturer will achieve greater profit with a versioning strategy over an add-on strategy.

• Extremes aversion has been used to explain the tendency of customers to select the middle option within a versioning offering.