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Price Bundling to Profit

January 2008 Pricing

Price Bundling to Profit

What is distinct about price bundling vs. other types bundles?  Is price bundling just another form of discounts or can it improve profits?   When should an executive investigate price bundling?  What must be known before one can conclusively state that a price bundle is good?  Valid questions, all, and they deserve some answers.

Bundling is often discussed loosely and there exist valid strategies that support both bundling and unbundling.   As such, a causal strategist can easily behave like a two-handed economist with one hand contradicting the other.  To provide some clarity on the subject and perhaps force the two-handed strategist to put more weight behind one of their palms, we look specifically at price bundling in this article.

In its simplest form, price bundling, as defined here and as used by others, is to take two distinct products and offer them in a single bundle sold at a single price, in order to serve two distinct market segments with contrasting willingness to pay with one offer and improve profits.

Identifying the Price Bundle

Price bundling is practiced in many industries.  Telecom operators, such as AT&T and O2, often price bundle internet and phone service, and in some instances include mobile and digital television as well.  Microsoft offers Word, Excel, Outlook and other products in MS Office Suite price bundles.  Even supermarkets will, at times, offer discounted dishware in exchange for loyal shopping, and this too can be described as a form of price bundling.

Price bundling is not the same as using market dominance to force acceptance of related products.  Microsoft has repeatedly found itself in the courts for practicing such forms of bundling, most recently in the European courts with respect to its Media Player tie-in with its Windows operating system.  Similar arguments concerning abuse of market dominance with respect to bundling can be found relating to cases regarding Sony Blu-ray and Intel’s use of market development funds to drive sales of chip sets related to its core microprocessor line.  Using demand for a dominant product to drive sales of a secondary product is a bundling strategy that may improve profits by creating barriers to entry that reduce competition.  However, the logic that supports price bundling is distinct from the logic supports market dominance bundling.  Specifically, price bundling is a market-driven strategy while market dominance bundling is a competition-driven strategy.

Price bundling is also not the same as interacting with a single purchasing agent who requests multiple products in a single transaction but at a lower bundled price.  When dealing with distributors, many manufacturers will find a purchasing agent that request the entire order but at a lower bundled price.  Here, this is usually a case of a purchasing agent simply seeking a discount at the seller’s expense.  Rather than falling for such a purchasing agent’s ploy, the company should first investigate whether there are certain items that the customer values more than others, and then determine if the increased sales volume warrants a discount which would still leave both parties better off.  Furthermore, such a bundled discount offered in one year may lead to the expectation of the same discount being applied to a premium product the next year, thus sapping the profits out of the most valuable products.

What separates price bundling from market dominance bundling and the purchasing agent’s ploy is the second part of the definition of price bundling:  the goal of serving two distinct market segments with contrasting willingness to pay with a single offer in order to improve profits.

Contrasting Demand between Market Segments is Key

In profitable price bundling, the market must be described as having, at a minimum, two distinct market segments with contrasting willingness to pay.

If we plot the willingness to pay of the two products, for example Rho and Omicron, along two axes and find that the market can be described as having two distinct segments, one that values Rho more and the other that values Omicron more, then we have contrasting willingness to pay.  (See Exhibit 1.)  In order for price bundling to improve profits, the market must have at least two segments with contrasting willingness to pay.

08-01-tsexhibit-1

By comparison, the willingness-to-pay plot in the case of market dominance bundling would not have two segments.  For instance, if Omicron is the dominant product and Rho is the secondary product, the plot would appear as in Exhibit 2.  There are not two distinct segments, but rather only one and the demand for Rho is low.

08-01-tsexhibit-2

Likewise, the willingness-to-pay plot in the case of the purchasing agent’s ploy would have a single point, where the purchasing agent is simply driving the transaction price towards the origin and away from profitability.  See Exhibit 3.

08-01-tsexhibit-3

Simple Example

The profitability of price bundling can be demonstrated with a simple example.  Suppose the market has two distinct segments.  The Rho Lovers have 600,000 members and the Omicron lovers have 400,000 members.  Rho lovers are willing to pay $110 for Rho, but only $65 for Omicron.  Meanwhile, Omicron lovers are willing to pay $170 for Omicron, but only $50 for Rho.  The situation is summarized in Exhibit 4.

08-01-tsexhibit-4

Let us furthermore assume that Rho and Omicron are products with no variable costs.  Such products can be found in markets dependent upon intellectual property or large infrastructure projects, such as pharmaceutical, software, information, telecom, and transportation.

In this market, profit maximization along single product lines would encourage the company to offer both Rho and Omicron at high prices corresponding with the higher willingness to pay.  As such Rho Lovers would buy Rho at $110 and Omicron Lovers would buy Omicron at $170.  Any customer seeking both Rho and Omicron would have to pay $280, and our map of customer demands indicates that no customer is willing to pay that sum.  With these prices, the company would gain $134 million in revenue.  See Exhibit 5.

08-01-tsexhibit-5

However, the company could instead offer the RhoOmicron bundle.  Such a bundle would be priced at the minimum sum of the cross product willingness to pay between the two bundles.  In this case, it would $175.  At $175, the RhoOmicron bundle would be valued by both Rho Lovers and Omicron Lovers.  As such, all market participants would purchase and the company would gain $175 million in revenue.  See Exhibit 6

Clearly, $175 MM is better than $134 MM, and so price bundling leaves the company better off.  Even though the sum of the individually profit-maximizing prices is $280, and the bundle price is $175, a sizable $105 discount, the price bundle is more profitable than maximizing the profits of the individual products.  Price bundling can also be said to leave customers better off because Rho Lovers now have access to using Omicron and Omicron Lovers have access to Rho.

Exhibit 6

Executive Decision Making

As the example illustrates, price bundling can improve profitability.  To some, price bundling may appear as a form of deceptive magical trickery in which a discount increased profits.  Yet, it was not.  There were distinct features to the market and the cost structure that enabled price bundling to improve profits.

Profiting through price bundling requires at least two distinct market segments with contrasting demand between two different products.  It is also favored by products with low marginal costs.  (While marginal costs in the example were zero, this was not a requirement and was used only for simplicity.)

Price bundling does not have to be pure.  Companies can offer both the bundled product and the stand-alone products alongside each other in a profit-maximizing approach.  Price bundling also does not have to be static.  The bundle of goods and services can evolve and grow or dissolve overtime; just as the product strategy evolves.

To convincingly execute price bundling, pricing strategists must reach beyond their internally focused efforts of creating list prices, reporting transactional prices, and managing discounting routines.  They must have market research that indicates contrasting demand between at least two distinct market segments.  When the pricing strategist understands the structure of the market they serve, they are in a better position to uncover the hidden profits that are unleashed through price bundling.



About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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