Bundling complementary products of the firm

Bundling is selling separable products  or services to buyers only as a package, or “bundle.” For example, IBM bundled computer hard­ ware, software, and service support for many years, while the manufac­ turers of antiknock additives for gasoline have traditionally  provided various technical services along with their product all at a single price. Bundling in some form is pervasive, though not always recognized. Identifying when bundling is occurring often requires a rather funda­ mental look at   an   industry  akin   to   that  in   segmentation  (Chapter 7). All the potentially separable products and  services that are offered must be isolated, even though they may not be seen as separate  by industry participants. For  example, delivery and after-sale service are often included as part of the product although  they are potentially separable and could be sold separately. Similarly, retailers often provide free parking, while airlines provide free meals and  baggage handling. Because some forms  of bundling are age-old industry  practices, firms may not even perceive that they are bundling.

Bundling means that all buyers are provided with the same pack­ age of products and services, regardless of differences in their  needs. Some buyers of antiknock compounds, for example, would prefer to sacrifice the service provided by manufacturers in return  for a lower price, but they do not have that option. Buyers often differ in their receptiveness to bundling because they want  different collections of products or services, or because they   differ in   the   intensity   of their need for the various products or services. In either case, bundling is suboptimal for some buyers.

Bundling will not be desirable unless it has some countervailing benefits that overcome the fact that it is suboptimal for some buyers. Bundling can create competitive advantage in a number of ways, how­ever, that vary in importance from industry to industry and even by industry segment. In some   industries  bundling  also   has   significant risks that must be identified.

1. Competitive Advantages  of Bundling

The potential competitive advantages  grow broadly  out of the ability to share activities   in   the   value   chains   for   providing   parts of the bundle   if the   entire bundle  is supplied   together.  The  advantages of bundling can be grouped into a number of categories:

Economies o f Providing the Bundle.      A firm may lower its costs by providing only a single package instead of whatever mix of products or services a particular buyer desires. These economies arise from interrelationships in a firm’s value chain  that  can be exploited by supplying only the package. Bundling can allow a firm to better share activities in the   value chain   in supplying  the parts  of the bundle. If the same bundle of products is sold to each buyer by the same salesper­ son,   shipped on   the   same truck,  or serviced   by the same technician, for example, there may be cost savings in providing the bundle together. The price of the bundle  could thus  be lower than  the collective price of the individual parts. For example, in providing services for offshore drilling for oil, a firm that  provides two related services together may need only one person on   the   rig while competitors  require   a person for each service. Economies from bundling can also result from shared cost of gathering information  about  buyers. A consulting  firm may learn about a client through providing one service, and apply this knowledge at low cost in providing other services in the bundle. The unbundled competitor must make the full investment in information even though it provides only one service.

Bundling may also reduce costs by promoting  manufacturing economies of scale or learning. Providing  the same package to all buyers guarantees an equivalent volume  of all items in the bundle, perhaps lowering cost. For example, manufacturing a fire engine with standard features would allow a m anufacturer to achieve greater econo­ mies of scale and learning than  if each engine gets a different collection of bells and whistles, the current U.S. industry practice. Providing a common package may also increase the productivity  of the sales force, by eliminating the need to inform the buyer about  what  parts of the bundle to select. Finally, bundling can significantly reduce administra­tive and selling costs. Providing the same package to all buyers usually simplifies transaction costs, including paperwork,  logistical arrange­ ments, and  the like. Economies  of standardization,  scale, or learning can in some cases allow a firm   to   sell the bundle  at   a lower price than it would have to to charge  customers  who only wanted  part  of it.

Economies from bundling will yield a substantial competitive ad­ vantage to a bundled firm only if unbundled competitors cannot dupli­ cate them through coalitions or contractual arrangements among themselves. However, the difficulties of reaching agreement on such coordination with independent firms often preclude a contractual solu­ tion.

Increased Differentiation.      Bundling may allow a firm to differen­ tiate itself vis-a-vis competitors  selling only parts  of the bundle. The role of bundling  in   differentiation   arises   from   linkages   among  parts of the bundle in the buyer’s value chain  because they are used or purchased together. W ithout bundling, a firm may not only forgo differentiation but be forced to compete with each specialist competitor in its area   of greatest  strength.   Bundling  can   increase   differentiation in the following ways:

m o r e      b a s e s      f o r       d i f f e r e n t i a t i o n        .      A firm that  can bundle has more dimensions on which to differentiate itself than  a competitor with a more  limited offering.   For  example, a bundled  firm may be able to guarantee  reliability of the entire bundle or offer a single point for after-sale service. Similarly, it may differentiate itself or its service even though its product is not unique.

h i g h p e r f o r m i n g            i n t e r f a c e . Bundling   may be necessary when the interface among complementary products is not standardized. Compatibility among  items in the   bundle  is facilitated   if the   same firm provides the whole package of items needed jointly to meet the buyer’s needs. This presumes that interface technology is relatively difficult, and that compatibility cannot be achieved.

o p t i m i z e d         p a c k a g e         p e r f o r m a n c e      .      Even   if   the   interface among products in the bundle is standard,  the bundled  firm may be able to optimize the performance of the whole package (system) by controlling the design,   manufacture,  and  service of all the parts.   It may have better information about the capabilities of each part of the bundle than a specialist competitor who must gather information externally about parts of the bundle and cannot control their design directly. This advantage of bundling presumes  that  the parts of the bundle are interdependent in determining its overall performance.

o n e   s t o p    s h o p p i n g    .    Bundling  simplifies the buyer’s shopping task. Offering the bundle  may also reassure  the buyer  that  all the items in the bundle  will work,   and   reduce  the buyer’s perceived   risk of purchase. A single point of responsibility, a single place where complaints  can be lodged, and a single service organization  may also be valued by buyers.   Buyer  frustration  over divided responsibility in the newly deregulated Bell System is a good example of how unbun­ dling can lower differentiation through this mechanism.

Enhanced Opportunity for  Price Discrimination. Bundling  may allow a firm to increase total profits where different buyers have differ­ ent price sensitivities for the individual  parts  of the bundle. Particularly in a “mixed” bundling  strategy— where  a firm offers both the full bundle at one price and the individual  parts  of the bundle  at prices which sum to greater than  the bundle  price— bundling  may increase total revenue compared to selling the parts separately.5

The mechanism  by which   this   occurs  is a   function   of the cost of the bundle versus the cost of the parts of the bundle a buyer would want if they could be purchased separately. Bundling can cause some buyers to buy the whole bundle  even though  they would not buy all the parts individually, provided  the incremental  cost of the whole bundle over the cost of the parts  they desire is low. In addition, a mixed bundling  strategy can allow the firm   to   extract  high   prices from   buyers who   strongly   desire only   one part  of the bundle,  while at the same time selling the whole bundle to other buyers.

The value of bundling  in pricing depends  on the distribution of buyer needs in the   industry.  Bundling  is most  likely   to   raise profits if buyers have widely differing price sensitivities for parts of the bundle. Bundling is a way of capturing  differing price sensitivities without charging different prices to different buyers for the same product.

Increased Entry/Mobility Barriers. Bundling may lead to higher entry/m obility barriers, presuming there are one or more of the other competitive   advantages  of bundling.   Bundling  raises barriers  because a competitor must develop capabilities in all parts of the bundle rather than being able to specialize.

Mitigated Rivalry.    Rivalry among a group of bundled  competi­ tors may be more stable than rivalry in an industry  containing both bundled and unbundled competitors. If all competitors offer the same bundle and the only industry price is the bundle price, the ability to recognize mutual dependence  among  firms is likely to be higher and the incentives for price cutting may  be less than  if competitors  offer any part of the bundle separately.

2. Risks of Bundling

A bundled strategy involves a number of risks, which vary in importance depending  on   a   firm’s strategy   and   industry  structure. The risks of bundling  are   determined  by   the   potential  vulnerability of a bundled firm to attack  by an unbundled  competitor  employing a more focused strategy.6 Sometimes a firm with a substantial competi­ tive advantage can preserve bundling  despite significant risks, as IBM did for many years in computers.

Diversity o f Buyer Needs. Bundling presumes that a significant proportion of buyers desire and are willing to pay for the whole bundle. If buyer needs vary   widely   in   an   industry,  a bundled  strategy   may be suboptimal for a segment of buyers  and thereby vulnerable to a focused competitor who tailors the particular bundle  it offers to the needs of the segment. For  example, if the need for after-sale service varies widely among buyers in an industry,  a focused competitor may be able to enter by selling only the product with no service included, and achieve enough market share to be viable. People Express, for example, unbundled  the airline   product  by   eliminating   free   meals, free baggage handling, and other parts of the traditional airline bundle. This appealed to price-sensitive buyers  who   had   little   need   for the parts of the bundle  that  were eliminated.  Similarly, off-price retailers have successfully attacked traditional retailers with strategies involving little service, no credit,   no   alterations,  and   no   advertising   to   appeal to a particular buyer segment.

Buyer  Ability   to Assemble the Bundle.    In   a bundled  strategy, the firm assembles the bundle  and sells it as a package  to the buyer. This strategy is vulnerable if buyers   have the   technological, financial, and administrative capabilities to assemble the bundle themselves. The buyer may purchase the parts of the bundle individually from suppliers and put them together, or purchase some parts  from suppliers and produce others (e.g., service) in-house.

Specialist Ability to Provide Parts o f the Bundle on More Favorable Terms.     A   bundling  strategy   is   vulnerable  if specialists   that  focus on one or a few parts of the bundle can achieve low cost or differentia­ tion in producing them. A specialist may gain a competitive advantage for the reasons described in Chapter  7. It can tailor  its value chain to produce and sell just one item in the bundle  that  it views as its primary  business.   A   specialist   may  also   avoid   costs   of coordination or compromise  with shared  activities supplying other  parts of the bundle that are borne by a bundled competitor.

A specialist that focuses on one part of the bundle can also poten­ tially   reap   advantages  from   interrelationships  with   other  industries. A specialist electronics company may have a cost advantage in produc­ ing an electronic part for an electromechanical system vis-a-vis a bun­ dled competitor  who provides the entire system, for example, because the electronics company can share value activities (e.g., R& D, test equipment) with other related electronics businesses.7

Bundling Through Coalitions.      A bundled competitor is vulnera­ ble if the advantages of bundling can be duplicated by focused competi­ tors who form coalitions among  themselves. Coalitions can take many forms, such as technology sharing and joint sales or service organiza­ tions.

3. Bundled  Versus Unbundled  Strategies

The balance between the competitive  advantages  of bundling and its risks   determines  the   appropriateness  of the   bundled  strategy   for a firm. The risks of bundling provide the strategic levers with which focused competitors attack bundled competitors. Bundling will be the predominant strategy in an industry if the competitive advantages of the bundled firm are significant and  the risks of bundling low. Bundled and unbundled strategies are natural  adversaries, however, and the balance between them can shift quickly in an industry  in either direc­ tion.

In many industries, it may be difficult for the bundled and unbun­ dled strategies to coexist. If a successful unbundled competitor becomes established, this creates pressure on the bundled  competitor to unbun­ dle. The  presence of an unbundled  competitor  makes buyers more aware that  their needs are not being exactly met by the bundled firm, and provides an alternative to purchasing the whole bundle.

In entering an industry against bundled firms, an unbundled com­ petitor is likely to attack those parts of the bundle that by themselves would fully   satisfy   the   needs   of a   significant   group  of buyers,   such as a basic product without the ancillary services. Another likely avenue of attack is to supply a peripheral item such as spare parts or service, where the bundled competitor is inefficient or overcharging. Attacking a bundled firm through  unbundling  is one of the characteristic  ways of gaining market  position   that  are   discussed   in   detail   in   Chapter 15.

After  the first entry   by   an   unbundler,  the   incentive   is created for other  unbundled  competitors  to   enter  and   offer other  parts of the bundle. Over time, then, more buyers are able to construct  the particular bundle they desire. Once a number of unbundled competitors achieve significant market penetration, some of the motivations for bundling, such as scale economies, rivalry reduction,  or building barri­ ers, are often eliminated. Thus  the   remaining  bundled  competitors may be forced to unbundle.

The bundled and unbundled strategies can coexist in an industry, however, if there are wide differences in buyer needs and compelling advantages to bundling for some buyer segments that are not a function of volume (or of bundling being the dom inant strategy). For example, optimization of system performance through bundling may be particu­ larly critical for some buyers, and thus a bundled strategy will remain sustainable for this buyer segment despite the fact that specialist compe­ titors supply parts  of the bundle  to   other  segments.   Bundling  may also be particularly valued by less sophisticated buyers, even though sophisticated buyers want  to assemble the bundle  themselves. In busi­ ness aircraft, for example, Cessna   is offering   a bundle  including   a plane, maintenance,  pilots,   a hangar,  office space,   and   landing   fees all for a single monthly price. This appeals to buyers that want the convenience of one firm’s taking responsibility for everything. A strat­egy of mixed bundling may also be appropriate depending on the particular competitive advantages  sought from bundling.  While offer­ ing the buyer an option to purchase  either  the whole bundle  or parts of it from the same firm tends to undermine  the firm’s ability to sell the bundle, mixed bundling  may be appropriate if the key advantage to bundling is differentiation or price discrimination.

4. Bundling and Industry  Evolution

The appropriateness of bundling often changes as an industry evolves, because industry  structural change alters advantages of bun­ dling or the risks. There  is no valid generalization  possible about whether bundling becomes more  or less attractive  as an industry evolves, because many patterns are observed in practice. In the majority of industries, however, there seems to be a tendency towards unbundling as an industry evolves. In commercial insurance, for example, standard­ ized insurance packages have been replaced by the separate  sale of services such as loss prevention counseling. Buyers are able today to purchase broad coverage or specialized services depending  on their needs. Another industry where unbundling may well occur is video systems. Just as audio systems were once bundled but are now often unbundled, video systems are likely to unbundle into displays, speakers, controllers, game units, and so on. Unbundling trends  have also been evident in such other industries as building control systems, gasoline retailing, computers, and hospital management services.

The tendency for unbundling to occur over time is due to some characteristic changes in the competitive  advantages  and risks of bun­ dling that accompany industry evolution:

Buyer Ability to Assemble the Bundle Increases.      Buyer learning over time, coupled with diffusion of technology,  implies that  buyers may become more  able to   assemble   the   bundle  themselves.   Buyers can gain the expertise to ensure compatibility, and need less reassurance from a single source of responsibility. This is reinforced by the tendency of buyers to backward integrate as industry  volume grows. Buyers become more able to make some parts of the bundle themselves, and therefore do not desire the whole package.

Product/Technological Standardization Occurs.     Standardization of the product as an industry matures often reduces the need to control the entire package in order to optimize  system performance.  It also lowers entry barriers into parts of the bundle,  and simplifies the buyer’s task of assembling the bundle in-house. The problems of interface compatibility also tend to be reduced over time as an industry matures and standards  are established. Qualified suppliers thus  appear for parts of the bundle where there were none previously, and trigger the unbun­ dling process described above.

Needs for Various Parts o f the Bundle Are Reduced/Changed. Industry maturity tends to reduce  the need of many  buyers for ser­ vice,   applications   engineering,   and   other  parts   of   the   bundle.   Early in industry development, product quality is often erratic, products are unproven, and the perceived risk of purchase is often high (see Chapter 8). All of these characteristics lead buyers  to seek the security of a bundled competitor, and bundling may be necessary to get an industry off the ground (the case in fiber optics and in electronic fuel injection systems for cars). As the industry  matures,  however, service and sup­ port either move in-house or are less needed   by   buyers.   In   addition, new buyers are often attracted to the industry  and/or  competitors segment the industry  more finely, increasing the diversity   of buyer needs. Different bundles  thus become appropriate  for different buyers, and the stage is set for an unbundled competitor to enter.

Industry Size Offsets Bundling Scale Economies. As an industry passes from emerging to maturing,  the increase in industry  size may make it possible for specialists to viably provide only parts   of the bundle. Growth in demand for the parts of the bundle overcomes manufacturing  scale thresholds  as well   as fixed selling costs.   This   is a special case of the emergence of  a new   segment  as   viable for a focus strategy, discussed in Chapter 7.

Increasing Buyer Price Sensitivity Leads to Pressures for Cost Re­ duction through Unbundling.   Increasing buyer price sensitivity leads buyers to press for cost savings. One avenue is often for a buyer  to purchase parts of the bundle and  assemble it in-house, or to purchase just   those   parts   of the   bundle  that  it   needs.   Buyers   often   provide the impetus for unbundling even if no specialist competitors emerge.

Specialist   Competitors Are   Attracted.      The  success   and   growth of bundled firms may attract  competitors  looking for a way to get into the industry. Since entering with a bundled  strategy usually in­ volves overcoming higher entry barriers, new entrants naturally gravi­ tate toward unbundled strategies (see Chapter 15). All the other forces described above provide the opening for them to succeed.

The tendency for unbundling to occur over time tends to be accen­ tuated where an industry  has powerful, capable  buyers. Such buyers often have the technological strength to quickly develop in-house capa­ bility to assemble the bundle  themselves, the bargaining  leverage to force suppliers to unbundle,  and the resources to lower the barriers facing specialist competitors.  For  example,   the   leading   automobile firms purchase entire systems such as brake systems or fuel injection systems only very early in their development.  Later, when the technol­ ogy becomes   developed,   these   firms break  the   systems   into   parts to be sourced from   separate  suppliers.   They  in   the   process often help put unbundled suppliers  in business.

Unbundling  is also triggered or accelerated during  periods of in­tense industry rivalry, such as an economic downturn. Desperate com­ petitors turn  to unbundling for incremental  revenue, setting in motion an often irreversible process. This  pattern  seems to have been at work in commercial insurance, where a disastrous downcycle has made firms anxious to gain incremental sales.

Industry followers or new entrants  are often the first to break down the bundle. Followers tend  to lead unbundling  because of their desire to neutralize their competitive disadvantages in competing with bundled competitors. Often the best hope is to change the competitive rules in order  to lower mobility barriers.  New   entrants  also often break down   the   bundle  by   identifying   latent  or   emerging   segments or situations where there is no clear economic motivation for bundling, where bundling  creates mixed motives in retaliation for bundled  firms, or where buyer  needs are changing. A prime  source of new entrants that unbundle  is spinoffs from bundled  competitors,  who recognize that some buyers’ needs are not being served.

Despite a tendency  for unbundling  to occur  over time, bundling is sustainable if the competitive advantages from bundling remain sig­ nificant and unattainable any other  way. Performance or cost benefits of bundling can persist, for example, even after the buyer’s need for reassurance or assistance in assembling the   bundle  disappears.   Bun­ dling is also sustainable  if an industry  leader controls  a proprietary part of the bundle  and buyers are forced to purchase  the entire bundle to gain access to it. Moreover, a leader can sometimes protect the bundle by protecting proprietary  interfaces among parts of it. By mak­ ing the problem   of  interfacing with   its products  difficult, the   leader can deter the entry  of specialist competitors.9 IBM has   been   accused of such behavior, for example.

While   the   more  common  direction   of change  is   from   bundled to unbundled competition, it is im portant to recognize the opposite possibility. Technological  changes may   lead to   product  performance or interface motivations for bundling.  Economies of scale in providing the bundle may also sometimes increase over time if the manufacturing process changes. Regulatory barriers that prevented economically ra­ tional bundling may fall. Unbundled strategies may also have developed over time in an industry where in fact there are economic motivations for bundling. If   many  specialists   initially   entered   the   industry   and no firm   had   the   resources   or orientation  to   develop   total   capability in the whole bundle,  buyers may have   been   forced   to   take   the   role of assembling the bundle  themselves. A strategic   innovation  by one firm in bundling may transform the industry structure.

Two cases where bundling appears to be supplanting unbundled strategies are financial services and health care. Services such as Merrill Lynch’s Cash M anagement Account (CMA), which combine stock brokerage, a checking account, a credit  card, and other financial ser­ vices, are bundles of previously separate services. They are a manifesta­ tion of deregulation as well as developments in information system technology that made such accounts feasible. Similarly, health mainte­ nance organizations are combining separate services. In the same health care sector, however, home  care services and   specialized   emergency room or firms performing  m inor  surgery  are a form   of  unbundling of the product  line offered by hospitals. This example  illustrates how the competitive advantages of bundling must be viewed on a segment- by-segment basis.

5. Strategic Implications of Bundling

The analysis of bundling  carries im portant  strategic   implications for both bundled and unbundled competitors. There is usually a con­ stant tension between bundled  and  unbundled  strategies that  requires that both be continually reexamined:

Bundle  Where the Advantages Outweigh the Risks.       Bundling can be a powerful source of competitive advantage where the benefits de­scribed above outweigh the risks. W here producers  of products  have lost sight of the buyer’s ultimate  need to integrate  them into a system, a bundled competitor can sometimes  transform  the industry  in its favor. Sophisticated analysis of the buyers  value chain   and   how   it varies by segment is a prerequisite to effective choices to bundle  and unbundle.

Avoid Unconscious Bundling. Many  companies  have de facto bundled strategies though they do not recognize them as such. Uncon­ scious bundling is dangerous because a bundled  firm may be vulnerable to attack by   a focused   competitor  but  may   not  perceive   the   threat. A bundled strategy should  be the   result   of a conscious decision in which the advantages  of bundling  are judged  to outweigh the risks, and not the result of a failure to distinguish  among  the potentially separable products or services that the firm offers.

Be Prepared to Unbundle  Over Time  i f   Conditions   Change. Given the tendency for unbundling to occur over time, a bundled competitor must be constantly aware of the potential  need to unbundle if the balance of advantages and risks shifts. A firm must distinguish between hard  economic  reasons for bundling  and   reasons based on lack of buyer sophistication that may be transient. Many bundled competitors have surrendered market share unnecessarily because they have stubbornly clung to bundled strategies.

Bundled Competitors May Represent Opportunities for Industry Restructuring. Bundling can create vulnerabilities that an unbundled competitor can exploit, particularly  if bundling  is unconscious or if the industry is evolving structurally.  Industries  in which bundling is being practiced, ideally as a long-standing  industry  convention, are potential entry targets for a firm.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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