Developing New Products and Services The Marketing Research Collection

Sanders
Learning, Differentiation, and Innovation Naresh Malhotra, Editor
G. Lawrence Sanders
With contributions by Ron Huefner, Sung Jin,Yong Jin Kim, Lorena Mathien,
Barbara Sherman, Xiao Tang, and Chul Woo Yoo

This outstanding contribution to market research focuses on the up-

front activities and ideas for new product and service development.
A central theme of this book is that there is, or should be, a constant
Developing
struggle going on in every organization, business, and system between
delivering feature-rich versions of products and services using extrava-
gant engineering and delivering low-cost versions of products and ser-
New Products
vices using frugal engineering.
A number of powerful concepts and tools are presented in the book
to facilitate new product development. For example, three templates
and Services

Developing New Products and Services

are featured that facilitate new product and service development. The
FAD (features, attributes, and design) template is used to identify the Learning, Differentiation,
features and attributes that can be used for product and service dif-
ferentiation. The Ten–Ten planning process contains two templates: an
Organizational and Industry Analysis template and the Business Plan
and Innovation
Overview template. These two templates coupled with the FAD tem-
plate can be used to develop a full-blown business plan. Entrepreneur-
ship, technology and product life cycles, product and service version-
ing, product line optimization, creativity, lock-in real options, business
valuation, and project management topics are also covered.

G. Lawrence Sanders, PhD, is a professor in the Department of Manage-

ment Science and Systems in the School of Management at the State
University of New York at Buffalo. He was a recipient of the Provost’s G. Lawrence Sanders
Exceptional Scholars Sustained Achievement Award from the Universi-
ty of Buffalo in 2007. He has served as a department chair and the chair
of the PhD program in the School of Management. He has published
over 50 refereed research papers in a variety of publications such as
The Journal of Business, MIS Quarterly, Information Systems Research, the
Journal of Management Information Systems, the Journal of Strategic Infor-
mation Systems, Communications of the ACM, the Journal of Management
Systems, and many others.

The Marketing Research Collection

Naresh Malhotra, Editor

ISBN: 978-1-60649-241-3
90000

9 781606 492413
www.businessexpertpress.com www.businessexpertpress.com
Developing New Products
and Services
Developing New Products
and Services
Learning, Differentiation,
and Innovation

G. Lawrence Sanders

With contributions by
Ron Huefner
Sung Jin
Yong Jin Kim
Midas
Lorena Mathien
Barbara Sherman
Xiao Tang Atlas

Chul Woo Yoo

Hermes
Developing New Products and Services: Learning, Differentiation,
and Innovation
Copyright © Business Expert Press, LLC, 2012.
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted in any form or by any
means—electronic, mechanical, photocopy, recording, or any other
except for brief quotations, not to exceed 400 words, without the prior
permission of the publisher.

First published in 2011 by

Business Expert Press, LLC
222 East 46th Street, New York, NY 10017
www.businessexpertpress.com

ISBN-13: 978-1-60649-241-3 (paperback)

ISBN-13: 978-1-60649-242-0 (e-book)

DOI 10.4128/9781606492420

A publication in the Business Expert Press Marketing Research

collection

Collection ISSN: Forthcoming (print)

Collection ISSN: Forthcoming (electronic)

Cover design by Jonathan Pennell

Interior design by Scribe Inc.

First edition: September 2011

10 9 8 7 6 5 4 3 2 1

Printed in the United States of America.

This book is dedicated to my mother Phyllis Sanders. She is a constant
source of inspiration in my life.
 Abstract
The focus of the book is on the up-front activities and ideas for new prod-
uct and service development. A central theme of this book is that there
is, or should be, a constant struggle going on in every organization, busi-
ness, and system between delivering feature-rich versions of products and
services using extravagant engineering and delivering low-cost versions
of products and services using frugal engineering. Delivering innovative
products is accomplished by an endless cycle of business planning, crea-
tive and innovative insight, and learning-about and learning-by-doing
activities.
A number of powerful concepts and tools are presented in the book
to facilitate new product development. For example, three templates are
presented that facilitate new product and service development. The FAD
(features, attributes, and design) template is used to identify the features
and attributes that can be used for product and service differentiation.
The Ten–Ten planning process contains two templates: an Organiza-
tional and Industry Analysis template and the Business Plan Overview
template. These two templates coupled with the FAD template can be
used to develop a full-blown business plan. Entrepreneurship, technology
and product life cycles, product and service versioning, product line opti-
mization, creativity, lock-in real options, business valuation, and project
management topics are also covered.

Keywords
Developing new products services, NPD, product design, learning, dif-
ferentiation, price discrimination, product features, innovation, business
planning, organizational analysis, diffusion, entrepreneurship, technology
and product life cycles, product and service versioning, product demand,
product line optimization, creativity, lock-in real options, business valua-
tion and project management
 Contents

Preface ..................................................................................................ix
Acknowledgments................................................................................. xix
Chapter 1 Understanding Entrepreneurship, Diffusion,
and R&D in the Context of Monopolistic
Competition ..................................................................1
Chapter 2 Fundamental Concepts of Product and Price
Differentiation .............................................................27
Chapter 3 Differentiation in Action .............................................43
Chapter 4 The Role of Dynamic Tension in Constructing
Versioning and Product Differentiation Curves ............75
Chapter 5 Examples of Product Differentiation and
Versioning Curves ........................................................95
Chapter 6 Facilitating Creativity and Innovation ........................115
Chapter 7 Conceptualizing Products and Services
Using the FAD Template ...........................................133
Chapter 8 Strategic Planning Approaches for Product
Differentiation and Innovation ..................................169
Chapter 9 The Ten-Ten Planning Process: Crafting a
Business Story ............................................................193
Chapter 10 Lock-In and Revenue Growth ....................................213
Chapter 11 Valuing the Business ..................................................223
Chapter 12 Developing a Business Plan ........................................251
viii CONTENTS

Chapter 13 Project Management for New Product and

Services Development ................................................275
Chapter 14 Re-priming the Business Using Real
Options Concepts ......................................................295
Chapter 15 Wrap-Up ...................................................................311
Notes .................................................................................................315
References ...........................................................................................327
Index .................................................................................................337

For PowerPoint slides and other supplemental materials that accompany

this book, please visit www.glsanders.wordpress.com.
 Preface
A central theme of this book is that there is, or should be, a constant
struggle going on in every organization, business, and system. The strug-
gle is fueled by the dynamic tension that exists between delivering Midas
feature-rich versions of products and services using extravagant engineer-
ing and delivering low-cost Hermes versions of products and services
using frugal engineering (see Figure 1). Midas versions are high-end
products for nonprice-sensitive consumers. Hermes versions are for price-
sensitive consumers. The results of this dynamic tension between Midas
versioning and Hermes versioning are Atlas products and services. Atlas
products and services are designed for mainstream consumers. Atlas prod-
ucts and services incorporate the product design features that will attract
the broadest customer base and will also be profitable. The driving force
behind the development of Midas, Atlas, and Hermes versions is driven
by the implicit creative genius that everyone possess and most businesses
should possess as they engage in continuous learning-about and learn-by-
doing activities.
Anyone can learn how to be creative and innovative. Just work hard
by learning about the problem, and then try to solve the problem by

Midas Hermes

Atlas

Extravagant engineering & design Frugal engineering & design

Figure 1. Dynamic tension between Midas design and Hermes design.
x PREFACE

making or doing something. Not all systems and businesses can be crea-
tive and innovative. Some companies can work hard and they can learn
about a problem but they cannot build and do things because they have
lost the ability to do so. They have lost the ability to learn-by-doing.

The Dueling Mantras

Our primary mantra for a business is “differentiate through innova-
tion or perish.” This is accomplished primarily through extravagant
engineering and design and the construction of Midas versions. This is
not an easy path to follow, because there is a natural tendency toward
inertia and resting on one’s laurels.1 It is our assertion that creative and
innovative business planning driven by learning-about and learning-by-
doing leads to sustainable businesses. Our focus will be on the upfront
activities and ideas for product and service differentiation that result
in competitive products and services. They include the endless cycle of
business planning, creative and innovative insight, learning-about, and
learning-by-doing.
The second mantra of the entrepreneur is to “strive to reduce costs.”
This is accomplished primarily through frugal engineering and design
and the construction of Hermes versions. Some organizations have been
overly enthusiastic in embracing this mantra. In some businesses, learn-
ing-by-doing has been abandoned in an attempt to dramatically cut costs
and increase margins in the wake of intense international competition.
But this has had a negative impact on the ability of many organizations
to innovate, because many companies have lost the ability to exploit new
knowledge and information when it becomes available. Many organi-
zations have lost what is referred to as absorptive capacity. Absorptive
capacity is the ability of a firm to “recognize the value of new informa-
tion, assimilate it, and apply it to commercial ends.”2 It is the ability to
apply previously gained knowledge and insight to understanding how
new information and knowledge can be applied. Developing absorptive
capacity is synonymous with developing insight. Insight is the ability
to perceive complex situations, problems and opportunities clearly and
deeply. Andy Grove, a past founder and CEO of Intel, pegs the current
situation perfectly:
 PREFACE xi

Silicon Valley is a community with a strong tradition of engineer-

ing, and engineers are a peculiar breed. They are eager to solve
whatever problems they encounter. If profit margins are the prob-
lem, we go to work on margins, with exquisite focus. Each com-
pany, ruggedly individualistic, does its best to expand efficiently
and improve its own profitability. However, our pursuit of our
individual businesses, which often involves transferring manufac-
turing and a great deal of engineering out of the country, has hin-
dered our ability to bring innovations to scale at home. Without
scaling, we don’t just lose jobs—we lose our hold on new tech-
nologies. Losing the ability to scale will ultimately damage our
capacity to innovate.3

The USA is losing the ability to compete in high-tech fields in part

because it has abandoned learning-by-doing. Basic research and applied
research involving broad-based collaboration by government, academia,
and business are essential for solving societal problems and in providing a
base for technology-based businesses.4 Basic research involves understat-
ing the fundamental principles and dynamics of physics, chemistry, biol-
ogy, and cybernetics to name a few. Applied research involves translating
the principles and dynamics of basic research into commercial applica-
tions. The U.S. government up to about 1990 distributed about the same
amount of funds to both basic and applied research projects. In recent
years, the gap between basic research funding and applied research fund-
ing has been widening. The U.S. government has provided less money for
applied research.5
Outsourcing has also reduced the level of applied research. New prod-
uct development is essentially applied research. New product develop-
ment is facilitated when an organization has core competencies in research
and development (R&D), product design, and manufacturing. Everyone
is beginning to realize that there is a synergistic interplay between R&D,
product design, marketing, and manufacturing. New product develop-
ment is put at risk when these activities are outsourced, off-shored, or
both. Entire industries are affected as the knowledge is not readily avail-
able for solving problems and realizing new opportunities essentially
because it is embedded elsewhere.
xii PREFACE

Learning-by-Doing as the Basis for

Competitiveness and Sustainability
Learning-by-doing means that the organization makes and builds things,
conducts experiments, and builds prototypes. This includes the manu-
facturing process. The loss of absorptive capacity insight can often be
traced to outsourcing. Outsourcing typically occurs when products and
service margins are under severe market pressure, and organizations are
forced to increase productivity by turning to locations where labor costs
are substantially lower. This can have serious consequences. If the organi-
zation loses its absorptive capacity, then the organization may not be able
to understand and recognize when an emerging technology is impor-
tant. In essence, the organization does not have the ability to acquire
know-how, expertise and skills because it has lost the ability to learn-by-
doing and learn-about emerging ideas and technologies. Grove’s solu-
tion to recapturing creative and innovative mojo is to reduce costs by
also increasing the scale of operations. The essence of his idea is that if
an organization can produce more, it will also be able to take advantage
of learning effects and to cover the fixed costs of production. Intel is
committed to product differentiation, scale and cost reduction, in-house
manufacturing, and in-house design. Long-term sustainability is inextri-
cably linked to the synergistic interplay of design, manufacturing, and
market awareness.
There is a revolution taking place in all businesses. Additive and
desktop manufacturing, open-source software, and the do-it-yourself
movement are fueling this revolution. Products and components can be
conceptualized, designed, and built using 3D printers. These printers
use a process that is similar to building up layers of plastic and com-
posite materials to build products and parts and to prototype ideas. A
do-it-yourselfer can assemble such a printer for under $1,000. A com-
mercial printer can be obtained in the $10–$20K range. The products
produced from these printers can be used to produce commercial prod-
ucts and for prototyping. Large-scale 3D printers are being developed
to produce products and components the size of aircraft wings. There
is also a revolution taking place in the development of services. Cloud
computing, applications development tools, and open-source software
 PREFACE xiii

are having a profound impact on the delivery of software-related services

and applications. Software start-ups and prototypes can be constructed
without investing in large-scale hardware infrastructure. The software
itself can be cobbled together with a variety of development tools and
open-source software. Competition can come from any size of company
from anywhere in the world. All that is needed is an idea, hard work, and
experimentation.

The Big Aha and Learning-by-doing

As we shall see throughout the book, the magic sauce of innovation
involves learning and experimentation. Weaving together the little ahas
through a continuous learning process is the basis of interesting ideas
and innovation. As illustrated in Figure 2, learning-about and learning-
by-doing are the drivers of innovation and new product development.

Learn Learn by
about doing
Innovation

Build business Write 10–20 page plan

Idea

Build
product

Prototype

Quickly gather
market and product Pitch your
information plan
Develop a small 2–3 page plan

Figure 2. Learning about and learning by doing drive innovation and

new product development.
xiv PREFACE

This process involves the continuous mixing together of collaboration,

searching for ideas, and then making things. As noted in chapter 6, the
little ahas eventually lead to the big aha and the big aha is not necessarily
the solution to the original problem. The big aha is simply illuminating,
insightful, and innovative. Peter Sims suggests the placing of little bets
to explore possibilities and engage in innovation.6 Little bets are essen-
tially low-risk investments with a chance of failure that incorporate the
development and testing of ideas. Placing little bets leads to little ahas
and eventually to the big aha. Placing little bets are actually investments
in what are referred to as real options, and that topic will be covered in
depth in chapter 14.
There are of course other important issues in the execution of a suc-
cessful business, including the development of an efficient supply chain
and the development of a strong brand. The supply chain and developing
a brand are discussed throughout the book, but they deserve more atten-
tion and detail and the reader is encouraged to learn-about these topics
by reading and attending professional development programs. As noted
in chapter 8, organizations need above-average performance in terms of
product and service innovation, the supply chain, and branding in order
to survive.

Book Chapters
This book is concerned primarily with the early stages of conceptualizing
new ideas that can enhance existing business models and subsequently lead
to the creation of new businesses (see Figure 3). The material in this book
has been in development over the last 10 years in a course on technology
management and development. One purpose of the course is to under-
stand how technologies unfold and how they guide the strategic direction
of contemporary business. The course involves reading and discussing over
a dozen cases a wide variety of successful, emerging, and unsuccessful busi-
nesses. The cases used in the course are usually matched to chapter topics.
The case studies and class dialog coupled with the reading of the book
chapters are part of the learning-about process. The learn-by-doing part
of the course involves the development of a business plan for a start-up
company.
 PREFACE xv

Book focus Business re-conceptualized. May need

turnaround management support.
Business growth

Need professional management as business

grows to institute more controls and structure.
Launch

Need project management for additional product

development and to develop initial business processes.

Business conceptualized and planning is started

Time

Figure 3. The focus of this book is on early stages of product

development.

Chapters

Chapter 1: Understanding Entrepreneurship, Diffusion, and R&D

in the Context of Monopolistic Competition

The first chapter introduces the fundamental concepts related to under-

standing innovation, diffusion, technology life cycles, R&D, and entre-
preneurship within the context of monopolistic competition. The
importance of learning-about and learning-by-doing for developing
innovative products and services is discussed.

Chapter 2: Fundamental Concepts of Product and Price

Differentiation

Chapter 2 illustrates the importance of product and price differentiation

and how they relate to a consumer’s willingness-to-pay and to price sen-
sitivities. The chapter also describes first-, second-, and third-degree price
discrimination strategies and how they can be implemented.

Chapter 3: Differentiation in Action

Chapter 3 illustrates why product differentiation and price discrimination

can generate additional revenues. The chapter focuses on the use of version-
ing to aid in product differentiation. A spreadsheet is dashboard presented
xvi PREFACE

that can be used to assist in product versioning. The importance of comple-

mentary and substitute goods and their impact on revenues is also examined.

Chapter 4: Role of Dynamic Tension in Constructing Versioning

and Product Differentiation Curves

Chapter 4 illustrates a model for constructing product differentiation

curves that draws on the dynamic tension that exists between developing
high-end Midas products and low-end Hermes products. The results of
this dynamic tension between Midas versioning and Hermes versioning
are Atlas products and services. Atlas products and services are designed
for mainstream consumers.

Chapter 5: Examples of Product Differentiation and Versioning Curves

This chapter shows a variety of product differentiation and versioning strat-

egies that have been used by businesses. Some businesses focus on version-
ing at the high end, some businesses focus on price-sensitive consumers,
and some businesses try to offer products across the entire demand curve.

Chapter 6: Facilitating Creativity and Innovation

Chapter 6 discusses the concepts of creativity and innovation. Foster-

ing creativity and innovative activity can be accomplished by dialog and
discussion, learning-about, encouragement, time, solitude, experimenta-
tion, construction, and by having a supportive environment.

Chapter 7: Conceptualizing Products and Services

Using the FAD Template

This chapter introduces the FAD (features, attributes, and design) tem-
plate. The FAD template is used to identify the features and attributes that
can be used for product and service differentiation. The FAD template
incorporates concepts from meaning-driven design (MDD), user-driven
design (UDD), and technology-driven design (TDD) and also uses a clas-
sification scheme that can be used to ascertain whether attributes and
features are increasing or declining in importance.
 PREFACE xvii

Chapter 8: Strategic Planning Approaches for Product

Differentiation and Innovation

Chapter 8 presents a brief overview of the more popular approaches for

strategic planning. This chapter also sets the stage for the Ten–Ten plan-
ning process, a simplified yet robust approach to planning that will be
detailed in chapter 9.

Chapter 9: The Ten–Ten Planning Process: Crafting a Business Story

This chapter details the Ten–Ten planning process. The Ten–Ten planning
process contains two templates: an Organizational and Industry Analysis
template and the Business Plan Overview template. The idea behind the
Ten–Ten approach is that once you have gathered some background data
related to the industry and the organization, you should be able to com-
plete the two very quickly. The chapter also describes how the Business
Plan Overview template and the Industry and Organizational template in
conjunction with the FAD template can be used to develop an executive
summary for the business plan.

Chapter 10: Lock-In and Revenue Growth

Chapter 10 discusses the importance of lock-in from the producer’s per-

spective in achieving revenue goals through network effects. The chapter
also highlights how buyers try to avoid lock-in in order to maintain flex-
ibility and avoid switching costs.

Chapter 11: Valuing the Business

The entrepreneur, the entrepreneur’s friends and family, investors, and

banks are interested in how much a business is worth. This chapter dis-
cusses several approaches for valuing a business and presents several exam-
ples of how they can be applied.

Chapter 12: Developing a Business Plan

Chapter 12 presents a detailed approach for constructing a business plan.

The expanded business plan provides additional focus by adding details
xviii PREFACE

on the what, why, how, when, and for whom a product or service will be
produced. The FAD template, the Organizational and Industry Analysis
template, the Business Plan Overview template and the executive sum-
mary are used as the basis for developing a full-scale business plan. A
variety of issues are also discussed including the plan format, the writing
style, investors, and legal issues. This chapter also discusses how to pitch
the plan to interested parties.

Chapter 13: Project Management for New Products and Services

Development

This chapter presents an overview of the essential tools and techniques for
project management. Once the initial business model has been created,
the hard work begins. In most situations, everything is new and needs
to be built up from scratch. The entire supply chain has to be built and
tested to insure that orders for products and services can be accepted,
filled, and supported. Project management is a critical tool in the never-
ending process of business growth and renewal. It allows the entrepreneur
to minimize and mitigate inherent risks and increase the potential for the
successful launch of the enterprise and the ensuing business renewal.

Chapter 14: Re-priming the Business Using Real Options Concepts

This chapter is about business renewal. It does not matter how innovative
or how much money the current business is making. There is a life cycle for
products and technologies, and eventually the business will decline unless it
can find new opportunities. This chapter focuses on how real options con-
cepts can be used as the foundation for continually reinventing the business.

Chapter 15: Wrap-Up

This chapter discusses the importance of being entrepreneurial in renewal.

If a business does not make little and big tweaks to products and services,
it will become a business footnote. The ideas presented in this book will
not guarantee success, but they can be used to confront and also to ignore
the competition by identifying and creating opportunities that supersede
the competition.
 Acknowledgments
I would first like to thank the series editor Naresh Malhotra. His guid-
ance and comments dramatically improved the content and delivery of
the material.
I would also like to thank colleagues Bill Hamlen, Ken Kim, Alan
Dick, and Yong Li for providing guidance and reviewing book chapters
related to their expertise. I would also like to thank Larry Meile from
Boston College for reading early drafts of several chapters. His comments
helped to focus the theme of the book. Elisabeth Beccue was very instru-
mental in her deft copy editing during the final phase of the book. Thanks
are also extended to Keith Randolph, my source of engineering insight,
for listening to my ideas and providing feedback.
It was clear after working on the book for over a year that the com-
plexity and breadth of topics would require assistance if the book was to
be completed in a reasonable time. Special thanks are extended to the
following individuals who contributed in many ways to the content and
structure of the book:

• Ron Huefner assisted with preparing the chapter on firm

value. Ron actually took my initial draft of the chapter and
completely rewrote it. He also read the first draft of the book
and provided invaluable editorial comments.
• Sung Jin assisted with preparing the chapters on lock-in and
creativity. Sung also assisted with a variety of editing activities
to get the book ready for production.
• Yong Jin Kim assisted with preparing the chapter on real options.
• Lorena Mathien assisted with preparing the chapter on
project management.
• Barbara Sherman assisted with preparing the chapter on the
FAD template.
• Xiao Tang assisted with preparing the chapters on strategic
planning, the Ten–Ten planning process, and the chapter
xx ACKNOWLEDGEMENTS

on the development of the business plan. Xiao also assisted

with a variety of editing activities to get the book ready for
production.
• Chul Woo Yoo assisted with preparing the chapter on product
and price differentiation and also assisted with preparing the
chapter illustrating how the concepts can be applied.

Thanks to my spouse Jody and my son Sean for listening to my

recount of the numerous business plans developed by the students and
for serving as a sounding board for several ideas.
David Parker, publisher and founder of Business Expert Press, was
always available to listen to my concerns and to help solve what I believed
were difficult problems. Cindy Durand, Production Liaison at Business
Expert Press, was very understanding and always available to solve the
various technical issues and move the book through the production pro-
cess. Thanks are also extended to Kumararaja and the production staff at
Exeter Premedia Services for their excellent work on the book.
I would like thank Scott Isenberg, the Principal and Consultant for
Counselpub Publishing Services, for believing in the project and helping
me prepare the proposal for Business Expert Press.
Finally, I would like to thank the nearly 1,000 students who pushed me
to reach further and further to formulate and develop the course content.
 CHAPTER 1

Understanding
Entrepreneurship, Diffusion,
and R&D in the Context
of Monopolistic Competition
I always like to start class with a pop quiz. It is a good way to get
the old gray matter going and stirs up a bit of angst and loathing.
There are only three matching questions and they all relate to the
dominant types of markets: (1) perfectly competitive markets, (2) per-
fectly monopolistic markets, and (3) the market hybrid referred to as
monopolistic competition.

Question 1: Match the market types with their definition

1. Perfectly competitive market a. Many sellers trading a similar product to many
buyers
2. Monopoly market b. One seller trading a similar product to many
buyers
3. Monopolistic competition c. Many sellers trading a slightly differentiated
market product to many buyers

If you matched 1 with a, 2 with b, and 3 with c, give yourself one point.

Question 2: Now match the types of markets with their percentages of

total activity
1. Perfectly competitive market a. Less than 1%
2. Monopoly market b. Less than 1%
3. Monopolistic competition market c. Over 99%

If you matched 1 with a, 2 with b, and 3 with c, give yourself one

point.
2 DEVELOPING NEW PRODUCTS AND SERVICES

Question 3: Now match the type of market that is easiest to enter

1. Perfectly competitive market a. Somewhat easy to enter
2. Monopoly market b. Very difficult to enter
3. Monopolistic competition market c. Very easy to enter

If you matched 1 with a, 2 with b, and 3 with c, give yourself one point.
Give yourself a passing grade if you get above a zero.1 Based on
the description of the three types of markets, this brief question-
naire illustrates that the best place, and perhaps the only place for
entrepreneurs to compete is in markets characterized by monopolistic
completion.

Monopolistic Competition
Edward Chamberlin published the foundations of monopolistic competi-
tion in his 1933 book entitled The Theory of Monopolistic Competition. It is
considered by some economists to have the same stature as John Maynard
Keynes’s General Theory in revolutionizing economic thought in the 20th
century.2 The idea behind monopolistic competition is simple in form
and powerful in practice.
Monopolistic competition involves many buyers, many sellers, and
easy exit and entry, with slightly differentiated products. The sellers in
these markets sell products that are closely related, but not identical. They
have features that differentiate them from the competition. Usually, the
buyers and sellers also have good information on the attributes of the
products and the prices of the products in the marketplace. Indeed, most
products and services are sold in markets characterized by monopolistic
competition. The list includes jewelry, movie production, food, entertain-
ment, many electronic gadgets and components, some durable goods,
books, crafts, soda, houses, cars, consulting businesses, software, game
consoles, restaurants, bars, and so forth.
A monopolist is a price setter and a business competing in a per-
fectly competitive market is a price taker. Most businesses strive to be
price setters within a certain range of prices by offering a product that is
closely related, but not exactly identical to other products in the market.
The key strategy for competing in markets characterized by monopolistic
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 3

competition is to offer products that are differentiated. The products are

sort of quasi-substitutes, but they still resemble the original product or
service. For example, Apple developed the iPod to compete with existing
MP3 players.
According to standard economic theory, a purely competitive market
has many buyers and sellers and each individual firm is a price taker. In
essence, consumers and producers determine the market price for a prod-
uct or service. In perfectly competitive markets, there are many sellers and
buyers, and entry into and out of the market is easy. In a perfectly com-
petitive market, companies sell their products at prevailing market prices
where marginal revenue equals marginal cost. In actuality, every business
would like to control the market, set the price, and be a monopolist. All
businesses should strive to compete as a monopolist, even if it is in the
short term. The goal is to rake in lots of money in the short term because
your company is the only seller of a slightly differentiated product or
service.3 This will be short term (unless you have an exclusive patent on a
product, own a large oil field, or have exclusive rights to providing cable
or utility services) because successful products will always attract the com-
petition. The only way to compete in contemporary markets is to become
a serial entrepreneur, to constantly refine and reposition your products,
and to function as a near-monopolist in the short term.

The Importance of Being Entrepreneurial

and Being a Short-Term Monopolist
The notion of the entrepreneurial enterprise as a monopolist is not new.
Indeed, it has a long tradition and history. Kirzner4 noted in 1973 that
entrepreneurship may be a step to monopoly power. It is possible to
acquire market power by adding unique features or services that are not
offered by the competition. When the unique features of a product are
combined with a well-thought-out production and distribution process
and an understanding of the competitive environment, the results are
usually positive. This knowledge and the unique knowledge resources
are of course transitory, but in the short run they can provide for near-
monopoly power.
4 DEVELOPING NEW PRODUCTS AND SERVICES

Entrepreneurship is currently being viewed as a set of skills that are

part of a rational and logical process for identifying and creating oppor-
tunities.5 The process and the skills have been likened to learning how to
read, write, calculate, and conduct scientific reasoning. Being a successful
entrepreneur requires insight and knowledge of problem solving, strategic
planning, new product development, project management, and portfolio
management among others. An important reason for participating in the
entrepreneurial process is that it involves a significant amount of making
and building things. This, in turn, leads to learning-by-doing and the crea-
tion of new unforeseen opportunities because you have been participating
in the entrepreneurial process. Participation in entrepreneurial activity
leads to the creation of opportunities in the form of products and services
that were not even conceptualized or anticipated in the beginning. The
entrepreneurial process actually creates new markets via innovation and
product differentiation. Our definition of entrepreneurship focuses on a
continuous process for creating new and enhanced products and services.

Entrepreneurship is a risky endeavor involving the continuous

creation and re-creation of a new enterprise, a new product, or a
new idea.

The origin of the word entrepreneur can be traced to Old French. Entre-
preneurs were individuals who undertook risky endeavors such as theatri-
cal productions. Risk is an inherent part of entrepreneurship. If there is
no risk involved and there is still money to be made, then the endeavor
is probably a gift.

The Entrepreneur Should Design Products

and Services for Continuous Product
Differentiation and Innovation
Developments in economics, marketing, operations management, and
information technology have now brought the vision of customization
and personalization to reality.6 Consumers want products and services
tailored to their personal needs, but they also want products that are
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 5

standardized, mass produced, and inexpensive. It is possible to assemble

products and services using standardized processes and standardized
modular components and still achieve product differentiation. Autos,
global positioning systems (GPSs), tax software, operating systems, refrig-
erators, and so forth are all designed so that features and performance can
be easily added and subtracted. The key principle in designing products
and services is to design for flexibility and to continuously improve those
products and services. This is the essence of a product differentiation
strategy and the only way to survive under monopolistic competition.

Entrepreneurship Can Be Found in Large

and Small Companies
Large companies can be entrepreneurial, but as a company scales up it
is difficult to maintain entrepreneurial momentum. For example, sev-
eral promising employees left Google for the relatively entrepreneurial
environment of Facebook.7 This is a natural phenomenon in high-tech
enclaves such as Silicon Valley, but there was reason for concern because
Google had grown to 23,000+ employees. Google was being viewed as
slow and lumbering, too bureaucratic, and too slow to respond to the
innovative possibilities of emerging technologies. Google has taken sev-
eral steps to retain entrepreneurial talent by permitting them to work
independently and letting them recruit individuals with relevant skills.
It does not matter if a firm is a gigantic monolithic multinational
or a small start-up company manufacturing kazoos or even a mom and
pop organization designing and launching Web services. The objective
is the same: design products and services that are new and unique, eas-
ily differentiable, and adaptable to the needs of consumers. Entrepre-
neurial guru, blogger, and author Guy Kawasaki describes the situation
perfectly:

A great company anticipates what a customer needs—even before

she knows she wants it … the key to driving the competition crazy
is outinnovating, outservicing, and outpricing … Create a great
product or service, put it out there, see who falls in love with it …8
6 DEVELOPING NEW PRODUCTS AND SERVICES

The Kingpins of Product Differentiation and

Entrepreneurial Innovation Activity
Two companies with very large sales revenues are led by entrepreneurs.
Jeff Bezos, founder and CEO of Amazon.com, and Steve Jobs, the former
CEO of Apple, are serial entrepreneurs and the kingpins of the differenti-
ation strategy. Many businesses give lip service to the notion of satisfying
customers’ wants. Bezos means it. He is a maker of markets, a veritable
doer and inventor. Amazon did not have skills in developing electronic
books or selling cloud computing, so Bezos embarked on a mission to
develop competencies in electronic books and cloud computing. His goal
was to satisfy customer needs for books anywhere and computing any-
where at any time at an attractive low price. Bezos even enlisted a Harvard
MBA to craft a business plan for the cloud computing initiative. Here is
the essence of the Bezos approach for developing new businesses:

• The business should be capable of generating significant

returns.
• The business should be able to scale substantially.
• The business should address an underserved market.
• The market should be highly differentiated.
• The opportunity should be in an area where a company is
well-positioned to provide a new service.

Steve Jobs was always an experimenter and a doer. Although some

of Apple’s products, such as the Newton, the Lisa, and Apple TV, might
be considered failures, he bounced back numerous times and introduced
dazzlingly exceptional products that have and still are dominating the
market. He is a superb example of an experimenter who sometimes failed
in the marketplace, but learned from his mistakes and achieved subse-
quent success. This is the hallmark of the serial entrepreneur.
Our view of innovation does not require an expensive research lab,
but it can. It does not demand a large team of physicists, chemists, engi-
neers, and software developers, but it can. It does not need lots of money,
even though it helps. Innovation, as always, just demands hard work and
constant attention to searching for new ideas and building things, and
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 7

is often accompanied by failure. Success is the result of a never-ending

process of trial and error and being entrepreneurial.

Radical and Incremental Innovation

The two primary categories of innovation are radical and incremental.
Radical innovation tends to replace existing ideas, products, services, or
processes. They are innovations that are very different or even revolution-
ary and they replace existing ideas, products, services, or processes and
perhaps lead to markets that were previously nonexistent. Radical inno-
vation can lead to massive changes in an industry and to what is referred
to as creative destruction in the marketplace. The internet, the horseless
carriage, GPSs, and digital encoding of music and video technology were
radical innovations resulting in the development of new markets.
Incremental innovations involve smaller improvements in ideas,
products, services, and processes. They are like adding unique features
to a product or service. But even incremental improvements can have a
radical effect on the marketplace. For example, consider the incremental
improvements in wireless phones that eventually lead to the development
of Apple’s iPhone and to the numerous smartphone offerings.

Product and Technology Life Cycles

Life cycles are a very useful way to understand how products and technol-
ogy evolve over time. They are very useful in tracking product and process
differentiation. They can be used to understand the evolution, growth,
and decline of ideas and phenomena in the physical world, the plant and
animal kingdom, and technology. The most commonly used life cycles in
business are the technology life cycles and the product life cycles. They are
used to track the diffusion of technologies and products.
Diffusion is the acceptance, adoption, and awareness of a technology
or a product by individuals. The technology and product life cycles are
essentially the same, except the product life cycle is focused on selling
products while the technology life cycle is focused on innovation. The
technology and product life cycles consists of four phases that follow
the classic S-curve and they consist of awareness of the technology,
8 DEVELOPING NEW PRODUCTS AND SERVICES

technological growth, technological maturity, and a decline of interest in

the technology (see Figure 1.1). Figure 1.2 illustrates a snapshot of where
we believe several technologies belong in the life cycle in 2011.
Diffusion

Awareness Expansion Maturity Decline

Time

Figure 1.1. Technology life cycle.

Windows XP
Desktop computers
Offshoring
Outsourcing
e-Book readers
Windows 7
Diffusion

Mobile business apps

Tablet computers
4G wireless, GPS & Social Network apps
3-D video
Nanotechnology & Biotechnology
Cloud computing
Thin client computing
Controlling computers using brainwaves

Awareness Expansion Maturity Decline

Time

Figure 1.2. Technology life cycle profile in 2011.

 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 9

Diffusion of a Technology Usually Lags Performance

There are a number of factors that influence the diffusion of products
and technology. These factors include whether the technology solves an
important problem, how well the public or target market understands
the technology, the value versus cost calculation made by consumers,
how well the product or technology has been marketed, the effectiveness
of the social network in communicating the benefits of the technology,
the effectiveness of the supply chain in delivering quality products in a
timely manner, and finally, how well the technology performs. Perfor-
mance is the most important factor influencing diffusion, but it can be
trumped by any of these factors. There were nearly a quarter of a million
patents granted by the U.S. Patent Office in 2010. There have been nearly
5.2 million patents granted since 1963.9 The point is that technology
development never stops.
The diffusion and subsequent awareness of a product usually lags
increases in product performance (see Figure 1.3). This is in part related
to Moore’s law. The essence of Moore’s law is that the performance of
products increases over time, whereas the cost of the product stays the
same or decreases. This increase in performance is a function of techno-
logical developments and, of course, the learning curve. The idea behind

This is performance of
technology in terms of size,
weight, speed, capacity, and features.
Diffusion and performace

Diffusion and adoption This is the diffusion and

starts to take off when adoption curve.
performance is
at this level.

Time

Figure 1.3. Diffusion lags performance.

10 DEVELOPING NEW PRODUCTS AND SERVICES

the learning curve is that a company or an individual gets better at doing

something the more they do it. Moore originally stated the idea in the
context of computer-processing power (see Figure 1.4).
Moore is widely known for “Moore’s Law,” in which he predicted
that the number of components the industry would be able to place on
a computer chip would double every year. In 1975, he updated his pre-
diction to once every 2 years. It has become the guiding principle for
the semiconductor industry to deliver ever-more-powerful chips while
decreasing the cost of electronics.10
Over time, individual firms and the industry become more efficient
and the products have better features. The net result is that product
performance increases, production capabilities increase, and the cost of
production decreases. Increases in product performance are coupled with
improvements in manufacturing efficiency and attract more customers.
Research and development (R&D) and learning curve effects drive all
this.11 One of the most important outcomes of the learning curve is that it
provides short-term cost advantages to those firms that achieve large mar-
ket share and additionally creates barriers to market entry. The essence
of Moore’s law is that organizations learn by doing. They begin to break
down tasks, tasks become specialized, and some tasks are automated.
These organizations also begin to develop complementary competencies
that are the foundation for new innovations and products.

Discontinuities, Chasms, and Hype

in the Diffusion Process
Some technologies and products fail very quickly because they are
simply not effective. Others do not fail initially because of the hype
surrounding the product. But they eventually flop because existing cus-
tomers become disillusioned and communicate their dissatisfaction in a
variety of informal and formal communication networks. There are also
instances where a product is very useful, yet fails because of inadequate
marketing and a problematic supply chain. In all of these instances, the
traditional S-curve is not suitable for understanding and illustrating dis-
continuities in the diffusion and awareness of a new product or emerg-
ing technology.
 2,000,000,000 Dual-core Itanium 2 Quad-core Itanium Tukwila
POWER 6 GT200
1,000,000,000 G80 RV770
Itanium 2 with 9MB cache
K10
Core 2 Quad
Core 2 Duo
Itanium 2
Cell
100,000,000 K8
Barton Atom
P4
Curve shows ‘Moore’s law’: K7
K6-III
transistor count doubling
10,000,000 K6 PIII
every two years PII
K5
Pentium

486
1,000,000

Transistor count
386
286
100,000

8088

10,000
8080

2,300 4004 8008

1971 1980 1990 2000 2008

UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D

Date of introduction

Figure 1.4. Transistor count and Moore’s law.

11
12 DEVELOPING NEW PRODUCTS AND SERVICES

A very popular approach to understanding growth and diffusion of

technologies and products is Gartner’s Hype Cycle.12 It is an adaptation
of the technology life cycle and attempts to deal with discontinuities in
adoption. One of the more interesting features of Gartner’s Hype Cycle
is that it takes into account the unbridled and almost euphoric optimism
that accompanies the introduction of some technologies and, of course,
the inevitable precipitous decline of the next-best thing (see Figure 1.5).
The Hype Cycle consists of five phases: (1) the Technology Trigger, (2) the
Peak of Inflated Expectations, (3) the Trough of Disillusionment, (4) the
Slope of Enlightenment, and (5) the Plateau of Productivity.
Another approach to handling the very difficult cross-over between
awareness of the technology and massive adoption was developed by
Geoffrey Moore.13 He uses a bell curve to model technology and adds a
couple of cracks or discontinuities in the curve to illustrate the difficult
diffusion issues that need to be dealt with when selling high-technology
products. He notes that there is a large chasm that has to be crossed when
a technology transitions from emerging and glitchy technology to pro-
ductive, easy-to-use, and readily applicable to solving problems. The early
adopters of an emerging technology are usually more willing to put up

Peak of
Visibility

inflated
expectations
Plateau of productivity

Slope of
enlightenment

Trough of
Technology dissilusionment
trigger

Time

Figure 1.5. Gartner Hype Cycle.

 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 13

with the glitches than the masses. Technologies and products that are not
capable of making the transition fade into the chasm.

The Bridge Model of Technology Life Cycle

We have adapted the Hype Cycle model and the chasm approaches
and integrated them into the traditional S-curve that is used to model
the technological life cycle. As illustrated in Figure 1.6, there is often
a crisis of adoption as a technology begins to transition from aware-
ness to expansion. There is a major bridge to be crossed where atten-
tion to design and marketing and performance are critical. It is the
Bridge of Hope. If the performance of the technology is inadequate
or the technology falls off of the public’s radar, then there is a diffu-
sion crisis, and the technology can fall into the chasm and become
irrelevant. It is possible to crawl out of the chasm with better product
design, an influx of resources, and better marketing, but it is a difficult
climb out of the abyss. The climb out of the abyss is over the Bridge of
Adversity. Companies that have invested in emerging technologies are
forever hopeful that they can cross the abyss from relative obscurity to

Technology can fall into abyss because

it is ineffective or it has been over-hyped
and people are dissilusioned
e
hop
Diffusion

of
ge
id
Br
Bridge of adversity

Technology can emerge from the abyss

with better product design and marketing

Awareness Expansion Maturity Decline

Time

Figure 1.6. Crossing the bridge of hope and climbing the bridge of
adversity.
14 DEVELOPING NEW PRODUCTS AND SERVICES

expansion and reap the monetary rewards derived from the expansion
of the marketplace.

Technologies Do Not Necessarily Fall Into the Abyss:

They Become Embedded in New Technology
In some ways, technological change is similar to evolutionary change.
Some technologies are simply eclipsed by other technologies and fade
or die away, such as in the case of the horse and buggy giving way to
the Model T and analog TVs succumbing to digital TVs. Sometimes,
technologies evolve through subtle differentiation such as the case with
cell phones, GPS devices, and operating systems. There are instances
where major mutations take place when two different technologies are
combined such as in the case of the merging of GPS, cell phones, MP3
players, and Web 2.0 social networking.
In many instances, technology does not just die out or become obso-
lete, it just becomes part and parcel of a new technology. One of the early
partitioning and time-sharing and operating systems, IBM’s VM370,
was developed in the 1960s and 1970s. The concepts developed for the
VM370 operating systems are the foundation for many existing operat-
ing systems, including UNIX, Linux, and all of Microsoft’s products, as
well as the current crop of the so-called virtual machine applications. The
cloud-computing concept is actually an extension of the IBM’s VM370
architecture. Thin client computing, where a significant part of the pro-
cessing is done on a central server, was touted as the next big technology
in the early 1990s. It faded for a while and then has reemerged as an
important concept with the emergence of cloud computing.

There is Power in Numbers: Network Effects

and Metcalfe’s Law
Metcalfe’s law states that the value or utility of a network is proportional
to the number of user’s of the network. At one time, Metcalfe indicated
that utility was a square function (utility = n2). For example, a phone
network with 10 people has a utility of 100 and a network with 1,000
people has a utility value of 10,000. He has since scaled that back and
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 15

the utility of a network is based on a log function (utility = n × log(n)).14

The log model is presented in Figure 1.7. Thus, for a 100-user network,
this would translate to utility = 100 × 2 = 200 or 200 utility units. The
equation is not the important issue. It is the idea that if you have more
people using a phone, a fax, railroad, a Web 2.0 application or whatever,
your network will become more attractive and attract even more users.
Consider the choice to go with a local cable TV network or a satellite
TV network. If individuals take into account what network other people
are choosing, then there is a network externality or a network effect that
influences the decision.
In the economics literature, a network effect typically refers to a
change in the positive benefit that a consumer receives from a good, when
the number of consumers of the good increases.15 Network effects are not
limited to phone, wireless, and telecommunications networks. They can
also include the following:

• Transportation networks such as roads, railroads, and flight

paths.
• Communication systems such as the postal service, express
mail services, and pony express.

220
200
180
160
140
120
Utility

100
80
60
40
20
0
0 10 20 30 40 50 60 70 80 90 100 110
Number of adopters

Figure 1.7. The size of the network increases the value of the
network.
16 DEVELOPING NEW PRODUCTS AND SERVICES

• Communication media such as books, printed materials,

schools, and universities, because they disseminate ideas and
knowledge and those ideas have greater utility.
• Social networks involving a social structure between
individuals or organizations with similar interests. They
include political, cultural, religious, sports clubs, social clubs,
volunteer groups, family, friends, industry trade groups,
and market segments. Facebook, Twitter, and Web 2.0
social-networking applications.

Economists also talk about network failures. That is a situation

where the technology or network selected is not the best technology,
thus leading consumers and business down a path that is not opti-
mum. In reality, consumers are often very aware of the trade-offs in
performance that exists between competing technologies. Take the
case of the success of the VHS recording format over the Beta format.
The success of VHS is often touted as an example of network failure.
The picture quality of the VHS format was, in fact, reasonably close
to the quality of the Beta format.16 In addition, the VHS tapes had a
greater capacity and cost less than the Beta tapes. It was not a failure
of the market to recognize the superiority of Beta; it was rather that
consumers revealed their preferences for certain features by purchas-
ing the VHS format.
The best of all worlds is when the stars are aligned properly and an
organization can realize network effects and take advantage of Moore’s
law by increasing the performance of a product while reducing or main-
tain costs. The net result is to spur hypergrowth in the diffusion and sales
of a product or service.

The Role of R&D Process in Innovation

The objectives of R&D are to develop existing and new core competen-
cies, to further existing and new products, and to develop existing and
new business processes through invention and innovation.17 The R&D
process is the engine that drives product and process differentiation.
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 17

Innovation is typically defined as the ideas, the products, the services, or

processes that are perceived as being new and different and they have been
implemented or even commercialized.
Research and development are usually thrown together as one con-
cept, but in reality they are somewhat distinct processes.18 Research is
typically considered to be science-oriented whereas development is the
mechanism for translating the science into commercial products and
services. Basic science can be thought of as the engine for pushing new
discoveries and ideas into society. This is in contrast to the concept of
market pull. Market pull is essentially the process of translating the basic
science into products and services in order to satisfy customer needs,
wants, and demands. The interaction between science push and market
pull creates a very powerful feedback loop that spurs on the development
and diffusion of new products and services.19
As noted earlier, the diffusion and awareness of technologies typi-
cally follows an S-curve. In the early stages of the S-curve, there are very
few people aware of the technology. Market research is not important
at this stage because there are few untapped wants because of the lack
of awareness. As a technology matures and begins to take off, there is a
propagation of awareness with increased insight of the possibilities of a
technology.20 It is at this stage that market research becomes viable. It is
also at this stage that many similar products begin to emerge because of
the surfacing of a kind of group aha because of the interconnectedness
of businesses and research groups. This group aha occurs because market
research by producers and product development laboratories leads to the
same conclusions about consumer wants. Once consumers begin to use
products and have had the opportunity to experience a product, they also
begin to identify areas of deficiencies in the product and areas where a
feature might be added. And this is where market research is very effec-
tive because market researchers are very adept at identifying changes in
consumer wants.
As the market matures, the demand for the products also begins to
decline with the emergence of substitute products and technological
obsolescence. It is then necessary to re-prime the pump and reload sci-
ence. This is done by working with new science and new technologies in
18 DEVELOPING NEW PRODUCTS AND SERVICES

Need to
reload science
Diffusion

Market
pull

Science
push

Awareness Expansion Maturity Decline

Time

Figure 1.8. Push, pull, and reload.

order to identify new opportunities for developing products and services.

Figure 1.8 illustrates the concepts of science push and market pull and
how they relate to diffusion and awareness.

Push, Pull, and Reload can go on Forever

Some individuals believe that there is a limit on the ability of innova-
tive activities to bring new products to the market. This suggests that
differentiation cannot go on forever. This line of reasoning is similar
to the idea attributed to someone in the U.S. patent office that: “Eve-
rything that can be invented has been invented.” There is good news,
however, from the patent office. Research has shown that companies
can keep innovating and still contribute to the bottom line because it
appears that, in general, there are no diminishing returns to scale for
R&D expenditures.21 In essence, continued investment in R&D yields
rewards, revenues, and profits. Even though a particular technology may
have a performance limit, advances in R&D and in basic science along
with customer pull will start the process anew. Moore’s law continues to
work for Intel because they continuously re-prime the pump. They have
gone from focusing on the clock rate of their CPU, which is constrained
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 19

by thermodynamic considerations, to exploring multiple CPU cores and

restructuring the overall microarchitecture of their chips.

R&D for Start-Ups and Small Businesses

For the entrepreneur, there is significant overlap related to research,
product development, and the actual production of products and ser-
vices. Many organizations are just too small to become involved in basic
research and they have to rely on combining existing and emerging tech-
nologies in creative ways. Entrepreneurs view R&D as interdependent
processes that are intertwined and not very distinct. For the entrepreneur,
research and product development includes:

• generating an idea for a product or services;

• gathering and synthesizing information on the idea;
• designing the product or services;
• developing a prototype of the product or service;
• developing a production process for the product or service;
• producing the product or service.

Our focus in this book is primarily on the first four steps including
idea generation, gathering information, preliminary design, and prototyp-
ing. From the standpoint of the entrepreneur, these steps are the essence
of R&D. Steps 5 and 6 are part of product engineering and they will not
be discussed in depth.

Search and the Role of Learning-About in Developing

Ideas for New Products and Services
In addition to generating new knowledge, conducting R&D leads to
smarter organizations because the knowledge these organizations already
have helped understand new information when it becomes available. The
best way to conduct R&D and to improve the organizational innovation
and creativity is to learn-by-doing and to engage in search activity. In
this section, we will discuss searching for ideas first and we will discuss
learning-by-doing later.
20 DEVELOPING NEW PRODUCTS AND SERVICES

Learning-about, or the search process, involves reading maga-

zines, books, and technical articles, attending schools, observing the
competition, one-on-one discussion, interacting with customers, and
attending symposia and conferences. It involves acquiring knowledge
and integrating and synthesizing that knowledge. This is the first step
in developing individual and organizational knowledge structures.
Learning-about in its basic form is search and synthesis. It is too
expensive in terms of time and resources for organizations to build
every product and service that is conceived. Many companies therefore
learn-about an idea by reading, interacting with experts, and also by
attending symposia and conferences related to an emerging technology.
The goal is to gain insight and understand the potential of an emerging
technology or a new idea.
It is our thesis that book learning, lectures, and even homework are
usually beneficial. This is essentially the learning-about process. Search
plays a key part in the learning-about process. This is particularly true
when an organization searches outside the organization for ideas related
to product innovation. Search can be classified in terms of the breadth
and depth of the search.22 The breadth of the search refers to the num-
ber of outside sources used and consulted. The depth of search refers to
the intensity of the relationship between the searcher and the external
sources. Table 1.1 lists potential sources of external information that can
be used by entrepreneurs and product developers when engaging in an
innovative activity.
As illustrated in Figure 1.9 (adapted from Laursen and Salter23), it
appears that the breadth of search is important for incremental improve-
ments innovation and that both breadth and depth of search are impor-
tant for new and radical innovation. In terms of the breadth of the search,
it appears that the sweet spot is about eleven sources plus or minus two
sources (see Figure 1.10, adapted from Laursen and Salter24). This is a
rather useful finding upon further reflection. When searching for new
information, it is often difficult to determine how much information to
gather and the number of sources for collecting information in order to
avoid information overload. The point is that you have to seek out a vari-
ety of sources of information in order to improve the chances of introduc-
ing a successful innovation.
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 21

Table 1.1. External sources of information25

Sources of information from the market
Suppliers of equipment, materials, components, or software
Clients or customers
Competitors
Consultants
Commercial laboratories/R&D enterprises
Sources of information from institutions
Universities or other higher education institutes
Government research organizations
Other public sectors, e.g., business links and government offices
Private research institutes
Sources of information from the profession
Professional conferences and meetings
Trade associations
Technical/trade press and computer databases
Fairs and exhibitions
Sources from specialized places
Technical standards
Health and safety standards and regulations
Environmental standards and regulations
Innovative activity

Breadth of search important for

incremental innovation as
technology matures

Breadth and depth of search important

for radical innovation during expansion

Awareness Expansion Maturity Decline

Time

Figure 1.9. Breadth and depth of search and innovative activity.

22 DEVELOPING NEW PRODUCTS AND SERVICES

Innovative performance

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Number of sources consulted

Figure 1.10. Breadth of search and innovative performance.

Building Things and the Role of Learn-By-Doing in

Developing Ideas for New Products and Services
Learning-by-doing means that the organization or entrepreneur makes
and builds things, conducts experiments, and builds prototypes. R&D
is essentially learning by doing. Individuals and organizations ben-
efit from learning-by-doing because it builds up absorptive capacity.26
Absorptive capacity is the result of having already developed knowledge
and insight in a particular domain, for example, in medicine, baseball,
networking, or memory chips. Having absorptive capacity means that
prior knowledge facilitates the learning of new knowledge. Develop-
ing absorptive capacity is synonymous with developing insight. It gives
an individual or an organization the ability to understand, assimilate,
transfer, and exploit new knowledge and new information as it becomes
available and then to apply it to solving problems and developing com-
mercially viable products. Learning-by-doing is essentially design and
development.
The key activity for innovative activity is the learning-by-doing
process. Learning-by-doing means that you make and build things,
try experiments, and construct prototypes. Sometimes, there is a
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 23

facilitator, such as a teacher, a project manager, colleagues, a fellow

student, a book, or a YouTube video, to get you started on the path
to creativity.
Roger Shank is a well-known expert on artificial intelligence, learn-
ing, and knowledge. He has been on a crusade to change the way kids are
taught. He wants children to learn by doing and engage in more experi-
mentation and reflection and spend less time on being tested on the so-
called “body of knowledge that everyone must know.”27

If you want to learn to throw a football, drive a car, build a

mouse trap, design a building, cook a stir fry, or be a manage-
ment consultant, you must have a go at doing it. Throughout
history, youths have been apprenticed to masters in order to
learn a trade … Parents usually teach children in this way. They
don’t give a series of lectures to their children to prepare them
to walk, talk, climb, run, play a game, or learn how to behave.
They just let their children do these things. If he throws poorly,
he simply tries again. Parents tolerate sitting in the passenger
seat while their teenager tries out the driver’s seat for the first
time. It’s nerve-racking, but parents put up with it, because they
know there’s no better way.… When it comes to school, how-
ever, instead of allowing students to learn by doing, we create
courses of instruction to tell students about the theory of the
task without concentrating on the doing of the task. It’s not easy
to see how to apply apprenticeship to mass education. So in its
place, we lecture.

R&D is essentially learning-by-doing. Individuals and organizations

benefit from learning-by-doing in the context of R&D because it builds
up absorptive capacity.28 Absorptive capacity is simply a function of hav-
ing previously developed knowledge structures in a particular domain
(e.g., domain knowledge in medicine, baseball, networking, or memory
chips). It gives an individual or an organization the ability to under-
stand, assimilate, transfer, and exploit new knowledge and information
and then to apply it to solving problems and developing commercially
viable products.
24 DEVELOPING NEW PRODUCTS AND SERVICES

The Role of the Supply Chain and the Brand

in Product Differentiation
Differentiation should be the engine driving the business, but businesses
must also attend to improving the supply chain and the brand in order to
succeed. Improving the supply chain and improving the brand image are
also methods for product differentiation. They contribute to the unique
bundle of perceptions that customers have towards a business.
The supply chain is the connected activities related to the creation of a
product or service up through the delivery of the product to the customer.
It includes the upstream suppliers as well as downstream activities such
as wholesalers and distribution warehouses and after sales support.29 Key
activities for improving the supply chain are to reduce transaction costs
to improve business processes. Consumers often perceive efficient and
responsive supply chains as an attribute or a product feature.
The brand is the image of a product or service in the marketplace.
Consumers essentially perceive the brand as being a feature of the prod-
uct and, in many instances, it is viewed as the avatar for the product.
Images and visions are immediately invoked when mentioning Apple, or
Amazon, Google, Wal-Mart, and Disney. Our focus in this book will be
on the process of innovation and differentiation, but we also recognize
that successful companies must attend to improving the supply chain and
developing a strong brand.

Conclusion
In this chapter, we have introduced many of the fundamental concepts
related to understanding differentiation and the diffusion of innovations
within the context of monopolistic competition. The key points are the
following:

• Monopolistic competition involves many buyers and sellers of

products that are closely related, but not identical where entry
and exit are easy. It is the dominant form of competition.
• Entrepreneurship is the best method for competing in
monopolistically competitive environments. Entrepreneurship
involves engaging in a risky endeavor with continuous
 UNDERSTANDING ENTREPRENEURSHIP, DIFFUSION, AND R&D 25

creation and re-creation of a new enterprise, a new product,

or a new idea.
• Radical innovation tends to replace existing ideas, products,
services, and processes. Incremental innovations involve
smaller improvements in ideas, products, services, and
processes.
• Technology life cycles and the product life cycles are used to
understand the diffusion of technologies and products.
• Diffusion is the acceptance, adoption, and awareness of a
technology or a product by individuals.
• The diffusion of a technology usually lags the performance
of a technology and this can be understood using Moore and
Metcalf ’s laws.
• The Bridge model is a useful way to understand discontinuities
in the technology life cycle where problems can occur.
• R&D activities are present in large and small organizations,
they are just implemented differently.
• Learning-about involves searching, reading, inquiry, and
synthesis. Learning-by-doing involves making and building
things. Learning-about and learning-by-doing are the
foundation of R&D.
• Developing a strong supply chain and a strong brand through
marketing are critical for delivering differentiated products
and services.

This chapter has illustrated the foundational concepts for competing

in the current marketplace. Subsequent chapters will build on this foun-
dation and present additional details on how to accomplish differentia-
tion and innovation through product and services versioning.
 CHAPTER 2

Fundamental Concepts
of Product and Price
Differentiation
One of the key concepts for the entrepreneur to understand is that
product differentiation permits them to change their price accord-
ing to what consumers believe they can afford. Some consumers are
very price-sensitive and others are not so price-sensitive, and this can
change by the type of product being purchased and by the buying con-
text. The price that a consumer is willing to pay is called the reservation
price or the willingness-to-pay price and it is somewhat unique across
individuals. If you can determine the willingness-to-pay price for a
product, then you may be able to charge different prices according to
the willingness-to-pay. This is, of course, a form of price discrimina-
tion, or in more polite terms, price differentiation. The terms price
discrimination and price differentiation will be used interchangeably
throughout this discussion.
Hal Varian1 has identified three approaches to price discrimination.
They are personalized pricing, versioning, and group pricing. The ideas
will be briefly introduced and then examined in greater depth in a later
chapter.

The Demand Curve

The typical demand curve has the price on the y-axis and the quantity
demanded on the x-axis and is downward-sloping. A demand curve can
be represented as a linear mathematical formula with quantity or price
as the dependent variable. A demand curve is a very useful diagram
for describing the relationship between the price level and the quan-
tity demanded at each price level. In general, as the price of a product
28 DEVELOPING NEW PRODUCTS AND SERVICES

increases, the demand for the good decreases. Similarly, as the price of a
product decreases, the demand for the good increases. The next section of
the chapter discusses how the demand curve can be used to identify the
optimal price and quantity for selling just one version of a product.

First-Degree Price Discrimination:

Personalized Pricing
First-degree price discrimination has been around ever since people began
bartering and exchanging goods.2 It is simply an attempt to charge differ-
ent prices to different customers for the same product. Figure 2.1 presents
an example of an aggregate demand curve for a cord of wood in a small
town. In an ideal world, from the producer’s perspective, one producer
could identify each consumer’s willingness-to-pay function and set prices
accordingly (cf. Varian 1996). Let us assume that one company owns all
of the timber in the area and is therefore a monopoly. Instead of charging
$40 to each consumer, the monopolist charges a different price to each
consumer depending on their ability and willingness to pay for the cord
of wood. This is essentially personalized pricing, where the selling price is
customized for each buyer. This is a good strategy for a monopolist because
they can generate more revenue than just picking a single price point. Each
consumer is thus charged a different price for the same product.

70

60 Potential additional revenues

with continuous differental pricing
50

40
Price

30
Revenues of
$16,000 when
20 selling cord of
wood for $40
10

0
0 100 200 300 400 500 600 700 800 900 1000 1100 1200
Quantity demanded

Figure 2.1. Need a way to capture additional revenue.

 FUNDAMENTAL CONCEPTS OF PRODUCT 29

This strategy is also known as perfect price discrimination. Personal-

ized pricing is very difficult to implement in practice for four reasons.
First, it is difficult to identify the willingness-to-pay functions for each
consumer. Second, customers often get upset when they find out that
another consumer has paid less for a product or service than they have
paid. The third reason that personalized pricing causes problems is that
perfect price discrimination can lead to arbitrage, where opportunistic
buyers purchase the product at a discounted price in one market and then
sell it at a profit in another market. The fourth and final reason that it is
difficult to implement is that, in certain instances, it is illegal. This issue
will be dealt with at the end of the chapter.
Though personalized pricing is difficult to implement, it can be
accomplished and is in fact embraced by some companies. Amazon, for
example, presents their customers with personalized product recommen-
dations using past search and buying behavior, and large supermarkets use
their scanner data to configure promotions tailored to their customers.
Personalized pricing requires the effective measurement of consumer
preferences. The supplier must in some way conduct market research to
determine individualized pricing strategies. This can be accomplished by
using technology to analyze historical buying patterns. Online retailers,
such as Amazon, can very easily analyze transactions using historical data.
Offline retailers have to collect and sort the data from a variety of sources
unless their customers participate in a rewards program or a customer
discount program that incorporates a mechanism for gathering customer
transaction information. Amazon has participated in many of types of
personalized marketing and pricing schemes because they have the infra-
structure in place to gather and analyze behavior. Companies such as
Amazon use some form of collaborative filtering to determine product
recommendations for books, videos, and many other products.

Collaborative Filtering

There are many ways to implement collaborative filtering. Collaborative

filtering goes something like this. John likes audio books by David Sedaris.
Other people who have bought audio books by David Sedaris also bought
books by George Carlin. Therefore, the so-called recommender system at
Amazon or at Audible books would make a recommendation to John that
30 DEVELOPING NEW PRODUCTS AND SERVICES

he should buy a book by George Carlin. Collaborative filtering systems

can also include rating systems; in fact, Amazon and a number of other
online retailers will try very hard to get you to help them by asking you to
rate a product you have just bought. They will use the ratings to develop
an entire web of recommendations to many of their customers and to
retarget you with similar products. Here is another example of collabo-
rative filtering in action: John bought and gave his new Kindle e-book
reader a five star rating. He and many other buyers of the Amazon Kindle
also bought a leather case. The recommender system will subsequently rec-
ommend a leather case to everyone who subsequently buys the Kindle.
Collaborative filtering can also involve price differentiation and price
personalization. If the person who buys the Kindle does not buy the
leather case at the same time, then the recommender system will send an
email indicating that the leather case is on sale or wait until the Kindle
customer logs back onto the system and then presents the customer with
a discounted price on the leather case.
Auctions are also a form of personalized pricing. Theoretically, an
auction participant will bid up to their reservation price or their will-
ingness-to-pay level for a product. Figure 2.2 illustrates that the revenue
generated by offering a product at a single price of $30 will generate

60

50
Revenues of $900 are generated
by offering product at a single price
40
Price

30

20

10

0
0 5 10 15 20 25 30 35 40 45 50 55 60
Quantity

Figure 2.2. Revenues derived by selling a product at a single price.

 FUNDAMENTAL CONCEPTS OF PRODUCT 31

60

50 Revenues of $1,400 generated by selling

multiple units of a product at an auction
40
Price

30

20

10

0
0 5 10 15 20 25 30 35 40 45 50 55 60
Quantity

Figure 2.3. Auctions can be used for personalized pricing.

$900 in revenues. As illustrated in Figure 2.3, the use of an auction could

theoretically generate revenues of $1,400. Auctions permit sellers to price
discriminate according to the customers’ willingness-to-pay. Some indi-
viduals will bid $10 or $20 and others will bid $30, or $40 or more. As
a result, a seller could theoretically generate additional revenues of $500
by offering multiple units of a product at an auction. The next chapter
will illustrate in detail how this revenue is generated using versioning.
Developing personalized pricing is an idealized goal for producers
because the potential opportunities for revenue generation are excep-
tional. However, because it is difficult to accomplish in practice, produc-
ers often turn toward second- and third-degree price discrimination to
generate additional revenues.

Second-Degree Price Discrimination: Versioning

As noted by Varian and Shapiro in 1998, the idea behind versioning is to
engage in differential pricing by offering different versions of a product.
Figure 2.4 illustrates the versioning concept. Ideally, the different versions
should be perceived as having different levels of quality. We also maintain
that the number of versions should be related to the number of distinct
32 DEVELOPING NEW PRODUCTS AND SERVICES

90

80 Potential additional revenues

with a high-end version
70

60 Mainsteam or
middle-ground version
50
Price

Midas
40 Potential additional revenues
with a low-end version
30
Atlas
20

10 Hermes

0
0 50 100 150 200 250 300 350 400 450 500 550 600
Quantity

Figure 2.4. Second-degree price discrimination.

market segments. In many instances, it is difficult to identify the opti-

mum number of market segments, and it is also difficult to develop prod-
ucts for each market segment. Goldilocks pricing is a rule of thumb that
suggests that you should start out with three price levels. The idea behind
Goldilocks pricing is that 1 product is too few, 10 products too many,
and 3 is just the right amount.3 There is evidence that having too many
choices places a significant cognitive and emotional burden on the ability
of individuals to make decisions.4 It is my experience that somewhere
between two and four versions should be offered. A subsequent chap-
ter will illustrate how Goldilocks pricing has been implicitly or explicitly
implemented by a variety of companies. The key to versioning is to try
to anticipate customer’s needs and then to try and develop organizational
competencies for delivering those products and services.
As noted earlier and illustrated in the next chapter, versioning also
leads to increased revenues and profits. You will leave money on the
table if you do not have a high-end product for consumers who are not
price-sensitive. In addition, you will not sell any product to custom-
ers who are very price-sensitive. There are several additional compelling
reasons for versioning. By having several products, you can experiment
and watch economic behavior as consumers will focus on the features
 FUNDAMENTAL CONCEPTS OF PRODUCT 33

and products that are most desirable. This sort of experimentation is the
basis of monopolistic competition and the mechanism that allows the
entrepreneur to successfully compete. Product versions can be generated
in a variety of ways, including distinct product features, product design,
and product promotions such as product rebates and product availabil-
ity, for example, when the product is delivered.
In this book, we will refer to three foundational versions of products.
The high-end product is referred to as a Midas version and it is targeted
toward nonprice-sensitive consumers. Midas products are extravagantly
engineered and contain advanced features and attributes. Hermes prod-
ucts are targeted toward price-sensitive consumers and are frugally engi-
neered and designed with basic features. Atlas products are designed for
the middle ground or the mainstream. They not only have basic features,
but also have several advanced features, and are priced between Midas
and Hermes versions. More details on the motivation behind the three
versions will be presented throughout the book.
An example of versioning is found in the airline industry. Airline
companies usually provide two or three levels of seats, such as economy
class seats, business class seats, and first-class seats. The first-class tickets
are the most expensive and they offer customers the highest quality ser-
vice. Consumers who are willing to pay for the extra services will purchase
the first-class ticket. On the other hand, customers who purchase the
economy-class ticket receive a lower level of service. But they are not
willing to pay for the extra services and features offered to the first-class
and business-class customers. As illustrated in the hypothetical example
in Figure 2.5, if an airline offers only an economy ticket at a set price
of $300, then the revenues generated would be $36,000. However, as
illustrated in Figure 2.6, if the airline offers an economy ticket at $300,
a business-class ticket for $600, and first-class tickets for $800, then the
company could potentially generate additional revenues of $22,000.
Bundling is a special type of versioning that often involves informa-
tion content that is in a digital format. Online and offline newspapers,
encyclopedias, and magazines are examples of information bundles.
Software in addition to having versions is also bundled. Examples
include the so-called office bundles containing word processing, pres-
entation, and spreadsheet software and the tax software bundles that
34 DEVELOPING NEW PRODUCTS AND SERVICES

1000

900

800

700

600
Total revenue of $36,000
Price

500 with economy seat only

400

300

200

100

0
0 20 40 60 80 100 120 140 160 180 210
Quantity

Figure 2.5. Revenues generated by only offering economy seats.

include electronic filing, state filing, as well as additional tax prepara-

tion features.
Bundling strategies frequently appear in markets for informational
goods. As you can imagine, the marginal cost of information goods is theo-
retically close to zero. Let us imagine four consumers who are interested in
buying two computer games such as the Football Madness game and the
Soccer is My Life game. Suppose also that the four customers (Bob, Carol,
Ted, and Alice) are willing to pay $18, $10, $8, and $2, respectively, for
Football Madness. Suppose also that Bob, Carol, Ted, and Alice have dif-
ferent reservation prices for the Soccer is My Life game. Bob would pay $3
for the game, Carol would pay $16, Ted would pay $17, and Alice would
pay $19 for the soccer game. If the retail cost of both games is $16, then
none of these individuals would buy both games. In this case, Bob would
only buy Football Madness and Carol, and Ted and Alice would only buy
Soccer is My Life. In this scenario, the seller would only obtain $64 in
revenues (4 × $16). However, if the seller bundles the two titles together
and sells the total package for $20, then the seller could generate $80 in
revenues. The bundled product price is under what each individual was
willing to pay for the two games (Bob: $21, Carol: $26, Ted: $25, and
Alice: $21). In this case, the seller is better off and the four consumers are
 FUNDAMENTAL CONCEPTS OF PRODUCT 35

1000
Total revenue of $58,000
900
Revenues of $16,000 with 3 versions versus
800 with first class seat $36,000 with economy only

700

600 Revenues of $24,000

with business class seat
Price

500

400
Revenues of $18,000
300 with economy class seat
200

100

0
0 20 40 60 80 100 120 140 160 180 210
Quantity

Figure 2.6. Versioning airline seats generates additional revenue.

happy because of the bundling strategy. Bundling is particularly useful

with digital goods because the cost to reproduce digital copies is trivial.

Third-degree Price Discrimination: Group Pricing

Groups are the collection of customers with some common character-
istics. The idea behind group pricing is to establish different prices for
different groups or customer segments. Usually, the groups are segmented
because one group is price-sensitive and the members of the group have
a lower-willingness-to-pay function. Examples of such groups include
retired seniors versus the nonretired, business travelers versus tourists,
and students versus the general public. These groups are targeted by using
senior discounts, student discounts, rewards programs, frequent-flyer
programs, and buying clubs.
For example, statistical software companies, such as SAS and SPSS,
sell their product to students at a much lower price than they do to
commercial businesses because the student customer segment is price-
sensitive and not willing to pay the high price for the statistical software.
Statistical software is usually very expensive costing over $1,000, but
often the student edition is around $100. By charging a lower price,
36 DEVELOPING NEW PRODUCTS AND SERVICES

companies can extract revenues from segments that are price-sensitive

and not willing to pay for the product. As illustrated in the Figure 2.7,
a hypothetical company offering statistical software could generate
$5,000,000 in revenues by selling their software to individuals and busi-
nesses at a price of $1,000. However, if the statistical software company
also sells a nonsupported version to students through academic institu-
tions, then they could theoretically generate an additional $2,000,000 in
revenues (see Figure 2.8).
One objective of having products for price-sensitive groups, such as
students, is to acquire them as customers by trying to get them locked-in
to using a product. They may eventually become customers for high-end
products and services. In addition, it is better to have them as paying
customers, rather have them engaged in copying the software. Group
pricing is a common form of price discrimination, which is illustrated
in Figure 2.9.
As noted by Phillips, there is not a clear line that distinguishes ver-
sioning from group pricing.5 Indeed, most approaches contain elements
of group pricing and versioning. The Midas, Atlas, and Hermes categories
are also product versions, but they are also targeted at Midas, Atlas, and

1400

1200
Total revenues of $5,000,000
with one price solution for
1000 statistical software
Price

800

600

400

200

0
0 5000 10,000 15,000 20,000 25,000 30,000
Quantity

Figure 2.7. Revenues generated by set price for statistical software.

 FUNDAMENTAL CONCEPTS OF PRODUCT 37

1400
Revenues of $5,000,000
1300
selling to commercial businesses
1200
1100
1000 Total revenues of $7,000,000
900 with group pricing
800
Price

700
600
500
Revenues of $2,000,000
400
selling to students
300
200
100
0
0 5000 10,000 15,000 20,000 25,000 30,000
Quantity

Figure 2.8. Group pricing and additional revenues.

500

450 Potential additional revenues

with addition of version for non-price
400 sensitive group
350

300 Potential additional revenues

Price

250 with addition of version for

price sensitive group
200

150

100

50

0
0 200 400 600 800 1000 1200 1400
Quantity

Figure 2.9. Third-degree price discrimination: group pricing.

Hermes groups according to their price sensitivities and their willingness-

to-pay. As noted above, additional details on the motivation behind the
three versions and the willingness-to-pay segments will be presented in
later chapters.
38 DEVELOPING NEW PRODUCTS AND SERVICES

Legal Issues Related to Price Discrimination and

Product Differentiation
Price discrimination has a negative connotation because monopolies and
oligopolies sometimes use their market power to unfair advantage and
engage in predatory pricing schemes. Predatory pricing, however, is rare
in markets characterized by monopolistic competition because there are
many sellers and the products are largely substitutable, even if only slightly
differentiated. In some ways, price discrimination is the rule rather than
the exception in contemporary commerce transactions. Here are several
relevant guidelines on price discrimination from the FTC (Federal Trade
Commission):

A seller charging competing buyers different prices for the same

“commodity” or discriminating in the provision of “allowances”—
compensation for advertising and other services—may be violat-
ing the Robinson-Patman Act. This kind of price discrimination
may give favored customers an edge in the market that has noth-
ing to do with their superior efficiency. Price discriminations are
generally lawful, particularly if they reflect the different costs of
dealing with different buyers or are the result of a seller’s attempts
to meet a competitor’s offering.

… There are two legal defenses to these types of alleged Robinson-

Patman violations: (1) the price difference is justified by different
costs in manufacture, sale, or delivery (e.g., volume discounts), or
(2) the price concession was given in good faith to meet a com-
petitor’s price.6

… Can prices ever be “too low?” The short answer is yes, but not
very often. Generally, low prices benefit consumers. Consumers
are harmed only if below-cost pricing allows a dominant competi-
tor to knock its rivals out of the market and then raise prices to
above-market levels for a substantial time. A firm’s independent
decision to reduce prices to a level below its own costs does not
necessarily injure competition, and, in fact, may simply reflect
particularly vigorous competition. Instances of a large firm using
 FUNDAMENTAL CONCEPTS OF PRODUCT 39

low prices to drive smaller competitors out of the market in hopes

of raising prices after they leave are rare. This strategy can only
be successful if the short-run losses from pricing below cost will
be made up for by much higher prices over a longer period of
time after competitors leave the market. Although the FTC exam-
ines claims of predatory pricing carefully, courts, including the
Supreme Court, have been skeptical of such claims …7

There is a significant amount of latitude in the way that firms can use
price discrimination, yet still remain on the right side of the law. Here
are a few guidelines, derived from the FTC pronouncements, which can
be used to assist in determining whether versioning strategies and group
pricing strategies are legal.

Guideline 1: You may be able to legally charge different prices for a

product (price discrimination) if you differentiate your product, by way
of features and services.
Guideline 2: You may be able to legally charge different prices for a
product (price discrimination) to different groups if you can demonstrate
that there are different price sensitivities between the groups.
Guideline 3: You may be able to legally charge different prices for
a product if the price discrimination reflects the costs of dealing with
different buyers or it reflects an attempt to meet a competitor’s offering.

In general, a versioning strategy may be legal if a product is differ-

entiated by way of features and services. It can be inferred that a prac-
tice is probably not price discrimination if you can segment people into
different income groups according to their price sensitivities and their
willingness-to-pay. Groups such as seniors and youth are price-sensitive.
It is sometimes ok to charge differential prices to groups that are under-
represented in a market. For example, women are often charged less when
they attend happy hour. The key to avoiding charges of predatory prac-
tices is to set the price above the marginal cost to produce the product.
Selling a product at a price that is lower than the variable costs to produce
the product can lead to charges of dumping. This strategy is illegal, but
many companies use it in subtle and not so subtle ways in international
40 DEVELOPING NEW PRODUCTS AND SERVICES

markets to gain market share. The final key is to always seek legal counsel
if there is any doubt that a business practice is predatory, illegal, or both.

Conclusion
The primary reason for engaging in product differentiation is to avoid
some of the ruinous effects of price competition.8 Producers are involved
in a never-ending process of introducing new products and services and
then observing economic behavior. By having several products, producers
can experiment and watch economic behavior as consumers will focus on
the features and products that are most desirable. The benefits of being a
monopolist via differentiation are short-lived, however. Just as cattle are
attracted to water, producers are attracted to excess profits.9 As long as
profit potential makes it feasible, competitors will enter the market and
begin to drive profits to zero.10
In this chapter, we have illustrated that there are three approaches to
price discrimination and product differentiation. Each pricing strategy is
employed under various contexts in practice. The key takeaways include
the following:

• First-degree price discrimination, also called personalized

pricing, involves charging different prices to different
customers for the same product.
• It is difficult to implement first-degree price discrimination
because of the difficulty in measuring each consumer’s
willingness-to-pay, because some consumers may be irritated
when they find out they paid more for the same good,
because of arbitrage issues and finally because of the potential
legal issues.
• Second-degree price discrimination is referred to as product
versioning and bundling.
• Versioning involves offering a high-end product for
nonprice-sensitive consumers, and a low-end product for
price-sensitive consumers.
• Bundling is a special form of versioning in which two or more
products are offered as a package at a single price.
 FUNDAMENTAL CONCEPTS OF PRODUCT 41

• According to Goldilocks pricing, three versions may be just

right. The key is to make the versions different enough so that
consumer groups can be segmented.
• Third-degree price discrimination involves setting different
prices for different groups of consumers such as seniors and
students and other groups. It is often based on the price
sensitivities of the groups.
• In some instances, price discrimination can be illegal. If there
is any doubt that a business practice is in violation of laws,
legal counsel should be sought.
 CHAPTER 3

Differentiation in Action
Joan’s Handcrafted Jewelry Boxes

Joan started out as a tinkerer in her garage. She had a band saw and a
table saw and started making wooden toys for her kids. She then decided
to make a jewelry box for her daughter. Her daughter and husband were
so impressed that she showed the box to all of her family and friends.
Word started to get around and soon Joan was getting calls to make
the jewelry boxes for numerous customers. She sold the jewelry box for
a flat price of $40. It costs Joan about $20 for the wood, the fasten-
ers, and decorations. Joan made a tidy little profit of $20 per box. She
enjoyed being a craftsperson and enjoyed the extra income.
Joan worked as an economist for the city government and decided she
would like to start a side business making jewelry boxes. She named her
business Joan’s Handcrafted Jewelry Boxes. Joan subsequently started
applying her economic training to launching her jewelry box business.
44 DEVELOPING NEW PRODUCTS AND SERVICES

She knew that understanding how much consumers are willing-to-pay

for different products and services was critical to running any business.
Over the course of several years, Joan had offered the jewelry box at sev-
eral different prices and, as a result, she had a good feel for the demand for
her jewelry boxes at different price levels. She also had many discussions
with her customers and potential customers on the amount they would
be willing to pay for a jewelry box. She would actually ask her friends and
customers how much they would be willing to pay for pearl inlays, exotic
woods, and gold-plated hinges. Joan would sometimes send out question-
naires to customers who bought her jewelry boxes asking them what they
liked and did not like about their jewelry box.
Joan took the task of understanding consumer preferences and the
demand for jewelry boxes very seriously. Joan went so far as to sell her
jewelry boxes with different woods and features on a local Internet
auction. The Internet auction gave her very precise information on how
much customers would be willing to pay for the jewelry box features. Joan
had a friend who was in the jewelry business and she also asked her about
market demand.
Joan took all the information, integrated it with local demographic
and economic information, and developed a forecast and demand
curve for her jewelry boxes in the surrounding county. There were
approximately 720,000 families in the region and Joan estimated that
she could, at most, sell to 0.5% of these families over the course of
a year in the current economic environment. She was confident that
income levels would not change dramatically over the next year. Joan
then used all these information to develop a monthly demand curve
for jewelry boxes.
Figure 3.1 presents a 1-month demand curve for Joan’s jewelry boxes
in her county. The curve was derived after Joan determined that if she
charged $60 she could sell 100 units, at $40 she could sell 200 units,
and at $20 she could sell 300 units. Joan also spent time examining all
the costs that she would incur building the jewelry boxes in her newly
remodeled garage. Her garage was now a small factory. She found that the
variable and fixed costs are different for each type of jewelry box. After
spending considerable time examining the costs and the revenues, Joan
decided to sell only one type of jewelry box at a price of $40.
 DIFFERENTIATION IN ACTION 45

90

80

70

60

50
Price

40

30

20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 3.1. Demand curve for jewelry box.

90

80

70

60 Revenues of $8,000
with only one version of
50 jewelry box
Price

40

30

20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 3.2. Revenue with one type of jewelry box selling for $40.

Joan determined that she could make a small profit by selling the
box for $40. The revenue generated by selling only one model of her
jewelry box is illustrated in Figure 3.2. Her fixed costs, consisting of rent,
46 DEVELOPING NEW PRODUCTS AND SERVICES

utilities, and tool maintenance, would run about $2,000. The variable
costs for the wood, fasteners, and decorations would be about $15 when
bought in bulk quantities. The monthly revenue from the business would
be $8,000 ($40 × 200) and the profit from the business would be $3,000.
The contribution margin is the difference between the selling price and
the variable cost to produce each jewelry box. The contribution margin
for each jewelry box is $25. The calculations for profit, using q as the
quantity and p as the price, are as follows:

Total revenue = p × q
Total revenue = $40 × 200
Total revenue = $8,000
Profit = Total revenue – Total variable costs – Total fixed costs
Profit = p × q – Vc × q – Fc
Profit = $40 × 200 – $15 × 200 – $2,000
Profit = $8,000 – $3,000 – $2,000
Profit = $3,000

Price and Product Differentiation and Enlightenment

Joan really enjoyed owning a business and being an entrepreneur, but she
wanted more. After rereading an interesting article on price discrimina-
tion by Hal Varian,1 Joan decided to expand her product line. Expansion
was easy because she had plenty of floor space and could hire one of her
talented nephews to assist in producing the boxes. Joan understood the
relationship between price discrimination and profitability and this led
her to design an additional high-end version and a low-end version of her
jewelry box.
The fixed costs for the two new products were about the same. In
addition, the variable cost for the high-end jewelry box was $30 and the
low-end jewelry box was $10. As illustrated in Figure 3.3, this resulted in
additional revenue of $2,000 for the high-end jewelry box and $2,000
for the low-end jewelry box. Now that there is a high-end jewelry box,
100 customers will purchase the high-end box instead of the middle-level
box. There are also 100 new customers who will now be willing to pay for
a $20 jewelry box. The total revenue for the three boxes is $12,000. The
 DIFFERENTIATION IN ACTION 47

90

80 Potential additional revenues of

$2,000 with addition of $60 version
70

60

50 Potential additional revenues

Price

of $2,000 with addition

40 of $20 version
30

20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 3.3. Potential revenue when adding versions.

net profit with only one type of jewelry box was $3,000. The net profit
with three versions was $4,500 as illustrated in the following calculations:

Profit = ($60 – $30) × 100 + ($40 – $15) × 100 + ($20 – $10)

× 100 – $2,000  {fixed costs}
Profit = $3,000 + $2,500 + $1,000 – $2,000
Profit = $6,500 – $2,000
Profit = $4,500

Notice that there are only 100 additional people purchasing the $40
box because 100 customers are now purchasing the high-end jewelry box
for $60. There are also only 100 people who will purchase the low-end
box. If Joan just adds the high-end box, her profit will increase from
$3,000 to $3,500. If she just adds the low-end box, then her profit will
increase from $3,000 to $4,000. If she adds both a low-end and high-
end box, her net profit will increase from $3,000 to $4,500. The deci-
sion to expand and offer additional product versions is complex and will
have a profound effect on her business model. She will of course examine
her current operations and cost structure and make decisions on what
versions, if any, that she will produce.
48 DEVELOPING NEW PRODUCTS AND SERVICES

After considerable soul searching and analysis, Joan decides to intro-

duce three different jewelry box versions. Figure 3.4 illustrates the financial
profile for the three jewelry versions designated as the Athena, the Stryker,
and the Natural. Figure 3.5 provides an overview of how the features of
each version of the jewelry box are used to differentiate each version.

90

80
Net profit = $3,000 + $2,500 + $1,000 – $2,000
70 Revenue Net profit = $6,500 – $2,000 {fixed costs}
$6,000 Net profit = $4,500
60

50 Athena Revenue
Price

profit = $3,000 $4,000

40

30 Stryker Revenue
profit = $2,500 $2,000
20
Costs = $3,000 Natural
profit = $1,000
10
Costs = $1,500 Costs = $1,000
0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 3.4. Financial structure for three versions of Joan’s jewelry

boxes.

90

80 The Athena: cherry wood, brass stop hinges

and knobs, brass lock, faux pearl inlay of godesss
70

60 The Stryker: maple wood,

brass hinges, wood inlay
50
Price

The Natural: cedar wood,

40 brass-plated hinges and
knobs, with wood-burned
30 picture of flower

20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 3.5. Differentiating features for three versions of Joan’s jewelry

boxes.
 DIFFERENTIATION IN ACTION 49

The Athena jewelry box is a high-end product targeted toward non-

price-sensitive consumers. It is part of what we refer to as a Midas product
that was extravagantly engineered and designed. The Natural jewelry box
is a Hermes product and is targeted toward price-sensitive consumers,
and it was frugally engineered and contains basic features. The Stryker
jewelry box is an Atlas product designed for the middle ground. The
Stryker has several attractive features; yet it is still priced between Midas
and Hermes versions. The Stryker is a mainstream version that appeals to
the widest audience. Additional motivation behind the three versions will
be presented in chapter 5.

Generating Additional Revenues: Willingness-to-Pay

It might appear obvious that the goal is to extricate as much as possible
from the universe of consumers. But many large and small businesses, for
reasons of simplicity, turn to the one-product, one-price solution in order
to have a simplified management agenda. Adding additional product ver-
sions introduces complexity and requires additional investment in the
supply chain as well as having an impact on the cost structure for each
version. The one-version, one-price approach is a natural solution for the
harried entrepreneur who has gazillion things to worry about. However,
offering just one version is not a good strategy for several reasons.
If Joan offers only the high-end version, then the profit accrued will
be $1,000 [($60 – $30) × 100 – $2,000]. If Joan offers only the low-
end version, then the profit accrued would be $1,000. If Joan decides to
offer only one product, then it makes sense to go with the middle-level
product and the middle-level price, where the profit is $3,000. However,
such a strategy leaves a lot of money on the table. First, the high-end
consumers would be willing to pay more for the product. Economists
call this additional amount they are willing-to-pay as consumer sur-
plus. The consumer surplus is the difference between the amount the
nonprice-sensitive or affluent person would be willing to pay for the
high-end product and how much they actually paid for the product.
Second, price-sensitive consumers can be drawn into the market if an
affordable option is made available.
By adding two additional versions, Joan has dramatically increased
the present value of her business. A very simple way to calculate the value
50 DEVELOPING NEW PRODUCTS AND SERVICES

of a business is to use the perpetual annuity formula of cash-flow/cost-of-

capital. If we assume a cost-of-capital number of 10%, then having one
product leads to a firm value of $360,000 (12 × $3000/0.10). The present
value of the business with three products is higher at $540,000 (12 ×
$4,500/0.10). The business is worth $540,000 rather than $360,000.
There is a $180,000 difference. (Additional discussion on the time value
of money and how it affects the value of the firm will be presented in a
later chapter.)
From the above discussion, we can infer that offering two or more
versions of a product is a better strategy than offering only one ver-
sion. We believe that the best strategy is to always offer at least three
different versions of a product; that is, a high-end version, a middle
range version, and a low-end version. Varian refers to this type of price
discrimination as Goldilocks pricing. However, the value of price and
product differentiation goes above the short-term profit considerations.
Versioning is critical for long-term survival of the firm because price
and product differentiation puts the firm closer to consumers. Version-
ing helps the seller to understand what product and features are desired
by consumers. Versioning is a form of experimentation that affords the
seller the opportunity to conduct experiments by introducing versions
of products with different features and observing how consumers react.
Price and product differentiation permits consumers to acquire
goods that they want at their price point. Consumers come in a variety
of sizes with different wants and satisfaction levels and different levels of
discretionary income. They have different degrees of their willingness-
to-pay for products and services. Price and product differentiation can
not only facilitate the extraction of money from the affluent, but it can
also benefit the four billion people who live on less than $1,500 per
year.2 This is the so-called bottom-of-the-pyramid. Indeed, price and
product differentiation is the basic strategy for selling to the bottom of
the pyramid and for providing pharmaceuticals, health care, and many
other products to the poor.
We are sometimes asked whether the low-end product will canni-
balize the demand for the higher-priced products. That is, will affluent
consumers with more money who are less price-sensitive buy the low-
end product and ignore more expensive products? This can, of course,
 DIFFERENTIATION IN ACTION 51

occur if the products are not perceived as being adequately differenti-

ated with higher-end features and additional functionality. The key
activity for the producer is to conduct experiments by offering differ-
entiated products and watching economic buying behavior unfold.3
The information garnered from these experiments can then be used to
continually refine product offerings and understand the willingness-
to-pay functions of your consumers. In essence, if the buyers flock to the
low-end product, then this information can be used in future product
design decisions.

Demand and Differentiation Dashboards

We have developed a spreadsheet tool that can be used to assist in product
differentiation. You are encouraged to visit http://glsanders.wordpress.com/
and obtain the newest version of the spreadsheet. You are also encouraged
to read the Appendix of this chapter because it contains an overview of the
math for identifying the optimal price and quantity for a demand equation.
Figure 3.6 illustrates the demand spreadsheet for Joan’s jewelry.
The demand dashboard spreadsheet is used to calculate the slope
and the maximum amount consumers would be willing to pay for a
product. Figure 3.7 presents a differentiation dashboard spreadsheet.
The differentiation dashboard is used to determine the profitability
due to product differentiation. The differentiation dashboard also
computes an optimal solution for the demand curve when only one
version is offered. The optimal price would be $47.50 and, at that
price, Joan would sell 162.5 jewelry boxes. As you can see from the
solution in Figure 3.7, the monthly cash flow using the optimal solu-
tion yields a monthly profit of $3,281.25, which is still not very close
to the monthly net profit of $4,500 with three versions. The value of
the business would be $393,750 if we assume a cost-of-capital value
of 10% (12 × $3,281.25/0.10). The optimal solution is very helpful
for identifying a starting point for selecting a price point for one
product and for identifying price points for additional versions. The
differentiation dashboard is very useful for conducting sensitivity
analysis and what-if analysis for differentiating up to three products
and services.
 52
Demand dashboard version 4.1 MAC and PC compatible
Only change input values in orange Estimated demand from points
Enter product name here: Joan’s Jewelry Demand slope (estimated from points): –0.2000
Demand slope: –0.2000 The slope of the demand curve is between –0.2000 There will be no confidence
Price where there is zero demand $80.00 and between at the 95% confidence level –0.2000 interval if only 2 points are entered
Maximum revenue $8,000 Price where there is zero demand: $80
Optimal price $40.00 Maximum revenue from statistical estimate: $8,000
Optimal quantity 200 Optimal price for demand estimate: $40.00 Number of points 4
This solution is optimal. Optimal quantity for demand estimate: 200
It will change when variable cost are added Correlation coefficient price & quantity: –1.0000 Point Price Quantity
in the demand dashboard 1 $60.00 100.00
2 $40.00 200.00
3 $20.00 300.00
$90.00
4 $10.00 350.00
5
$80.00
6
7
$70.00
8
$60.00 9
10
$50.00 11
12
$40.00 13
14
DEVELOPING NEW PRODUCTS AND SERVICES

$30.00 15
16
$20.00 17
18
$10.00 19
20
$0.00 21
0 50 100 150 200 250 300 350 400 450

Joan’s Jewelry Estimated demand from points

Figure 3.6. Demand analysis dashboard.

Differentation dashboard version 4.1 MAC and PC compatible
Only change input values in orange
Enter product name here: Joan’s jewelry Demand curve
Demand slope: –0.2000
Joan’s jewelry Optimal profit one product
Price where demand is zero $80.00
Optimal maximum revenue
Midas product $100.00
Price $60.00 $80.00
Quantity sold 100 $60.00
Variable costs $30.00

Price
$40.00
Profit (before subtracting fixed costs) $3,000 $20.00
Atlas product $0.00
Price $40.00 0 100 200 300 400 500
Quantity sold 100 Quantity
Variable costs $15.00
Profit (before subtracting fixed costs) $2,500
Differentiation versus single product
$5,000
Hermes product $4,500
Price $20.00 $4,500
Quantity sold 100 $4,000
Variable costs $10.00
$3,500 3281.25
Profit (before subtracting fixed costs) $1,000 $3,000
$3,000
$2,500
Differentiation strategy $2,500
Fixed costs: $2,000 $2,000
Net profit with 3 versions $4,500
$1,500
$1,000
Optimal solution with only Atlas product $1,000
Optimal price 47.50 $500
Optimal quantity 162.50
Total revenue 7718.75 $0
Total variable costs 2437.50 Midas product Atlas product
Fixed costs 2000.00 Hermes product Net profit with 3 versions
Optimal net profit with 1 version 3281.25 Optimal net profit with 1 version
DIFFERENTIATION IN ACTION
53

Figure 3.7. Differentiation dashboard using demand analysis dashboard input and financial data from Joan.
54 DEVELOPING NEW PRODUCTS AND SERVICES

Monopolistic Competition at Work

Monopolistic competition involves many buyers, many sellers, and
easy entry and exit with one difference. The sellers in these markets sell
products that are closely related, but not identical. Joan sells jewelry
boxes that are similar to other jewelry boxes in function and form,
but they are nevertheless different. They are differentiated from the
competition. Joan’s products are unique and differentiated because of
their features (handcrafted, unique words, styling, etc.) and her unique
brand.
As noted earlier, a purely competitive market has many buyers and
sellers and each individual firm is a price taker. In this market, the
price for a product or service is determined via market interactions
(buying and selling) between consumers and producers. In perfectly
competitive markets, there are many sellers, many buyers, and entry
into and out of the market is easy. In a perfectly competitive market,
Joan would price her jewelry boxes at prevailing market prices where
marginal revenue equals marginal cost. In actuality, Joan can function
as a quasi-monopolist or as a near-monopolist in the short term until
the competition recognizes that they can make money selling unique
jewelry boxes.

Independent, Complement, and Substitute Goods

and Services
Most of the action in business involves not just the product line, but also
the markets for related products and services. There are three key con-
cepts related to product and service differentiation and the type of related
goods being offered; they are independent, substitute, and complementary
goods and services.
Two goods are independent if their consumption or use is not related.
The use of toothbrushes, for example, is not related to the consumption
or use of motorcycles. Independent goods are goods that are not depend-
ent in any way on how the other good is used. Since demand for one
does not affect the demand for the other, product differentiation has little
impact on these types of product trade-offs.
 DIFFERENTIATION IN ACTION 55

Much of the interesting economic activity in terms of strategy and

differentiation comes from complementary and substitute products and
services. Complementary goods are typically used together. When the
demand for one rises, for example, burgers, it leads to a rise in demand for
the other product, for example, fries. Examples of complementary prod-
ucts and services include toothbrushes and toothpaste, PCs and moni-
tors, travel services and global positioning systems, console game systems
and broadband demand, and operating systems and business applications
suites. In the case of Joan’s jewelry boxes, a complementary good would
be an expensive wood polish to maintain the wood or perhaps a limited
line of earrings that could be placed in the jewelry box as part of a gift.
Substitute goods are goods that are alike. In other words, substitute goods
have an equivalent function and one substitute good can be consumed or
used in place of another. They are largely interchangeable and when the
demand for one substitute increases, the demand for the other good decreases.
Examples of substitute services include cable systems and satellite systems.
Although they work very differently, they can be effectively substituted for
one another. Other examples include margarine and butter, satellite phones
and cell phones, powdered and liquid laundry detergent, and CDs and MP3
files. None of these products are actually perfect substitutes because they all
have slightly different features and have different performance characteris-
tics. A perfect substitute works essentially the same way and has the same
features and qualities as another technology. In practice, many competing
technologies are imperfect substitutes. MP3 files are imperfect substitutes
for CDs because CDs produce better sound than MP3 files. However, MP3
files are smaller and more easily copied than CDs. Butter and margarine are
slightly differentiated in terms of taste and the way our bodies assimilate
these two fats. In the case of Joan’s jewelry boxes, product substitutes would
be any jewelry box or container that could be used to house jewelry. This
would include a plastic food storage container, a vase, or even a glass.

Price Discrimination and Price Differentiation

It is a fundamental economic principle that the way to maximize profits is
to charge a price that equates to the value of the product to each consumer,
instead of selling at a uniform price to all consumers. This is the idea
56 DEVELOPING NEW PRODUCTS AND SERVICES

behind price discrimination.4 Pure price discrimination involves selling

the same good at different prices to different consumers. Flat pricing can
have perverse consequences, because it encourages the producer to sell to
the high end of the market.5 The producer simply starts at the top price of
the demand curve and then ratchets the price down. The flat price selected
is a function of how the fixed costs and variable costs lead to the highest
profit. Producers who understand differential pricing have a strong incen-
tive to supply several versions of a product because they will usually make
more money. Rather than sell the same exact good at different prices, the
goal should be to modify a product and sell a differentiated product at
different prices. This could be accomplished using the following strategies:

• Adding and subtracting product features

• Adding and subtracting convenience
• Adding and subtracting durability
• Adding and subtracting design appeal
• Adding and subtracting speed of delivery and processing
• Changing the level of customer service
• Advertising and branding and perhaps generating a cool
factor and snob appeal

There are two situations that lead to very high demand for products. The
first involves scarcity. When a product is scarce, it is usually in demand. Price
discrimination is easy for scarce products, even though such situations are
sometimes transitory (e.g., snow blowers during extended winter storms,
games consoles at launch, and oil consumption in the winter). The other
approach to generating high levels of demand is to design products that
make people and their kids look smarter or more attractive. Products that
give kids an academic edge are always in demand. Parents will flock to such
products because they may be able to differentiate their children from the
competition.

Irritating Consumers
There are several lessons that can be learned from monopolistic behavior
(and misbehavior) for those interested in engaging in monopolistic
 DIFFERENTIATION IN ACTION 57

competition. The first lesson that can be gleaned relates to the behavior
of the cable TV companies. Monopolies tend to take their customers for
granted, as was the case with cable TV subscribers in previous decades. As
soon as alternate products became available with better features, such as
those provided by satellite and optical fiber carriers, consumers started to
abandon the cable TV ship. They felt little allegiance to cable providers
because of the years of neglect. The cable provider’s strategy was to make
a profit by providing few existing and new features, keep raising subscrip-
tion rates, and providing poor service. There was enduring ill will toward
cable providers because they did not constantly differentiate and improve
their services and they were unwilling to streamline costs. Service has
improved dramatically and, in some instance, surpasses the competition,
but the remnants of ill will survive.6
Companies have to be very cautious how they use price differentia-
tion to personalize prices lest they incur the wrath of customers. Amazon
found this out in 2001 when they started to sell their DVDs at different
prices.

The price test, which ran early last week, affected dozens of
Amazon’s top-selling titles. Because of the test, which assigned
prices at random to customers as they shopped, some customers
found DVDs at prices up to $15 greater than other customers.
Amazon spokesman Bill Curry said that Amazon would reim-
burse customers who ordered DVDs affected by the test for the
difference between the price they paid and the lowest test price.
Although Amazon has no plans to do any more pricing tests, the
company guarantees that should it run another one, customers
will pay the lowest test price even if they order goods at a higher
price during the test.7

Personalized pricing can tick-off consumers when consumers find out

that they are paying a premium for the same product or service. Some of
the current ill will directed toward the airline companies is related to the
wide range of prices charged for identical seats and, of course, to their
very proficient use of versioning in the form of baggage surcharges, meals,
early boarding, and fast tracking through security. In 1995, the average
58 DEVELOPING NEW PRODUCTS AND SERVICES

U.S. domestic price for an airplane ticket was $292.8 In 2009, the average
airplane ticket price was $309. This is equivalent to $220 in 1995. The
airlines turned to product differentiation in order to achieve profitability.
It is sometimes necessary for producers to use approaches that disguise
personalized pricing approaches. Here are a few of the strategies used by
businesses to engage in product and service differentiation; some of them
are more acceptable to consumers than others:

• Charging higher prices where you have bundled other prod-

ucts with low variable costs with the original product.
• Charging lower prices if the customer buys a product or ser-
vice that will be consumed 6 months or a year into the future.
• Permit customers to purchase products at a reduced price
because they are part of a price-sensitive customer segment
such as the student or senior citizen populations.
• Make a customer submit a rebate coupon in order to get a lower price.
• Offer the product at a lower price if they wait a couple of days
before they receive the product. Offer the customer a lower
price the next day.
• Give customers the opportunity to play a game that lets them
win the product at a lower price.
• De-bundle services and charge for each service (airlines are a
good example).

It should be noted that some consumers will figure out how to game
these systems. They will then pass this information on and it will eventu-
ally reach a substantial number of consumers as the specter of efficient
markets looms its ugly head.

Waves of Innovation Fueled by Substitutes

and Complements
Innovation comes in waves. It is driven by consumers in the form of
demand for better products and services: “I need a smaller product with
more features and capabilities at a lower price.”
 DIFFERENTIATION IN ACTION 59

Substitute and complementary products are part of the engine that

drives innovation. For example, transportation has spurred the devel-
opment of substitute energy sources such as steam, electric, fuel cells,
and solar energy. The emergence of the automobile was the driving force
behind the development of better roads, fueling stations, and diners.
Demand for clearer and faster communication has been the key driver for
many modern-day substitute products as illustrated in Figure 3.8. This
has in turn driven the development of a wide range of products to support
the communication process.

Arbitrage: Producer’s Paradise and Consumer’s Dread

When I was a youngster in Helena Montana, I wanted to learn how to
play the bongo drums like Desi Arnaz.9 I went to a local store and inquired

Couriers
Smoke
Mail
and light
routes
signals

Talking Wagons
Complements
Language, straw, wood,
shoes, bags, horse care,
inns, diners, road materials,
construction, energy sources,
Photon phones, movies, storage, Pony
& Laser computers, TV, Email, express
PDAs, GPS, Internet…

Autos &
Satellite
Trucks

Wireless Wire

Figure 3.8. Innovation driven by substitute and complements.

60 DEVELOPING NEW PRODUCTS AND SERVICES

about the cost for a set of bongo drums. I believe that they wanted $40;
this was too much money and I decided to forgo the purchase and take
up the tuba because it was available through the school.10 I found out a
year later that the same bongos were available in a mass-market catalog
for a lot less money. I possessed inferior information on the value of the
bongos. Information asymmetry occurs when the seller has better infor-
mation about the value of a product than the buyer. In many situations, it
is the seller who knows more about the value of a product than the buyer;
however, it is possible that the buyer knows more about the value of the
product than the seller. Selling a product at a higher price in a market
where consumers are not knowledgeable or privy to the true market price
is called arbitrage. Arbitrage can lead to excess profits and inefficiencies
in the supply chain because the consumer cannot turn to other suppli-
ers and because the consumer does not know the competitive price for
the product and/or cannot get access to competitively priced products.
Arbitrage presents the opportunity for suppliers and producers to exploit
the consumer’s lack of product knowledge and earn higher profits.
Arbitrage is very important to commodity traders. Arbitrage enables
the seller to buy a product, such as a commodity, in one market and sell
the product in another market for a higher price. The arbitrageur makes
money by taking advantage of the price disparity by selling in one mar-
ket while simultaneously buying in the other. Excess profits are sympto-
matic of asymmetric information and inefficient markets. When someone
knows more than someone else about a product, they will often use that
information to achieve above-average profits or to secure resources at a
steep discount. The benefactor of the windfall rarely views good deals
as gluttonous. The number of suppliers and consumers for bongos in
Helena Montana during the 1960s was very small, and there were very
few opportunities to locate musical instrument catalogs that contained
bongo drums. This is asymmetric information at work. A market is
efficient when price discovery is easy and information is transparent and
readily available to all market participants.
Arbitrage can also hurt the producer of a low-cost item. Someone
could buy all of Joan’s low-cost jewelry boxes, repackage the jewelry box,
add a little do-dad, and then sell them at a higher price in the same mar-
ket. This could effectively reduce her high-end revenues. Continuous
 DIFFERENTIATION IN ACTION 61

product differentiation along with marketing and searching for the most
up-to-date information can reduce the impact of arbitrage. This can be
summed up in the following relationship:

Information Asymmetries  Arbitrage  Bad Deals.

Conclusion
As we have seen in this chapter, product differentiation leads to additional
revenues and is the basis for conducting experiments for determining what
products and product versions to introduce in the future. We have also dis-
cussed how substitute and complementary products and services further drive
innovation. Subsequent chapters will explore how product differentiation
forms the basis for experimentation, innovation, and product development.
In this chapter, we have illustrated how price discrimination could
be applied to Joan’s jewelry box case and optimum prices for product
versioning could be derived. The key takeaways include the following:

• By adding additional versions, Joan has dramatically increased

the present value of her business.
• Many large and small businesses, for reasons of simplicity,
offer products using a one-price solution in order to have a
simplified management agenda.
• By adopting a one-price solution, companies overlook the
high-end consumers and the premium prices that they will
pay for a product.
• A one-price solution also ignores the price-sensitive
consumers who could be drawn into the market if an
affordable option is made available.
• If a high-end product is not perceived as being adequately
differentiated with higher-end features and additional
functionality, the low-end product could cannibalize the
demand for the higher-priced product.
• Two goods are independent if their consumption or use is
not related. For example, cell phones and lawn mowers are
independent goods.
62 DEVELOPING NEW PRODUCTS AND SERVICES

• Complementary goods are typically used together like

toothbrushes and toothpaste.
• Substitute goods have an equivalent function and one
substitute good can be consumed or used in place of another.
Examples are CD players and MP3 players and cable TV
carriers versus satellite TV carriers.
• Companies have to be very cautious how they use price
differentiation to personalize prices lest they incur the wrath
of customers.
• Information asymmetry occurs when the seller has better
information about the value of a product than the buyer and
vice versa.
• Selling a product at a higher price in a market where
consumers are not knowledgeable or privy to the true market
price is called arbitrage.
 APPENDIX

Determining the Optimal

Selling Price Using Demand,
Revenue, and Cost
Equations
Even though Joan is an economist, her knowledge of the market for
jewelry boxes was based on experience and insight. She understands the
market because she has bought and sold jewelry boxes and their raw
materials and she has built them from scratch. Joan decided she should
put some of her economics training to work and determine the ideal
price and quantity to sell that would generate the most profit.
The typical demand curve has the price on the y-axis and the quantity
demanded on the x-axis and is downward-sloping.11 A demand curve
can be represented as a linear mathematical formula with quantity as
the dependent variable (q = –5p + 400) or with price as the depend-
ent variable (p = –5q + 80). A demand curve is a very useful diagram
for describing the relationship between the price level and the quan-
tity demanded at each price level. In general, as the price of a product
increases, the demand for the good decreases. Similarly, as the price of a
product decreases, the demand for the good increases. This section dis-
cusses how the demand curve can be used to identify the optimal price
and quantity for selling just one version of a product.
Since Joan is a near-monopoly working in a market characterized by
monopolistic competition, she can set her variable costs and fixed costs
within certain limits related to the features she has established for her
Jewelry boxes. Joan used algebra to come up with the optimal selling price
for her standard jewelry box. This is the price that generates the greatest
profit given the $15 variable costs and the $2,000 fixed costs.
64 DEVELOPING NEW PRODUCTS AND SERVICES

Her first task was to develop a demand equation. The demand equa-
tion relates the quantity of the good demanded by consumers to the
price of the good. Demand equations are in the form: Price = constant +
slope*Quantity. This can be calculated by finding the slope of the curve
using any two points (see Figure 3.9). We will use the points (q1, p1) or
(100, $60) and (q2, p2) or (200, $40). The slope is the rise over the run or:

Slope = (60 – 40)/(100 – 200)

Slope = 20/–100
Slope = –0.2

The constant is calculated by determining where the demand line

crosses the y-axis or, in this situation, the price or P-axis. This is accom-
plished by using the point slope form of the demand equation and any
point such as (100, $60). The resulting constant is 80.

p – p1 = slope(q – q1)
p – 60 = –0.2(q – 100)
p = 60 + 0.2q + 20
p = 80 – 0.2q

90

80

70
(q1, p1)
60

50
Price

(q2, p2)
40

30

20

10

0
0 50 100 150 200 250 300 350 400
Quantity

Figure 3.9. Two points are used to derive the demand curve.
 DIFFERENTIATION IN ACTION 65

In many instances, the demand curve is expressed in terms of p because

the price determines the amount demanded. You can just substitute a
price into the following formula and find out how many units will be sold.

q = –5p + 400

So if Joan decides to price each box at $50, then she will be able to
sell 150 units.
Now that the demand equation has been found (p = –0.2q + 80 or
q = –5p + 400), Joan’s next step was to determine the quantity where prof-
its are maximized. This is accomplished by identifying where marginal rev-
enue equals marginal cost. This is completed in two steps. The first step is
to substitute the demand curve equation into the total revenue equation in
order to get the total revenue calculation in terms of the quantity sold or q.

p = 80 – 0.2q
Total revenue = p × q
Total revenue = (80 – 0.2q) × q
Total revenue = 80q – 0.2q2

The above equation can be used to express the total revenue as a func-
tion of the quantity produced. We can check this answer by substituting
200 into the total revenue equation. For example, the total revenue when
production is 200 units would be 80 × 200 – 0.2 × 2002 or $8,000. This is
the same value for total revenue using the p × q equation for total revenue
($40 × 200 = $8,000).
The second step is to find the quantity where marginal cost equals mar-
ginal revenue. This is accomplished by taking the first derivative of the total
revenue equation with respect to q. This is then set to the marginal cost
and then solved for q. The marginal cost is actually the variable cost in this
example. The marginal cost to produce one additional jewelry box is $15.

Total revenue= 80q – 0.2q2

Marginal revenue = dtr/dq = 80 – 0.4q
Marginal revenue = Marginal cost
80 – 0.4q = 15
–0.4q = –65
q = 162.5
66 DEVELOPING NEW PRODUCTS AND SERVICES

The 162.5 quantity is rounded up to 163 and then substituted into

the p = 80 – 0.2q equation.

p = 80 – 0.2(163)
p = 47.4

The 47.4 price was rounded down to $47. This is the short-term
optimal revenue solution.

Profit = $47 × 163 – $15 × 163 – $2,000

Profit = $3,216

Joan decided after her analysis to produce fewer jewelry boxes since
she could make more money selling fewer boxes at a higher price. She
could have done a similar analysis using spreadsheet software and come
up with a similar solution. She would, however, still need the original
demand function along with an understanding of her variable and fixed
costs to produce the jewelry boxes.

Optimal Solution for Three Versions of Jewelry Box

The demand dashboard can also be used to determine the optimum

solution when there are three jewelry boxes. The optimum solution is
calculated using a mathematical programming algorithm that is usually
referred to as a solver add-on in spreadsheet programs (see Figure 3.10).
The solver essentially identifies the price for the Athena, the Stryker, and
the Natural that would maximize profit with all the other variables such
as the variable costs remaining the same.
As you can see from Figure 3.10, the optimal Athena price would
be $76.25 and about 19 units would be sold. The optimal price for
the Stryker would be $57.50 and about 94 units would be sold.
The Natural would be priced at $33.75 and would sell 119 units. The
net profit for all three versions would be $5,672. This is in contrast to
the non-optimized solution of $4,500. Joan just picked prices for each
version using her intuition and insight into what consumers would be
willing to pay.
Differentation dashboard version 4.1 MAC and PC compatible
Only change input values in orange
Enter product name here: Joan’s jewelry Demand curve
Demand slope: –0.2000
Joan’s jewelry Optimal profit one product
Price where demand is zero $80.00
Optimal maximum revenue
Midas product $100.00
Price $76.25 $80.00
Quantity sold 19 $60.00
Variable costs $30.00

Price
$40.00
Profit (before subtracting fixed costs) $867
$20.00
Atlas product $0.00
Price $57.50 0 100 200 300 400 500
Quantity sold 94 Quantity
Variable costs $15.00
Profit (before subtracting fixed costs) $3,984 Differentiation versus single product
$6,000 $5,672
Hermes product
Price $33.75
119 $5,000
Quantity sold
Variable costs $10.00 $3,984
Profit (before subtracting fixed costs) $2,820 $4,000
3281.25
Differentiation strategy $3,000 $2,820
Fixed costs: $2,000
Net profit with 3 versions $5,672 $2,000

Optimal solution with only Atlas product $1,000 $867

Optimal price 47.50
Optimal quantity 162.50
Total revenue 7718.75 $0
Total variable costs 2437.50 Midas product Atlas product
Fixed costs 2000.00 Hermes product Net profit with 3 versions
Optimal net profit with 1 version 3281.25 Optimal net profit with 1 version
DIFFERENTIATION IN ACTION
67

Figure 3.10. Optimal profit with three versions of jewelry boxes.

68 DEVELOPING NEW PRODUCTS AND SERVICES

You should note that the optimal solution for only having the Atlas
product is $3,281. This is little different than the $3,216 solution
obtained using the algebraic solution detailed in the last section because
we rounded the price and quantity in the algebraic solution.
The optimal solution provides insight into the demand curve and the
product mix, but it is not a magic potion for setting prices and developing
versions. There are a number of factors that go into identifying the price and
the characteristics for each version. There might be significant setup costs
for constructing the Athena or, perhaps, it would be difficult to find artisti-
cally talented employees to work on the fake pearl inlays for just a couple
of hours. Perhaps Joan does not want to focus on the Natural because she
wants to eventually focus on upscale jewelry boxes and she is concerned that
her product would not be considered a high-end offering because of the
proliferation of inexpensive jewelry boxes. And, of course, it is very difficult
to actually know if the demand curve is valid for all levels of prices.

Linear and Nonlinear Demand Curves

The demand curve for a good does not have to be linear or straight. As
illustrated in Figure 3.11, the demand curve could be curvilinear. It
appears that the price at which there is no demand is $80 and that there
is essentially unlimited demand for jewelry boxes that cost <$15. Let us
examine how a different and, in particular, a nonlinear curve could influ-
ence the amount of revenues generated. Using Figure 3.11, if Joan charges
$60 for the Athena unit, she would sell 50 units. If she charged $40 for
the Stryker model, she would sell 50 units (100 – 50). If she charged $20
for the Natural, she would sell 150 units (250 – 100). If Joan still had the
same variable cost structure as before, she would generate the following
revenues and profit:

Profit = ($60 – $30) × 50 + ($40 – $15) × 50 + ($20 – $10)

× 150 – $2,000 ← {fixed costs}
Profit = $1,500 + $1,500 + $1,500 – $2,000
Profit = $4,500 – $2,000
Profit = $2,500
 DIFFERENTIATION IN ACTION 69

90

80 The Athena: cherry wood, brass stop hinges

and knobs, brass lock, faux pearl inlay of godesss
70

60 The Stryker: maple wood,

brass hinges, wood inlay
50
Price

40 The Natural: cedar wood,

brass-plated hinges and
30 knobs, with wood-burned
picture of flower
20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 3.11. Nonlinear demand curve for Joan’s jewelry boxes.

This amount is noticeably less than the $3,216 algebraic solution

( $47 × 163 – $15 × 163 – $2,000) for the single version where it was
assumed that demand was linear. This example illustrates that a slight
miss in identifying the appropriate demand function can have a dra-
matic impact on profitability. Even though the demand and differentia-
tion dashboards can only deal with linear relationships, we can estimate
a linear function using only a portion of the demand curve. It appears
that there is a linear relationship within the price range of $20–$80. The
price where demand is zero (the Y intercept) and the slope of the demand
curve were both estimated using the demand analysis dashboard as illus-
trated in Figure 3.12. Figure 3.13 shows the solution for the nonlinear
demand curve using the differentiation dashboard. The key difference for
this solution versus the solution that was presented earlier in the chap-
ter is that the demand curve was estimated using points that were not
linear with a linear regression algorithm. This leads to several interesting
results.
The profit for one product using the optimal solution for the nonlinear
curve is $1,415.69. Using Figure 3.13, again you can see that when the
 70
Demand dashboard version 4.1 MAC and PC compatible
Only change input values in orange Estimated demand from points
Enter product name here: Joan’s Jewelry Demand slope (estimated from points): –0.2378
Demand slope: –0.2378 The slope of the demand curve is between –0.0939 There will be no confidence
Price where there is zero demand $72.00 and between at the 95% confidence level –0.3818 interval if only 2 points are entered
Maximum revenue $5,450 Price where there is zero demand: $72
Optimal price $36.00 Maximum revenue from statistical estimate: $5,474
Optimal quantity 151 Optimal price for demand estimate: $36.08 Number of points 5
This solution is optimal. Optimal quantity for demand estimate: 152
It will change when variable cost are added Correlation coefficient price & quantity: –0.9498 Point Price Quantity
in the demand dashboard 1 $80.00 0.00
2 $60.00 50.00
$80.00 3 $40.00 100.00
4 $30.00 150.00
$70.00 5 $20.00 250.00
6
$60.00 7
8
$50.00 9
10
$40.00 11
12
13
$30.00 14
DEVELOPING NEW PRODUCTS AND SERVICES

15
$20.00 16
17
$10.00 18
19
$0.00 20
0 50 100 150 200 250 300 350 21

Joan’s Jewelry Estimated demand from points

Figure 3.12. Demand curve for nonlinear estimation.

Differentation dashboard version 4.1 MAC and PC compatible
Only change input values in orange
Enter product name here: Joan’s jewelry
Demand slope: –0.2378 Demand curve
Price where demand is zero $72.00 Joan’s jewelry Optimal profit one product
Optimal maximum revenue
Midas product $80.00
Price $60.00
Quantity sold 50 $60.00
Variable costs $30.00 $40.00

Price
Profit (before subtracting fixed costs) $1,514
$20.00
Atlas product $0.00
Price $40.00 0 50 100 150 200 250 300 350
Quantity sold 84 Quantity
Variable costs $15.00
Profit (before subtracting fixed costs) $2,103
Differentiation versus single product
Hermes product $3,000
Price $20.00
Quantity sold 84 $2,458
$2,500
Variable costs $10.00
$2,103
Profit (before subtracting fixed costs) $841
$2,000
Differentiation strategy $1,514
$1,500 1415.69
Fixed costs: $2,000
Net profit with 3 versions $2,458
$1,000 $841
Optimal solution with only Atlas product
Optimal price 43.50 $500
Optimal quantity 119.85
Total revenue 5213.41
$0
Total variable costs 1797.73
Fixed costs 2000.00 Midas product Atlas product
Optimal net profit with 1 version 1415.69 Hermes product Net profit with 3 versions
DIFFERENTIATION IN ACTION

Optimal net profit with 1 version

71

Figure 3.13. Joan’s profit using estimates of nonlinear demand.

72 DEVELOPING NEW PRODUCTS AND SERVICES

original variable and fixed costs are entered in the differentiation dash-
board, three versions produce a net profit of $2,458. This is in contrast to
the $4,500 profit for the three versions using the original linear demand
curve.
When the demand is nonlinear, economists use “tricks” to transform a
nonlinear demand data into a linear formula.12 For example, they take the
natural log of the price and quantity data and then perform the regression
analysis in order to develop an estimate of the function. The trick I used
was to estimate the demand function by only using prices between $20
and $80.
If a new product is being introduced, then there may not be any
data available for estimating a demand curve. Historical data are often
scarce or nonexistent for new products and significantly revised versions
of products. Sometimes, the entrepreneur has only two points for esti-
mating demand. The first point is where the price crosses the Y-axis.
This is essentially the maximum amount that most consumers would
be willing-to-pay for a product. The second point is also a guestimate
using a hypothetical question. What demand would result if we were to
introduce a product at the prevailing market price using typical product
features?
The key takeaway is that it is difficult to model consumer demand
when products are new and untested, and even where there is a pro-
liferation of historical data, it is still a difficult task. Another takeaway
is that versioning will almost always generate more revenues and also
greater profits in the long run. The crucial activity is to constantly
experiment and continuously introduce product versions in order to
understand the constantly changing nature of consumer behavior.
Quantitative tools can provide insight, but they should be used to pro-
vide insight and not used as a sole solution for pricing and versioning
products.
From an economist point of view, the primary goal of versioning
is to capture consumer surplus. As one of my economist colleagues
(Bill Hamlen) noted, it is very difficult to develop a reasonable math-
ematically grand optimal solution for capturing consumer surplus with
even two versions. Economists have not attempted to tackle the problem
of versioning because of the mathematical complexity. I have taken the
 DIFFERENTIATION IN ACTION 73

liberty of using the same demand curve for all the versions. In reality,
there is a separate demand curve for each version. Bill Hamlen suggested
that since it is so difficult to find a grand optimal solution, that I should
continue the approach used in the book because it still provides an
insight into the important issue of capturing consumer surplus from a
strategy perspective.
 CHAPTER 4

The Role of Dynamic

Tension in Constructing
Versioning and Product
Differentiation Curves
Midas Hermes

Atlas

The demand for a product is influenced by a number of factors includ-

ing product availability, the utility or usefulness of a product, consumer
income levels, product features, marketing efforts, product awareness, the
quality and performance of substitute products, fashion and the cost of
complementary products. This chapter illustrates how product differen-
tiation curves (PD curves) can be used to increase revenues and continu-
ally deliver updated products and services. We will sometimes refer to PD
curves as versioning curves. The focus will not be on the math or even on
the actual form of the demand curve. Our focus will be on using product
differentiation or versioning curves as a conceptual tool for developing
different product versions.
76 DEVELOPING NEW PRODUCTS AND SERVICES

A PD curve is very useful in illustrating the relationship between price

and the quantity demanded. But there is one major difference between
the PD curve and the typical demand curve. The PD curve can include
different versions of a product on the curve and also segments each prod-
uct version according to willingness-to-pay characteristics of the buyer
groups as illustrated in the case of Joan’s jewelry (see Figure 4.1). These
major groups are Midas, Atlas, and Hermes consumers. The primary pur-
pose of the PD curve is to assist in identifying product versions and prices
levels for discriminating each product version. The process for matching
products to the willingness-to-pay segments is rooted in experimentation
and the continuous introduction of new versions of products and services.
The PD curve is very useful for product positioning. Product posi-
tioning is the process where sellers and producers try to create an image,
an identity, or an emotion toward a product or a service in the minds of
consumers. This is the essence of the brand concept. A brand is simply
something that lives in the head of consumers.1 The brand is a compos-
ite of the mental associations that are generated when you see or think
about a certain product. Our focus will be on positioning products and
services according to the different customer segments’ willingness-to-pay
and price sensitivities. The PD curve can of course be used to illustrate

90

80 The Athena: cherry wood, brass stop hinges

and knobs, brass lock, faux pearl inlay of godesss
70

60 The Stryker: maple wood,

brass hinges, wood inlay
50 The Natural: cedar wood,
Price

brass-plated hinges and

40
knobs, with wood-burned
30 picture of flower

20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 4.1. Product differentiation or versions curve for Joan’s

jewelry.
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 77

how a single standardized product can be differentiated by geography, by

market segment, and through branding efforts.
One promising application of the PD curve is that it can be used
to identify the so-called Blue Ocean markets. A Blue Ocean market is a
market that does not in exist. The goal is to create a new product that is
radically differentiated from existing products that are being offered and
to create the Blue Ocean market.2

Versioning and Goldilocks Pricing

The idea behind versioning is to engage in differential pricing by offering
different types or editions of a product.3 Ideally, the different versions should
be perceived as having different levels of quality. The number of versions
can also be related to the number of distinct market segments. In many
instances, it is difficult to identify the optimum number of market segments,
and it is also difficult to develop products for each market segment. Goldi-
locks pricing, and therefore versioning, is a rule of thumb that suggests that
you should start out with three price levels.4 The idea behind Goldilocks
pricing is that offering 1 product is too few, 10 products is too many, and
offering 3 differentiated products is just the right amount. A case was made
in the chapter discussing Joan’s jewelry boxes for having more than one
product because of the increased potential for generating revenue for Joan.
If a company does not introduce multiple versions of a product, they
will be leaving money on the table. If a company does not have a high-
end product for consumers who are affluent or price-insensitive, then they
will not have extracted the consumer’s surplus from affluent customers
or customers who simply do not care how much the product costs, they
just want it. On the other hand, a business will also leave money on the
table if they do not have a lower-end product for price-sensitive individu-
als because price-sensitive individuals will not purchase products that are
above their willingness-to-pay. Price-sensitive customers, such as students,
also present another opportunity; they can be the foundation for establish-
ing a long-lasting relationship when they have more discretionary income.
There is one additional reason for offering more than one product to
consumers. Introducing multiple versions of a product permits a company
to experiment and observe consumer’s economic behavior in action. The
78 DEVELOPING NEW PRODUCTS AND SERVICES

company can monitor purchase behavior and determine which features

and products consumers deem most desirable. Such experimentation is
actually the most effective activity for conducting research and engaging
in new product development.

Using Dynamic Tension Differentiation to Develop

Products and Services for the Entire Demand Curve
In their book on developing creative approaches for solving problems,
Barry Nalebuff and Ian Ayres describe the “What Would Croesus Do?”
approach.5 The gist of the approach is to consider how a consumer would
solve a problem when he or she has unlimited resources. Need tech sup-
port, have the tech sit outside your office, and enter when called. Bored,
become a cosmonaut. This approach can help to identify high-end
products and services for the consumer who is not price-sensitive and is
interested in many different features (see Figure 4.2). We have renamed
Croesus to Midas products because it is easier to remember and because
it imparts a very colorful and explicit image of high-end features. Midas
products and services are designed for consumers who are not price-
sensitive and demand high-end features. Products that are designed with

What would Midas do?

Extravagantly engineered
Consumers not price-sensitive
Higher-end product with enhanced features and exciters
Skimming pricing strategy pricing
What would Atlas do?
$$$ The result of dynamic tension between Midas and Hermes
Extravagantly and frugally engineered
Mainstream product with mass appeal, middle-of-the road price
Standard and prototypical features
Some advanced features
$$ What would Hermes do?
Frugally engineered
Consumers price sensitive
Lower-end functional product or service
Has reduced and scaled-back features
Penetration pricing strategy
$

Q1 Q2 Q3

Figure 4.2. Dynamic tension between Midas and Hermes leads to

Atlas products.
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 79

high-end features for individuals who are affluent or individuals who are
simply interested in high-end products are designed using extravagant
engineering. Extravagant engineering is less concerned with costs and
more concerned with using new technology and concepts to develop
innovative and perhaps even radical products and services. In general,
products and services that are extravagantly engineered contain advanced
features and attributes.
Pricing high-end Midas products and services is tricky and very
important. The goal is not only to cover variable costs but also to make
a profit. There is more at stake with Midas products. Another objective
is to get consumers to focus on the attributes of a Midas product that
distinguish it from other products. The point is to determine what prod-
uct features customers value the most. This is accomplished partly by
marketing research but also through economic experiments in the form
of introducing products with different features and observing buying
behavior. Bertini and Wathieu have identified several strategies that can
stop consumers from fixating on price and focus on product features.6
One noteworthy approach is to willfully overprice the product in order
to stimulate curiosity. It appears that some consumers are more inclined
to analyze product features and even buy a product when there is a high
price premium in the 30–80% range.
There is a part of the demand curve where the consumers are price-
sensitive. This segment could include students, seniors, and, in general,
individuals with low levels of discretionary income or individuals who are
truly value-conscious. In designing products and services for this group,
you can use the “What would Hermes Do?” approach. Hermes was the
god of the traveler, the shepherd, the athlete, the merchants, the cunning,
and was linked to invention and commerce. We are now designating
Hermes as the patron for the part of the demand curve that does not have
a patron.7 Hermes products and services are designed for consumers who
are price-sensitive and demand features that are functional for the task
at hand. Hermes products and services are still functional, but they have
reduced and scaled-back features. There are a variety of very interesting
products and services that have been developed for Hermes customers
occupying the price-sensitive end of the demand curve. An important
reason for offering Hermes products and services is to acquire customers
80 DEVELOPING NEW PRODUCTS AND SERVICES

who might eventually become Midas consumers. For example, students

become less price-sensitive as they enter the work force and generate more
discretionary income. Consumers’ tastes can also change as they become
more familiar with a product line or because they get caught up in the
hype around fashionable product. Designing Hermes products requires
skills in frugal engineering.
Frugal engineering is the ability to design useful low-cost products
and services for price-sensitive consumers.8 Frugal engineering is the clean
slate approach for engineering and designing products and services. The
first step is to identify the fundamental or essential functions of a product
or service. The next step is to concurrently design or redesign the existing
product or service and the manufacturing process so that the process is
very efficient and the components and materials used are inexpensive. The
individuals using Hermes products can be price-sensitive because they are
thrifty, but they can also be Hermes customers because they are part of
the approximately 4 billion people in the world with a purchasing power
of <$1,500 per year or consumers who are looking for a bargain.
Midas and Hermes products have an important role in developing
new ideas for products and services for the middle of the demand curve.
Midas gives product developers the license to create ideas that are unique
and perhaps superfluous. Hermes products and services establish a mini-
mal baseline for a product or service with the additional prompting of
being inexpensive to produce. Hermes products should be less expensive
to produce because they are meant to attract price-sensitive customers.

Dynamic Tension Between Midas and Hermes

Spawns Atlas
From the producer’s perspective, the idea is to get the creative juices
flowing and use the top and bottom of the demand curve to generate
new ideas for products and services by drawing on both extravagant and
frugal engineering approaches to develop Atlas products. The mass-appeal
or mainstream products in the middle are called Atlas products. Atlas was
a Greek mythological figure that supported the weight of the heavens on
his shoulders. Atlas products support the broad-based customer segment
in the middle that requires products that have standard features and also
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 81

have slightly differentiated features to meet the demand of monopolistic

competition. The point is to create dynamic tension between the two
ends of the demand curve, anchored by extravagantly engineered and
designed Midas products and frugally engineered and designed Hermes
products. The result of this dynamic tension is an Atlas product.9 This
is a product with attractive features and with an attractive contribution
margin. The result is also a robust process for continually inventing and
reinventing the products and services to stave off the competition and
establish a strong foundation for survival.

Midas, Atlas, and Hermes Versions

The three categories for product versioning and experimentation are
the high-end or Midas product, the mass-appeal or Atlas product, and
the low-end or Hermes product (see Figure 4.3). We will often use the
terms version and product interchangeably; however, a version is usually
related to a particular product. The Midas product is targeted toward
the consumer who is not price-sensitive and is interested in many differ-
ent features. Midas products might have an extended warranty or may
be bundled with other products and services. Examples of Midas prod-
ucts include Cadillac, Acura, Lexus, TurboTax Premier, and specialized

High-end (Midas)
90 - New, advanced and more product features
- Consumers not as price sensitive
80 - Skimming pricing strategy

70 Mainstream & mass appeal (Atlas)

- Some advanced features
60 - Standard & prototypical features
Lower-end & price-sensitive (Hermes)
50 - Functional and standard features
Price

- Consumers price sensitive

40 - Try and buy
- Penetration pricing strategy
30

20

10

0
0 50 100 150 200 250 300 350 400 450
Quantity

Figure 4.3. Midas, Atlas, and Hermes characteristics.

82 DEVELOPING NEW PRODUCTS AND SERVICES

boutique stores. Sometimes, a Midas version is not even different than the
Atlas version of a product or even the Hermes version of a product. Mar-
keting efforts via branding may have infused the notion that the product
is better than another product with the same features. This happens in the
commodities markets, the car-rental business, and in electronics markets
where standardized products such as CDs and DVDs are being sold.
Mass-appeal or Atlas products and services are developed to appeal to a
large percentage of consumers. Mass-appeal products and services will con-
tain elements of what is essentially a prototypical product. A prototypical
product is the archetype product that other products are patterned after. In
order for this product to appeal to the masses, it usually has a minimal set
of standard features. In order to distinguish a prototypical product from the
competition, there will also be a few features that are differentiators or there
will be standard features that have been enhanced or amped up a bit to dis-
cern the product from other mass-appeal products. Examples of mass-appeal
products include the Camry, the Accord, the Malibu, and TurboTax Deluxe.
Examples of mass-appeal retail outlets include Sears, Safeway, and Amazon.
Low-end or Hermes products and services are designed for markets
where the consumers are price-sensitive. These products have the essence
of the prototypical product, but they are scaled back in order to meet the
price sensitivities of this segment. These groups could include students,

TurboTax home & business

$99.95

P3 TurboTax premier
Midas $74.95
P2
Price

TurboTax deluxe
$49.95
Atlas
P1

Hermes

Free software

Q1 Q2 Q3
Quantity

Figure 4.4. TurboTax versioning.

 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 83

seniors, and, in general, individuals with low levels of discretionary

income or even individuals who are value-conscious. Examples of prod-
ucts and services designed for the Hermes customers include TurboTax
Free Edition, the Honda Fit and Tata Nano, and many of the large lot
stores such as Sam’s Club, BJ’s, and Costco. Figure 4.4 presents the all-to-
familiar price and product versioning that is used by Intuit for TurboTax.

Bottom of the Pyramid

Low-end, low-cost products and services are of emerging importance
because of the huge market at the so-called bottom of or base of the pyra-
mid (BoP).10 Price and product differentiation can benefit the 4 billion
people who need pharmaceuticals, health care, personal grooming, and
low-priced durable goods and electronics. In the past, many businesses
have ignored this substantial collection of individuals. But there is money
to be made at the BoP because there is demand for inexpensive products
by these consumers. Price-sensitive consumers have many of the same
wants and desires as the affluent consumers.11 They just have to spend
more money on the basic necessities of life and have little discretionary
income. Products can actually be designed at the high end and the mass
appeal levels, and then scaled back so that they can be sold to individuals
at the BoP. As noted above, price-sensitive customers can be the foun-
dation for establishing a long-lasting monetary relationship when those
customers attain more discretionary income. Here are a few additional
examples of versioning approaches. The next chapter will provide many
more examples of how versioning has been used by various businesses.

Versioning Restaurants, Hotels, and Motels

Competition in the restaurant, hotel, bars, and motel businesses is fiercely
monopolistically competitive. Typically, these businesses compete on
atmosphere, the level of service, and the uniqueness of their offerings. A
Midas high-end hotel can have boutique rooms, spas and fitness rooms,
and a vast array of food choices from room service to expensive high-end
dining. In contrast, the Hermes hotel can be clean, Spartan, and in close
proximity to fast food and casual dining outlets. The drama is in the
84 DEVELOPING NEW PRODUCTS AND SERVICES

Fine dining
- Unique and very upscale atmosphere
- Exceptional table service
- Unique menu & ingredients

$$$ Casual dining

- Comfortable & upscale atmosphere
Midas - Table service
- Diverse menu choices
Average price

$$ Fast food
- Spartan atmosphere
Atlas - Self service
- Limited menu

$
Hermes

Q1 Q2 Q3

Figure 4.5. PD curve for restaurants.

details. Fresh flowers in the room, a free breakfast, and free cookies can
attract customers. In most instances, the benefits of a given differentiation
strategy are transitory, and new features have to be added or existing fea-
tures need to be refreshed in order to compete effectively. Figure 4.5 illus-
trates a PD curve for fast food, casual dining, and fine dining restaurants.

Versioning Commodity and Standardized Products

Standardized and commodity products can also be versioned. Sometimes,
the high-end product is not even that different from the mass-appeal prod-
uct or even the low-end product. Marketing efforts via branding may have
instilled the notion that the product is better than another product with
the same features. As illustrated in Figure 4.6, the way to sell a standardized
product to the high end is to have a distinct brand, offer extended warran-
ties, deliver products and services faster, or all three. This happens in the auto
business, commodities markets, and the entertainment industries. There are
also ways to sell a standardized product to the low end without upsetting
individuals who purchased a product at a higher price. This can be accom-
plished by offering customer rewards programs, having customers use cou-
pons, and delaying the shipment of a product. If you buy months ahead
from the airlines, you can sometimes get a better price than an individual
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 85

- Gold customer service: 7×24 call-in with account rep

- 3-year warranty
P3 - Overnight delivery

- Premium customer service: weekday call-in

- 2-year warranty
- 2 day delivery
Price

P2 - Standard service: online only service

- 1-year warranty
- 5–7 day delivery
- Distribute coupons & rebates

P1

Q1 Q2 Q3
Quantity

Figure 4.6. Differentiating a standard or similar product.

who buys ticket days before departure. Rebates are also a way to sell at a
lower price for standardized product. The product is not the same because of
the hassle of filling out the documentation and the uncertainty that comes
from not knowing whether the rebate or coupon will be honored.

Versioning Strategies
There is no superset of features that can be used for product and ser-
vice differentiation because demand is subject to the development of new
technologies, changing wants, the social context, culture mores, and the
fickleness of fashion. Here is a subset of the attributes of products and
services that can be modified:

• Focus on the uniqueness of the product or service.

• Have a version that is simpler and easier to use than other
products or services.
• Introduce a product or service that uses new emerging
technology.
• Design a more attractive product and frequently refresh the
product.
• Use creative and attractive packaging and labeling and
continuously refresh the packing.
86 DEVELOPING NEW PRODUCTS AND SERVICES

• Increase or decrease the size and weight of the product.

• Differentiate the product by performance, including speed
and capacity.
• Offer different levels of convenience. Offer convenience that
is not available in the marketplace.
• Product or service is available quickly and price-differentiated
by availability.
• Use packaging and labeling that are unique and up-to-date.
• Offer products and services that are more reliable and durable
than competitors.
• Have better customer support and warranties than the
competition. Differentiate your products by the length of the
warranty and the level of customer support.
• Increasing the cool factor, prestige, and elitism related to the
product or service.
• Focus on how the product improves health and personal
attractiveness.
• Focus on how the product or service improves some form of
intelligence such as reasoning, verbal abilities, analytical skills,
social adaptation, and emotional adaptation.
• Focus on how the product improves physical abilities and the
ability to compete in sports.
• Illustrate how the product improves the children and family
in some way so as to differentiate them from the masses.
• Focus on how the product or service facilitates connectivity
and communication and social networking.
• Improve the brand through marketing and promotion efforts.
• Modify the price.

As you can see from the above list, and from the chapter, there are
numerous strategies for versioning. Some of them require significant
product and development and research and development (R&D), and
others require modest investments and change in a product or service.
Some of them require repositioning of the product through marketing
and promotion efforts. The FAD (features, attributes, and design) tem-
plate, which is introduced in chapter 7, is very useful for identifying fea-
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 87

tures and attributes that can be used to version products and services for
Midas, Atlas, and Hermes customers.

Version Rollout Strategies

Many companies start by introducing and designing the mass-appeal or
Atlas product first. The objective is to get the product out the door and
generate as much revenue as possible by setting the price and developing
the features in such a way that profit and cash flows are near the optimum
level. That was the strategy used by Joan’s jewelry. She then introduced
a high-end Midas version to attract affluent consumers. This is some-
times followed by introducing a scaled-back Hermes version with easy-to-
produce features after the production process has been fine-tuned. Some
businesses introduce a low-end Hermes product at the same time that the
Atlas and Midas versions are introduced. Their objective is to use the low-
end version to attract buyers to the mass-appeal and high-end products.
Sometimes, a version is given away or is offered on a try-and-buy basis.
This is referred to as a freemium version.
The key consideration is to design products and services so that features
can be easily added and subtracted and new versions can be quickly intro-
duced. This of course implies that the producer will use modular design
approaches and agile production processes in product development.

Customer Segments and Midas, Atlas, and Hermes

Versions
A customer segment is a group of prospective consumers with similar prod-
ucts and services. Potential segments can be based on age, gender, income,
family structure, affluence, city size, location within a country and around
the world, interests, life style, behavior, psychological characteristics, cul-
ture, and product function. Segmentation is also found in business-to-
business relationships. Businesses can be segmented by product and service
needs, business function, and industry, location within a country and
around the world, culture, and by the size of business.
The goal of segmentation is to target and sell to consumer groups that
have similar characteristics and demand habits. Segmentation can be use-
88 DEVELOPING NEW PRODUCTS AND SERVICES

ful in describing the target market, but it should be used sparingly. Poten-
tial customers can be a member of many segments. There is a tendency
toward oversegmentation. There are three key criteria available for devel-
oping and using a customer segment. The first question relates to whether
the customer segment is easily identified and whether the customer seg-
ment make sense? The second question is related to the first and asks if
the individuals in the customer segment are relatively homogeneous? The
third question relates to being able to target and reach those customers in
the segment. Can the organization effectively use advertising and promo-
tion to target those customers in the customer segment?
Segmentation and grouping are typically based on age, gender,
income, family structure, affluence, city size, interests, life style, behavior,
psychological characteristics, culture, and product function. However,
many businesses and marketers use more detailed and descriptive words
to describe their customer segments. Here are a few of the many words
that can be used to describe customers segments:

Traditionalists, Conventionalist, Survivalist, Easterners, Westerners,

Northerners, Yankees, Southerners, Pioneers, Enthusiasts, Gamers,
Minimalists, Organics, Granolas, Back-to-Naturists, Adventure
Seekers, Risk takers, Romanticists, Aficionados, Connoisseurs,
Fast trackers, Soccer Moms, Techies, Umbrella/Helicopter par-
ents, Seniors, Oldsters, Middle Agers, Middle age crises and
cruisers, Teens, Goths, Hip, Impulsive, Tweeners, Generation X,
Millennials, Baby Boomers, Hippies, Yuppies …

It is interesting to note that many of the customer segments are

related to the meaning that consumers attach to products and services.
Additional discussion of the importance of the meaning underlying a
product or service will be presented in chapter 7. The best use of segmen-
tation is to provide additional insight and to describe in greater detail the
consumers who will be buying the Midas, Atlas, and Hermes versions.
Usually, a product or service is targeted toward a particular customer
segment. For example, suppose a company wanted to develop a global
positioning system for Adventure Seekers and Risk Takers. After they
identified the customer segment, they would then develop two or three
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 89

versions (Midas, Atlas, or Hermes) of the product that were linked to

price sensitivities. Here is another example. Suppose a company wanted
to develop high-end head phones for listening to MP3 songs using a new
speaker technology. They could target both the Tweeners and the Baby
Boomers with different versions and marketing campaigns. They could
also develop three versions (Midas, Atlas, or Hermes) of the product for
Baby Boomers according to their price sensitivities as well as three ver-
sions of the product for Tweeners. Usually, but not always, businesses
identify the customer segment or segments first. They then engage in
versioning to obtain more revenues and to assist in identifying the prod-
uct features that are attractive and in demand. The bottom line is that
versioning complements and assists in the customer segmentation. Here
is a summary of how customer segments fit into product development:

1. Conceptualize product or service

2. Identify appropriate customer segments for product or service
3. Design and develop two or three versions for each customer segment
4. Obtain feedback from potential customers, employees, vendors, and
interested parties
5. Revisit step 1

This is of course not a linear process. For example, step 1 and step 2
often occur at the same time. It is similar to the creative problem-solving
process discussed in chapter 6. There are periods where product develop-
ers are engaged in leaning-about customers, emerging technologies, and
other products offered in the marketplace. There are also periods of learn-
ing-by-doing, where prototypes are built and scrutinized, and where the
feedback is obtained from relevant parties. It is, however, a never-ending
process of refinement and experimentation.

Pricing and Product Differentiation Strategies

Pricing plays a key role in developing and formulating a market strategy.
The use of PD curves in developing products and services incorporates
several important pricing and product strategies.12 Modern businesses
often turn to product-line pricing strategy to offer a number of products
with differences in quality, design, size, and style in order to maximize
90 DEVELOPING NEW PRODUCTS AND SERVICES

profits. The product portfolio can include products that are complemen-
tary and even products that compete with each other.
The use of PD curves is also in line with the two major pricing strat-
egies for marketing new products: skimming pricing and penetration
pricing. Skimming pricing is used to tap into the so-called “cream of the
market.” It is an attempt to attract the high end of the demand curve
where price elasticity is low. That is, the customers are not price-sensi-
tive. The objective of using this strategy is to facilitate profitability with
a slowly maturing innovative product, covering the high cost of R&D.
In many instances, marketers introduce the high end first and then go
for the mass market by lowering prices. Penetration pricing is a strategy
of entering the market with a low initial price in order to capture a large
share of the marketplace. One objective of this strategy is to tap into the
demand curve where the price elasticity is high and customers are price-
sensitive. It is used to lure customers, get at a large mass Atlas market,
discourage competition, and build economies of scale.13

Dynamic Tension in Action at Singapore Airlines

Singapore Airlines (SIA) is a prime example of a business that uses
dynamic tension to deliver high-end, innovative, differentiated services
and still be efficient and cost-effective. SIA has garnered numerous
awards for their world-class service in their coach, business, and first
class offerings.14 The rest of the story is that they have one of the lowest
cost structures compared with any other airline at just under 5 cent per
kilometer per seat. Here is an overview of how Heracleous and Wirtz
describe SIA’s strategy for delivering world-class services and still being
a cost leader.
They keep their fleet young and up-to-date. Their planes are much
younger than most of the competition. This translates to fewer mechani-
cal failures, more air time, lower fuel costs, reduced maintenance costs,
and happy customers. Salaries are linked to SIA’s profitability. SIA pro-
vides twice as much training to their 14,500 employees than the industry
average. They also recruit top-notch university graduates. SIA realizes that
their employees are the critical touch point with their customers. SIA also
realizes that their employees can be the first line of defense in cutting costs.
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 91

SIA holds town hall meetings where senior executives stress the importance
of reducing costs in order to remain competitive. SIA also staffs most of
their flights with more cabin crew members than the industry standard.
SIA encourages their employees to find ways to reduce costs. For example,
cabin crew recommended carrying less food for late night flights and they
stopped putting jam jars on every breakfast tray because some passengers
did not use them. SIA’s back-office costs lag behind that of their competi-
tors and its sales and administration costs are low and lean.
The secret sauce of SIA’s success includes harnessing the power of
its employees, using technology effectively and appropriately, and pur-
suing the dual strategies of creative differentiation and reducing costs.
SIA understands that long-term success is a function of balancing the
dynamic tension between delivering high-end Midas services with the
Hermes cost reductions.

Conclusion
In this chapter, we have illustrated a model for constructing PD curves
that draws on the dynamic tension that exists between developing Midas
and Hermes products. The key points are the following:

• PD curves are used to increase revenue and foster

experimentation and R&D.
• A versioning curve is the same thing as a PD curve.
• Midas products and services are feature-rich versions of a
product that are developed using extravagant engineering
and design. Midas versions are high-end products for
nonprice-sensitive consumers.
• Hermes versions of products and services are developed
using frugal engineering and design. Hermes versions are for
price-sensitive consumers.
• Atlas products and services are the result of the dynamic tension
created between Midas versioning and Hermes versioning.
• Atlas products and services are designed for mainstream
consumers. Atlas products and services incorporate the
product design features that will attract the broadest customer
base and will also be profitable.
92 DEVELOPING NEW PRODUCTS AND SERVICES

• Even standardized products can be versioned.

• There are a variety of version strategies available and some
of them require R&D and some of them can be developed
through packaging and marketing.
• A customer segment is a group of prospective consumers with
similar products and services. Versioning complements and
amplifies customer segmentation.
• Versioning assists in developing and executing pricing strategies.

As noted earlier, we believe that using a combination of pricing and

product-versioning strategies facilitates product experimentation and
the ability to observe economic behavior in action and perform research
and product development. It allows the company to monitor purchase
behavior and determine which features and products consumers deem
most desirable. The next chapter will introduce a variety of product dif-
ferentiation versioning strategies that are being used by businesses to
compete.

Addendum on Pareto Economics,

Welfare, and Efficiency
Price discrimination and product differentiation leads to more efficient
markets. Many contemporary discussions of economics begin by address-
ing the issue of the so-called Pareto efficiency or optimality. Vilfredo Fed-
ericao Damaso Pareto was an Italian intellectual during the later part of
the 19th century and early part of the 20th century. A Pareto optimal
distribution of a bundle of goods is one where all parties agree that the
allocation cannot be improved upon without hurting at least one other
party. It does not mean that everyone is happy with the distribution; it
just means you cannot improve on the distribution without creating a
disadvantage for one of the groups or parties. I like to use the word Pareto
OK rather than Pareto optimal. A Pareto OK distribution of goods takes
into account the idea the distribution of goods is equitable and the wel-
fare of all is optimal given a distribution of incomes and consumer wants.
A Pareto OK distribution is also more in tune with Pareto’s original
 THE ROLE OF DYNAMIC TENSION IN CONSTRUCTING VERSIONING 93

conceptualization of optimality and welfare economics. The so-called

Paretian welfare economics is built on three principles:15

• Each individual is to be treated as the final judge of his or her

welfare.
• The welfare of society depends on the welfare of the individu-
als who make up the society.
• If one person’s welfare increases, other things being equal,
then societal welfare increases.

These three principles can be distilled into a single maxim: “as far as
social choice is concerned, all that matters is the satisfaction of wants”
(Robert Sugden, p. 507).
One goal of developing multiple products and using a product and
price differentiation strategy is to deliver products that satisfy wants.
Economists are always worried about economic efficiency and societal
welfare. The natural questions related to price differentiation is whether
this leads to efficient markets and whether society is better off. I propose
the following definition of market efficiency:

A market tends to be efficient when the market participants have

complete knowledge about the prices and features of products and
services offered in the market.

This definition is somewhat different than the traditional definition

because it incorporates the idea that market participants are knowledgea-
ble about prices and that they are also knowledgeable about the features of
a product. Efficient markets emerge when information is freely available.
Dynamic and adaptive markets emerge when there are a variety of prod-
ucts and services available and market participants have the tools available
to gather information on the products and services. Search engines and
auctions are extremely effective tools for gathering information and devel-
oping knowledge about pricing and features and that is why the Internet
has been such a powerful force for facilitating efficient markets.
 CHAPTER 5

Examples of Product
Differentiation and
Versioning Curves

Midas

Atlas

Hermes

In this chapter, more examples of product differentiation and versioning

curves are presented. As noted earlier, the purpose of the product
differentiation curves (PD curves) or versioning curves is primarily
conceptual. However, the underlining rationale behind the curves is
to generate more revenue and to provide a foundation for conducting
economic experiments on what features attracts consumers. In essence,
introducing multiple versions of a product permits a company to experi-
ment and observe economic behavior in action. The company can monitor
purchase behavior and determine which features and products consumers
96 DEVELOPING NEW PRODUCTS AND SERVICES

deem most desirable. Such experimentation is actually the most effective

activity for conducting research and engaging in new product develop-
ment. This chapter presents several examples of how versioning is being
used for a variety of products and services.

Versioning Automobiles
Figure 5.1 illustrates a PD curve for Toyota cars that uses sales estimates
from 1 month projected to a year. This PD curve also illustrates that
demand curves are rarely linear and this is particularly true at the high
end and low end of the demand curve for Midas and Hermes versions.
It is difficult to obtain precise sales data and the graph should be used to
understand how Toyota differentiates their cars and not to illustrate actual
sales figures for the company. This is true in many of the graphs used in
the book. There are other products in the company’s lineup, but these
are their primary products for the Midas, Atlas, and Hermes customers.
Within each line, there is also product differentiation. Figure 5.2 illus-
trates the product price and product differentiation for the Camry line.
Toyota actually has another high-end product, the Lexus line. This line is
actually more luxurious than the Toyota Avalon model and appeals to indi-
viduals at the highest income levels. The PD curve in Figure 5.3 illustrates

$45,000

$40,000

$35,000 Avalon
$33,000+
$30,000
Price

Prius
$25,000 $23,000+
Camry
$20,000+
$20,000 Corolla
$16,000+
Yaris
$15,000 $13,000+

0 200,000 400,000 600,000 800,000 1,000,000

Units sold

Figure 5.1. PD curves for Toyota passenger cars.

 EXAMPLES OF PRODUCT DIFFERENTIATION 97

35,000
Camry XLE
30,000 $27,000+
Camry SE
25,000 $23,000+ Camry LE
Camry
$21,000+
$20,000+
20,000
Price

15,000

10,000

5000

0
0 Q1 Q2 Q3 Q4
Quantity

Figure 5.2. PD curve for Camry.

80,000
Lexus LS
70,000 $66,000+

60,000 Lexus GS
46,000+
50,000
Lexus ES
Price

40,000 $36,000+ Lexus IS

$32,000+
30,000

20,000

10,000
0
Q1 Q2 Q3 Q4
Quantity

Figure 5.3. PD curve for Lexus sedan.

that there is also Midas, Atlas, and Hermes versions for the Lexus sedans.
The width of the Lexus ES quantity reflects the fact that the ES sedan
dominates Lexus sedan sales. The top of the line for the Lexus sedans can
be found in the hybrid cars. The Lexus hybrids start around $45,000 and
scale all the way up to around $120,000 for a fully loaded LS hybrid.
98 DEVELOPING NEW PRODUCTS AND SERVICES

Hydrogen fuel cell &

pure electric motor
$$$

Midas
Hybrid: combution & electric motors
Average price

$$

Atlas
Combustion engines

$
Hermes

Q1 Q2 Q3
Quantity

Figure 5.4. PD curve for engine technologies.

Motor technologies can also be placed on PD curves. Figure 5.4

illustrates that combustion engines are at this time occupying the lower
end of a PD curve. However, the hybrid cars that involve both inter-
nal combustion and electrical components are emerging as mass-appeal
technologies. The hydrogen fuel cell autos and pure electric cars occupy
the high end of the PD curve.

Versioning at Dell
Dynamic differentiation is the ability to sell personalized closely related,
but not identical products to consumers. In a perfectly competitive mar-
ket, there are a large number of knowledgeable sellers selling a standard-
ized product to a large number of knowledgeable consumers. In such a
market, product and price differentiation is difficult, if not impossible. In
such a market, it is also impossible to extract any additional money from
such consumers even if you can identify how much each consumer is
willing-to-pay. That is why businesses turn toward product differentiation
and the monopolistic competition model. As noted before, over 99% of
the approximately 23+ million businesses are involved in monopolistic
competition.1 The king of monopolistic competition is certainly L’Enfant
terrible Michael Dell and his creation, Dell.com.
 EXAMPLES OF PRODUCT DIFFERENTIATION 99

Michael Dell started out with three guiding principles:

1. Always listen to the customer.

2. Never sell indirectly.
3. Disdain inventory.

It appears that always listen to the customer is the driving force behind
his model, but in reality, never selling indirectly is the engine behind the
Dell model. Dell believes that the best way to listen to his customers is
watch the customer select from a menu of system features and let the
customer tell them what they value. This is the epitome of dynamic dif-
ferentiation. By selling directly, Dell is very close to the customer and Dell
can constantly adapt to subtle shifts and changes in customer preferences.
Because they know what features are in greatest demand, they can move
them to the high-end products. It is indeed manipulation, and a way to
extract consumer surplus. And as an added benefit, Dell can carry very
little inventory because they are listening to their customers and building
the systems as the orders arrive.
Dell has of course adapted its model and has put more emphasis on
listeneing to their customers. They are now selling products indirectly in
the USA, in China, and all over the world. This is, in part, because PCs
and laptops are becoming commodity products and less differentiable,
but also because Dell has been listening to their current and potential cus-
tomers. Some of them want the instant gratification of buying and taking
it home today and some of them want to touch and feel before they buy.

Dell’s Migration and Evolution

At one time, Dell was more-or-less a pure pull company, just like Amazon.
com. Much of their entire production system was driven by actual orders
from customers. Part of their production process has also pushed prod-
ucts to consumers, but they are on balance a pull process company. They
have been drawn toward the dark side and push production because of
the demands of the marketplace. In a push production process, orders
are forecasted and some products are scheduled for production based on
forecasts and retailer demand rather than end-consumer. This change in
100 DEVELOPING NEW PRODUCTS AND SERVICES

9000

8000

7000

6000

XP
Dell offers numerous

Sa
desktop versions

lie
5000

nw
between $300
Price

are
and $8,000+

ga
m
4000

in
g
XP
Sp
3000

er
fo
r m
2000

an
ce
In
1000
sp
iro
n

0
Quantity

Figure 5.5. Differentiation at Dell.

attitude toward selling directly also coincides with Dell’s move to sell off
their manufacturing units. They are attempting to alleviate the risk inher-
ent in manufacturing products before customers order them. The risk is
of course excess inventory and Dell disdains inventory. After Dell sells
their manufacturing facilities, their systems suppliers will then absorb
some of the risk of carrying excess and outdated inventory.
Dell, because of its direct selling and the ability to install numerous
features, is a prime example of dynamic differentiation. They offer liter-
ally thousands of different product configurations or versions. As illus-
trated in Figure 5.5, Dell has feature points over a broad range of prices
(these statistics approximate Dell’s line in 2011).

Versioning at Microsoft2
Microsoft over the past couple of years has jumped on the price discrimi-
nation bandwagon. It was difficult for them to engage in product and price
differentiation because they were generating piles of cash as a monopoly.
Microsoft is a monopolist in the operating systems arena and with their
 EXAMPLES OF PRODUCT DIFFERENTIATION 101

office suite of applications. The marginal cost to produce incremental

levels of software and other information goods, such as DVDs and music,
is essentially zero. But as usual, the fixed costs are substantial, and because
Microsoft is a price setter, they chose to sell at a price that covers their
fixed costs but still permits them to make a large profit without irritating
too many consumers.
For many years, Microsoft was not interested in price discrimination
based on geography, market segment, or per capita GDP. But Microsoft
had to move toward price discrimination because the willingness-to-
pay for software was related to software piracy. Students and individuals
with low incomes are price-sensitive and will simply turn to piracy when
the price exceeds their willingness-to-pay. They also had to offer certain
market segments lower prices because piracy was essentially rampant.
Microsoft began to realize that they were leaving money on the table
because they did not take dramatic steps to price discriminate through
product differentiation. They have, in general, avoided unwanted atten-
tion by the FTC by attempting to follow the three guidelines outlined
in chapter 2.
Sometimes product differentiation does not work.3 Microsoft tried to
differentiate the Vista operating system (see the snap shot of Windows 7
and Vista Versioning in Figure 5.6). But Vista never gained legs for a vari-
ety of technical, customer support and marketing reasons. The product
was not ready for prime time. They continued to product differentiate
and price discriminate with the release of Windows 7. Home Premium
was priced at $199.99, Professional at $299.99, and Ultimate at $319.99.
They definitely used the Goldilocks versioning. It appears that Windows
7 was a success because it was a stable, fast, and friendly operating system.
Of late, Microsoft has also had to contend with Google’s foray into
the online office application suite called Google Docs and IBM’s offer-
ing of open-sourced Linux-based applications. The competition is heat-
ing up and the Microsoft monopoly is under attack on many fronts.
Monopolies are often transitory as the competition looks for a crack in
the armor and a chance to drink from the fountain of plenty. The growth
of cloud computing (where data storage and CPU cycles move toward
the utility model) and the availability of net-centric applications could
continue to erode Microsoft’s market share. They have, however, started
102 DEVELOPING NEW PRODUCTS AND SERVICES

480
440 Windows 7 ultimate $319 Windows 7 professional $299
Vista ultimate $319 Vista business $299
400
Vista home premium $259
360
Windows 7 home premium $199
320 Vista home basic $199
Average price

280
240
200
160
120
80
40
0
Q1 Q2 Q3
Quantity

Figure 5.6. Windows 7 and Vista product differentiation.

to address the attack by introducing a cloud-based Office 365 and the

Azure development platform.

Versioning Wireless Communications

The most important activity in the history of humankind has been in
the area of communications. As illustrated in Figure 5.7, the desire to
communicate has been the driving force behind most of the advances
in modern technology. The wireless phone is the current battle ground
for the universal communication device that will be used for talking,
texting and tagging friends and colleagues, scheduling, listening to
music, reading eBooks, and in location assistance. Apple and Nokia’s
strategies are distinctly different. Apple has gone after the cream and
focused on the high end, competes primarily in the smartphone arena,
and is also beginning to compete with the net-book laptops. Smart-
phones have applications such as scheduling, location assistance, email,
and Internet access.
Nokia is not only interested in the high-end smartphone market, but
they are also selling to the price-sensitive demographic and have an even
bigger target in their sight. They want to become the biggest entertainment
 EXAMPLES OF PRODUCT DIFFERENTIATION 103

Couriers
Smoke
and light Mail
signals routes

Talking Complements Wagons

Language, straw, wood,

shoes, bags, horse care,
inns, diners, road
materials, construction,
energy sources, phones,
Photon Pony
movies, storage,
& Laser express
computers, TV, Email,
PDAs, GPS, Internet …

Autos &
Satellite
trucks

Wireless Wire

Figure 5.7. Communication drives innovation.

media network in the world.4 They are trying to reach the entire market
by using research and development (they have numerous research labora-
tories throughout the world) and by pursuing a comprehensive differen-
tiation strategy. Nokia offers devices to satisfy every budget and they are
trying to make their products and services indispensable. They have, how-
ever, been under an intense attack by Apple and Android-based phones.
Android-based phones are very versatile and there are numerous models
available at many price points.
Figure 5.8 illustrates a PD curve for several cell phone devices. Apple
and Android-based phones have been making steady gains in the smart-
phone business. Apple has been willing to offer a downscaled version of
the iPod to the price-sensitive masses with the Nano and Shuffle. We sus-
pect that iPhone technology will be adapted to the price-sensitive tail of
the demand curve because of the competitive pressure of Android-based
phones.
104 DEVELOPING NEW PRODUCTS AND SERVICES

800

700

600

Br
500 H
i A n oad
Ri h-g d r -ba
Price

m en o i d sed
Bl d d - b a di
400 ac if sed ffe
kb fer
er en
r y ti & rent
& ati No iat
iP on k i a on
300 ho
ne

200

100

0
Quantity

Figure 5.8. Broad-based versus high-end differentiation strategies for

cell phone devices.

How Wireless Companies Compete on Price: Hide the True Price

One way to compete on price is to make it difficult for the consumer to

know the true price of the product. Companies sometimes use differen-
tiation to hide the true cost of purchasing products and services. Many
companies accomplish this task by offering very complex pricing and
bundling plans (numerous versions). Wireless service and long-distance
providers have become very good at this strategy. These providers rarely
offer simple plans such as 5 cents per minute for a certain level of usage or
3 cents per minute for a certain level of usage. Instead, they offer custom-
er’s very complex pricing schemes and service bundles that are difficult to
disentangle. This helps these providers as well as providers of cable and
Internet services to reduce the damage of price competition. Consumers
have to engage in a large amount of price and feature comparisons in
order to understand the features provided in the tableau of products and
 EXAMPLES OF PRODUCT DIFFERENTIATION 105

services. This is essentially a form of product differentiation but it is more

precisely service differentiation.

Versioning at Apple
Because Apple had such a strong brand and was very successful, they were
able to secure part of the ongoing revenue stream that AT&T received as a
wireless carrier. The success of the iPhone resulted in extreme demands on
the AT&T network and this led to the introduction of a pay-for-level-of-use
program in the middle of 2010 when the Apple iPhone 4 was introduced.
One objective of the service differentiation plans was to reduce network
traffic, but it also gave Apple and AT&T the ability to extract more revenue
from their existing customer base and to attract new more price-sensitive
customers. The original data plan was $30 with no restrictions on the
amount of data streamed. Under the new pricing structure, customers with
deep pockets and less sensitive willingness-to-pay functions would readily
pay $25 for 2 gigabytes of streaming and $10 for each additional giga-
byte. Apple has recently introduced new iPhones at substantially reduced
prices than their earlier launches. The iPhone models entered in at what we
view as Atlas levels of $199 and $299. Apple also revamped their data plan
to capture some Hermes-level customers by introducing a revamped data
plan. The new low-end plan was $15 and this included 200 megabytes of

60
55 $55 4GB

50
$45 3GB
45
40
35 $35 2GB
Price

30
$25 1GB
25
20
$15 250MB
15
10
5
0
Quantity

Figure 5.9. iPhone 4 data stream plans.

106 DEVELOPING NEW PRODUCTS AND SERVICES

streamed data for more price-sensitive customers. These plans will of course
evolve as Apple and AT&T conduct further competitive experiments on
the right combination of phones and data plans. Figure 5.9 illustrates the
service differentiation curve for the data plans.

Versioning e-Books
One particularly interesting area of competition is in the e-book arena.
The Amazon Kindle started out very strong and looked like a strong con-
tender to capture the market for electronic books. Apple founder Steve
Jobs was not impressed and stated, “It doesn’t matter how good or bad the
product is, the fact is that people don’t read anymore.”5 Well he did release
an e-book reader, the iPad, that also had additional functionality. Amazon
responded by releasing three Kindle versions and by developing an iPad
app for downloading and buying books from Amazon. Figures 5.10
and 5.11 illustrate PD curves for the iPad and Kindle, respectively. It is
apparent that the Apple has taken great pains to develop versions for a
wide range of individuals with differing price sensitivities at the high end.

$829 64GB + 3G
800

$729 32GB + 3G
$699 64GB
700
Price

$629 16GB + 3G

600 $599 32GB

$499 16GB
500

400
Quantity

Figure 5.10. iPad differentiation.

 EXAMPLES OF PRODUCT DIFFERENTIATION 107

450

400 $379 Kindle DX: 10" screen, 3G, & WiFi

350

300

250
Price

200 $189 Kindle 3G: 6" screen, 3G & WiFi

150 $139 Kindle 6" screen WiFi only

100

50

0
Quantity

Figure 5.11. Differentiating the Kindle.

Versioning Digital Content

AOL Time Warner lost over $98 billion in 2002. This happened after
AOL had purchased Time Warner for $106 billion in 2001.6 The Time
Warner content was supposed to propel AOL, the king of distribution,
to the next level. Differentiating content and getting people to pay for
the content is one of the most difficult problems facing many compa-
nies including newspaper and magazines publishers. As illustrated in
Figure 5.12, it is possible to differentiate content, but it is still difficult
to get the consumer to pay for digital content. Many consumers simply
do not want to pay for the content because much of the content on the
Web was free in the past and even when it was not free, it could be read
indirectly by creative searching and by pirating.
One way to make all contents desirable is to deliver the content
faster and more conveniently than any other business. This can, in some
instances, change the demand curve and increase the amount consumers
are willing-to-pay for a content version. One way this is being tested is
through the use of tablet computers such as the iPad or the Kindle. Deliv-
ering content faster and more conveniently than the competition ampli-
fies the value of the content, even aggregated and repackaged content.
One of the challenges of providing content is to develop versions for
mobile devices, for traditional Web browsing, and for print media.
108 DEVELOPING NEW PRODUCTS AND SERVICES

Develop one-of-a-kind content that is customized

for a particular customer. Assign expert/analyst to customer.
P3

Midas Develop or acquire unique content using writers,

bloggers, journalists, analysts and experts
and let customers select the relevant content.

P2
Price

Consolidate, aggregate and

repackage inexpensive content.
Atlas

P1

Hermes

Q1 Q2 Q3
Quantity

Figure 5.12. Digital content differentiation strategies.

Content has to be written so that it can be used simultaneously for perusal

on a mobile device, on the Web, and in traditional print media.7 The key
is to have different versions of content available that do not cannibalize
each other. Headlines can effectively make-or-break a business model.
For example, a headline received from a mobile phone should not only
be interesting enough so that it is passed on to others, but also tweak the
interest of the reader so that they will turn to more in-depth content on
the Web or in print. If it provides too much information, then the reader
will be satisfied and will not look toward other media outlets. Versioning
via the type of media outlet is critical to the survival of content providers.
Content needs to be carefully crafted in terms of its length and the infor-
mation provided so that it conveys some information, but not too much;
yet it has to be compelling so that it entices the consumer to delve into
other outlets. This is the essence of the versioning process.

Versioning Digital Entertainment

The primary characteristic of entertainment and media content is that the
fixed costs for development are very high and the variable costs for repro-
ducing digital movies, video game software, television programs, elec-
tronic books, and music are very low. The key is to find ways to sell at low
price levels for those individuals who are price-sensitive and to capture
 EXAMPLES OF PRODUCT DIFFERENTIATION 109

some of the consumers’ surplus from customers who are price-insensitive.

Movies are typically consumed only once and it is important to try to
meet demand when there is a lot of hype around the release. In the case of
movie releases, this is accomplished by charging more for movies attended
in the first 3 or 4 weeks of introduction at theaters, charging less when
they are released on pay-per-view, and even less when they are rented on
DVD. Consumers who want the movie for a repeat view will pay a price
that is usually above the price of attending the movie at a theater.
Video game publishers have found a unique way of differentiating their
product on launch day by offering unique packaging and complementary
items that are useful to game play and other items that are collectibles.
These bundles amplify the consumer’s feelings of game uniqueness, but
in reality the game is essentially the same. Microsoft used this strategy
when they released Halo Reach. The standard game was sold for $59.99
and essentially just came with a disc and brief manual. The limited edi-
tion cost consumers $79.99 and the Legendary edition cost $139.99.
They were packaged differently and they also contained supplementary
materials, such as journals, unique armor that could be downloaded and
worn during battles, and statues of the virtual team members who sup-
port the game players during battles. The game was a resounding success,
and sales on the first day were estimated to be in excess of $200 million.
Soon after the launch, the $139.99 legendary version was discounted to

160 $139.99 legendary edition

special disc housing, artifact bag, map, patch,
xBox live trial, journal & large statue of characters
140

120

$79.99 limited edition

Price

100
special disc housing, artifact bag,
special armor skin, map & patch
80
$59.99 standard edition
disc with brief user manual
60

40

20
Quantity

Figure 5.13. Product differentiation for the Halo Reach game.

110 DEVELOPING NEW PRODUCTS AND SERVICES

$99.99. This illustrates that even a successful product can be overver-

sioned and overpriced. Consumer behavior on the upper (Midas area)
and lower (Hermes area) parts of the demand curve is difficult to pre-
dict. There is a large measure of demand uncertainty at the extremes of
the demand curve. Consumers expect prices to be in a certain range and
when they are not, it is difficult to predict the demand. Figure 5.13 pre-
sents a product differentiation graph for Halo Reach on launch day.

Versioning Disease Treatments

According to the American Cancer Society, the estimated number of new
cancer cases in 2010 was over 1.5 million.8 One of my classes recently ana-
lyzed a case involving NovaCure, a company that developed a promising
approach for treating cancer.9 NovaCure developed a technique to disrupt
cancer cell division using electromagnetic waves, called Tumor Treating
Fields. Early clinical trials suggest that when the Tumor Treating Fields
are used in conjunction with chemotherapy, the survival time of glioblas-
toma patients improves significantly. NovaCure estimates that the therapy
might be suitable for treating 200,000 different types of cancers including
brain tumors, head and neck tumors, presurgical breast treatment, nons-
mall lung cancer, and pancreatic cancer. Since the NovaCure approach is
not a drug, but a medical device, the approval process is abbreviated, but it
is still extensive and expensive. The question raised during the case analyses
was whether versioning could be applied to treating diseases?10 The total
expenditures for life sciences’ R&D in the USA in 2010 were over $59
billion and over $133 billion globally.11 Life sciences include pharmaceuti-
cals, medical devices and equipment, and biotechnology. The approval of
pharmaceuticals and medical treatments and the accompanying R&D can
exceed hundreds of millions of dollars. Versioning can even help solve the
difficult problem of covering costs of developing expensive treatments for
diseases and treating a substantial number of patients.
Figure 5.14 illustrates a hypothetical demand curve for a hypotheti-
cal treatment for a hypothetical cancer that affects 200,000 individuals a
year. The made-up variable costs for treating the cancer were set at $4,000.
This is the base or minimum variable cost. As illustrated in Figure 5.14,
if the company only sold one version at $35,000 per month, they would
 EXAMPLES OF PRODUCT DIFFERENTIATION 111

36,000

32,000 Offering only one version at $35,000/month

about 11,000 patients treated with a net profit of $341M
28,000

24,000
Monthly fee

Offering only one version at $15,000/month

20,000
about 49,000 patients treated with a net profit of $539M
16,000

12,000 $4,000 variable cost per month

8000 Offering only one version at $2,000/month

about 140,000 patients treated net loss -$280M
4000

0
0 30,000 60,000 90,000 120,000 150,000 180,000 220,000
Patients treated

Figure 5.14. Net profits when only one version of the treatment is
offered.

net $341 million per month. If they sell only the Atlas version at $15,000
per month, they would net $539 million per month. If they sell the Hermes
version at $2,000 per month, they would lose $280 million per month.
The first thing that has to be dealt with is that there are two
conflicting goals. The drug and medical devices community want to
cover the cost of development and eventually makes a profit. The goal
of patients, doctors and some policy makers is to cure as many people
as possible. This situation also illustrates that there is a difference in the
willingness-to-pay and the ability-to-pay. In most situations, consum-
ers are engaged in a never-ending calculus involving how much money
they have to spend and how they want to allocate their money. These
calculations are hidden, yet ongoing, and always involve trade-offs
related to wants and desires and the consumers’ willingness-to-pay for
a product or service. When there are decisions related to sustaining life,
the life-sustaining trade-off dominates. There is a mismatch between
the willingness-to-pay and the ability-to-pay. Versioning can help.
Figure 5.15 illustrates how a hypothetical drug or medical device com-
pany could make a nice profit by versioning the cancer treatment and also
treat 70% of the patients having the disease. The company could just offer
one version of the product and net $539 million and treat 49,000 patients,
112 DEVELOPING NEW PRODUCTS AND SERVICES

36,000 Offering Midas version at $35,000/month

about 11,000 patients treated
32,000 variable costs of $16,000
net pro t for Midas version $209M
28,000
Total net profit with 3 versions = $293M
Total patients treated = 140,000
24,000
Monthly fee

20,000 Offering Atlas version at $15,000/month

about 38,000 patients treated
variable cost of $8,000
16,000 net proft for atlas version $266M
12,000 $4,000 variable cost per month for treatment (minimum)

8000 Offering Hermes version at $2,000/month

about 91,000 patients treated
4000 net loss for Hermes version -$182M

0
0 30,000 60,000 90,000 120,000 150,000 180,000 220,000
Patients treated

Figure 5.15. Net profit when three treatment versions are offered.

or offer three versions and net $239 million and treat 140,000 patients.
This should cover the fixed costs of product development. The actual imple-
mentation of versioning would of course be subject to a variety of inputs
and serious dialog involving the public, the drug and medical device com-
panies, insurance companies, the health care community, economists, pol-
icy makers, and politicians. And of course arbitrage would have to be dealt
with. Some sort of mechanism would have to be in place to prevent the
purchase of a Hermes treatment and selling it in the Midas market. As we
have demonstrated throughout this book, versioning is a keystone founda-
tion of the current competitive marketplace. Versioning has the potential to
bring beneficial medical products and services to a broader base of individu-
als suffering from serious diseases. It will just take a concerted effort on the
part of the various constituencies to develop a versioning solution.

Conclusion
In this chapter, we have illustrated a variety of product differentiation and
versioning strategies that have been used by businesses. The key points are
the following:

• Versioning concepts can be applied to products and services,

including new product development, enhancements, digital
 EXAMPLES OF PRODUCT DIFFERENTIATION 113

content, and medical services and devices, and to emerging

technologies.
• Some companies focus on versioning at the high end where
consumers are less price-sensitive. Some businesses try to offer
products across the entire demand curve from price-sensitive
Hermes consumers through less price-sensitive Midas con-
sumers.
• Versioning can be applied in a variety of ways including new
product development, adding and subtracting features, offering
complementary products, and packaging and marketing.
• Versioning also has the potential to be used in delivering
medical treatments to a greater number of individuals
suffering from serious diseases.

This chapter has illustrated the various ways firms have used to differ-
entiate their products and services in order to compete effectively in con-
temporary markets. There are three general categories for differentiation.
They are the high-end Midas products and services, the mass-appeal Atlas
products and services, and the low-end Hermes products and services.
There are identifiable revenue benefits for using a product differentiation
strategy, but there are also R&D implications. As noted earlier, offering
several products permits a company to conduct economic experiments
that will help delineate trends in the marketplace and to actually create
new markets.
 CHAPTER 6

Facilitating Creativity
and Innovation
The engines behind research and development are creativity and inno-
vation. Creativity is typically defined as the ability to generate ideas.
Creativity is actually a subset of innovation and refers primarily to the
process of idea generation. Innovations are defined more narrowly as the
ideas, the products, the services, and processes that (a) are perceived as
being new and different and (b) have been designed, built, and commer-
cialized. Innovation thus includes both creative idea generation and the
actual implementation of the idea.1 An invention is an innovation that
is not ready for prime time. Inventions are ideas that have been built or
conceptualized, but not widely used and available and usually not com-
mercialized.
Creativity is the force behind innovation and invention. Creativity
has been studied for many years and a variety of models and insights have
been developed in order to understand and facilitate the creative process.
Figure 6.1 illustrates an updated five-phase model of the creative pro-
cess that incorporates problem solving, leaning-about, and the learning-
by-doing concepts.2 Here are the details of the model:

Trigger. This is the problem or opportunity that initiates the creative

process. The trigger could occur at home, work, play, or while traveling.
Learn-about activity. This involves searching for information and syn-
thesizing that information. It also involves struggling to understand the
information and the creation of new knowledge by analyzing the prob-
lem or opportunity. The learning-about activities include reading books
and magazines; one-on-one dialog with colleagues and knowledgeable
individuals; looking at competitor offerings; interaction with suppliers,
116 DEVELOPING NEW PRODUCTS AND SERVICES

Trigger
Problem or opportunity

Development of Learn-about
know-how Search, synthesize
Integrate insight and and analyze problem
knowledge or opportunity

Learn-by-doing Incubate
Design, develop and Contemplate and
build product, system discuss problem or
or service opportunity

Figure 6.1. Creative problem solving and the creative star model.

customers, universities and research institutes; and attending courses,

trade shows, symposia, and conferences.
Incubate. Incubation gives the mind time to work on the problem in the
background. This not only involves contemplation, but also involves
engaging in one-to-one dialog with family, friends, and colleagues on the
problem or opportunity.
Learn-by-doing. This involves designing and constructing a solution to the
problem or opportunity. It also involves designing and building a proto-
type, modeling with diagrams, drawing pictures, developing flowcharts,
drawing digital or CAD diagrams in 2D or 3D CAD, conducting simu-
lation, identifying system specifications, developing system mock-ups,
developing business plans, and even the use of narratives. Designing and
constructing might include very rough diagrams or developing mock-up
pictures of the product or service by using sketching, drawing software,
photo software, or presentation software. If the product is a software,
then a mock-up screen can be designed by using a word processor, pres-
entation software, or mock-up software. If the idea behind the product or
service involves a complex process or business process, then flow diagrams
 FACILITATING CREATIVITY AND INNOVATION 117

can be constructed or a business process diagram can be developed with

presentation software or specialized flowchart and business process dia-
gramming software.
Development of know-how. This is the expertise, skill, and knowledge that
can be used to produce a product or service.3 It is the outcome of the crea-
tive process that can be used to provide insight and to build and construct
products, services, and business processes. It is the applied and practical
knowledge that can be used to make the product or service. In start-ups
and small organizations, this knowledge is in the minds of the owner,
management and staff, and developers. The knowledge may be codified in
lists or in what we refer to as Knowledge Books. These Knowledge Books
can be maintained on tablets and spiral notebooks and in computer files.
They can contain the following information:

• Descriptions of procedures for providing services and

products
• Descriptions of what organization is good at and what it is
not so good at
• Job descriptions and links to individuals with certain expertise
• Descriptions of how business processes and tasks are
completed.

The Creative Process is Inherently Nonlinear

As illustrated in Figure 6.1, the process is iterative and not always linear.
It is indeed a rare instance that creativity emerges through a simple linear
process. For example, leaning-by-doing can spur additional learning-
about activity and vice versa. This, in turn, can lead to a series of little
ahas that eventually translates into the big aha. The big aha is sometimes
referred to as illumination where a solution is found to the initial prob-
lem or opportunity identified in the beginning of the creative process.
This is similar to what Peter Sims refers to as investing in little bets.4
Investing in little bets leads to little ahas, which eventually lead to the
big aha.
Search is very important as we have seen in an earlier chapter, but
in the early stages of developing a solution for a problem or taking
118 DEVELOPING NEW PRODUCTS AND SERVICES

advantage of an opportunity, searching should be limited to a couple

of sources. Hal Varian, chief economist at Google and one of the most
insightful economists in this generation, details the following approach
for generating economic models.5

I think that you should look for your ideas outside the academic
journals … in newspapers, in magazines, in conversations, and
in TV and radio programs. When you read the newspaper, look
for the articles about economics … and then look at the ones
that aren’t about economics, because lots of the time they end
up being about economics too. Magazines are usually better
than newspapers because they go into issues in more depth.…
Conversations, especially with people in business, are often
very fruitful.… In many cases your ideas can come from your
own life and experiences…. However, my advice is to wait a bit
before you look at the literature. Eventually you should do a
thorough literature review, of course, but I think that you will
do much better if you work on your idea for a few weeks before
doing a systematic literature search. There are several reasons
for delay.

First, you need the practice of developing a model. Even if you

end up reproducing exactly something that is in the literature
already you will have learned a lot by doing it … and you can
feel awfully good about yourself for developing a publishable idea!
(Even if you didn’t get to publish it yourself …)

Second, you might come up with a different approach than is

found in the literature. If you look at what someone else did your
thoughts will be shaped too much by their views … you are much
more likely to be original if you plunge right in and try to develop
your own insights.

Third, your ideas need time to incubate, so you want to start mod-
eling as early as possible. When you read what others have done
their ideas can interact with yours and, hopefully, produce some-
thing new and interesting.6
 FACILITATING CREATIVITY AND INNOVATION 119

The takeaway from this discussion is that the creative process is recursive
and iterative. For example, you can spend a little time on learning-about
by examining just a few magazines or talking to a few people and then go
to learning-by-doing after you let the idea season in the incubation phase.
Then, you might go back to the learn-about stage or even the trigger stage
as you begin to converge on a solution to the problem. The initial search
process should be limited to a few sources and then expanded in order to
take advantage of ideas that might have been missed in the early stages of
the creative process.

The Lonely Genius

A common theme that pervades the creativity literature is that creativ-
ity demands discourse, tension, dialog, and debate among the interested
parties.7 Creativity endeavors are driven by interaction, search, and soli-
tude. One of the most pervasive myths is the notion of the lone genius.
The lone genius is the individual who toils away in the confined small
room developing a grand theory and innovative ideas with little or no
interaction. In reality, many inventions and innovative ideas are derived
not in a vacuum of isolation, but rather in a sea of collaboration that is
countered with periods of solitude and incubation. The prototypical lone
genius is Albert Einstein. Einstein worked as a patent examiner during
the time that he developed his ideas on relativity and theoretical phys-
ics. Einstein did not develop his ideas in solitude. His knowledge was
based on intellectual foundations including his university studies, con-
temporary research papers of his time, and patent applications he viewed
at the patent office. There is also evidence that he drew extensively on
his academic contemporaries including Marcell Grossman (a classmate),
Michele Besso (a friend at the patent office), and Mileva Einstein (his
first wife) as sounding boards for his ideas.8 The point is that anyone can
become a wizard of ahas if they engage in serious learning-about and
learning-by-doing with a pinch of collaboration and dialog. Curiosity and
questioning are central to the success of creativity.9 We are assuming that
curiosity and questioning have not been completely driven out of the
creative DNA that is hardwired in all humans.
120 DEVELOPING NEW PRODUCTS AND SERVICES

The Habits of Successful Entrepreneurs

Creativity, as we have suggested earlier, can be learned. Dyer, Gregersen,
and Christensen investigated the habits of 25 successful innovative entre-
preneurs (e.g., Steve Jobs, Jeff Bezos, etc.) over the course of a 6-year
study.10 Here is an overview of their findings related to entrepreneurs:

• They make unusual and unique associations and

combinations of processes, products, and technologies.
• They are good at asking questions related to the why, why
not, and what-ifs processes, products, and technologies.
• They like to observe and scrutinize processes, products, and
technologies.
• They are experimenters with processes, products, and
technologies.
• They are good at networking.

The authors of the study also note that these skills can be developed
through practice and by creating an environment conducive to their
development. The following section presents a series of steps that we have
identified to create an environment that fosters creativity.

Environmental Factors Affecting Creativity

and Innovation
Creativity, invention, and innovation are driven by a series of little ahas.11
When the little ahas are stitched together, they lead to innovative prod-
ucts, services, and business processes. Creative ideas are built on a tapestry
of other ideas and the little ahas are the basis for both incremental and
radical innovation.
Although innovation and creativity can emerge in a variety of set-
tings and situations, some environments are more conducive to the
creative process. In one large study, it was found that having a vision,
being task-oriented, and engaging in external communication had a
strong relationship to creativity and innovation.12 The following section
presents the environmental factors that encourage the creative process.
 FACILITATING CREATIVITY AND INNOVATION 121

They are drawn from a variety of sources including Sawyer,13 Amabile,

Hadley, and Kramer,14 Goldenberg and Mazursky,15 and Nalebuff and
Ayres,16 and Michalko.17 The following environmental factors can facil-
itate the creativity and innovation in individuals, departments, and
organizations:

Need a shared mission that is focused on a single goal. Creative and intel-
lectual energy is not unlimited. If an individual or a group is working on
too many projects, then it is difficult to focus on one particular problem.
If the group has a shared mission, this will also lead to group cohesion and
further contribution to solving a problem.
Create an atmosphere that facilitates one-on-one collaboration. Group
meetings can sometimes provide focus and insight, and assist in bring-
ing focus to the team. It, however, is the one-on-one collaboration that
is most effective in fostering the little ahas and individual creativity. It
is like reciprocal tutoring. Through discussion and dialog, both indi-
viduals, the tutor and student, are better able to understand and grasp
their particular problem. This is true even when one individual has
more knowledge than the other. The teacher often learns more than the
student during discussions.
Promote risk-taking and permit failure. There are many paths in life that
can lead one astray. Sometimes we can avoid them by gathering additional
information, but many times we cannot know that a path is a dead end or
is too roundabout until we travel the path. Risk-taking should be encour-
aged even when the risks are daunting. The road less traveled may be the
right path. The idea of learning by making mistakes is the essential part
of the learn-by-doing approach. Consider Steve Jobs. He is the prototypi-
cal example of failure leading to success. The path to success was fraught
with disappointments including the Apple Lisa, the Power Mac G4 Cube,
NeXT computers, and perhaps Apple TV. Counter these failures with the
iPad one of the most successful technologies ever released.

Experimentation not only invariably involves some level of failure, but

also leads to understanding and insight into what works. As illustrated in
a later chapter, investing in a variety of projects diversifies risk and pro-
vides opportunities for the future. Making the right investment decision
122 DEVELOPING NEW PRODUCTS AND SERVICES

on the right projects and the right products is a combination of having

the right information, intuition, and luck by learning-by-doing. Steve
Jobs (Apple) and Jeff Bezos (Amazon) intuitively or explicitly invested in
real options by exploring the applicability of emerging technologies to
create unique products and services.

Allocate quiet time and solitude in order to help individuals think inside
the box. There are some creative people who have a special place to go
when they want to solve a problem. Quiet time and solitude are essential
for the creative process and generating the little ahas. Quiet time can be
in an office, in a special room, inside a refrigerator box, during an evening
run, on the treadmill, in bed, or in the shower. Isolation and quiet time
facilitate the creative process. The first thing solitude does is to help us
focus on the problem. Even if you are not focused on the problem during
quiet time, the mind works in the background reorganizing knowledge
and ideas to help solve a problem. For many people, the best time for
solitude and creative work is during the first 2 or 3 hours in the morning.
I call these hours the Golden Hours. The mind has spent the previous
8 hours organizing knowledge and is primed for problem solving and
insight. There is some evidence that artists have their Golden Hours after
10 pm.18 These so-called Night Owl Learners seek the cover of night and
solitude to produce their creative endeavors.
Make things by developing prototypes and experimenting. A prototype is a
real, workable, and quasi-usable system built economically and quickly
with the intention of being modified. As noted earlier, a key strategy for
sparking creative activity is the learn-by-doing process. Learning by doing
means that you make and build things, try experiments, and construct
prototypes. Prototypes can be built for products and services, including
software. A prototype is essential for learning about what you are trying
to invent and also for illustrating proof of concept. The prototype is part
of a continuous ongoing process of experimentation and review. If you
need to write something or develop something that is artistically creative,
then the same advice applies. The initial writing, photograph, painting,
or sculpture is the prototype. The mantra of those involved in creative
pursuits should be Prototype or Perish or Build or Bust.
 FACILITATING CREATIVITY AND INNOVATION 123

Anyone can be creative. Half of the battle of being creative is convincing

yourself and others that anyone can be creative. I sometimes hear friends
and students say that they are not creative. Anyone can be creative; it just
involves applying all of the following strategies:

• Have a mission and focusing on a single goal

• Need one-on-one collaboration
• Take risks and permit failure
• Need quiet time and solitude
• Need to prototype and experiment
• Work hard

In an ideal world, management would be responsible for creating an

environment that is conducive to creativity. In reality, it is the individual’s
responsibility to create such an environment by balancing time at work,
at play, and at home that will match the desired level of creative activity.
Everyone needs a bit of aha in his or her life.

How to Hinder Creativity

The first way to hinder creativity is to reduce thinking time and try to
eliminate solitude. Management can accomplish this in six easy steps:

1. Schedule many meetings. In addition to weekly project meetings,

schedule daily meetings to solve all kinds of problems and to show
off what has been accomplished.
2. Have each team member account for all of his or her time in detail.
3. Tell people not to talk to each other about their tasks.
4. Interrupt individuals whenever possible. Give team members new
tasks to accomplish. If problems arise on other projects, then send
them over to help out.
5. Change the product specifications and put in new features at the last
minute.
6. Have the team members stay at work 12 hours per day and have
them work on weekends.
124 DEVELOPING NEW PRODUCTS AND SERVICES

Lack of time and interruptions are enemies of the creative process.

Creativity is diminished when individuals are under-the-gun and the
workdays are fragmented with many meetings, with busy work and inter-
ruptions.19 Creativity is not very efficient. It takes time to understand a
problem and to develop ideas.

Embrace Some Adversity and Avoid

Chronic Stress
There is some indirect evidence that some adversity can make you
stronger. Researchers such as Mark Seery, Alison Holman, and Roxanne
Cohan Silver found that a certain level of exposure to adverse life events
resulted in better mental health and well-being outcomes.20 They found
that a history of lifetime adversity, in contrast to low and high levels of
adversity, was related to lower global distress, lower levels of functional
impairment, less post-traumatic stress, and high levels of satisfaction. Yes,
some levels of adversity can make us feel better.
Chronic stress, however, can have a negative influence on health,
the immune system, cognitive performance, learning, memory, and
brain development in general.21 When the brain detects some sort
of threat, it releases hormones that are used to cope with the threat
and the body goes into a fight-or-flight response. Extended or chronic
exposure to these hormones and the fight-or-flight arousal state can
significantly impair health and cognitive functions and, by extension,
the creative process. The bottom line is that a little adversity might be
ok; but if the adversity leads to chronic stress, then it will damage the
individual.

Creativity Techniques
The effectiveness of creativity techniques is unclear. This section presents
several techniques that have been used to foster the creative process. They
are essentially problem-solving strategies for generating new ideas for
product and services. This section is a compendium of ideas from a vari-
ety of places. You are encouraged to look at the various books that are
available for additional insight into the approaches.22
 FACILITATING CREATIVITY AND INNOVATION 125

Challenge Assumptions by Recombining, Adding, Deleting,

or Changing Product Features

Assumptions about how a product should look and perform create intel-
lectual boundaries. As noted by Michalko,23 they become so ingrained that
they are never challenged. Flipping24 and reversing are techniques for chal-
lenging the assumptions. For example, it is assumed that delivered pizzas
should be cheap, hot, fast, and have standard toppings. How about cold,
slow, and nonstandard toppings? Cold pizza is not a good idea, but per-
haps expensive pizza, with slow delivery and gourmet ingredients, could
be a winner. The first thing to do in this approach is to list all the features
of a product, reverse the features, and then see what features make sense.
Other ideas where assumptions and product features have been
challenged include the following:

• Taking your car to the glass shop to have the window repaired
New assumption: The glass shop repairs the crack in the car
window at your work.
• High-resolution expensive camcorder with many features
New assumption: The popular Flip Mino was a
low-resolution inexpensive camera with very few features. It
was popular at one time because it could easily upload files
to the Internet.
• Use global positioning system to get you to a location
New assumption: Give other people your location and let
them find you or come to you.
• Putting condiments in glass bottles
New assumption: Flipping by putting condiments in plastic
and turn them upside down (ketchup).
• Have spaghetti tonight, chili tomorrow, and macaroni and
cheese the next day
New assumption: Have Cincinnati City chili tonight. It
includes spaghetti, chili, onions and lots of cheese.

Social networking Web sites have championed the idea of combing ser-
vices in new ways (often referred to as mashups). For example, Facebook
126 DEVELOPING NEW PRODUCTS AND SERVICES

combines blogging, photo sharing, marketing, and instant messaging.

Twitter has combined text messaging, mini-blogging, instant news, cus-
tomer tracking, and paparazzi activities in one simple yet powerful system.
All in one printers, multipurpose stadiums and Kansas City Chili are addi-
tional examples of how simple ideas can be combined into useful products.

Idea Arbitrage: Steal Ideas and Products From Someone Else

Taking ideas from others is idea arbitrage.25 If the idea is not patented or
copyrighted, it will be copied. And even if it is copyrighted or patented,
it will probably still be copied.26 Legal searching for ideas can come from
a variety of sources including basic science journals, the popular press,
conferences, and trade associations. As noted earlier, innovation benefits
from search. And usually, the more sources you search, the better (this is
probably true up to about 11 outside sources). The ideas can also come
from other countries and cultures. There is a Web site in China called
AliBaba.com where there are literally thousands of products that have
never been seen in the West. With idea arbitrage, the goal should be to
steal the gem and not the entire crown. Take the best ideas and combine
them in order to differentiate your products from the competition.
One interesting application of the idea arbitrage is Etsy.com. Etsy is
an online store that provides a market for crafts and handmade items. It
has drawn on ideas from both Amazon and eBay and has recently begun
to encroach on both eBay’s and Amazon’s market. It is a superb example
of a monopolistic competition marketplace, where product differentia-
tion rules the day.

Midas Approach: Product and Services Developed

with Unlimited Resources

The idea behind this approach is that you can generate ideas for solving
problems by throwing money at the problem.27 The problems are the
headaches. Even though contemporary life in the USA is pretty much
headache free, by 18th-century standards, there are numerous instances
where products and services are being developed to relieve irritations.
 FACILITATING CREATIVITY AND INNOVATION 127

For example, if you have a problem with technical support, then have a
technical guru sit outside the door until you call for his or her expertise.
Need help with school and homework? Hire a full-time assistant as a
tutor. Having problems with snow on the driveway? Install a heated coil
driveway. If you cannot guess when the mail arrives; install a sensor that
transmits the status of the mailbox.
Barry Nalebuff and Ian Ayers describe the “What Would Croesus Do?”
approach in their book entitled Why Not?28 This is essentially a problem-
solving approach where you have unlimited resources at your disposal.
The goal is to identify products and services for the high end where the
consumer is not price-sensitive and is interested in many different fea-
tures. As noted earlier, we have renamed Croesus to Midas because it is
easier to remember and because it imparts a very colorful and explicit
image of high-end features. Midas products and services are designed for
consumers who are not price-sensitive.

Hermes Approach: Products and Services Developed

with Limited Resources

In an earlier chapter, we discussed the Hermes approach to problem

solving and developing products and services to relieve headaches.
The Hermes part of the demand curve is where the consumers are
price-sensitive. This could include students, seniors, and, in general,
individuals with low levels of discretionary income or individuals who
are value-conscious. In designing products and services for this group
you can use the “What would Hermes Do?” approach. Hermes was the
god of the traveler, the shepherd, the athlete, the merchants, and the
cunning, and was linked to invention and commerce. There are a variety
of very interesting products and services that have been developed for
the price-sensitive end of the demand curve. The idea is to use the top
and bottom of the demand curve to generate new ideas for products and
services. The point is creating dynamic tension between the two ends of
the demand curve and eventually producing the best products for the
price-sensitive (Hermes), the high end (Midas), and the middle of the
demand curve (Atlas).
128 DEVELOPING NEW PRODUCTS AND SERVICES

Nightmare Features: Think of Ways to Put Your Company

Out of Business

An extension of the alleviate headaches approach is to think about ways

to put your company out of business or for that matter any company out
of business.29 When using this approach, the individual should marshal
all the creativity approaches, including using unlimited resources to gen-
erate problem solutions, borrowing ideas using idea arbitrage, flipping
ideas, and recombining products and services. Many of the ideas that
have led to putting companies, industries, and even countries out of busi-
ness were the result of disruptive technological innovation (e.g., the print-
ing presses, armaments and tactical innovations, networking, computing,
communications innovations, etc.). Disruptive technologies are prod-
uct or process innovations that eventually eclipse or overturn the exist-
ing dominant technology. They are part of a product life cycle described
by 19th-century economist Joseph Schumpeter that leads to Creative
Destruction.30 Schumpeter was a strong proponent of the entrepreneurial
spirit. It was his position that products and services emerge, die, adapt,
and re-combine in a never-ending cycle of birth, growth, and decline.

Fostering Creativity in Meetings and with Your Colleagues

The way we perceive the world is constrained by culture, social mores,

institutions, education, and neurobiology. In some cultures and busi-
nesses, there is a distinct power distance that separates and modifies social
interactions.31 Power distance is the degree to which powerful individuals
in a country, culture, occupation, or an institution accept and indeed
demand subordination, obedience, and differential respect. Institutions
with high levels of power distance are characterized by bosses pulling
rank, requiring subordinates to clear everything with the boss, and hav-
ing excessive rules for interaction and task completion. In general, when
power distance is high between superiors and their subordinates, there is
an aura of authoritarianism and class distinction. This is in contrast to
work environments where the power distance between superiors and sub-
ordinates is low. In this situation, superiors treat individuals as somewhat
 FACILITATING CREATIVITY AND INNOVATION 129

equal, giving subordinates important tasks, permitting failure, and giving

credit where the credit is due.
It should be noted that the appropriate degree of power distance is
contextual. There are some jobs where high levels of power distance are
needed (e.g., the military, some construction jobs, and police work) and
others where low levels of power distance are desirable (e.g., research and
development, piloting a plane, and creative endeavors). Malcolm Gladwell
described a situation where high levels of power distance between flight
crew members contributed to the plane crashes of a Korean Airlines in the
late 1990s.32 Planes produced by Airbus and Boeing are supposed to be
flown by two pilots without a significant power distance between them,
where one pilot corrects the other when necessary. As a result of the large
power distance between the pilots of Korean Airlines, the co-pilot would
not correct mistakes made by the other pilot, which in turn led to the fatal
mistakes and crashes. There has even been speculation that the Madoff
debacle was the result of too much power distance between the Securities
and Exchange Commission and Bernard Madoff.33
It is important to reduce the power distance relationship within
teams and at meetings when the objective is to encourage creativity and
innovation. As noted earlier, having a mission, focusing on a single goal,
encouraging one-on-one collaboration, encouraging risk taking, embrac-
ing failure, and having quiet time can all facilitate creativity. This can, of
course, be very difficult to do because the power distance relationship is a
somewhat durable, cultural, and institutional variable. Overcoming situ-
ations where the power distance relationship is high requires a dramatic
approach, such as the Six Thinking Hats technique.

Six Hats Approach to Creativity

Edward de Bono has developed a technique for creativity that has been
outlined in his book the Six Thinking Hats.34 The objective of his approach
is to encourage problem solving and creativity by having team members
wear different hats. This approach just might help to reduce relationships
where the power distance is high. The following presents a brief overview
130 DEVELOPING NEW PRODUCTS AND SERVICES

of how the different hats influence team interactions and information

gathering:

• White Hat Thinking: This involves gathering facts and figures

related to the problem. It is also used to identify areas where
more information is required.
• Red Hat Thinking: This involves emotional thinking. Gut
feelings and passionate evangelism are permitted.
• Green Hat Thinking: This is where creativity is encouraged.
Creative solutions are in order and you can draw it from
the approaches discussed earlier (flipping, idea arbitrage,
combining ideas, and unlimited resources).
• Black Hat Thinking: This involves the use of critique and
judgment to assess the negative aspects of a solution. Key
questions to be asked include whether the solution is viable
and whether can it be executed.
• Yellow Hat Thinking: This involves the positive aspects of a
solution. It is important to be optimistic about the solution
when under the yellow hat.
• Blue Hat Thinking: This involves trying to get a strategic look
at the problem. An attempt is made to get at the big picture
in terms of where were we, where do we want to go, and how
do we get there.

The six hats approach is a useful activity that may help to bring dif-
ferent perspectives into the creative process as well as reduce high levels
of power distance. When implemented properly, it encourages partici-
pation and helps reduce dysfunctional power relationships among team
members.

Conclusion
In this chapter, we have discussed the concept of creativity and innova-
tion, and identified various approaches on how to foster them. There are
 FACILITATING CREATIVITY AND INNOVATION 131

several all-encompassing lessons that can be derived from the previous

discussion:

• Innovation is the result of willful and serendipitous

interconnections between the little ahas.
• Innovation usually involves intellectual and technological
maturity levels so that learning-by-doing is possible.
• Innovation requires dialog, learning-about, encouragement,
time, solitude, experimentation, construction, and some
pressure, but not too much.
• Learning-about, learning-by-doing using prototyping, and
hard work are the keys to creativity and successful innovation.

Innovation is an important driver leading to organizational financial

performance.35 It is after all the catalyst for developing differentiated
products and services for competing in monopolistic competition mar-
kets. Research and development is driven by the diffusion of science
and the translation of basic science into commercially viable products
and services. R&D by entrepreneurs may not involve basic scientific
research, but it does involve searching for ideas that will lead to differ-
entiated and marketable products and services.
 CHAPTER 7

Conceptualizing Products
and Services Using the
FAD Template
The previous chapters have focused on learning the basic concepts related
to product differentiation in the context of monopolistic competition. The
focus of this chapter is learning-by-doing. We will use techniques to help
transform a nagging idea about a new product to be more explicit and real.
The tool for completing this task is called the FAD (features, attributes,
and design) template. The FAD template is used to identify the features
and attributes that can be used for product and service differentiation.
The first part of the chapter will introduce the key concepts necessary to
understand and motivate the use of the FAD template. The FAD template
will then be introduced and used to demonstrate and structure the devel-
opment of important attributes and features of a new product or service.

Features, Attributes, Form, Design, Function, and

Meaning are Interrelated Concepts
Here are some definitions and concepts that can be used to understand
how products and services can be differentiated:

• An attribute is used to describe the characteristics or

properties of something.
• A feature is often described as a prominent attribute.
• A function is what something does.
• Form is the external experience or shape.
• Design involves all the above.
• Meaning involves all the above plus the relationship of the
product or service to emotional and psychosocial needs.
134 DEVELOPING NEW PRODUCTS AND SERVICES

Figure 7.1. SuperDuper smartphone.

A very simple way to view all the above is that features, function,
form, design, and meaning are all attributes, with different levels of
information about a product. Consider the SuperDuper smartphone in
Figure 7.1. The SuperDuper phone has a keypad (attribute, feature, func-
tion, and form), with lighted square keys (attribute, feature, and form),
and a high color indestructible screen (attribute, feature, and form) with a
black onyx color and coarse texture (attributes, features, and form), which
can be used for calling and texting (attributes, features and functions),
listening to stereo music (attribute, feature, and function), and locating
friends within 1 mile (attribute, feature and function). This smart and
futuristic SuperDuper phone (attribute and overall design) creates feel-
ings of connectedness, comfort, and security (attributes and meanings).

Meaning and Product Design

There are three fundamental approaches to design (Figure 7.2). The
user-driven design (UDD) school is focused on researching consumer
wants and needs. The technology-driven design (TDD) school is not a
school per se, but rather an approach that is focused on applying new and
emerging technologies to develop products and services. The meaning-
driven design (MDD) school focuses on the emotional and psychologi-
cal relationships that people have with things, objects, and products and
 CONCEPTUALIZING PRODUCTS AND SERVICES 135

Meaning-driven-design (MDD)
Integrates user-driven design and technology-driven design

User-driven-design (UDD) Technology-driven-design (TDD)

Focus is on customer Focus is on science and
requirements and demands emerging technologies

Figure 7.2. Fundamental design approaches.

attempts to design products that satisfy these meanings. Most products

can be designed using all three approaches, for example, software, custom
houses, furnishings, electronics, clothes, personal care, appliances, and
transportation. Some products such as CPUs’ semiconductors and nano-
technology and health equipment are primarily technology driven.
MDD also involves UDD, but it is not the motivation behind the
entire process. In MDD, the company executives and research and devel-
opment (R&D) personnel design the next-generation product and then
present it to consumers. They still obtain a reaction from potential con-
sumers, but it is not the sole driving force behind the process. The MDD
approach also incorporates technology-push innovation, where innova-
tive emerging technologies are pushed to the market. In essence, MDD
uses elements of both UDD and TDD to deliver innovative products.
The unique part of MDD is the search for meaning. There is a search for
meaning in the way that people relate to objects. This is often accom-
plished by collaborating with other organizations and with experts in the
product domain on how the product should be designed. The design of
the product is not solely derived from customer pull as is the case of UDD,
but is also driven by the innovator and new and emerging technologies.
136 DEVELOPING NEW PRODUCTS AND SERVICES

In MDD, the innovator synthesizes information from a variety of sources

and then uses this knowledge to design innovative products.1
The idea behind the MDD School of innovation is to look for mean-
ing in everyday products and to try to determine how they can be changed
in a radical way to support the emotional and psychological needs of con-
sumers. The MDD approach to developing a Blue Ocean market involves
understanding how customers relate to products and then developing
new products that get at the core of what meaning customers attach to
products.2
Many individuals in the MDD school believe that the user-centered
design is a hindrance to developing radical innovations.3 The focus of
the MDDapproach is to find the meaning in the way people relate to
objects in their everyday life. The MDD school of innovation not only
contemplates beauty and form, but also examines the emotional and psy-
chological relationships that people have with things, objects, and prod-
ucts. Proponents of MDD believe that developing innovative ideas that
transcend existing product concepts requires more than just attending to
product differentiation. Since the MDD school of innovation uses a push
strategy. Product ideas are conceived as a vision and offered to consum-
ers as a proposal. As noted by Verganti: “These proposals are not dreams
without a foundation. These proposals eventually emerge as the products
users were actually looking for. They end-up being what people were wait-
ing for—and thus are great marketing successes” (p. 116).
We alluded to the fundamental meaning of product in the earlier dis-
cussion of the basic functions of products. There are many different types
of meanings that can be attached to products, some of them are tangible
and some of them are complex and elusive. Key areas of meaning include
the following: provide physical and emotional sustenance; facilitate con-
trol over the environment; provide entertainment; provide feelings of
status, superiority, and elitism; provide a sense of stewardship; provide
a sense of altruism; provide feelings of adventure; provide security and
comfort; facilitate the completion of some work or home task; provide
familial support; support learning and adaptation; help us to change loca-
tion; provide opportunity for communication and networking; provide
for respect and recognition; and, of course, be a source of satisfaction and
happiness.
 CONCEPTUALIZING PRODUCTS AND SERVICES 137

Traditional user-centered design approaches are not focused on under-

standing the meaning of the relationship that people have with objects.
The Wii is not a game machine, it is the campfire surrounded by family
and friends. Embedding diamonds in wireless phones contributes little to
the calling function. But in some people’s minds, diamonds are a symbol
of affluence and sophistication and are used to convey that image. The
iPhone is not just a phone and the iTouch is not just an MP3 player, they
are status symbols that also provide comfort and social networking. A
Cirque du Soleil performance is not just a circus or just entertainment, it
is a risky adventure in an ethereal world never seen before. The iPad is not
a replacement for a netbook or a laptop, it is the adventurer’s guide to the
galaxy of knowledge and entertainment. It is the present day Hitch Hikers
Guide to the Galaxy.
Attaching meaning to objects is of course somewhat subjective and
strongly influenced by the researcher’s background and by social mores.
There are numerous types of meaning that can be examined and they are
often interdependent.
Designing products that draw on meaning requires creativity and
hard work. Creativity can be cultivated and is within the grasp of most
people as discussed in chapter 6. The hard work is the never-ending
process of determining the proper ingredients that go into the secret
sauce to keep people from becoming bored or even worse, ignoring
your product.
A key part of the MDD process involves partnering with interpreters.
This partnering involves both learning-about and learning-by-doing. The
interpreters are the organizations and individuals who are working on
products that are similar to the products that you are examining. They
can be suppliers and component manufactures, consultants, consumers,
competitors, universities, research firms and think tanks, trade association
and publications, research conferences, and of course one of the most
important interpreters, the search engine.
There are other approaches to design that focus on marketing, project
management, product management, portfolio management, product
engineering, creativity, and controlling the process. Later chapters will
discuss the role of project management, new product development and
portfolio management in providing structure to the innovation process.
138 DEVELOPING NEW PRODUCTS AND SERVICES

Many companies use hybrid approaches that draw on UDD, TDD,

and MDD. Our focus in this chapter is primarily on MDD. But we
also rely on user-centered design for refining products and making them
usable. Even Apple, who we believe is the wunderkind of MDD in the
USA, listens to their customers. For example, they redesigned Apple TV
to become an inexpensive video-streaming device and put buttons on
the smallest shuffle because consumers did not like having all the music
control buttons on the ear bud cord.4 UDD is also very important for
software development, whether it be in the context of game development,
applications development, or social networking applications. A customer-
centric agile development process is essential for delivering products that
will be used. Ergonomics, ergonomics laboratories, and usability research
are the foundation for delivering high-quality software products to the
consumers.
There is one more design strategy that can be linked to many product
failures. It is a purely functional design strategy that does not incorporate
user needs or meaning at all. There is little if any UDD or MDD. This
situation occurs where someone thinks that there is a need or demand
for a product or service, but the end-users were not listened to or were
ignored completely. This often occurs when there is no need or demand
for a product or service, but someone thought that it would be a good
idea to develop it anyway. I was involved with such a product when I
worked as a programmer. Here is the story.

Functional Design and User Ignored

Barlow was the head of our IT group and he was also the head scorekeeper
for the plant’s golf league. Every Monday morning Barlow would take
the golf scores from the past week of play and compute the league stand-
ings as well as calculate the handicaps. Barlow had been doing this for
years. Someone in human resources thought that he was spending too
much time on the league and they also thought it was a burden to Bar-
low. So HR commissioned a golf handicapping and league scoring sys-
tem. A complete cost–benefit analysis was actually implemented and
the payback was deemed acceptable, so the green light was given to the
project. A team of analysts and programmers were assigned to gather
 CONCEPTUALIZING PRODUCTS AND SERVICES 139

requirements and implement the system. Tens of thousands of dollars

were spent developing and programming the system. The system was
used just a couple of times. It was a pain to use, the results were incor-
rect, and most importantly, Barlow could finish his calculations faster
than it would take to key-in the data and generate the reports. Barlow
actually liked his manual system and took pride in his ability to produce
weekly updates in a few hours. He said as such, in quiet tones, but he
was not listened to.
In the current market context, functionally designed products and
services are sometimes at risk, unless the meaning of the design is to con-
vey simplicity and functionality. There are numerous examples of success-
ful products and services that simply do what they are supposed to do,
because they are functional. Functionally designed products can be even
more successful when they are accompanied by user-centered design and
meaning-centered design.

Identifying Key Meanings, Attributes, and Features

One thing is for sure. There are literally thousands of attributes, features,
designs, and meanings that can be used to define products and services.
This section details the major attributes that should be considered during
product and service development.

Functions of the product or service and target customers. What does the
product do? What important subfunctions does it perform? What type
of customers or customer segment are you trying to attract?
Quality. How well does the product or service conform to specifications?
Does the product or service do what it says it is supposed to do in the user
manual? Is it effective in performing its function?
Reliability. Does the product or service perform as it is supposed to over
the expected life of the product or service. Is it prone to failure? Is it eas-
ily maintained? Can parts be obtained at a reasonable cost and are they
easy to change? Does the product perform satisfactorily in a variety of
environmental conditions?
Ease-of-use. Is the product or service easy to use and can consumers learn
how to use it without much trouble? Is the product convenient to use?
140 DEVELOPING NEW PRODUCTS AND SERVICES

A convenient product or service is readily available, performs the task for

which it was designed, and reduces the time it takes to complete a task.
Performance. Is the product smaller than the competition? Is it more pow-
erful? Does the product or service complete a task faster? Is the product
adaptable to many situations?
Design. Is the external form attractive? Is the product packaged properly?
Does the product suggest a certain meaning? Do the materials used in
developing a product also contribute to the overall look and feel? Thus,
the meaning of a product is derived from the type and color of the mate-
rial used to construct a product, the texture and feel of the product, the
size, the product name, and from the overall form or style of the product
or service.5 Examples of abstract design meanings might include: futur-
istic, scary, hallow, delicate, intellectual, feminine, masculine, macho,
healthy, psychedelic, smart, fashionable, earthy, retro, metal, avant-garde,
youthful, personal, worldly, mature, luxurious, elite, western, oriental,
simple, sassy, cool, organic, green, and even abstract.

Design attractiveness and innovation also applies to services. Packaging

for a service includes the overall look and feel of the service. It is the gestalt
or form and configuration of the service as perceived by the consumer. The
key success indicator for a service is the customer’s perception of the overall
experience with the service process.6

Technology. Is there an emerging technology or a process that can improve

the quality, reliability ease-of-use, performance, value, design, and mean-
ing of the product?
Value creation. Is there any intrinsic value in the product that significantly
distinguishes it from other products or services offered by your company
or the competition? Does the product or service solve a problem that
consumers want to solve and will the solution attract them to the product
or service?
Meaning. The meaning of a product or service can be thought of as
super-attribute or super-feature that nurtures the inner needs of the
individual. Meaning can include the following: provides physical,
health, religious, or emotional sustenance; provides feelings of being
needed or being listened to; supports artistic and creative needs;
 CONCEPTUALIZING PRODUCTS AND SERVICES 141

facilitates control over the environment; supports feelings of closeness

to the earth and being organic; provides entertainment; supports feel-
ings of status, superiority, and elitism; provides a sense of stewardship
or a sense of altruism; supports feelings of adventure; supports gender
needs; supports feelings of security and comfort; facilitates and assists in
the completion of some work or home task; provides feelings of familial
support; helps an individual or a community to learn and adapt; helps
us to change location; provides an opportunity for communication and
networking; has above-average intrinsic value to some or many people;
provide for respect and recognition; and finally, provides a source of
satisfaction, happiness, or hope. The meaning of a product or service is
very much tied-in to what the product does. For example, communi-
cating is one of the most important and ongoing functions in our lives
and we attach significant meaning to products and services that support
communication.

Overlap in Meanings, Attributes, and Features

After reading through the list, you can probably notice that there is a
significant amount of overlap among the different attribute categories.
This is in part related to the imprecision of words in all languages and to
the proliferation of synonyms. A Venn diagram illustrating the relation-
ships among words and their meanings would visually depict significant
degrees of overlap. This ties in very well with the concept of a brand and
MDD. Recall that a brand is simply something that lives in the head of
consumers.7 A brand is simply a composite of the mental associations that
are generated when you see or think about a certain product. Another
way to think about branding is as a gestalt view of the product. It is more
than the sum of its parts (the attributes, features, functions, form, design,
and meaning). It is the meaning we attach to the product and all the neu-
ral associations that are invoked when the product or service is recalled.

Design Products and Services that Facilitate Control

A fundamental force of adaptation in human beings is our attempt to
control the environment.8 Infants try to get control their environment
142 DEVELOPING NEW PRODUCTS AND SERVICES

by crying. Cuteness is a built-in genetic adaptation that augments crying

and also facilitates environmental control. As we age, this strategy does
not work very well and people control the environment by fitting-in,
which is another type of control. Security, freedom, independence, and
emancipation are the rewards of obtaining control. Getting wheels and
driving, acquiring a secure and comfortable home, obtaining a job, and
achieving financial security are milestones in achieving control. One per-
son’s gain in control can sometimes lead to a loss of control by another.
This is the collateral damage that can occur when someone gains too
much control over others. For example, colleagues, family, and friends
can facilitate (or hinder) the drive for environmental control. However,
that same individual can in turn use the control to dominate those who
helped him or her to achieve environmental control. Many individual
and group conflicts can be traced to someone seeking excessive control or
to someone else seeking emancipation from the excessive control.
The two fundamental strategies used to control the environment are
primary control and secondary control. Primary control occurs when an
individual tries to directly engage with and change the external environ-
ment to fit his or her needs and wishes.9 Secondary control is a type of
control that is directed at changing the self in order to cope with the
environment. Secondary control is a goal-directed coping strategy for
minimizing losses in primary control and also a mechanism for main-
taining and increasing primary control. Individuals that do not engage
in primary or secondary control have relinquished control and this is
manifested by passivity and helplessness. Individuals engaging in pri-
mary control try to fix the environment, and those engaged in secondary
control try to adapt to the environment. Both strategies assist in coping
with the stress and complexity that are part of the everyday activities in
the external environment.
We have found that primary and secondary controls also influence
feelings of psychological ownership an individual has towards his or her
avatar in an online game.10 Psychological ownership occurs when people
have feelings of ownership towards material things or tangible objects
and even immaterial or intangible objects.11 It occurs when an individual
views the object as mine. We have found that the key to obtaining lock-in
in online gaming environments is to get game players to embrace the
 CONCEPTUALIZING PRODUCTS AND SERVICES 143

system as though they own it. This ownership is the direct result of being
able to exercise both primary and secondary controls over their online
character by way of the user interface and by successfully interacting with
members of the online guilds.
Facebook is a very interesting case of using systems to gain environ-
mental control. It is very difficult for people to actually brag about their
day-to-day accomplishments and activities in the real world or nononline
world. It is much easier, and is indeed acceptable, in Facebook interac-
tions to talk about oneself. There are several mechanisms built into Face-
book that encourage bragging. For example, if a picture is added to the
photo library or is used to display the image on the Facebook profile,
then it is acceptable to brag or tout one’s stuff on the accomplishment or
the activity. Facebook permits people to control what is known and what
is not known about them. It also opens up new lines of communication
and it can sometimes alleviate loneliness and even increase recognition
and status. LinkedIn is the social networking tool of choice for bragging
about professional accomplishments and looking for a job, while Twit-
ter is the outlet of choice for serial braggers and businesses that want to
obtain exposure.
The bottom line is that if people can control a product or service or
if a product or service helps to actually control the world, people will feel
that they own the artifact and thus become locked-in to using that prod-
uct or service out of loyalty.
There are of course issues of having too much control and having
too many options. There is some evidence that having too many choices
leads to decision paralysis and some people believe that having too many
choices contributes to depression.12 Novice users of any product or ser-
vice need directed guidance. A wireless phone or a DVR needs to be easy
to use for the first-time user, but also readily customizable as experience
grows and new features are sought.

Categorizing the Importance of Product Attributes

Some attributes of products were important 5 years ago, but they are
not today. Some product features were not even available last year,
but they are mandatory today. Similarly, product designs and their
144 DEVELOPING NEW PRODUCTS AND SERVICES

accompanying meanings are constantly in flux. The importance of

product attributes changes. The following classification scheme can
be used to ascertain whether attributes and features are increasing or
declining in importance. The classification scheme was derived from a
variety of sources.13

Points of Parity and Must-Haves (POPS)

These are attributes that most of the products in a category usually have.
They are the basic features found in a product or service. They help to
define the prototypical product. A product is something that is tangible
and it does something and has a function.14 For example, it provides sus-
tenance; it provides security and comfort; it helps us to complete some
task; it helps us to learn and adapt; and it helps us to change location,
communicate, and network. The product should do what it is meant to
do, with certain features that are compelling and functional. These fea-
tures with their accompanying functionality are “must-haves” for a prod-
uct or service to be minimally acceptable, and preferably strongly desired.
If a product does not possess these essential features and functionality,
it might be eliminated from consideration. For example, an auto global
positioning system (GPS) should have the ability to enter an address and
display how long it will take to get to a location; a word processor should
have spell-checking capabilities; and a movie theater should sell treats.

Points of Difference and Differentiators (PODs)

These are the attributes of a product or service that assist in distinguishing

products from the competition and from similar models in a product line.
Product and service features that are differentiators are usually derived
from Midas products and are high-end products. They are for nonprice-
sensitive consumers. You can think of the demand curve as a steep incline
where product features roll down from Midas products to Atlas products.
When costs are further driven down, the features become the standard
of Hermes products. Hermes products are for price-sensitive consumers.
Important differentiators for auto GPSs include Bluetooth capability,
voice recognition, and topography maps. A movie theater could have very
 CONCEPTUALIZING PRODUCTS AND SERVICES 145

comfortable seats. A word processor could have voice control. As noted

earlier, the features tend to roll down the demand curve and the differen-
tiators become must-haves over time.

Blue Ocean Features and Exciters (BOFs)

These features are typically in the very early stages of R&D and part of a
secret plan to develop a new market. BOFs have the potential to deliver
a knockout punch by developing a Blue Ocean market, a brand new
uncontested marketplace. In general, BOF features are in their infancy—
beginning to unfold and emerge. Examples for auto GPS might include
location of friends and family in close proximity.
Another way to identify exciters or BOFs is to think about ways you
could go about putting your company out of business or for that mat-
ter any company out of business. These are nightmare features and tech-
nologies. Many of the ideas that have contributed to putting companies,
industries, and even countries out of business were derived from radi-
cal technological innovation. Examples include the printing press;
armaments and tactical innovations; and networking, computing, and
communications innovations. These so-called disruptive technologies
are product or process innovations that eventually eclipse or overturn
the existing dominant technology. Disruptive technologies can lead to
sunrise features and to sunrise products. Sunrise features and products are
the dawn of new technological and conceptual capabilities.

Extinct and vestigial features (EXTs)

These are attributes that are no longer necessary or on the verge of becom-
ing extinct. They are sunset features. They are features that are on the
verge of becoming obsolete and fading into darkness and oblivion. Some-
times EXTs cannot be removed because there may be a small subset of
people that demand the feature. In this case, a decision has to be made
to abandon the features or keep the feature. Sometimes the decision to
abandon is the best way to go because of cost issues and because the
company is going down a new technology path. This was the case with
recent versions of Microsoft’s operating systems that abandoned some of
146 DEVELOPING NEW PRODUCTS AND SERVICES

the legacy DOS code. Apple made a similar decision in regards to aban-
doning DVD drives in the MacBook Air product and the decision not
to include a camera in the iTouch. All of Apple’s decisions are influenced
by product positioning, product costs, and the emergence and decline of
technologies.
The next category is actually a subcategory of extinct features. When
products or services lead to actual dislike of a product or service, then
they should be retired or at a minimum require major redesign.

Dissatifiers (DISs)

There are instances when products and features in existing products can
discourage consumers from using your product or your competitor’s
products. Sometimes features can actually cause consumers to actually
avoid using a product. The feature may be a negative attribute of the
product. This can occur because the product or service has not been
designed correctly and is basically unusable. Numerous products and
services have failed because consumers have been dissatified with the
design. Consumers can also be dissatified with a product because the
consumer does not want the feature in the product or service. DISs are
often sunset features. For example, many people did not attend circuses
because they were opposed to the use of wild animals in the shows or
because they thought that the animals were not interesting. That is one
of many reasons why Cirque du Soleil became popular with a larger
adult market. Cirque du Soleil simply abandoned the use of animals in
their programs.

The FAD Template

The purpose of the FAD template is to try to facilitate and provide a
degree of structure for conceptualizing new products and services (see
Exhibit 1). The first step in using the FAD template is to provide a
description of the product or service that is being considered. The second
step in using the FAD template involves describing the meaning of the
product. Several product meanings have been listed to provide a start-
ing point. The next step in using the FAD template involves identifying
 CONCEPTUALIZING PRODUCTS AND SERVICES 147

potential attributes. The attributes can be features, performance charac-

teristics, form, design, and even additional meanings. We have included
a few attributes that are often considered, but you are encouraged to seek
the attributes that are important in the development of your product
or service. One goal of using the FAD template is to facilitate product
differentiation. Focusing on attributes that are exciters and Blue Ocean
features will assist in the differentiation process. It is sometimes helpful
to focus on features that are on the verge of extinction or features that
consumers are not satisfied with or wish they were not there. Consid-
ering exciters and disastisfiers helps to expand the way designers view
the meaning behind a product or service, and it allows the designer to
gain deeper insight into how to improve the current performance of the
product.

Prototyping and the FAD Template

The final stage of using the FAD template is to provide a way to visual-
ize the product by: a drawing, a schematic of the product or service,
or a physical model (see several examples in Appendix 1). Learning-
by-doing means that you make and build things. You try experiments
and you construct prototypes. Prototypes need to be constructed for
tangible products, for services, and also for systems applications. If the
product is a tangible product, then a generic mock-up of the product
needs to be constructed as early as possible. The idea is to develop a
very rough prototype of the product or service. There are many differ-
ent ways to do this. It could be a report developed in a word-processing
program, an interface developed in a presentation program, a sketch
using a vector or raster-based drawing program or even drawn using a
pencil on the back of a napkin, a three-dimensional (3D) model devel-
oped in Google’s free SketchUp program, or a flow diagram illustrating
a process. If the product is a computer application, then a prototype
can be constructed using a rapid prototyping language or demon-
strated via a presentation package such as PowerPoint. There are also
many excellent applications available for tablet computers that are very
effective for developing mock-ups of applications and for drawing or
sketching preliminary product ideas.
148 DEVELOPING NEW PRODUCTS AND SERVICES

Services should also be prototyped. A uniquely designed service can

be used as a way to differentiate a firm from the competition. Service
design should always focus on the customer and how the customer inter-
acts with the business in receiving the service. These interactions between
the customer and the business are referred to as the touch points or con-
nections. There are many components that go into the design of a ser-
vice. They include the people, the verbal and nonverbal interactions, the
processes, the scripts, the tools, the materials, the infrastructure, and the
technologies. Execution of the service is a function of how all the service
components work together.
One popular tool for designing services is service blueprinting. It
is a visual and descriptive tool for modeling visible customer interac-
tions with employees and processes that also illustrates how the hid-
den processes support the customer interactions.15 There are a number
of tools that can be used to conceptualize, design, and test the design
of the service including drawings, sketches, scenario analysis and
task structuring, mock-ups, storyboarding, systems, Lego mock-ups,
and many more (see http://www.servicedesigntools.org/repository).
Because services often involve queues or lines, simulations can be used
to understand how fast or how slow a service will be performed in a
particular situation.
The goal of the first-cut prototype is to learn-by-doing, to get other
people to understand what you are thinking about, and to help you
understand what you are trying to do. Developing a prototype in some
form or another is an important part of the learning-about and the learn-
ing-by-doing process that will facilitate creative insight.16
Many prototypes start out with paper and pencil and then become
increasingly more sophisticated as they mature. The basic sequence of
iterative design with stepwise refinement includes the following:

1. Initial Prototype: In the early stages, develop a pencil and paper

picture of the product, the application, or the process. The key
is to focus on the key or essential functions of the product or
service.
2. Review: Let business stakeholders, family, friends, and eventually
potential customers provide feedback on the product or service.
 CONCEPTUALIZING PRODUCTS AND SERVICES 149

3. Revise and redesign prototype: Use the feedback to refine and

improve the design of the product or service. Use more advanced
tools as the prototype becomes more refined and detailed. This usu-
ally leads to the use of graphics, drawing, and mock-up software.
Towards the later stages of development, the prototype might be a
functioning product or service or an actual application with some
level of functionality.
4. Go back to step 2 after revising and redesigning the prototype.

There are some very exciting prototyping tools for manufactured

products. Although currently in their infancy, they have the potential
to completely change the way that products are prototyped and even-
tually how everything will be manufactured.17 These new tools are part
of a new approach for manufacturing called additive manufacturing
or desktop manufacturing. Rapid prototyping is becoming a reality
because additive manufacturing assists in producing prototypes very
quickly. One of the most promising technologies for implementing
additive manufacturing is the 3D printer. Very detailed and complex
plastic working models of products can be generated using 3D print-
ers.18 The parts or products are made by using 3D digital descriptions
to print successive thin layers of plastic on top of plastic until a 3D
solid emerges. Some of these plastic products and parts can be used as
final products and not just as prototypes. There are versions of the 3D
printers that use titanium powder to construct very complex objects
such as jewelry and avionics components. Several aviation companies
are investigating the use of very large 3D printers to create entire air-
craft wings.

Example of the FAD Template in Wine Aging Cooler

Aged wine has always been attractive to wine enthusiasts and wine
connoisseurs, but aged wine is expensive because of the time involved.
A merlot can take up to 15 years to age and Shiraz-based wines may
require 20 years of aging. Several products have been introduced and
patents have been secured and applied for that are purported to speed
up the aging process.19 Suppose an inventor found that it was possible to
150 DEVELOPING NEW PRODUCTS AND SERVICES

dramatically speed up the wine aging process by exposing a wine to an

electromagnetic field with a very specific magnetic field strength. Sup-
pose that the same inventor found that the taste of all wines could be
improved using the special aging process. The net effect is that the tech-
nology could reduce the time to produce fine aged wine and also increase
the quality of low-priced wines as well as increase the status of the owner
of the wine aging product. Appendix 2 illustrates how the FAD template
could be used to conceptualize a new wine storage refrigerator that can
be used to age wine. This example will be extended in chapter 9 using the
Ten–Ten planning process.

Use the FAD Template to Develop the Blue Ocean Strategy Canvas

Chan Kim and Renée Mauborgne developed a technique they call the
Strategy Canvas to assist in identifying a Blue Ocean market.20 A Blue
Ocean market is essentially an uncontested new market with high profit
and significant growth potential. They use the Strategy Canvas as a tool
to assist in identifying Blue Ocean markets. One purpose of the Strategy
Canvas is to understand where the competition is playing and investing
their time and resources. Another purpose of the Strategy Canvas is to
try to identify new customer segments in uncontested market spaces. The
idea is simply to create new markets and attract customers.
One area where the Strategy Canvas is deficient is in the identifica-
tion of attributes and features for competition and differentiation. The
FAD template is ideally situated for assisting in that process. The FAD
template can be used as an input device for constructing the Strategy
Canvas by facilitating the identification of important attributes and fea-
tures on which to compete.
The following approach can be used to develop a strategic canvas:

• Use the FAD template to identify the key competitive factors in

terms of product and process features including price, meaning,
technology, performance, design, availability, customer support,
technology, size, weight, speed, ease of use, and other product
features. These key competitive factors are then placed on the
X-axis of the canvas (either at the top or the bottom).
 CONCEPTUALIZING PRODUCTS AND SERVICES 151

• Then, each competitor and your company are plotted on the

Y-axis. If a competitor has a high level of a particular factor,
then it is plotted above the middle of the Y-axis. Similarly,
competitors with low levels of a factor are plotted below the
middle of the Y-axis.

A generic Strategy Canvas with the FAD categories is illustrated in

Figure 7.3. It incorporates the essential concepts from the FAD template
into the development of a Strategy Canvas. Figure 7.4 illustrates how the
Strategy Canvas could be used to position the Nintendo Wii. We identified
what we believed is the key meaning of the Wii along with several impor-
tant attributes and key design issues for the Wii. The feature categories that
apply to the attributes are highlighted in bold. For example, the Appeal to
the entire Family attribute is considered a point of differentiation and a Blue
Ocean Feature. The attributes and their values are, of course, contingent
on who actually constructs the Strategy Canvas and they will change very
quickly according to the whims of the market. Figure 7.5 illustrates a more
attractive graphic that was created using the Strategy Canvas data.

Meaning of BOF POD BOF POD BOF POD BOF POD BOF POD BOF POD
product or
service↓ POP EXTDIS POP EXTDIS POP EXTDIS POP EXTDIS POP EXTDIS POP EXTDIS
Attribute name Price Quality

Very High
High
Average
Low
Very Low
Not Applicable

Figure 7.3. Preliminary strategy canvas with FAD categories.

Meaning of BOF POD BOF POD BOF POD BOF POD

product or
service↓ POP EXT DIS POP EXT DIS POP EXT DIS POP EXT DIS

Attribute Name Price Family Ease of use Appeal to Resolution Disk space
campfire entire family
Very High Wii Wii
High PS3 Xbox Wii PS3 Xbox PS3
Average PS3 PS3 PS3 Xbox
Low Wii Xbox Xbox Xbox
Very Low Wii
Not Applicable Wii

Figure 7.4. Potential strategy canvas for Nintendo Wii.

152 DEVELOPING NEW PRODUCTS AND SERVICES

Very high
Wii
High
PS3
Average

Low
Xbox 360
Very low

Not app

Price Family Ease of Family Resolution Disk

campfire use appeal space

Figure 7.5. Nintendo wii strategy canvas.

Benefits of the FAD Strategy Canvas

The FAD strategic canvas can be used to determine where a company

wants to differentiate themselves from the competition. The objective is
to determine where you would add, delete, or change the level of a factor
in order to identify a Blue Ocean. It can also be used to identify attributes
or factors that could be eliminated because the product features are con-
sidered low-value, extinct, or dissatisf iers. It could of course be used to
assist in identifying unique features that could be added. You can also use
the ideas discussed earlier such as combining products, borrowing ideas
from other industries and products, and flipping ideas.
It should also be noted that the approach can be used in conjunction
with a SWOT (Strengths, Weaknesses, Opportunities, and Threats analy-
sis) diagram to identify the major strengths and weaknesses in the design
of existing and new products.

Lateral Marketing, FAD, and the Strategy Canvas

Lateral Marketing, a related concept found in the marketing literature,

can also be used to assist in identifying Blue Ocean markets. The goal of
lateral marketing21 is to help create new markets by:

• trying to reach a new set of customers by radically changing

the product features either by adding or subtracting features;
 CONCEPTUALIZING PRODUCTS AND SERVICES 153

• trying to identify substitute products or services that can

compete with an existing product or service;
• trying to identify complementary products and services for
existing lines;
• trying to reposition a product by having it satisfy different
needs for different market segments.

The lateral marketing approach along with the other ideas presented
in this chapter complements the Blue Ocean approach as a mechanism
for identifying how product features can be added, subtracted, and
adapted to create innovative products and services. Not all products
and services introduced will be Blue Oceans; nevertheless, the approach
using the FAD template and the Strategy Canvas will certainly provide a
useful tool for understanding the positioning of your products and your
competitors.
Marketing research is a complementary and systematic avenue for
identifying key attributes and marketing opportunities for products and
services. The literature describes a number of approaches for identifying
what features are relevant to consumers:

• Brainstorm to identify a superset of existing and future

product and service features
• Use auctions to identify what products and features are
relevant to consumers
• Develop consumer surveys and sampling approaches
• Ask consumers what features they think are important
• Ask consumers to evaluate, compare, and rank the features
they deem important in a product and service
• Use statistical analysis to disentangle and understand the
relationships between customer wants and product features
• Look at consumer and editorial reviews and try to understand
what features of a product or service appear to be attracting
people.

For additional and more detailed insight into the concepts and
approaches for conducting market research, you are encouraged to read
154 DEVELOPING NEW PRODUCTS AND SERVICES

Naresh K. Malhotra and David F. Birk’s very thorough book on the

topic22 and the Cavusgil, Knight, Riesenberger, and Yaprak23 book on
conducting international marketing research.

Developing Blue Ocean Markets from Complementary

Products and Services
Many innovative products and services are actually complements of the
original products. The innovation can be an add-on feature, an after-
market service, or a different product or service. Transportation devices
have spurred the development of substitute energy sources such as steam,
electric, fuel cells, and solar energy. The automobile was the driving force
behind the development of better roads, fueling stations, diners, and truck
stops. The development of better sailing ships led to the need for comple-
mentary devices for navigation tools such as maps, star maps, compasses,
sextants, and GPSs. The FAD template and the Strategy Canvas can also
be used to identify competitive complementary products and services.

Avoid the Swiss Army Knife Approach to

Product Differentiation
One model of the Wenger Swiss Army knife, called the Giant, has 87
tools, performs 141 functions, and costs $1,400.24 If you were sent to
a deserted island and were limited to what you could bring, that knife
would certainly be on a short list of must-have items. The Giant was
probably introduced because Wenger could introduce it and also because
it creates a great image in the mind of consumers. Wenger has excellent
engineering skills. In general, however, specialized tools perform better
than the all-in-one tool. There is a trade-off between having everything
in one place that is readily accessible and having superb capabilities and
functionality. The cork-screw, the scissors, the magnifier, the golf club
cleaner, and the wire cutter in a Swiss Army knife are OK, but they are
not the best tools for doing the respective jobs.
Wireless phones have become the Swiss Army knife for communica-
tion, networking, and entertainment. Not all the implements (camera,
music playing, video, net interface, retail showroom and purchasing,
 CONCEPTUALIZING PRODUCTS AND SERVICES 155

gaming, GPS, social networking, and communications) are stellar; they

are, however, always available to the user. Apple has been very successful
at integrating features on the iPhone, the iPad, and their other products
that are attractive to their customers, but they are very cautious in add-
ing features for feature sake.25 Some of the hubris exhibited by Apple
is attributable to the cache of the superb Apple brand. But there is a
secret sauce for Apple’s success. There are strong design principles at
work at Apple, involving minimalism, attention to quality, and focusing
on the design of a high-quality user interface. Apple is also very big on
attaching meaning to their entire product portfolio. Their commercials
exude the development of meaning. The Flip Mino video camera was
once very successful because it was simple and very easy to use. The
very young and the old are always looking for easy-to-use products and
services.
Feature creep occurs when a new feature is added and many of the
old features are retained. Sometimes features are beneficial. Sometimes
they become vestigial and forever encoded in the DNA of the product
or service. They are like vestigial physical characteristics in human beings
that are no longer needed. For example, humans have tailbones or coc-
cyx, but they do not have tails. Once a feature is in place, it is difficult to
remove it because some company will use the features to illustrate how
they have more features than competition. Automobile GPSs illustrate
how feature creep occurs over time. Feature creep has been the boom
and the boon of companies that produce automobile GPS applications.
Figure 7.6 illustrates the numerous product features that can be found in
automobile GPS products. It is unlikely that many people are using the
MP3 and photo players on their auto GPSs to play music or view photos,
but these features have crept into many of the units sold by GPS manu-
facturers. The point is that there are instances where it might make sense
to scale back on features because the features are either truly vestigial or
overkill. This would also reduce the cognitive burden facing consumers
because of the numerous choice points. Sometimes the vestigial features
hinder design changes and can adversely affect the ability to add new fea-
tures that are truly valuable to the consumer. One of the greatest impedi-
ments facing hardware and software developers in redesigning systems is
in maintaining backward compatibility.
156 DEVELOPING NEW PRODUCTS AND SERVICES

800 Features used to differentiate GPS

- Screen size
700 - Bluetooth support
- Spoken street names
600 - Traffic information
- Lane change assistance
- Lifetime map updates
500
- Routing options
- Detour capabilities
Price

400 - MP3 player

- Photo player
300 - Video player
- Points of interest search
200 - Data entry assistance

100

0
0 500,000 1,000,000 1,500,000 2,000,000 2,500,000 3,000,000
Quantity

Figure 7.6. Features used to differentiate GPS offerings.

Conclusion
Successful product development should involve both UDD that is focused
on consumer wants and needs and MDD that is predicated on under-
standing the emotional and psychological relationships that people have
on products as well as incorporating the importance of new technological
developments (TDD). We have also introduced the FAD template. The
FAD template is based on the various design approaches and also draws
on a classification scheme that can be used to ascertain whether attributes
and features are increasing or declining in importance. The FAD template
in conjunction with the Strategy Canvas can be used to assist in taking
an abstract product concept and preparing a first-cut prototype of the
product. The key points are the following:

• The focus of MDD allows the innovators to develop ideas

that transcend existing product concepts, conceiving product
ideas as a vision rather than only on product differentiation.
• Concentrating on function and ignoring user input is a recipe
for failure.
• Identifying key meanings, attributes, and features is an
essential step in MDD, including the customer relationship
 CONCEPTUALIZING PRODUCTS AND SERVICES 157

to the product, quality, reliability, ease-of-use, performance,

design, technology, and most importantly, value creation and
meaning.
• The meaning of a product or service is very much tied into
what the product does.
• Attributes of a product to help users control either their
internal or external environments have the power to make a
significant impact.
• Psychological ownership of a product promotes user
attachment and use, keeping users locked into the product
out of loyalty.
• Attending to POPS as well as PODS is necessary to keep
your product competitive. POPS ensure that your product
meets the minimal essential features. PODS are necessary for
distinguishing a product from the competition.
• Disruptive technologies and sunrise features are the dawn of
new technological and conceptual capabilities.
• Use the FAD template to facilitate and provide structure
when conceptualizing new products and services.
• Create a FAD Strategy Canvas to understand the attributes
of your product in the context of your current and potential
competitors.
• Seriously consider your feature list in terms of must-haves,
points of differentiation, and vestigial features. Try to avoid
feature creep, which involves adding features just for the sake
of adding new features.
 EXHIBIT 1

FAD Template
1. Product or service description (what will it do or what is its func-
tion?). What type of customer or customer segment(s) are you
targeting?

2. What is the meaning(s) behind the product or service?

Potential meanings: The product or service provides physical,

health, religious, and emotional sustenance; provides feelings of
being needed or being listened to; supports artistic and creative
needs; facilitates control over the environment; provides entertain-
ment; supports feelings of status, superiority, and elitism; provides
a sense of stewardship; supports feelings of closeness to the earth
and being organic; provides a sense of altruism; supports feelings of
adventure; supports gender needs; supports feelings of security and
comfort; facilitates and assists in the completion of some work or
home task; provides feelings of familial support; helps an individual
or a community to learn and adapt; helps us to change location;
provides an opportunity for communication and networking; has
above-average intrinsic value to some or many people; provides for
respect and recognition; and finally, the product or service is a source
of satisfaction, happiness, and hope.
3. Identify potential product and service attributes, features, and
functions. Here are some ideas for the attributes, features, and
functions:

Price: How much does it cost?

 CONCEPTUALIZING PRODUCTS AND SERVICES 159

Quality: How well does the product or service conform to the prod-
uct specifications? Does the product do what it says it is supposed
to do in the user manual? Is it effective in performing its function?

Reliability: Does the product or service perform as it is supposed to

over its expected life? Is it prone to failure? Is it easily maintained?

Ease-of-use: Is the product or service easy to use and can consumers

learn to use it without much trouble?

Performance: Is the product or service faster, smaller, more con-

venient, greater capacity, better resolution, compatible, and adapt-
able? Which features, functions, and processes are unique or
distinguishing?

Design: Is the external form attractive? Is it visually, tactically, audi-

bly, and olfactorily attractive? Is the product packaged properly? Is
the service experience attractive and positive from the consumer’s
perspective? Does the product or service suggest a certain meaning?

Technology: Is there an emerging technology or a process that can

improve quality, reliability, ease-of-use, performance, value, design,
and meaning?

Value creation: Is there any intrinsic value in the product that distin-
guishes it from other products or services? Does it solve a problem that
consumers want to solve and will attract them to the product or service?
160 DEVELOPING NEW PRODUCTS AND SERVICES

4. List the key attributes, features, and functions that will be

focused on and, in particular, those that reinforce or detract from
the meaning. Attribute can be in more than one category. Attrib-
utes can refer to the product you are planning to introduce and
to existing products,

Points of parity and must-haves (POPS): List the attributes, fea-

tures, and functions that most of the products or services in a cat-
egory usually have.

Points of difference and differentiators (PODs): List the attrib-

utes, features, and functions of a product that distinguish it from
the competition.

Blue Ocean features and exciters (BOFs): List the sunrise attrib-
utes, features, and functions that could be used to develop a new
Blue Ocean market.

Extinct and vestigial features (EXTs): List the sunset attributes,

features, and functions that are no longer necessary or on the verge
of becoming extinct for the product or service.

Dissatisf iers (DISs): List the attributes, features, and functions that
can cause some consumers to avoid using your product or your com-
petitor’s product.

Design and Prototype Product or Service

Put a mock-up picture of the product or service here (use sketching,
drawing software, mock-up software, photo software, or presentation
 CONCEPTUALIZING PRODUCTS AND SERVICES 161

software). If the product is a software, put an example of a critical report

or input screen here (use a word processor or presentation software). If
the idea behind the product or service involves a complex process or busi-
ness process, then draw a flow diagram or a business process diagram
(use presentation software or specialized flowchart and business process
diagramming software).
 APPENDIX 1

Examples of Prototypes

Decision support system:

location tracking, alerting
the chance of disease
occurring, micro-climate,
web based solution

Servers

Friend Location App

Mike
Sally
Murali Current Location
CONCEPTUALIZING PRODUCTS AND SERVICES 163
 APPENDIX 2

FAD Template for Wine

Aging Product
1. Product or service description (what will it do or what is its func-
tion?) What type of customer or customer segment(s) are you
targeting?

Uses some type of technology to age inexpensive wines and make

them more pleasant. Considering using an electromagnet with a
specific magnetic field strength. The potential target customers
are wine connoisseurs and individuals interested in fine wine.

2. What is the meaning(s) behind the product or service?

Appeals to status.

Potential Meanings: The product or service provides physical,

health, religious, and emotional sustenance; provides feelings of
being needed or being listened to; supports artistic and creative
needs; facilitates control over the environment; provides entertain-
ment; supports feelings of status, superiority, and elitism; provides
a sense of stewardship; supports feelings of closeness to the earth
and being organic; provides a sense of altruism; supports feelings of
adventure; supports gender needs; supports feelings of security and
comfort; facilitates and assists in the completion of some work or
home task; provides feelings of familial support; helps an individual
or a community to learn and adapt; helps us to change location;
provides an opportunity for communication and networking; has
above-average intrinsic value to some or many people; provides for
respect and recognition; and finally, the product or service is a source
of satisfaction, happiness and hope.
 CONCEPTUALIZING PRODUCTS AND SERVICES 165

3. Identify potential product and service attributes, features, and

functions. Here are some ideas for the attributes, features, and
functions:

Price: How much does it cost?

Unsure but will have two versions priced at $300 and $1,000
price level.

Quality: How well does the product or service conform to the

product specifications? Does the product do what it says it is sup-
posed to do in the user manual? Is it effective in performing its
function?

Need to test the effectiveness of the technology in a research

setting.

Reliability: Does the product or service perform as it is supposed to

over its expected life? Is it prone to failure? Is it easily maintained?

Unsure. Plan on having a refrigerator function in the high-end

version.

Ease-of-use: Is the product or service easy to use and can consumers

learn to use it without much trouble?

Will have either knobs or a digital key pad to program the aging
time.

Performance: Is the product or service faster, smaller, more con-

venient, greater capacity, better resolution, compatible, and adapt-
able? Which features, functions, and processes are unique or
distinguishing?

We are optimistic that it will be faster than existing wine aging

products. Will also have greater capacity than existing products.

Design: Is the external form attractive? Is it visually, tactically, audi-

bly, and olfactorily attractive? Is the product packaged properly? Is
166 DEVELOPING NEW PRODUCTS AND SERVICES

the service experience attractive and positive from the consumer’s

perspective? Does the product or service suggest a certain meaning?

The high-end model will look like a high-end, high-tech

refrigerator.

Technology: Is there an emerging technology or a process that can

improve quality, reliability, ease-of–use, performance, value, design,
and meaning?

Unsure. However, our approach could be ineffective.

Value Creation: Is there some intrinsic value in the product that

distinguishes it from other products or services? Does the product
or service solve a problem that consumers want to solve and will the
solution attract them to the product or service?

It may attract wine enthusiasts because it has the potential to

improve the taste of all wines We also think that it will also appeal to
buyers of wine storage devices including refrigerators and coolers.

4. List the key attributes, features, and functions that will be focused on
and, in particular, those that reinforce or detract from the meaning.
Attribute can be in more than one category. Attributes can refer to
the product you are planning to introduce and to existing products,

Points of parity and must-haves (POPS): List the attributes, fea-

tures, and functions that most of the products or services in a cat-
egory usually have.

Capable of aging

Points of difference and differentiators (PODs): List the attrib-

utes, features, and functions of a product that distinguish it from
the competition.
Sophistication aging
High-tech
technology. Aging refrig-
design
erator available.
 CONCEPTUALIZING PRODUCTS AND SERVICES 167

Blue Ocean features and exciters (BOFs): List the sunrise attrib-
utes, features, and functions that could be used to develop a new
Blue Ocean market.

Sophistication aging High-tech

technology design

Extinct and vestigial features (EXTs): List the sunset attributes,

features, and functions that are no longer necessary or on the verge
of becoming extinct for the product or service.

Traditional wine aging process

Dissatisfiers (DISs): List the attributes, features, and functions that

can cause some consumers to avoid using your product or your com-
petitor’s product.

Does not age wine

Design and Prototype Product or Service

Put a mock-up picture of the product or service here (use sketching, drawing
software, mock-up software, photo software, or presentation software). If
the product is a software, put an example of a critical report or input screen
here (use a word processor or presentation software). If the idea behind the
product or service involves a complex process or business process, then draw
a flow diagram or a business process diagram (use presentation software or
specialized flowchart and business process diagramming software).

Wine aging time

 CHAPTER 8

Strategic Planning
Approaches for Product
Differentiation and
Innovation
To be strategic is to have plans of action that provide directions for oper-
ating in an uncertain world. In this section, our focus is on develop-
ing strategic plans to compete in a world characterized by monopolistic
competition. Notice that the emphasis is on plans of action and not on a
single plan. There is no single plan or single planning approach that can
deal with the complexity of contemporary markets. What is needed is a
continuous process for churning out new plans, for differentiated prod-
ucts and services, in order to compete in a dynamic environment. This
chapter presents a brief overview of the various approaches to strategic
planning and provides an overview of the planning literature. There is a
lot of material to slog through, but each approach to planning has some-
thing to offer. This overview will set the stage for presenting the Ten–Ten
planning process in the next chapter. The next chapter will integrate the
various planning approaches and present a simplified, yet robust approach
to planning called the Ten–Ten planning process. The key benefit of the
Ten–Ten planning process is that it can be used for developing business
plans in a very short time span.

Planning Concepts
There are two generic planning strategies that a business can pursue.1 It
can strive to be efficient, it can differentiate, or both. In other words, a
170 DEVELOPING NEW PRODUCTS AND SERVICES

firm can focus on delivering Midas versions of products, Hermes versions

of products, or both. A firm that employs a strategy of efficiency strives to
be the low-cost producer and compete on the basis of charging less than
the other competitors. In contrast, a firm that is competing on the basis of
product differentiation can charge premium prices. If charging premium
prices yields larger-than-average profits, the market will, of course, attract
attentions. Competitors will enter the market with a slightly different
product, perhaps even a better product, at a lower price and ultimately
drive down the premium prices. The firm will then have to embark on
further cost-cutting initiatives, improve their product in order to hold on
to market share and survive, or do both. The market is relentless and it
demands a two-pronged approach of developing differentiated products
and services and cutting costs.
The first mantra of the entrepreneur is “differentiate through inno-
vation or perish” or in simpler terms “differentiate or die.” The second
mantra of the entrepreneur is “strive to reduce costs.” The first mantra is
accomplished by focusing on Midas versions of products using extrava-
gant engineering and design. Differentiation is the not only engine
driving business success under monopolistic competition, but it is also
buttressed by attempting to improve costs and product design through
frugal engineering. The second mantra is accomplished by focusing on
Hermes versions of products using frugal engineering.
As noted earlier, over 99% of the approximately 23 million businesses
compete in markets that are characterized by monopolistic competition.
That is there are many buyers, many sellers, market entry and exit is easy,
and the products are closely related but not identical. There are the two
approaches for differentiating products. The first uses marketing and
advertising to develop a brand. The second approach is to engage in prod-
uct development through some sort of research and development (R&D)
process and to develop goods and services with updated features. Both
approaches are necessary parts of the differentiation process. Marketing
and advertising can help illustrate the features and can sometimes delay
encroachment by the competition. But in the long run (probably less
than a year), successful differentiation depends on product development
and R&D.
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 171

The Planning Process

Planning can be accomplished in a variety of ways. Figure 8.1 presents a
typical model of the strategic planning process.2 The mantra is an often-
repeated phrase that provides the basis for the existence of the company.
It is a slogan, a watchword, a byword, or a motto that breathes life into
the firm’s existence. The mantra is not a replacement for the mission
statement. The mission statement is an overall view of the business at an
abstract level. It describes what the company does and why it exists and
how it satisfies customer needs. The mission statement can also include a
statement reflecting whether the company will focus on product differen-
tiation and niche markets, focus on being price-competitive, or focus on
both. The mantra and the mission are rarely static but ever-changing and
emerging throughout the life of the firm.
The essence of the planning process consists of looking-inside and
looking-outside analysis. Analysis involves both introspection and
extrospection. The internal and external organization environments are
examined using a number of analytical approaches, several of which are
included in Table 8.1. These techniques will be covered in the next sec-
tion. There is a lot of confusion related to identifying goals and objec-
tives. Many view the terms goals and objectives to be interchangeable.
Goals are more abstract and broader than objectives. Objectives are gen-
erally more detailed. The important point that will be discussed in the
next chapter is to identify the goals and objectives that will help support
the mantra, the mission, and the value proposition over a certain time

External
(looking outside)

Mantra & Goals and

Analysis Tactics
Mission objectives

Internal
(looking inside)

Figure 8.1. The planning process (adapted from May).

172 DEVELOPING NEW PRODUCTS AND SERVICES

Table 8.1. Orientations of Strategic Planning Approaches

External
Inter competitive
organizational environments
focus focus Time to execute
Value and supply High Low Moderate
chain analysis
Porter’s five force Low High Long
model
Resource-based High Moderate Long
framework
Strategy maps High Moderate Long
Creating Blue Moderate to high Moderate to high Short
Ocean markets
using the strategy
canvas
SWOT analysis Moderate to high Moderate to high Short

frame. The tactics are the activities the organization will use over the
next 3 months to a year to reach their goals and objectives. The tactics
can include timetables and schedules related to the goals and objectives.
The key to the model in Figure 8.1 is that this is not a linear process.
Sometimes a new mission emerges after analysis has been completed.
Mission statements that change, reflect an organization that can adapt to
dynamic environments.
We will revisit the definitions in the next chapter and illustrate how
the planning process can be streamlined and made more efficient and
facilitate the development of business plans in a very short time span
using the Ten–Ten planning process.

Analytical Approaches for Strategic Planning

There are a number of analytical approaches that can be used to develop
a process for churning out new plans for differentiation. We will review
several of the more popular strategic planning approaches because they all
provide insights into the differentiation process. A discussion of planning
concepts can be at times boring; however, such discussion is also crucial
for developing good plans.
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 173

The approaches to be discussed include value chain and supply chain

analysis, Porter’s five-force model, the resource-based framework, the use
of Strategy Maps, creating Blue Ocean markets using the Strategy Canvas,
and SWOT (Strengths, Weaknesses, Opportunities, and Threats) analy-
sis. As illustrated in Table 8.1, each of the approaches can be classified as
having an internal organizational focus (looking inside) or an external
environmental focus (looking outside). Several of the strategic analysis
approaches are better for understanding the organization and others are
better suited for understanding the competitive environment. This table
illustrates that there is no “best” approach for conducting strategic anal-
ysis and that a combination of approaches is necessary for completing
an examination of the inner workings of an organization as well as the
organizational context. Each of the strategic analysis tools will be covered
in this chapter.

Value Chain and Supply Chain Analysis

Value chain analysis is a framework developed by Michael Porter that

divides the company into primary and secondary activities related to
delivering a product or service.3 The primary activities include inbound
logistics, operations, sales and marketing, and outbound logistics. The
secondary activities are supporting activities and include the firm infra-
structure, human resources, information technology, and procurement.
Figure 8.2 illustrates the components of the value chain.
A closely related concept is the supply chain. A supply chain is
defined as the connected activities related to the creation of a prod-
uct or service up through the delivery of the product to the customer.
It includes upstream suppliers as well as downstream activities such
as wholesalers and distribution warehouses. Figure 8.3 illustrates the
supply chain.
In general, the terms value chain and supply chain can be used inter-
changeably; although the value chain is rooted in the strategic planning
literature, the supply chain is linked to the work in the operations man-
agement area. The key concept is that products and services have to be
created and eventually delivered to consumers and the in-between activi-
ties can be referred to as the supply chain or the value chain.
174 DEVELOPING NEW PRODUCTS AND SERVICES

Technology
Firm
development
infrastructure
Marketing,
sales & service
Customers
Suppliers Inbound Operations
Outbound
Human resource
management Procurement

Figure 8.2. The value chain (adapted from Porter).

Information flows
Transfer Transfer
Transfer

Manufacturing Distribution
Supplier
warehouse
Consumer

Supporting cast

Finance Information R&D Marketing & sales Management

technology

Legal Engineering Human resources Accounting

Figure 8.3. Supply chain.

The supply chain is an important visual tool because it can be used to

understand where to look for processes that can be reengineered. That is,
improvements can be made in connecting, coordinating, and controlling
activities across linkages. It can also be used to determine what kind of
information should be gathered to improve communications throughout
the value chain and where value chain performance could be improved.
For example, the firm can investigate where information technology can
be marshaled to support the supply chain activity and where technology
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 175

can be used to automate tasks. The goal, of course, is to reduce transaction

costs up and down the supply chain.4 Transaction costs refer to the effort
that goes into choosing, organizing, negotiating, and entering into agree-
ments for products and services.5 Transaction costs come in a variety of
flavors and there is significant overlap among the various costs.

• Search costs: In general, these costs are related to gathering

information on a product or service, including the costs
associated with locating a product and offering a product for sale.
• Discovery costs: These costs are involved in locating an
acceptable price for a product.
• Decision costs: These costs are associated with making a
decision on what product to purchase. These include personal
cognitive effort and organizational decision processes related
to selecting a product or service.
• Negotiation costs: These costs are related to agreeing to the
terms of a contract including the price, what will be delivered,
how much, and when.
• Acquisition costs: These costs are involved in transporting,
receiving, infrastructure development, and managing the
product in inventory.
• Enforcement costs: These are the costs that the parties in the
contract incur in order to enforce the terms of the contract.
• Settlement costs: These are the costs related to paying and
getting paid for a product or service.
• Social costs: These include costs that are not necessarily picked
up by the buyers and the sellers. Examples include pollution
costs, health costs, privacy costs, and bankruptcy costs.

Porter’s Five-Force Model

Michael Porter has also developed a technique for assessing the desirability
of competing in a particular industry and how a firm can compete in that
industry.6 Porter’s five-force framework considers the buyers, the sellers,
the suppliers, the current competition, and the threat of competition
176 DEVELOPING NEW PRODUCTS AND SERVICES

from substitute products. The key idea is that a firm can be more profit-
able by understanding how the five forces influence the competitive envi-
ronment, as will be explained next.

Threat of new entrants. This is the degree to which entry into an industry is
easy to accomplish. If it is easy to enter an industry and start competing,
then there is a threat of new entrants. If an industry has high fixed costs,
such as in the case of semiconductor manufacturing, auto manufacturing,
or operating systems construction, then there is a low threat of entry. This
is in contrast to the situation where entry is easy and relatively inexpensive
such as found in online retail stores, home maintenance businesses, and
restaurants.
Entry into a market can of course be precluded because of the scarcity
of expertise and resources. For example, in the late 1990s, there were very
few individuals with expertise in Enterprise Resource Planning systems
and in COBOL to handle the Y2K date problem. Numerous firms turned
toward India and Singapore to find employees with skills in these areas.7
Resource scarcity can also limit entry into a market. Examples of industries
where resource scarcity is critical include diamond mining, where DeBeers
owns a substantial amount of the diamond resources, and oil production
where Exxon has access to oil production and installed refining capability.
Threat of substitute products. Substitute products are a constant threat
in contemporary commerce. If another product can be substituted for
a product in the industry under consideration, then there is a threat of
substitute products. It is sometimes impossible to know where your com-
petition will come from. For example, video and audio content can be
delivered via satellite, wireless, coax cable, cat 5, and fiber optics. The
content can in turn be delivered to a variety of devices including mobile
phones, televisions, IPODs/MP3 players, game consoles, DVRs, and
computers. A similar situation exists for transportation. You can travel via
electric car, bus, and air and, in the future, by way of a personal jet craft
or some type of Segway device. Indeed content delivery can be a substi-
tute for transportation. As video and audio becomes more robust and
easy to use, it may be possible to be there without actually being there.
Families will soon get together by linking-up and interacting with their
plasma and LCD screens using a high bandwidth carrier to communicate
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 177

video and audio feeds of a birthday party or anniversary. This has already
occurred in businesses with the emergence of virtual meetings. This
brings up another issue. People set aside a certain amount of dollars for
entertainment. However, although technology is not a perfect substitute
for entertainment outside of the home, it can be a substitute for spending
on entertainment. Thus, a console or a game might threaten the launch-
ing of a new movie during the holidays or vice versa.
Bargaining power of buyers. If individuals, companies, or groups of com-
panies can influence the price and the features required in a product or
service, then the buyers have the bargaining power. This often occurs
when there are few buyers or when the buyer is large. The auto companies
have bargaining power over the component manufactures. The same goes
for Dell’s component suppliers and Wal-Mart’s suppliers. When a buyer
is large and switching costs are small, then the buyer has the bargaining
power. Wal-Mart is in such a position with its suppliers. Dell, however,
has less buyer power because it cannot simply switch the component sup-
pliers because desktops systems are built around integrated components
and the performance of the system can be adversely impacted when com-
ponents are not integrated.
Bargaining power of suppliers. If a company supplying a product or service
can dictate the terms of the transaction, then the supplier has the bargain-
ing power. The bargaining power of suppliers can be derived from many
factors including the scarcity of the resource or technology, the number of
suppliers, the characteristics and features of the technology, whether the
technology is proprietary, and even the brand image. Intel and Microsoft
have some bargaining power over Dell, but the hard drive, dram, mother-
board, and monitor manufacturers have less bargaining power. The power
supply and case manufacturers have even less bargaining power with Dell.
The game console and global positioning system (GPS) manufactures
have some power over Wal-Mart when they introduce a new model, but
a holiday candle manufacturer has much less power. In many ways, the
bargaining power is related to the threat of new entrants and the threat of
substitute products or services. The key issue surrounding the bargaining
power of suppliers is the availability of other sources of the products and
services. If alternative or second sourcing is available, then the bargaining
power of the supplier is lessened.
178 DEVELOPING NEW PRODUCTS AND SERVICES

Rivalry among existing competitors. This is the degree to which there is

competition among the firms. When there are several competitors and
the products they are selling are fairly standard or readily obtainable and
the competitors cannot easily leave the industry, then the rivalry will be
intense. Examples of intense rivalries include breakfast cereals, flash mem-
ory, dram and electronics industries, housing construction, online and
offline retailing, and the airline industry. Intense rivalries among com-
petitors are again driven by the threat of new entrants and the threat of
substitute products and services. In this context, product differentiation
is essential in order to reduce the ruinous effect of perfect competition.
This is the reason that the producers of GPS systems are constantly refin-
ing and adding features to their product line. Airlines, breakfast cereal
producers, and the housing industry are constantly looking for ways to
differentiate their offerings and at the same time reduce costs.

The Five-Force Model in Practice

The five-force model can be used as the basis for conducting an industry
analysis. The goal of an industry analysis is to understand the dynamics
of competition and to ascertain how the five forces influence profitability.
The following steps are used for conducting an industry analysis:

• Develop a brief description of the target industry

• Identify the competitors, buyers, suppliers, potential entrants,
and potential substitutes
• Determine the strength and weaknesses of the forces
• Identify any recent changes in the dynamics of the forces
• Determine the potential for short- and long-term profitability
• Ascertain who in the industry is positioned to be profitable
• Determine where the organization should invest.

Porter’s five-force model provides an overarching view of the competi-

tive environment and is extremely helpful for understanding the competi-
tive environment. It does, however, have several deficiencies. First of all, it
takes a long time to conduct a full-blown expose of the five forces because
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 179

many devotees to the approach tend to overanalyze the industry and the
competition. This in turn leads to organizational fatigue. Overanalysis is
related to the second deficiency. The ideas are very abstract and broad,
and the technique requires consulting expertise in order to be applied
effectively. Finally, it takes too long to implement for small organizations.
For the entrepreneur working under extreme pressure, under the umbrella
of monopolistic competition, there is very little time to attend to apply
the approach effectively. Even though Porter’s ideas are very powerful,
they do not resonate with the entrepreneur because they are abstract and
difficult to apply.

Resource-based Framework

The resource-based view, also referred to as RBV, is very popular with aca-
demics. The intellectual foundations for the RBV approach are many, but
the work by Prahalad and Hamel on core competencies8 and the work by
Barney9 on the link between resources and sustained competitive advan-
tage established a strong foundation. The basic idea of RBV is that some
organizations are more competitive because they have access to unique
resources or special capabilities and competencies. Resources can be tan-
gible or intangible and include raw materials, land, brand, knowledge
and expertise of people, reputation with customers and suppliers, plants,
equipments, patents, trademarks, copyrights, and funds. A capability or
competence is the ability of a firm to turn its resources into customer
value and profits. Capabilities or competencies can be manufacturing
prowess, order fulfillment and delivery, customer service, marketing,
finance and accounting, management expertise and leadership, and in
essence any proficiency or prowess in the supply chain and value chain.
Porter’s force model, and the accompanying industry analysis, tends
to focus on locating a firm in an attractive industry and then taking steps
to achieve competitive advantage over rival firms. In contrast, the RBV
approach suggests focusing on competitive arenas where the firm has unique
resources and competencies. For example, if you own property with rich
productive topsoil, if your workers are diligent, and if your daughter is an
excellent agronomist, you will probably be a successful farmer. The key to
being successful in the context of RBV is that the resources and competencies
180 DEVELOPING NEW PRODUCTS AND SERVICES

are hard to imitate and help to establish a strong basis for competitive advan-
tage. In essence, the status of the internal resources and competencies will
assist in pursuing a particular strategic direction. Amazon has a core compe-
tency in selling online and it simply kept pursing that competency by selling
construction tools, electronics, audio books, eBooks, and developing part-
nerships with brick and mortar vendors. Most of Google’s successful ven-
tures are related to its core competency of search. Joan’s foray into the jewelry
box business discussed earlier was linked to her excellent craftsman skills.
Joan had a core competency in jewelry box design and fine woodworking.
Core competencies are the very critical skills that define an organiza-
tion. For Google, it is their search capability, for Amazon it is their ability
to sell online, and for Joan it is her prowess at jewelry box design and her
knowledge of the marketplace. In the case of Joan, her knowledge and
skills can probably be imitated and replicated in a shorter time frame than
the competencies developed by Amazon and Google. But of course, Joan’s
jewelry box business is more agile and can change direction much faster
than Amazon and Google. Eventually, all capabilities and competencies
(even Amazon and Google’s) can be imitated, replicated, and improved.
Even scarce resources and monopolies can succumb to the onslaught of
new technology, time, and market forces. There are substitutes for oil,
diamonds, and operating systems.
The RBV is a powerful idea for understanding strategic direction, but
it has several deficiencies. First of all, it is very broad in scope and hard
to implement as part of a concrete business plan. Delineating the unique
capabilities, competencies, and resources and then using this informa-
tion in strategic planning are time-consuming. In addition, there is little
guidance on how to build competencies. Indeed, some theorists believe
that core competencies cannot be built but simply emerge. For additional
discussion on RBV, see Henry10 and Grant.11 Later on, we will discuss
how this approach can be effectively integrated with SWOT analysis and,
in the next chapter, we will discuss how this approach can be integrated
with the Ten–Ten planning process.

Strategy Maps

A strategy map is a visual diagram that represents a causal structure of an

organizational strategy. The strategy map is an outgrowth of the balanced
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 181

scorecard approach developed by Robert Kaplan and David Norton.12

The purpose of the balanced scorecard is to develop a series of measurable
performance indicators that are linked and aligned with organizational
missions and objectives. Measurement at the operational and tactical
levels is a key part of the balanced scorecard approach and essential for
developing and benchmarking best practices. Measurement can be used
to identify where management should redirect its attention and also to
identify whether best practices are already in place.
There are four primary areas where performance indicators can be used.
They are the financial performance indicators, customer performance indi-
cators, performance indicators related to internal organizational processes,
and performance indicators related to the ability of the organization and
employees to innovate and learn. The strategy map is an overview of the
causal relationships related to the four perspectives. Figure 8.4 is an example
of a strategy map for a railroad. You are encouraged to use Google’s image
search using the keyword strategy map for additional examples.
In general, the balanced scorecard/strategy maps approach is more
suitable for older larger organizations with a lot of time for develop-
ing and executing a strategic plan. Kaplan and Norton point out that a
strategy map presents an integrated overview of the outcome measures
and the performance drivers of outcomes using cause-and-effect rela-
tionships. The strategy map can serve as a strategic measurement system
and strategic control system that align departmental and personal goals
with overall strategy.13 There are, however, problems in assumptions
and the time it takes to implement the approach.14 The first problem
is that the approach is too hierarchical and not particularly suitable for
dynamic and complex environments. Some researchers also question the
causal relationships among the variables. For example, are there causal
links related to enhancing cost control leading to increases in the rate
competitiveness, which in turn are leading to improvements in customer
satisfaction?15 In essence, does cost control always lead to customer satis-
faction through competitiveness? One hopes that this is the case, but it is
not easy to verify from both research and practice perspectives.
The major problem from an entrepreneurial perspective is that
the balanced scorecard approach using strategy maps approach is very
complex and difficult to implement. In general, strategy maps and the
balanced scorecard approach are more applicable to relatively mature
 Safety: corporate citizenship Capital efficiency Unified plan: network efficiency
182

Increase returns to Sustainable growth Increase

shareholders stock price

Shareholder
Increase profits and sustain profitability

Increase network profitability

Decrease Increase
costs goodwill Decrease Increase revenue

Financial
expenses per carload

Improve customer Network fluidity

and community Reduced and velocity
safety and inline work
environmental events

Customer
awareness

Accident Green Increase terminal

reduction initiatives Efficient Reduce FSC throughput
engines fuel use
Install
Customer inventory Reduce Reduce Turnaround

Internal
cameras on Derailment
prevention management system dwell switching coordination
DEVELOPING NEW PRODUCTS AND SERVICES

engines
(CIMS) rate

Operating
Safety value: Process and management
employee safety technology training
education and training improvement program

Learning/innovation
Figure 8.4. Example of a strategy map for a railroad. from the public sector, permission of Wikimedia Commons License Agree-
ment, http://commons.wikimedia.org/wiki/File:Strategy Map.jpg.
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 183

companies and are not conducive to new venture development. New ven-
tures, whether they are intrapreneurial or entrepreneurial, need a more
adaptive and agile approach. A customer orientation, with an attention to
securing and reducing the cash burn rate, a focus on executing the plan
by attending to developing internal processes, and focusing on R&D and
learning are the most important takeaways from the balanced scorecard/
strategy maps approach.

Creating Blue Ocean Markets Using the Strategy Canvas

As noted throughout the earlier chapters we believe that the Blue Ocean
concept is an important contribution to the strategic planning litera-
ture.16 The idea is very similar to the so-called killer-app concept and
lateral marketing approach. The goal of the Blue Ocean approach is to
identify uncontested market spaces for profit and growth rather than
compete in traditional Red Ocean market spaces where there is a ten-
dency to focus on either cost-cutting or differentiation. Table 8.2 illus-
trates how the concepts developed in the book with Midas, Atlas, and
Hermes products relate to the Blue Ocean concepts. This process of
developing Blue Ocean market is facilitated by developing the Strategy
Canvas and by using the FAD template as an input into the Strategy
Canvas.
This is in contrast to the competitive strategy approach where a large
and growing already-served market is identified and the entering firm
tries to find a way to compete. Several research projects have been con-
ducted on the efficacy of the Blue Ocean approach, and the results suggest
that organizations pursuing Blue Ocean markets can in some instances
be successful. A Blue Ocean strategy that is focused on intense innova-
tion and on product differentiation and brand creation has been found
to be profitable.17 The Blue Ocean approach apparently helps to insulate
a firm from intense competition. In many instances, Blue Oceans are
not completely blue, but rather have patches of red. The net effect is
that it is sometimes necessary to find a niche in a large market and then
use Porter’s five-forces model to assess the desirability of competing in
a particular industry and how a firm can compete in that industry. The
key idea is that a firm can be more profitable by understanding how the
184 DEVELOPING NEW PRODUCTS AND SERVICES

Table 8.2. Red Versus Blue Ocean Strategy

Red Ocean Blue Ocean
The major goal is to best the competition The major goal is to make the competition
in an already established market space. irrelevant and superfluous by developing
a new product or service in a new market
space.
Compete on the existing demand curve in Compete and capture a new uncontested
the existing market space. Growth is slow. demand curve in a new market space.
Growth is above average.
Develop either Midas, Atlas or Hermes Develop and introduce Midas, Altas and
products and services Hermes products and services
Focused on product differentiation or Focused on product differentiation and
being a low cost producer also being a low cost producer.
Focused on cost cutting, outsourcing, Focused on research, product design, and
brand management, and advertising. learning.

five forces influence the competitive environment. The most important

part of the Blue Ocean approach is that is to assist in identifying strategic
opportunities for product differentiation using the Strategy Canvas. This
was discussed in an earlier chapter where we used the FAD template to
develop a Strategic Canvas for the Nintendo Wii.

SWOT Analysis

The genesis of the SWOT approach to strategic planning is usually attrib-

uted to Albert S. Humphrey during his tenure with the Stanford Research
Institute.18 Even though the SWOT technique can trace its roots to the
1960s, it is still an important and useful tool that it is constantly evolving
and improving to deal with the ever-increasing complexity of contempo-
rary markets.
The objective of a SWOT analysis is to facilitate the development of
a strategy for completing a new venture, completing a large-scale pro-
ject, and diagnosing deficiencies in an existing organization by taking its
temperature in a particular environmental context. A SWOT diagram
consists of four quadrants (see Figure 8.5). The upper two quadrants relate
the internal strengths and weaknesses of the organization. The bottom two
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 185

Internal strengths Internal weaknesses

(Helpful to mission) (Harmful to mission)
•Try to exploit existing •Try to improve weaknesses
strengths, competencies by investing in R&D and
and resources. the supply chain
•Engage in learning-about •Engage in learning-about
and learning-by-doing and learning-by-doing

External opportunities External threats

(Helpful to mission) (Harmful to mission)
•Try to monitor •Try to reduce or eliminate
opportunities pursued by threats by investing in R&D
the competition, be the and the supply chain.
first mover, differentiate, •Engage in learning-about
and compete on cost. and learning-by-doing
•Engage in learning-about
and learning-by-doing

Figure 8.5. SWOT diagram.

quadrants relate to the external organizational environment in terms of the

opportunities and threats faced by the organization in the marketplace.
One of the benefits of SWOT is that it can be used to analyze the
organization as well as the organizational environment in order to iden-
tify areas of competitiveness and areas that need attention. It is a very
useful tool for looking inside and looking outside to identify the state of
the organization and the competitive environment. In an ideal situation,
it draws on organizational constituencies and scans the external environ-
ment for opportunities and threats. Several examples of how SWOT can
be used to analyze the strategic context are presented below.

Example 1: iPhone 4

Figure 8.6 illustrates a SWOT analysis for Apple’s iPhone 4. Substitute prod-
ucts are the greatest threat; however, Apple has been able to counterbalance
such encroachment by paying attention to product differentiation through
research and product development and, of course, the coolness index.
186 DEVELOPING NEW PRODUCTS AND SERVICES

Strengths Weaknesses
•Research and product •Reception issue because
development of faulty antenna
•Product design •Battery life
•iPod functionality •Extra storage
•Wi-Fi enabled •Voice clarity
•User base lock-in •Dropped calls
•Power over suppliers •Expensive carrier
•Steve Jobs contracts

Opportunities Threats
•Distribute paid-for content. •Substitutes: competition
•Attract new customers to from look-a-likes phones,
Apple clan PDAs, handheld games,
•Network effects linked to Microsoft, Google
coolness and functionality •Everyone has access to
•Crowd-based app similar technology
development •Steve Job's health
•Further lock-in

Figure 8.6. iPhone 4 SWOT analysis.

Example 2: Dell’s Entrance Into the Chinese Computer Market

Dell decided to enter the Chinese PC market in the 1990s. They faced many
impediments to entering such a complex environment. Figure 8.7 illustrates
a hypothetical SWOT analysis for Dell as they embark into the Chinese
PC market. The Dell supply chain is top-notch as well as their strong com-
mitment to R&D. They have numerous business process patents as well as
product patents. One of the earlier knocks on Dell was that the Chinese cul-
ture was not conducive to Dell’s golden rules of disdaining inventory, always
selling directly, and always listening to the customer. They have subsequently
begun to listen to the customer and have started to sell through retail outlets.

Integrated SWOT Analysis

Even though a SWOT analysis is fairly easy to understand and apply, it is

not necessarily easy to develop a good one. One of the primary criticisms
of SWOT is that it leads to a large laundry list of strengths, weaknesses,
opportunities, and threat factors. It is also criticized because it lacks
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 187

Strengths Weaknesses
•Supply Chain and •Knowledge of Chinese
just-intime manufacturing government
•Customer service •Knowledge of culture and
•Research and development people
•Product customization •Adherence to Dell’s golden
•Brand rules

Opportunities Threats
•Market size •Threat of copycat systems
•Growing demand •Intellectual property
protection
•Chinese government
•Intense competition
•Wages and payment systems

Figure 8.7. SWOT analysis for Dell entering China.

direction and focus. The net effect is that strategic planners are not sure
what variables are important or where to start in the process. This is par-
ticularly relevant in a world characterized by strong domestic and global
competitions where risk and uncertainty are driven by the winds of tech-
nological change, political turmoil, and governmental actions.19
The quick SWOT approach alleviates the deficiencies of traditional
SWOT analysis by drawing on the other analytical approaches looking
at strategy presented earlier. It takes the key variables in value and sup-
ply chain analysis, the five-force model, the resource-based framework,
and the technology-based strategy approach and uses them to drive the
SWOT process. The critical variables or drivers that influence the SWOT
are listed below:
• Internal Organizational Drivers
Supply and value chain performance
Core competencies and organizational resources
Emerging technology
188 DEVELOPING NEW PRODUCTS AND SERVICES

• External Organizational Drivers

 Threat of substitute products
 Threat of new entrants
 Bargaining power of buyers
 Bargaining power of suppliers
 Local and world economy, culture, and government
influence

Some of the variables influence both the internal and external organi-
zational environment. For example, the supply chain boundary affects
the internal environment, but it is also part of the external environment
and involves logistics and financial institutions. Similarly, the onslaught

Core competencies
and tangible and
intangible
resources

Supply/value chain Emerging

performance technologies

Strengths Weaknesses
• List no more • List no more
than four than four

Bargaining power Economy, culture

of buyers and government
Opportunities Threats
• List no more • List no more
than four than four

Bargaining power Threat of new

of suppliers entrants

Threat of
substitutes

Figure 8.8. Key drivers for quick SWOT analysis.

 STRATEGIC PLANNING APPROACHES FOR PRODUCT 189

of new technologies also influences the internal as well as the external

environment. Figure 8.8 illustrates the SWOT template along with the
key variables that should drive the SWOT analysis.

The Quick SWOT Supported With Strategy Canvas

A SWOT analysis should be conducted very quickly as illustrated

below:

1. Conduct a brief external industry analysis.

 Identify the competitors, buyers, suppliers, potential
entrants, and potential substitutes.
 Understand the industry supply chain and how it works.
2. Conduct a brief internal organizational analysis.
 Identify organizational capabilities/competencies related
to manufacturing prowess, order fulfillment and delivery,
customer service, marketing, finance, accounting, R&D,
employees, and management. This is essentially the internal
supply and value chains.
3. Use a strategy canvas to identify how you can add or subtract features
for product differentiation. The idea is to identify new opportunities
and perhaps Blue Ocean markets.
4. Develop a 4 × 4 SWOT diagram using the template. Try to limit the
number of factors in each quadrant to four factors.
5. Start the process over after 4 months.

The next chapter will provide a simple template as part of the Ten–Ten
planning process for conducting an organizational and industry analysis
that incorporates the quick SWOT approach.

Monopolistic Competition and SWOT

Monopolistic competition involves many buyers and many sellers offering

slightly different competitive products. Producers are always searching
for markets with potential. In such an environment, there are several
strengths that are critical for survival. Figure 8.9 illustrates the idea that
190 DEVELOPING NEW PRODUCTS AND SERVICES

Critical strengths Critical weaknesses

• Research & product • Research & product
If there are development development
substitute or • Brand • Brand
emerging • Efficient supply chain • Efficient supply chain
technology • Weak product or service
threats then
you need to
have 2 out of 3
critical
strengths
Opportunities Threats
• Survival • Substitute products
• Market share • Emerging technologies
• New products and
markets
• Lock-in
• Develop brand

Figure 8.9. Competing under monopolistic competition requires

strength in at least two areas.

if there are substitute products or emerging technology threats, then you

need to have 2 out of 3 critical strengths. The critical strengths are research
and product development, a high performance supply chain, and a strong
brand. The optimum situation is to be strong in all three areas, but this is
not very common. If any of these three are placed in the critical weakness
category, the organization is definitely at risk. It should also be noted that
an organization could be strong in all three critical strengths and still fail.
Survival is still linked to long-term profitability. Many of the very success-
ful companies are 3 for 3 and have above-average performance in R&D
and a strong brand and excellent supply chain.

Conclusion
In this chapter, we have reviewed many popular approaches for strategic
planning. The key points are the following:

• The two basic strategies for business planning include product

differentiation and striving to be the low-cost producer.
 STRATEGIC PLANNING APPROACHES FOR PRODUCT 191

• Product differentiation can be accomplished by focusing on

Midas versions of products using extravagant engineering
and design. Being the low-cost producer can be accomplished
by focusing on Hermes versions of products using frugal
engineering and design.
• Planning approaches can be classified as having an internal
organizational focus (looking inside) or an external or
environmental focus (looking outside).
• The development of an abbreviated SWOT analysis that is
supported with a strategy analysis can be used to integrate the
key attributes of the various strategic planning approaches.
• The planning process never ends. With continuous pressure
from market and competition, firms are suggested to develop
new strategy and planning from time to time.

This chapter reviewed the various analytic approaches for strategic

planning. There is no single business plan that can be used to deal with
the complexity of monopolistic competition nor is there a single planning
approach that will take the organization down the right path. A revised
analysis tool, called quick SWOT analysis, was introduced that combines
the various strategic planning approaches.
This chapter also sets the stage for the Ten–Ten planning process, a
simplified yet robust approach to planning. The next chapter will present
two templates for developing a business plan. The first template is the
Organizational and Industry Analysis template and it incorporates the
quick SWOT approach along with concepts from value chain analysis,
the resource-based approach, Blue Ocean market analysis, and the other
strategic analysis approaches discussed in this chapter. This information is
then used to fill in the Business Plan Overview template. The use of the
two templates is part of the Ten–Ten planning process. The approach can
be used to produce one plan and also to churn out new plans in order to
compete in dynamic environments characterized by monopolistic com-
petition.
 CHAPTER 9

The Ten–Ten Planning

Process: Crafting
a Business Story
As noted in the last chapter, the planning process is never-ending because
of the ongoing pressure in the marketplace. There is no single plan that
can deal with the complexity of monopolistic competition. The first man-
tra of the entrepreneur is: differentiate through innovation or perish, and
this is accomplished by focusing on Midas versions of products using
extravagant engineering. The second mantra of the entrepreneur is: strive
to reduce costs, and this is accomplished by focusing on Hermes versions
of products using frugal engineering and design. The dynamic tension
between delivering Midas and Hermes versions will also lead to main-
stream Atlas products. A continuous process for developing business
plans is necessary for competing and surviving under monopolistic com-
petition. As discussed in the last chapter, the strategic planning process
can be modeled using the diagram in Figure 9.1. The mantra and mission
are constantly evaluated and revisited throughout the life of the firm.
The Ten–Ten planning process contains two templates: an Organiza-
tional and Industry Analysis template and the Business Plan Overview
template that identifies the mantra, mission, money, goals, objectives, and
tactics in a very brief format. (These templates can be downloaded from
http://glsanders.wordpress.com/) The idea behind the Ten–Ten approach
is that once you have gathered some background data related to the indus-
try and the organization, you should be able to complete the two templates
in about 20 minutes.1 This will of course be a very rough first-cut, but it
will be the foundation for developing more refined plans. The Ten–Ten
process is meant to be quick and to the point, but it can be expanded to
10 hours, 10 days, or in some instances 10 weeks, but rarely more than
194 DEVELOPING NEW PRODUCTS AND SERVICES

External
(looking outside)

Mantra & Goals and

Analysis Tactics
Mission objectives

Internal
(looking inside)

Figure 9.1. Strategic planning process.

that. These templates along with the FAD (features, attributes, and design)
template can be used to develop the executive summary. This in turn can
be used to develop a full-blown business plan, which is the foundation
for building the business. Figure 9.2 illustrates the entire Ten–Ten process
from conceptualizing the business idea through building the business.

Organizational and Industry Analysis Template

The first template is the Organizational and Industry Analysis template
and it incorporates the quick SWOT analysis using concepts from supply
chain analysis, Porter’s value chain analysis and five-force model,2 the
resource-based approach,3 core competencies analysis,4 and the Blue
Ocean Strategy Canvas.5 The idea is to conduct a brief industry analysis
without getting bogged down in the details. This template is contained in
Table 9.1. The FAD template is a good source of information related to
what products or services are going to be produced and sold. The point of
the first planning template is to help you understand the current or pro-
posed organization and the target industry. Questions 1 through 5 assist
in detailing the basic question related to what business you are in and
what the industry looks like. Question 6 is a simplified SWOT diagram.
It is intentionally small so that that it is difficult to enter too many items.
Long laundry lists are a recurring critique of SWOT analysis. One area
where the simplified SWOT analysis differs from the traditional SWOT
approach is that the focus is not on just internal issues, but on any areas
where an organization has strengths and weaknesses. For example, the
 Problem or
opportunity Build business
triggers idea

Ten-Ten templates
Creative analysis & External analysis Develop business
insight (looking outside) plan

Conduct industry &

Conduct FAD Develop business Develop executive
organizational
analysis plan overview summary
analysis

Internal analysis
(looking inside)
THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY
195

Figure 9.2. The business development process.

Table 9.1. Organizational and Industry Analysis Template (do this first)
196

1. Give a brief description of your business model including what products or service you are producing or will produce.

2. Describe your target customers and the size of the market?

3. List and describe your current competitors?

4. List and describe your potential competitors?

5. Who will you purchase or acquire materials, components, resources, or other inputs from?
DEVELOPING NEW PRODUCTS AND SERVICES

6. SWOT (consider human resources, R&D, marketing, procurement, manufacturing, distribution, engineering, IT, finance, accounting, and legal)
What are your strengths (products, R&D, supply chain, brand, What are your weaknesses (products, R&D, supply chain, brand, pricing, core
pricing, core competencies, resources, infrastructure, scalability, and competencies, resources, infrastructure, scalability, and interfaces)?
interfaces)?
 What are the opportunities (growth, market share, product lines, What are the threats (substitutes, emerging technologies, new entrants, economic
Blue Ocean, complementary products, lock-in, brand, and first-mover climate, government regulations, and social/culture issues)?
advantage)?

7. Strategy Canvas for new product compared with competitor or industry (price and quality are example attributes)
Use the FAD template to add key attributes to the Strategy Canvas (you can continue the table if you need more attributes)
Meaning of
product or BOF POD BOF POD BOF POD BOF POD BOF POD BOF POD
service↓ POP EXT DIS POP EXT DIS POP EXT DIS POP EXT DIS POP EXT DIS POP EXT DIS
Attribute name Price Quality
Very high
High
Average
Low
Very low
Not applicable

BOF, Blue Ocean features and exciters; POD, points of difference and differentiators; POP, points of parity and must-haves; EXT, extinct and vestigial features; DIS, dissatisf iers
THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY
197
198 DEVELOPING NEW PRODUCTS AND SERVICES

research and development (R&D) and product development areas are

typically considered internal functions, but the supply and value chains
along with the brand image are interconnected functions that span the
internal and external organizational environment.
Another important feature of the Organizational and Industry
Analysis template is the presence of question 7 and the development of
a strategy canvas, the Blue Ocean strategy, for identifying the current
product features and how they compare with one or more competitors
or with a typical product or service found in the industry marketplace.
The goal is to assist in illustrating what product features are being used to
differentiate the competitors and to identify other areas where you might
want to reduce or add features or even increase or decrease performance.

Business Plan Overview Template (Mantra, Mission,

Money, Goals, Objectives, and Tactics)
The second template is the Business Plan Overview template (see
Table 9.2). This template uses the Organizational and Industry Analysis
information and FAD template to identity the organizational mantra, the
mission, the money or value proposition, goals and objectives, and tactics.
It is essentially a scaled-down business plan that can be used to develop
the full-blown business plan that will be discussed in a later chapter.

1. The mantra: Guy Kawasaki prefers using a mantra in lieu of a mis-

sion statement.6 He is very critical of mission statements that are
crafted by a large committee of 60 at an offsite retreat. We do not
see the mantra as a replacement for the mission statement. We see
the mantra as an often-repeated phrase that provides the basis for the
existence of the company. It is a slogan, a watchword, a byword, and
a motto that breathes life into the firm’s existence. The meaning of a
product as identified in the FAD template is a good place to look for
the foundations of a mantra. Examples include the following:

• Hospital: Service, respect, and excellence in healthcare

• Software Developer: Quality software through hard work and
creativity
 THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY 199

Table 9.2. Business Plan Overview Template (do this second)

1. What is your mantra considering differentiation through innovation or perish or cost
reduction (3–10 words on why your company should exist)?

2. What is the overall mission of the business (1–3 sentences on what your company
does or will do and your target customers)?

3. How will you make money in terms of product differentiation, being the low-cost
producer, and what complementary products and services will be offered in order to
generate recurring revenues?

4. What are your goals and objectives over the next 3 months to year (2–6 phrases on
precise performance intentions)?

5. What tactics will you use over the next 3 months to a year to reach your objectives
and mission (2–8 phrases)?

• Manufacturing: Quality is our endgame

• Telecommunications: We hear our customers.

2. The mission statement: The mission statement presents a brief overall

view of the business. It describes what the company does and why it
exists. It should focus on meeting customer needs. It should address
at an abstract level what products or services are produced. It can
also include a statement reflecting whether the company will focus
on product differentiation and niche markets, focus on being price-
competitive, or focus on both. The FAD template is also a good
200 DEVELOPING NEW PRODUCTS AND SERVICES

source of information for the mission statement. Examples of a mis-

sion statement include the following:

• We use high-quality materials and craftsmanship to develop

superior jewelry boxes for the discriminating buyer.
• We develop general purpose and customized charity events
planning software for nonprofit organizations.
• We manufacture high-quality measurement instruments for
companies involved in oil exploration.
• Our school prepares students to work in highly productive
software environments.

3. The money: The purpose of this section is to provide an overview

for the value proposition. That is how your organization will
make money using the two generic business model strategies.
The organization can differentiate, be the low-cost producer, or
both. As noted earlier, most organizations attempt to differentiate
and be the low-cost producer at the same time. Because they are
often conflicting strategies, many organizations are slightly better
at one or the other. The best performers balance both strategies.
One important consideration is the generation of additional sales
by offering complementary products and services. For example, a
printer company can sell toner, warranties, and maintenance con-
tracts. A phone manufacturer might become a mobile application
developer and also sell accessories for the phone. Firms should
also discuss the potential size of the market when it is relevant and
whether there is potential for a Blue Ocean market. Examples of
money statements include the following:

• We will generate profits by constantly introducing jewelry

boxes with new features and cutting costs by using building
technology to lower costs.
• We generate most of our revenues by developing
high-end customizable charity planning software. We will
keep development costs down by developing software
modules that are conducive to adding and subtracting
THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY 201

features. We will generate additional recurring revenues

by offering upgrades and providing customized systems
development for nonstandard applications. It is a largely
untapped market with excellent revenue potential.
• We will sell a high-end social-networking project
management tool for large companies. The companies we
will sell our product to are not price-sensitive and we will be
able to charge a premium price to cover our high fixed costs.
We will generate additional recurring revenues by offering
upgrades and providing customized systems development for
nonstandard applications.
• We will build an inexpensive house using modular and
inexpensive building materials. We will be the low-cost
supplier. We will generate additional recurring revenues by
offering house maintenance services to our customers.

4. The goals and objectives: There is a lot of confusion related to goals

and objectives. Goals are thought of as being more abstract and
broader than objectives. This is a rather overstated and specious
claim that creates more harm than good. This section of the business
plan template encourages you to list both goals and objectives. The
important point is to identify the goals and objectives that will help
support the mantra, the mission, and the value proposition over the
next 3 months to a year. Examples include the following:

• Launch new product line in July

• Increase sales by 5% over the next year
• Service 10% more customers than last year
• Reduce waste by 5%.

5. The tactics: The tactics are the activities the organization will use over
the next 3 months to a year to reach a company’s goals and objectives.
In the context of the military, the tactics are the techniques used to
deploy troops, hardware, aircraft, and ships for combat. In business,
this includes the activities related to marshaling human resources,
manufacturing resources, acquiring equipment, and related supply
202 DEVELOPING NEW PRODUCTS AND SERVICES

chain activities to attain the goals and objectives. The tactics can
include timetables and schedules related to the goals and objectives.
Examples of tactics include the following:

• Purchase a high-performance band saw in February

• Hire employees in April to develop new customer interface
software
• Develop a radio-marketing plan for introducing new product
in November
• Have the sales force contact every customer who has not
purchased a product in the last 2 years.

Developing an Executive Summary: Crafting

a Business Story
One of the most common reframes we hear from entrepreneurs is that:

They just don’t understand our business model.

They just don’t understand what we are doing.

Who are they? They can be friends, family, investors, and even the busi-
ness founders. In reality, they sometimes do not understand because the
business concept is faulty, but sometimes they do not understand because
you have not communicated the essence of the vision to the relevant par-
ties. The Ten–Ten planning templates can alleviate some of the confu-
sion; furthermore, at some point, the Ten–Ten templates will have to be
converted into a well-crafted executive summary that tells an interesting
story. This will help further refine the business model, and it will also serve
as a platform for communicating with the many theys that are encountered.
The executive summary should tell a story in one or two pages or per-
haps even three pages. The best way to prepare the business plan is to use
Business Plan Overview template information as a starting point and use
the Industry and Organizational and the FAD templates for additional
input into the development of the executive summary. Here is a general
format for the executive summary:
 THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY 203

• Paragraph 1: Introduce the idea (four to six sentences).

 The first line of the executive summary should be a catchy
sentence that captures the essence of the mantra.
 The remaining sentences of the paragraph should discuss
the mission of the company.
• Paragraph 2: Describe your business model and what products
or services will be produced (four to eight sentences).
 Describe your target customers.
 Describe your product or service and tell what it does.
 Describe how it will benefit consumers or other businesses.
 Discuss why your business model will work in terms of
product differentiation, being the low-cost producer,
or both.
 If appropriate, describe how your approach and your
products are superior to the competition.
 If appropriate, describe the size of the market and if it is a
Blue Ocean opportunity.
 You can add additional paragraphs if you think that
more detail is needed to describe your product or service.
Sometimes a technology or a concept is very unique and it
needs additional discussion.
• Paragraph 3: Discuss your strengths (three to six sentences).
 Use the SWOT analysis to discuss the strengths, core
competencies, and resources that are keys to the company’s
success.
• Paragraph 4: Discuss the opportunities and how the goals and
objectives relate to achieving the opportunities.
 Use the opportunities in the SWOT analysis to identify the
business opportunities.
 Discuss how you will make money and generate revenues.
 Use the goals and objectives in the Business Plan Overview
to indicate how the firm will take advantage of the
opportunities.

The executive summary can be up to three pages and have additional

paragraphs, but you should still aim for brevity, crispness, and clarity.
204 DEVELOPING NEW PRODUCTS AND SERVICES

Remember, the goal of the executive summary is to communicate your

business model to the readers by telling a story. One of the best ways
to communicate ideas is to keep the readers interested and avoid long
meandering discussions. Here are a few ways for increasing attention and
interest.
The first thing is to avoid using bullet points in your executive sum-
mary. Bullet points create the impression that you have just cut and pasted
the presentation into the executive summary. In addition, readers tend to
skim bullet points and sometimes even ignore them. You should also vary
the length of your sentences. For example, have two short sentences, one
long sentence, and one short sentence followed by a long sentence and
then a short sentence. The idea is to mix up the sentence structure and
create interest. Always try to begin and start your executive summary
with a catchy phrase related to the mantra. Finally, editing is important,
and having someone else edit your plan is essential. Even if you do not
use the edited version, you will obtain insight into where the executive
plan is unclear and needs work.7 One example of an executive summary
is exhibited in the Appendix at the end of this chapter.

Extending the Wine Aging Cooler Example

Using the Ten–Ten Templates
Chapter 7 introduced the concept of a device that could be used to
reduce the time that it takes to age wine. The FAD template was pre-
sented in chapter 7 for a storage and refrigerator device that could be
used to age wine. This example is extended in the Appendix of this chap-
ter. The Appendix contains a completed template for the Organizational
and Industry Analysis and a completed template for the business plan
overview. The Appendix also contains an executive summary for the wine
aging cooler and the picture of the proposed product. The product was
subsequently named the Addvinter Star.

Conclusion
In this chapter, we have illustrated a model for quickly crafting a business
plan. The key points are the following:
 THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY 205

• The Ten–Ten planning process is very brief yet dynamic and

adaptable to a variety of situations.
• It draws on the major strategic planning approaches as well as
the FAD template discussed in chapter 7.
• It consists of completing two templates and developing an
executive summary.
• The first task consists of collecting internal and external
information completing the Organizational and Industry
Analysis template. This template also uses information from
the FAD template.
• The second task uses the Organizational and Industry Analysis
template along with the FAD template to complete a Business
Plan Overview template.
• The information gathered using the FAD template, the
Organizational and Industry Analysis template, and the
Business Plan Overview template are then used to write an
executive summary.
• The goal is to communicate with partners, confidants, and
funding sources.

Strategic planning is often criticized as taking too long, being too

complex, and even being counterproductive. The Ten–Ten approach
alleviates many of these criticisms by its conciseness and the way
it focuses on learning-by-doing. It is still hard work. However, the
author has actually had groups of people complete a Ten–Ten plan
in one night. This includes conceptualizing a new business model up
through the completion of the business templates. The feedback was
generally positive from the experience, although the participants were
exhausted.
The business plan serves many purposes. But the primary goal is to
foster communication with the business founders, partners, confidants,
and funding sources. The Ten–Ten business plan presents a succinct
overview of the what, how, when, and why of the business. It provides
a concise overview of what the business is about and how money can
be made. In many ways, the Ten–Ten documents are a prototype of
the business model. This is in essence a scaled-down business model
206 DEVELOPING NEW PRODUCTS AND SERVICES

that describes how the business will function and serve as a platform
for the business founders to communicate with each other and identify
strengths and weaknesses of the emerging firm. In chapter 12, we will
present the infrastructure for a full-blown business plan that can be
used as a blueprint for operating the business the first year.
 APPENDIX

Illustrations of Completed
Ten–Ten Templates and an
Executive Summary for the
Addvinter Star
Example of an Organizational and Industry Analysis
Template
1. Give a brief description of your business model including what
products or service you are producing or will produce?

We will develop high-tech devices that will significantly reduce the wine
aging process. Most wines can benefit from aging. The typical Merlot
needs 15 years to age and Pinot Noirs and Burgundies sometimes need 5
years to age. Shiraz-based wines sometimes require more than 20 years.

2. Describe your customers?

We will target wine connoisseurs, the wine aficionado, upscale restaurants

and clubs, wine enthusiasts, and dabblers in sophistication. The wine con-
noisseur is one who understands the details, technique, and principles of
wine as an art and is competent to act as a critical judge. The aficionado
includes individuals who like, know about, and appreciate and fervently
pursues fine wines. The enthusiast and dabblers includes individuals who
are interested in wine and enhancing prestige at a reduced price.

3. List and describe your current competitors?

Existing wine production companies and distributors.

Japanese inventor at http://www.timesonline.co.uk/tol/news/world/

article576802.ece
208 DEVELOPING NEW PRODUCTS AND SERVICES

Wine aging tester at http://www.vinummaster.com/Eng/InfosClefEn.

htm

Wine aging accelerator http://www.amazon.com/Vintage-Express-

Accelerator-Bourbon-BEVERAGES/dp/B001I2S308

Wine aging patent: http://www.freepatentsonline.com/7334516.

html

4. List and describe your potential competitors?

Any business interested in wine aging technology. Companies cur-

rently producing wine refrigerators are also a threat.

5. Who will you purchase or acquire materials, components,

resources, or other inputs from?

We will secure local manufacturers to develop the device and will

hire local people to assemble the device.

6. SWOT (consider human resources, R&D, marketing, procure-

ment, manufacturing, distribution, engineering, IT, finance,
accounting, and legal)

What are your strengths (products, What are your weaknesses (products,
R&D, supply chain, brand, pricing core R&D, supply chain, brand, pricing, core
competencies, resources, infrastructure, competencies, resources, infrastructure,
scalability, and interfaces)? scalability, and interfaces)?
The idea R&D
Creative team of researchers and Supply chain
entrepreneurs Brand
Infrastructure
What are the opportunities (growth, What are the threats (substitutes,
market share, product lines, Blue Ocean, emerging technologies, new entrants,
complementary products, lock-in, brand, economic climate, government
and first-mover advantage)? regulations, and social/culture issues)?
Per capita wine consumption in the USA Market can be easily entered.
exceeds 9 liters. Our research or our competitors may show
http://www.wineinstitute.org/files/PerCapi- that it does not work.
taWineConsumptionCountries.pdf Wine companies may go after our product.
Gen X and millennial wine drinking high. For example, expensive wine vintners
http://www.winemarketcouncil.com/ may take out advertisements to attack our
research_slideview.asp?position=9 product.
Will try to secure wine connoisseurs, Wine refrigerator companies: http://www.
aficionados, clubs, enthusiasts, and dabblers. winerefrigerator.com/
 THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY 209

We also plan on developing a series of

complementary products and services. For
example, we could engage in wine consult-
ing to producers. We could also introduce a
line of wine accessories for consumers.

7. Strategy Canvas for existing product compared with competitor

or industry
BOF POD POP BOF POD POP
Meaning EXT DIS EXT DIS
Attribute name Price Sophistication Wine aging and Design
refrigeration
Very high Us Us Us

High Us Us

Average Us

Low Competition

Very low Competition Competition Competition

Sample Business Plan

Business Plan Overview Template for AddVintner (confidential draft)

1. What is your mantra considering differentiation through inno-

vation or perish or cost reduction (3–10 words on why your com-
pany should exist and company name)?

AddVintner: Creating fine wine before its time.

2. What is the overall mission of the business (1–3 sentences on

what your company does or will do)?

We will develop high-tech refrigeration devices that will signifi-

cantly reduce the time to age wines for a broad range of customers.

3. How will you make money in terms of product differentiation,

being the low-cost producer, or both?

We plan on offering at least two products. One is targeted at

the wine connoisseurs, aficionado, and expensive restaurants/
clubs. The other product will be targeted toward wine enthusi-
asts and dabblers. The high-end products will be prices in the
$1,500–$2,500 range. The low-end product will start at $400.
210 DEVELOPING NEW PRODUCTS AND SERVICES

4. What are your goals and objectives over the next 3 months to year
(2–6 phrases on precise performance intentions)?

Sell 5,000 units of $2,000 unit by December.

Sell 10,000 units of $400 unit by December.
Conduct research on the effectiveness of the wine aging process.

5. What tactics will you use over the next 3 months to a year to
reach your objectives and mission (2–8 phrases)?

Purchase warehouse for manufacturing by March.

Conduct additional research on the viability of the aging process.
Hire additional designers to develop product portfolio.
Develop marketing strategy by March.
Develop production process by May.
Hire 10 employees by June.
Start advertising by July.
Start production by August.

Executive Summary (first draft not for distribution)

It is said that music is the wine of silence. Aged wine is for those seek-
ing silence and comfort in the chaos of everyday life. It is our mission to
bring aged wine to the discriminating concern and to give everyone the
opportunity to drink aged wine at a reasonable price. A good Merlot can
take up to 15 years to age, a Pinot Noir or a Burgundy can take up to
5 years to age, and Shiraz-based wines may require 20 years. We sell the
most advanced solutions for improving the aged quality of most wines
without having to pay high prices or wait many years for the wine to be
ready for the palate.
Our product (see prototype below of the Addvinter Star) can attract
variety wine drinkers including wine connoisseurs, the wine aficionado,
and expensive restaurants/clubs and wine enthusiasts and dabblers. Our
product will help to reduce the time that a consumer has to wait for
fine wine, it will also increase the quality of low-priced wines and it will
increase the status of the owner of the product. We are strong believers
 THE TEN–TEN PLANNING PROCESS: CRAFTING A BUSINESS STORY 211

in design-driven innovation and will spend several months experimenting

with new ideas and concepts for creating new customer meanings for wine
aging. R&D will be the key driver for developing products that are unique,
contemporary, and relevant to the wine community. The competition will
simply not be able to keep pace with our research-based design-driven
products.
We are an idea-driven company and have assimilated a creative team
of researchers and entrepreneurs to deliver products to compliment and
reflect contemporary tastes. Our marketing and production plans are
in place and we have a strong grasp of the critical elements in the sup-
ply chain. We are developing an organization that will not just listen to
consumers but will also be proactive in developing products that will
anticipate and drive demand.
Per capita wine consumption in the USA exceeds 9 liters per year.8
Wine drinking by the Gen Xers and the Millennial’s exceeds the con-
sumption of beer and spirits.9 We have an opportunity to tap into that
huge market and develop products that are relevant to the life style of
Gen Xers and the Millennial’s. We believe that we can generate nearly
$7 million in revenue the first year. It is our goal to enter the market
by January with two new products for producing fine wine before its
time.

Wine aging time

The Addvinter Star

 CHAPTER 10

Lock-In and Revenue

Growth
Lock-in occurs when there are costs involved in switching from one prod-
uct or service to another product or service. For example, consider how
cable television broadband providers and wireless phone providers have
penalties for the customers who terminate a contract within the term
of specific agreement period. Switching costs can also involve time and
psychological effort. When you switch cable providers, there is a definite
learning curve related to using the new station guide and digital video-
recording device. Cable providers try to increase monetary and psycho-
logical switching costs so that consumers are locked-in to their service.
The nature of psychological switching costs can be traced to past use of a
product and to the learning effects as consumers become attached to the
product and become familiar with the interface and how to control the
interface. Economists have identified a related concept that they refer to
as the increasing-returns-to-adoption phenomena where the use of a tech-
nology leads to greater use and this in turn leads to technological improve-
ments.1 This “learning by use” approach, which we have also described in
an earlier chapter as the learning-by-doing phenomena, creates a situation
where locking-in customers essentially locks-out the competition.

Lock-In Leads to Network Effects and Increased

Product Performance
Lock-in also increases the so-called network effect phenomenon. A
network effect occurs when the value of a good is dependent on the
number of customers already owning that good. Metcalfe’s law states
that the value or utility of network is proportional to the number of users
of the network.2 In the economics literature, a network effect typically
214 DEVELOPING NEW PRODUCTS AND SERVICES

Diffusion
Lock-in
customer
acquisition &
retention

Product Network
performance effects
Time

Figure 10.1. Growth and lock-in.

refers to a change in the positive benefit that a consumer receives from

a product when the number of consumers of the good increases.3 Lock-
in is also related to Moore’s law, whereby the performance of products
always increases over time and the cost of the product stays the same
or decreases. This increase in performance is a function of technologi-
cal developments and learning curve effects. When network effects are
combined with increased product performance, product diffusion can
increase dramatically and result in exponential market growth and sales
(see Figure 10.1).

Switching Costs are Everywhere

Switching costs are the costs that result from switching to a new prod-
uct or a new service. They are often viewed in terms of dollars but
they can also be conceptualized in terms of time and psychological
effort. Switching costs can include early termination costs, the amount
of time and effort to switch, all learning costs required to understand
the new product or service, cash outlays for switching, and even the
emotional discomfort caused by switching.4 The goal of buyers is to try
and avoid switching costs and not be locked-in to a particular product,
service, or technology. Buyers want flexibility and they try to avoid
lock-in.
The goal of producers is to essentially lock-in their customers and
lock-out the competition. This is accomplished by creating a value propo-
sition for their customers and make it difficult for them to leave the fold
 LOCK-IN AND REVENUE GROWTH 215

because of the high switching costs. Here is a list of situations that result
in product and service lock-in:5

• High-quality product and service that are in demand. Examples

include high-end cars and newly introduced game consoles.
• Products that are sold at a relatively low price while its
development costs are recouped through replacement parts,
consumables, and maintenance. Examples include printers,
razors, and autos.
• Recently purchased products that are relatively expensive will
probably be too new to abandon. Examples include new cars,
freezers, most durable goods, and houses.
• Products or services that cause customers to continue using
the product because it forces them down a particular path.
The path can be related to technology and is often proprietary.
Examples include operating systems, game consoles,
computers, tax software, banking, colleges, social networks,
Internet service providers, word-processing, and various other
applications software.
• Products, services, and vendors that are usually the lowest
cost. Examples include Kohl’s, Wal-Mart, Target, Newegg,
inexpensive cars, off-brand inks, alternative materials (plastic
for metal), discount airlines, and most of the Hermes
products and services.
• Brands that customers will turn to because they engender
trust, confidence, and quality. Examples include IBM, Audi,
Clark’s shoes, Expedia, Amazon, Tide, and many of the
companies selling Midas products and services.
• Legal contracts for providing products and service. Examples
include wireless phone, broadband, cable, and outsourcing
agreements between businesses.
• Loyalty programs and frequent use programs. Examples
include airlines, retail stores, and in general discounts for
repeat purchases.
• Product and services that complement the main product or
service. Examples include software applications for operating
216 DEVELOPING NEW PRODUCTS AND SERVICES

systems, mobile phone applications, social networking

applications, and maintenance and repairs departments
connected with the dealer.
• Customers who are socially and emotionally involved with
the product and services. Examples include online and offline
social networks, online role-playing games, colleges, and
church groups.
• Products that facilitate control of one’s environment. If a
consumer can control a product or service, then they feel that
they own it and thus become locked-in to using that product
or service out of loyalty.

Figure 10.2 illustrates the author’s view of the degree of lock-in for
several business activities. One particular interesting example of lock-
in is related to social networking sites such as Facebook, MySpace, and
LinkedIn. Social networking sites have an abundance of features that
facilitate lock-in. First, they encourage the development of very strong
emotional ties among the participants. Secondly, some of them attempt to
thwart searching by search engines. And finally, they encourage the cus-
tomization and control of the home screen. Our research has found that if
you can give users the ability to control and customize their environment,

Lower lock-in

• Search providers
• Local retail stores
• Online retailers
• Online auctions
• Online travel agencies
• Social networks
• Tax software
• Your bank
• Broadband providers
• New durable goods
• Email address
• Game consoles
• Operating systems
• Word processing, spreadsheets etc.

Higher lock-in

Figure 10.2. Levels of lock-in for several businesses.

 LOCK-IN AND REVENUE GROWTH 217

then they will begin to exhibit feelings of ownership toward a virtual

place.6 It appears that in some people, the emotional ties are stronger than
the ties exhibited by some individuals toward a house or a car. In addi-
tion, there is a positional effect. This can reduce the influence and reduce
the network effects:

Positional goods purchases, consequently, are interdependent:

what we buy is partially a function of what others buy. Put another
way, the value of a positional good arises in part from social con-
text. The positionality of a particular good is often two-sided: its
desirability may rise as some possess it, but then subsequently fall
as more possess it.… A particular fast car is most desirable when
enough people possess it to signal that it is a desired object, but
the value diminishes once every person in the neighborhood pos-
sesses one. Nothing about the car itself has changed, except for its
ability to place its owner among the elite and to separate her from
the crowd. Similarly, part of the appeal of a “fashionable” resort is
that only a few people know about it, or are able to afford it. For
these goods, the value of relative exclusivity may be a large part of
the goods’ total appeal.”7

A Lock-In Index
We have developed a set of questions that can be used to measure lock-in.
It can be viewed as a lock-in index. Try to think of a product or service
and then answer the following questions:

• The people who use this product are very cool. Add 1 point.
• This product has a strong brand. Add 2 points.
• The product or service is relatively expensive and was recently
purchased. Add 1 plus 1 point for each time you use the word
very.
• The replacement parts for the product are relatively expensive.
Add 2 points.
• There is a service contract. Add 1 point for each year.
218 DEVELOPING NEW PRODUCTS AND SERVICES

• There is a significant learning curve for using the product

effectively. Add 1 plus 1 point for each time you use the word
very.
• This product is a social networking application or has social
networking features. Add 3 points.

If the score for the product or service is above 9, then this is a prod-
uct or service with significant switching costs and lock-in. If the score is
between 6 and 9, then the lock-in is moderately strong. If the score is
between 3 and 6, then the lock-in is average. And if the score is <3, then
the lock-in is minimal. If the score is zero, then you are probably buying
an off-brand candy bar.
There are some products where the lock-in is transitory. Consider the
fashion and clothing industry where the lead designers develop an anchor
for next year’s fashion.8 The premier lines typically develop seasonal
themes for the fashion community. Everyone copies the anchored themes
including the fashion leaders with their slightly scaled-back bridge lines
(e.g., Gap Inc. represented by Banana Republic, the Gap and Old Navy
and the Armani Group represented by Giorgio Armani, Armani Collezi-
oni, and Emporio Armani). Copying is actually beneficial to the fashion
industry. Copying an emerging fashion concept helps to standardize the
design for a year or two until the design becomes obsolete. Some level of
standardization is essential or chaos would ensue and costs would sky-
rocket because the supply chain would never stabilize. Nevertheless, the
fashion themes are extremely transitory because, in a very short time, a
new theme emerges and the old theme is out-of style.

The Downside of Lock-in

A consistent theme of this book is that companies must pursue inno-
vation and differentiation constantly. Locking in your customers does
not mean you can abandon innovation and let your products and ser-
vice languish in mediocrity. Because consumers will eventually abandon
your products and services and you will eventually fade from the mar-
ketplace. As we have said in an earlier chapter, people want to control
their environment and they do not want to be controlled. Google has
 LOCK-IN AND REVENUE GROWTH 219

been very proactive on this front because they realize that lock-in is very
transitory and they have attempted to engender trust through innova-
tion.9 Cable companies were able to lock-in their customers because
there was very little competition. The landline cable companies avoided
innovation and they treated their customers poorly. It is only recently
that they have been able to shirk their earlier image and begin to engen-
der trust and acceptance in the marketplace. All businesses must change,
even if it is only in the minds of consumers, or they will eventually be
abandoned.

Outsourcing and Lock-in

Outsourcing is a contractual relationship between one business and
another. The outsourcee, the company trying to outsource some organi-
zational function, can have the outsourcer company provide manufactur-
ing, product design, product distribution, IT services and infrastructure
support, and about everything else including strategic planning support.
There are many reasons why companies turn toward outsourcing, includ-
ing reducing costs, access to expertise, and increased production capacity,
as illustrated in Table 10.1.10 At the same time, there are many reasons

Table 10.1. Benefits of Outsourcing

Simplifies management and can increase flexibility.
Management can focus on core competencies.
Can reengineer and downsize organization.
Helps develop strategic alliances.
Can improve the quality of service to customers and within organization.
Reduces short-term costs and transactions costs.
Possible large influx of cash resulting from transfer of assets to the new provider
especially in outsourcing IT.
Access to technical expertise and the ability to free in-house resources. Outsourcer has
access to technology and to specialized expertise.
Eliminates a process area that was a headache.
Outsourcer has above-average management skills.
Outsourcer has better cost control because they have benchmarked best of breed
processes.
Outsourcer has capacity on demand and bulk purchasing power.
220 DEVELOPING NEW PRODUCTS AND SERVICES

that outsourcing can create problems as illustrated in Table 10.2. There is,
however, one major reason that outsourcing creates problems. Outsourc-
ing causes the organization to lose its absorptive capacity in the area that
was outsourced. As noted in an earlier chapter, having absorptive capac-
ity means that a company is able to evaluate new technological develop-
ment because the company or the owner has insight and expertise into
a particular area. Organizations with absorptive capacity have developed
knowledge structures and insight in a particular domain. Having absorp-
tive capacity gives an organization the ability to understand, assimilate
and exploit new knowledge and information, and then to apply it to solv-
ing problems and developing commercially viable products. If an organi-
zation outsources an ability or capability, which is a core competency,
then the organization may not be able to understand and recognize when
an emerging technology is important. In the worst case, the organization
may not be able to develop products because it does not have the know-
how since it has already lost the ability to learn-by-doing and learn-about.

Table 10.2. Risks of Outsourcing

Loss of control.
Costs may be greater than anticipated.
Transition costs including process reengineering and severance pay.
Managing the outsourcing agreement.
Vendor may not implement emerging technologies.
Poor customer service.
May lose good staff.
May hurt current employee’s morale and performance.
Vendor may not survive.
They know all of your secrets and you might not be able to get away from them.
Very high lock-in and switching costs.
Limits your options and the ability to develop additional core competencies.
Loss of absorptive capacity. They may not be able to recognize a new opportunity or take
advantage of a new opportunity.
Because company has lost the ability to do something, they may not be able to do it for
a long time.
 LOCK-IN AND REVENUE GROWTH 221

Customer Acquisition, Customer Retention,

and Lock-in
Customer acquisition and customer retention through lock-in are the
two primary components of market share. Once customers have been
acquired, the next step is to retain them. There has been an ongoing
debate on whether to focus on acquisition or retention marketing.11 Both
are important. But there has been significant interest in retention because
of the research findings on customer retention. For example, increasing
customer retention by just 5% can increase profits by 25–95%.12
The point is that customer retention should be a critical goal for all
organizations. This is particularly true in the current business climate
where substitute products and competitions from unforeseen sources are
the norm. Customer acquisition and customer retention are related to the
development of a viable business model and having good products, good
people, a good brand, successful marketing, a capable R&D process, and
an efficient supply chain.

Conclusion
In this chapter, we have discussed the concept of lock-in and identified vari-
ous issues on the lock-in such as how companies can achieve it, the downside
of it, and the lock-in index for practical use. We also have addressed the
relationship between the lock-in and companies’ absorptive capacity within
the framework of outsourcing. The key points are the following:

• Lock-in is pervasive. It is part of the normal day-to-day

transactions in business.
• If you are a producer, then you need to take steps to acquire
customers so that you can lock them in (see Figure 10.3). This
may include giving potential customers money, providing
additional complimentary services, and developing attractive
incentives for participation.
• Producers will always try to lock-in consumers. It is important
that consumers try to get producers to offer incentives in
order to offset present and future switching costs.
222 DEVELOPING NEW PRODUCTS AND SERVICES

Sellers try to increase

lock-in and buyers try
to avoid lock-in

Lock-in increases
switching costs and
discourages customers
from moving to
another seller

Lock-in creates barriers

to market entry

Figure 10.3. Lock-in issues.

• The initial stage of bargaining is important because once the

consumer has committed to a seller, then the lock-in has been
cast. If you are a business and are considering outsourcing,
then you will be locked-in as soon as you sign on the dotted
line. In that case, you should look for second sources.
• When a company or an individual outsources, they are
essentially merging with another entity that has a competitive
advantage in a particular area. Identifying the processes where
having a core competency is critical for the firm to survive
and to engage in learn-by-doing activity in that area.
 CHAPTER 11

Valuing the Business

Everyone is interested in how much a business is worth. The entrepre-
neur and the entrepreneur’s family are interested because they hope to use
some of the income from the business to live on or because they are inter-
ested in how much they might sell the business for someday. Then, there
is a simple curiosity factor: “I wonder what I could get for this?” If the
entrepreneur seeks outside funding from friends, banks, angels, and ven-
ture capitalists (VCs), they will be very interested in the potential value of
the firm. When a public company is being sold, its current trading price
establishes a starting point—usually a minimum transaction price—but
the acquiring company must still decide on the maximum bid consist-
ent with a profitable acquisition. But when selling a nonpublic company,
even that starting point does not exist. The field of business valuation has
developed techniques designed to estimate the value of a business.1
One author gives this thorough definition of business valuation:

A business valuation determines the estimated market value

of a business entity. A thorough, robust valuation consists of an
in-depth analysis by a qualified independent professional who
combines (a) proven techniques; (b) analysis and understanding
of a specific company and its associated industry; (c) research and
analysis of industry, association, and other publications; academic
studies; the national and local economy; and online databases
with (d) judgment honed by education, training, and experience;
and (e) intuition. A valuation estimates the complex economic
benefits that arise from combining a group of physical assets
with the intangible assets of the business enterprise as a going
concern. The resulting valuation, part science and part art, is a
well-founded estimate that represents the price that hypothetical
224 DEVELOPING NEW PRODUCTS AND SERVICES

informed buyers and sellers would negotiate at arms length for an

entire business or for a partial equity interest.2

Why are Businesses Bought and Sold?

A major reason why businesses are bought is that parties interested in
beginning or expanding business activity often prefer acquiring an exist-
ing business rather than starting a new one. Existing businesses are “up
and running,” and have in place a product or service line, a work force,
customers, suppliers, the necessary physical resources, and various intan-
gibles—technology and “know-how,” systems and procedures, location,
reputation, and the like.
From a seller’s perspective, business owners need to have an
exit strategy, a means of extracting value from their investments of time
and resources in the business. A sale may be occasioned by the death or
intended retirement of the owner, or by a desire to “cash out” the invest-
ment at a time when its value is perceived to be high. Or, an owner may
wish to expand the business by taking on new partners, selling a portion
of ownership to new parties. Sometimes this is done to reward and retain
key personnel by offering them an ownership interest in the business.
Even when no transfer of ownership is involved, a business valuation
may be done when seeking major new financing. A valuation provides
the prospective lender with an indication of the safety of a loan secured
by the business.

Overview of Business Valuation Techniques

The foundations of business valuation techniques and practice lie in the
tax law, as it has long been necessary to value businesses for estate and
gift taxation. Though over 50 years old,3 Revenue Ruling 59–60 is still
recognized by professionals and by the courts as an important source of
standards for valuation. Section 1 of the Ruling states its purpose:

The purpose of this Revenue Ruling is to outline and review in

general the approach, methods, and factors to be considered in
valuing shares of the capital stock of closely held corporations for
 VALUING THE BUSINESS 225

estate tax and gift tax purposes. The methods discussed herein will
apply likewise to the valuation of corporate stocks on which mar-
ket quotations are either unavailable or are of such scarcity that
they do not reflect the fair market value.

Subsequent rulings enhance and expand these basic standards:

• Revenue Ruling 65-193 clarifies that the procedures outlined

in RevRul 59-60 apply to intangible as well as tangible assets.
• Revenue Ruling 68-609 extends the provisions of RevRul 59-60
beyond estate and gift taxation to any type of business interests
and any tax purpose, and provides a “formula approach.”

The basis for business valuation is the familiar concept of fair market
value, which is defined in Section 2.02 of RevRul 59-60 as follows:

Fair market value [is] the price at which the property would
change hands between a willing buyer and a willing seller when
the former is not under any compulsion to buy and the latter is
not under any compulsion to sell, both parties having reasonable
knowledge of relevant facts. Court decisions frequently state in
addition that the hypothetical buyer and seller are assumed to be
able, as well as willing, to trade and to be well informed about the
property and concerning the market for such property.

This definition remains the common definition of fair market value:

the price negotiated by well-informed, willing, and able buyers and sellers
who are not compelled to act.

Controlling and Noncontrolling Interests

One consideration in determining the value of a business ownership
interest is the extent to which that interest can exercise control over busi-
ness activity. Control refers to the power to direct the policies and man-
agement of the business. Control is most commonly measured by voting
power—holding more than 50% of the voting equity of the company. In
some cases, when there is no majority stockholder, other circumstances
can lead to one owner having effective control.
226 DEVELOPING NEW PRODUCTS AND SERVICES

When there is a controlling interest, other ownership interests are

said to be minority or noncontrolling interests. Such interests rep-
resent <50% of the voting power in the company. A voting interest
of exactly 50% is neither a controlling nor a minority interest. While
a 50% interest cannot cause things to happen, it can prevent things
from happening. Having two 50% owners is often considered an inef-
ficient business structure, as a stalemate occurs if the two owners do not
agree. However, that structure—shared control—appears in many joint
ventures.
A controlling interest is generally considered to be worth more, on a
per-share basis, than a noncontrolling interest. Among the powers of a
controlling interest are the abilities to:4

• establish the nature and policies of the business;

• select officers, employees, and directors, and set their
compensation and benefits;
• enter into contracts with suppliers, customers, and others;
• determine the existence and amount of dividends;
• decide on acquisition and disposition of assets;
• determine the financing and capital structure of the company.

A controlling owner has different options for disposing of the invest-

ment (exit) or converting it to cash (liquidity) than does a noncontrol-
ling owner. The controlling owner’s exit or liquidity options include selling
the controlling interest, taking the company public, or deciding to liq-
uidate the business. The noncontrolling owner’s exit or liquidity options
include selling to the controlling owner or selling to another noncontrol-
ling owner. When a buyer does not exist, the noncontrolling owner effec-
tively has no exit option. Continuing to hold the investment is a liquidity
option to the extent that the business pays dividends.

Specific Valuation Techniques

A variety of techniques are available for conducting a business valua-
tion. Part of the skill and expertise of a valuation analyst is the ability
to select the appropriate technique for the situation at hand. Even when
 VALUING THE BUSINESS 227

one technique is chosen, valuation under other techniques is often deter-

mined for comparative and confirmative purposes. Some analysts present
a weighted average of the outcome of several techniques as their final
conclusion, while others select a final value from the range of outcomes
without resorting to formal weighting.

Factors to be Considered in a Business Valuation

Whatever the technique, the analyst should consider a variety of factors

about the business and its industry. Among the factors to be considered
are the following:5

• What is the stage of the company’s development? Is it new,

established and growing, mature, or declining?
• What is the current and prospective state of the industry in
which the company operates, and of the economy in which it
competes? How attractive is the industry to capital suppliers?
• What is the experience and competence of the members of
top management and the company’s Board of Directors?
• What is the company’s position in the marketplace—for
example, its market share—and what major competitors does
it have?
• Are there barriers to entry in the company’s marketplace?
• What are the competitive forces in the company’s industry
(recall Porter’s five competitive forces, discussed in an earlier
chapter)?
• Does the company have proprietary technology, products,
or services, and what is the nature of the protection, such as
patent rights or exclusive licensing?
• What is the nature and quality of the company’s work force,
including employer–employee relations, pay and benefits,
labor supply, and the like?
• What is the nature and quality of the company’s suppliers and
of the company’s customers? Is the company dependent on a
small number of customers or vendors, or does it have a broad
base? Are the customers and suppliers financially solid?
228 DEVELOPING NEW PRODUCTS AND SERVICES

• Are there strategic relationships with suppliers, customers, and

sources of financing? The existence of such relationships may
be a positive or a negative factor when valuing the company.
• What is the company’s cost structure (operating leverage,
fixed-variable mix) and its financial strength indicated by debt
capacity, free cash flow, and the like?
• What risk factors does the company face?

The consideration of risk factors is an especially important part of

business valuation. Uncertainties or concerns in any of the above areas
may signify risks to be considered.
Two simple approaches to business valuation are (a) determining the
value of the company’s net assets (assets minus liabilities) and (b) identify-
ing the fair market value of a similar business. We discuss them briefly in
the following sections, although they often prove unsatisfactory.

Asset-Based Methods

One approach to business valuation involves direct estimation of the value

of the net assets to be acquired (=assets to be acquired by the buyer minus
any liabilities to be assumed by the buyer). An asset-based approach
typically begins by examining the firm’s balance sheet. However, there
are several reasons why book (recorded) values are typically unsatisfactory
indicators of business value:

• Book values reflect the accumulated effects of applying

Generally Accepted Accounting Principles to the past
transactions of the firm and have no necessary connection to
current economic value.
• Book values may not reflect the impact of changing prices
(inflation) or technological change.
• Balance sheets may not include all the relevant assets of the
business, especially unrecorded intangible assets.

Given these deficiencies, the analyst attempts to adjust book values

to arrive at an overall business valuation. The analyst examines and values
each asset and liability to estimate its fair market value, using techniques
such as the determination of market values for comparable assets, expert
 VALUING THE BUSINESS 229

appraisals, and price index-based inflation adjustments. It is important

to identify and value unrecorded intangible assets, including goodwill,
and unrecorded liabilities, such as environmental liabilities, operating
leases, and other off-balance-sheet and contingent obligations.

Direct Comparison Approach

The logic of a direct comparison approach lies in the idea that similar
assets should sell for similar prices, a principle well established in other
markets.6 In real estate, for example, the market value of a house could be
estimated by finding recent selling prices for substantially similar houses
in comparable neighborhoods. Finding sales of comparable businesses,
however, is difficult. Transactions are few, and comprehensive data sources
do not exist. Thus, a true direct comparison approach cannot generally be
used in business valuation.
However, a form of direct comparison exists when some measure or ratio
serves as the link between the business valuation in question and other busi-
nesses. For example, professional practices like Certified Public Accountant
(CPA) firms often sell for a multiple of billings, perhaps two to three times
annual billings. For example, the average price–earnings (P/E) ratio of simi-
lar public firms in the industry might be used. If such firms sell for 12 times
earnings, we can apply that same measure to a business being valued. The
capitalized earnings approach discussed later is a version of this technique.
As with the discounted future returns approach discussed later, one needs to
select a particular cash flow or income measure, such as gross revenues. One
also needs to select the “other variable”—number of years’ billings, P/E ratio,
and the like—that will link the business being valued to other businesses.
Direct comparison techniques serve as a quick way of estimating busi-
ness value, with little need for extensive estimation. However, because
the comparison typically reflects an average of other businesses, this tech-
nique does not do a good job of incorporating distinctive features of the
business being valued.

Payback Method

The payback for an investment is the number of periods management

must wait before the accumulated positive cash flows from the investment
230 DEVELOPING NEW PRODUCTS AND SERVICES

exceed the initial cost of the investment project plus any negative operating
cash flows. Investments are considered acceptable when the payback period
is less than some predetermined time period, for example 3 years. Here is
the computation:

Beginning investment: $100,000

Cash flow year 1: –$15,000 (with the beginning investment,
$115,000 still left to recover)
Cash flow year 2: $50,000 ($65,000 still left to recover)
Cash flow year 3: $60,000 ($5,000 only left to recover)
Cash flow year 4: $60,000
Cash flow year 5: $60,000

In this example, the payback occurs at about 3 years and 1 month.

Many people do not consider payback to be a discounted cash flow tech-
nique because it does not take into account the time value of money.
This is not entirely true. A short payback period, say, for example,
2 years, reflects the importance of dollars received in the short term and
thus the time value of money.7 The payback approach does not take into
account cash flows that are outside of the payback threshold and they do
not take into account the magnitude of the cash flows. Amazon is now
a viable business but early investors did not consider the payback to be
an important tool for deciding whether to invest in Amazon. This is a
normal situation for many start-ups where positive cash flows do not
occur until many years in the future. Discounted cash flow approaches
incorporate the importance of distant cash flows and the magnitude of
the cash flows.

Discounted Future Returns

Perhaps the most common, and conceptually best, technique for business
valuation is calculation of the present value of expected future returns
from the business. Although present-value computations are easy, deter-
mining the relevant inputs is not. Choices need to be made for:

• the type of future return to be measured (income or cash flow);

• estimates of the future amounts;
 VALUING THE BUSINESS 231

• an appropriate discount rate;

• the time period for the analysis; and
• the estimation of a terminal value.

We consider each of these areas.

Definition of Future Return

Numerous measures of future return are available to the business valuation

analyst. Although cash flow measures are the most common, the analyst
must still decide on a particular cash flow measure to use. One possibility
is cash flow from operations, which reflects the cash impact of all operat-
ing activities during a time period. Others use free cash flow, a term for
which different definitions exist.

The most common definition of free cash flow is cash flow from
operations minus cash investments in new assets needed to main-
tain operations. A less common definition is cash from operations
minus cash investments in new assets needed to maintain opera-
tions minus debt repayments (this measure is designed to approxi-
mate cash available to the new owners).

Other analysts use income rather than cash flow measures. There are
many variations here as well: net income as conventionally measured by
accounting; earnings before taxes (EBT); earnings before interest and
taxes (EBIT); earnings before interest, taxes, depreciation, and amorti-
zation (EBITDA); and the like. In some cases, especially if a minority
investment is being evaluated, expected dividends is the relevant meas-
ure of future return.

Estimating Future Returns

Estimating future returns is a difficult task. Often the starting point is

past returns, perhaps adjusted for unusual and nonrecurring items that
have occurred. Knowledge of the business, industry, economic condi-
tions, and other factors must be brought to bear.
232 DEVELOPING NEW PRODUCTS AND SERVICES

One important task is to separate the expected future returns from

the business in its present form from the expected future returns under the
guidance of the new owner. Often, the efforts of the new owner will be
more influential in determining future success than continuing the same
uses of assets already in place. Because the business valuation is usually
being conducted to establish a selling price, the buyer should not pay the
seller for the buyer’s anticipated improvements in the business.
Another consideration is whether to conduct the analysis on a con-
stant dollar basis or to estimate revenue and cost increases resulting from
inflation. Whichever is chosen, the discount rate should be selected in a
consistent manner, as discussed in the next section.
Although discounting expected future returns is a conceptually sound
approach to business valuation, it is often not used due to the practical
difficulties of implementing it. We need projected returns for several years
into the future, and such estimates can be highly speculative.

Choice of Discount Rate

Many considerations enter into the selection of a discount rate. First let
us consider the focus of the analysis. If the analyst employs return to
all invested capital, then a discount rate appropriate to the entire capital
structure should be chosen. This rate is usually called a weighted average
cost of capital, because it includes costs for both debt and equity capital.
In contrast, a return to equity capital focus calls for an equity-based
discount rate. Following the well-known capital asset pricing model of
finance, this rate includes at least two components: a risk-free rate and a
risk premium, reflecting both the risks of general economic conditions
and the risks of the specific business and industry. The beta (b) coefficient
is the typical measure of risk premium used.
Next we consider adjusting for growth or inflation. When the esti-
mates of future returns reflect inflation, then a discount rate that includes
an inflation component applies. If future returns are estimated on a
current (constant) dollar basis, then the inflation component should be
subtracted from the discount rate. For example, suppose that an appro-
priate discount rate, including inflation, is determined to be 25%. The
analyst uses this rate to discount estimated future returns that include
inflation-based growth in revenues and costs (nominal dollars). On the
 VALUING THE BUSINESS 233

other hand, if estimated future returns are based on current (constant)

dollars, and the inflation assumption is 4% annually, then a discount
rate of 21% (=25% minus 4% inflation adjustment) should be used to
discount the current-dollar future returns. To express this another way,
if the future dollar amounts in the valuation analysis reflect future prices
and costs, the discount rate should include the inflation component. If
the future dollar amounts are based on current prices and costs, reflecting
no growth or inflation, the discount rate should exclude the inflation
component.
These two discounting approaches do not provide exactly the same
answer, but they are close enough. Given the many assumptions that
go into a valuation calculation, the slight difference is usually deemed
acceptable. For example, assume that the annual cash flow is currently
$300,000. An 8-year time horizon is used for the analysis. It is estimated
that cash flows will grow by 5% annually. A discount rate of 15%, includ-
ing growth, is deemed appropriate. The present value of $300,000 annu-
ally discounted at 10% (15% minus the 5% growth assumption) and the
present value of the growth-adjusted cash flows discounted at 15% are
shown in Table 11.1.

Table 11.1. Comparison of Present Values With and Without Growth

Present Present
value of value of
cash flow cash flow
Projected without Projected with 5%
annual growth annual cash growth
cash flow at 10% flow with at 15%
without discount 5% growth discount
Year growth ($) rate ($) ($) rate ($)
1 300,000 272,727 315,000 273,913
2 300,000 247,934 330,750 250,095
3 300,000 225,394 347,288 228,347
4 300,000 204,904 364,652 208,491
5 300,000 186,276 382,884 190,361
6 300,000 169,342 402,029 173,808
7 300,000 153,947 422,130 158,694
8 300,000 139,952 443,237 144,895
Total $1,600,476 $1,628,604
234 DEVELOPING NEW PRODUCTS AND SERVICES

When multiyear analysis is used, a growth or inflation factor should

be considered in some way. If growth is completely ignored in the above
example, the present value of a $300,000 annual cash flow discounted at
15% would be approximately $1,350,000. If growth is expected, ignoring
it clearly understates the value of the business. Of course, if future declines
in cash flows are expected, indicating a business with initial appeal but lit-
tle staying power, ignoring the expected negative growth would overstate
the business value.
As seen in the above example, a positive growth assumption can either
be built into the cash flow estimates, or incorporated by a reduction of the
discount rate. Either approach will increase the business value relative to
making no adjustment for growth.
The two present values in Table 11.1 are approximately the same, dif-
fering by <2%, which may be more precise than the cash flow estimates
themselves or the discount rate selection. Nonetheless, one could easily
find the precise discount rate and use that. If one accepts 10% as the
correct rate without growth, then the correct rate with 5% growth that
would discount the cash flows with growth (fourth column above) to
the $1,600,476 present value turns out to be 15.50%. Similarly, if one
accepts 15% as the correct rate with growth, then the correct rate with-
out growth that would discount the constant cash flows (second column
above) to the $1,628,604 present value turns out to be 9.52%. But for
most purposes, the process illustrated above is sufficient.
Most of the literature on the weighted average cost of capital is based
on information from public capital markets. Recently, work has been
done to try to establish a private cost of capital approach.8 They identify
five different capital markets for private firms: bank lending, asset-based
lending, mezzanine financing, private equity, and venture capital. Median
rates of returns for these markets (first quarter 2010) were found to range
from 6.8% for bank lending to 38.2% for venture capital financing.

Selection of Time Period for Discounting

The analyst who uses a discounted future returns approach must deter-
mine how far into the future to project. The general answer is as far as
 VALUING THE BUSINESS 235

possible, keeping in mind that the uncertainty of the estimates increases as

they get further away. Because a business is usually assumed to be a going
concern, returns are presumed to continue indefinitely. Thus one could
assume that returns continue forever. Alternatively, the analyst could limit
the analysis to a fixed time period, say 10 years. In this case, one makes
specific annual projections for 10 years and estimates a terminal value of
the business at the end of that period.
Although estimates of future returns, or of terminal value, become
more speculative the further in the future they are, the effect of discounting
mitigates the increased uncertainty. For example, at a discount rate of
20%, $1,000 in year 10 contributes only $161 to the present value, and
$1,000 in year 20 contributes only $26 to the present value.
When we assume that future returns will continue forever in equal
amounts, we have a perpetuity. The present value is given by:

Present value of ordinary perpetuity

= Constant annual return/Discount rate

For a discount rate of 20%, the present value is five times the
annual return ($5 = $1/0.2). As shown in Table 11.2, about 60% of
the present value occurs in the first 5 years, and about 84% in the
first 10 years. Returns in later years have relatively little impact on the
present value.

Capitalized Earnings

Despite the conceptual soundness of the discounted future returns

method, the subjectivity of future return estimates is a major deterrent to
its use. Parties to the negotiations will likely disagree over the assumptions
employed in arriving at the estimates. As a result, business valuation often
employs a conceptually similar approach that appears to avoid future esti-
mation. This approach is known as capitalized earnings.
We saw that the discounted future returns method computes a pre-
sent value based on applying a discount rate to the estimated returns of a
number of future time periods. The capitalized earnings approach, on the
236 DEVELOPING NEW PRODUCTS AND SERVICES

Table 11.2. Impact of Time on Present Value

Percent of
Present Value Cumulative perpetuity
Period of $1 at 20% Present Value value
1 0.833 0.8333 0.1667
2 0.6944 1.5278 0.3056
3 0.5787 2.1065 0.4213
4 0.4823 2.5887 0.5177
5 0.4019 2.9906 0.5981
6 0.3349 3.3255 0.6651
7 0.2791 3.6046 0.7209
8 0.2326 3.8372 0.7674
9 0.1938 4.0310 0.8062
10 0.1615 4.1925 0.8385
11 0.1346 4.3271 0.8654
12 0.1122 4.4392 0.8878
13 0.0935 4.5327 0.9065
14 0.0779 4.6106 0.9221
15 0.0649 4.6755 0.9351
16 0.0541 4.7296 0.9459
17 0.0451 4.7746 0.9549
18 0.0376 4.8122 0.9624
19 0.0313 4.8435 0.9687
20 0.0261 4.8696 0.9739
Note: Annual payments assumed to occur at the end of year.

other hand, computes a present value based on applying a capitalization

rate to a single amount of present or past returns, as follows:

Present value = Amount of return to be capitalized/capitalization rate

This formula is equivalent to the present value of a perpetuity

discussed above.
What amount of return should be capitalized? First, as discussed pre-
viously, any measure of return can be used—a cash flow measure, an
income measure, or even revenues or dividends. Second, the return
 VALUING THE BUSINESS 237

measure may be based on past, present, or even future data. Examples

include the following:

• Return for the past 12 months or most recent fiscal year

• An average return, either simple or weighted, for some
number of past years
• A normalized current or average return, excluding unusual or
nonrecurring items
• A forecast for the current period or a future period.

Most commonly, the use of present returns, or an average of past

returns, appears to avoid the estimation problem. But one cannot really
avoid estimation. To base a present value on current or past returns
implicitly assumes the continuation of such returns in the future.
The capitalization rate is the relevant discount rate, discussed
above, minus the assumed rate of growth (or decline) in future returns.
As an example, suppose last year’s net income of $200,000 is the
amount to be capitalized, that we decide on a relevant discount rate of
20%, and that we expect 3% earnings growth. The capitalized value of
the company is:

Present value = Amount of return to be capitalized/capitalization rate

= $200,000/(0.20 – 0.03)
= $200,000/0.17
= $1,176,471

On the other hand, if we anticipate a 3% earnings decline, the capital-

ized value is:

Present value = Amount of return to be capitalized/capitalization rate

= $200,000/(0.20 + 0.03)
= $200,000/0.23
= $869,565

A capitalization rate for equity returns is the inverse of the familiar

P/E ratio commonly cited for publicly traded companies, and thus is
238 DEVELOPING NEW PRODUCTS AND SERVICES

sometimes called an earnings–price (E/P) ratio. For example, a company

selling at 17 times earnings has an effective capitalization rate of 5.88%
(0.0588 = 1/17). In selecting a capitalization rate for a specific business,
one could use E/P ratios of reasonably similar public companies as guides.
However, when valuing small nonpublic companies, lower P/E ratios
(higher E/P ratios and capitalization rates) are typically appropriate, to
allow for increased risk. It is not uncommon for small nonpublic compa-
nies to sell for 3–10 times earnings.

Capitalizing Excess Earnings

A widely used variation of the capitalized earnings method is called

the capitalization of excess earnings. This hybrid method reflects the
concept that earnings derive from both the tangible assets and intangible
assets of the business. Earnings from tangible assets are assumed to be
relatively constant from one firm in an industry to another, whereas
earnings from intangible assets may vary widely. The method proceeds
as follows:

• Estimate the value of net tangible assets

• Estimate the earnings attributable to the tangible assets,
perhaps by multiplying the value of the tangible assets by the
average industry return
• Subtract this amount from total reported earnings; the
difference is excess earnings, the amount above what is
explained by the company’s tangible assets
• Capitalize the excess earnings.

The value placed on the business has two components:

Business value = Net tangible assets

+ Capitalized value of excess earnings

Because we tend to consider earnings attributable to intangibles to be

more risky than earnings attributable to tangible assets, we tend to use
high capitalization rates (low multiples).
 VALUING THE BUSINESS 239

Table 11.3. Capitalization of Excess Earnings ($)

Value of net tangible assets 350,000
Reported earnings of the 50,000
company
Earnings attributed to tangible 35,000
assets = $350,000 × 0.10
Excess earnings 15,000
Capitalized value of excess 60,000
earnings = $15,000/0.25
Estimated value of company 410,000

When we calculate negative excess earnings, the business is still pre-

sumed to be worth the value of its net tangible assets and we make no
reduction for apparent negative intangibles.
For example, suppose a company reports earnings of $50,000 and net
tangible assets of $350,000. Average industry earnings are 10% of net
tangible assets, and we decide to capitalize excess earnings at 25%. The
value estimate for the business is $410,000, as shown in Table 11.3.
The excess earnings method, like much of business valuation, has
its foundation in materials promulgated by the Internal Revenue Ser-
vice. Revenue Ruling 68–609 sets forth a so-called formula method, as
follows:

The question presented is whether the “formula” approach, the

capitalization of earnings in excess of a fair rate of return on net
tangible assets, may be used to determine the fair market value of
the intangible assets of a business. The “formula” approach may
be stated as follows:

A percentage return on the average annual value of the tangible

assets used in a business is determined, using a period of years
(preferably not less than five) immediately prior to the valu-
ation date. The amount of the percentage return on tangible
assets, thus determined, is deducted from the average earnings
of the business for such period and the remainder, if any, is con-
sidered to be the amount of the average annual earnings from
the intangible assets of the business for the period. This amount
240 DEVELOPING NEW PRODUCTS AND SERVICES

(considered as the average annual earnings from intangibles),

capitalized at a percentage of, say 15 to 20 percent, is the
value of the intangible assets determined under the “formula”
approach.

The percentage of return on the average annual value of the tangi-

ble assets used should be the percentage prevailing in the industry
involved at the date of valuation, or (when the industry percent-
age is not available) a percentage of 8 to 10 percent may be used.

The 8 percent rate of return and the 15 percent rate of capitaliza-

tion are applied to tangibles and intangibles, respectively, of busi-
nesses with a small risk factor and stable and regular earnings;
the 10 percent rate of return and 20 percent rate of capitaliza-
tion are applied to businesses in which the hazards of business are
relatively high.

The above rates are used as examples and are not appropriate in
all cases.…

The past earnings to which the formula is applied should fairly

reflect the probable future earnings. Ordinarily, the period
should not be less than five years, and abnormal years, whether
above or below the average, should be eliminated. If the busi-
ness is a sole proprietorship or partnership, there should be
deducted from the earnings of the business a reasonable amount
for services performed by the owner or partners engaged in the
business.…

The “formula” approach should not be used if there is better

evidence available from which the value of intangibles can be
determined.…

Because of the extensive guidance given in Revenue Ruling 68–609,

many business valuation analysts follow it closely, even though it contains
many cautions and qualifications, especially in performing valuations
for tax purposes. This approach has come to be known as the Treasury
Method.9
 VALUING THE BUSINESS 241

Valuation Premiums and Discounts

After initially estimating the value of a business, that estimate may be

adjusted upward (premium) or downward (discount) to reflect other
factors related to the ownership interest in question. For example, a con-
trolling interest in a business is worth more on a per-share basis than a
minority interest, as the holder of a controlling interest has authority over
business decisions, whereas the minority interest holder does not. This
section briefly examines some common premiums and discounts.10
Business valuations typically begin with a base value, using techniques
applicable to a broad range of businesses. A premium or discount is an
upward or downward adjustment to this base value, to reflect some dif-
ferent characteristics of the particular business being considered. These
characteristics are reflected in various ways. If one uses a discounted cash
flow approach to valuation, a higher or lower discount rate could reflect
the special characteristics. Alternatively, the analyst could adjust the
initial valuation estimate upward or downward for specific features of the
business. Knowing how to identify and quantify premiums and discounts
is one of the specific skills of a business valuation expert. The following
situations can increase or decrease the discount premium:

• Control premium: The buyer acquires a controlling interest—

usually defined as more than 50% of the voting power—in
the acquired company. Because of all the powers a controlling
owner has, a controlling ownership interest is clearly worth
more than a noncontrolling interest. These premiums can be
in the 30–50% range.
• Minority interest discount: A minority interest discount, also
known as a discount for lack of control, is the logical opposite
of a control premium. If the ability to exercise control
commands a premium, the lack of that ability is worth less.
• Strategic acquisition premium: Sometimes the acquisition of a
business may be important from a strategic perspective. For
example, an acquisition may complement the existing product
line, broadening the geographic market, ensure a source of
supply, or eliminate a key competitor, for a specific buyer.
242 DEVELOPING NEW PRODUCTS AND SERVICES

• Lack-of-marketability discount: Publicly traded equity shares

have a high degree of liquidity—they can be readily converted
into cash at close to prevailing prices. Because investors value
liquidity, a negative factor exists when the investor lacks the
ability to sell on short notice at a market price. Studies report
that thinly traded stocks realized a 30–50% price decline
when the brokerage firm that was their sole market-maker
went out of business.11 Studies of restricted stock of public
companies that itself cannot be publicly traded find discounts
for the lack of marketability ranging from about 20% to
70%.12 Ownership interests in nonpublic companies almost
always are discounted for the lack of marketability.
• Key person discount: Some acquisitions include an arrangement
for the key person(s) to join the new company for a period of
time. In other cases, the key persons do not accompany the
acquisition, perhaps due to death or retirement. When the
key person does not continue with the business, attributes
such as the loyalty of customers, suppliers, or employees may
be lost, as well as the key person’s particular business skills.
Research studies and court cases find the key person discount
to typically be in the range of 5–10% in public companies,
and 10–25% in private companies.13

Discounts may be applied to base business valuations for factors other

than those described earlier. One possibility is a discount for contingent
liabilities, reflecting potential future claims resulting from past business
activities that will become the responsibility of a buyer. Such contingent
liabilities involve potential litigation such as product liability, poten-
tial environmental claims, or potential tax adjustments for prior years.
Because these liabilities are situation-specific, the valuation analyst must
look sharply for them!
The above discussion indicates that discounts are more frequent
than premiums. After achieving a base valuation, the analyst consid-
ers adjustments for the various factors discussed above. Note that the
impact of these factors can be incorporated into the base analysis—for
example, by adjusting the estimates of future income or cash flows—or
can be reflected as an adjustment to the base value calculation. However,
 VALUING THE BUSINESS 243

incorporated into the business valuation analysis, discounts can have a

large effect on the ultimate value.

Valuing Start-Up Businesses

Businesses that are yet to be undertaken, or are in the early stages of
their development, are especially hard to value. Suppose an entrepreneur
with a concept for a new business needs capital to launch the business.
Because of the high risk of new businesses, traditional capital sources—
banks and other institutional lenders, and the public equity markets—are
usually not available. Most new businesses begin with capital raised from
the founder’s own resources, and perhaps from friends and family. Some-
times, an unrelated investor who believes in the concept, referred to as an
“angel,” also provides some seed capital. Angels are especially common in
artistic ventures, such as movies or stage shows. As the business begins to
develop, VCs often provide the next influx of capital. These investors take
short-term ownership stakes in promising new businesses. Business valu-
ations have a role to play in these situations as well as in the financing or
purchase of established businesses.14

Approaches to Valuing a Start-Up

Because a new business has little to no history, and because it may be pur-
suing innovative products, services, or other business features, uncertainty
about its future prospects is especially high. A capitalized earnings approach
cannot be used, as new companies frequently report losses in the early
years, and their present earnings (losses) may not be indicative of expected
earnings. A discounted earnings or discounted cash flow approach is typi-
cally most appropriate. Many analysts favor using cash flows rather than
earnings, because of the importance of cash management in start-up firms.
Many start-ups fail because they quickly run out of cash. During the “dot.
com” era, analysts often focused on the rate at which a start-up consumed
cash, a phenomenon colorfully known as its burn rate.
When performing a discounted cash flow approach to valuing a new
business, the analyst must decide on the estimate of cash flows to use. The
entrepreneur’s forecasts are likely to be highly optimistic, reflecting his or
her vision of a successful future. When using an entrepreneur’s forecasts,
244 DEVELOPING NEW PRODUCTS AND SERVICES

the analyst typically tries to neutralize the entrepreneur’s optimism with

a high discount rate. A high rate reflects both the degree of risk involved
and the expectations of capital providers for high returns to compensate
for the risk. VCs might seek rates of return of 50% or more during the
seed capital stage and 30–50% at later stages.
VCs are not long-term investors. They seek to cash out after 3–5 years.
Their investments often take the form of specialized equity, such as a
preferred stock issue with a high dividend rate and mandatory redemp-
tion at a specified future time, either at a high cash price or at a generous
conversion into common shares. The latter option is appealing when the
VCs anticipate an initial public offering of the start-up’s shares.
Venture capital investing is high risk. First-time start-ups have a 21%
chance of succeeding. Even previously successful venture-capital-backed
enterprise still only have a 30% chance of succeeding in the next venture.15

Multiscenario Approaches

In addition to using high discount rates for start-up companies, valuation

analysts may use a multiscenario approach. One multiscenario approach
begins by constructing alternative outcomes under different degrees of
optimism about the future of the company. The approach next estimates
a discounted cash flow value for each outcome, called a conditional
value, and then weights each outcome according to a probability esti-
mate of its likelihood of occurring. Often referred to as the First Chicago
Approach,16 this methodology frequently creates a table such as the one
shown below, using the success percentages cited above:

Conditional Weighted
Scenario value ($) Probability value ($)
Very optimistic 150,000,000 0.02 3,000,000
Optimistic 80,000,000 0.08 6,400,000
Conservative 20,000,000 0.20 4,000,000
Break even 0 0.30 0
Pessimistic (25,000,000) 0.40 (10,000,000)
Weighted Average $3,400,000
 VALUING THE BUSINESS 245

Examples of Valuation
Many considerations and estimates enter into a business valuation. It is
more art than science, with the skill and insight of the valuation expert
playing an important role.
To illustrate some of the effects of the estimates and assumptions
involved, consider a new business venture, Ron’s Business Valuation Ser-
vices, with the first-year cash flow estimates as shown in Table 11.4.
The first question is the expected growth of the business. Consider
first an assumption of 6% annual growth. We assume that collections
and all expenses will grow at that rate, though other assumptions could
be made. A 5-year cash flow projection for Ron’s Business Valuation Ser-
vices, with 6% growth, would be as shown in Table 11.5.
A discount rate needs to be chosen. Since growth is already built into
the cash flow assumptions, the discount rate reflects only the riskiness of
this business. If we believed that the business had relatively little risk, we
might choose a discount rate of 10%. This would give a present value for
the 5 years of cash flow of $76,080. If we believed the risk was high, we
might choose a discount rate of 30%, which would give a present value
of $47,968. Clearly, the choice of discount rate has a major influence on
the calculated present value.
Instead of estimating the cash flow of each of the first 5 years, suppose
we simply estimated that the average annual cash flow over 5 years would
be $20,293. This would not make a big difference in the present-value

Table 11.4. First-year Projected Cash Flow

Cash receipts ($)
Cash collections from clients 200,000
Cash payments ($)
Payroll 80,000
Marketing and customer service 16,000
Rent 30,000
Office supplies and equipment 20,000
Taxes and licenses 36,000
Total cash payments ($) 182,000
Net cash flow ($) 18,000
246 DEVELOPING NEW PRODUCTS AND SERVICES

Table 11.5. Five-year Cash Flow Projection, 6% Growth Rate

Year 1 Year 2 Year 3 Year 4 Year 5
Cash collections ($) 200,000 212,000 224,720 238,203 252,495
Cash payments ($)
Payroll 80,000 84,800 89,888 95,281 100,998
Marketing and 16,000 16,960 17,978 19,056 20,200
customer service
Rent 30,000 31,800 33,708 35,730 37,874
Office supplies and 20,000 21,200 22,472 23,820 25,250
equipment
Taxes and licenses 36,000 38,160 40,450 42,877 45,449
Total cash payments ($) 182,000 192,920 204,496 216,764 229,771
Net cash flow ($) 18,000 19,080 20,224 21,439 22,724

calculations, giving $76,926 at a 10% discount rate and $49,425 at a

30% discount rate. These amounts are somewhat higher than shown
earlier, because using an average in this case attributes somewhat higher
cash flows to earlier years and somewhat lower cash flows to later years,
thus increasing the present value.
This example considered only 5 years; what about subsequent years?
One approach would be to continue the growth projections for more
years, although the confidence in our estimates decreases as we go
further out in time. At the other extreme, we could assign zero value
beyond 5 years, on the basis that the survival of the business beyond that
time is too uncertain. A third possibility is to assume that the average cash
flows calculated above would continue indefinitely; the present value of
that perpetuity would be $202,930 (=$20,293/0.10) at a 10% discount
rate or $67,643 (=$20,293/0.30) at a 30% discount rate. As can be seen,
the value of this business depends heavily upon the assumptions used in
our calculations.
Consider next an assumption of 16% annual growth. Again, we assume
that collections and all expenses will grow at that rate, though other assump-
tions could be made. A 5-year cash flow projection for Ron’s Business
Valuation Services, with 16% growth, would be as shown in Table 11.6.
Here the present value of the 5 years of projected cash flows is $91,244
at a 10% discount rate and $55,836 at a 30% discount rate. These present
 VALUING THE BUSINESS 247

Table 11.6. Five-year Cash Flow Projection, 16% Growth Rate

Year 1 Year 2 Year 3 Year 4 Year 5
Cash collections ($) 200,000 232,000 269,120 312,179 362,128
Cash payments ($)
Payroll 80,000 92,800 107,648 124,872 144,851
Marketing and 16,000 18,560 21,530 24,974 28,970
customer service
Rent 30,000 34,800 40,368 46,827 54,319
Office supplies and 20,000 23,200 26,912 31,218 36,213
equipment
Taxes and licenses 36,000 41,760 48,442 56,192 65,183
Total cash payments ($) 182,000 211,120 244,899 284,083 329,536
Net cash flow ($) 18,000 20,880 24,211 28,096 32,592

values are 20% and 16% higher, respectively, than those calculated under
the 6% growth assumption. Average 5-year cash flow for this scenario is
$24,758; the present value based on the 5-year average is $93,842 at 10%,
and $60,300 at 30%, both 22% higher than the corresponding figures for
the 6% growth scenario. Perpetuity values are $247,580 (=$24,578/0.10)
at 10% and $81,927 (=$24,578/0.30) at 30%.
These comparisons represent the importance of sensitivity analy-
sis in performing business valuation calculations. Sensitivity analysis
addresses the question of how much difference in the outcome results
from different assumptions. The more sensitive the outcome, the less
confidence we should place in the result.

The Importance of Growth Rate on Firm Value

The growth rate of revenues can have a dramatic impact on the value of
the business. As noted earlier, one way to determine the value of a busi-
ness is to use the formula for the present value of perpetual annuity. The
following formula was used.

Present Value of Ordinary Perpetuity

= Constant annual return/Discount rate

This formula can be slightly modified to include a growth in annual returns.

248 DEVELOPING NEW PRODUCTS AND SERVICES

2,600,000

2,000,000
Initial annual return = $50,000
Discount rate = 12%
Firm value

1,500,000

1,000,000

500,000

0
0 1 2 3 4 5 6 7 8 9 10 11

Percentage growth rate of initial return

Figure 11.1. The influence of growth rate on firm value.

Firm Value = Initial Annual Return/(Discount Rate

– Growth Rate of Initial Return)

If the initial annual return is $50,000 and the cost of capital is 8%

and revenues are not expected to grow then the value of the firm would
be $625,000. If the initial annual return is expected to grow at 2%, then
the value of the firm would increase to $833,333.
Figure 11.1 presents a graph where the growth rate ranges from 0–10%
with a discount rate of 12% and an initial annual return of $50,000. The
present value of a firm with 0% growth rate is approximately $417,000.
The present value of the firm with a 10% growth rate is $2,500,000. As
the growth rate approaches the discount rate the present value of the firm
increases exponentially. This in part illustrates why companies with very
modest returns are sometimes valued very highly by potential investors.
A firm with strong growth potential, even with small initial returns, is an
attractive target for investors.

Conclusion
In this chapter, we have presented an overview of business valuation. The
key points are the following:
 VALUING THE BUSINESS 249

• Business valuation is a complex and challenging field that

offers several methods to choose from, and requires that many
decisions be made when applying any method.
• These choices and decisions are typically guided by the
purpose of the valuation, the nature of the business being
valued, the availability of data, and the skill and expertise of
the valuation professional.
• Multiple valuations based on different methods are likely to
yield different results. Some analysts choose to average the values
to arrive at a composite estimate. Others frame the valuation as
a range of values defined by those outcomes that are reasonably
consistent with one another, ignoring any outliers. There is
considerably more art than science involved in this field.
• Once an initial valuation is completed, consideration should be
given to any factors that may lead to an increase (premiums) or
decrease (discounts) in the value of the business.
• Start-up or early-stage businesses are especially hard to value,
due to the lack of a track record. Expected rates of return on
investment are high at this stage, to compensate for the much
higher risk that the endeavor will not be successful.

Business valuation for a start-up is often ignored because it is complex

and because there is no historical financial patterns to turn to. It is, how-
ever, important because of the numerous stakeholders who are interested
in the value of the business. It is also significant because it provides key
insight into the overall financial structure and the firm’s value proposition.
 CHAPTER 12

Developing a Business Plan

The terms strategic planning and business plan are often used inter-
changeably, even though they are different. The strategic planning
process is essentially the upfront activity related to generating a busi-
ness model. It involves using the analytical strategic planning approaches
discussed in chapter 8, such as value chain analysis, Porter’s five-force
model, the resource-based view of strategy, the technology life cycle, and
SWOT analysis among others.1 In chapter 9, we introduced an abbrevi-
ated approach to planning, called the Ten–Ten planning process that
can be quickly implemented and assist in bringing focus and clarity to
the entrepreneur’s vision. You are encouraged to complete the FAD tem-
plate, Organizational and Industry Analysis template, and the Business
Plan Overview template and to also develop an executive summary using
the material in earlier chapters before you develop a full-scale business
plan. There are two reasons for this. The first reason is that the material
developed during the Ten–Ten planning will be very useful in devel-
oping a focused, more complete, and better plan. The other reason for
using the Ten–Ten process is that business models evolve very rapidly,
and sometimes it is better to let the idea incubate and to also present
the plan to a variety of audiences before committing and finalizing the
full-blown plan.
In this section, we will present a more detailed approach for con-
structing a full-blown business plan. The expanded business plan pro-
vides additional focus by adding details on the what, why, how, when,
and for whom a product or service will be produced. The business plan
is an abbreviated description of the business model (see Table 12.1).
The business plan is presented to the outside world through a business
presentation and is accompanied by a business plan document.
252 DEVELOPING NEW PRODUCTS AND SERVICES

Table 12.1. The Business Model: Important Business

Model Decisions
What will the product features and product mix look like?
How will the firm acquire market share, define market segments, and market the
product mix?
What type of pricing strategy will be used (menus, auctions, and bartering)?
Where will the organization build core competencies and capabilities?
With who, when, and why will partnerships and alliances be formed?
How and why are funding and resource decisions made?
How will the supply chain work? This involves the when, who, and how to tasks are
performed.
Should supply chain tasks be outsourced, off-shored, or in-tasked?
How will employees be acquired and retained?
What will the information technology look like in terms of hardware, software, and
networking?
How will product, process, and content innovation be carried out in terms of R&D?

Adapted from Afuah and Tucci.2

Purpose of the Business Plan

The business plan serves many purposes. The business plan presents a
succinct overview of the what, how, when, and why of the business. First,
it is used to communicate with investors. It provides investors with a
concise overview of what the business is about and how investors can
make money. In many ways, the business plan is a prototype of the busi-
ness model. It is a scaled-down version that describes how the business
will function. The business plan also serves as a platform for the business
founders to communicate and it can be used as a blueprint for operating
the business the first year.3 It also helps mentors and consultants to iden-
tify weaknesses, missed opportunities, strange assumptions, and overly
optimistic projections. Finally, the business plan also serves as a tool for
educating new employees on how the business works and how they will
fit into the business activities.

Approaches for Developing Business Plans

There are several approaches for developing a business plan. The first
approach is to thoroughly develop the business plan and then make a
 DEVELOPING A BUSINESS PLAN 253

presentation to investors, other entrepreneurs, interested parties, and

family members. The feedback from the presentation is then used to
rewrite and modify the business plan. The updated business plan is then
presented to the relevant parties. The major criticism of this approach is
that too much time is spent developing the business plan and not enough
time on refining and streamlining the business model.
The second approach consists of writing an executive summary, or a
business concept paper, and then to prepare a presentation and deliver it
to the relevant parties without any modification from presentation feed-
back. We have used this approach for over 10 years. Guy Kawasaki uses a
similar technique called the pitch and plan approach.4
Kawasaki believes that one purpose of the plan is to attract investors,
but that the most important reason for developing a plan is to solidify
the management team’s objectives. He believes that the executive sum-
mary plays a critical role in attracting investors and creating focus for
the management team. He recommends pitching the idea first and then
developing a full-blown plan.
As noted above, we completely agree with that assertion and have
used a similar approach for years. The FAD template, the Business Plan
Overview template, the executive summary, the business presentation,
and the full-blown business plan are in reality prototypes of the busi-
ness. They are all abbreviated business models. They give the manage-
ment team, the founders, and the investors an opportunity to focus on
something that represents the actual business. How many times have you
heard the following refrains?

They just don’t understand our business model!

They just don’t understand what we’re doing!

One of the most important duties of the entrepreneur is to educate

and facilitate the learning process of the management team, the
founders, and investors. The objective should not be too obscure the
way the business works, but rather to help interested parties under-
stand why the business will work. The Ten–Ten planning approach
coupled with the executive summary, the presentation, and the full-
blown business plan should facilitate the learning process and lead to
254 DEVELOPING NEW PRODUCTS AND SERVICES

better communication. Better communication will in turn lead to an

improved business model.

Prototyping the Product or Service

As noted throughout the book, a key activity for innovative activity is
to engage in learning by doing. Learning by doing means that you make
and build things, try experiments, and construct prototypes. Prototypes
need to be constructed for tangible products and also for systems appli-
cations. If the product is a tangible product, then a generic mock-up of
the product needs to be constructed as early as possible. If that is not
possible, because of limited resources or an overly complex product, a
handmade drawing with a graphics program or with CAD/CAM soft-
ware or Google’s free SketchUp application can be used to develop a
prototype. If the product is a computer application, then a prototype can
be constructed using a rapid prototyping language or with a presentation
package such as PowerPoint. There are also many excellent applications
available for the iPad to develop mock-ups of applications and drawings
for product ideas.
One interesting way of presenting the idea behind the business is to
tell a story about how the product or service solved a problem. Presenting
a problem and solution scenario is a very effective way for communicating
a business plan concept. One business plan presentation used a clipart in
the form of a scenario comic book to communicate the business concept.
It involved a consumer coming home to find the inside of the house
flooded. The story then went on to describe how the consumer would use
a new emergency repair network to find a reputable contractor via a com-
petitive bidding process. It was a very convincing story and quite effective
in illustrating how the service was much different than the competition’s
service. The goal of using a scenario is to get the readers to understand the
details of what the business has to offer.

Business Plan Template

Table 12.2 presents an overview of a business plan. It should not be viewed
as a checklist, to be filled in extensively with bullet points and narratives.
 DEVELOPING A BUSINESS PLAN 255

Table 12.2. Business Plan Template Part 1

1. Business pan title
a. It should include the name of the business and the name of the founders.
2. Acknowledgements page
3. Table of contents
4. Executive summary (1–2 pages)
5. Business overview (2–3 pages)
a. Description of products and services to be offered. If it is a complex product,
provide a detailed description of the functions.
b. Provide a prototype, a scenario, a picture, a diagram, or a mock-up of your
product or service. Briefly discuss the prototype. It is often a good idea to illus-
trate your concept early if the product or service is complex or very unique.
c. Describe how the product or service solves an important problem or presents
an opportunity to fill an important market niche. Be sure to explain why the
product or service is not just a good idea, but a sustainable source of revenue that
can eventually generate a profit.
d. Discuss how product is competitive compared with existing product or service
offerings.
e. Will you differentiate your product on price, quality, service, or all the three?
f. Present a Strategy Canvas illustrating how your product or service compares to
the competition.
g. What is the size of the market you expect to enter?
h. What is the growth potential of the market?
6. Industry, economic, and regulatory analysis (2–3 pages)
a. Describe the current and potential competitors (substitute products). Be sure
to discuss potential products and technologies that could make your offering
irrelevant.
b. How will the competition react to market entry?
c. What are the barriers to entry in the marketplace?
d. Are there any governmental or regulatory issues that should be considered?
e. Economic issues?
7. Marketing strategy (1–3 pages)
a. Exactly how will you price your product?
b. What customer segments are you trying to reach?
c. How will versions be matched to customer segments?
d. How will you go about promoting your product?
e. What techniques will be used to acquire customers?
f. How will you answer inquiries about the product specifications, features, and
functions?

(Continued)
256 DEVELOPING NEW PRODUCTS AND SERVICES

Table 12.2. Business Plan Template Part 1 (Continued)

g. How will you retain and lock-in customers?
h. How will you interact and distribute your product to your customers?
8. Operations strategy (1–3 pages)
a. Who will design the product or service and where will product or service design
take place?
b. Where will the product be made, who will make it and how will it be made?
c. What are the detailed variables and fixed costs for producing the product or
service?
d. Are their important issues related to the supply of components and materials?
e. How will order fulfillment take place? Are there important issues related to the
fulfillment of orders?
f. How will you provide customer service and support including tech support?
9. Human resource strategy (1–3 pages)
a. What kind of employees do we need to run the business?
b. Where will we recruit them from?
c. What kind of compensation incentives will be offered in terms of salary, stock
options, and benefits?
d. How will employees be trained and developed?
e. How will employees be evaluated?
10. Financials and forecasts (1–3 pages)
a. Present a simple pro forma sources (cash inflows) and uses of funds cash outflows)
for 3 years after launching.
i. The sources of funds include starting cash, incoming cash from sales, investor
funds, loans, and personal funds.
ii. The uses of funds include payroll or salaries, rent, materials, supplies, land,
office space, equipment, warehouse costs, transportation costs, maintenance,
marketing, and other overhead.
iii. Include ending cash balance for each year. Can also include net present value
and internal rate of return calculations.
b. Present a simple pro forma income statement for 3 years after launching. Be sure
to discuss assumptions for sales, expenses, and growth.
i. Income should include total sales, less production costs or cost of goods sold,
and net or gross margin.
ii. Include operating expenses that have been somewhat aggregated and total
expenses.
iii. Bottom line should list net profit or loss.
c. Start-up and development costs needed before launch (see above). How will
they be funded?

(Continued)
 DEVELOPING A BUSINESS PLAN 257

Table 12.2. Business Plan Template Part 1 (Continued)

d. What are the capital or funds requirements over the next 3 years?
e. What type of accounting system will be utilized? Will it be ready by launch date?
f. Risk assessment: How will you handle extraordinary events (such as changes in
demand, turnover, economic conditions, disasters, and employee loss)? How will
the risk factors affect the bottom line.
11. Stage of development and the implementation plan (1–2 pages)
a. What resources have already been committed?
b. What stage of development are you in?
c. What needs to be done before launch?
d. When and how will the system be implemented (show timeline here)?
12. How much angel and venture capital funding do you need (1–2 pages)
a. What are you offering in return for funds?
b. When can your investors expect a return on their investment?
c. What are your projections for the investors return on investment?
13. Business plan summary (1 page)
14. Appendices (1–5 pages)
a. Short bios or resumes for principals.
b. Critical financial, operational, marketing, or financial details.

It should be viewed as a set of guidelines for constructing and developing

a business model. Some of the subheadings for the sections may not even
be addressed in the business plan and others may be addressed in great
depth. It depends on the business context. A plan should typically be
between 10 and 20 pages without appendices.

Writing, Organization, and Formatting: Helping

the Reader to Read
Content is of course the king in all writing activities and this is also true
for the business plan. However, the appearance and the look and feel
of a document can often overcome minor deficiencies and sometimes
hide major flaws. The most important element of the business plan is
the “look.” It must look clean. In general, the business plan should be
258 DEVELOPING NEW PRODUCTS AND SERVICES

between 10 and 20 pages.5 Here are a few recommendations for preparing

a business plan or an executive summary that will improve the way they
look and read.
The first step in helping the reader to read is accomplished by having
a document with the following features.

• Use good-quality paper.

• Use at least 1-inch document margins.
• Always double-space between lines. Never single space in the
body of the business plan. You can single space tables, quotes,
and the appendices.
• Use descriptive headings and subheadings to set off sections
and to assist in transitions between content.
• Use a simple typeface, such as Arial, Calibri, Times-Roman, or
Cambria or a related typeface that is easy to read. Use color to
improve the appearance, but do not overuse.
• Include some figures and tables and refer to them in your
discussion. Each figure and table should have a number
and a caption. Make sure the figures, tables, and financial
spreadsheets look attractive and are understandable. Use color
to improve the appearance.
• Never present your business plan as a series of bullet points.
The plan should have paragraphs and tell a story. It should
not look like a presentation.

Simple fonts facilitate reading, understanding, and even the accom-

plishment of tasks. Psychologists at the University of Michigan conducted
an experiment where they were trying to get 20-year-old college students
to exercise.6 They divided the students into two groups. One of the groups
received instructions for a regular exercise routine in an Arial typeface and
the other received the same instructions in a Brush typeface. The sub-
jects who had read the exercise instructions in Arial indicated that they
were more willing to exercise and they believed that the routine would be
easier and take less time than those subjects reading the instructions in
a decorative typeface. They conducted another test in which two groups
of students read instructions in preparing sushi rolls in a simple typeface
 DEVELOPING A BUSINESS PLAN 259

and a decorative typeface. The results were similar. The students using the
simple typeface instructions were more willing to attempt making sushi
rolls than those reading from instructions in a decorative typeface.
Reader fatigue is an important issue. Another way to reduce fatigue
is by changing the lengths of your sentences. For example, have two
short sentences and one long sentence and one short sentence followed
by one long sentence and then one short sentence. The idea is to mix
up the sentence structure and create interest. The second method that
fatigues readers is of course having too much to read.7 This is particularly
true when the business plan involves difficult and unfamiliar material.
Succinct and clear writing coupled with informative figures and tables
will alleviate reader fatigue. This is the essence of pithy writing. The
length of the business plan narrative should usually be between 10 and
20 pages and rarely if ever exceed 20 pages. You can also add between
4 and 6 pages of figure, tables, and appendices. Graphics and tables are
also important elements for assisting in chronicling and presenting the
business plan. Tables and figures should always have numbers and cap-
tions, and they should always be referred to by their figure number or
table number in the text.
The last point is extremely important. “Never present your business
plan as a series of bullet points.” Remember, the goal of the business plan
is to tell an interesting story. Bullet points need background and discus-
sion. The business plan should never look like it was simply lifted from a
presentation. This is a serious rookie mistake. Use bullet points sparingly
and when you do use them, you need to discuss them, just as you would
discuss a point during a presentation.
Finally, how can you cram all of this information into one busi-
ness plan and not bore your readers. It requires hard work and constant
refinement so that the core aspects of the business are communicated in
less than 20 pages. Several trade-offs have to be made; some areas will
expand and others will be reduced. Very few business plans look the
same. They are highly differentiated. It is the role of the entrepreneur and
the entrepreneurial team to educate and facilitate the learning process of
the reader. The objective should not be too obscure the way the business
works, but rather to help interested parties understand why the business
will work.
260 DEVELOPING NEW PRODUCTS AND SERVICES

Business Presentation
The business presentation is the dog and pony show. One of my students
asked me whether the business presentation should be informational
or a pitch. It should be both, and that is the ongoing dilemma for the
presenters. Including the proper mix of information and creating excite-
ment about the business is a difficult task. The presentation should have
conveyed approximately the same content as the business plan, but in an
abbreviated format (see Table 12.3). The goal is to maintain interest and
communicate your ideas. The ideal number of slides for the presenta-
tion should be approximately one slide for each section. However, this
can be increased if the slides are not too dense. This means that you will
have to talk around the key concepts of each section. You do not want to

Table 12.3. Business Plan Presentation

General guidelines for business plan presentations

1. Introduction of team (30 seconds)

2. Company overview (4 minutes)
a. Description of products and services to be offered.
b. Presentation of your product, service, or system prototype. Could be a prototype,
a scenario, a picture, a diagram, or a mock-up of your product, or service. Briefly
discuss the prototype.
c. How does the product or service solve an important problem or present an
opportunity to fill an important market niche
d. Discuss how product is competitive.
e. How do you intend to differentiate yourself (price, quality, or service)?
f. Present a Strategy Canvas illustrating how your product/service compares to the
competition.
g. What is the size of the market you intend to enter?
h. What is the growth potential of your market?
3. Industry analysis (1 minute)
a. Description of current and potential competitors (substitute products).
b. How will competition react to market entry?
c. What are the barriers to entry?
d. Are there critical governmental or economic issues?

(Continued)
 DEVELOPING A BUSINESS PLAN 261

Table 12.3. Business Plan Presentation (Continued)

4. Marketing strategy (2 minutes)
a. How will you price your product?
b. What customer segments are you trying to reach? How will versions be matched
to customer segments?
c. How will you promote your product?
d. What techniques will you use to acquire customers?
e. How will you retain and lock-in customers?
f. How will you distribute your product?
5. Operations strategy (2 minutes)
a. Where will the product be made?
b. How will it be made?
c. Who will the product or service?
d. What are the detailed variables and fixed costs for producing the product or
service?
e. Are their important issues related to the supply of components/materials?
f. Are their important issues related to the fulfillment of orders?
6. Forecasts and financials (2 minutes)
a. What do your projections show for sales, profit, expense, growth, and
investment?
b. Capital requirements over the next 3 years.
i. Development costs
ii. Advertising costs
iii. Human resources
iv. Sources of capital
7. Stage of development and the implementation plan (1–2 minutes)
a. What resources have already been committed?
b. What stage of development are you in?
c. What needs to be done before launch?
d. When and how will the system be implemented (show timeline here)?
8. How much venture capital funding do you need? (1 minute)
a. What are you offering in return for funds?
b. When can they obtain return?
c. Return on investment expected?
9. Summary (30 seconds)
These are the restrictions I use: Questions (4 minutes): Total allowable time for
presentation and questions is 19 minutes. Be sure to conduct a trial run of your
presentation so that you will not go over the 15-minute presentation limit.
262 DEVELOPING NEW PRODUCTS AND SERVICES

read your slides. Just have the key concepts on the slide and talk around
them. The most important thing you can do is to practice your presenta-
tion and, if possible, memorize your notes. There are always limits on
the length of the presentation and it is important to hit that mark within
30 seconds. Practice helps to convey the impression that you know what
you are talking about and that you have the best product since sliced
white bread. Guy Kawasaki suggests a 10/20/30 rule. That is 10 slides, for
20 minutes using a 30-point font. This is good advice, but it is sometimes
necessary to extend the number of slides depending on the particular
business context and the amount of content in each slide.
Be sure to illustrate a prototype or at least show an illustration of
your product or service. The prototype could be an illustration, a picture,
a diagram, an example report, a scenario, or a mock-up of your prod-
uct or service. If you are developing a complex process that is hard to
understand, then you should still try to convey the idea using some sort
of flow diagram or business process diagram. The goal here is to try to
get your audience to understand just what you are trying to sell and try
to get them to buy your product or service. The goal is not to be vague
or obscure. As noted earlier, the scenario is very effective tool for com-
municating the business concept. An actual or even a fictional scenario
can be a powerful tool for explaining how the product or service works.
Scenario presentations can include live acting, movie clips, storyboards
using clipart and drawings, simulations and even the use of stick figure
animation.
The business should be pitched and presented several times before
the final plan is developed. The business plan presentation along with the
executive summary will help to structure the business and make it more
focused, clear, and understandable. It is all part of the learning process
consisting of learning-about and learning-by-doing. It is important to
have someone document all the questions that arise during the presenta-
tion and then to try to understand what the questions mean. It could be
simply that the business model was not communicated effectively during
the presentation, or a critical issue was not considered and that it needs
to be addressed. Businesses are emergent; they take time to design, build,
and to be successful; and the pitch and presentation is a critical part of
the growth process.
 DEVELOPING A BUSINESS PLAN 263

Identifying Potential Investors

Investors invest in people and then they investigate the idea.8 This is true
even when your investors are your family and friends and when economic
times are challenging. Superstars in music, cinema, and in baseball garner
the accolades and ultimately the money because of their above-average
expertise. Music and movie publishers and baseball general managers go
to the superstars because they are a known commodity and have a track
record for delivering hits. This is also true for start-ups. The investors look
at the management team, the CIO, the VP’s of marketing, operations,
and finance, and the lawyers in terms of their reputation, education, job
history, and previous experiences with start-ups.
Many start-ups have difficulty in getting funds.9 There are a variety
of avenues for generating additional funds that do not involve the pro-
fessional investors. The first search for funds usually includes savings,
credit cards, home equity loans, bank loans, and selling equity to family,
friends, and selling personal assets. Bootstrapping is the process of start-
ing a business from scratch with little or no outside capital. The goal of
bootstrapping is to minimize expenditures and to reinvest the cash flow
generated by the start-up back into the business.
Figure 12.1 illustrates the typical level of funds that can be generated
as the business grows.10 Figure 12.2 presents additional detail on where
funds are generated as the business grows.11
Here is a list of additional sources of funds to keep the business going
as it grows that the entrepreneur can turn to in lieu of professionally
managing funds.

Stage 0 Seed/start-up Close to launch Early Later

pre-seed

Source Founders friends Individual Angel groups Venture funds

and family angels

Investment $25,000 to $100,000 to $500K to $2M $2M/ $5M and up

$100,000 $500,000 depending on region

Figure 12.1. Typical amount of funds generated during business

development.
 264

Venture capital
launch to sustainability

Owner, friends, family, angel investors Private equity

conceptualization to launch growth to turnaround

Seed Start-up First round Second Third round Expansion Management Work-out
•Develop and •Develop •Launch first round •Show steady •Established buyout •Troubled
prove a concept product; engage product; show •Penetrate initial increase in privately-held •Operating company with
market ability to markets; show revenues; company management plan for
generate ability to achieve pursues acquire business turnaround
revenue generate profitability` aggressive division
revenue growth
DEVELOPING NEW PRODUCTS AND SERVICES

Figure 12.2. Funds generation as firm grows.

 DEVELOPING A BUSINESS PLAN 265

• Trade credit: Where a business sets up an account with

another business and does not have to pay for the goods and
services until a certain time period has elapsed (e.g., 30–90
days. Lumber and hardware companies often set up such
accounts for contractors.
• Asset-based loan: A business will use its equipment, inventory,
or facilities as collateral for a loan.
• Factoring of accounts receivables: A business sells its accounts
receivables to the lender or factor. The lender usually handles
most of the transactions that occur after the sale, such as
sending out invoices and collecting the funds that are owed.
• Loan: Loan is given after the financial statements have been
analyzed, a small business credit score is obtained, or both.
Could be a bank or some other financial institution or
individual. Sometimes involves collateral or assets such as
inventory, facilities, or equipment or personal assets of the
borrower.
• Leasing: The lender purchases the asset and then charges a
monthly or some periodic fee for the lessor to use it (purchase
of fixed assets by lessor).
• Relationship lending: This is the good buddy loan. The lender
has dealt with the borrower in the past and grants a loan
because of past success. There is often an ongoing advisory
and guidance relationship between the lender and borrower.
Could be a bank or some other financial institution or
individual.

Sources of funds and their timing depend on the economic context,

the type of business, and the capabilities and attitudes of the founders,
and these figures reflect averages and processes that are forever changing.

Angel Investors
Angel investors are very early participants in funding start-ups. When the
amount of financing required is <$1 million, then the start-up should
probably approach angel investors. The angel investors are usually not
266 DEVELOPING NEW PRODUCTS AND SERVICES

involved in managing the start-up. Angel investments range from $100K

to $500K. Angel investors usually look for a 20–40% return on their
investment after 3 years or somewhere between two and three times their
original investment. For example, a $500K investment would return
about $1M–$1.5M in three to 4 years with a 25% return. Not all of the
investments by angel investors are successful (about 50%). A small per-
centage of the investments carry the load and subsidize the marginal and
failed businesses.12

Venture Capital Funds and Venture Capitalists

Venture capital funds are professionally managed funds that provide
high-potential start-ups with funds in exchange for management fees and
equity or shares of stock in the start-up. Venture capitalists (VCs) invest
between $1 and $20 million in a start-up, but it can vary. The venture
capital funds are themselves funded by wealthy investors. The venture
capital funds sometimes charge about 2–4% per year as a management
fee. In addition, they charge 20–25% return (sometimes more) on their
investment over the course of 5 years. So if a start-up borrows $5 million
from the venture fund, then they may have to pay $100,000 in manage-
ment fees per year (at 2%) and then pay out approximately $13.3 million
in 5 years (at 20%) for the return on the VCs investment. The manage-
ment fee is a kind of coaching or consulting fee. A typical fund can have
15–20 ventures with about half-generating returns. Only a few of the
businesses are hits and the hits subsidize the failures and the marginally
successful ventures.

Potential Problems with Venture Capital

There has been much criticism in the engineering community in refer-

ence to venture capital funds stifling innovation.13 Some of it is related
to investing in start-ups with superstar management and some of this
is related to the tendency of VCs to pursue incremental innovations
where there are lower levels of risk. VCs are not interested in technol-
ogy; they are interested in adding a business to their portfolio that has a
good chance of generating above-average returns. They know that some
start-ups will fail, and they rely on their knowledge and expertise and
 DEVELOPING A BUSINESS PLAN 267

portfolio diversification to deliver a few successful start-ups. The point

is that it is hard for the new entrepreneur to make a splash because there
are no previous splash patterns. Start-ups with little experience usually
rely on the founder’s money, family and friends, and a variety of other
approaches to run the company (see http://brainz.org/startup-funding/
for an excellent overview of nonventure-capital fund sources). There are
many opportunities to raise funds outside of professionally managed
money and indeed that give the company’s founder a degree of control
and flexibility that may exceed the benefits of securing funds that reduce
flexibility and control are accompanied by very high interest rates.

Importance of Market Potential to VCs

VCs are interested in firms that have the potential to acquire substantial
market share in large markets.14 They want to know whether the market
is large, whether it is growing rapidly, and whether the start-up can cap-
ture some of that growth. They also want to know whether the business
is scalable. A scalable business model means that the business can shrink
or grow very quickly with minor changes in the cost structure. In the
best situation, growth should not increase variable costs and fixed costs
(perhaps even decrease variable costs). Ideally, growth should not incur
large fluctuations in business processes as new customers are added.
Remember, however, that scalable growth is usually scalable within a
relatively narrow range.
The potential investors will also want to know whether the start-up
can acquire customers and keep them. They will also be interested in the
market forecast. Savvy investors will question market forecasts that indi-
cate that the firm will garner either 1% or 10% of the market. The 10%
share of the market usually means that the market is relatively small and
the start-up needs 10% to break even. The 1% usually means that the
market is huge and the start-up will be lucky to acquire even 1%. Market
forecasts need to be based on realistic assumptions, rather than based on
what makes for easy spreadsheet construction. There should be a strong
rationale why the start-up will acquire 10% of the market the first year
and increase that share by 20% in subsequent years.
Guy Kawasaki has several good ideas for developing market fore-
casts. His first idea is to develop a forecast from the bottom-up. In this
268 DEVELOPING NEW PRODUCTS AND SERVICES

approach, the start-up would try and identify the number of sales outlets
and then estimate how many items might be sold at each outlet. Another
example would consist of looking at the number of sales contacts each
week for each salesperson and then estimate the percentage that will be
successful. This approach, admittedly, also relies on percentages and, in
some ways, is also seat-of-the-pants as is the 10% solution. The important
point in developing forecasts is to examine and test assumptions and to
constantly refine the forecasts.

Contingency Planning and Risk

Suppose you are developing a green or environmentally friendly product
line that is particularly attractive because of a government tax credit. What
if the government rolls back the tax credit? Or what would happen if a key
member of the management team leaves the company? What if interest
rates sky rocket? What if a key employee deletes the design specifications
of a new product? What if a disgruntled employee destroys the social net-
working application and backup files? It is impossible to have a fall-back
plan for every situation. But if there are key people and key assumptions
that will determine business success, then a contingency plan is essential.
Risk is the probability that some adverse event will happen that will
have a negative impact on the start-up’s ability to survive. Risk man-
agement is an attempt to identify the adverse events within a company
and in the external organizational environment, and in turn develop
strategies to deal with the consequences. Many of the internal risks to
the start-up are related to the critical assumptions involving the tenure
of the management team, the ability to attract key personnel, the abil-
ity to set up key organizational systems such as operations and market-
ing, the ability to manage cash flows, and the ability to adapt untested
technologies. There are also external industry-related risks related to the
ability to forecast market growth, and the risks related to unforeseen
competitors and unforeseen emerging technologies that might affect
profitability. There are also external risks related to economic down-
turns, interest rates, government intervention, political movements,
and even changes related to social norms. Risk assessment also has to
be made in terms of the impact of adverse weather conditions, earth-
quakes, and other natural disasters.
 DEVELOPING A BUSINESS PLAN 269

As noted earlier, there is some danger in pointing out weaknesses and

threats, but they need to be addressed in a surreptitious manner. This can
be accomplished by presenting alternative scenarios and focusing on the
probability of their occurrence. Contingency planning and risk assess-
ment should be addressed in the business plan or at least informally docu-
mented and communicated among the founders of the business and key
management employees.

Due Diligence
Professional investors such as angels and VCs, potential employees, and
family members use a variety of criteria for evaluating a business plan. The
process of evaluating the plan is referred to as due diligence. The Merriam
Webster dictionary defines due diligence as:

1. The care that a reasonable person exercises under the circumstances

to avoid harm to other persons or their property;
2. Research and analysis of a company or organization done in prepara-
tion for a business transaction (as a corporate merger or purchase of
securities).

Due diligence can be evaluated in terms of how careful investors

are in evaluating a business plan and how diligent the founders are in
preparing the business plan. There is evidence that when the investor is
duly diligent, the business will have a greater chance of succeeding.15 We
also believe that due diligence becomes very important as the business
emerges from the conceptualization stage and is being built. Due dili-
gence becomes important when the shoe meets the pavement or rather
when the entrepreneur starts interacting with the investor. Here are the
modified definitions of due diligence:

1. How wise and careful did the entrepreneur put together the busi-
ness plan?
2. How wise and careful did the investor examine the business plan?

We usually read about 20–40 business plans per year. We evaluate

the plans in terms of organization and format of the plan, writing, and
270 DEVELOPING NEW PRODUCTS AND SERVICES

content. All three areas are interrelated, and it is our experience that hard
work usually leads to a great format, good writing, and strong content.
Table 12.4 presents an overview of the major due diligence questions
asked by investor, founders, and potential employees. It is one checklist
that needs to be checked off. Some of the questions are more important
to one group than to another. Just go through them before submitting
the final plan. One thing is clear, if the writing style is poor and the plan
is poorly organized, then it will be very difficult to sell your ideas. At least
2 or 3 people outside of the founding group should be sought to provide
editorial support for the plan format and the content to insure that the
plan makes sense.

Table 12.4. Due Diligence Checklist Questions Asked by Investors,

Founders, and Employees
• Could such a business make money? Yes No Maybe NA Needs Work
• Solves a problem or presents unique Yes No Maybe NA Needs Work
opportunity?
• Is the business concept scalable? Yes No Maybe NA Needs Work
• Is the market large and expanding? Yes No Maybe NA Needs Work
• Has the target market been adequately Yes No Maybe NA Needs Work
identified?
• Is the product or service differentiable? Yes No Maybe NA Needs Work
• Can customers be acquired at a Yes No Maybe NA Needs Work
reasonable cost?
• Can customers be locked-in? Yes No Maybe NA Needs Work
• Is pricing addressed adequately? Yes No Maybe NA Needs Work
• Are current and potential competitors Yes No Maybe NA Needs Work
identified?
• Addresses competition’s reaction to Yes No Maybe NA Needs Work
market entry?
• Is the marketing plan adequate and Yes No Maybe NA Needs Work
executable?
• Is the operation’s plan adequate and Yes No Maybe NA Needs Work
executable?
• Is the implementation plan adequate/ Yes No Maybe NA Needs Work
executable?
• Are the projected financial statements Yes No Maybe NA Needs Work
reasonable?

(Continued)
 DEVELOPING A BUSINESS PLAN 271

Table 12.4. Due Diligence Checklist Questions Asked by Investors,

Founders, and Employees (Continued)
• Can the key management personnel Yes No Maybe NA Needs Work
get the job done?
• Can the business be built and fulfill Yes No Maybe NA Needs Work
promises?
• Any hidden traps, oversights, Yes No Maybe NA Needs Work
oversimplifications?
• Is there contingency planning and risk Yes No Maybe NA Needs Work
assessments?

Legal Issues
Since we are on the topic of due diligence, this is a nice segue into the
importance of attorneys in developing a business. Guy Kawasaki has
identified a number of difficulties that arise when dealing with lawyers.16
But Kawasaki also believes that lawyers are critical for the success of busi-
ness start-ups.17 Lawyers and entrepreneurs often have trouble interacting
because lawyers focus on what can go wrong and the entrepreneur is the
eternal optimist and focuses on getting things done. Entrepreneurs tend to
embrace risk and focus on the prize, whereas lawyers tend to be risk averse
and focus on what can go wrong. Entrepreneurial enthusiasm tempered
with a bit of lawyerly caution that can alleviate many hazards on the road
to building the business. Lawyers can assist with the following activities:

• They can help in selecting the appropriate form of business

incorporation such as a sole proprietorship, a corporation, or
a limited liability corporation.
• They can provide guidance on whether you can leave a
company and start a business in the same industry.
• They can provide insight and counsel on protecting intellec-
tual property in using copyright, patents, and trademarks.
• They can assist with real estate and rental transactions.
• They can check employee benefits and employment contracts.
• They can provide legal expertise on venture and angel
investment funds.
• They can assist in selling the business and going public with
the issuance of stock.
272 DEVELOPING NEW PRODUCTS AND SERVICES

A good starting place for information on the selection of legal counsel,

working with accountants, and incorporating companies can be found at
http://www.entrepreneur.com and http://www.sba.gov/. You probably do
not have to include the lawyering and legal issues in the business plan, but
you need to be aware that there are numerous legal issues and accounting
issues that are looming. Professional expertise is expensive, but in some
instances their advice is critical for successfully navigating through the
legal and financial systems.

Conclusion
In this chapter, we have illustrated the process and the elements that
are used to develop a full-blown business plan. The key points are the
following:

• The FAD template, the Organizational and Industry Analysis

template, and the Business Plan Overview template and
executive plan are used as the basis for developing the
full-blown business plan.
• The business plan serves many purposes including serving as a
communication tool for investors; it is a scaled-down version
of how the business will function and it is used as a platform
for communications among the founders, employees,
consultants, and mentors; and finally, it can be used as a
blueprint for operating the business the first year.
• A business plan template is presented that illustrates the
typical sections that are contained in the business plan.
• The writing style, the organization and the formatting are just
as important as the content for communicating the essence of
the business model.
• It is important to pitch and present the business plan before
finalizing the full-blown plan. This will help to bring focus
and clarity on the emergent business.
• In many instance, investors invest in the management as
much as in the idea.
• Many investors are interested in market potential in terms of
the growth of the market and the total size of the market.
 DEVELOPING A BUSINESS PLAN 273

• Contingency planning and risk assessment should be

addressed in the business plan or at least informally
among the founders of the business and key management
employees.
• Time, hard work, and attention to details will lead to better
business plans.
• Legal counsel and accounting expertise are essential for
incorporating the business and providing guidance through
the legal and financial systems.

The business plan is presented to the outside world through a busi-

ness presentation and the presentation leads to the development of a
short business plan document. An important part of developing the
business plan is the learning-by-doing process. It is important that the
emerging company make and build things, try experiments, and con-
struct prototypes. Prototypes need to be constructed as early as possible
for tangible products and also for systems applications. As illustrated in
Figure 12.3, the process is iterative and ends only after the business is
not in existence.

Build business Write 10–20 page plan

Idea

Build
product

Prototype

Quickly gather
information using Pitch your
FAD template & plan
Ten–Ten templates
Develop a small 2–3 page plan

Figure 12.3. Planning process is ongoing an iterative.

274 DEVELOPING NEW PRODUCTS AND SERVICES

The most important element of the business plan and the business
presentation is the “look and feel.” The plan and the presentation should
look clean and streamlined. The development of a business model and
plan begins with the moment that the entrepreneur has the original aha
experience; this is followed with a very brief strategic planning process
(we recommend the Ten–Ten approach coupled with a FAD analysis) and
this is in turn followed by the development of the executive summary.
 CHAPTER 13

Project Management
for New Products and
Services Development
As discussed throughout the book, there is an overarching business life
cycle involving several key development points. These points are primar-
ily under the control of the entrepreneur, the founders, or executive man-
agement. They are the initial conceptualization of the business through
some form of business plan, the development of the initial business pro-
cesses using some form of project management, the business launch, the
addition of additional controls and structure as the business grows, and
finally the re-conceptualization of the business as it begins to decline
(Figure 13.1).
Once the business model has been created and the business plan has
been developed, the hard work begins. In most situations, everything is
new and needs to be built up from scratch. The entire supply chain has
to be built and tested to insure that orders for products and services can
be accepted, filled, and supported. This is the Building-the-Business phase
and it is vital to a successful business launch. As illustrated in Table 13.1,
several key business questions must be answered before launching the
business.
The hard part is to install initial processes or systems to make the busi-
ness work, and that is where project management is essential. We use the
term project management system loosely, since in many instances the system
can be self-contained and organized in the mind of the entrepreneur. Nev-
ertheless, the hard part involves building the business to produce the prod-
uct and deliver the service. This requires project management. Even if you
have plans for manufacturing, marketing, and distributing the product,
you still need to have a process to accomplish or execute the plan.
276 DEVELOPING NEW PRODUCTS AND SERVICES

Building the business

Business re-conceptualized. May need turn-

around management support.
Business growth

Need professional management as business grows to

institute more controls and structure.

Launch
Need project management for additional product
development and to develop initial business processes.

Business conceptualized and planning is started.

Time
Figure 13.1. Key management activities during the business life cycle.

Table 13.1. Key Business Questions Before Launch

a. Where will the product or service be made?
b. Who will make the product?
c. How will it be made?
d. How will orders be tracked?
e. With who, when, and why will partnerships and alliances be formed?
f. What will the supply chain look like and how will dependencies work?
g. Should supply chain tasks be outsourced, off-shored, or in-tasked?
h. What will the information technology look like in terms of hardware, software, and
networking?
i. Are there important issues related to the supply of components/materials?
j. How will order fulfillment work?
k. Are there important issues related to the fulfillment of orders?
l. Where will the organization build core competencies and capabilities?
m. How will employees be acquired and retained?
n. How will business and accounting transactions be handled?

In many instances, entrepreneurs turn to turnkey systems for

accounting and inventory management. Turnkey systems are ready-to-go-
software, ready-to-go-processes, or both for running a business. Time and
effort is still needed to identify the turnkey solution and then more time
and effort is required to actually implement it. Some sort of mechanism is
necessary for determining what solution fits the business, how the system
will be implemented, who will operate the system, and how it fits in with
 PROJECT MANAGEMENT FOR NEW PRODUCTS 277

the other business activities. Even if the so-called turnkey solutions have
been identified for accounting and inventory management, additional
planning is needed for implementing and creating business processes for
installing and running the system.
Project management is the tool for executing the plan and installing
the business processes. It helps to detail what tasks will be accomplished,
who will be involved in completing the tasks, and when tasks should start
and finish. The minimal tasks that need to be accomplished for a business
to start or launch include marketing and sales, production and operations,
staffing, and accounting. In addition, some sort of research and develop-
ment (R&D) process needs to be initiated soon after launch in order to
re-prime the pump. These are the first steps in designing organizations for
the long term.
Organizational design involves the simultaneous integration of the
tasks that need to be completed by overlaying some type of organizational
structure that uses a blend of technology and people to fulfill the organi-
zational mission.1 Here are the Building-the-Business functions and critical
questions that need to be in place before or soon after launch:

Need a marketing function or system:

• How will you promote your product or service?

• What techniques will you use to acquire customers?
• How will you retain and lock-in customers?
• How will you distribute and sell your product?
• How will you support your customers and maintain an
ongoing relationship?
• How will you track customer satisfaction?

Need an operations or production function or system:

• Who will design the product/service and where will product/

service design take place?
• Where will the product be made and who will make it?
• How will it be made?
• Who will supply the components and materials?
278 DEVELOPING NEW PRODUCTS AND SERVICES

• How will the company keep track of finished goods inventory,

components, and raw materials and track the production
process?
• How will order fulfillment take place?

Need a human resource function or system:

• What kind of and how many employees are needed to run the
business?
• Where will we recruit employees?
• What criteria will be used to select employees?
• How will performance be evaluated and rewarded?
• What kind of compensation incentives will be offered (salary,
stock options, and benefits)?
• How will employees be trained and developed?

Need an accounting function or system:

• How will you keep track of business transactions?

• How will you track business performance?
• How will the company handle accounts payable, accounts
receivables, general ledger, purchase orders, and payroll?

Need an R&D function or system (immediately after launch):

• What organizational functions will be involved in product

development and deployment?
• Who, where, and how will R&D (learning-about and
learning-by-doing) be conducted?
• How will product and service development and deployment
be evaluated?
• How will scientific, product, and organizational knowledge be
retained and utilized (knowledge management)?

Need legal counsel and assistance:

• Assist in selecting appropriate form of business.

• Assist with real estate and rental transactions.
 PROJECT MANAGEMENT FOR NEW PRODUCTS 279

• Assist in developing contracts for employee benefits and

employment contracts.
• Provide legal expertise on venture and angel investment funds
and with initial public offerings of stock and related financial
funding issues.
• Assist in protecting intellectual property in the form of
copyrights, patents, and trademarks.

Even the simplest start-up company has to accomplish the functions

described above in some capacity. These systems may be in the mind of
the entrepreneur and also executed by the entrepreneur, but they are still
necessary for survival. There are other system processes that need to be in
place as illustrated in Figure 13.2. These systems or functions typically
emerge and evolve as the business grows and prospers. A good way to con-
sider the complexity of a large business is to think about the components

Business

Design &
implement
product
support

Design and
Design and
implement
implement
production
supply chain
process

Design and Design and

implement implement
financial human
system resource
system
Design and Design and
Design and
implement implement
implement
product or marketing
R&D process
service solution

Figure 13.2. Systems emerging over time.

280 DEVELOPING NEW PRODUCTS AND SERVICES

Supply chain
Information flows
Transfer Transfer
Transfer

Manufacturing Distribution
Supplier
warehouse
Consumer

Supporting cast

Finance Information R&D Marketing & sales Management

technology

Legal Engineering Human resources Accounting

Figure 13.3. Large organizations need many systems and structures.

of the supply chain. This is again illustrated in Figure 13.3 where a num-
ber of critical processes need to be in place for a large and growing supply
chain. In larger organizations, these activities are part of a more formal
approach. The formal approach is project management. If a business only
has one employee, the entrepreneur, then all the systems will be con-
ceptualized and executed by the entrepreneur. However, even in a small,
one-person operation, understanding and implementing some type of
project management is necessary in order to deal with the complexity
of the start-up process. Just having a checklist of things to do and things
that have been accomplished will help in dealing with the overwhelming
complexity of launching a start-up.

Why Project Management is Beneficial

Project management involves time and effort, but it can also be a friend
of the start-up. There are two reasons that project management is impor-
tant. First, project management assists in dealing with complexity and
time pressure. Many organizational tasks are difficult, and from the per-
spective of the entrepreneur, they are close to rocket science because the
number of hands for completing tasks are so few. Project management
 PROJECT MANAGEMENT FOR NEW PRODUCTS 281

is structured problem solving and it assists with problem decomposition

and with managing the risk inherent in product and service development.
Even though the focus of this book has been on product differentiation,
many products and services also suffer from too much differentiation and
feature creep.
Features are critical for maintaining an edge over the competition in
the context of monopolistic competition, but there is some point where
products need to be delivered and specifications stabilized. Project man-
agement is there to assist in converging on a satisfactory solution to
problems related to delivering products and services by freezing the speci-
fications. The specs are not frozen for long; perhaps a couple of weeks, a
month, or even two, until it is time to renew the innovation process and
develop an upgraded product.
Another important feature of project management is that it is
very useful in developing and maintaining localized managerial and
scientific knowledge related to core competencies and know-how.
Project management assists in formalizing the learn-by-doing and
learning-about processes into the genetic foundations of the emerg-
ing organization.

What is a Project?
The Project Management Institute, an organization that sets industry
standards in project and portfolio management, conducts research and
provides education, certification, and professional exchange opportuni-
ties for project managers, defines a project as: “a temporary endeavor
taken to create a unique product, service, or result.”2 Temporary means
the project has a definite beginning and end. This applies to the project,
and not necessarily to the product, service, or result. All the systems that
need to be built by the entrepreneur and his or her partners are basically
projects.
Typically, projects progress in steps or incremental stages. The goal of
a project is to reach a stated objective, and then terminate, passing results
to ongoing operations. Initiation of projects is usually due to a market,
customer, or organization demand, a technological advance, or a legal
282 DEVELOPING NEW PRODUCTS AND SERVICES

Define and Plan the project Track & manage the

organize project project

• Establish the project • Develop the work

organization. breakdown structure. • Collect status.
• Define the project • Develop schedule. • Plan & take adaptive
parameters • Analyze resources. action.
• Plan the project • Optimize tradeoffs. • Close out the project.
framework. • Develop risk
• Assemble the project management plans
definition document.

Figure 13.4. Project management.

requirement. Figure 13.4 presents an overview of the project manage-

ment process.3 It is sometimes referred to as a waterfall process because
the process is typically sequential or linear.
In many instances, project management can be carried out in a linear
fashion. Linear projects follow the waterfall approach to project manage-
ment. That is, the activities for completing the project are sequential and
each separate activity follows in a more-or-less precise order. In general,
the linear approach is amenable to very straightforward projects. Many
of the activities related to setting up accounting systems, human resource
systems, and many inventory management systems could be handled
using the linear approach to project management.
There are instances where the project to be accomplished cannot be
solved using a linear project management approach. Some projects are
very complicated, with very loose specifications, and the final outcome
in terms of success and features of the product are unpredictable. For
example, new product development in the nanotechnology area where
there are few products with similar features and the territory is largely
uncharted needs a different approach to project management. Many of
the emerging software applications involving social networking and game
development also need a different approach. Agile project management
is suitable in situations where learning-by-doing plays a more dominate
role in product development. Discovery is the key as new territory is
charted and the solution to the problem unfolds. Scrum development is
one example of an iterative and agile approach to project management.4
The key difference from the traditional, waterfall process is that the agile
process will be iterative and occur many times.
 PROJECT MANAGEMENT FOR NEW PRODUCTS 283

Regardless of the process, there are several tools that may be used to
help manage a project and to communicate to the project team. There
are of course sophisticated approaches and tools to managing the pro-
cess as well as software tools for tracking projects. The simplest of tools
includes a diary that can be used to track the amount of time that is
spent on project activities. Exhibit 1 is a sample Project Management
Individual Diary for the initiation of a new business, as outlined ear-
lier in the chapter. This diary outlines the tasks or activities needed to
complete the project or subproject. Exhibit 2 presents the Project Man-
agement Summary Diary, an aggregation of the individual project tasks
used to manage projects.
Another useful tool is the work breakdown structure (WBS). The
WBS is always based on the project deliverables, rather than the tasks
needed to create those deliverables, and is built from the top-down. It is
constructed through decomposition. Deliverables are broken down into
progressively smaller pieces. The result is a graphical, hierarchical chart,
logically organized from top to bottom. Figure 13.5 represents a portion
of a simple WBS.
A Gantt chart is another very useful tool for understanding where
a project has been, where it is going, what tasks need to be completed,
and the tasks that have already been completed. Bar charts, or Gantt
charts, show activities represented as horizontal bars and have a cal-
endar along the horizontal axis. The length of the bar corresponds to

End
product

1. 2.
Human Accounting 3. 4.
resource plan plan R&D plan Legal plan

4.1 4.2 4.5

4.3 4.4
Incorporation Real estate Intellectual
Contracts Investments
plan plan property plan

Figure 13.5. Work breakdown structure.

 284

Planned Actual Show Gantt chart for: Planned Highlight month: 2

% Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11
Task
Start Duration Start Duration Done 1 2 3 4 5 6 7 8 9 10 11 12
Human resources
Resource estimates 11-Jul 20
Employee recruitment plan 11-Jul 5
Performance mesurement plan 11-Aug 5
Compensation and incentive plan 11-Aug 5
Training and development plan 18-Aug 10
Recruitment 1-Sep 60
Accounting
Accounting management plan 11-Jul 5
Performance measurement plan 18-Jul 5
Functional plan (AP, AR, GL, POS, Payroll) 25-Jul 20
Research & development
R&D resource plan 11-Jul 15
Development plan 4-Aug 60
Evaluation plan 4-Aug 10
Knowledge management plan 4-Aug 5
Development 27-Oct 120
DEVELOPING NEW PRODUCTS AND SERVICES

Legal
Business incorporation assessment 11-Jul 15
Real estate/rental plan 11-Jul 15
Employee contracts 24-Sep 10
Funding and investments 11-Jul 60
Intellectual property 8-Dec 90

Figure 13.6. Gantt chart.

 PROJECT MANAGEMENT FOR NEW PRODUCTS 285

the length of time the activity should require. A bar chart can be easily
modified to show percentage complete (usually by shading all or part
of the horizontal bar). It is considered to be a good tool to use to com-
municate with management because it is easy to understand at a glance.
A typical Gantt chart for a project is illustrated in Figure 13.6.

Launching the Business or Project

There is extensive literature by academics and practitioners on why busi-
nesses and projects fail. There is some agreement that management com-
mitment and participation, along with involvement of employees, are the
key success and failure factors, but after that the literature is somewhat
confusing and inconclusive.5 Table 13.2 presents a few of the areas that
can cause problems and perhaps even cause the project to fail. These issues
should be treated as watch outs.
Risk is inherent in all businesses and projects. It is virtually impossible
to make everything perfect and deliver a perfect product or service. Guy
Kawasaki in Reality Check is very aggressive in his view of launching a new
product or service.6 He states “Don’t worry, be crappy” and thinks that it
is acceptable to ship a version of a product with elements of crappiness.
He believes that the crappiness can be subsequently fixed in version 2.1

Table 13.2. Watch Outs During Project Management

Management did not spend enough time and resources on the project and/or business.
The employees that were to use a system were not sufficiently involved in the
development.
Insufficient resources were allocated to the project. This includes money, technology,
time, and staff and others.
The function or process was not developed to match the tasks that were to be
accomplished.
The system interfaces were poorly designed.
Not enough time to complete the project and too many competing commitments.
Too many changes were made to the original specifications of the project.
An emerging and immature technology was not ready for prime time.
There was no demand for the business or the project.
There was little if any project management.
286 DEVELOPING NEW PRODUCTS AND SERVICES

Table 13.3. Kawasaki Insights

“Innovation had better create wealth because it is so damn hard to do.”
Build something that you want to use. Don’t look towards the “visionary entrepreneurs”
(that is a “crock of bull shitake”). People start companies because they want to use the
products or services they create.
Make meaning. Great innovations enable people to do something better or permit people
to do things they never wanted to do. For example, the iPad, iPod, iPhone, the Frisbee,
and auto global positioning system.
Jump to the next curve. Most companies spend all of their time duking it out on the same
demand curve. True innovation occurs when companies jump to the next demand
curve. We do not need icehouses and landline phones anymore.
Don’t worry be crappy. It is ok to ship an innovation with elements of crappiness. First
versions are seldom perfect and you will never ship if you wait till it is perfect.
Churn, baby churn. It is all right to ship with elements of crappiness, but you should not
stay crappy. You need versions 1.5, 1.9, 2.0, and so forth. Employees do not want to hear
about product complaints during launch. They just want to ship. “Innovation is not an
event it is a process.”
Don’t be afraid to polarize people. Deliver great products and do not worry if your product
does not appeal to every demographic, socioeconomic, and geographic location. You
want to incite passion in the marketplace.
Break down barriers. It takes a long time to gain acceptance in the marketplace. Do not
become flustered when acceptance is slow. You need to keep on chugging and get people
to test drive your innovation.
Let a hundred flowers blossom. Be flexible in how people use your products. People used
Apple for desktop publishing rather than use it for the spreadsheet, word-processing,
and so forth. Recall that Avon Skin-So-Soft was also used as a bug repellent.
Think digital act analog. Use all of the technology to deliver innovation, but remember it
is the happy people and not the coolness of the technology that is important.
Never ask people to do what you wouldn’t want to do. If the product solves a great problem
and it is hard to use, then it will not stick.
Don’t let the bozos grind you down. Do not let influential people outside of the company
influence you. Stick to your knitting.

of the product. Kawasaki has a number of very insightful views on the

innovation process as illustrated in Table 13.3.

Launch Date
There comes a time when a decision has to be made when to launch the
business or project. Problems inevitably arise as the launch date approaches
and the question whether to continue with the launch date or delay it
looms its ugly head. Delaying a launch after the date has been announced
 PROJECT MANAGEMENT FOR NEW PRODUCTS 287

• Will our company and the entire supply chain

process be able to successfully complete most
tasks, such as fulfillment, at launch given
expected demand?
Yes
• Will our company and the entire supply chain launch
process be able to successfully complete most
tasks at launch even with above average
demand?

• Will product design defects at launch

adversely affect our customers and our
reputation?

• Did we have a successful dry run and

adequate testing before launch.

• Do most of our employees have confidence in No

the products and the processes that are being launch
launched?

• Is there a backup plan and are there

processes available if problems occur at
launch.

• Will competitors launch and gain critical

market share and gain first mover advantages
if we do not launch?

Figure 13.7. To launch or not to launch: these are the questions.

can adversely impact the employees of a start-up and create a negative

view of the business by consumers and the media. We have developed
a very simple set of questions that can be used to ascertain if the launch
should go as scheduled.7 The questions are outlined in Figure 13.7.
There is no simple answer regarding the decision to launch, even in
the face of numerous deficiencies and potential problems. Sometimes it
only takes a negative answer to only one question and the launch should
be delayed. If a new online banking service is being launched, then any
hint of problems should preclude launching. In some instances, there can
be numerous problems with a product and downloading software patches
can alleviate them. Online gaming developers are notorious for launch-
ing software with numerous bugs. It is a very contextual decision and
dependent on the product features and what the product will be used for.

Growing Up and Professional Management

Growing pains are an inevitable part of life for the start-up and they
begin to emerge soon after launch (see Figure 13.1). They are impossible
to avoid because the world is not stagnant. The entrepreneur may not
288 DEVELOPING NEW PRODUCTS AND SERVICES

be looking for stability and consistency in the face of market dynamics

and change, but the organization and the employees are looking for sta-
bility and consistency. Organizations and organizational members seek
control in the form of standardized, coordinated business processes and
systems; they want well-defined, enriched, and specialized jobs; and they
also want salaries and benefits with the potential to grow. Small compa-
nies with astute founders can manage and perhaps even perform these
tasks admirably. As the business grows, there may be a need to hire pro-
fessional managers with the knowledge and skills to implement better
practices.
Growing up does not mean that the founder should be ostracized
or relegated to honorary duties. This may in fact put the organization at
risk. The founder may have a certain entrepreneurial mojo that cannot be
replaced. Steve Jobs had an almost magical power to guide Apple in the
right direction and the company. The company certainly performed bet-
ter under his leadership than when he was away. Identifying professional
managers is itself a project, requiring project management. Deciding on
how to manage and guide the growth of the business is a key decision for
survival.
Growing up also means that there are more groups that are trying to
protect their own turf with somewhat unique objectives. This includes
operations, managerial accounting, marketing, human resources, and
product design groups. The six hats approach discussed in a previous
chapter can help to reconcile conflicts during meetings, but a new organi-
zational process for product development may be necessary in order to
reconcile the inevitable differences that will occur when the functional
silos begin to emerge. Concurrent engineering may be a solution for
organizations as they become larger and more complex.
Concurrent engineering is the simultaneous design and development
of a product and the manufacturing process for building a product.8 An
important part of concurrent engineering is the use of multifunctional
teams. Concurrent engineering design teams are typically very com-
prehensive. They could include customers, suppliers, workers, dealers,
regulators, design and manufacturing engineers, purchasing, materials
managers, marketing managers, customer support, and financial and
accounting representatives, among others. The objective of assembling
 PROJECT MANAGEMENT FOR NEW PRODUCTS 289

such teams is to instill the diversity of opinion into the design and manu-
facturing process. Using such teams also forges trust among the parties
and can also help to develop organizational knowledge that can be used
to reduce development times for new products.

Conclusion
In this chapter, we have illustrated that the business cycle for a new ven-
ture involves several development points, mostly under control of the
entrepreneur. The key takeaways include the following:

• Project management is the primary tool for executing

the business plan, installing the businesses processes, and
achieving the strategic ambitions of the entrepreneur.
• Project management helps to detail what tasks will be
accomplished, who will be involved in completing the tasks,
and when tasks should start and finish.
• Typically, projects progress in steps or incremental stages;
however, other approaches for rapid, interactive project
management are also widely used.
• Several tools can be used to manage the project and
communicate timing and status, including task diaries,
WBSs, and Gantt charts.
• Projects fail for many reasons. It is management’s
responsibility to determine whether the inherent risks
in the project can be accepted and the project can be
launched, or whether the project be delayed.

Project management is not a panacea, but rather a critical tool in the

never-ending process of growth and renewal of the business. It allows
the entrepreneur to minimize and mitigate inherent risks and increase
the potential for success of the launch and the ongoing operations.
 EXHIBIT 1

Project Management
Individual Diary (This is
Used by an Individual to
Track How Much Time is
Spent on Project Activities)
Group Number Project Individual(s) Review Date
and Group Description Preparing
Name
Legal Team Project Norma 4/1/11
Firestorm Gleeson

What’s going well?

What’s not going
well?
Additional resources
(people, technology)
required?
Are users and
Task or Hours management
subtask Date worked participating?
Needs assessment 2/12/11 8 Cross-functional team,
conducted including management.
Need documented and
agreed upon.
Name search 2/14/11 4 No issues.
conducted, name
approved
Real estate search 2/19/11 40 Various properties researched
conducted and visited.

(Continued)
 PROJECT MANAGEMENT FOR NEW PRODUCTS 291

What’s going well?

What’s not going
well?
Additional resources
(people, technology)
required?
Are users and
Task or Hours management
subtask Date worked participating?
Rental contract 2/21/11 4 Ahead of plan.
signed
Incorporation 2/21/11 40 No issues.
paperwork com-
pleted and filed
Incorporation 3/3/11 16 On target with plan.
status completed.
Investors con- 3/31/11 36 In process.
tacted for funding
opportunities
 EXHIBIT 2

Project Management
Summary Diary (This Diary
is an Aggregation of the
Individual Project Diaries)
Group Number and Group Project Description Individual(s) Preparing Preparation Date Review Date
Name
PMO Project Firestorm James Xu 2/11/11 4/1/11

What’s going well?

What’s not going well?
Additional resources (people,
technology) required?
Hours Hours Percent Are users and management
Task or subtask Assigned to Due Date scheduled accumulated completed participating?
Requirements gathered James Xu 2/16/11 40 32 100
Team development and James Xu 2/16/11 8 8 100
project planning
Legal plans Norma Gleeson 3/3/11 240 240 100
R&D plans Garry Hall 3/10/11 480 540 100 Over budget due to expanded scope.
Accounting plans Michel Bulan 3/24/11 240 240 100 On budget and on plan.
HR plans Davis Wilson 3/31/11 440 420 100 Completed on budget and ahead of plan.
Funding and investments Norma Gleeson 5/5/11 480 240 50
Employee recruitment Davis Wilson 6/23/11 480 0 0
Employee contracts Davis Wilson 7/7/11 80 0 0
PROJECT MANAGEMENT FOR NEW PRODUCTS

Development Garry Hall 11/10/11 960 0 0

IP (patents) Norma Gleeson 11/10/11 730 0 0
293
 CHAPTER 14

Re-priming the Business

Using Real Options
Concepts
It does not matter how innovative or how much money the current
business is making. There is a life cycle for products and technologies,
and eventually, the business will decline unless it can find new opportu-
nities. The business needs to be constantly re-primed with new products
and services or it will fade and dissolve (see Figure 14.1). Critical in
re-priming a business is scalability of the business. Scalability means
that the business can shrink or grow very quickly with minor changes
in the cost structure. Ideally, the ability to grow will not require a large
change in variable costs, perhaps even decreasing variable costs and little
increase in fixed costs. In addition, a scalable business should be able to
handle a large influx of new customers and still be able to handle them
without having to drastically change business processes. However, scal-
ability cannot be achieved without investing money and time in step-
ping stones for future business that provide the business with options.
For this reason, real options concepts can be used as the catalyst for
differentiation and to re-prime the business pump. This chapter will
focus on how real options concepts can be used as the foundation for
continually reinventing the business.

Investment Decisions
Making the right investment decision on the right projects and the
right products at the right time is a combination of having the right
information, intuition, and luck. As Figure 14.1 illustrates if there is a
 296

Process for
differentiation and
Business new product
growth development may
alleviate decline.

Business re-conceptualized. May need turn-

around management support.

Need professional management as business grows to

institute more controls and structure.

Launch
DEVELOPING NEW PRODUCTS AND SERVICES

Need project management for additional product

development and to develop initial business processes.

Business conceptualized and planning is started.

Time
Figure 14.1. Critical organizational activities during business life cycle.
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 297

High risk & high rewards

Blue oc
ean
Add new
product li
ne
Add Midas
or Hermes
products

Add compl
imentary
products

Maintain
existing
products

Abandon

Low risk & low rewards

Figure 14.2. Risk is inherent as you get closer to the top.

process in place for differentiation and new product development, then

the decline of the business may be alleviated. There are choices and deci-
sions to be made related to populating the product and project portfo-
lio. These are the critical investment decisions that the entrepreneur has
to make. Figure 14.2 illustrates that the potential profitability is greater
as you climb up the inverted pyramid, but there are also greater levels
of risk and uncertainty toward the top. All businesses face the following
investment decisions while climbing the reward pyramid:

Maintenance decision: They can maintain their current investment in prod-

ucts, projects, machines, and technologies. This also takes into account
investment to deal with depreciation. This is the maintain option. The
goal of the maintain strategy is to keep current customers with existing
products and services. Learning-about and learn-by-doing are maintained
at current levels.
Growth decision: They have the option to invest a little or a lot in new
products, projects, machines, and technologies. There is a step-up in
298 DEVELOPING NEW PRODUCTS AND SERVICES

learning-about and learning-by-doing. This is the growth option and it

includes a number of approaches:

• Differentiate by scaling-up existing product line. Scaling

up your investment and investing even more. For example,
adding features for Midas customers and acquiring new
Hermes customers on the existing demand curve.
• Differentiate by scoping-up and developing complementary
products for existing product line.
• Differentiate by scoping-up and developing new products that
are not part of the existing demand curve.
• Differentiate by switching-up the growth path. A switching-up
decision incorporates both growth and abandonment options.
When a company makes a switch-up decision, it may discard
previous investments and take a different path for growth
based on the capabilities accumulated from the previous
investments. It typically concerns a switch of input, output,
or location. For example, instead of using technology A, a
firm may use technology B to produce the same thing. Instead
of using the current machine to produce product X, a firm
may produce product Y (cf. flexible manufacturing system).
A company can switch among locations for research and
development, manufacturing, distribution, and so forth.
• Develop new Blue Ocean market. This involves scaling-
up, scoping-up, and switching-up. This can be a substitute
product that competes with an existing line.

Abandon decision: They have the option to abandon investing in new or

existing products, projects, machines, and technologies. The abandon
strategy relates to the inadequacy of the current business model and the
need to bail.
Postpone decision: They can defer investing in a product or a technology
until a later date. Some investment might occur in the form of moni-
toring and very early exploratory work. The major investment includes
learning-about in the form of search and synthesis.
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 299

There are three primary approaches for evaluating investment deci-

sions. They are payback, discounted cash flow analysis, and real options
analysis. We discussed the discounted cash flow techniques in the last
chapter. The focus of this chapter is on real options analysis.

Real Options
Amazon was incorporated in July of 1994.1 Amazon reported its first-ever
profits of $5 million (a penny a share at a $12.60 closing price) in the
fourth quarter 2001 over 7 years after selling its first book.2 I doubt that
most investors using net present value (NPV) and internal rate of return
(IRR) analysis would have been willing to wait so long to receive such a
modest return. Profits in the fourth quarter of 2009 were $384 million
(85 cents a share).3 As Jeff Bezos noted in his articulation of Amazon’s
strategy:

We start with the customer and we work backward. We learn

whatever skills we need to service the customer. We build what-
ever technology we need to service the customer. The second thing
is, we are inventors, so you won’t see us focusing on “me too”
areas. We like to go down unexplored alleys and see what’s at the
end. Sometimes they’re dead ends. Sometimes they open up into
broad avenues and we find something really exciting. And then
the third thing is, we’re willing to be long-term-oriented, which
I think is one of the rarest characteristics.4

NPV, IRR, and payback approaches may not be suitable for pursu-
ing projects that will provide a competitive edge. The benefits of new
technologies sometimes result in very strange NPV calculations that
are either very high or very low. They are difficult to apply in situa-
tions involving emerging technologies where some level of investment is
required in order to examine their long-run potential. There are inher-
ent difficulties in data collection, decision analysis, and risk assessment
when new and emerging technologies are involved. To put it bluntly, it is
very difficult to apply discounted cash flow techniques for analyzing Blue
Ocean markets. Real options can play an important role in developing a
300 DEVELOPING NEW PRODUCTS AND SERVICES

diversified product and technology portfolio for competing in dynamic

environments.

The Role of Real Options in Investment Decisions

A real option is a decision or choice to invest a little or a lot in a product,
a technology, or a project. They are called real options because they are
investments in tangible assets, products, processes, and services rather
than financial instruments such as stocks. For financial investments,
option-pricing techniques are heavily used to take into account the
flexibility issue. The most popular is the Black–Scholes option-pricing
model where the option value is determined by five input values of the
exercise price of an option, the time to exercise date, the current price of
the asset, the variance per period of rate of return on asset, and the risk-
free rate of interest. If you plug all these values into the Black–Scholes
option-pricing model, you would get a positive value (do not forget all
options have a positive value). This is the option value. This value would
be added to the NPV analysis. So, what is initially a negative NPV would
become a positive NPV once the project’s option value is incorporated.
This calculation looks very simple. However, investments in technology
differ from those in financial assets in terms of priceability and tradabil-
ity of the underlying asset. Contrary to financial investments, in tech-
nology investment situations, the price of an underlying asset is hard to
know, and the underlying asset cannot be traded easily.
The purpose of a real option is to explore the potential of a product or
new technology. Car manufacturers are constantly making small invest-
ments (from their perspective) in emerging technologies. They purchase
real options in fuel technologies, engine technologies, drive-by-wire tech-
nologies, steering and braking technologies, advanced construction mate-
rials, and design. Sometimes they invest a little money and just search
for information and try to understand whether a technology is applica-
ble and cost-effective. Sometimes they invest a lot of money and develop
full-blown prototypes using a variety of technologies and showcase the
technologies in the so-called concept cars. Sometimes they decide to go
whole-hog and develop a fresh line with modern features and technologies.
Sometimes they just abandon a product or a technology completely.
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 301

Amazon did not just settle into the production of the Kindle e-book.
They explored various technologies such as the screen technologies, the
book delivery mechanism, and the file format for storing the books as well
as if consumers would be interested in reading e-books.
The following example illustrates how a real options analysis can be
conducted.

Jin Beans Tonic Elixirs

Jin Beans Tonic Elixirs produces exotic health drinks containing a

combination of vitamins, herbs, fruit extracts, and supplements.5 The
competition is fearless and they compete with a number of highly com-
petitive vitamin water, energy drink, and sports drink and boutique
water industry. They are known for delivering healthy drinks in unique
high-quality safe plastic biodegradable containers. The super high qual-
ity of their ingredients, the design of their bottles, as well as the design
of their labels set them apart from the competition.
Most of their bottles are being produced overseas and because they
change the design of the bottles every 2 months, the cost of design,
development, and delivery is very high. They are exploring the idea
of manufacturing the bottles at each of their five bottling centers in
the USA. This will require the purchasing of injection blow molding
equipment (see Figures 14.3, for an overview of the blow molding
process).

Jin Beans Real Option Decision

The president of Jin Bean’s assembled a group of financial analysts; the

marketing department and the operations department conducted a study
to ascertain the cost of switching bottle production in-house. They deter-
mined that it would cost the company an additional $1 million per year
to purchase the machines, hire staff, and maintain the machines over
what they are currently paying to import their bottles. Each machine
costs $250,000 and will involve personnel costs and maintenance costs
exceeding $100,000. No matter how they put the numbers together,
they could not generate a positive NPV. Even though the figures did not
302 DEVELOPING NEW PRODUCTS AND SERVICES

A B C
1 2 3 4 5 6 7 8

Steps in the creation of plastic blow-molded product.

1. Plastic is fed from the extruder.
2. The plastic (yellow) is melted and passed through the extruder pipe.
3. The extruder head (green) separates the plastic into two pipes (see 5).
4. The air tube (silver/black) is used to blow air into the mold.
5. This is the tubular shape of the hot plastic.
6. This is the mold.
7. Air pressure expands the plastic in the mold.
8. The end product.

Figure 14.3. Blow injection molding diagram. Developed by Laurens

van Lieshout, available under Creative Commons Attribution share
license.6

look good, the presidents of Jin Bean decided to go ahead and purchase
one machine and install it in Florida. The decision of Jin Bean’s president
was based on her knowledge of real options analysis. By purchasing and
using one machine, they were able to learn and conduct an economic
experiment. The company could obtain insight and also acquire the flex-
ibility to expand in the future as the effect of the investment on the
bottom-line gets clearer and knowledge about the use of the machine is
accumulated.
The result of this experiment and installation was enlightening. Jin
Bean was able to generate more sales with the new injection molding
machine and they were also able to provide external consulting to other
businesses and to sell specialized plastic containers at a premium price.
Jin Bean also used the injection machine to experiment with new bottle
designs and product ingredients. In the past, it would take them a year to
introduce a new bottle to the market and several months to understand
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 303

the sales results. Now they were able to deliver a new product in less than
a year. They were able to increase their market share and became very
responsive to market demands because of their increased flexibility. The
data they were able to gather by experimenting with one machine was
then used to conduct an NPV and IRR analysis and resulted in a very
attractive return for their investment (see Figure 14.4). Jin Bean subse-
quently decided to obtain four additional machines because they have the
confidence to further pursue a growth option and invest in more injection
molding machines.

Projected cash flows before investing

Cash receipts Year 0 Year 1 Year 2 Year 3 Year 4
Additional cash sales $150,000 $ 165,000 $181,500 $199,650
Total cash in $150,000 $ 165,000 $181,500 $199,650

Cash out
Payroll expenses $ 60,000 $ 66,000 $ 72,600 $ 79,860
Maintenance $ 15,000 $ 16,500 $ 18,150 $ 19,965
Training $ 15,000 $ 16,500 $ 18,150 $ 19,965
Mechine cost $ 250,000
Startup costs $ 15,000
Total cash out $265,000 $90,000 $99,000 $108,900 $119,790

Net cash flow (in - out) $ (265,000) $ 60,000 $ 66,000 $ 72,600 $ 79,860

Discount rate 12.00%

NPV $ (50,345)
IRR 2%

Projected cash flows after investing

Cash receipts Year 0 Year 1 Year 2 Year 3 Year 4
Additional cash sales $ 260,000 $ 299,000 $ 343,850 $ 395,428
Consulting revenues $ 100,000 $ 115,000 $ 132,250 $ 152,088
Total cash in $ 260,000 $ 299,000 $343,850 $395,428

Cash out
Payroll expenses $104,000 $ 119,600 $137,540 $158,171
Maintenance $ 26,000 $ 29,900 $ 34,385 $ 39,543
Training $ 26,000 $ 29,900 $ 34,385 $ 39,543
Machine cost $ 250,000
Startup costs $ 15,000
Total cash out $265,000 $156,000 $179,400 $206,310 $237,257

Net cash flow (in - out) $ (265,000) $104,000 $ 119,600 $137,540 $158,171

Discount rate 12.00%

NPV $ 108,590
IRR 31%

Figure 14.4. Financial analysis before and after installing one

machine.
304 DEVELOPING NEW PRODUCTS AND SERVICES

Many real-world investment decisions are not easily analyzed with

NPV and IRR analysis. Investing in a new technology can take the firm
down many different paths as the organization learns about and learns by
doing and experimenting with new technology and products. If you look
at most of the Blue Ocean markets, for example, Cirque du Soleil, social
networking services, and global positioning system products, they come
about as a result of experimentation and the progression of little ahas that
turn into the big aha. It is basically a learning and adaptation strategy that
is focused on product and process differentiation.

Business conditions are fraught with uncertainty and risks.

These uncertainties hold with them valuable information. When
uncertainty becomes resolved through the passage of time,
actions and events, managers can make the appropriate mid-
course corrections through a change in business decisions and
strategies. Real options incorporates this learning model, it is
akin to having a strategic road map, while traditional analyses
that neglect managerial flexibility will grossly undervalue certain
projects and strategies.7

Real options analysis can be very technical, requiring a significant

amount of financial and technical scrutiny. However, we believe that using
complicated calculations is overkill for small- and medium-sized busi-
nesses. Real options concepts are nevertheless important. The takeaway
from the perspective of the entrepreneur is that you need to experiment
and also need to diversify your portfolio of products and projects under
consideration. This does not mean that you have to actually buy machin-
ery, make products, and constantly modify your business processes, but it
does mean that you should learn-about many products and technologies
related to your business and learn-by-doing and experimenting when an
opportunity looks promising.
There are two important considerations related to real options that
companies should consider before making large investment decisions.
The first important consideration is how will the investment interact with
current investments, and the second important consideration is how will
the competition respond to an investment decision.8
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 305

The influence of Interaction Effects

on Investment Decisions
New investments can interact positively or negatively with existing assets
of the firm. For example, when Amazon started offering electronic books
(Kindle) and electronic audio (Audible), there was an obvious and natural
synergy with existing content and their core competencies. These invest-
ments improved Amazon’s firm performance because they complemented
existing company assets. When Amazon began adding tools and a variety
of other home improvement products and then started selling groceries
in certain markets and branched out into cloud computing, there were
concerns related to synergy. Part of the answer relates to Amazon’s core
competencies. Amazon is good at online retailing and it is very good
at maintaining a very scalable and robust server and processing infra-
structure. They had core competencies that were transferable to those
businesses.
There are numerous examples where an investment lacked synergy
with existing assets. Many believed that eBay’s acquisition of Skype was
ill conceived because there did not appear to be any positive synergies
between the businesses.9 The businesses did not appear to mesh and the
executives at both eBay and Skype were constantly fighting. eBay eventu-
ally sold Skype at what was considered a very modest amount. In some
ways, eBay’s competitive advantage was undermined because of the rela-
tionship. The interaction effects between eBay’s assets and Skype’s assets
were negative.

The Influence of Competitor’s Response

on Investment Decisions
A new investment may force competitors to think about their existing
investments and engage in counterinvestments to compete with a new
investment. These competitor reactions or counterinvestments made by
competitors can affect the revenue base and cost structure of a firm in the
long term. This is part of the reason that first-mover advantages are tran-
sient. If a move appears to be threatening, then competitors may invest
substantially more in the technology or product in order to catch up and
306 DEVELOPING NEW PRODUCTS AND SERVICES

perhaps even surpass the first mover’s investment. The net effect is that the
new entrant can dilute earnings and performance. An investment that is
projected to produce profits can prompt the competition to overreact and
invest at even higher than expected. These types of responses are common
in the consumer electronics marketplace and, in general, are found in
many types of markets.
When Amazon entered the cloud-computing market in 2006 with
the introduction of Amazon Web Services, there was a definite reaction
by many companies, some of them were competitors and others were
just interested. Data storage vendors, CPU and hardware manufactur-
ers, infrastructure companies, operating systems companies, service pro-
viders, consulting companies, ERP vendors, and all sort of applications
software developers took note. Many of these companies responded by
investing more and more money in cloud computing. Amazon’s con-
tinued pursuit of the growth option in cloud computing was in turn
answered with many other companies pursuing a growth option in cloud
computing. Dell, for example, invested more than a billion dollars in
cloud computing.

The Strategic Actions Model: Combining Interaction

Effects and Competitor Response
Figure 14.5 illustrates how these two dimensions can be combined to
provide guidance into the investment decision process. The implication
is that when there are positive interactions with existing capabilities,
then growth options should be pursued. If competitor reactions are low,
then an aggressive growth option should be pursued. When competitor
reactions are high, then a switching-up option should be pursued. The
point is if there are strong competitor reactions, a company may want to
change its future investment for growth, even if the interaction effects
are high.
Risk enters in the framework when the synergies between existing
competencies are low and competitors are not responding. The impli-
cation is that the technology may not be important and there is little
reason to pursue it if the market is not responding accordingly. The other
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 307

High
Moderate to aggressive
Aggressive growth growth and investment
and investment Monitor and learn more
about investment.
Major increase in
learning-by-doing. Moderate to major increase
in R&D and learning-by-
Merge or acquire. doing.
Consider merger or
Interaction effects

acquisition.

Postponement Consider
abandonment
Learn more about
investment.
No more investment.
Consider licensing. Sell technology.

Same level of
investment.

Low Competitor reactions High

Figure 14.5. Strategic action framework (modified from Kim and

Sanders).

tricky quadrant occurs in the instance where there is a competency and

interaction effects and competitors are not signaling that it is important.
In that instance, the product or technology may need to be monitored
closely.

The Project Selection Model: Considering

Risk and Reward
After a company decides a strategic action to pursue based on the stra-
tegic action model, it needs to decide how it will proceed with the
action, that is, what kind of project it will launch to implement the
action, how much of risk it can bare, and how much of reward it wants
308 DEVELOPING NEW PRODUCTS AND SERVICES

to gain. Most companies want to minimize risk and maximize reward

in launching a project. O’Sullivan and Dooley10 have categorized
projects in terms of their risk and reward as being pearls, oysters, bread
and butter projects, and white elephants (see Figure 14.6). It would be
nice if all investments translated into pearls and a few ended up being
successful oysters, but that is not possible. Therefore, when selecting a
project, companies take into account the strategic action they will pur-
sue. For example, if the strategic action chosen is aggressive growth, it
may want to develop a project falling into the category of pearls. If the
strategic action chosen is switching-up growth, it may want to develop
a project falling into the category of oysters. On the other hand, if the
strategic action selected is postponement, it may want to play with a
bread and butter project, a small, simple, low-risk project, and wait for
additional information.

High
Oysters
Risky projects but
White elephants with high potential.
Can be
Low reward and high
transformational
risk.
Blue Ocean projects.
Risk

Bread and
butter Pearls
Small, simple, and Low risk and high
low risk projects
involving continuous reward.
improvement.
Growth oriented.
Often maintenance
oriented.

Low Rewards High

Figure 14.6. Project categorization (modified from O’Sullivan and

Dooley).
 RE-PRIMING THE BUSINESS USING REAL OPTIONS CONCEPTS 309

Conclusion
In this chapter, we have discussed real option concepts and strategic
action framework. The key points are the following:

• It is often difficult, if not impossible, to use the financial

techniques including discounted cash flow, NPV, and
economic value added to justify an investment in certain
projects, “exploratory” or “experimenting” or learning
projects in particular. The “Jin Beans Tonic Elixirs” case nicely
illustrates this very point.
• Firms should keep options open under the conditions of
uncertainty and irreversibility and develop a portfolio of
investment opportunities. Firms can defer “commitment”
under uncertainty and irreversibility. This way of thinking can
make a big difference for firms’ strategy, including portfo-
lio decisions, mergers and acquisition decisions, governance
choice, technology adoption decisions, and so forth.
• To develop a portfolio of investment opportunities, firms
need to keep monitoring risk, assessing market trends, and
trying new things on a small basis of experimentation.

Investment decisions are never easy. Cash flows, whether they are
positive or negative, are fraught with uncertainty. Selecting the appro-
priate discount rate is never easy, but it has a dramatic influence on the
go/no-go decision. Technical analysis using discounted cash flow tech-
niques does not alleviate the uncertainty and does not permit hunches
and intuition. One student noted that his presentation in another class
was marked down because he had a hunch that a company should invest
in a project, even though the NPV analysis was unfavorable. After dis-
cussing the issue for a short time, I let him in on the great secret that
was revealed to me by one of my mentors after I had spent days try-
ing to justify a modest expenditure using return on investment calcula-
tions. He told me to tinker with the numbers until they fit the desired
outcome. Investment in emerging technologies and a new product line
rarely result in positive NPVs unless the data have been cooked. Real
310 DEVELOPING NEW PRODUCTS AND SERVICES

options when combined with the development of a product and project

portfolio can bring truth, beauty, and enlightenment into the invest-
ment process.
Real options concepts can be applied in a variety of ways. Smaller
organizations can focus on learning-about by investing in education,
reading high-tech magazines and trade publications, attending trade
shows, and attending research conferences. Larger organizations can use
real options as the basis for learning-about as well as investing in basic
research and using learning-by doing strategies to develop prototypes.
The important point is to keep ones options open and to develop a port-
folio of investment opportunities. Important activities included in the
development of the portfolio include monitoring risk and frequent moni-
toring and assessment of the product and project portfolio by a cross-
functional team of key personnel who understand and are aligned with
the business mission.
 CHAPTER 15

Wrap-Up
Carol Roth1 is convinced that most people are not right for entrepreneurship.
Some people try to become entrepreneurs because they want to be the boss;
but they end up working for more people. They end up working for inves-
tors, lenders, landlords, customers, suppliers, and even their employees.
Some people think that if they start a business involving their favorite hobby,
they will have more time to spend working on the hobby that they love. The
reality is that they end up spending less time on the hobby and more time
running the business. Baking cakes is different than running a bakery.
The business of the entrepreneur is primarily about designing and
maintaining business systems.2 As illustrated in the project management
chapter, there are at least 30 main activities and systems that have to be
attended before launch date and very few involve cake baking and deco-
rating. After one of my students filled out the Ten–Ten business template,
she told me that her life-long desire to own a florist shop was gone. The
two templates can be filled out very quickly, but they also highlight the
numerous details that eventually need to be dealt with before launching
the business. Filling out the simple templates and preparing an executive
summary is a good check on reality.
Roth’s other contention is that most of the great ideas for businesses
are already taken. And she argues that the value of a business is not in the
idea, but in the execution. We agree, in part. The best execution of an out-
dated idea can surely lead to failure. Where are the old icons of the music
industry, how about telegraphy, where are desktop PCs headed, and what
about those old persimmon woods? The key for survival is product differ-
entiation coupled with improving execution and driving down costs. The
key is the dynamic tension created from developing Midas and Hermes
versions of products and services.
312 DEVELOPING NEW PRODUCTS AND SERVICES

Ideas for products do not seem to be diminishing, but rather increas-

ing. Compared with the approximately 49,000 patents granted in 1963,
there were over 244,000 patents granted in 2010.3 Knowledge develop-
ment and the ensuing products and services are the result of the cumu-
lative progression of ideas over years, decades, and even centuries.4 The
foundational knowledge for a simple digital voice recorder are the results
of discovering the properties of metals, research in physics on ferromag-
netic theory, and the development of electronics components such as
vacuum tubes in the late 18th century and earlier. The world of today is
truly built on the shoulders of ancient ideas.
I am constantly amazed at the diversity of products and services
students developed for term project in my class. They include a robotic
surgical simulator, a 100-amp cable dispenser, an online animated user
manual development system, an organic chemistry tutorial system, a
penny auctioning site where anyone could offer a penny auction, various
smartphone apps, numerous shopping assistance applications, a franchise
system for asphalt sealing, generic mentoring software, home, pet and
child monitoring systems, home improvement and emergency repair ser-
vices, a variety of health monitoring and health-related products, adult
pajamas with footies, an atomic scale measuring device, different types
of cloud-computing systems, and many others. Because of my ongoing
interest in global positioning system technology, there have been several
products related to bus scheduling, tracking assets, and social network-
ing. I am still amused by the Smell-Me-Up-Clock that produces smells,
such as coffee brewing, to wake a person up. I am also bemused by the
Rent-a-Friend. It was funny and provided a poignant commentary on
contemporary society.
Several projects have been or in the process of being patented,
including a technology that isolates atoms and molecules and then
measures the effect of electrical and mechanical stimulus on atoms and
molecules. Then there was the hockey puck that had radio-frequency
identification (RFID) chips embedded in the puck that could be used
to determine when a gala was scored. The prototype for the puck was
developed using 3D printing technology. Another interesting product
was the improved lightning arrestor device used by utility companies
that would last longer and perform better.
 WRAP-UP 313

The point is that there are many new opportunities for new busi-
nesses, but there are also many good ideas for improving existing compa-
nies. Many of the projects developed in the class are related to improving
existing businesses and improving existing versions of products and ser-
vices. Monopolistic competition is relentless. If a business does not make
little and sometimes big tweaks to products and services, it will become a
business footnote. The ideas and concepts presented in this book will not
guarantee success, but they can be used to confront and sometimes even
ignore the competition. Ignoring the competition is achieved by focus-
ing on the development of new opportunities rather than meeting the
checklists of product features touted by the competition. A definition of
entrepreneurship was presented in the beginning of the book:

Entrepreneurship is a risky endeavor involving the continuous

creation and re-creation of a new enterprise, a new product, or a
new idea.

The traditional concept of the entrepreneur is that the entrepreneur

starting the business absorbs most of the risk. In today’s climate, how-
ever, businesses need to be entrepreneurial. Businesses must absorb and
deal with the risk of product development and enhancement. In today’s
climate, the individual has to be entrepreneurial in terms of their career
path. Knowledge and skills have transitory value that can be in demand
today and out next year. Differentiation of the individual can only be
achieved by continuous leaning-about and learning-by-doing.
As noted in the beginning of the book, entrepreneurship is currently
being viewed as a set of skills that are part of a rational and logical process
for identifying and creating opportunities. The skills have been likened to
learning how to read, write, calculate, and conduct scientific reasoning.
Entrepreneurship requires insight and knowledge of problem solving,
strategic planning, new product development, project management, and
portfolio management among others. Participation in entrepreneurial
activity leads to the creation of opportunities for individuals, businesses,
and countries.
Entrepreneurs are made though life experiences and a willingness to
work hard and become totally immersed in a goal. Being an entrepreneur
314 DEVELOPING NEW PRODUCTS AND SERVICES

is the goal of the entrepreneur. The research on the personal and demo-
graphic factors contributing to the entrepreneurial activity supports the
idea that the entrepreneur cannot be identified by any single demo-
graphic characteristic. There are demographic tendencies, but in reality
entrepreneurs can be young or old, male or female, and from wealthy or
disadvantaged backgrounds. The key is participation and self-motivation
and, most importantly, continuous learning and adaptation. It is hoped
that this book will put you on the right path to becoming an entrepreneur
on your own or as an intrapreneur in an existing organization.
 Notes
Preface
1. We do not believe that technology and new product development should be
pursued with abandon and without analysis. We do believe that bandwagon
effects can occur and that unbridled enthusiasm can lead to faulty business
models and major mistakes. A sound planning process can alleviate many of
these issues.
2. Cohen and Levinthal (1990), p. 128.
3. Grove (2010).
4. Pisano and Shih (2009).
5. Pisano and Shih (2009).
6. Sims (2011).

Chapter 1
1. By the way, I detest pop quizzes. They may work to force people to read the
material, but they make learning miserable.
2. Brakman and Heijdra (2004).
3. An oligopoly is a special case of a monopoly. There are a small number of
firms (e.g., 2–8) and they control more than 50% of the market. An oli-
gopolistic market is characterized by low levels of product differentiation
and very high fixed costs of entry, where competition is often based on price
with elements of both price taking and price leadership. Sample sectors
include steel, copper, autos, breakfast cereals, tires, some appliances, and
home-care equipment. See McConnell, Brue, and Campbell (2004).
4. Kirzner (1973).
5. Sarasvathy and Venkataraman (2008).
6. Arora et al. (2008).
7. Miller (2010, November 28).
8. Kawasaki (2008).
9. Patent Technology Monitoring Team (n.d.).
10. Moore (n.d.).
11. Spence (1981).
12. Gartner (n.d.).
13. Moore (1999).
316 NOTES

14. VC MIKE (2010).

15. Liebowitz and Margolis (1994).
16. Liebowitz and Margolis (1994).
17. Matheson and Matheson (1998).
18. Annacchino (2006).
19. Schmoch (2007).
20. Goldenberg and Mazursky (2002).
21. Madsen (2007).
22. Laursen and Salter (2006).
23. Laursen and Salter (2006).
24. Laursen and Salter (2006).
25. Laursen and Salter (2006).
26. Cohen and Levinthal (1990).
27. Schank and Cleary (1995), p. 74.
28. Cohen and Levinthal (1990).
29. In general, the terms value chain and supply chain can be used interchange-
ably, although the value chain is rooted in the strategic planning literature
whereas the supply chain is linked to the work in the operations manage-
ment area.

Chapter 2
1. Shapiro and Varian (1998); Varian (1996).
2. Lipsey and Chrystal (2007).
3. One of my colleagues says that 2 is the perfect number because many con-
sumers will delay purchase when there are more than two choices because
of the excess demands on cognitive processing.
4. Schwartz (2003).
5. Phillips (2005).
6. Federal Trade Commission (n.d-a.).
7. Federal Trade Commission (n.d-b.).
8. Anderson (2008).
9. Research on cattle using global positioning system devices has shown that
water is a more powerful draw than salt in attracting cattle to new grazing
ground. See Ganskopp (2006).
10. Becerra (2009).

Chapter 3
1. Varian (1996).
2. Prahalad (2006).
 NOTES 317

3. Traditional marketing analysis techniques such as focus groups can still be

used to identify features. However, they are just part of the input used to
identify product versions.
4. As noted in the last reading, the terms price discrimination and price dif-
ferentiation can, in general, be treated as synonymous. Companies use price
discrimination to differentiate prices.
5. Varian (1996).
6. It is ironic that some of the ill will that was directed at cable companies is
now being directed at satellite TV carriers. The lesson is that quality cus-
tomer service and perception management are never-ending processes.
7. Wolverton (2000).
8. See the Research and Innovative Technology Administration Bureau of
Statistics site at: http://www.bts.gov/programs/economics_and_finance/
air_travel_price_index/html/annual_table.html
9. The “I” is Sanders.
10. I eventually got the bongos as a Christmas gift from my grandmother. She
bought them from JC Penney’s for a substantially lower price.
11. See the following Web site for a good discussion of the Law of Demand:
http://www.investopedia.com/terms/l/lawofdemand.asp
12. Oz Shy (2008).

Chapter 4
1. Adamson (2006).
2. Kim and Mauborgne (2005). A related concept in the marketing literature,
called lateral marketing, was developed by Kotler and de Bes (2003).
3. Shapiro and Varian (1998).
4. Shapiro and Varian (1998).
5. Nalebuff and Ayres (2003), also see Why not? About the book. Also visit
Wikipedia.
6. Bertini and Wathieu (2010).
7. I realize that there are many patrons for this large segment of humanity. The
goal is to have a question for the bottom of the pyramid. Please see Prahalad
(2006) and many others who have been committed to this group.
8. Athreye and Kapur (2009).
9. Dynamic Tension was an exercise approach developed by Charles Atlas, but
it also works here.
10. Prahalad (2006).
11. See the discussion at the end of this chapter on Pareto Economics, Welfare,
and Efficiency.
12. Jain (2000).
318 NOTES

13. Shapiro and Varian (1998).

14. Heracleous and Wirtz (2010)
15. Sugden (1984).

Chapter 5
1. Slavin (2008).
2. This section has been adapted from a paper by Gopal and Sanders (2000).
3. Ihnatko (2009).
4. Borden (2009).
5. Markoff (2008).
6. Lieberman (2003).
7. A special note of thanks is extended to Emily Wester, consultant and owner
of Magic City Media, for providing insight into the material used in this
section.
8. American Cancer Society (2010).
9. Sahlman and Flaherty (2010).
10. The students analyzed the case by first using the FAD (features, attributes,
and design) template and the Ten–Ten planning templates. In general, the
case analyses were superlative and several creative solutions for versioning
were identified.
11. Grueber and Studt (2011).

Chapter 6
1. Cf. Hülsheger, Anderson, and Salgado (2009).
2. The classic four-stage model of creativity was published by Wallas in 1926.
The art of thought. New York: Harcourt Brace Jovanovich.. See Lubart
(2001), for an overview of the various approaches for modeling creativity.
The updated model used in this book has been adapted and extrapolated
from the following papers: An, Hunt, and Sanders (1993); Cerveny, Garrity,
& Sanders (1990).
3. In large organizations, this information may be put into complex knowl-
edge management repositories and is referred to as knowledge management.
A significant amount of knowledge is actually maintained in the largest
knowledge repository of all, the World Wide Web.
4. Sims (2011).
5. Varian (1997), pp. 2–3.
6. Varian (1997).
7. Gardner (1994).
 NOTES 319

8. See, for example, Highfield and Carter (1993); Isaacson (2008); Ohanian
(2008).
9. For an overview of convergent and divergent thinking and questions related
to these typologies and the psychological, sociological, and biological theo-
ries related to creativity, see Runco (2006).
10. Dyer, Gregersen, and Christensen (2009).
11. Sawyer (2006).
12. Cf. Hülsheger et al. (2009).
13. Sawyer (2006).
14. Amabile, Hadley, and Kramer (2002).
15. Goldenberg and Mazursky (2002).
16. Nalebuff and Ayres (2003).
17. Michalko (2006).
18. Wang and Chern (2008).
19. Amabile et al. (2002).
20. Donovan (2010).
21. Lupien, McEwen, Gunnar, and Heim (2009).
22. c.f. Michalko (2006).
23. Michalko (2006).
24. Nalebuff and Ayres (2003).
25. Nalebuff and Ayres (2003).
26. Choate (2005).
27. Nalebuff and Ayres (2003).
28. Nalebuff and Ayres (2003).
29. This idea has been attributed to Alan Kay, one of the pioneers behind
object-oriented programming and the graphical user interface, when he was
a scientist at Xerox’s Palo Alto Research Corporation in the 1970s.
30. Rose (2002).
31. Hofstede and Hofstede (2004).
32. Gladwell (2008).
33. Selling (2009).
34. de Bono (1999).
35. Han, Kim, and Srivastava (1998).

Chapter 7
1. Software developers often use a technique referred to as user-centered
design or participative design that has elements of UDD and MDD. In
user-centered design, there is an iterative process of building the application
and having the user continuously validate software solution.
320 NOTES

2. As noted in an earlier chapter. A Blue Ocean market is a market that is not

in existence. A Blue Ocean product is a new product that is radically dif-
ferentiated from existing products that are being offered.
3. Cf. Verganti (2009).
4. Lyons (2010b, September 1).
5. Verganti (2009).
6. Bitner, Ostrom, and Morgan (2008).
7. Adamson (2006).
8. Cf. Jo, Moon, Garrity, and Sanders (2007).
9. Heckhausen and Schulz (1995); Skinner (1996).
10. Jo et al. (2011).
11. Pierce, Kostovab, and Dirks (2003).
12. Schwartz (2003).
13. Iyer and Muncy (2005); Keller, Sternthal, and Tybout (2002); Keller and
Tybout (2002); Kim and Mauborgne (2005); McGrath and MacMillan
(2000); Tybout and Sternthal (2005).
14. Adamson (2006).
15. Bitner et al. (2008).
16. This notion is discussed in the chapter on innovation and is also the result
of several research projects I have been involved with. See in particular
Cerveny, Garrity, and Sanders (1986).
17. The Printed World (2011).
18. In 2011, the 3D printers start at around $10,000 (just search for “3D print-
ers” to see what is currently available.). There are hobbyists versions of 3D
printers in the $1,000 range.
19. Search for “wine aging” at the U.S. patent office and with any search engine.
20. Kim and Mauborgne (2005).
21. Kotler and de Bes (2003).
22. Malhotra and Birks (2009).
23. Cavusgil, Knight, Riesenberger, and Yaprak (2009).
24. http://www.wengerna.com/giant-knife-16999#
25. Manjoo (2010).

Chapter 8
1. Michael Porter originally identified three generic strategies. He noted that
a business can also focus on a market that is not very competitive. Most
people consider this to be a special case of the other two strategies. See
Porter (1980).
2. Adapted from May (2010).
 NOTES 321

3. Porter (1985).
4. Coase (1937).
5. Williamson (1985).
6. Porter (2008).
7. This is in part the reason that outsourcing and off-shoring started to increase
so dramatically.
8. Prahalad and Hamel (1990).
9. Barney (1991).
10. Henry (2007).
11. Grant (2007).
12. Cf. Kaplan and Norton (1996, January–February, 2003b) and visit http://www.
balanced scorecard.org/BSCResources/AbouttheBalancedScorecard/tabid/55/
Default.aspx
13. Nørreklit (2000).
14. Nørreklit (2000).
15. Nørreklit (2000).
16. Kim and Mauborgne (2005).
17. Burke, Stel, and Thurik (2009).
18. Before he died in 2005, Humphrey wrote a brief history of SWOT develop-
ment. He indicated that it was initiated in 1960 because long-range plan-
ning approaches were not working properly. The research team interviewed
1,100 organizations and had 5,000 executives complete a 250-item ques-
tionnaire. The approach was originally called SOFT (Satisfactory, Oppor-
tunity, Fault, and Threat) but after subsequent adaptations by a number
of consultants and academics, it evolved into SWOT. There are devotees
of SWOT that believe it originated at Harvard Business School under the
guise of Albert Smith, Roland Christensen, and Kenneth Andrew. See
Humphrey (2005); Panagiotou (2003).
19. Panagiotou (2003).

Chapter 9
1. See Horan (2007). This is an alternative approach to Horan’s approach
developing a brief plan. One deficiency of the Horan approach is that it
does not integrate the key ideas found in the major planning approaches.
The deficiency in all of the other planning approaches discussed in chapter
8 is they take too much time and, yet, they are not comprehensive enough
because they do not include and build on other approaches. The Ten–Ten
approach attempts to reconcile speed with comprehensiveness.
2. Porter (1998).
322 NOTES

3. Barney (1991).
4. Prahalad and Hamel (1990).
5. Kim and Mauborgne (2005).
6. Kawasaki (2008).
7. See the Appendix at the end of the chapter for an example of an actual
business where the templates have been filled in.
8. http://www.wineinstitute.org/files/PerCapitaWineConsumptionCountries.
pdf
9. http://www.winemarketcouncil.com/research_slideview.asp?position=9

Chapter 10
1. Arthur (1989).
2. Shapiro and Varian (1998).
3. Liebowitz and Margolis (1994).
4. Burnham, Frels, and Mahajan (2003).
5. This section is based on Kaplan and Norton (2003a, September 15); Shap-
iro and Varian (1998).
6. Jo, Moon, Garrity, and Sanders (2007).
7. Raustiala and Sprigman (2006), p. 1719.
8. Raustiala and Sprigman (2006).
9. Fitzpatrick and Lueck (2010).
10. Belcourt (2006), pp. 269–279.
11. Lenskold (2003).
12. Reichheld and Schefter (2000).

Chapter 11
1. This chapter is adapted from material originally appearing in Huefner,
Largay, and Hamlen (2005 and 2007, Thomson Custom Publishing; used
by permission of the copyright holders).
2. Jones and Van Dyke (1998).
3. The first two digits in a Revenue Ruling number signify the year of issue.
Thus, Revenue Ruling 59–60 was issued in 1959.
4. Pratt (2001).
5. This listing is drawn from American Institute of Certified Public Account-
ants (2003).
6. See Cornell (1993).
7. The payback approach is related to the hyperbolic discounting phenomena.
There appears to be psychological as well as economic reasons behind the
fact that people prefers a reward today rather than wait for a substantial
 NOTES 323

reward. Studies have found that people sometimes use average annual dis-
count rates of over 300% over the course of 1 month and over 100% over a
1-year horizon. They ask people whether they prefer $100 today rather than
$200 next month. See Noor (2009).
8. See Slee and Paglia (2010).
9. See Pratt et al. (1993) for an expanded discussion of the excess earnings
method.
10. For an extended discussion of premiums and discounts, see Pratt (2001).
11. Pratt (2001), p. 79.
12. Pratt (2001), chapters 5–9.
13. Pratt (2001), chapter 12.
14. For an expanded discussion of valuation of startup companies, see Abrams
(2001), especially chapter 12, and Evans and Bishop (2001), especially
chapter 15.
15. Gompers, Kovner, Lerner, and Scharfstein (2010).
16. Abrams (2001), pp. 410–413.

Chapter 12
1. The SWOT analysis is rarely part of the business plan and is usually not part
of the business presentation. The purpose of a SWOT analysis is to assist the
founders in understating what the business is all about and where it is head-
ing. The strengths and opportunities will of course be woven into the busi-
ness plan and the business plan presentation. But there is little to be gained
from focusing on the threats and the weaknesses. Indeed, a significant part
of the business plan and presentation involves developing strategies for deal-
ing with weaknesses and threats.
2. Afuah and Tucci (2001).
3. Sahlman (1997, July-August).
4. Kawasaki (2008).
5. An interesting book on the details of writing a business plan was published
by Chambers (2007).
6. Herbert (2009).
7. Guy Kawasaki posits that for every 10 pages over 20 you reduce reading and
funding probability by 25%.
8. Sahlman (1997, July-August).
9. See the following Web sites for an overview of funding issues and general
entrepreneurial concepts:
http://www.sba.gov/
http://www.entrepreneur.com/
http://www.nvca.org/
324 NOTES

10. Applegate, Simpson, White, and McDonald (2010).

11. Applegate et al. (2010).
12. Applegate et al. (2010).
13. Stuck and Weingarten (2005).
14. Sahlman (1997).
15. Applegate et al. (2010).
16. http://blog.guykawasaki.com/2007/09/the-top-ten-six.
html#axzz18O5LrqfG
17. http://blog.guykawasaki.com/2007/10/ten-questions-1.html
#axzz18OGNAE1M and http://blog.guykawasaki.com/2007/06/482413_
for_lega.html#axzz18OGadUe2

Chapter 13
1. Adapted from Leavitt (1965).
2. Project Management Institute (2004).
3. IPS Associates (1997).
4. Cf. Takeuchi and Nonaka (1986).
5. We have been involved in several research papers on the subject including
Garrity, Glassberg, Kim, Sanders, and Shin (2005) and Garrity and Sanders
(1998).
6. Kawasaki (2008).
7. Varianini and Vaturi (2000).
8. Anderson (2010).

Chapter 14
1. http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-faq
2. http://news.cnet.com/2100-1017-819688.html
3. http://online.wsj.com/article/SB10001424052748704878904575031504
159206726.html
4. Lyons (2010a, January 4).
5. The company used in the example is fictitious. Jin Bean is a compendium
of numerous examples of actual companies that have decided to go ahead
with an investment in the face of negative values for NPV. See Mauboussin
(1999); Mun (2005); Trigeorgis (1996), for additional examples that also
include financial calculations.
6. “Permission is granted to copy, distribute and/or modify this document
under the terms of the GNU Free Documentation License, Version 1.2
or any later version published by the Free Software Foundation; with no
 NOTES 325

Invariant Sections, no Front-Cover Texts, and no Back-Cover Texts. A copy

of the license is included in the section entitled GNU Free Documentation
License.” http://commons.wikimedia.org/wiki/File:Blow_molding.png
7. Mun (2005), p. 16.
8. This section is based on an article by Kim and Sanders (2002).
9. http://dealbook.blogs.nytimes.com/2010/03/15/skype-poised-for-a-big-
initial-stock-offering/
10. O’Sullivan and Dooley (2008).

Chapter 15
1. Roth (2011).
2. Gerby (1995).
3. Visit the U.S. Patent Office at http://www.uspto.gov/web/offices/ac/ido/
oeip/taf/us_stat.htm
4. Cf. Garud and Nayyar (1994).
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 Index
The italicized f and t following page numbers refer to figures and tables,
respectively.

abandon decision, 298 chronic stress, 124

absorptive capacity, 22 collaborative filtering, 29–30
acquisition costs, 175 complementary goods, 55
Angel investors, 265–266 concurrent engineering, 288–289
arbitrage, 59–61 conditional value, 244
asset-based approach, 228–229 contingency planning, 268–269
controlling interest, 225–226
Bezos, Jeff, 6 control premium, 241
Black Hat Thinking, 130 creativity
blow injection molding definition, 115
diagram, 302f entrepreneurs, 120
Blue Hat Thinking, 130 environmental factors, 120–123
Blue Ocean market, 77, 154–156, five-phase model, 115, 116f
183–184 hinder, 123–124
bottom of the pyramid (BoP), 83 inherently nonlinear, 117–119
breadth of search, 20, 21f–22f techniques, 124–130
Bridge model, 13–14 customer acquisition, 221
building-the-business customer retention, 221
functions, 277–280 customer segment, 87–89
Bundling, 33–35
burn rate, 243 de Bono, Edward, 129
business development process., 195f decision costs, 175
business life cycle, 276f, 296f demand curve, 27–28, 44, 45f, 63
business plan demand dashboard, 51, 52f
approaches, 252–254 demand equation, 64–66
presentation, 260–262, 260t–261t depth of search, 20, 21f
purpose, 252 differentiation dashboard, 51, 53f
template, 254–257, 255t–257t diffusion, 7
Business Plan Overview template, diffusion lags performance, 9–10
198–202, 199t direct comparison approach, 229
business valuation discount premium, 241–242
definition, 223 discount rate choice, 232–234
techniques, 224–225 discovery costs, 175
dissatifiers, 146
capitalization of excess earnings, due diligence, 269–271,
238–240, 239t 270t–271t
capitalization rate, 237 dynamic differentiation, 98
capitalized earnings approach, dynamic tension differentiation,
235–238 78–81, 78f, 90–91
338 INDEX

earnings–price (E/P) ratio, 237–238 investment decision, 295–299,

enforcement costs, 175 305–306
entrepreneurial innovation investors, 263–265
activity, 6
entrepreneurship, 4, 313 Jobs, Steve, 6
estimating future returns, 231–232
executive summary, 202–204, Kawasaki, Guy, 5
210–211 key person discount, 242
exit strategy, 224
extinct and vestigial lack-of-marketability discount, 242
features (EXTs), 145–146 lateral marketing, 152–154
launching business, 285–287
fair market value, 225 learn-about activity, 115–116
features, attributes, and design learning-about process, 19–20
(FAD) template, 133, 146–154, learning-by-doing, 22–23, 116–117
158–160, 164–167 linear demand curve, 68–73
First Chicago approach, 244 lock-in, 213–214, 214f, 216f,
first-degree price 218–221, 222f
discrimination, 28–31 lock-in index, 217–218
flat pricing, 56
free cash flow, 231 maintenance decision, 297
frugal engineering, 80 market efficiency, 93
market pull, 17
Gantt chart, 283–285, 284f markets, types, 1
Gartner’s Hype Cycle, 12 meaning-driven design (MDD),
Goldilocks pricing, 32, 77–78 134–138
Green Hat Thinking, 130 meaning of a product, 140–141
group pricing, 35–37, 37f Metcalfe’s law, 14
growing up, 287–288 minority interest discount, 241
growth decision, 297–298 monopolistic competition, 2–3, 54,
growth rate, 247–248, 248f 189–190
Moore’s law, 9–10, 11f
Hamlen, Bill, 72–73
negotiation costs, 175
incremental innovation, 7 net present value (NPV), 299–300,
incubation, 116 303–304
independent goods, 54 network effects, 15–16, 213–214
information asymmetry, 60 noncontrolling interest, 226
innovation nonlinear demand curve, 68–73,
categories, 7 69f, 71f
definition, 17, 115
driven by substitute and comple- optimal solution, 66–68
ments, 59f Organizational and Industry
environmental factors, 120–123 Analysis template, 194–198,
R&D process, 16–18 196t–197t, 207–209
integrated SWOT outsourcing, 219–220
analysis, 186–189
internal rate of return (IRR), 299, Paretian welfare economics, 93
303–304 Pareto efficiency, 92
 INDEX 339

payback method, 229–230 Revenue Ruling, 224–225

penetration pricing, 90 risk assessment, 268–269
P/E ratio, 237–238 Robinson-Patman Act, 38
perfectly competitive markets, 3, Roth, Carol, 311
54, 98
perfect price discrimination, 29 search costs, 175
perfect substitute, 55 secondary environment control, 142
perpetuity, 235 second-degree price
personalized pricing, 28–31, 31f discrimination, 31–35, 32f
planning process, 171–172, segmentation, 87–88
171f, 273f selling a product, 60
points of difference and sensitivity analysis, 247
differentiators (PODs), settlement costs, 175
144–145 Shank, Roger, 23
points of parity and must-haves Singapore Airlines (SIA), 90–91
(POPS), 144 skimming pricing, 90
Porter’s five-force model, 175–179 social costs, 175
postpone decision, 298 social networks, 16
power distance, 128 standard economic theory, 3
predatory pricing, 38 strategic acquisition premium, 241
price differentiation, 46–49, 55–56 strategic actions model, 306–307
price discrimination, 55–56 strategic planning
price-sensitive customers, 83 process, 172–190, 194f
primary environment control, 142 strategy map, 180–183, 182f
product attributes, 143–146 substitute goods, 55
product differentiation supply chain analysis, 173–175, 174f
and enlightenment, 46–49 switching costs, 214–217
legal issues, 38–40 SWOT analysis, 184–190,
strategies, 89–90 186f–188f
supply chain, 24
product differentiation curves technology-driven design (TDD),
(PD curves), 75–77, 76f, 84f, 134–138
96f–98f, 106f–107f technology life cycle, 7–8, 8f
product life cycle, 7 Ten–Ten planning process, 193–202
project management, 282f, 285f third-degree price discrimination,
definition, 277 35–37, 37f
features, 280–281 transaction costs, 175
individual diary, 290–291 treasury method, 240
summary diary, 292–293 trigger, 115
project selection model, 307–308
prototype, 122, 162–163, 254 user-driven design (UDD), 134–138
psychological ownership, 142–143
push, pull, and reload, 18–19, 18f value chain analysis, 173–175, 174f
Varian, Hal, 27
radical innovation, 7 Venn diagram, 141
real options analysis, 299–304 venture capital funds, 266–268
recommender system, 29–30 venture capitalists, 266–268
Red Hat Thinking, 130 versioning, 31–35, 35f, 77–78
resource-based framework, 179–180 automobiles, 96–98
340 INDEX

categories, 81–83 version rollout strategies, 87–89

digital content, 107–108 virtual machine applications, 14
digital entertainment, 108–110
disease treatments, 110–112 White Hat Thinking, 130
e-Books, 106–107 willingness-to-pay, 49–51
standardized and commodity work breakdown structure (WBS),
products, 84–85 283, 283f
strategies, 85–87 wrap-up, 311–314
wireless communications,
102–105 Yellow Hat Thinking, 130
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Developing New Products and Services: Learning, Differentiation, and Innovation
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 Developing New Products and Services The Marketing Research Collection

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to facilitate new product development. For example, three templates
and Services

Developing New Products and Services

are featured that facilitate new product and service development. The
FAD (features, attributes, and design) template is used to identify the Learning, Differentiation,
features and attributes that can be used for product and service dif-
ferentiation. The Ten–Ten planning process contains two templates: an
Organizational and Industry Analysis template and the Business Plan
and Innovation
Overview template. These two templates coupled with the FAD tem-
plate can be used to develop a full-blown business plan. Entrepreneur-
ship, technology and product life cycles, product and service version-
ing, product line optimization, creativity, lock-in real options, business
valuation, and project management topics are also covered.

G. Lawrence Sanders, PhD, is a professor in the Department of Manage-

ment Science and Systems in the School of Management at the State
University of New York at Buffalo. He was a recipient of the Provost’s G. Lawrence Sanders
Exceptional Scholars Sustained Achievement Award from the Universi-
ty of Buffalo in 2007. He has served as a department chair and the chair
of the PhD program in the School of Management. He has published
over 50 refereed research papers in a variety of publications such as
The Journal of Business, MIS Quarterly, Information Systems Research, the
Journal of Management Information Systems, the Journal of Strategic Infor-
mation Systems, Communications of the ACM, the Journal of Management
Systems, and many others.

The Marketing Research Collection

Naresh Malhotra, Editor

ISBN: 978-1-60649-241-3
90000

9 781606 492413
www.businessexpertpress.com www.businessexpertpress.com