Bundling and Pricing of Product with After-sale Services
S. Kameshwaran
N. Viswanadham
∗
Centre for Global Logistics and Manufacturing Strategies,
Indian School of Business,
Gachibowli, Hyderabad 500032
Email: Kameshwaran S@isb.edu, N Viswanadham@isb.edu
∗
Corresponding Author
Vijay Desai
Department of Industrial Engineering and Operations Research,
Columbia University,
NY 10027-6699.
Email: vvd2101@columbia.edu
Abstract: Bundling is the sale of two or more products in combination as a package.
In this paper we consider the bundling and pricing of a complex durable product with the
after-sales repair and maintenance services. The product and service are two different, but
related markets for this scenario. The problem of bundling and pricing are considered for
two pro duct market structures: monopoly and duopoly. In the monopoly case, the decision
framework is an optimization problem, whereas for the duopoly, the strategic interactions of
the two firms are modeled as a two stage non-cooperative game. These decision frameworks
enable the manufacturing firms to decide upon the product-se rvice bundling and pricing.
Keywords: manufacturing service integration, product bundling, non-cooperative game,
sub-game perfect equilibrium
Biographical Notes: S. Kameshwaran is currently a senior researcher at the Indian School
of Business. Prior to this, he worked as a Research Engineer in The Logistics Institute-Asia
Pacific, Singapore and as a post doctoral fellow in INRIA Lorraine, France. He received
his Ph.D in Computer Science from the Indian Institute of Science, Bangalore in 2004. His
research interests are in the areas of algorithmic operations research, discrete optimization,
and game theory with applications in supply chain management and e-commerce.
Professor N. Viswanadham is the Executive Director of Centre of Excellence for Global
Logistics and Manufacturing Strategies at the Indian School of Business. Prior to this, he
was the Deputy Executive Director of The Logistics Institute-Asia Pacific and also Professor
in the Department of Mechanical and Production Engineering at the National University of
Singap ore. He is the recipient of the IBM Faculty Award for 2006. He was a GE Research
Fellow and Tata Chemicals Chair Professor at the Indian Institute of Science, Bangalore and
was also a faculty member at the Indian Institute of Science till 1998. Professor Viswanadham
is a Fellow of a number of professional societies and academies such as the IEEE, INSA, IASc,
INAE, and the TWAS. He is the author of three textbooks, six edited volumes, over eighty
journal articles and more than hundred conference papers on automation.
Vijay De sai is currently a PhD student at Dept. of IEOR in Columbia University. He holds
a Bachelors degree from Indian Institute of Technology, Bombay and Masters degree from
Singap ore- MIT Alliance. He has worked as a research engineer at The Logistics Institute -
Asia Pacific. His research interests are in the area of revenue management and optimization.
1
1 Introduction
Integration of service with pro duct is considered as one of the innovative supply chain initiatives
of the next decade (Anderson and Delattre, 2002). At the outset, it can be seen as the merging
of the old economy (manufacturing) with the new economy of service industries. However, the
manufactured products are linked to services via the competitive strategies of individual firms
(Marceau and Martinez, 2002). The service can be linked to the product at various stages in
the supply chain. In this paper, we consider the linking at the final stage of distribution and
marketing. In particular, the focus is on the packaging of a complex durable product with its
after-sales repair and maintenance services as a single bundle.
Manufacturing has traditionally meant the production of tangible goods, but for today’s
customers it is the bundling of the tangible product with an array of intangible services that
makes for the most desirable service-enhanced product (Lester, 1998). With more customers
seeking solutions instead of spe cific products or brands, a growing number of products are
becoming commodities. Thus the emphasis of customer satisfaction is on total cost of ownership,
which is determined not only by the product but also by the after-sales service. Companies
can provide good quality after-sales service to make product usage as hassle free as possible.
Towards this end, offering product-service bundles would be attractive to both customers and
manufacturers. The customers are freed from the burden of looking after upkeep of product and
has more control over the total cost of ownership. The manufacturers on the other hand, will
earn additional revenue with the sale of every product in terms of after-sales service. Numerous
studies (Alexander et al., 2002; Dennis and Kambil, 2003) s how that service tends to be a high
margin activity and bundling of products and services can be a good strategy for entering the
service market.
There is an interdependence between product and service sales, and decis ion making should
focus on the profitability from both sale of products and after-sales services, rather than on
per-transaction or per-p eriod profitability. For example, an article in San Jose Mercury News
(Nauman, 1994) reported that new car sales represented 59.9% of dealers revenue but only
1% of profit, while the se rvice and parts department generated 14.7% of their total revenue
and two-thirds of their total profits. Manufacturers such as Epson and Hewlett-Packard sell
their printers at loss to secure continuing profits from the sale of toner cartridges. Study by
Cohen (Cohen et al., 1997) indicate that manufacturers in electronics/computing industry are
acting aggressively for service revenue (through maintenance contracts) after relatively short
warranty periods. Thus across various industries, companies are beginning to regard initial
product sales primarily as positioning opportunities for pull through sales and service. In this
context, product-service bundle pricing becomes an important problem.
In this paper, we adopt a strategic framework to analyze the problem of product-service
bundling and pricing between two competing firms. The product and after-sales service are
two different markets with various players. A product manufacturer who intends to enter the
after-sales service market should take into account the strategic behavior of the players in both
the markets. In particular, the manufacturer should make the following decisions: (1) should he
enter the after-sales service market?, (2) if so, should he bundle it with the product?, and (3) at
what prices to offer the product and service?. Our focus is on complex durable products that
are economically attractive to maintain and service rather than replace . The product could be
an automobile, a farm equipment, or an elevator. It may be noticed that all of these products
require after sales support for preventive maintenance, spare parts for repair and emergency
breakdown servicing. We analyze this problem in a representative setting of monopoly and
duopoly product markets. The decision making in the monopoly market is an optimization
problem. The duopoly market has strategic competitors and the decision making is modeled as
a two stage non-cooperative sequential game. The subgame-perfect Nash equilibrium in pure
strategies is used as the solution concept. A preliminary version of this work was presented in
(Kameshwaran et al., 2007).
2
The remainder of the paper is organized as follows. Section 2 briefly explains and reviews
the literature in the integration of manufacturing and service. The model for the product market
and the service market, with the consumers’ preferences are explained in Section 3. The decision
making framework for the monopoly situation is considered in Section 4 and the duopoly game
model is solved in Section 5. The model assumes that consumers valuation for the product is
deterministically known to the manufacturers. This assumption is relaxed with the valuation to
be uniformly distributed in Section 6. In Section 7, we conclude the pap e r with the promising
avenues for future research.
2 Integration of Manufacturing and Service
The service industry is difficult to define because it includes many diverse activities. Although
there is no consensus on the definition of a service industry, there is a broad agreement about
the attributes of its outputs: they are not tangible; they are consumed at the same time they
are produced; they have intangible value added; they are labor intensive (Karaomerlioglu and
Carlsson, 1999). However, these attributes do not necessarily apply all at once to all service
industries. Services also serve different markets: consumer markets, interme diate (producer)
markets, and state or public service markets, and involve different production proc es se s, includ-
ing the transformation of the state of physical objects, people or codified information (Miles,
1994). The services that are commonly incorporated within manufacturing include assembly,
testing, system integration, material purchasing, design, labelling, distribution, repair and main-
tenance. The after-sales repair and maintenance accounts for much apparent consumer spending
on services (Marceau and Martinez, 2002). In (Howells, 2000), the trend within manufacturing
industry firms towards bundling together their physical products and associated services is de-
scribed. Many manufacturing firms are increasing the proportion of their turnover earned from
selling services by bundling, as a single package or as add-ons to products at different times.
There are three major strategies used by firms in product-service packaging (Marceau and
Martinez, 2002):
• Product-service integration: Service in incorporated through the different stages of the
production process.
• Product-service bundling: Service is packaged with the product at or after the point of
sale.
• Service enterprises: These are firms that package products produced by others with a raft
of services.
In product-service integration, s ervice comp onents are added during the production pro-
cess, influencing the characteristics and/or physical composition of the product itself. Such
service components may involve extra input of R&D, design, technical or engineering services
from clients in the downstream of the supply chain. Many of these are knowledge intensive. In
contrast, less knowledge intensive se rvices are bundled at the point of sale with the product. The
financial services and the after-sales repair and maintenance services belong to this category.
Some firms adopt both product-service integration and bundling strategies. In (Viswanadham
et al., 2005), manufacturing and service were integrated in a single network to investigate the
impact of manufacturing and service phases on each other, when product-service bundles are
being offered. Service enterprises do not manufacture products but provide after-sales services
to products manufactured by other firms. For example, there are engineering service enterprises
that provide repair and maintenance service for home appliances, manufactured by different
firms, as authorized service providers. In addition to the warranty provided by the manufactur-
ers, these enterprises provides extended warranty by collecting a premium from the consumer.
This is equivalent to selling of service but there is no bundling involved. In this paper, we focus
on the selling of product-service bundles by the manufacturing firm.
3
Bundling is the sale of two or more products in combination as a package. The bun-
dled products are assumed to have separate markets so that at least some consumers buy or
want to buy the products separately. Bundling has been studied from various perspectives in
the literature: consumer evaluation of bundles (Herrmann et al., 1999; Johnson et al., 1999;
Soman and Gourville, 2001; Yadav, 1994); optimality of bundling (Eppen et al., 1991; Guilti-
nan, 1987); pricing of bundles (Hanson and Martin, 1990; Ansari et al., 1996); optimality of
bundling for monopolists (Adams and Yellen, 1976; Schmalensee, 1982); and equilibrium theory
of bundling (Chen, 1997). Bundling was suggested as an alternative technique for price discrimi-
nation for monopolists (Stigler, 1968), which was further analyzed in (Adams and Yellen, 1976).
It was shown with stylized examples that a multiproduct monopolist can gain by selling the
different products in bundles, when the reservation values are negatively correlated. Bundling
was shown to be profitable even if the reservation values are uncorrelated or positively corre-
lated (Schmalensee, 1984). It reduced the effective dispersion of reservation values and thereby
the seller can extract a greater fraction of the p ote ntial surplus. The conditions under which
bundling is an optimal strategy was investigated in (McAfee et al., 1989) for a multiproduct
monopolist. A graphical analysis of bundling in (Salinger, 1995) showed the interaction between
the cost effects and demand effects, which in turn can be used to predict the conditions under
which bundling is profitable. Bundling has also been studied with varying assumptions on mar-
ket structure of the bundled products. In (Schmalensee, 1982), market of the first product is
assumed to be a monopoly and that of the second product to be in perfect comp etition. It was
shown that in such a scenario, the monopolist can never gain by bundling the product from the
first market with that from the second market. In (Whinston, 1990), the second market had
an oligopoly structure and the result showed that the bundling can be profitable because of the
strategic effect in the second market.
The focus of bundling can be product bundling or price bundling or both (Stremersch
and Tellis, 2002). Price bundling is the sale of two or more separate products in a package at
a discount, without any integration of the products. As there is no integration of products,
bundling itself does not create added value to consumers, and thus a discount must be offered
to motivate at least some consume rs to buy the bundle. This kind of bundling is usually used
to sell unpopular pro ducts along with the product ones and for also introducing a new pro duct
in the market, which is bundled initially with a popular product.
Product bundling is the integration and sale of two or more separate products at any
price. This integration provides at least some consumers with added value. Thus product
bundling is more of a long-term differentiation strategy than price bundling, which is a short-
term promotional tool. In this paper, our focus is on bundling of a complex durable product
with after-sales repair and maintenance services. Clearly, the product and the service are two
different products, as there exist different markets for each of them and consumers can buy
them separately. Further, this is product bundling as there is integration between the product
and the after-sales service that is provided by the product manufacturer. In general, after-sales
service market has numerous players (service providers), due to the relatively less entry barriers
in terms of technology and cost than that of the manufacturing sector. It is not uncommon for
the manufacturer to have a service station, thus acting as a common player in both the markets.
Thus the decision of bundling the service with the product for a given manufacturer should
take into account the comp e tition he faces from both the markets (the other manufacturers and
the se rvice providers). The markets are populated with non-cooperative players, who try to
maximize their individual profits. This leads to the use of game theory as the decision tool. In
the next section, we describe the model mathem atically.
4
3 The Model
3.1 Product and Service Markets
We consider a complex durable product P , which is economically attractive to maintain and
service, than to replace. The product P is not identified by its brand or model but by its type,
which explains its usage. For example, an automobile can be categorized as luxury or sports or
utility vehicle. We consider a particular category, which defines the product P and assume that
all consumers value the P at v = V . This simple assumption of deterministic reservation value
is later relaxed in Section 6, where the valuation v is assumed to be uniformly distributed in
range [V , V ].
The intention of bundling the after-sale services with the product is to offer the entire
package as a c ommodity. Thus for the manufacturer, entering the se rvice market is not just
opening a service center, but providing the service for a designated lifetime of the product,
for a previously agreed upon cost. The lifetime can be just considered as a fixed p e riod of
time, until which the consumer would definitely use the product. Currently, for many durable
products, the service market is populated with small independent service providers. In any
city, one can find several electrical equipment service centers for repairing refrigerators and
air conditioners of various brands and models. Similarly there are several service centers for
handling automobiles from different manufacturers. The cost and the quality of the service vary
across such service centers and consumers choose the ones that meet their s ervice requirements
and budget constraints. We model our service market similar to the above scenario. The service
market for the P has s everal small independent s ervice providers, who provide the service at a
cost that depends on the quality of the service. At any given point of time, a consumer would
choose a service provider who meets her service requirements and cost constraint.
Let w be the total cost a consumer is willing to pay for servicing the product during
its lifetime. We model the variation in consumer’s willing to pay for the service by assuming
w to be uniformly distributed in range [W , W ]. The w denotes a consumer’s willingness to
pay (WTP) for the lifetime service. This total spend for the service is distributed across the
lifetime of the product and possibly across many service providers. The service providers service
similar products produced by different manufacturers. We do not assume the independent
service providers to be strategic players in the market. This is because the independent service
providers do not service the product for its entire lifetime for a previously agreed up on cost. Thus
a manufacturer need not take into account the cost of service of the independent service providers
for making his strategic decisions. However, the presence of such independent service providers
ensures that a consumer will always be able to avail the service for her WTP w ∈ [W , W ] for
the lifetime. A consumer can thus choose to buy the service from the manufacturer or can avail
it across different independent service providers during the lifetime.
3.2 Manufacturing Firm and the Consumers
The marginal c ost of producing the product is assumed to be a c onstant c
P
. For a manufac-
turing firm (henceforth referred simply as firm) to survive in such a market, the cost c
P
≤ v
and the price of the product α should be such that c
P
≤ α ≤ v. Let the constant marginal cost
of providing the lifetime service for the firm be c
S
∈ [W , W ]. If the firm provides the lifetime
service for price β, then all the consumers with WTP w ≥ β will buy the service from the
manufacturer for the entire product lifetime. This is b e cause the quality of service provided by
the manufacturer can be assumed to be higher than any of the independent service provider and
hence the consumers with w ≥ β would prefer the service from the manufacturer directly. The
WTP w and the price β are money values for the service that is provided during the lifetime of
the product. Since the money value would change during the lifetime of the product, they are
assumed to be suitably discounted using a common discounting factor for both the manufacturer
and consumers. This assumption of common discount factor for both manufacturers and con-
5