Clear Water Technologies, Inc.: A Case Analysis

Clear Water Technologies : A Case Study

QTX is a sales support server that allows multiple users to simultaneously maintain
their sales account databases. These databases covers contact information, quote histories,
copies of all communications, and links to the customer's corporate database for
shipping records. The basic QTX package consists of a processor, chassis, hard drive,
and network interface, with a manufacturing cost of $500. The package provided simultaneous
access for 10 users to the system, referred to as 10 "seats." Each seat represented
one accessing employee. The product line consisted of 10-, 20-, and 30-seat
capacity QTX servers. Each incremental 10 seats required $200 of additional manufacturing
cost. Yearly sales were at the rate of 4,000 units across all sizes. In initial sales,
approximately 30 percent of customers bought the 30-seat unit, 40 percent bought the
20-seat unit, and 30 percent bought the 10-seat unit. Customers who needed more than
30 seats typically went to competitors servicing the medium-to-large company market
segment.

Clearwater set a per-seat manufacturer's suggested retail price (MSRP) that decreased
with higher quantity seat purchases, reflecting the customer perception of declining manufacturing
cost per seat. Clearwater also saw this as advantageous because it encouraged
customers to maximize their initial seat purchase.

Clearwater typically sold its products through value-added resellers (VARs). A VAR was
typically a small local firm that provided sales and support to end users. The value added
by these resellers was that they provided a complete solution to the end user/customer from
a single point of purchase and had multiple information technology products available from
various vendors. Using VARs reduced Clearwater's sales and service expense significantly
and increased its market coverage.

These intermediaries operated in several steps. First, the VAR combined the QTX from
Clearwater with database software from other suppliers to form a turnkey customer solution.
Second, the VAR loaded the software with customer-specific information and linked
it to the customer's existing sales history databases. Finally, the VAR installed the product
at the customer's site and trained the customer on its use. Clearwater sold the QTX to resellers
at a 50 percent discount from the MSRP, allowing the VARs to sell to the end user at
or below the MSRP. The discount allowed the VARs room to negotiate with the customer
and still achieve a profit.

The Upgrade
Initially, the expectation had been that the 30-seat unit would be the largest volume seller.
In order to gain economies of scale in manufacturing, reduce inventory configurations, and
reduce engineering design and testing expense to a single assembly, Clearwater decided to
manufacture only the 30-seat server with the appropriate number of seats "enabled" for the
buyer. Clearwater was effectively "giving away" extra memory and absorbing the higher
cost rather than manufacturing the various sizes. If a customer wanted a 10-seat server, the
company shipped a 30-seat capable unit, with only the requested 10 seats enabled through
software configuration. The proposed upgrade was, in reality, allowing customers to access
capability already built into the product.

Clearwater knew that many original customers were ready to use the additional
capacity in the QTX. Some customers had added seats by buying a second box, but because
the original product contained the capability to expand by accessing the disabled
seats, Clearwater saw an opportunity to expand the product line and increase sales to a
captive customer base. Customers could double or triple their seat capacity by purchasing
either a 10- or a 20-seat upgrade and getting an access code to enable the additional
number of seats. No other competitor offered the possibility of an upgrade. To gain additional
seats from the competitor, the customer purchased and installed an additional
box. Because customers performed a significant amount of acceptance testing, which
they would have to repeat before switching brands, the likelihood of changing brands to
add capacity was low.

The objective of this morning's meeting was to set the price for the two upgrades.
As QTX product manager Rob Erickson stopped to collect his most recent notes from
his desk, he reflected:

What a way to start the week. Every time we have one of these meetings, senior management
only looks at margins. I spent the whole weekend cranking numbers and I'm going in there
using the highest margin we've got today. How can anybody say that's too low?
He grabbed his notes, calculator, and coffee and headed down the hall.
From the other wing of the building, financial analyst Hillary Hanson was crossing the
lobby towards the conference room. She was thinking about the conversation she had late
Number MSRP to VAR Unit Unit
of Seats End User Price Cost* Margin**
10 $8,000 $4,000 $500 87.5%
20 $14,000 $7,000 $700 90.0%
30 $17,250 $8,625 $900 89.6%
TABLE 1
*Unit cost reflects additional $200 for memory capability for each additional 10 seats.
**Margin _ VAR Price _ Unit Cost
VAR Price
Number Original Original Actual Actual
of Seats Unit Cost Unit Margin Unit Cost Unit Margin
10 $500 87.5% $900 77.5%
20 $700 90.0% $900 87.1%
30 $900 89.6% $900 89.6%

TABLE 2
Friday afternoon with her boss, Alicia Fisher, Clearwater's CFO. They had been discussing
this upcoming meeting and Alicia had given Hillary very clear instructions.
I want you to go in and argue for the highest price possible. We should absolutely maximize
the profitability on the upgrade. The customers are already committed to us and they
have no alternative for an upgrade but with us. The switching costs to change at this point
are too high since they've already been trained in our system and software. Let's go for it.
Besides, we really need to show some serious revenue generation for the year-end report to
the stockholders.

Hillary had not actually finalized a number. She figured she could see what the others
proposed and then argue for a significant premium over that. She had the CFO's backing so
she could keep pushing for more.

From the parking lot, Brian James, the district sales manager, headed for the rear entrance.
He, too, was thinking about the upcoming meeting and anticipating a long morning.
I wish marketing would realize that when they come up with some grandiose number for a
new product, sales takes the hit in the field. It's a killer to have to explain to customers that
they have to pay big bucks for something that's essentially built in. It's gonna be even tougher
to justify on this upgrade. At least with the QTX, we have something the buyer can see. It's
hardware. With the upgrade, there isn't even a physical product. We're just giving customers
a code to access the capability that's already built into the machine. Telling customers that
they have to pay several thousand dollars never makes you popular. If you think about it,
that's a lot of money for an access code, but you won't hear me say that out loud. Maybe I
can get them to agree to something reasonable this time. I spent the weekend working this
one out, and I think my logic is pretty solid.

Price Proposals
Once everyone was settled in the conference room, Rob spoke first:
I know we have to come up with prices for both the 10-seat and 20-seat upgrades, but to keep
things manageable, let's discuss the 20-seat price first. Once that number is set, the 10-seat
price should be simple. Because the margin on the 30-seat unit is the highest in the line, I
think we should use that as the basis to the price for the upgrade.

He went to a whiteboard to show an example:
If a customer is upgrading from a 10-seat unit to a 30-seat unit, they are adding two steps of
capacity costing $200 each to us, or $400. $400 /1-0.90 _ $4,000 to the reseller, and $8,000
to the end user. We keep the margin structure in place at the highest point in the line. The
customer gets additional capacity, and we keep our margins consistent.

He sat down feeling pleased. He had fired the first shot, had been consistent with the existing
margin structure, and had rounded up the highest margin point in the line.
Brian looked at Rob's calculations and commented:
I think that's going to be hard for the customer to see without us giving away information
about our margins, and we don't want to do that, since they are pretty aggressive to begin
with. However, I think I have solved this one for us. I've finally come up with a simple, fair
solution to pricing the upgrade that works for us and the customers.
He walked over to a whiteboard and grabbed a marker:
If we assume an existing 10-seat customer has decided to upgrade to 30-seat capability, we
should charge that customer the difference between what the buyer has already paid and the
price of the new capacity. So . . .

New 30-seat unit $17,250
Original 10-seat unit $8,000
Price for 20-seat upgrade $9,250
It's consistent with our current pricing for the QTX. It's fair to the customer. It's easy for the
customer to understand and it still makes wads of money for us. It also is easy for the customer
to see that we're being good to them. If they bought a 20-seat box in addition to the
10-seat box they already have, it would be costing them more.

He wrote:
New 20-seat unit $14,000
A new unit provides customers with redundancy by having two boxes, which they might want
in the event of product failure, but the cost is pretty stiff. Upgrading becomes the logical and
affordable option.

Hillary looked at the numbers and knew just what she was going to do.
That all looks very logical, but I don't see that either of you has the company's best interests
at heart. Brian, you just want a simple sale that your sales people and the customers will buy
into, and Rob, you are charging even less than Brian. We need to consider the revenue issue
as well. These people have already bought from us; are trained on our hardware and software
and don't want to have to repeat the process with someone else. It would take too long.
They've got no desire to make a change and that means we've got them. The sky is really the
limit on how much we can charge them because they have no real alternative. We should take
this opportunity to really go for the gold, say $15,000 or even $20,000. We can and should be
as aggressive as possible.

All three continued to argue the relative merits of their pricing positions, without notable
success. Jefferies listened to each of them and after they finished, he turned to a clean
whiteboard and took the marker.

I've done some more thinking on this. In order to meet the needs of all three departments, there
are three very important points that the price structure for these upgrades must accomplish:

1. The pricing for the upgrades shouldn't undercut the existing pricing for the 30-seat QTX.

2. We want to motivate our buyers to purchase the maximum number of seats at the initial
purchase. A dollar now is better than a potential dollar later. We never know for sure that
they will make that second purchase. If we don't do this right, we're going to encourage
customers to reduce their initial purchase. They'll figure they can add capacity whenever,
so why buy it if they don't need it. That would kill upfront sales of the QTX.

3. We don't want to leave any revenue on the table when buyers decide to buy more capacity.
They are already committed to us and our technology and we should capitalize on that,
without totally ripping them off. Therefore, while Hillary says "the sky's the limit," I think
there is a limit and we need to determine what it is and how close we can come to it.

If we assume that those are the objectives, none of the prices you've put together thus far answers
all three of those criteria. Some come close, but each one fails. See if you can put your
heads together and come to a consensus price that satisfies all three objectives. OK?
Heads nodded and with that, Jefferies left the conference room. The three remaining occupants
looked at one another. Brian got up to wipe the previous numbers off the whiteboards
and said:
OK, one more time. If our numbers don't work, why not and what is the right price for the
20-seat upgrade?