ABSTRACT. Title of Dissertation: STRATEGIC PRODUCT DESIGN FOR RETAIL CHANNEL ACCEPTANCE UNDER UNCERTAINTY AND COMPETITION

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1 ABSTRACT Ttle of Dssertaton: STRATEGIC PRODUCT DESIGN FOR RETAIL CHANNEL ACCEPTANCE UNDER UNCERTAINTY AND COMPETITION Nathan Wllams, Doctor of Phlosophy, 2007 Dssertaton drected by: Shapour Azarm, Professor Department of Mechancal Engneerng A. J. Clark School of Engneerng P. K. Kannan, Assocate Professor Department of Marketng R. H. Smth School of Busness Sgnfcant recent research has focused on the marrage of consumer preferences and engneerng desgn n order to mprove proftablty. However, n many markets, the proftablty of new products for manufacturers s also a sgnfcant functon of the retal channel structure through whch the new products reach the ultmate customer. At the crux of the ssue s the fact that channel domnatng retalers, lke Home Depot, Toys R Us, Wal-Mart have sgnfcant power arsng from ther hundreds of bllons of dollars of sales revenue and have the ablty to unlaterally control a manufacturer s access to the customers. A product desgn methodology s proposed that accounts for ths new and mportant power asymmetry. Manufacturer s product success as defned by proft s affected by prcng at the retal and wholesale levels whch n turn s dependent on the channel structure,.e., retaler monopoly or duopoly. These channel structures are explored n ths dssertaton under an econometrc or game theoretc framework and the results are shown to have mportant mplcatons for desgners. Addtonal nontradtonal consderatons for engneerng product desgn such as bundlng and exclusve

2 contracts whch are typcal for retal channels are also explored by ntegratng marketng models wth a desgn optmzaton structure. Lastly, some desgn methods for mtgatng uncertanty n the strategc landscape of retaler domnated channels are developed. The dssertaton has three research thrusts. Research Thrust 1 s devoted to developng a product desgn optmzaton approach wth retaler acceptance as a probablstc constrant on canddate desgns. Slottng allowances are consdered n concert wth engneerng desgn as complmentary approaches to achevng access to consumer markets. The retaler s decson framework and the desgn optmzaton approach of Thrust 1 are extended n Thrust 2 to nclude compettve prcng responses from both competng manufacturers and channel controllng retalers. In Thrust 2 the mplcatons for product desgn when manufacturers face monopolstc and duopolstc retal channels s explored as well as the desgn mplcatons of an exclusve manufacturer/retaler relatonshp. Fnally, n Thrust 3 the pror thrusts are mplemented for multple product categores and product bundles n order to consder synergy and competton amongst multple complementary desgns. Under ths fnal Thrust 3, an approach to mtgatng the rsk of uncertanty n compettor desgn attrbutes s also developed.

3 STRATEGIC PRODUCT DESIGN FOR RETAIL CHANNEL ACCEPTANCE UNDER UNCERTAINTY AND COMPETITION by Nathan Wllams Dssertaton submtted to the Faculty of the Graduate School of the Unversty of Maryland, College Park n partal fulfllment of the requrements for the degree of Doctor of Phlosophy 2007 Advsory Commttee: Professor Shapour Azarm, Co-Advsor/Char Assocate Professor P. K. Kannan, Co-Advsor (Dean s representatve) Professor Blal Ayyub Assocate Professor Lnda Schmdt Assocate Professor Peter Sandborn

4 Copyrght by Nathan Wllams 2007

5 To My Dear Wfe, Holly

6 ACKNOWLEDGEMENTS Frst and foremost I would lke to express my sncere grattude to my advsors, Dr. Shapour Azarm and Dr. P.K. Kannan. Ther tremendous energy, generosty and patence cannot be overstated. I am especally grateful for ther selfless focus on preparng me for a productve career n academa. I can only hope to provde such wonderful gudance and nspraton to students as I embark on my career. I would also lke to thank Dr. Blal Ayyub, Dr. Lnda Schmdt, and Dr. Peter Sandborn for servng on my dssertaton commttee. Ther gudance and comments have been nvaluable n developng a much more focused presentaton of ths work. Such effort requres sgnfcant sacrfce of tme and energy on ther part and I am extremely grateful. I would lke to thank the U.S. Natonal Scence foundaton for ts partal support of ths work through Grant CMMI Such support does not consttute an endorsement by the fundng agency of the opnons expressed n the paper. Several of my colleagues and mentors should also be noted for ther efforts and advce durng the development of ths dssertaton and nclude: Dr. Genz L, Mr. Vkrant Aute, Dr. Pat Moran, Dr. Denns Hasson, CDR Len Hamlton, Dr. Russ Smth and Dr. Joel Schubbe. In partcular, I d lke to thank Mr. Man L whose selfless ad could always be reled upon. Our collaboraton was the most productve and enjoyable part of the past few years whch I hope we contnue n future endeavors. I would lke to thank my parents and famly (Ben, Wendy, Cheryl, and Wayne) for ther encouragement. Most mportantly, I m ndebted to my wfe, Holly, who has supported me through so many years of school. Her love and understandng has pushed me past the most dffcult tmes wth enough momentum to now fnsh.

7 TABLE OF CONTENTS ABSTRACT... LIST OF FIGURES...v LIST OF TABLES... v NOMENCLATURE... v NOMENCLATURE... v CHAPTER 1: INTRODUCTION MOTIVATION AND OBJECTIVE RESEARCH THRUSTS Research Thrust 1: Engneerng Product Desgn Optmzaton for Retal channel Acceptance Research Thrust 2: Desgn for equlbrum Prcng n Channel Markets Research Thrust 3: Mult-Category Desgn of Bundled Products for Retal Channels Consderng Demand Dependences and Uncertanty n Compettve Response ASSUMPTIONS ORGANIZATION OF DISSERTATION...13 CHAPTER 2: DEFINITIONS AND TERMINOLOGY INTRODUCTION MARKETING AND ECONOMICS DEFINITIONS AND TERMINOLOGIES MULTI-OBJECTIVE GENETIC ALGORITHM (MOGA) SUMMARY...23 CHAPTER 3: ENGINEERING PRODUCT DESIGN OPTIMIZATION FOR RETAIL CHANNEL ACCEPTANCE INTRODUCTION BOTTUM-UP DESIGN FRAMEWORK THE RETAILER S PRODUCT ACCEPTANCE DECISION Computng the Retaler Value Proposton Retal Models wth Slottng Allowances Soluton to the Full Retaler Model Estmaton of Product Demand THE MANUFACTURER S DECSION Parametrc Producton Cost Model The Combned Manufacture/Retaler Model CASE STUDY APPLICATION Marketng Model Example: Angle Grnder Cost Model Example: Angle Grnder Engneerng Model Demonstraton: Unversal motor and Bevel Gears CASE STUDY RESULTS Tradeoffs n Manufacturer s Proft vs. Retaler s Acceptance Slottng Allowance Senstvty DISCUSSION OF APPROACH AND CASE STUDY Implcatons of Customer Preferences and Assortments on Product Desgn Importance of Retaler Acceptance Crtera to Desgn Slottng Allowances: Consderatons for the Frm n Desgn Selecton SUMMARY...70 CHAPTER 4: STRATEGIC ENGINEERING PRODUCT DESIGN FOR MONOPOLISTIC AND DUOPOLISTIC RETAIL CHANNELS...72 v

8 4.1 INTRODUCTION MARKET STRUCTURE AND PROPOSED FRAMEWORK FROM PRODUCT DESIGN TO MARKET SHARE APPROACH TO STRATEGIC INTERACTIONS Prcng Framework Strategc Cases CASE STUDY Optmzaton Approach DISCUSSION OF APPROACH AND CASE STUDY Interpretaton of Manufacturer vs. Retal Profts Comparson of Strategc Envronments: Cases Analyss of Exclusve Strategy Optmal Engneerng Desgns SUMMARY CHAPTER 5: MULTI-CATEGORY DESIGN OF BUNDLED PRODUCTS FOR RETAIL CHANNELS CONSIDERING DEMAND DEPENDENCIES AND UNCERTAINTY IN COMPETITIVE RESPONSE INTRODUCTION APPROACH TO MULTI-CATEGORY DESIGN WITH BUNDLES Layer 1: Dscrete Choce Marketng Model Layer 2: Retal Prcng Model Layer 3: Manufacturng Engneerng and Prcng Model Multdscplnary uncertanty CASE STUDY: CORDLESS ANGLE GRINDER AND RIGHT ANGLE DRILL Nested Logt Demand Model Engneerng Performance Model Case Study Sources of Uncertanty OPTIMIZATION APPROACH RESULTS AND DISCUSSION SUMMARY CHAPTER 6: CONCLUSIONS CONCLUDING REMARKS Engneerng Product Desgn Optmzaton for Retal Channel Acceptance Strategc Engneerng Product Desgn for Monopolstc and Duopolstc Retal Channels Mult-Category Desgn of Bundled Products for Retal Channels Consderng Demand Dependences and Uncertanty n Compettve Response MAIN CONTRIBUTIONS FUTURE RESEARCH DIRECTIONS Improvements n the Retaler Acceptance Crteron Improvements n Strategc Interactons Product Lne Formulaton APPENDIX APPENDIX A APPENDIX B - PROOFS B.1 Preparatory Materal B.2 THEOREM 1 Retalers multproduct Nash equlbrum B.3 Theorem 2 Manufacturer s sngle product Nash equlbrum APPENDIX C: COMPUTATIONAL ISSUES REFERENCES v

9 LIST OF FIGURES Fgure 1.1.1: Product Desgn for Domnant Retalers wth Competton... 7 Fgure 1.2.1: Desgn Consderatons for Retal Channels... 9 Fgure 1.4.1: Organzaton of Dssertaton Fgure 2.3.1: Flowchart of MOGA n One Generaton Fgure 2.3.2: Solutons to Mult-Objectve Problem Fgure 3.2.1: The Bottom Up Framework Fgure 3.5.1: 4.5 Angle Grnder Commonly Used for Masonry and Metal Work Fgure 3.5.2: Engneerng Components Fgure 3.6.1: Proft vs. Probablty of Acceptance (%) Fgure 3.6.2: Effect of Slottng Allowance Fgure 4.2.1: Strategc Desgn Framework Fgure 4.3.1: Product Desgn to Market Share Fgure 4.4.1: Prcng Framework Fgure 4.5.1: Optmzaton Formulatons Fgure 4.6.1: Strategc Envronment Comparson Fgure 4.6.2: Exclusve Channel Comparson Fgure 5.2.1: Mult Layered Desgn Framework Fgure 5.2.2: Dscrete Choce Desgn for Product Bundlng Fgure 5.2.3: Retaler Prcng Layer Fgure 5.2.4: Manufacturer's Bundle Desgn Framework Fgure 5.2.5: Nested Optmzaton Fgure 5.2.6: MORO: Robust Optmzaton Fgure 5.2.7: Robust Optmzaton Topology Fgure 5.3.1: Desgn Varables Fgure 5.5.1: Robust/Nomnal Pareto Comparson Fgure B1: Lemma Fgure C1: MNL Proft Functon v

10 LIST OF TABLES Table 1.1.1: Domnatng Retaler Profts... 3 Table 3.5.1: Utlty Estmates for Four Segments Table 3.5.2: Example Segment Share Table 3.5.3: Engneerng Desgn Varables Table 3.5.4: Unversal Motor Desgn Computatons Table 3.5.5: Bevel Gear Desgn Computatons Table 3.5.6: Grnder Constrants g(x) Table 3.5.7: Customer Level Product Attrbutes y Table 3.6.1: Example Market Share Table 3.6.2: Prevous and New Product Development (NPD) Comparson Table 3.6.3: Pareto Fronter of Desgns Table 4.5.1: Example Assortment at a Retaler Table 4.6.1: Desgns for Monopoly Retaler Table 4.6.2: Desgns for Duopoly Identcal Retalers Table 4.6.3: Desgns for Duopoly Dfferentated Retalers Table 4.6.4: Desgns for Exclusve Case (Identcal Duopoly) Table 4.6.5: Pareto Desgns Table 5.3.1: Grnder and Drll Category Utltes Table 5.3.2: Bundle Category Utltes Table 5.3.3: Cordless Tool Mass Computatons Table 5.3.4: Common Constrants Table 5.3.5: Grnder and Drll Performance Constrants Table 5.5.1: Sample of Optmal Desgns v

11 NOMENCLATURE Slottng allowance ($) A Swtchng cost threshold ($) b Producton cost of the th product ($)* C Cost of goods (producton costs) ($) COG Cost of merchandse ($) COM Objectve functons f Norm-nverse functon F -1 Gross margn (%) GM Engneerng constrant g(x) b Product ndex for an n product assortment =1,2,..n Category ndex l=1,2,..l,b Overall market share of the th product (unts)* m Market share of the th product n segment k (%)* m k Manufacturer s Suggested Retal Prce ($) MSRP Market sze (unts) N Nest Mult-Nomal Logt functon NMNL New Product Desgn/Development NPD Retal prce ($) of the th product* at retaler r P r Market segment sze (%) S k Total product utlty for a product n segment k* U k Utlty for attrbute j of product n segment k* u jk Wholesale prce ($) of the th product* W Weght Adjusted Cost of Captal (%) WACC Engneerng desgn varables x Customer level product attrbutes* y Number of Monte Carlo teratons Z Probablty of retaler acceptance (0%-100%) α Mean market share* µ Retaler s proft on new assortment ($)* π N Retaler s proft on pror assortment ($)* π O Proft of Retaler r on product ($)* π r Proft of manufacturer on product ($)* Π Standard devaton of market share* σ Market penetraton (%) Ф Value proposton ($)* Ψ * Functons of engneerng desgn varables v

12 CHAPTER 1: INTRODUCTION Ths dssertaton presents new methods for ntegratng engneerng desgn optmzaton wth marketng and strategy models n the consderaton of a major force n the modern retal market: the channel domnatng retaler. The methods proposed mprove upon exstng methods by ncorporatng the retaler s ablty to control and even possbly deny market access to manufacturer products by vrtue of ther consoldated poston. Includng ths externalty (the retaler) provdes a more realstc product desgn context. Addtonally, the product desgn optmzaton context s enrched through the proposed methods by allowng retalers and manufacturers to prce products strategcally n response to any ntroducton of a new desgn. The mpact of tghtly controlled channels (by retalers) s the overarchng theme for ths dssertaton and several methodologes and analyses are developed to address new desgn and marketng practces relevant to ths type of market. The dssertaton nvolves three research thrusts. In research Thrust 1, a desgn methodology that accounts for the common practce of payng a retaler a fxed fee (slottng allowance) to guarantee shelf space s developed. Ths analyss s performed under statc compettor prces (.e., retal and wholesale prces are assumed statc). In research Thrust 2, an approach s presented that accounts for the strategc prcng of compettor products n response to any desgn ntroducton whch allows desgners to consder strategc response n advance of ntroducng any desgn. Usng ths approach, the mpact of retaler characterstcs (desrablty to certan consumer segments) and the possblty of usng one retaler exclusvely as a channel partner are evaluated wth respect to optmal desgns. Fnally, n research Thrust 3 the smultaneous desgn of multple products and product bundles 1

13 competng across categores for market share s consdered. In ths fnal approach, the prmary focus s on the strategc desgn of product bundles for greater proftablty but addtonally uncertanty n compettor strategy, cost models, and even desgn attrbutes s consdered as a prelmnary nvestgaton nto desgn for uncertanty n retal channels. 1.1 MOTIVATION AND OBJECTIVE Engneerng desgn s the foundaton for product desgn. Engneerng desgn decsons are ultmately realzed n products as attrbutes and features that are mportant to customers and the retalers who carry the products. The realzaton that the decson for many of these attrbutes and features are made early n the desgn stage and are prohbtvely costly to change n order to mprove the marketablty of the product, has led engneerng desgn to focus on customer preferences n addton to the conventonal engneerng crtera. To that end, many approaches have been developed n recent years to collect and ntegrate customer preferences n the early stages of desgn n order to develop market-focused products. However, a new force has emerged n the modern marketplace that requres addtonal consderaton: the domnant retaler. Consoldaton n the retal market has created some of the world s largest corporatons that control n excess of 70% of many markets (Cappo, 2003) thereby controllng the access manufacturers have to the consumer market. In some cases, retalers have even become prncpal buyers for a suppler s or manufacturer s entre product lne (Smth, 2002, Useem et al., 2003; Dukes et al., 2006). In effect, the Bg-Box retalers such as Wal- Mart and Home Depot are gatekeepers to consumer markets and the manufacturer s success depends on convncng retalers to carry ther products (Bounds, 2006). In fact 2

14 accountng for just 7 select retaler revenues revealed a total revenue n excess of $562 Bllon n 2006 (see Table 1.1.1) (Annual Reports, 2006). Retaler Revenue ($B) Wal Mart $313 Home Depot $91 Target $60 Lowes $43 Best Buy $31 Crcut Cty $12 Toys R' Us $12 Total $562 Table 1.1.1: Domnatng Retaler Profts Ths revenue total s nearly 4% of the U.S. gross domestc product and hgher than the 2007 U.S. Department of Defense Budget of $502 Bllon (GPO, 2006). Whle these fgures convey the consoldated nature and sheer sze of modern retalers they do not express the drastc power shft from manufacturers to retalers. As lttle as 30 years ago, the majorty of retal products were sold through small local retalers frequently referred to as Mom and Pop stores (Boyd, 1997). U.S. census data (U.S. Census, 2002) reveals that the number of retal establshments s contnually dwndlng and fell by 800,000 establshments to 1.1 mllon establshments between 1972 and Consderng a populaton ncrease of 50% durng that same perod the number of retalers per person has declned by 60% snce Not surprsngly, the revenue per establshment also supports ths consoldaton trend: $650K/establshment n 1972, $1.1M/establshment n 1992 and $3M/establshment n 2002 (controlled for nflaton). Further evdence of ths power comes from the fact that multnatonal chans of stores have become commonplace as the rate of chan store openngs contnues to ncrease. In the early 1960s the number of Wal-Mart stores numbered less than 15 whle today they 3

15 amount to over 6,600 stores nternatonally. Smlarly, Crcut Cty and BestBuy now operate over 1,500 and 750 stores respectvely (Annual Reports, 2006). Lastly, ths power shft s mportant because for most of the 20 th century the manufacturers capable of developng and dstrbutng products were the larger of the two partes nvolved n the retal channel (manufacturer and retaler) and could n effect push products on retalers. One need not search too hard to observe the reversal of ths relatonshp. Examples of retalers greatly overshadowng manufacturers nclude Home Depot s $91 Bllon n revenue vs. $6.5 Bllon for ts largest power tool suppler or Toys R Us $12 Bllon vs. Mattel s less than $5 Bllon (Annual Reports, 2006). Manufacturers are already forced to take ths retaler power nto account n the area of prcng and marketng. In ths dssertaton, the retaler focus s extended to an overall product desgn approach n the belef that manufacturers should be proactve n ther engneerng desgn consderatons as they prce and market ther products. Retalers are prmarly nterested n vastly dfferent metrc than the manufacturers such as revenue per square foot versus the proft of a specfc product offerng. Logcally, a retaler wll only carry those products that maxmze overall category proft. For example, Home Depot wll only carry the fve out of twenty avalable drlls that generate the greatest revenue for the drll category. Ths revenue depends on the compettve envronment (e.g., prces at Lowes), preferences of customers toward the assortment of drlls carred at Home Depot, and the accessores that are avalable for the drlls. The retaler puts together these assortments and accessores n such a way to maxmze the chances that customer wll buy a product (and spend more) on any vst to the store. Gven that the retaler s shelf space s lmted, manufacturers have to carefully 4

16 consder (1) the attrbutes and features of ther product vs-à-vs the assortment the retaler carres, (2) the strategc envronment of the retaler (monopoly, duopoly, olgopoly, exclusve contract etc.), (3) the possble bundle of the product and the accessores, and (4) uncertanty n parameters supportng the desgn selecton, all at the early desgn stage. In consderng the gate-keeper role of retalers and the compettve products and ther desgns, a product desgner cannot afford to take a myopc perspectve n the desgn decsons by consderng only hs/her desgn and ts mpact on the market. Because engneerng desgn decsons determne product cost and attrbute postonng at the foundaton of the development process t s logcal to conclude that engneerng decsons are transmtted to compettors and retalers as strateges to whch they are forced to counteract. For example, just as a manufacturer consders retalers assortment, proft crtera, and compettors exstng products n desgnng a new product, other compettors may antcpate ths strategy and make ther own move to nfluence the retaler. They mght, for example, reduce ther wholesale prces to the retalers to make the retaler margns more attractve. Or they may offer some addtonal features to ther products to make them more appealng to retalers as well as consumers. Retalers, on the other hand, may also consder such strategc maneuvers n new product offerngs and wholesale prces to make ther own assortment decsons. Thus, these counteractons leadng to a game of moves and countermoves n the marketplace call for the manufacturer to be strategc n ther desgn decsons that s, make desgn decsons by antcpatng the moves of the compettors and retalers so that when the market s n equlbrum, none of the compettors or retalers have any ncentve to 5

17 change the status-quo. Ths dssertaton seeks to ntegrate the strategc decson perspectve wth desgn engneerng and marketng n a quanttatve manner. The strategc desgn of the frm depends upon the projected market share of a new product offerng as well as manufacturng costs estmated n the engneerng phase consderng the antcpated moves of competton and the retalers. Marketng reles upon engneerng desgn to produce customer desred product attrbutes. Engneerng desgn s charged wth the complex task of developng products for uncertan customer preferences and compettve envronments. Last but not least, uncertanty arses n many forms n product desgn. Tradtonally, engneerng desgn has focused on uncertanty n desgn parameters, customer usage and more recently customer preferences. Gven the aforementoned lack of attenton to strategc consderatons and domnant retalers t should come as no surprse that uncertanty n compettor responses and channel controllng retalers have not been addressed. Ths uncertanty can arse from lack of knowledge about compettor or retaler assessments of: equlbrum prcng strateges, customer segment preferences, compettor costs (fxed and varable), compettor s or retaler s averson to rsk or exstence of future compettor offerngs. Ultmately, the manufacturer would lke to mtgate rsk from uncertanty and explot opportuntes presented by the strategc envronment. Ideally a manufacturer s decson makng approach (See Fgure 1.1.1) would smultaneously: Maxmze the chance of the product beng selected by the domnant retalers Maxmze hs/her own proft under strategc/compettve wholesale and retal prce responses 6

18 Reduce the uncertanty n the projected proft propagated from uncertantes n compettor strateges, customer preferences, demand fluctuatons and cost projectons. None of the current desgn methodologes reported n the lterature account for the gate-keeper role of the retaler or the strategc nteractons nherent n a channel envronment whle desgnng a product for success. The focus of ths dssertaton s on addressng ths gatekeeper role usng the objectves lsted above as overarchng goals for any method developed. Customer Product Selecton Retaler Competton Lmted Shelf Space Manufacturer Competton Product Flow Target Market Engneerng Desgn Costs Desgn Engneer Fgure 1.1.1: Product Desgn for Domnant Retalers wth Competton 1.2 RESEARCH THRUSTS There are three man concerns (See Fgure 1.2.1) that a manufacturer faces when developng products for retaler markets whch wll make up the thrusts of ths dssertaton. Frst the manufacturer must ensure that the product makes t to market and 7

19 therefore must have a tractable approach for predctng the retaler s acceptance decson (Research Thrust 1). Second, responses of compettors wll affect the proftablty of the retalers and the focal manufacturer. Realzng ths, n Research Thrust 2 an econometrc approach to accountng for compettve response at retal and wholesale levels wll be ntegrated nto the basc framework developed n Research Thrust 1. Thrusts 1 and 2 only consder strategc and desgn nteractons wthn one product category. In Thrust 3, the very common retal practce of bundlng complmentary products (e.g., two dfferent tools) from dfferent product categores to compete n multple product categores s explored. Addtonally, ths thrust mplements an ntal nvestgaton of the mportant elements of uncertanty n the channel envronment. 8

20 Research Thrust 1: Access to Customers and Customer Preferences Retaler Research Thrust 3: Mult-Category Desgn (Investgaton of product bundlng under uncertanty) Whch Product Desgn? Research Thrust 2: Compettve/Strategc Prcng Cost Demand Fgure 1.2.1: Desgn Consderatons for Retal Channels RESEARCH THRUST 1: ENGINEERING PRODUCT DESIGN OPTIMIZATION FOR RETAIL CHANNEL ACCEPTANCE An approach to modellng the mportance of product acceptance by a domnant retaler wll be nvestgated. Ths foundatonal effort wll assume that competng manufacturers do not have the capablty to change ther wholesale prces or product attrbutes n the near term, although the effects of competton wll be addressed n subsequent chapters. The purpose of the thrust wll be to provde a manufacturer wth a decson framework under whch engneerng desgn varables can be optmzed for proft 9

21 whle smultaneously ensurng that the domnant retaler remans as proftable or more proftable (ndcatng a hgh probablty of acceptng the new product by the retaler). The approach wll endogenze the uncertanty n market segment s preferences through a bottoms-up 1 transformaton of determnstc engneerng desgn varables to customer relevant product attrbutes. Ths s mportant because the value placed by each customer segment on each product attrbute s uncertan and drectly affects the decson framework of the rsk-averse retaler RESEARCH THRUST 2: DESIGN FOR EQUILIBRIUM PRICING IN CHANNEL MARKETS In the short term, a prce change s the only strategc move that s possble for a compettor (.e., a desgn cannot change overnght for a compettor). However, the prces are fxed for two quarters to several years. Strategc moves are analyzed n the context that equlbrum s reached where none of the compettors (at the wholesale and retal level) can be made better off by changng ther prce. Ths equlbrum prcng wll ultmately affect the proftablty of the retalers and manufacturers. As such, a methodology s proposed that allows a manufacturer to predct both retal and wholesale prce equlbra that result from engneerng desgn decsons. The manufacturer s equlbrum proft s proposed as a substantally mproved engneerng optmzaton objectve as t more accurately reflects realty. Several cases are nvestgated that 1 Bottoms-up refers to the selecton of specfc engneerng varables that when aggregated at the hghest level result n quantfable customer level product attrbutes. Ths approach s dstnct from the extant lterature where attrbutes are selected at the hghest level before engneerng takes place (see e.g., Luo et al., 2007). 10

22 hghlght the mportance of: (1) monopolstc retalers, (2) duopolstc retalers, (3) customer preferences for dfferent retalers, (4) and the possblty of exclusve contracts (whch are prevalent for many retalers) RESEARCH THRUST 3: MULTI-CATEGORY DESIGN OF BUNDLED PRODUCTS FOR RETAIL CHANNELS CONSIDERING DEMAND DEPENDENCIES AND UNCERTAINTY IN COMPETITIVE RESPONSE One prevalent approach to ncreasng both retaler and manufacturer revenues s to mprove the attractveness of a product offerng (to end customers) by bundlng related tems together for one prce. To be most effectve, bundled products should be developed wth an ntegrated desgn approach that seeks to acheve synerges of value for the end customer as well as cost effcences through measures such as usng common parts. Gven these mportant nteractons, a bundled product desgn approach s developed that takes nto account strategc reactons (prce changes) of retalers across the bundled and unbundled product categores and accounts for demand dependences between bundled and unbundled goods. Addtonally, there exsts poorly defned uncertanty n terms of competng manufacturer product attrbutes, customer preferences, and even engneerng desgn tolerances for many product categores. To mtgate the rsk of these multdscplnary uncertantes a robust desgn approach s mplemented n a novel manner to ensure acceptable product proftablty and market share under a range of uncertan possbltes. A bundled product desgn case study s presented for two complmentary power tools that offer a synergy n value. Manufacturer proft and market share are optmzed both determnstcally and under ntervals of uncertanty (robust optmzaton) surroundng compettor actons, cost models and engneerng parameters. 11

23 1.3 ASSUMPTIONS In developng the desgn approaches n ths dssertaton, a few assumptons are made that are common to each of the research thrusts: Frms have multple competng objectves that are, to a large extent, functons of engneerng desgn varables. Foremost, a frm wshes to maxmze proft but addtonally a frm may wsh to maxmze market share or the proftablty of ts channel partners. These objectves are usually competng and therefore canddates for mult-objectve optmzaton. Durng game theoretc or econometrc prce settng t s assumed that strategy sets of each compettor are known to all compettors and that players (retaler and manufacturers) are ratonal, strategc and exhbt foresght. Ratonalty mples that decson makers attempt to maxmze utlty (Osbourne and Rubnsten, 1994). Maxmzng utlty for game players (retalers and manufacturers) wll generally mean maxmzng proft. Frms are rsk averse and value the ablty to choose less rsky alternatves. Akn to some nvestors preferrng hgh yeld rsky stocks and others preferrng the 10 year treasury, t s assumed that frms are not merely rsk neutral (.e., wantng to maxmze expected value). Each frm can have a dfferent rsk tolerance or preference. As such, analyses are presented to show the tradeoff between predcted proft and a rsk metrc. Frequently, n ths dssertaton, rsk s quantfed n terms of desgn rejecton by the channel controllng retaler. 12

24 1.4 ORGANIZATION OF DISSERTATION The dssertaton s organzed n a sequental fashon as presented n Fgure Chapter 2 provdes termnology and nomenclature common to the rest of dssertaton as well as background nformaton on tools such as Multple Objectve Genetc Algorthm (MOGA). The ntal analyss of the decson makng by channel domnatng retalers s made n Chapter 3. Ths chapter provdes an approach to desgn optmzaton assumng that retalers wll only accept products that relably mprove proftablty (Thrust 1). It also assumes other retalers and manufacturers do not change ther wholesale and retal prces. In Chapter 4 addtonal layers of complexty are added to the modelng process by allowng manufacturers and retalers to alter prces n response to any new desgn offered by the focal manufacturer. The goal of ths effort s to understand how compettors wll react to a presumably strong new desgn entrant. A strategc or game theoretc framework s developed n Chapter 4 that allows these prcng reactons to take place (Thrust 2) and be accounted for durng desgn optmzaton. Chapters 3 and 4 analyze optmal desgn for the retal channel but for one product category only. Chapter 5 extends the effort to multple product categores and ncludes an analyss and case study of product bundle desgn optmzaton for retal channels. As shown n Fgure uncertan modelng parameters are consdered n Chapters 3 and 5 whle Chapter 4 s determnstc. Smlarly, compettve prcng s only consdered n Chapters 4 and 5 wth the greatest emphass on multlayered strategc prcng n Chapter 4. In each chapter a multdscplnary case study s presented that demonstrates the approach. Fnally, n Chapter 6 conclusons about the work are presented and comments about contrbutons of the dssertaton are made along wth optons for future research. 13

25 Fgure shows the organzaton and flow of nformaton n ths dssertaton. Chapter 1 Introducton; Motvaton and Objectves; Research Thrusts; Assumptons Chapter 2 Defntons and Termnology Non-Strategc Prcng Chapter 3 Probablstc Desgn for Retal Channel Acceptance wth Statc Compettor Prcng Strategc Prcng Response Consdered Chapter 4 Strategc Engneerng Product Desgn For Monopolstc and Duopolstc Retal Channels Chapter 5 Mult-Category Desgn of Bundled Products for Retal Channels Consderng Demand Dependences and Uncertanty n Compettve Response Channel Uncertanty Consdered Chapter 6 Conclusons Man Contrbutons Future Research Fgure 1.4.1: Organzaton of Dssertaton 14

26 CHAPTER 2: DEFINITIONS AND TERMINOLOGY In ths chapter, several defntons and termnologes are provded to facltate understandng of the multdscplnary envronment that s the focus of ths dssertaton. Marketng and economcs defntons that may not be well known n the engneerng communty are dscussed n Secton 2.2. In Secton 2.3, Multple Objectve Genetc Algorthms (MOGA) are descrbe to facltate understand of Chapters 4 and 5 where a MOGA s used extensvely. 2.1 INTRODUCTION In the past, engneerng and marketng practtoners have been accused of each operatng n a vacuum. Although there have been several methods put forward to ntegrate engneerng and marketng, none have specfcally address the growng power of the retaler. Ths ssue s addressed n the present dssertaton. Due to the crossdscplnary nature of the problem we provde ntroductory defntons and termnologes n Secton 2.2. Addtonally, less common defntons related to decson makng and robust optmzaton are presented n Secton 2.2. An overvew of MOGAs s also presented n ths chapter as one of the preferred methods for solvng non-convex problems wth dscrete desgn varable nputs. Addtonally, MOGAs are capable of handlng multple objectves clearly very realstc gven the sales and proft targets smultaneously pursued by most frms. Solvng such mult-objectve problems generally yelds and optmal set of solutons (Pareto fronter) whch s dscussed. In ths chapter we focus on the detals of MOGA computatons and demonstrate ts usefulness n subsequent chapters for solvng multdscplnary problems. 15

27 2.2 MARKETING AND ECONOMICS DEFINITIONS AND TERMINOLOGIES A few terms from the marketng and economcs lterature are used throughout ths dssertaton that t may be useful to defne: Assortment - For ths work an assortment s defned as the products wthn a product famly offered to consumers by the retaler (e.g., the 5 handheld angle grnders n the angle grnder product category at Home Depot) (Kotler, 2002). Bundle The sale of two or more dfferent products or servces as a package. Bundlng can occur wth varyng levels of ndependences between products. Product bundlng has sgnfcant dependency whle prce bundlng does not. Product bundlng requres sgnfcant foresght as the desgns of the two or more products must perform well together to create any demand synergy. In offerng a bundle to a retaler the manufacturer should be mndful that the offerng wll lkely cannbalze from two dfferent product categores. Cannbalzaton When a vendor ntroduces a new product that decreases demand for an exstng product of the same vendor cannbalzaton of the exstng product occurs (Kotler, 2002). Channel A channel s a condut by whch goods or servces are transferred from the producer to the customer (Coughlan, 2001). For ths dssertaton, retal channels are explored where manufacturers use ntermedares (retalers) to transfer ther goods to customers. 16

28 Choce (Demand) Model Choce or demand models predct the demand for a product for a partcular market or segment through the comparson of ts utlty to all other products avalable n the assortment (competng products) (Lourvere et al., 2004). Conjont Analyss A methodology for utlty functon estmaton that reles on the comparson of hypothetcal product profles by potental customers. The results of customer scorng, rankng or ratng of the profles are evaluated wth a statstcs package to estmate utlty for ndvdual attrbutes of a product whch can n turn be used to obtan the overall utlty for all attrbutes and based on choce model used to desgn or poston a product (Green and Srnvasan, 1990). market. Duopoly a specal type of olgopoly where only two producers exst n one Exclusve (exclusve channel) a strategy where a manufacturer uses only one reseller or retaler for hs products (Moner-Coloques, 2006). Games or Game theory refers to a broad array of mcroeconomc technques used to analyze nteractons amongst decson makers (Osborne and Rubnsten, 1994). In ths dssertaton competton for proftablty of frms s modeled as game amongst non-cooperatve players. That s, players do not form coaltons are collude to rase prces but rather compete to maxmze ther ndvdual proftablty. Thus we are nterested n non-cooperatve games. Addtonally, the games are modeled under the assumpton of perfect nformaton. Perfect nformaton mples that that all players know the state of nature. For example, all manufacturers and retalers know the preferences of customers wth certanty. Addtonally, perfect nformaton mples that all players know that the other players know the state of nature (consumer market n our case) and vce versa. 17

29 Monopsony A sngle customer exsts for a servce or product. Ths s smlar to the stuaton where a sngle producer or manufacturer exsts (e.g., monopoly). No Choce Opton The no-choce opton s the opton for customers to choose to not purchase any of the competng products. It s ncluded wth a utlty value for the nochoce opton n the demand model (Lourvere et al., 2004). Nomnal Optmum An optmal value for a determnstc (.e., wthout uncertanty) optmzaton problem. Olgopoly a market wth only a few compettors (Vves, 1999). Prce Equlbrum A prce equlbrum s reached when none of the players (compettors) has an ncentve to change ther product s prce: commonly referred to as a Nash equlbrum. A Nash equlbrum s a wdely accepted soluton to compettve games that makes no clam about how the soluton s reached only that t s a soluton reached by ratonal decson makers takng nto account the objectves of hs/her opponent. A Nash equlbrum exsts under the compettve crcumstances frequently encountered by manufacturers and retalers. In games where the player s proft functons are assumed to be contnuous and twce dfferentable n prce t s suffcent to say that a Nash equlbrum exsts f the proft functons for each player are quas-concave n ownprce (Osborne and Rubnsten, 1994). Many proft functons exhbt quas-concavty and for the basc cases of the logt choce model t has been proven that quas-concavty exsts (Anderson et al., 1992). Ratonal Decson Maker A ratonal decson maker s one that s aware of hs alternatves, forms expectatons about unknowns (e.g., compettor prcng), has clear 18

30 preferences (e.g., prefers more proft to less) and chooses hs acton delberately after some process of optmzaton. Robust Optmum A robust optmum (for a maxmzaton problem) for ths dssertaton wll assume the defnton that t s a desgn that wth the hghest value that does not vary outsde of an acceptable objectve varaton range when the uncontrollable (or uncertan) parameters are consdered. For ths approach a decson maker must specfy the acceptable varaton range. See L et al. (2006) for full mplementaton detals. Slottng Allowance - A slottng allowance s a fxed payment to a retaler by a manufacturer that entces the retaler to carry a product. Ths payment offsets the retalers rsk n commttng shelf space to a product wth uncertan demand (Larvere and Padmanabhan, 1997), (Sudhr and Rao, 2006). Segments Frequently consumers have heterogeneous preferences as an entre market yet can be grouped n to several groups or segments wth sgnfcant nternal homogenety (Kamakura and Russell, 2003). Segments have utlty functons that are dstnct from one another whch provdes an opportunty for ncreased accuracy n estmatng demand. For example, one segment of consumers may prefer heavy products for ther perceved robustness whle another segment mght prefer lght products for moblty. If one just averages the two segment preferences the two extremes (heavy and lght) could have equvalent utlty whch cannot provde nsght as to whch attrbute to desgn toward (heavy or lght). In contrast, ths s not a problem f dstnct segment utlty functons are used. For example, when three products already exst n the heavy product segment the desgner wll be able to automatcally dentfy the greater 19

31 proftablty of the lght segment whch s underserved (fewer products wth the lght attrbute exst). Utlty Utlty s a measure of satsfacton that one derves from a good or servce (Von Neumann and Morgenstern, 1944). Value Proposton The added beneft of a seller s product relatve to the next best alternatve (Kotler, 2002 or Donaldson et al., 2006). The value proposton made by a manufacturer to a retaler would be the mproved proft for the retaler resultng from the mproved product attrbutes. From the retaler s perspectve an acceptable value proposton would result n a greater retaler proft by ncreasng the retaler s overall market share or by reducng wholesale cost. 2.3 MULTI-OBJECTIVE GENETIC ALGORITHM (MOGA) MOGA s an optmzaton technque capable of optmzng two or more objectves, f, at one tme. It has the desrable property of beng capable of globally optmzng non-convex problems wth or wthout dscrete desgn varables (Deb, 2001). MOGA wll be used n chapters 4 and 5 to smultaneously optmze proft and market share objectves for the focal manufacturer. Lke all genetc algorthms, the MOGA s populaton based n that t starts wth an ntal set of desgns (or a populaton) whch are successvely altered based on a strategy untl the best populaton s found. As shown n Fgure our MOGA mplementaton proceeds through a few smple steps. Frst, desgn varables are generated as canddates to make up the frst populaton. These desgn varables are encoded and concatenated as bnary strngs for each nstance of desgn varables or ndvdual that s a member of the populaton. Each ndvdual s evaluated by an objectve functon call. Ths s referred to as smulaton n Fgure

32 Once the objectve values are known for the populaton the ndvduals can be ranked n terms of performance. Ths s known as ftness assgnment or evaluaton whch s performed usng a non-domnated sortng algorthm (NDSA) (Deb, 2001). Consder Fgure whch s the mnmzaton of two objectves f 1 and f 2. Usng NDSA, the purple dots are ranked lower (better) than all blue dots. Essentally, the algorthm ranks lowest (best) the desgns that no other desgn can clam to be better wth respect to all objectves. The best ranked ponts are removed from the populaton and the NDSA s run repeatedly untl all ponts are ranked. Each tme the NDSA loops through the populaton the rank ndex ncreases by one whch means successve desgns are ranked (worse) as they are selected by the NDSA. Once all ponts are ranked ftness assgnment or evaluaton s complete. In the next two steps (Fgure 2.3.1) after ftness assgnment a new populaton s created. One approach (as employed n ths dssertaton s MOGA) s to partton the current populaton n to domnated and non-domnated desgns. The non-domnated desgns and possbly more low ranked desgns are coped to elte fractonal space of the populaton to preserve the best members of the current populaton. The remanng populaton members are generated usng mutaton or crossover functons wth non-domnated and domnated desgns as parents. Ths mutaton (flppng chromosome bts) and crossover procedure (swappng bnary chromosome sectons) guarantees that some offsprng retan some of the non-domnated parent s chromosome and can even mprove upon the parent s performance dependng on the outcome of the mutaton. Snce the process s random t s also possble to have two domnated parents mate and create non-domnated offsprng. 21

33 Once the new populaton s developed and sent back to the smulaton stage for evaluaton one generaton has passed. The process s repeated untl a stoppng crteron s met. The stoppng crtera can be a number of generatons or a geometrc evaluaton of whether the Pareto Fronter (best ranked desgns) s stll gettng better relatve to a reference poston n objectve space. The approach s mplemented n Matlab s genetc algorthm toolbox (Matlab, 2007) and uses the feasble over nfeasble approach (Deb, 2001) for constrant handlng. That s durng ftness evaluaton nfeasble desgns are ranked worse than all feasble desgns regardless of ther objectve functon performance. Code desgns Current populaton of desgns Smulaton Ftness evaluaton Non-domnated desgns Domnated desgns Next populaton of desgns Elte desgns Offsprng Fgure 2.3.1: Flowchart of MOGA n One Generaton 22

34 f 2 f 1 Fgure 2.3.2: Solutons to Mult-Objectve Problem 2.4 SUMMARY Ths chapter has provded an ntroducton to background economcs and marketng materal that may not be famlar to some engneers. These defntons wll be used throughout subsequent chapters n the development of our multdscplnary approach. Addtonally, MOGAs were descrbed brefly because they are used extensvely n Chapters 4 and 5 to deal wth multple objectves smultaneously. MOGAs are also deal for solvng dscontnuous objectve functons wth dscrete desgn varables such as those frequently encountered n product desgn. In the next chapter the channel desgn optmzaton problem wll be tackled consderng uncertanty n end customer preferences but wll be lmted non-strategc competton n terms of wholesale and retal product prcng. That s prces are developed from a frm level analyss of margns rather than a game theoretc approach as presented n Chapter 4. 23

35 CHAPTER 3: ENGINEERING PRODUCT DESIGN OPTIMIZATION FOR RETAIL CHANNEL ACCEPTANCE Sgnfcant recent research has focused on the marrage of consumer preferences and engneerng desgn n order to mprove proftablty. The extant lterature has neglected the effects of marketng channels whch are becomng ncreasngly mportant. At the crux of the ssue s the fact that channel domnatng retalers, lke Wal-Mart, have the ablty to unlaterally control manufacturer s desgn decsons as gatekeepers to the consumers or market. In ths chapter, we propose a new methodology that accounts for ths power asymmetry and wll be used by all subsequent chapters. A chance constraned optmzaton framework s used n ths chapter to model retaler acceptance of possble engneerng desgns and accounts for the mportant effect on the proftablty of the retaler s assortment through a latent class estmaton of demand from conjont surveys. The approach allows the manufacturer to optmze a product desgn for ts own proftablty whle relably ensurng that the product wll make t to market by makng the retaler more proftable wth the addton of the new product to the assortment. As a demonstratve example, we apply the proposed approach for product desgn selecton n the case of an angle grnder. For ths example, we analyze the market and are able to mprove expected manufacturer proftablty whle smultaneously presentng the desgner wth tradeoffs between slottng allowances, market share, and rsk of retaler acceptance. Secton 3.1 provdes the ntroducton and motvaton for desgnng for retal channel acceptance along wth a revew of the extant research of ntegrated engneerng and marketng desgn models. An overvew of the framework that s used to tackle the 24

36 problem multdscplnary problem s provded n Secton 3.2. Sectons 3.3 and 3.4 model the decson crtera of the retaler and manufacturer respectvely whle Secton 3.5 provdes a demonstraton example that wll be used throughout ths dssertaton. Secton 3.6 provdes analyss and dscusson of the approach and conclusons are provded n Secton INTRODUCTION Manufacturers have tradtonally focused on consumers preferences as a strategc gudng lght for desgnng successful products. The recent development of the superstore and strong retal channels has rendered ths consumer-centrc paradgm somewhat nadequate. In an expose (Frontlne, 2004) of Wal-Mart busness practces the queston was asked Is Wal-Mart good for Amerca? To answer ths queston one must delve nto the changes brought about by massve consoldaton of retal storefronts by companes lke Wal-Mart, Target and Home Depot. The changes are sweepng to say the least. One salent example exsts n the lawnmower product category: Amercans now buy more than 8.5 mllon push and rdng lawn mowers a year and they buy more than 70% of them at Wal-Mart, Home Depot, and Lowes. Just twenty years ago 80 percent of lawn mowers were sold at ndependent retalers. The Wal-Mart Effect (Fshman, 2006) The answer to the Frontlne s queston largely depends upon whether or not you are a consumer, a producer (manufacturer) or competng retaler. Consumers have benefted tremendously from reduced prces (8-27%, Sngh, 2006), competng small retalers have obvously been negatvely mpacted or even drven out of busness but the 25

37 less obvous affect s that manufacturers have less market power and must take nto account strategc domnance of these retal players to gan access to consumers. Ths change n power over the last 20 years amounts to a shft from push to pull producton (Frontlne, 2004). Tradtonally manufacturers operated n a push mode where they desgned products they determned consumers wanted and tred to convnce or push retalers to carry the product. Ths worked for a large part of the 20 th century when manufacturers were relatvely large compared to the small retal stores that carred ther products. The aptly named pull approach s a reversal of roles where the retaler partally dctates desgn requrements. The retaler pulls n products based on ther own objectves rather than entrely makng the decson base on the desres of end customers. The retaler stll makes an assessment of what the consumer wants to stay compettve but, n a way, nsdously arranges assortments to maxmze retaler profts rather than customer utlty. Thus the pull paradgm as dscussed n ths chapter amounts to a retaler proft focus vs. a focus totally on consumer utlty. As mentoned n the Chapter 1, modern retalers have grown to such dsproportonate sze compared to ther supportng manufacturers that one should expect a paradgm shft from the push to pull producton to persst. An obvous concluson from massve retaler revenues present n Chapter 1 (Table 1.1.1) s that market power or control s derved from these revenues. Gven ths poston of power, the manufacturer must admt (perhaps grudgngly) that the retaler s concerns ought to be taken nto account n the manufacturer s desgn decson process. The retaler and manufacture both have the customer s nterests n mnd but have conflctng objectves to maxmze ther own profts whle servng the customers. These conflctng objectves put them on 26