United States. Congress. Senate. Committee on the.

The Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) online

. (page 96 of 140)
Online LibraryUnited States. Congress. Senate. Committee on theThe Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) → online text (page 96 of 140)
Font size
QR-code for this ebook


to PCM peripherals, private companies would be less hesitant to install non-IBM
equipment. In FebruaiT, 1970. the peripheral problem was designated a Key
Corporate Strategic Issue, an IBM method of focusing attention on major prob-
lems which required intensive study and management decision making. A task
force was set up under H. E. Cooley, vice president of the Systems Development
Division, to carry out an examination of the extent of the PCM problem and
potential solutions for IBM.

TABLE S-l.-IBM AND PCM PERIPHERALS-JANUARY, 1970



PCM IBM PCM percent

installations installations of IBM



Deuica*

729 tape drives - — — 1,214 6,820 17.8

2400 tape drives - - - 1,713 45,010 3.8

2311 disk drive spindles 971 23,730 4.1

2314 disk spindles - - - - 3 140,000 0.0



I About.

Source: IBM, "Data Processing Group Peripherals Task Force," April7, 1970 (Telex v. IBM, plaintiff's exhibit 19).

The Cooley Task Force made a careful examination of the plug compatible
problem during the second quarter of 1970. At the time of the task force report
to IBM's Management Committee in July, 1970, PCM companies had gained 4%
of IBM's disk drive market and 11% of the tape drive market, up substantially
from the January survey. If no changes were made to the IBM plans, the task
force projected that by 1976, the PCM's would only have 11% of the tape market
and 15% of the disk market. (4) Although this penetration meant a substantial
loss of revenue, the Mana.gement Committee decided that no further action was
called for to protect the 360 peripherals, and that attention should be concen-
trated on new products for the 370 series, the first models of which had been
announced the previous month.

Among the possibilities considered by the Cooley Task Force for protecting
the 370 peripherals were "mid-life Idckers", proprietary diagnostics, unique inter-
faces between peripherals and CPU's, and physical integration of control units
inside the CPU, as well as an increased level of research in new technologies.
The "mid-life kickers" idea was to add small improvements to products every six
uioziths in order to incorporate new technological advances. The idea was also
exi3ected to fragment the market and to avoid a large base of identical IBM
products toward which the PCM's could direct marketing efforts. Proprietary
diagnostics would have been diagnostic programs which could recognize the
difference between an IBM and a PCM devise and would fail to work properly on
the PCM device. One of the advantages PCM's had gained through compatibility
was the ability to use IBM's established diagnostic programs for maintenance,
thus saving the cost of developing their own diagnostics. Regarding the pro-
prietary diagnostics, Cooley wrote: "The proposal which would make concur-
rent maintenance an IBM exclusive could be a real swinger." (o)

The purpose of unique interfaces was to make it more difficult for PCM's to
attach their equipment to IBM channels, against increasing costs and forcing
the PCM's to develop many variations of their products rather than a standard
line. Regarding this, Mr. Cooley was warned during the study period that IBM's
Basic Channel Adapter which would have further standardized interface "is a
step in the wrong direction since a competitor could easily attach a communica-
tions subsystem." (6) Physical integration of the control units would have reduced
the PCM market as well as made attachment more difficult. Control units are
small processors which control the oi>eration of one or more types of peripheral
devices. The initial PCM tape di-ives and 2311 disk drives attached to IBM control
units, but the 2314 disk drives and later tape drives came with their own control
units which then attached directly to an IBM channel. Depending on the con-
figuration used, the control unit could amount to 50% or more of the cost of a
disk system. If the control unit was put inside the CPU, the PCM's would have
no chance to replace it and would also have to use the IBM interface between
control and drive instead of only between control and channel, restricting their
design freedom.



5668

The piimaiy recommenclation adopted initially from the Cooley task Force
was the Mallard Program, described by Cooley as "the plan we came up A,A-ith to
kludge three 2314's repriced into the NS 1".(7) Tlie Cooley report also recom-
mended price cuts but the Management Committee refused. The Mallard Pro-
gram was announced as the 2319A with the Integrated File Adapter for the
370/145 in September, 1970. The Integrated File Adapter (IFA) was a modified
2314 control unit put under the covers of the CPU where it was safe from
competition.

The controller price was cut from $1420 per month to $555 per month for the
IFA version. The 2319 was a set of three 2314 spindles put together in a single
box along with some of the control electronics previously in the 2314 controller.
The price was set at $1000 per month for the three spindle box compared with
the price of $1455 for three 2314 spindles. The total cost for a three spindle drive
and IFA controller dropped from $2875 per month to $1555 per month, a 46%
price cut which brought IBM's price well below the price of any of the inde-
pendents. However, the new combination could only be used on the announced
but undelivered 370/145 ; it could not be fit on the existing base of 360 machines.
The 2319A program protected disks for the 370/145 both because of its low price
and because of the difficulty of attaching independent drives directly to the
integrated file adapter. Similar programs with integrated controllers were plan-
ned for the remaining unannounced machines in the 370 line.

The 2319 program gave the improved price performance in disk drives that
could have been expected wath a new series without the necessity of developing
a new medium speed technology or manufacturing new drives. Because large
users were expected to be returning 2314 spindles as they switched to the 3330
(IBM's high performance new technology disk drives for use on large 370
models), IBM could expect an ample supply of 2314 spindles to repackage as the
2319A for smaller 370 users without substantial cost. By restricting the program
to the 370, IBM was able to continue charging the full original rental for the
lage base of 360 based 2314 spindles installed on rent. The 2319A program was
expected to save 1,200 spindles from competition without a general price cut on
the 2314 drives.

TABLE 8-2.-F0RECASTED PRICE SENSITIVITY OF 2319A PROGRAM



$1,000 $1,200 $1,400

2319 spindles per month per month per month



Revenue (million) $178 $189

Profit (millions) $58

Profit (percent) 33

Additional 2314 type spindles on 370 systems:

Revenue (millions) .- - - - - $174

Profit (millions) — $86

Profit (percent) - 49

Total revenue from 2314 type spindles on 370:

Revenue (millions) $352

Profit (millions) - - $144

Profit (percent)... 41



$69
37


$74
39


$152
$74
49


$133

$65

49


$341

$143

42


$321

$139

43



Source: IBM, "Mallard Financial Analysis," September, 1970 (Telex v. IBM, plaintiff's exhibit 135), p. 17.

As with other products, IBM prepared an extensive forecast of the effects
of different prices for the 2319 before announcement. The detailed announce-
ment showed acceptance, removals, and inventory for both lease and purchase
at various prices for all 2314 tvpe spindles on the System 370 machines for each
year from 1971 to 1979. A summary of the Mallard forecast is contained in
Table 8-2. As can be seen from the table, the highest profit percentages occur
at the $1400/month price, but the highest absolute amount of profit occur at
$1000/month. The 2319 program itself made the highest profit at $1400, but the
lower price on the 2319 was expected to sell enough additional 2314 spindles at
the original prices to overcome the advantages of higher profits * * * of previous
expense to the new program. An analysis of the source of increased sales at the
lower price predicted that 40-45% of the increased sales would come from in-
creased demand both for complete systems and for disk spindles on current
systems and 55-60% of the increase would come from saves from PCM com-
panies The PC:^I companies were expected to get 23% of the 2319 spindles on
370 svstems at the $1400/month price and 6% of the 2314 spindles at the $1000/
month price (8). The low elasticity of demand for IBM 2314-type spindles m the



5669

absence of consideration of PCM effects indicates that there would have been no
incentive to cut the price on tlie 2319 if the I'CM competition liad not existed.

Tlie decision to concentrate on protecting the 370 base of peripiierals ratlier
than talcing strong action to stop inroads into the huge installed 360 base was
based on a presumption that PCM competition would be limited to a small per-
centage of the 300 base, that the SCO's would rapidly be replaced by 370's, and
that the PCM companies faced stingent capacity contraints. However, PCM
penetration of the 300 base was much faster than expected during late 1970. Of
particular concern to IBM was the PCM success in replacing installed -!314's, a
base of 47,000 spindles amounting to twenty-three million dollars per month
in rental equivalent. When combined with the assoicated controllers, the value
of installed 2314's was greater than that of the entire equipment installations
of any company other than IBM. An IBM study in late 1970 showed that total
losses to PCM's had risen from $1.4 million monthly rental value in 1969 to
$4.2 million monthly rental value in 1970. Eighty-two percent of the increase was
due to increased 2314 penetration which changed from zero in 1969 to $2.3 mil-
lion monthly rental value in 1970. (9) .

In October, 1970, a second peripherals task force was organized to examine
the costs and capabilities of the PCM's in more detail than the Cooley task
force had done, and in particular to determine how low the peripheral com-
l>anies could go on 2314 prices and when they would be able to produce a replace-
ment for the 3330. At the time. Telex was the largest PCM competitor. IBM's
analysis of Telex's 2314 costs showed that the break even point for Telex with
no profit margin or contingency fund was at a monthly rental of $381 per month,
per spindle, based on a sixty month life. (10). IBM's analysts concluded that if
the 2319 was olfered for the 360, Telex's necessary price cuts on its 2314 equiva-
lent drives would eliminate all profits and cause Telex to incur a $1700 loss on
each drive. (11)

In December, 1970, IBM announced the 2319B, a provision to extend the 2319
to the 360. The three drive 2319 at $1000/month ($333 per drive) was made
available for attachment to a modified 2314 controller on the 360 system rather
than only to the Integrated File Adapter on the 370. The modified controller
was left at the original price of $1480 per month. Although they had exactly
the same performance specifications, the repackaged 2314 spindles were treated
as a different product than the installed 2314 spindles. The 26% price cut on
2314 spindles was not available to installed equipment. In order to get it, the
customer had to order a 2319 system and have it physically exchanged for the
installed 2314 system. This arrangement restricted IBM's revenue loss from the
aimouncement. Customers who were not particularly aware of the market place
and were satisfied with their current equipment were likely to miss the an-
nouncement or fail to give it serious consideration. Customers Avho were plan-
ning a relatively quick upgrade to 3330's or other new equipment were not likely
to face the disruption of ordering and installing new equipment with the same
performance as the old for a short term reduction in rental. An IBM analysis
stated: (12)

'•Customers installing 2314-B Series drives will largely be replacing installed
A Series equipment. A majority of these installations will be for over 1 year or
the customer would not accept the freight charges and system downtime in-
volved in the conversion."

The primai-y customers taking immediate advantage of the 2319 announce-
ment could have been expected to be those considering switching to PCM
equipment. The 2319 achieved a substantial amount of price discrimination
through inertia, the delay between order and delivery times, freight charges,
and the disruption of removing and installing equipment.

The 2319 price per spindle was below the lowest price then charged by a
PCM company. The PC;M companies reduced prices substantially immediately
following IBM's announcement. The new prices were lower than IBM's 2310
price, but not as great a differential as before the 2319 announcement. For ex-
ample, Telex cut its prices on a complete 2314 subsystem by 8% to 15% depend-
ing on the number of drives chosen, while the IBM cut amounted to a 20% to
a 2.5% reduction. This reduced Telex's price advantage over IBM from 22-
27% before the 2319 to 12-16% after the 2310. (13) In addition, the PCM com-
panies offered greater flexibility because they would sell any number of drives
while IBM would sell only multiples of three on the 2319 plan, while charging the
higher 2314 price for numbers not multiples of three.

At the same time as the 2314-2319 changes were being made, IBM made a
similar revision to its tape. IBM's primary tape drive systems for the 360 was



5670

the 2401 family. In order to take advantage of technological advances, IBil
announced the 2420 tape drives in 1968, a significant advance over the previous
drives which was supposed to fill the need for high performance tapes on both
the late 360's and the then unannounced 370 series. The 2420-7 was announced
in January, 1968 at a price of $1020 per month. It had a data transfer rate of
320,000 characters per second, 78% faster than IBM's previous high capacity
tape drive, the 2401-6. The 2420-7 was priced 22% higher than the 2401-6,
making the new series more price effective than the old for high volume users.
In November, 1968, the improved price-performance of the 2420 drives was
extended to lower volume users with the announcement of the 2420-5, a half
speed version of the 2420-7, for $565 per month.

IBM thought the earlier tape drives were exposed to PCM competition, but
at the time of announcement, the company thought the innovative technology
employed on the 2420 drives protected them from competition. Consequentfv,
high profit margins were set on the drives. An early 1969 forecast, made after
announcement but before delivery of the 2420, predicted a profit margin of
42.9% for the 2420-7 and 28.4% for the 2420-5. The 2420 series of tape drives
was expected to earn a total revenue of $1676 million dollars over their lifetime
with a total profit of $538 million, for an overall average margin of 32%. (14)
The differential profit margins on the 2420-5 and 2420-7 allowed IBM to extract
maximum revenue from high volume users while not pricing lower volume users
out of the market.

Encouraged by their success in replacing 2400 and 729 series tape drives,
and attracted by the high potential profits of replacements for the 2420, several
PCM companies began developing 2420 capability. By 1970, Potter, Storage
Technology, and Telex had announced replacements for the 2420 at prices far
below those of IBM. Recognizing that the high profit margin on the 2420-7
made it a very weak competitor once the technology was copied, IBM began
planning charges in the line. A simple price cut was rejected in favor of a "new""
tape drive. In November, 1970, the 3420 series of three tape drives was announced.
The top two models of the 3420, designated the 3420-5 and 3420-7, were identical
in physical and performance specifications to the 2420-5 and and 2420-7. The
bottom model, the 3420-3, had no counterpart in the 2420 series. The 3420 was
expected to correct the pricing mistake made on the 2420 from underestimating
competition. Soon after the 3420 announcement, an IBM tape analysis stated :
(15)

"Plan 23 [April, 1969 forecast] predicted the resumption in 1970 of better than
10% annual growth, subsequent to introduction of the 2420 series. The flatten-
ing inventory total during 1969 is an acknowledgment that the 240X tapes
were becoming less attractive. Although by then the first PCM competition was
recognized, it was not viewed as a threat serious enough to alter IBM's growth
in this market. Hence, the 2420's were introduced with high price umbrellas.
By mid-1970, the installed base was swiftly eroding and only the 3420 announce-
ment was expected to reverse the situation."

The price of the 3420-5 was set at $560 per month, almost identical to the
$565 per month charged for the 2420-5. However, the 3420-7 was priced at $670'
per month, a 34% price cut over the 2420-7 with identical performance specifi-
cations. As wdth the 2314-2319 price cut, the new price was not available on
the installed 2420-7 drives ; the customer had to remove the 2420-7 and have it
replaced by a 3420-7 in order to receive the new price. The 2420-3420 manipu-
lation was slightly different from the 2314-2319 change because the 3420 did
contain some new technology, but from the user's point of view, the two series
were effectively identical.

Besides being a price cut, the 3420 series pricing reflected more concern for
competition than the 2420 through the profit margins chosen for various models.
An analysis of the potential market for the 3420 before announcement con-
cluded : (16)

"Due to the increased amount of competition, it is our belief that the concept
of functional pricing is no longer the best suitable way to price in the magnetic
tape area. Apparently manufacturing cost of high and low performance drives
do not differ substantially and competition has concentrated in the higher per-
formance area and priced their drives very competitively ... a continuation of
this policy would contribute to future losses."

Functional pricing means charging according to the performance of the
machine, rather than according to its cost. If there is no competition, functional
pricing leads to the maximum profit. However, if competition is present,
functional pricing causes competitors to concentrate on the machines with the



5671

higliest profit margins, squeezing the original firm out of the market and bring-
ing down the price. In a highly competitive market, all products with similar
production requirements (such as the various models of a tape drive family) will
have the same profit margin. A compromise between functional pricing and
competition oriented mark-ups was adopted in the 3420 program. The estimated
profit margins at the time of announcement were 29.27o for the 3420-7 (versus
42.9% for the 2420-7), 26.5% for the 3420-5 versus 28.4% for the 2420-5), and
15.2% for the 3420-3. ( 17)

At the time of announcement, the 3420-7 price was equal to or lower than
the prices of the 2420-7 competitors. Following the 3420 announcement, the
PCM companies cut prices on the 2420 drives or announced new products in
order to remain competitive. As with the 2319, the new prices put the competi-
tors below IBM but did not restore the full percentage differential existing
before the IBM cut. Following the 3420 announcement, competitive prices for
the 3420-7 equivalent drive ranged from 10% to 15% under IBM's price; while
before the 3420, the competition had undercut the 2420-7 by around 30%. (18)
The 3420 program put a quick end to the 2420 program, causing a drastic
reduction in revenue and profits over what had originally been planned. It
did not immediately end the 2420 program because of long delay times for
delivering the 3420 (eighteen months) and the expense and problems caused by
removing the 2430 in order to put in a 3420. The expected 2420 revenue was cut
from $1676 million in early 1969 to $281 million after the 3420 announcement,
and the expected profit from $538 million to $24 million. The drastic cut in total
revenue while overhead expenses associated with the 2420 program continued
cut the expected profit margin on the entire program from 32% to 9.3%. (19)

While not restoring the full percentage differentials which existed before the
2319B and 3420 programs, the PCM price cuts following IBM's actions allowed
their continued rapid penetration of the IBM tape and disk base. PCM 2314 type
installations continued to accelerate, climbing from 2639 spindles in December,
1970 (at the 2319B announcement) to 3006 in February, 1971, 3491 in March,
and 4014 in April, 1971. By April, 1971. the PCM installation rate was 915 drives
per month (20% per month growth rate) and the order rate was 1022 drives per
month. (20) Tape drive replacements also accelerated, but much more slowly
than disks. At the end of 1970, the PCM companies had 4000 2400 series tape
drive installations and were adding to them at 190 per month (5% per month
growth rate). (21) During 1971, the installation rate rose to 220 per month. (22)
At that rate it would have taken over eight years to replace all of IBM's tape
drives.

While accelerating their installations of tapes and disks during early 1971,
the PCM companies also extended their product lines to memories and printers.
By February, 1971, memory competition was just beginning. Twenty-five main
memories had been replaced by competition (23 by Data Recall and 2 by Fabri-
tek) and 31 large core storage memories had been installetl. (23) However,
the memory market w^as a cause for concern because memories accounted for
a large fraction of the value of the 360 CPU's and advances in core technology
had allowed independent memory companies to fabricate memories far below
IBM prices.

Effective memory competition was not only a threat to current 360 revenue,
but low prices on memory could reduce the migration of 360 users to the 370,
because one of the primary attractions of the 370 was a much lower memory
price then the 360. Competition in the printer market was also just beginning
with five installations by February, 1971. Telex's entry into the printer market
had a (>-23% price advantage over IBM's popular 1403-Nl as well as higher
performance, and in dual configurations Telex's printer could out perform
IBM's new 3211 printer for the system 370. Printers accounted for about 10%
of the value of IBM installed computer systems, somewhat less than either tape
or disks.

With the PCM penetration accelerating rapidly in spite of the System 370
product innovations and the 2319 and 3420 price cuts, IBM appointed another
study group to devise stronger methods of protecting the 360 base of installed
peripherals. When the new study group, designated the Blue Ribbon Task
Force, was appointed, peripheral equipment potentially subject to attack by
PCM's accounted for 63%) of IBM's lease base. The Blue Ribbon Force recom-
mended extreme price cuts in order to eliminate the PCM problem. On the 360
inventory of equipment, the task force recommended a 50-55% reduction on
2311 and 2314 disk drives and controllers, and a 50-80% price cut on the 2401
and 2420 families of tape drives and controllers. The study group also recom-



5672

nipiifled a 20St drop in the price of the new 3330 dislj system for the 370 (not
yet delivered at that time, but anuomiced and many on order), and a 159o
price cut on the new 3420 (Aspen) series of tape drives for the 370. On May 6.
3971. the Management Review Committee rejected the recommended price cuts
and instructed the taslv force to worlv on a term lease plan as an alternative. (24)

The drastic price cuts recommended would most likely have eliminated the
PCM problem both by reducing prices below costs for existing companies and
by forcefully telling potential new companies that peripheral competition would
not be tolerated. However, it would also have cut IBM revenues drastically
because the cuts applied to such a large base of equipment, and would have
practically giuiranteed an antitrust conviction for IBM for predatory pricing.
At that time, all IBM lease pi'oducts were cancellable on thirty days notice,
while many competitive products were on one year or longer lease plans. An
IBM long term lease plan would have been ])oth a convenient excuse for cutting
prices and a method of protecting the installed inventory. With appropriate
penalty provisions in the lease, a customer would not consider a PCM replace-
ment except at the time his lease was up. This would restrict the marketing
flexibility of the PCM companies, and in particular, it would restrict their
attacks on the new devices being delivered with the System 370. Because of



Online LibraryUnited States. Congress. Senate. Committee on theThe Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) → online text (page 96 of 140)