DiskComp Systems

It was a Saturday evening late in March 1991 when Peter Lumley and John Slavco met to discuss the future of DiskComp Systems and its sole product, which seemed to be on the verge of commercialization. The firm, which was based in St John's, Newfoundland, had recently developed a micro-processor-controlled vending machine to sell individual computer disks in academic computer labs and other, similar locations.

Peter laid several graphs and spreadsheets on the table, and with his characteristic bright, enthusiastic eyes and optimistic tone, he began explaining to John Slavco the size of the market for the product that they had developed together. John leaned back on his chair and flipped through the various charts, but it was evident from his posture that something in Peter's explanation did not satisfy him. John was not sure what it was, so he thoughtfully examined each graph and quietly considered the figures. Peter had been preparing for this meeting for the past week since Datastorage Inc, a large, multinational diskette manufacturer, had offered to buy the exclusive rights to their vending machine in exchange for royalties of $100 per unit. Peter's graphs showed that there was a market for at least


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Copyright © 1993, the Atlantic Entrepreneurial Institute. Reproduction of this case is allowed without permission for educational purposes, but all such reproduction must acknowledge the copyright. This permission does not include publication.


40,000 units of their product in North America, at $2,000 each, and from his estimate, Datastorage would probably only install 500 a year. Peter was convinced that if they made the same offer to other diskette manufacturers and sold the machines directly to computer labs and stores, they would be much farther ahead.

The Opportunity

Computer diskettes were normally sold in boxes of ten, however, in areas where microcomputer usage was high, such as microcomputer labs in community colleges, universities, and high schools, there was a great demand for single diskettes. Often, students simply could not afford to purchase a box of ten, nor did they want to leave the computer work area to purchase disks. Generally, students could only purchase single diskettes through campus book stores and computer stores. Unfortunately, these stores were often not located near computer labs and, generally, had much shorter hours of operation.

The sale of diskettes was highly profitable for stores, but the overhead connected with the sale of individual diskettes was considerable. It took time to sell a diskette, and often customers left before they could get the attention of a salesperson in a busy campus computer store. DiskComp System had developed a vending machine for diskettes that would sell individual disks to users in microcomputer labs. The vending machine was thought to offer the following benefits:

  1. Diskettes could be sold whenever the computer lab was open, essentially whenever students might need them.
  2. The automated vending machine would lower the overhead costs associated with selling diskettes.
  3. The increased volume of sales, with attractive margins, should be profitable for the lab or computer store that maintained the machine.

The Entrepreneurs

Peter Lumley was 36 years old, married, and the proud father of two children. He had grown up in a family that valued business and entrepreneurship. His father had an MBA from Harvard and had held senior management positions in a number of multinational firms, before starting his own real estate development business. Peter's education had been somewhat eclectic - a BA in philosophy, followed by a BSc in math, and an MBA. Enjoying the university environment and seeking a challenge in business, Peter took over the management of the University computer store in 1989, soon after it was created, and in his first year, he built a multimillion-dollar business. With personal computers becoming cheaper and students wanting their own at home, he expected sales to continue to grow rapidly While building the business, he had negotiated contracts with IBM, Packard Bell, Zenith Data Systems, and several other distributers and manufacturers. He was a member of the Advisory Council of Zenith Data System's Educational Division and the Canadian Association of Campus Computer Stores. Peter enjoyed the University computer store, but he was prepared to take a leave of absence, if it were necessary, to get DiskComp Systems established. He thought a four-month leave of absence would be adequate to begin product commercialization and was prepared to take as much as a year off. In fact, if he could rely on an annual income of $50,000 and see the potential to build a significant business, Peter thought he might even leave the university to build DiskComp Systems.

John Slavco was 38 years old and married with two children as well. His academic background was in science and engineering (he held bachelor's degrees in both) but John's real interests were in the application of technology to solve complex problems. He had co-founded an engineering consulting and technology development company in Ontario (Blackburn and Associates) and helped build it into a multimillion-dollar business, but he was no longer active in the firm. En early 1989, John had moved to Newfoundland, the birthplace of his wife, to look for new opportunities and to be closer to his wife's family. While DiskComp Systems interested him, he did not see himself working full-time in the business. Most of the contribution which he was best suited to make had already been completed: the initial product design and prototype development. He saw his future involvement in DiskComp as a partner and part-time consultant on product development and production issues.

Company Background

DiskComp Systems was formed as a partnership between John Slavco and Peter Lumley in September 1989. The idea of producing a vending machine strictly for diskettes originated with Peter, who was the manager of a university computer store. He recognized that students preferred to purchase single diskettes and that profit margins were high when diskettes were sold that way. However, his campus store was only open five hours a day, five days a week, while the microcomputer labs on campus were open 18-24 hours a day, seven days a week. In order to take advantage of the opportunity, Peter approached John about developing a prototype vending machine for diskettes. John was a friend whom Peter trusted completely and who had, what Peter believed to be, the right skills to bring his concept into reality. John had developed product concepts into feasible prototypes before, and he was a man who got the job done. It took him six months to develop a working prototype vending machine. During that time, Peter discussed the concept with several university computer store managers to get their design input and then refined the product concept.

The management team was also strengthened during this period by adding three part-time advisors to round out Peter's and John's skills. George Sykes, a local businessman and entrepreneur, provided general management and financial management experience and an extensive network of business contacts. David Emerson (MEng) was an electronic systems designer and founder of his own consulting and design firm. He specialized in trouble shooting electronic systems. Nick Adams (BSc) completed the group of unpaid advisors. He was an electronics consultant, employed with a major consulting firm, and had taken part in electronics design and consulting for several products.

After the prototype was produced, Peter demonstrated it in Vancouver at a conference of the Canadian Association of Campus Computer Stores (CACCS). The dispenser was shown to eight potential purchasers, and within weeks orders were received for 20 machines at $1995 each. Peter then approached James Townsend, President, and Joseph Schacht, Vice President, of Datastorage Inc, one of the five largest diskette manufacturers worldwide. When the orders from the universities were shown to Datastorage Inc, talks were immediately underway for the further development and marketing of the product.

An agreement was reached whereby Peter and John were to produce 20 machines to be installed by January 1991. The locations were chosen from DiskComp's order file, and a 90-day test market was conducted. Datastorage paid $50,000 in advance for the machines, and DiskComp agreed not to disclose their idea to others until the completion of the test period. All rights, trademarks, and copyrights were to remain the property of DiskComp. Before the conclusion of the test period, Datastorage was to decide whether or not they would take the concept worldwide. The test market was very successful - the machines worked as expected, Datastorage was able to significantly increase its diskette sales in the accounts where vending machines were introduced, and the students were pleased with the convenient system for buying individual disks. The only complication that developed was a direct result of the concept's success and the large amounts of coin it generated. The computer labs, campus computer stores, and university administrative systems were not prepared to handle the cash; in some universities it became a problem. As a result, James Townsend called well before the 90 days were up and offered DiskComp a royalty of $100 per unit in exchange for exclusive worldwide rights to the vending machine. Datastorage was also prepared to guarantee annual purchases of 500 units.

The Machine

The vending machine (which is sketched in Exhibit 1) was designed under the following principles, which were based upon Peter's ideas and his consultations with other campus store managers:

1. That the machine would be able to take all four types of diskettes (i.e. double density 5.25", and high density 5.25", and both forms of 3.5" disks) and that it would have adequate storage capacity to minimize refills.

2. That the machine would be able to be secured either by Exhibit 1: DiskComp Prototype wall mounting or, if installed, free standing.

 

3. That the machine would be secure from pilferage.

4. That the machine would be unobtrusive in terms of design and size.

5. That the machine would be easy to operate and also incorporated security measures to account for cash receipts.

6. That the machine would have room on the front for advertising so that diskette manufacturers could subsidize the machine's purchase price.

7. That the unit would be modularized so that repairs could be handled by cross-shipping entire modules.

The prototype machine was designed to fulfil the above criteria and is sketched in Exhibit 1. John and Peter estimated that the unit cost of production (direct labour and materials), if they were to build the vending machines themselves and order parts based on 100 units at a time, would be about $1300. They expected to sell each unit for $2,000.

The Potential Market

Peter thought the potential market for their vending machine was large. He had spent some time in a local library and had collected statistics on the number and types of educational institutions in Canada (see Exhibit 2). He extended this data to the USA market by assuming that the USA had about ten times as many educational institutions and supported this assumption with statistics indicating that 883 universities operated in the USA. He also found information indicating that virtually all of the high schools in both countries had some kind of a microcomputer lab. Furthermore, he knew that the Canadian universities had, on average, five microcomputer labs each.

Exhibit 2

Educational Institutions in Canada and the USA

Canada USA
Universities 67 883
Community Colleges 325 3250
High Schools 2573 25730
Other Educational 200 2000

 

Notes:
  1. The Other Educational category includes secretarial schools, computer training institutes, and private colleges.
  2. The number of institutions in the USA reported above (except for universities) were Peter's estimates based upon ten times the Canadian numbers.

Source: Statistics Canada

When Peter took all the figures that he gathered for high schools, universities, community colleges, and private training facilities, he came up with a market potential in the USA and Canada of over 40,000 units. John was initially surprised by the numbers, but in his normal, conservative and cool manner, he said nothing other than that Peter should find out, in detail, how they could enter those markets, and what it would cost. This Peter immediately set out to do and wrote the following summary on the separate markets and how they could enter them.

Marketing Strategies

Peter had identified three marketing strategies that he felt could be used individually, or possibly in concert, to sell DiskComp's machine.

Partnership with a major diskette manufacturer

Peter thought that DiskComp could enter into an exclusive or non-exclusive joint venture with one or more major diskette manufacturers to distribute the disk-vending machine through their established channels. Sony, 3M, Kao-Didak, BASF, Datastorage, and Maxell were the major diskette manufacturers in the world. The benefit to DiskComp of such a plan was thought to be rapid market penetration without the need for a company sales effort directed at the ultimate users. The primary benefits to the diskette manufacturer would be increased sales, increased market share, and brand recognition in the university. As Peter saw this strategy, the diskette manufacturers would buy the machines from DiskComp with their brand name silk-screened on the machines and place them in university computer labs, subsidizing all or part of the initial cost to the operator. They could be used to open new accounts for the manufacturer at institutions buying from competitors or to increase their share of the existing business by requiring that only their disks be sold in the machines. Peter thought of this as the 'Trojan horse" strategy for disk manufacturers and had sold it to Datastorage on that basis.

However, Datastorage did not envision a joint venture. They preferred a straight licensing agreement and wanted exclusive, worldwide rights to DiskComp's machine. They had offered a royalty of $100 per machine, but were only prepared to guarantee the placement of 500 machines per year.

Direct marketing to academic computer stores and labs

On the other hand, Peter thought that direct marketing of DiskComp's machine might be much more profitable for the firm. The vending machine could be marketed directly to academic computer labs and stores through direct mail, advertising in computer magazines, and the use of trade shows. Peter envisioned demonstrating the product in educational computing product fairs such as EDUCOM (a non-profit body that held annual conferences attended by representatives from over 3000 educational institutions in North America), the Canadian Association of Campus Computer Stores which met 4-5 times annually, the National Association of College Stores (USA), COMDEX (the largest computer fair in the world, held annually in Las Vegas), MacWorld (held 2-3 times every year for Macintosh-related products), PUCC (Apple Computer Ines annual Pacific University Computer Conference) and several other computer product fairs.

A 1-800 toll-free phone service would support these activities and make it easy for potential buyers to contact DiskComp. In such a case, Peter and John would have to develop a sales force, but they would retain control over the selling effort and stay closer to their customers than would be possible if the product was sold through an intermediary.

DiskComp could manufacture the machines itself or subcontract the actual product assembly to other firms. John and Peter had already estimated the cost of producing the machines themselves at about $1300. Estimates from outside suppliers were significantly less when five firms were asked to bid on the manufacture of the machines. The lowest bid was for $700 per unit and came from a reputable manufacturer of electronic goods for the military.

Peter had prepared pro forma financial statements for the direct marketing option. (See Exhibit 3) He was aware that this option would require more investment than the alternatives. While he and John were not prepared to put any more money into DiskComp (together they had already invested about $50,000), he was confident that the firm could raise the necessary money if the business looked like a winner. In fact, there were already some interested investors in the wings, but their money had not been necessary, and John and Peter were hesitant to add investors until they were absolutely necessary and the firms prospects were more dearly defined.

Licensing the machine to a vending machine manufacturer

While Peter had not contacted any vending machine manufacturers, because he was concerned that they might simply copy his idea once they saw it, he recognized that licensing the idea to a major vending machine manufacturer might be a wise strategy to consider. Such a firm could bring the machine quickly to market and had existing distribution channels to sell it through. Furthermore, with their experience in vending machines they could probably make significant contributions to the machine's design and could undoubtedly produce the machines for a lower cost than DiskComp.

Future Growth Opportunities

Several opportunities for future growth existed in the company. Primary among them was the development and production of a diskette vending machine which would utilize a "Card Reader System" such as those used in photocopiers at government and business offices. This system could be marketed by diskette manufacturers for their large accounts. It would, like the lab vending machine, serve as a 'Trojan Horse" for diskette companies or distributors to sell their product in the dosed markets of larger organizations.

Peter also thought that the existing machine was ideally suited for vending other, similarly-shaped products. For example, it could accommodate packages of baseball or other trading cards, and with little modification the machine could be used to sell packs of cards in shopping centres and grocery stores which already use small, coin-operated, bubblegum and novelty machines. The trading card industry was a multi-million dollar industry that was growing rapidly and could benefit from the expanded distribution possibilities of vending machines.

Other future opportunities in academic computer labs were thought to include systems for maintaining unmanned computer labs, such as developing software for queuing print jobs in laser printers and accepting payment from the user when their job was on line. This system could also be used in government and business offices to log the usage of laser printers on site.

However, before their thoughts could turn to additional products and market expansion, Peter and John had to decide how to take their present product to market. Should they accept Datastorage's offer, or should they take their vending machine to market in some other way?

Exhibit 3

Pro Forma Income Statements for DiskComp Systems

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