Cruising to profitability

You may have come across this recent WSJ article that puzzles over how "A growing number of cruise lines have built lavish—and separate—cocoons for their biggest spenders. It is a departure from the egalitarianism that had reigned on most ships for the last several decades when everyone from the humblest inside stateroom to the most luxurious suite would rub elbows in the same bars, dining rooms and pool decks."

No longer, it seems.

The well-heeled are shooed in, while the less so are booted down to a lower class of travel. 
Some airlines, too, have introduced entirely new seating classes. They have, for example, re-labeled what used to be their economy class to "Premium Economy," while introducing a knee-crushing, reduced leg space "economy" experience for passengers who have their dinner fed to them by the catapult effect created when the passenger in front of them decides to recline or redress their seat.

In fact, in almost every product category, from watches to wine, from cars to pens, there is now a very wide range of price levels, with the top prices often hundreds of times those for the least expensive products in the category. The class system is alive and well.

So why are class systems so popular? Because they are profitable.

A class system is a form of vertical segmentation, where the market is sliced into groups of customers willing (and, almost as importantly, able) to pay different amounts. The more slices you create, the more profitable the outcome. But with one big caveat, of course: the complexity and cost of making and selling so many differentiated offers should not exceed the extra revenue you can capture from those willing to pay more for frilly perks such as adequate leg room.

Let's consider a simple example to see exactly where the extra revenue comes from. Imagine you're a manufacturer of ball point pens searching for ways to increase revenue in a market that consists of two consumers.  

Consumer A, you find, is the pragmatic, down-to-earth, let's-get-it-done-at-low-cost type. She is indifferent to the characteristics of a pen, as long as it writes without smudging.  She wants to spend no more than one dollar on a pen.  

Consumer B on the other hand is fastidious about the design of her pen.  She prefers a futuristic design with a structured, anti-slip rubber grip. And she is willing to pony up two dollars, provided the pen meets her picky requirements.  

So now you, the pen manufacturer, have three strategic options: (1) you can make only the basic pen; (2) you can make only the fancy pen; or (3) you can segment the market and make both types of pen. 

If you decide to make only the basic pen, remember that neither consumer will pay more than one dollar for it.  Both may buy the product, especially if Consumer B does not find a fancier alternative. But even if both consumers decide to buy from you, your total revenues will be no more than two dollars.

If you choose to make only the fancy pen and price it at two dollars, Consumer B will buy it, but A will pass.  Total revenues again will be no more than two dollars.  

However, if you decide to make both types of pen, pricing the basic pen at one dollar and the elaborate one at two dollars, each consumer will select her preferred pen. You have a shot at magically increasing your total revenues to three dollars. In other words, a segmented strategy can yield 50% higher revenues than an unsegmented one.

In any market where consumer preferences vary (and they always do), segmentation is the more profitable strategy, provided the costs of producing multiple types, and tailoring communications and distribution for the different segments of consumers can be kept below the extra revenue earned.

That's the theory. Does it work in practice?

Does it ever. 

Look around, can you think of a product category where it's not being applied?

And in recent years vertical segmentation has truly taken off. Rapidly declining costs of ‘customization’ of products (think flexible manufacturing), communication (think targeted ads), and distribution (think online retail) have made segmentation strategies increasingly viable and commonplace.

At the same time, the economic downturn has made many (but, crucially, not all) consumers more price sensitive. Those that aren't are prized clientele -- they're the 20% who contribute the proverbial 80% of the profits. 

So cruise lines, airlines, and sellers in almost any industry you can think of, are figuring out a fine balancing act: trying to capture the additional profit from those willing to pay more, while retaining the volume that comes from serving the thrifty. 

And that means more and finer market slices.

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See also: Why we segment


Photo Credit segmented apple zirconicusso / FreeDigitalPhotos.net

Next week: guest post by Martin Roll, author, consultant, and brand expert.