This is “Appendix: The Economics of Market Segmentation”, section 3.3 from the book Competitive Strategies for Growth (v. 1.0).
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Imagine that a company sells bottled water in a market of 500 customers, each of whom consumes one bottle during a given period of time (e.g., a day, every 2 days; the particular period is not relevant). The company sells its water for $1.00. Its variable cost is $0.50 and it has a 30% share of the market. That means it sells 150 bottles every period (500 × 30%) and earns a $75 contribution (150 bottles times a unit margin of $0.50; see Figure 3.2 "Increased Profitability Potential for Differentiating Between Market Segments", undifferentiated section on left).
The company keeps its eyes and ears open, however, and discovers that there are some consumers who enjoy bottled water and also believe that water might be a vehicle through which to obtain additional vitamins. In short, they represent a growing segment interested in health and in the impact of the products they consume on their well-being. Additional research identifies that of the 500 folks in the market, the health-driven segment now totals 150 people! These folks would get a lot of value out of a bottled water product that is vitamin-fortified.
Your product development folks figure out how to add vitamins for an extra $0.25 per bottle, raising your variable costs to $0.75. When this product enters the market, it reveals more about how the market has been (unbeknownst to you) segmented all along—see the right-hand portion of Figure 3.2 "Increased Profitability Potential for Differentiating Between Market Segments" labeled “differentiated.” The top circle reveals the fact that 70% of the market is actually price sensitive and enjoys the existing product at the low price of $1.00. It turns out that you have about a 40% share of this segment, so these folks accounted for 140 of the 150 bottles you were selling when you only had one undifferentiated product on the market. If we keep that product on the market and add a new product to appeal to the healthy segment, we increase our total contribution from $75 to $115! How does this happen? Well, we find that—if we have been on target in our new product development—the healthy segment is much more likely to purchase the vitamin-fortified product, even though it costs 50% more than our standard product. In fact, we get a 40% share of the healthy market, selling at a unit margin of $0.75, producing a total contribution of $45. Adding this to the $70 we earn from the price-sensitive market, we have increased total contribution from $75 to $115 by (a) understanding that there are segments in the marketplace, and (b) effectively targeting them.Note that there will also be new fixed costs involved in the marketing of the new product (e.g., a separate advertising budget and distribution costs). As long as these fixed costs are less than the incremental contribution of $40, segmentation and differentiation is a more profitable strategy.