(A multi-part co-blog series with CreditBubbleStocks.com  about the book The Art of Profitability. by Adrian Slywotzky )

Chapter 2, Pyramid Profit

The Pyramid Profit model consists of multiple quality and price tiers for products, targeted at multiple types of customers (and customer preference), which creates two powerful dynamics for the business:

1. Protects them from competition from market entrants below (commodity market)
2. Creates profitable customer migration opportunities as loyal customers move up the steps of the pyramid (franchise market)

Why is this model so powerful?

As guru David Zhao teaches,

Your pyramid has to be more than just a collection of different products at different price points. A true pyramid is a system in which the lower-priced products are manufactured and sold with so much efficiency that its virtually impossible for a competitor to steal market share by underpricing you. Thats why I call the lowest tier of the pyramid the firewall. But the most important factor is the nature of your customer set. The customers themselves form a hierarchy, with different expectations and different attitudes toward price.

The competitive environment all businesses would prefer to have is that of a franchise, where their product is deemed uniquely valuable and essential such that the business can capture a franchise premium in its margin structure, a premium which is enduring and protected from competition over time by the proverbial moat.

Simultaneously, the competitive environment all businesses fear is that of a commodity market, where the only way to distinguish your product from someone elses and incite the customer to buy is by offering the lowest price. It is a true race to the bottom and the turnover for businesses in commodity markets can be quite high.

As discussed in Clayton Christensens classic, The Innovators Dilemma. most innovators arrive in a market as low-cost entrants. Incumbent firms see no problem in giving the low-margin business dregs to them as theyre happy to play in the higher-margin markets upstream. The hungry commodity firms are constantly looking above them at the juicy margins available in this other market can they apply their innovative, low-cost practices to this higher-margin space and move in for the kill? As Christensen details, so often they try and succeed.

This is the genius of the Pyramid Profit model. Incumbent firms are protected from innovative, low-cost competition by offering a low-to-no margin product that creates a competitive firewall at the most vulnerable place in the market, the violently dynamic commodity space. Then, they are free to play in the middle and higher margin markets without stress.

There is an additional benefit, as well. By capturing new customers even at the low-margin end of the market, the firm is able to increase customer loyalty and brand familiarity over the customers lifecycle. Over time. these (presumably) younger, poorer customers turn into older, richer customers following the circumstances of life.

The value of a Pyramid Profit model depends on the shape of the pyramid. A pyramid with a wide base and a narrow top is relatively inefficient and less valuable as most of the business volume is captured in the low/no-margin mass market whereas the high-margin premium market remains under-promoted. An ideal shape would resemble something more like a skyscraper tower the same width for all tiers, all the way up, with enough segmentation via price/quality tier to progressively move customers up the pyramid at a rapid pace. The more business that is concentrated at the upper levels of the pyramid, the better the margins and the more profit the firm can earn.

The Pyramid Profit model can be found in many well known businesses, even though it is a rarer circumstance than that of the Customer Solution Profit model discussed in chapter 1. A good example is the automobile industry with its economy and premium brands (for example, Honda and Acura, or Chevy and Cadillac). Even within each brand, many manufacturers have managed to create a pyramid of quality, price and even features/capabilities (for example, Honda has the LX base model, EX, EX with leather and EX-L with navigation; it also has the Civic for the entry buyer, the Accord for the more sophisticated, the Odyssey for the family buyer, etc.). Another example would be the airline industry, such as Virgin Atlantics Economy, Premium Economy and First Class seating and service tiers. However, no airline seems to have created separate brands/carriers that focus on one tier of the pyramid over another, instead this segmentation always occurs per aircraft (contrast this to a single class carrier such as JetBlue or Southwest Airlines, though notice that even these firms have begun to offer new passenger tiers for additional money such as early boarding, extra luggage capacity, etc.)

Speaking of the auto industry again, one of the most prodigious Pyramid Profit employers has been Toyota. Toyota offers three brands in the United States: Scion, Toyota and Lexus. Scion was a brand developed specifically for the young car buyer, initially offering lower price points, simpler model choices and a no bargaining purchase experience that was supposed to capture a first-time buyer and put them into the Toyota system for the rest of their automobile-buying lives. Then, there was the mass market, multi-trimmed and multi-segmented Toyota brand, offering cars, vans, SUVs and light trucks to the everyman. And finally, there was Lexus, the flagship brand for wealthy, older, image-conscious and highly-demanding customers.

Toyotas pyramid is awkwardly shaped, however. Its base, Scion, is miniscule and definitely low/no-margin. The middle step is enormous and fairly profitable relative to the rest of the industry. And the top is much wider than one would expect it to be, being both relatively high-volume for a luxury market and quite profitable despite ongoing margin erosion in the industry overall. Indeed, Lexus auto dealership franchises are consistently one of the most valuable and sought-after brands in the industry alongside BMW and Audi, commanding high market multiples reflective of their premium value.

The key to a successful and highly profitable pyramid is twofold. First, you must be lucky enough to operate in a market that is conducive to segmentation of customers (especially self-segmentation). Second, you must know your customers well the Customer Solution Profit at work again! The better you understand your customers and their specific needs, the better you will be able to create custom quality and pricing tiers in your pyramid that will meet their subjective needs.