How to Use Customer Segmentation to Drive Higher Profits

In almost every business,  just 20% of customers account for 80% of profits.  And many businesses would be better off if they simply did not have to serve the bottom 80% at all!  (That’s known as the “Pareto principle” or the “80/20” rule.)

But before you go out and fire 4 of every 5 customers, take a closer look.  By understanding the profitability of each customer segment, and adjusting your operations accordingly, you can keep the customers and maximize profits.

Sort the Wheat from the Chaff
Start by creating a list of all your customers.  Next to their names, write the total money they spent with you this year.  (You can add other more important indicators, like gross margin, but “annual sales” is often a good estimate of the customer’s importance.)

Rank Order the List by Sales
How much difference (variance) is there between the top-spending customer and the bottom-feeders?  If you are like most companies there is a big difference between top and bottom, but you’ll probably have customers that fall over the entire spectrum.

To make a big list of customers easier to work with, divide your customers into 5 groups – called quintiles. (Or simply 5 segments.)  Take the top spender and multiply their total purchases by 0.80.  That’s the cutoff line for the “top 20%” of your customers.  Do the same for each cut-off below, and the shuffle the customers into these 5 groups (called “quintiles”) based on their spend.

So, for example, in the first group will be those at the top of the list that spend 80% to 100% of the biggest spender.  Don’t worry about how many companies are in each quintile, only on the amount they spend with you.  When you are done, you’ll have 5 groups:

• Quintile #1:  80% to 100% of maximum spend
• Quintile #2:  60% to 79% of max spend
• Quintile #3:  40% to 59% of max spend
• Quintile #4:  20% to 39% of max spend
• Quintile #5:   0% to 19% of max spend

Take Action!
This kind of “quintile” customer segmentation analysis can be useful to strategy, marketing and budgeting.  Now that you know the sales that each customer generates, you can adjust your entire business strategy so that each quintile become more profitable.  In effect, you are going to make your business “respond” to each customer in a way that reflects their true value to the company

• Adjust your Promotional Budgets.  Rather than send all your customers a gift basket at Christmas, you should probably minimize what you spend on the smallest customers, while you really go all out for the big guys.
• Adjust your Pricing.  You should certainly charge the small guys slightly more than the larger accounts.  This will help balance the profitability of each quintile, but it will also encourage small customers to spend more to get the discount.
• Adjust your Sales.  Take a close look at the companies in the top 2 quintiles. These are your best customers. How can you get more customers like this?  What makes them different?  Make sure your sales people are targeting more great prospects and fewer that will likely fall into the 4^th and 5^th quintile.
• Adjust your Messaging.  Make your marketing message fit the unique perspective of each quintile.  Don’t send the small fries the “Big Sale” notice, and don’t send the big guys a “Get to Know us Better” message.  Focus on marketing messages that recognize the relationship you have, and encourage the accounts to move up in your rankings.  If you spend $1 each month promoting to the largest customers, you should spend just 10 cents advertising to the smallest customers.  Same goes for messaging to new prospects – shift your message to attract the right kind of customer.

If you use customer segmentation strategies long enough, you will start to see more “low spending” customers bubble up and spend more.  You may also find that some of the small-fries stay where they are or simply drop out.  That’s OK.

Grow Profitably
In fact, at some point, your business will be so much more profitable, that you may want to “fire” those customers who are left in the bottom quintile.  Adjust your minimum order or pricing policies until these companies buck up or drop out.

To survive and thrive, a business must make a profit from every customer.  Take the time to really understand who your best customers are – and to adjust your company to respond appropriately – and you’ll see profits begin to increase.

Dedicated to your (Segmented) profits,

David

PS: Need help with this?  Want to calculate even better segmentation metrics, like “Lifetime Value” or “Gross Margin Contribution”?  Give us a call today!