Please note that this blog post was first published in 2016 but has been updated in 2021.
It’s no secret that some customers are more profitable than others. But to be profitable over the long-haul, managers must have a clear understanding of how profitability correlates with customer segmentation.
Even if you have a highly-targeted customer demographic in your business, there are still variations between individual customers. Recognising these differences will allow you to tailor your approach to the needs of varying customer segments and allow you to effectively serve a wider group of people. Read on to learn more about why customer segmentation is important.
What is customer segmentation and what are the benefits?
Customer segmentation is the practice of dividing a customer base into groups of individuals that are similar in specific ways. You can provide different value propositions to different customer groups. Customer segments are usually determined on similarities, such as personal characteristics, preferences or behaviours that should correlate with the same behaviours that drive customer profitability.
A customer segmentation model allows for the effective allocation of marketing resources and the maximisation of cross and up-selling opportunities. When a group of customers is sent an email that is specific to their needs, it’s easier for companies to send those customers special offers.
Other benefits of customer segmentation include staying a step ahead of the competition and identifying new products that existing or potential customers could be interested in.
How do you measure customer profitability?
Many companies use the 80-20 rule, which can be applied to customer’s gross margins. This rule suggests that 20% of the customers are responsible for 80% of the profits. However, the 80-20 rule can be detrimental because internal cost is not one size fits all.
It’s natural for companies to use more costs on certain customer segments than others. Fluctuating costs must be taken into consideration, otherwise you could end up spending too much to serve one customer segment over others.
Customer profitability is not that simple; it requires you to track and determine exactly what resources within your company are consumed to serve a particular segment. At a minimum, companies should allocate sales, marketing, and customer service costs to lift customer profitability to a new level of understanding.
These costs will vary significantly between customer segments. Simple changes in the sales commission, invoicing terms, credit and collection costs, pricing, marketing specific cost, back-office cost dedicated to the customer segment, can significantly impact a segment’s profitability.
Today, most modern ERP systems offer accounting features (sub-accounts/dimensions) to track and allocate costs to specific segments. Allocating costs to customer segmentation is just one approach to gaining a better understanding of how your resources are spent across customer segments and how it reflects on customer profitability.
Another approach to understanding the value your customers provide is, “customer lifetime value” (CLV). CLV takes a different approach – customers are valued as assets. CLV recognises that the costs of attracting a customer represent an investment with a future income. Calculating CLV requires an understanding of customer retention rates, purchasing patterns, and costs for each segment, then discounting the values to the present.
Segmentation can be tricky and complex. However, segmenting your customers can provide tremendous returns when compared to ‘one-size-fits-all’ approaches.
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