Customer Segmentation – A Technique for Effective Marketing


Customer Segmentation – A Technique for Effective Marketing

Customer segmentation is also known as market segmentation. It is the practical division of potential customers in a given market into discrete groups. The division is based on customers having similar appearing needs and buying characteristics so that a common market approach can be used by an organization for the marketing of its products to them in a competitive and economical manner.

Also when the organization plans for expansion, then executing a marketing strategy without any knowledge of how the target market is segmented is similar to firing shots at a target blindfolded. In such case the likelihood of hitting the target is a matter of luck more than anything else. Without a deep understanding of how best the current customers of the organization are segmented, the organization often lacks the market focus needed to allocate and spend its precious human and capital resources efficiently. Furthermore, a lack of best current customer segment focus can cause diffused go-to-market and product development strategies that hamper the ability of the organization to fully engage with its target segments. All of these factors when combine together, can ultimately obstruct the growth of the organization.

All markets are heterogeneous and all the customers are not the same. The different customers have got different needs. Also customers’ behaviours towards a product vary based on their requirements as well as on the environment in which they are working. Hence marketing strategy of ‘one size that fits all’ does not work in present day situation. Therefore, effective marketing strategies requires a segmentation of the market into smaller and homogeneous customers’ segments, the understanding of needs and wants of these segments, the design of the products and services to meet these needs, and development of marketing strategies to effectively satisfy the target segmentation. Customer segmentation is most effective when the organization tailors offerings to segments that are the most profitable and serves them with distinct competitive advantages. This prioritization helps the organization to develop marketing campaigns and pricing strategies to extract maximum value from both high profit and low profit customers. The organization can use customer segmentation as the principal basis for allocating resources for its product development, marketing, service and delivery programs.

There are three main approaches to market segmentation. The first approach is known as ‘a priori’ segmentation. It is the simplest approach and uses a classification scheme based on publicly available characteristics to create distinct groups of customers within a market. However, ‘a priori’ market segmentation approach may not always be valid, since organizations in the same industry and of the same size may have very different needs. The second approach is the need based segmentation approach. In this approach customers’ segmentation is based on differentiated, validated drivers (needs) that customers express for a specific product or service being offered. The needs are discovered and verified through primary market studies, and segments are demarcated based on those different needs rather than characteristics such as industry or organization size. The third approach is value based segmentation approach which differentiates customers by their economic value and groups customers with the same value level into individual segments which can be distinctly targeted.

There are six standard segmentation methods which are generally applied for the purpose of customers’ segmentation. These are (i) segmentation by geographic base / reach, (ii) segmentation by industry / sub-industry / industry served / customer served, (iii) segmentation by product class / product usage, (iv) segmentation by organization size (normally determined by revenue and number of employees etc.), (v) segmentation by product delivery model / product format / packaging format / special technology /process methodology, and (vi) segmentation by special use / needs. However, it is important to know that even if a market is segmented by one of the above methods, it is still not a valid segmentation of the market unless it results in meaningful differences in customers’ values and needs, the organization’s value proposition, or the go-to-market strategy associated with each method. In such cases, it is merely a convenient organization of the market which has no strategic or operational value.

Benefits of customers’ segmentation

If the organization carries out the customer segmentation process exercise in a correct manner then there are several benefits available to it which can be exploited. A properly done customer segmentation exercise can tangibly impact the operating results of the organization due to the following.

  • It helps in improving the organizational products. It provides the organization a clear understanding which customers wants to buy the organizational product and what they need it for. This helps the organization to differentiate with the competitors so that the organization finds the best solution for their customers’ needs. This results into increased satisfaction and better performance against competitors. The benefits also extend beyond the organizational core product offering, since any insights into the customers’ needs allow the organization to offer better customer support, professional services, and any other offerings that make up the whole product experience for the customers.
  • It helps the organization to focus on the marketing communication. In parallel with improvements to the product, conducting a customer segmentation exercise helps the organization to develop more focused marketing communications that are customized to each of the customer segments, resulting in higher quality inbound interest of the customers in the organizational products.
  • It allows the marketing division of the organization to pursue higher percentage of opportunities. By spending less time on less lucrative opportunities and more on the most successful segments, the marketing team is able to increase its win rate, cover more ground, and ultimately increase revenues for the organization.
  • It helps the organization to receive higher quality revenues. Not all the sales revenue received by the organization has equal value. Marketing of the product into the wrong segment can be more expensive to sell and maintain, and may have a higher churn rate or lower upsell potential after the initial purchase has been made. Staying away from these types of customers and focusing on better ones helps the organization to increase the margins and to promote the stability of the customer base.

Conducting of the customer segmentation exercise properly can have several other supplementary benefits. The bottom line is that if the organization is able to sell more of its products to its most profitable customers, then it is able to operate more efficiently and ensure that everything it does revolves around the right things.

Customer segmentation exercise is also one of the first steps towards helping the organization which has its objectives to expand and prepare for future to make that transition. Ultimately, customer segmentation exercise can help the organization better define its ideal customers, identify the segments to which these customers belong to, and improve overall organizational focus.

Steps in the customer segmentation process

Customer segmentation process to be effective is required to be executed in a way which is driven by a clearly defined set of objectives and outputs. It is to be backed by all of the relevant stakeholders of the organization. The customer segmentation process is a five step process and with this process, the organization is able to identify its present customer segments, organize them by value to the organization, and prioritize them in a way that fosters stronger organizational focus over both the short and long term. The five steps in the process of customer segment exercise (Fig 1) are (i) preparation and setting up the objectives of the exercise, (ii) performing of customer data analysis, (iii) executing data collection, (iv) conducting of customer segment analysis, and (v) prioritization, and implementing the results into the organizational strategy.

Five steps of customer segmentation process

Fig 1 Five steps of customer segmentation process

Step 1- Preparation and setting up the objectives of the exercise

Customer segmentation process begins by defining the exercise and planning for it appropriately. Like any other exercise, adequate prior preparations are also necessary for this exercise. Without it, the initiative lacks focus and direction, which can ultimately take the exercise off course. To be effective, the organization is to execute the customer segmentation process which is driven by a clearly defined set of objectives and outputs, and is backed by all of the relevant stakeholders of the organization.

The objectives of the exercise are to contribute to the organizational goals on its completion. Ideally, these objectives are to overlap or to be aligned with the strategic goals of the organization. In this step the scope of the exercise and what is expected from the exercise is also to be determined. Further, the scope parameters are to include the amount of resources and/or time spent on the whole exercise or during each stage of it.

During this step, it is also important to make an action plan. Normally the action plan has two sets of plans namely (i) a high-level outline and (ii) a work plan. The outline usually carries details of the basic steps, methodology, and timeline of the project and is normally to be approved by the organizational management. By contrast, the work plan is a much more detailed document that elaborates significantly upon the outline, typically breaking steps down into specific tasks that clearly indicate what needs to be done and what the related inputs and outputs are. The work plan is to reflect inputs on key tasks as well as suggestions and specifications for outputs at key internal review steps. It is also to ensure that the methodology behind the main analytical tasks is consistent with the overall methodology of the exercise.

Further in this step, it is required to develop a customer list. For this, data from customer relationship management or billing database can be used. The list is required to be comprehensive and include all the relevant customers which are needed to be included for the data analysis. The selection of customers is very important for precision results and to avoid skewing of average values during data analysis.

Step 2 – Performing of customer data analysis

The next step in the customer segmentation process exercise is to develop a formula or set of criteria to measure the attractiveness or value of each customer in the organization’s customer base. This formula is determined by the actual economic benefits or net profits/loss that customer has generated over its lifetime. It creates an objective measure that can consistently and objectively be used to compare customers in different segments.

The hypotheses are to represent proposed relationships between customer characteristics and the goodness of the customer, as measured by the quality score. For the generation of an initial list of such segmentation hypotheses, it is necessary to analyze (i) the structure of the market, (ii)  market information residing within the organization, (iii) data available through market experts and their publications, (iv) competitive information collected by reviewing competitor websites for their marketing communications, promotions, sales content, and product features, (v) structurally similar industries by reviewing industries with similar organizational characteristics, and  (vi) standard, ‘a priori’ segmentation schemes. Once the hypotheses have been identified, they need to be tested for their validity with the data available from internal and external sources.

The ultimate goal of this workout and data collection is to determine what makes a good customer for the organization or its product. At this stage, no segmentation idea is too far-fetched, as long as there is some economic or logical rationale for why it could be true and it is a meaningful prediction that can be validated. At this stage it is necessary to capture every angle which might help the organization to segment the customer base.

Step 3 – Executing data collection

The next step is to build a comprehensive list of ways of using the customer characteristics which have been identified to distinctly classify the current customer base by attractiveness. This is done using inputs and recommendations as informed by the organizational employees, experts, and customers, as well as studies done on competitors. It is important to be as comprehensive as possible.

The data collection process is required to be properly managed. Best practices for the team for managing the data collection process include (i) to ensure proper and consistent documentation of the input and output specifications for each task, (ii) to leverage overlapping data collection needs for different segmentation hypotheses, (iii) to document tasks in the minute details since it has a large impact on the quality of the data, (iv) to establish a regular working rhythm which includes reviewing the outputs, allocating new tasks, and resolving any impediments, (v) to have separate personnel to focus on data quality assurance and to vet all the outputs, and (vi) to use proper software tools to better manage the vast number of data fields typically associated with the process.

To collect the data, it is necessary to develop a plan detailing where each variable is to be found, and which resource and method is to be used to find it. It is better if a standardized format is used. Also it is better that the data collection work plan is shared with the data collection team so as to get their feedback and support. Their input makes the plan more accurate and realistic, while their support makes the exercise more efficient.

The data collection work plan and the best practices described above are still relevant even if the data collection teams do not have access to any additional resources for data collection. When setting up the plan, it is necessary to identify potential weaknesses in the data set and special attention is paid to them as the data is being collected. These weaknesses might include (i) incomplete or hard-to-reach data, (ii) outdated data, (iii) data which is not easily standardized or has multiple definitions, and (iv) data which need qualitative judgment. For ensuring the quality of the data, it is necessary to conduct quality assurance before, during, and after the data collection process since the problematic data creates many issues during the segmentation analysis exercise.

Step 4 – Conducting of customer segment analysis

Conducting of customer segment analysis is essential to evaluate and prioritize the customer segments. Once the necessary data have been collected, it is required to be analyzed for validating each of the hypotheses. This helps in identifying whether a segmentation idea is right or wrong. Having done so, it is also important to analyze the relationships between validated hypotheses. The synthesis of these segmentation schemes is an overall segmentation of the customers which incorporates each of the validated segmentation hypotheses. This results in segments that are not only analytically proven to be attractive, but also intuitive and targetable for the purpose of developing and executing a segment-focused strategy for them.

The data is analyzed to validate or to reject each segmentation hypothesis as well as to uncover the relationship between them. There are many different ways to do so. One way is the ‘light weight clustering analyses’. This is usually done if there is a small customer base, and/or a small list of segmentation hypotheses. The second approach is the ‘tree-based clustering analyses’. This is used when there are more resources and time to spend on the analysis, or when there are many customers’ data to analyze. Once the segmentation variables using either of the methods described are found, the process can be taken one step further by numerically validating those hypotheses using regression analysis.

The regression analysis is started with a large set of variables, maybe all of the ones which appeared relevant in the initial quartering of the data set. A multivariate regression is run against those variables with the account quality score as the dependent variable. The result of the regressions allows identifying of variables which are insignificant, as well as variables which might be too closely correlated to each other to both be included in the analysis. Those variables are eliminated and the analysis is rerun so as to reach a set of variables which are all significant, and yet substantially independent of each other. These are the ultimate segmentation variables for the purposes of customer segment exercise.

The segmentation which is arrived at is most likely a combination of the main segmentation variables and the resulting segments are defined by a combination of specific values of the segmentation variables. However, some of the segments identified can also be merged together, and not all of the defined segments satisfy the following list of desirable segment characteristics.

  • The segments definitions are meaningful and intuitive. They make sense and do not require a lot of complex reasoning to be defined.
  • The segments are well-defined and preferably demarcated by observable variables so that it does not take a lot of effort to classify the customer into the segments.
  • The segments are addressable using modern communication and marketing tools.
  • The segments are substantial enough (in terms of number of prospects or economic benefits) to be considered an integral part of strategy.
  • The segments are sustainable and can be continued to be a meaningful part of the market, growing at least as fast as the overall market.

The above characteristics ultimately define actionable segments, as opposed to the analytically defined and validated segments which have been developed through the previous analysis. The main tradeoff in the selection and/or definition of segments based on the validated segmentation hypotheses is thoroughness versus practicality. To reduce some of this complexity, it is necessary to concentrate on a fewer number of segments which more fully satisfy the list of criteria above. This may result into a loss of some accuracy due to the ignoring of less important variables. Thus, even though many different hypotheses have been validated, work to synthesize them is to be continued so that the final segmentation scheme depends on just a few segmentation variables. Having more variables unnecessarily complicates the delivery of the results, and the subsequent efforts to target the identified segments.

Once a satisfactory overarching segmentation scheme has been reached, the last analysis to be done is to evaluate the resulting segments and prioritize the few that are most promising in terms of the following.

  • Customer quality – It is measured by the average customer score, this is the spread of the scores within all customers in that segment, as well the lowest and highest scores of customers in that segment.
  • Segment size – It is a rough estimate of the total economic value of all the prospects which have characteristics as defined by the segment.
  • Segment growth – It is a rough indication of future trends relative to the size and attractiveness of the segment.

Finally organization is to identify and define a few segments which form a big part of the total customer groups. These segments need to be most important segments which are to be of prime concern for the organization and on which the organization is to keep its focus.

Step 5 – Prioritization and implementing the results into the organizational strategy

It is the last step in the exercise of the customer segmentation process. This consists of targeting the selected customer segments identified through this exercise and aligning all the facet of the market strategy of the organization with this target segments. This may include aspects of product strategy, go-to-market strategy, sales, marketing, and even customer service. The organization is to ensure that the existing customers in the segments are well served.

Follow up action

After completing the five steps as described above, the organization has the critical customer segmentation data. With this information available, the organization is required to begin focusing on more productive and profitable customer segments. However, the customer segmentation process data is only useful if the organization put it into action immediately, since the data has a shelf life. The shelf life is because a number of factors, which decide the customer segments, are time and environment dependent and are bound to change with time and with change in the environment. Hence it is better if the customer segmentation process exercise is repeated at regular interval.