Perhaps you already know the marketing term "target market". In the world of finance and strategy, we take that concept further through a process called customer segmentation.
Why is this so important? In most businesses, just 20% of customers account for more than 80% of profits. (That's known as the “Pareto principle” or the “80/20” rule.) If you can identify which customers are in your "80" and which are in your "20" you can focus your efforts on the profitable ones and save yourself a lot of headaches with those that are not.
To do this you can use a simple customer segmentation process, and adjust your operations accordingly. Here's how:
1. Start With a List
Start by creating a list of all your customers. Next to their names, write the total money they spent with you this month or this year.
(Later you can add more important indicators, like gross margin, but for now “annual sales” is a good estimate of the customer’s importance.)
2. Rank Order the List by Sales
How much difference is there between the top-spending customer and the bottom-feeders? If you are like most businesses there is a big difference between top and bottom, but you’ll probably have customers that fall over the entire spectrum.
Now find the top spending customer and divide each of the others' spend by that maximum to get a percentage. So if customer "A" is your best customer, then calculate the percentage that customer "B" spends compared to "A".
(The formula is: A/B = % ... Remember, decimals are just percentages in disguise, so a result of 0.56 = 56%.)
Using that percentage, divide your customer list into 5 groups, or "segments". In the first group, or segment, will be those big customers who spend 80% to 100% of the top spender. Don’t worry about how many companies are in each segment, only on the amount they spend with you.
When you are done, you’ll have 5 groups:
- Segment #1: 80% to 100% of top spender
- Segment #2: 60% to 79% of top spend
- Segment #3: 40% to 59% of top spend
- Segment #4: 20% to 39% of top spend
- Segment #5: 0% to 19% of top spend
3. Take Action
Use the results from this customer segmentation analysis in your sales, marketing and budgeting. Since you now know the sales that each customer generates, you can adjust your entire business strategy so that each group become more profitable. Knowing how important a customer is helps you respond in a way that you can afford -- and that encourages them to spend more!
- Adjust your Promotional Budgets. Think of promotions as a percentage of a customer's spend with you -- maybe 1% to 3%. So rather than send all your customers the same $100 gift basket at Christmas, minimize what you spend on the smallest customers, while you really go all out for the big guys.
- Adjust your Pricing. Charge small accounts slightly more than the larger accounts. This will help balance the profitability of each group and encourage small customers to spend more to get the discount.
- Adjust your Sales. Take a close look at the companies in the top 2 groups. 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 lower groups.
- Adjust your Messaging. Change your marketing message to fit the unique perspective of each group. 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 $10 each month promoting to the largest customers, you should spend just $1 advertising to the smallest customers.
If you segment your customers well enough -- and stick to the strategies that leverage that information -- you will start to see more “low spending” customers bubble up and spend more. You may also find that some of the small-fries simply drop out. That’s OK.
You can't serve everyone, so focus on serving the most profitable accounts and let the small fish swim over to your competitors!
4. Fire Your Worst Customer
Segmentation strategies can make your business so much more profitable that you may want to “fire” those customers who are left in the bottom group. But don't just tell them to go away ... give them a chance to meet your needs. For example, 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. So 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,
PS: Need help? Want to calculate even better segmentation metrics, like "Lifetime Value" or "Gross Margin Contribution"?
David Worrell is a serial entrepreneur, financial analyst, and author of the book, "The Entrepreneur's Guide to Financial Statements". As a consulting CFO, David promotes financial discipline for new and growing companies. Learn more at FuseFinancialPartners.com.