Customer Segmentation - Absolutely Essential in a Commercial Excellence Initiative for Increased Profitability

Customer Segmentation

by Terry Stidham

Last week 2013 Richard Verity, Amit Gautam, Ralph Maenen, Otto Waterlander at Booz & Company published a white paper, Commercial Excellence Programs: A Way for B2B Companies to Pursue Growth in Hard Times discussing how B2B companies are using commercial excellence to grow their top and bottom lines after having cut their expenses as deeply as possible in recent years, and with no signs of rebounding growth in their markets.  

They point out that commercial excellence, as an approach that imposes discipline on a company’s pricing decisions and aligns its service offerings with its customers’ needs can quickly improve margins in designated regions, on select products, and on key accounts, and support an overall rise in corporate profitability…A company embarking on a commercial excellence initiative must develop expertise in more than a half-dozen disciplines that touch customers and its operating model. The most important disciplines are margin diagnostics, pricing and customer segmentation.

Since this blog focuses on Sales, Marketing and Business Development I will stay with Customer Segmentation. Customer segmentation is the subdivision of a market into discrete customer groups that share similar characteristics. It enables businesses to:

• Identify unmet customer needs
• Outperform the competition by developing uniquely appealing products/services
• Tailor offering to segments that are most profitable and serve them with distinct competitive advantages
• Position best resources on best accounts
• Extract maximum value from both high- and low-profit customers
• Over invest on high potential account and lower the CAC (Customer Acquisition Cost) on lower segments
• Allocate resources to product development, marketing, service and delivery programs

Methodology - Customer Segmentation requires businesses to:

• Divide the market into meaningful and measurable segment according to customers' needs, behaviors or their demographic profiles
• Determine the profit potential of each segment by analyzing the revenue and cost impacts of serving each segment
• Target segments according to their profit potential and the company's ability to serve them in a proprietary way
• Invest resources to tailor product, service, marketing and distribution programs to match the needs of each target segment
• Segment and adjust the segmentation approach over time as market conditions change decision making through the organization

Common Uses - Companies can use Customer Segmentation to:

• Prioritize new product development efforts
• Develop customized marketing programs
• Choose specific product features
• Establish appropriate service options
• Design an optimal distribution strategy
• Determine appropriate product pricing

Booz & Company says, “Business-to-business (B2B) firms’ financial results have rebounded since the crisis of 2008, but not because of a return of top-line growth. Instead, what has helped those in B2B report better earnings is a renewed focus on costs, along with a concerted effort to manage their supply chains to better align with uncertain demand. The difference between bottom- and top-line performance in recent years has been unmistakable: Companies in the S&P 500 had a cumulative 17 percent jump in EBITDA from 2009 to 2011, but only an 8 percent increase in revenue.

Most companies turn to inorganic growth when they can’t grow organically, but that has not been the case in recent years. In the chemicals industry, for example, acquisitions in 2012 amounted to only $67 billion, less than half of the value for 2007. An extensive study of M&A transactions between 1995 and 2010 showed that acquisitions don’t necessarily add value—the EBITDA multiples of the 767 acquirers during that period barely budged from two years before they completed their deals to two years afterward. Chief executives may not have these statistics at their fingertips, but a lot of them sense the limits of M&A as a solution.

What to do?

Some corporations are turning to commercial excellence as a new means of creating value. Commercial excellence is a state in which companies have such a clear understanding of different customers’ needs and profitability that they are able to achieve top- and bottom-line improvements without necessarily changing products or adding customers...

...Commercial excellence typically involves eight disciplines that gain power to the extent that they draw on, and reinforce, one another. For example...sales force effectiveness draws on other parts of the commercial excellence system to improve the quality of customer interactions—a front line activity critical to every company’s success.

Not all of the disciplines required for commercial excellence are equally important, of course. For every B2B company, however, three stand out as clear priorities:

1. Margin Diagnostics
2. Customer Segmentation
3. Pricing

Without developing excellence in these three areas, it will be impossible for most companies to realize the potential of a commercial excellence initiative. These three areas generate the largest returns in the shortest amount of time.”

“Customer segmentation can be important in both B2B and business-to-consumer (B2C) settings and is absolutely essential in a commercial excellence initiative—it gives form to all of a company’s customer-facing activities. For this reason, companies must avoid the many bad practices that undermine the effectiveness of segmentation and weaken the result­ing insights.

The most common pitfall is segmenting at too high a level— for instance, at the level of the manufactured end product or end markets. Suppose an agricultural seed company groups all of its customers that grow corn for food into one segment (“premium”), and all of its customers that grow corn for ethanol into another segment (“commodity”). There is some value in grouping customers like this—the external opportunities and obstacles of customers in the same end markets tend to be similar—but it is not the type of segmentation that provides the best intelligence on how to serve the customer. And it can lead to waste and inefficiency if a segmentation that is too loose means superficially alike customers get the same level of service...In that case, B2B companies may set up delivery and support mechanisms that overcharge customers that simply want the basics, while undeserving their most demanding customers.

The best kind of segmentation to start with is usually one based on service needs. A segmentation of this sort, for instance, allows companies to define distinct and standard ser­vice packages for groups of custom­ers with similar needs. In practice it may not make sense to create too many service clusters. But most B2B companies do offer multiple levels of service—from basic service for customers seeking the most cost-effective transactions, all the way up to premium service for customers that need a high level of responsive­ness (rush deliveries and flexibility on volumes, for instance) and are willing to pay for it. There’s a spec­trum of possibilities that grows out of a segmentation based on service needs, and companies need to figure out how to address those needs.

Determining the right questions to ask, in order to segment customers according to their service needs, can be tricky. While customer questionnaires typically focus on top-of-mind requirements including price, safety, and on-time delivery, these are qualifiers (things that allow companies to compete for business) rather than differentiators (things that position companies to win the business). Indeed, there are usually second-order needs—for example, customer intimacy, technical support, and a flexible supply chain—that determine who gets the order.

Grouping companies by their needs along two axes provides a useful segmentation…four is usually the right number of customer segments for B2B companies. Fewer, and the company drifts closer to one-size-fits-all simplification. More, and the company risks becoming entangled in unhelpful complexity. It is not unthinkable that a B2B company would have more than four customer segments, but any company that does should make sure it can justify the added complexity.

Although service needs are the most important input in doing segmenta­tion, two other inputs should be used to supplement the analysis. One is size, meaning the amount of revenue or net gross margin the customer produces. A size-based segmentation might cluster customers into quar­tiles. A segmentation based on size alone would be dangerous, because it measures only how the company sees the customer—not the other way around. It’s also by definition backward-looking, meaning it can leave a company unsure of what to do next. On the other hand, paired with a service-based segmentation, one based on size can be valuable in determining what premium to charge over and above the baseline price...

A third segmentation component is supply of product. It might seem that a product segmentation should be done independently of a customer segmentation—and it should, except insofar as it influences what the supply chain must do to deliver on the overall service package. In fact, companies should separate their products or SKUs into three groups: the ever-present “runners,” the less frequent but still common “repeat­ers,” and the truly unusual, low-volume “strangers.”

With these three inputs, this approach to segmentation (with customer needs leading) releases the supplier from the one-size-fits-all straitjacket. Suitable behav­iors follow, beginning with sales but driving deep into scheduling, logistics, and manufacturing. This alignment with a customer’s needs positions the supplier to achieve— and be rewarded for—commercial excellence."

CONCLUSION: THE POTENTIAL FOR A FAST PAYBACK

"The last few years have been tough for many B2B businesses. Their end markets have been flat and their cash flows weak, and after several years of aggressive cost containment, their options for continued profit gains through cost reduction are limited. But they can still derive significant value through commercial excellence.

Companies beginning commercial excellence initiatives should take a holistic approach, rather than pursue piecemeal change. That said, they would be well advised to focus first on the three interlocking commercial dis­ciplines that form the basis of future improvements. Margin diagnostics gives management confidence that commercial processes are under con­trol. Customer segmentation ensures that the company is aligning its various activities with customer needs to achieve a pricing premium. The premium, in turn, depends on strong capabilities in the area of pricing.

Building these three disciplines requires commitment from an organization, and can benefit from a high-level champion. But such a commitment can pay off handsomely. We have seen commercial excellence programs add 3 to 5 percentage points to profit margins within six months. It’s easy to create the business case for that.”