How to measure customer value and start using it for segmentation

Ever since the early days of ecommerce, too many companies have had a narrow customer acquisition focused culture, that ultimately led them into financial disasters. For instance, around 2018, some organizations were so much into the acquisition culture that I hit a wall every time I brought up the topic of customer lifetime value (CLV) with them.

The challenges of the modern consumer

Let me start with the example of Thomas Cook. As you know, they were the industry leader in tourism. Unfortunately, they didn’t adapt to the online behavior of the modern customer. And when its impact compounded with some of their bad M&A and other business decisions, it led to the 178-year-old company to close down in September 2019.

They could have taken the hint from the continuously changing customer behaviour, as early as in 2009. The data was public, right under their nose. Google Trends was indicating the change in the expectations of the modern consumer, in terms of a personalized experience. Rest is history.

Why did I start with the above story? 

Right now, Customer Lifetime Value (CLV) is going through a similar phase as the internet, and online businesses were in the 90s.

I was eight years old in 1998 when James C. Anderson and James A. Narus published a piece on customer value in the Harvard Business Review. The core message was that very few retailers understood what customer value meant and measured CLV.

Cut to 2020, and it still stands true. Sadly, only 20-30% of ecommerce players (the likes of Amazon and Costco) are making efforts to increase their customer lifetime value. 

Others tend to focus too much on acquiring customers, and not in retaining them. And it leads them to failure, especially when the acquisitions budgets tend to be way higher than what the acquired customers are ever likely to spend in their stores.

Interestingly, between 2013 and 2018, the CPC on Facebook grew by 800%, whereas ecommerce sales worldwide increased by 158% only.

So, the critical lesson is –Never confuse growth with growth generating factors.

There are only 3 2 ways to grow a business

Jay Abraham says that there are three main ways of growing a business.

While the first two points make sense, it serves only in the short term. And on the other hand, it’s not a secret that retaining a customer is 5X cheaper than acquiring a new one.

So, despite being a fan of Jay, I would tweak his pointers to:

• Acquire more customers
• Make your existing customers purchase from you repeatedly

All you need to do is understand your customer behaviour and focus your energies on the right ones. Treat them right, personalize your communication, show appreciation on special occasions and more importantly, give them a reason to choose you over a competitor. 

Easier said than done, right? 

Not really. Remember, not all customers are created equal. They have different needs, expectations, emotions and yet, not every customer brings the same amount of value to your business.

Understanding customer value

Everyone talks about customer value. But what does it mean? You can look at it from two perspectives – the perspective of the customer, and the perspective of the business.

For a customer, it merely refers to the worth they get in return to what they pay to the business. If they feel they are getting more than what they pay for, it is valuable for them. The value could be in terms of services, or the problem a product solves for, etc.

From a business standpoint, it is about profitability for a given customer and the potential lifetime value (i.e., how long a customer stays with them)

So, holistically put, you can define customer value as:

Customer value = Perceived customer benefit – Cost incurred on the customer

Therefore, if you want to increase your customer value:

1. You need to evaluate the current customer experience and fix the gaps (if any)
2. Experiment with your pricing (at least price differently for each type of customer, based on the amount of value they are seeking) 
3. Analyze customer data (first-party data), and improve your relevance based on data analysis
4. Identify the most loyal customers
5. Segment your customers based on value and loyalty.

As the Pareto principle suggests, 20% of your customers are responsible for 80% of your sales. If you can segment your customers according to their behaviour, you’ll know whom to prioritize and encourage repeat-buying behaviour.

But, why should you bother with segmentation?

Segmentation helps you tailor your marketing efforts specifically to each category or subset of your audience. More specifically, it helps you:

• Deliver targeted communication that resonates with a specific type of customers
• You can double down on the best channel that works for the segment
• Enables you to deepen your relationship with your customers
• You can try and test your pricing options
• Spend more of your energy on the customers that contribute to 80% of your revenue.
• Upsell and cross-sell other products and services.

Approaches to segmentation

1. Firmographics based prioritization

It is one of the most basic approaches, primarily used when you don’t have a lot of data or existing customer base. In such scenarios, you build a target list based on firmographic information such as industry and company size, targeted roles, etc. However, it is not the most effective one because it operates on your assumptions.

2. Need-based segmentation 

This approach to segmentation is based on validated drivers such as a customer’s interest for a specific type of product or service. And this happens using first-party data (i.e., the data available about your customers within your tech ecosystem). Typically these segments are useful for your upselling and cross-selling programs.

3. Value-based segmentation 

This category focuses on segmenting customers based on their economic value, i.e., their contribution and potential contribution to the overall revenue of your organization. But it is imperative to understand the time value of economic value-addition. 

So, it would be best if you looked at the transactional behaviour.

Customer segmentation based on transactional behavior

While there are several ways to segment your customers, one of the simplest and most effective methods is RFM segmentation. It refers to analyzing and segmenting your customers based on three factors: 

• Recency (R)
• Frequency (F)
• Monetary Value (M)

The idea is to group your customers based on their purchase history (how recently, with what frequency and what was the monetary value of it) and use that data to predict their likelihood to buy again.

RFM Analysis and Segmentation

There are several tools available to analyze and segment customers based on data. In this case, we use our tool called REVEAL to do that. As soon as the tool gets access to the customer data, it begins to reveal the anomalies, which in turn, allows you to identify your most important customer groups based on the customer acquisition cost spent on them vs the margin they generate.

Then comes the segmentation aspect. RFM Segmentation is all about grouping your customers and giving scores to their recency, frequency and monetary values, ergo transactional behaviour segmentation. If you are interested in the science of it, here’s my detailed article on it.

Each segment is scored for buying behaviour on a scale of 1-5, where 1 is the lowest and 5, the highest.

Soulmates

We call the first segment that gets a score of 5 in all three categories (RFM SCORE: 555) as Soulmates. The customers in this group are frequent purchasers with a high AOV (Average Order Value). This group is usually not too crowded, but the ones that fall in this segment tend to contribute to a big chunk of the brand’s margins.

New Passion

The ones in this category are newly acquired customers (who purchased recently and have a high order value). This segment tends to have a low-frequency score because they are first time buyers. But since their recency and monetary value is high (RFM SCORE: 514 or 515)

The customers in this group typically tend to be ones that bet big on you, because your brand story and message resonated with them. But before you are tempted to go full-throttle salesy on them, remember that their experience is going to be a paramount factor in determining their lifetime with you.

While I don’t want to go into all the remaining segments, here is a snapshot of the different segments and the margins they contribute to.

To sum up…

The whole point of optimizing for customer value and segmenting them in a mutually beneficial way is to improve the overall efficiency,  and have repeat customers and increased loyalty. And when that combines with excellent customer experience, you are on a long term growth path.