2.6 Tools: Customer Segmentation Techniques

To cost effectively implement a tailored logistics strategy, you need to segment customers. involves classifying customers based on their importance. You can then define appropriate service standards for each segment. Let's discuss two segmentation tools: and customer profitability analysis.

Pareto's Law; i.e., The 80-20 Rule

Are you a frequent flyer? If you are, you know about Pareto's law. The airlines classify their customers based on how much money they spend. For example, Delta segments customers as Silver, Gold, Platinum, or Diamond. If you fly often enough and buy more expensive tickets, you can earn Diamond status—and special treatment.

Simply put, Pareto's law—also called the 80/20 rule—observes that 80% of your revenues/profits are driven by your most important 20% of customers. As Figure 2-4 depicts, most companies classify customers using sales figures. Why? Because the data is readily available. As the name of this tool implies, ABC classification typically categorizes customers into three groups.

  1. "A" Customers: These are strategic key accounts—the most important of your key customers (typically 5-10%)—and make up a huge share of sales, profits, and growth. They receive the most-customized service.

  2. "B" Customers: These are also key accounts, but don't offer the same growth or profit potential. They receive very high levels of service.

  3. "C" Customers: These are the remaining 80% of your customers. They receive high levels of standardized service.

Figure 2-4: The Pareto Principle Applied to Customer Segmentation

Applying Pareto's law involves a two-step process.

Step 1: Classify Companies by Sales

Table 2-2 illustrates the classification process. Panel A lists a pharmaceutical supplier’s customers alphabetically. Panel B sorts the customers on last year’s sales. Three customers account for 56% of sales. The next eight largest customers represent 34% of sales. The remaining 42 customers drive only 10% of sales. As the example shows, this step is pretty easy.

Table 2-2
Customer Segmentation Using ABC Classification 1

Step 2: Modify Classifications Based on Strategic Issues

Sales figures only provide a snapshot regarding relationship importance and potential, making the story incomplete. You therefore need to consider other issues that might make a customer more or less important—both now and in the future. For example:

  • A customer may possess unique skills that will drive future market advantage.

  • A customer may control scarce resources (a new patent) that will spur sales growth.

  • Intensive collaboration may uniquely improve logistics customer service.

Such “qualitative” factors will help you define exactly where the lines are drawn between different customer segments. Step 2 requires experience, judgement, and good scanning skills to identify and accurately assess the right qualitative issues.

Finally, because both relationships and the competitive environment evolve over time, you need to periodically re-evaluate your classifications.

Customer Profitability Analysis

The goal of logistics customer service is to support profitable customer relationships. In reality, some customers buy higher-margin products; others cost more to serve (see Table 2-3). To execute a truly profitable tailored logistics strategy, you need to segment customers based on profitability. enables you to drill down into the real costs of logistics customer service. The Chartered Institute of Management Accountants defines ABCM as,

An approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. 1

Table 2-3
Customer-Imposed Costs in Order Fulfillment 1
Activity Low-Cost Customer High-Cost Customer
Order Receipt
  • Volume, blanket contract
  • Orders placed via web portal
    		•
  • Small orders placed one at a time
  • Orders placed by phone or fax
    		•
    Order Processing
  • Steady ordering pattern
  • Flexible delivery time windows
    		•
  • Sporadic ordering pattern
  • Tight time windows with late fees
    		•
    Order Picking & Preparation
  • Full pallet picking
  • Pallet-stacked loads
    		•
  • Case or each picking
  • Floor load
    		•
    Order Shipment
  • Full truckload orders
  • Infrequent expediting
    		•
  • Less than truckload orders
  • Frequent expediting
    		•

    The Logic of Activity-Based Cost Management

    Activity-based costing ties actual costs to the customers that drive them. Figure 2-5 shows that value is created—and costs generated—as resources are used to produce products, deliver services, or meet customer needs. Activity-based costing traces costs backward from the end cost object (in our case, a specific customer) to the resources needed to meet the customer’s service needs. To trace costs effectively, you need to ask and answer the following four questions:

    Figure 2-5: The Logic of Activity-Based Cost Management

    • Question 1: What are your cost objects? In a customer-segmentation scenario, you want to begin your analysis with your most resource-intensive “A” customers.

    • Question 2: What processes does each customer initiate? To meet customer needs, you must manage a variety of processes from new product development to reverse logistics. Figure 2-5 focuses on logistics order fulfillment.

    • Question 3: What activities comprise each process? Logistics service, like most value-added processes, is comprised of a variety of activities. Your task is to define core activity centers and identify the specific activities that are performed in them. For example, what are the specific steps involved in preparing an order for shipment? Order preparation could include picking, palletizing, shrink wrapping, labeling, staging, and loading. You can evaluate the costs associated with each of these activities using . Because this analysis is costly, you need to define how much accuracy is really needed to design a winning fulfillment strategy.

    • Question 4: What resources are used by each activity? Value-added activities consume five types of resources: labor, plant and equipment, materials, capital, and utilities. Your challenge is to tie the amount of each resource consumed to a specific order. Barcodes, RFID, and other sensor technology can help you track orders as they progress through a process, enabling you to link resources to specific orders.

    The Power of Activity-Based Cost Management

    Now that you know the mechanics of ABCM, let’s discuss how customer profitability analysis improves your ability to make good decisions. Activity-based costing gives you an accurate view of the costs of service, enabling you to build individual customer profit-and-loss (P&L) statements. When you know how profitable each customer is, you can avoid dedicating resources to unprofitable customers. For example, at one Fortune 500 company, ABCM revealed that the firm’s resource-intensive key accounts were unprofitable. However, the company had begun to stop selling to some of its low-volume “C” customers so that it could dedicate more resources to its so-called “best” customers. The profitability analysis showed, however, that these “C” customers were highly profitable and had been subsidizing the “A” customers. Without knowing it, the company had pursued a service strategy that would have led to bankruptcy.

    This reality raises an important question, "Once you know your best customers are not profitable, what should you do?" You have three viable options:

    • Option 1: Collaborate to reduce costs of service: Activity-based costing reveals which behaviors/decisions are driving costs. With this insight, you can begin a fact-based dialogue with customers about how you can work together to reduce costs. You will find that customers have no idea how their internal policies/processes affect you or what their requests really cost. Once you show them accurate numbers, most customers will be interested in working with you to bring costs down.

    • Option 2: Raise prices: A second advantage of a fact-based dialogue enabled by ABCM is that you can show the customers that they are truly getting value for their money. You will almost always be able to negotiate a price that yields a reasonable profit if your service is best in class and offered at competitive prices.

    • Option 3: Fire the Customer: If a customer is not willing to consider options one and two, you may need to stop doing business with that customer. Accurate costing enables you to make this tough decision.

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