How To Do Customer Segmentation Right

How To Do Customer Segmentation Right

Many segmentation efforts today are an exercise in futility because companies are basing their segments on inappropriate criteria.

RBC Royal Bank is one of the few companies that actually gets it. Here's how the bank has grown its market share by courting specific customer segments, such as retired snowbirds and future doctors.


  • How understanding your customers' needs can boost profits
  • How to segment customers according to their necessities at each life stage
  • Why segmenting by age or revenue alone is ineffective

If banks could choose their customers the way kids choose sides on the playground, customers in the 18-to-35 age bracket would be picked last. With their relatively small incomes, low account balances and large student loan debts, young customers aren't exactly the sort over whom the average bank salivates.

At RBC Royal Bank, however, executives recognized that some of those impecunious young customers might eventually turn into wealthy, profitable customers. So RBC analysts pored through the bank's data on its young customers looking for subsegments with a strong potential for rapid income growth. Their analysis identified medical school and dental school students and interns as a group with a high potential to turn into profitable customers. So in 2004 the bank put together a program to address the financial needs of credit-strapped young medical professionals, including help with student loans, loans for medical equipment for new practices and initial mortgages for their first offices. Within a year, RBC's market share among customers in this subsegment has shot up from 2 percent to 18 percent, and the revenue per client is now 3.7 times that of the average customer. Martin Lippert, vice chairman and CIO at RBC Financial Group, says the bank's willingness to help these young professionals get started will likely be rewarded with a lower attrition rate down the road.

"We may have customers we're not making money on, but we look at that as more our problem than the customer's," Lippert says. "Our opportunity lies in finding what the needs of the customer might be so we can offer them additional products and get them to a point where we're making some return."

While lots of companies claim they're customer-centric, RBC is one of just a handful of organizations that segment customers based on customer needs, not their own. And by focusing its operations on addressing those needs, RBC has grown its market capitalization from $US18 billion almost six years ago to close to $US50 billion today.

So far, few companies are as sophisticated at segmenting customers as RBC. Many don't do any customer segmentation at all, and those that do typically don't reap much value from the exercise because they segment on the wrong criteria. Precise, needs-based customer segmentation is time-consuming and difficult, and very much in its infancy. But it's worth doing because it enables cost-effective targeting of customers with product and service offerings that match their needs. That kind of precise targeting obviates spending a bundle on largely ineffective mass mailings - and alienating customers with irrelevant offers. It's the quintessential win-win: Customers get what they want and subsequently buy more; companies waste less money and increase sales and profits.

"The more you're able to do for the customer, the more likely she is to pay attention to the next offer," says Martha Rogers, co-author of Return on Customer and co-founder of Peppers & Rogers Group. "Yet companies are not doing nearly so much as they can."

The Wrong Way to Segment Customers

Many segmentation efforts today are an exercise in futility because companies are basing their segments on inappropriate criteria, says Larry Selden, co-author of Angel Customers & Demon Customers and professor emeritus of finance and economics at Columbia Business School. As a result, organizations often wind up with segments that drain resources, instead of with segments that lead to more effective ways of running the business or meeting customers' needs. For convenience, companies that are organized along product lines often segment customers by the products they buy. This approach, however, risks alienating customers in two ways: Customers who happen to be in more than one segment get bombarded with multiple uncoordinated offers. And big spenders in one product category who start buying in a second category are justifiably miffed when they're treated as strangers.

Segmenting by demographics is also quite common, but it's generally not useful unless customer needs happen to align neatly with demographic characteristics. Lego customers' needs, for example, do tend to shift with age. Preschoolers, after all, play very differently from kids who are between 5 and 14 years old (what Lego calls the in-school segment). And the 30,000-plus adult fans of Legos tend to be hobbyists with a completely different mind-set altogether. Yet considering age alone isn't sufficient; Lego also looks at what users do with their bricks. In-school kids who focus on building when they play will likely want plain bricks, but those who focus on role-playing usually gravitate toward themed sets. Cases in which demographics alone are an indicator of a common need are generally rare.

A lot of companies segment customers by revenue, intuitively assuming that revenue is a good indicator of profit. But, Selden argues, that's hardly ever the case. He maintains that an effective segmentation strategy should begin with a profitability analysis, divvying customers into 10 deciles ranging from most to least profitable. When he segmented one major retailer's customers by revenue, some that had the largest revenue generated among the lowest gross profits. And to get a true picture of profitability, banks need to think about the amount of capital they must allocate to high-risk customers.

It's not a given that all or even most customers within a certain profitability decile are necessarily alike. Even so, understanding which customers are profitable and which aren't is a good starting point. The trick is to delve into each profitability segment to look for hints of possible subsegments, that is, customers whose behaviour patterns or other shared characteristics suggest they might have common unmet needs. Once RBC identified the shared unmet needs of young medical professionals, it was able to put together targeted offers to meet those needs and increase the profitability of that subsegment. "The goal for segmentation is to put customers in homogeneous groups based on common needs and wants that you can act on with a common solution," says Selden. "So who are all the people you can go at with a common offer that will make you a boatload of money?"

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