Segment your customers for higher profits

If you're like most business owners, a long list of customers makes you happy. But as a business owner, you should also beware: A lot of profitability problems can lurk in a lengthy account list.

Not all customers are created equal. They are not all equally profitable, and thus your business can't afford to treat them all the same.

In almost every business, the "Pareto principle" applies to customer accounts. Also called the "80-20 rule," it maintains that just 20 percent of your customers account for about 80 percent of your profits. Many businesses would be better off if they simply did not have to serve the bottom 80 percent at all.

But before you go out and fire four of every five customers, take a closer look. By understanding the profitability of each customer segment and adjusting your operations accordingly, you can keep the customers and maximise profits.

Sort the wheat from the chaff

Start by creating a list of all your customers, noting the total money each one spent with you this year. You can add other more complex indicators, such as gross margin; but to start, annual sales are a good indicator of the customer's importance.

Rank order the list by sales. How much variance is there between the top-spending customer and the bottom feeders? If you are like most companies, the difference between top and bottom is large, but you probably have customers across the entire spectrum.

To make a big list of customers easier to work with, divide your customers into five groups, called quintiles. In the top group are those that spend 81 percent to 100 percent of the biggest spender's total sales. Don't worry about how many companies are in each quintile, just how much they spend.

When you are done, you'll have five groups. At the bottom are those that spend zero to 20 percent of the maximum. Group 2 spends 21 percent to 40 percent of the maximum. Group 3 spends 41 percent to 60 percent. Group 4 spends 61 percent to 80 percent, and then you have your top group.

Take action

This quintile analysis is useful to your strategy, marketing, and budgeting. Now that you know the sales each customer generates, you can adjust your business strategy so each quintile becomes more profitable.

In effect, you are going to make your business respond to each customer in a way that reflects their true value to the company:

  • Adjust your promotional budgets: Rather than send all your customers a gift basket at Christmas, minimize what you spend on the smallest customers while going all out for the big guys.
  • Adjust your pricing: Charge the small guys slightly more than the larger accounts. This will help balance the profitability of each quintile, but it will also encourage small customers to spend more to get a discount.
  • Adjust your sales: Take a close look at the companies in the top two quintiles: your best customers. How can you get more customers like this? What makes them different? Make sure your salespeople target more great prospects and fewer that will likely fall into the fourth and fifth quintile by analysing the characteristics of your top clients.
  • Adjust your messaging: Make your marketing message fit the unique perspective of each quintile. 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 $1 each month promoting to the largest customers, you should spend just 10 cents advertising to the smallest customers. The same goes for messaging to new prospects: Shift your message to attract the right kind of customer.

If you follow this prescription long enough, you will start to see more low-spending customers spend more. You may also find that some of the small fries stay where they are or simply drop out- that's okay.

Grow Profitably

At some point, your business will be so profitable that you may want to "fire" those customers who are left in the bottom quintile. 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. Take the time to really understand who your best customers are, and to adjust your company to respond appropriately to the rest, and you'll see profits begin to increase.

David Worrell is a lifelong serial entrepreneur who also coaches other business owners on strategy and finance issues. 

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