Not all Customers are Equal

I was at a small business conference earlier this week and one of the speakers said something which I have advised businesses for years.  What I have advised is that it isn’t just about working hard, it’s about working smart.

That isn’t denigrating hard work.  It is about applying effort and resources on activities which provide the best return for your business.

The concept of working smart can be combined with the Parato Principle.  This principle states that eighty percent of the return from an activity comes from twenty percent of that activity’s base.  In terms of business, the principle states that eighty percent of revenue results from twenty percent of the customer base.

So a small business, with limited resources, would be working smart by targeting its activities on those customers which provide the majority of its revenue.

There is one caveat, remember your most profitable customers may not be your best customers.  It is therefore a good idea to analyse the nature of your customer base and to develop appropriate levels of service to meet that nature.

There is a somewhat cynical model of customer behaviour which can be used to firm up a business proprietor’s classification of customer types.  It breaks customers down into four segments based on their needs and their willingness to pay for those needs. The segments are as follows:

  • Customers who are willing to pay a high price for goods and services but in return expect a very high standard of goods and service.
  • Customers who are willing to pay a low price and as a result are willing to accept a low level of goods or services.
  • Customers who are willing to pay a high price for goods or services and who have low expectations as to levels of service.
  • Consumers who want a low price but high levels of quality or service.

All these segments contain potential issues for small business owners.

Many small businesses may target high value customers but if that customer demands a high level of service, does the small business have the resources to meet that demand or is the cost of meeting that customer’s needs simply to great.

The second segment might mean low customer expectations but by offering a low price is there a sufficient return or is the small trader able to produce goods and services in the necessary volume to create that return.

The third segment are your price inelastic customers but studies show that these are only ever about ten percent of any market.  Is that ten percent a suitable niche for a small business?

Finally, the last segment are the customers no business really wants, they demand the earth but are not willing to appropriately compensate a business for that level of provision.

Here’s an example.  I used to work with a colleague who bought a new four by four every two years.  He was gadget mad and always purchased lots of optional extras on his new car.  However, he expected perfection and, at the slightest rattle or squeak from the vehicle he would call the garage.  He demanded a high level of service and expected the garage to keep him informed of progress in relation to the perceived fault.  This meant the garage had to provide him with regular updates as to their work servicing the vehicle or identifying the fault.

He was clearly a customer who met the high price, high service segment.  The garage was happy to deal with his high service demands because they knew he would regularly purchase a new vehicle from them with lots of profitable extras.  They also knew that they had the capacity to meet his expected levels of after-sales service.

However, what if he only bought a second hand vehicle every five years and wasn’t willing to have his vehicle serviced by the garage.  It would not be sensible for the garage to bend to every whim of this type of customer.  There simply isn’t the financial return.

An RFV analysis is a useful way of assessing whether a customer is within the 20% that forms the core of your business.  In such an analysis R stands for recency i.e. how long since the customer last traded with your firm. F stands for frequency i.e. how often a customer has purchased goods and services and V stands for monetary value i.e. what revenue a company receives from that customer.

Depending on the nature of your business, the importance of these three variables may need to be weighted.

For example, a business selling luxury cars may expect a customer to purchase a new car every three years so recency would have lower importance than frequency and monetary value.

A small city centre grocer may place frequency of purchase over monetary value but recency would also be important.

A firm offering garden design services may place importance on the recency of a customers purchase over frequency or monetary value i.e. a customer that last bought their services five years ago would have lower importance than one which bought the services in the last few months.

By applying a score on each customer based on each of the three RFV variables, you can identify the 20% of your customer base which are your key customers.  For each variable list your customers and give a 5 to the 20% of the customer base which are your most frequent, most recent or most valuable.  Score the next 20% a four and so on until the lowest 20% for that variable are scored a one.

Then multiply these scores with the appropriate weightings to identify the overall 20% of customers which are your most important.

Here’s an example.

A car trader expects a key customer to purchase a car every three years.  They expect significant monetary value from a key customer and are concentrated on more recent customers.

Therefore they have placed the following weighting to each of the variables.  Monetary value is twice as important as recency and frequency so:

Customer Value = R + F + (2 x M)

Take Joe Bloggs.

Joe usually buys a car every two years, he buys the top of the range model with lots of extras but he hasn’t bought a car for three years.

Joe scores one for recency, four for frequency and five for monetary value. Joe’s total score is 15.

Take Bill Smith:

Bill usually buys a second hand car every five years, he last bought a vehicle two years ago.

Bill scores four for recency, one for frequency and two for monetary value.  His total score is nine.

Take Sally Green:

Sally usually buys a second hand car every year. She last bought a vehicle eleven months ago.

Sally scores five for recency, five for frequency but three for monetary value.  Her total score is 16.

Sally and joe are clearly in or close to the 20% of customers with are key to the business.  With a total score of 20, Sally is on the 80% percentile.  If Joe had followed his usual pattern he would have as well.  Bill is one of the 80% of customers outside the Parato 20%.

Therefore, the garage should ensure that Sally is happy so that she continues her buying pattern.

Joe is a worry, he has not followed his usual nature and may for some reason have become dissatisfied.  The garage needs to contact him to find out why he not bought a new car.  perhaps he needs an additional incentive such as free servicing or better credit terms.

Bill is a lower priority customer so rather than a personal contact with him by a sales representative, he should be included on a mailing list or to receive a standard email about offers on second hand vehicles.

RFV analysis is a relatively simple way of assessing who is within the top 20% of your customer base and then applying appropriate marketing activity.  it is part of working smart as well as hard.