Continuing on the theme of segmentation, RFM Analysis is another tool for understanding and identifying different types of customers.  RFM stands for recency, frequency and monetary value.  This tool will help you:

1. understand customer value quickly when limited data are available (e.g., just purchase data)
2. develop a basic value segmentation that can be used to determine if your customer strategy is optimal
3. find untapped markets if there are segments which are not targeted
4. gain insight into gaps that might exist between accepted wisdom about the customer base and actual purchase behavior

The name suggests that recency is the most important factor for determining a customer’s value followed by frequency and monetary value.  However, you can set different priorities.  For one of my clients, monetary value was more important than recency and frequency.  Thus, their analysis was driven by monetary value first, recency and finally frequency.  It all depends on your product and the typical buying cycle.

The actual analysis involves calculating the R, F, and M dimensions, specifically:

1. creating a reasonable number of categories based on the date of most recent purchase (e.g., date was within the last month, within most recent 2 to 6 months, within prior 7 to 12 months, etc.)
2. breaking the number of purchases into a reasonable number of categories similar to recency
3. summing all revenue and creating a reasonable number of categories similar to recency

The number of categories you create depends on how you intend to implement the RFM analysis and should be guided by the means and standard deviations of the variables.

The fun part comes when you bring all of this together.  You first need to decide which dimension is most important and which is the least important.  Next, you need to determine the number of segments you want.  Will it be high, medium and low or 1 through 10?  If there are too few segments, then the segmentation will not be very targeted.  If there are too many segments, it may become a burden to implement and may ultimately be considered too complicated to use.  Business judgement and knowledge of the customers’ behavior should drive the creation of the segments. 

Once the segments have been decided, business rules or code can be written so that the segments are applied to your customer base on a regular basis.  This has the advantage of identifying new best customers or up and comers that can then be targeted with a special welcome communication.    Further, the segmentation can be used with other tools to drive marketing messages and campaigns.  However, you may need to revisit your RFM segments from time to time as your business changes significantly.   For example, if you raise or lower prices significantly after the segments are put into production, you will want to reassess the original recency categories.

My clients often know who their best customers are.  Typically the best are the top 20% of customers that generate 80% of the profits.  These are the customers you most want to retain.  The question becomes who are the customers that you should try to migrate into your best customer segment?  Figuring out who are the next best requires research into their behaviors, demographics or firmographics, and attitudes. 

 Segmentation is one way to separate your customer base into differentiated groups against which relevant marketing communicationsand strategies can be developed and executed.  There are many different types of segmentation and techniques including cluster analysis, RFM and CHAID.

Regardless of what method you choose, bear in mind that a good segmentation scheme is often a result of art and science.  Segments should make sense intuitively and, if they are data driven, should be sound statistically.  In my next post I will describe clustering and how that is used for segmentation.

I ran a 5K race recently and so I have been thinking about my pre-race routine.  I may not have a lucky rabbit’s foot but the morning of a race I have a ritual of sorts.  I eat my usual breakfast and of course drink coffee.  There are some things I just can’t do without!  I wear the same clothes and sneakers for the race as I wore training.  I will not do anything new or different.   

This ritual keeps me from being distracted so that I can concentrate on the race.  In this case, my ritual helps me.  But in the office, rituals can be limiting.  Always doing something the same way can get old and stale.  A colleague asked me about identifying best customers.  My first thought was an RFM or RAD segmentation because I was in the midst of a RAD segmentation.  It would have been easy to stop there.  However, I couldn’t stop until I also suggested clusters and CHAID.   If she had let me, I would have added modeling and NPV.   The trick is knowing when to stick with rituals and when to avoid them.