Copyright 2014 by the Acton Foundation for Entrepreneurial Excellence. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form without the written permission of Jeff Sandefer or the Acton Foundation for Entrepreneurial Excellence. The AFEE curriculum is taught in its entirety at The Acton School of Business, based in Austin, Texas, an intense one year program taught exclusively by successful entrepreneurs. To learn more, visit www.actonmba.org. 04/2014

Targeting the Right Customers Introduction You discovered an intense, unmet customer need; you made the sale and hustled in order to make and deliver a satisfactory solution; and you bootstrapped your way along. Soon you had more customers than you could handle, each with a slightly different need and each wanting a customized solution. Now, however, revenues have plateaued and profits have stagnated. There aren’t enough hours in the day to craft a personalized response for each and every customer, and you can’t seem to successfully separate the easy-to-serve and profitable customers from those who are stingy and impossible to satisfy. If only you could classify customers in a way that would let you focus on the most profitable ones. If only you could bundle orders to make operations run more smoothly. If only you could decide which groups to serve first, so that you could maximize efficiency, short-term profits, and long-term growth. When you find yourself in this scenario—and you will—you must take action. Unfortunately, there’s no magic formula for classifying, bundling, and sequencing groups of customers. Deciding which types of customers should belong to you, which products to offer, and which groups to serve first is a matter of trial and error. These decisions are made on the battlefield of competition, where brilliant (and lucky) moves are usually only evident with hindsight. But even though you can’t skip the trial and error process and jump straight to the success, there are experiments you can run to gain insights into how to:

1. Classify customers, so that you can judge the relative merits of different groupings 2. Amass groups of customers with similar needs, so that you can standardize sales and

manufacturing processes to lower the cost of making and delivering products and services Then you will have to make the tough calls: Which customers do you serve?1 How high do you set prices? Which investments and commitments do you make? How do you ward off competitors? 2 This note will get you started. 1 Often you will hear the phrase: “The customer is always right.” This is only true if you are serving the right customers for your business. 2 From Market Segments to Strategic Segments Nirmalya Kumar HBP excerpt from Marketing As Strategy: Understanding the CEO’s Agenda for Driving Growth and Innovation

2

What We Mean When We Say “Targeting” Most MBA programs teach “segmenting” as a function of the marketing department, something done from 35,000 feet, high above the battle. Segmenting decisions are viewed as a conceptual exercise, performed by multinational firms using focus groups and nationwide customer surveys. When we talk about “targeting,” we’re still talking about grouping customers, but as a trial and error” process, using a customer-by-customer series of experiments carried out by the sales department, carefully observing how and why customers buy, and creating provisional segmenting categories. Targeting is about deciding which group of customers you will focus your sales funnel on next. You must sequence groups of customers so that your costs per sale are constantly falling, while simultaneously grouping customers with similar needs so that the operations department can add new capacity in the right “chunks,” with the right product focus, at the lowest cost possible. The Role of Targeting in Creating an Attractive Opportunity The most fundamental task for a business is to create and retain customers.3 That means you must make the important decision of which types of customers you will serve. Choose those with the greatest need, who can be served at a reasonable cost, in a way that is difficult for a competitor to copy. Running the right targeting experiments and testing various ways to display customer data will help you answer three of the most important questions in business: (1) Who are your customers and how can you convince them to buy? (2) Which products or services should you deliver and what will each unit cost? And (3) Who can steal my customers? 1. Who are your customers and how can you convince them to buy? Before you can target, you need to assess the total pool of potential customers. How many related customer needs can you identify? Which customers have the most intense needs and the ability to pay high prices? How do they make purchase decisions? How do they use similar products? Where do they live?

There is an art to grouping customers together in ways that make them easier to attract or serve. You will need to experiment with different ways of classifying customers until you find groups of buyers with common needs and desires who will pay a high enough price for a solution and can be satisfied in batches with a similar product or service.4

3 Ted Levitt, Marketing Imagination, 1983. 4 See Turn Customer Input into Innovation by Anthony Ulwick and Transforming Strategy One Customer at a Time by Richard Harrington and Anthony Tjan.

3

Once you have identified customers, you’ll want to search for easily recognizable traits or behaviors, such as gender, location, age, or income, that seem correlated with the types of customer needs you want to serve. 2. Which products or services should you deliver and what will each unit cost? Once you have identified groups of customers with a common need, you can explore the cost of making and delivering a solution for each group. The larger the number of customers whose needs can be satisfied by a product with the same specifications, the better the chance you have of standardizing processes and tasks in a way that makes and delivers each unit more efficiently.

The contribution from each segment to fixed-period costs, like overhead, will depend on the average price per unit, minus the average variable cost per unit, multiplied by the number of units you produce and sell.

TABLE 1. SEGMENT

In order to find the customer segments and production processes that deliver the best margins with the lowest investment and risk, you’ll need to experiment with many different ways of grouping customers to find processes to deliver what they want in an efficient way. 3. Who can steal my customers? Segmenting customers and delivering products and services to satisfy them does not take place in a competitive vacuum. That means you must scan the horizon for competitors who serve similar or related needs. As you group customers together, you’ll need to ask which competitors might lure away a marginal customer by offering products or services more closely targeted to an individual customer’s needs by offering a lower price.

Segment A B C Units 10 50 100 Price per unit $50 $20 $10 Variable cost per unit $5 $10 $1 Revenue (units times price per unit) $500 $1,000 $1,000 Variable costs (units times variable cost per unit) $50 $500 $100 Contribution per segment to FPC $450 $500 $900

4

FIGURE 1. HOW CLOSE IS THE FIT BETWEEN SOLUTION AND NEED?

Customers whose needs are well matched will gravitate to your solution and will be more difficult to lure away. Conversely, customers who are “settling” for your product, but consider it a less attractive solution, may defect to competitors with a product or service that is a better fit.

Competitive realities might force you to re-examine your original targeting of customers and to look for even more powerful ways to use your gifts to attract and satisfy different groups of customers in a way no competitor can match. Tips for Collecting, Organizing, and Displaying Customer Data There is no magic formula for targeting and satisfying customers. In a competitive marketplace, companies are constantly looking for ways to identify and satisfy discrete groups of customers in ways that are difficult to copy. Finding such a strategy is a mixture of art and luck, often obvious only in hindsight. What can help is collecting and arranging customer data in ways that suggests correlation and causation, so you can target more attractive customers early and find efficient production processes to satisfy them. Tip One: Identify Customer Needs First determine how customers’ needs and desires are alike and different. When asked, “Who are your potential customers?” a naïve entrepreneur will treat all customers as equals and say something like, “If I could convince 1 percent of the population of China to buy my product, sales would be X.” An experienced entrepreneur knows to dig deeply into how customer needs and desires differ, so as to find those with the most intense needs. You can gather information on customer needs by: (1) asking customers, (2) observing how they buy your product, or (3) observing how they use your product. Let’s look at each of those one by one.

5

Asking Potential Customers As you query potential customers, conduct focus groups, or launch surveys, your goal will be to ask specific questions that help you define how customers are alike and different. For example, a certain group of people may want to travel from Point A to Point B. But some may want to go by plane, while others by train or car. Some may want to travel in the morning. Others may care more about being on time, every time. Still others may be looking for the cheapest ticket possible, no matter how inconvenient the service. To dig more deeply:

1. Start with a broad question that captures one of three primary advantages a customer is looking for.

a. a better product, b. a faster delivery or response, or c. the lowest price possible?

For example, you might have asked each potential customer to categorize the “need” for their purchase. You can then match the customer need for each segment, with the number of customers, total units sold, and price per unit in the segment.

TABLE 2. MATCHING THE CUSTOMER'S NEEDS

Given the example data above, you could focus on a small number of customers with a “high quality” need or use low prices to capture a large number of customers at a low price per unit. Even focusing on being different, say “faster,” might be a defendable strategy. The only clearly disastrous route would be to try to be all things to all customers, offering a fairly good product, reasonably soon, at a moderate price. Customers willing to pay for quality or speed would defect to high quality or nimble competitors. Those willing to accept less would gravitate to companies with the lowest prices. You would be left with cheap customers who are hard to satisfy.

2. Ask customers about why they are buying your product if it could serve multiple needs.

For example, for peanut butter, you might ask:

“Are you an adult using peanut butter as a sandwich spread for yourself, a parent using peanut butter to make sandwiches for your children, an institution (like a school) making sandwiches for hundreds, or a candy company using peanut butter for candy?”

6

FIGURE 3. PEANUT BUTTER NICHES

You could map these different segments, as above, to give you a sense of the needs of different groups. Such a map might point out that substitutes differ, depending on the combination of needs served. For example, the substitute for a cheap child’s sandwich might be bologna. The school cafeteria could use meatloaf and the candy company could use a caramel filling.

Of course, with such maps, there are always outliers. For example, some parents might be willing to pay a good deal more for a peanut butter with enhanced vitamins, making the low-cost child sandwich segment somewhat misleading.

3. Conduct after-the-sale surveys—they can reveal a lot about buyers’ needs and can

identify customer champions that should be courted. Enterprise Rent-a-Car learned that one of the most important questions to ask to identify your target customer is “Would you recommend our product to a friend?”5 This question is a strong indicator of loyalty because customers will only put their reputation on the line by recommending your product if they’re intensely loyal.

Seeing which segments had the most enthusiastic, evangelizing customers might tell you something about the relative attractiveness of segments.

4. Consider creating “customer stories” (psychographic stereotypes) that, when used in

narrative, make it easier for frontline employees to make decisions on how to approach or serve a customer.6

For example, as London Business School Professor Nirmalya Kumar points out, Porsche knows its primary customer group is male college graduates over forty with $200,000 a year in income. But Porsche further divides this group into five subgroups: (1) Top Guns: ambitious types who value power and control; (2) Elitists: old money blue bloods; (3) Fantasists: escapists; (4) Proud Patrons: trophy hunters; and (5) Bon Vivants: jet setters.

5 Frederick F. Reichheld, “The One Number You Need to Grow,” Harvard Business Review, December 2003. 6 Daniel Yankelovich and David Meer, “Rediscovering Market Segmentation,” Harvard Business Review, February 2006, pg 6.

7

The subdivisions help employees at Porsche sort customers into segments based on subtle clues they gather on the sales floor rather than objective demographic data. There is no perfect set of questions for segmenting. In essence, you want to ask potential customers “Why?” over and over again, record their responses, use these to define ways in which customers are alike or different, and place each of a series of discrete “buckets.” Through this practice of trial and error classification, natural segments will appear.7

Observing Buyer Behavior Querying customers has its limits. People are often unaware of why they buy. Some customers will answer differently depending on who asks or who is in the room. Many purchase decisions are more irrational, and some customers will intentionally lie about why they bought what they did. A more reliable way to group customers is by observing how customers buy products. You can:

• Set up controlled experiments in the field to watch how customers make tradeoffs between your product and a substitute. Which attributes or characteristics do the products that are chosen most often have?

• Observe the buying process from the point of view of the customer.8 “Staple yourself to an order” by following it through the whole buying process. This is particularly important for an expensive, complex offering to a large company that has influencers, gatekeepers, decision makers, and users all involved in a purchase decision.9 How do different steps in the buying process affect different customers differently?

• Observe more closely how customers move through your sales funnel.

Some customers may be easier to identify and motivate. For others, it will be more difficult to uncover and satisfy their objections. Still others will be hard to close. Grouping buyers based on the differences and similarities observed in real-life purchasing decisions can lead to a much more efficient and effective sales process. Observing Usage Patterns Customers will often find uses for products that are far different from the tasks for which they were designed. For example, because of their portability, strawberry milkshakes at a fast-food company, originally intended as a dessert, may unintentionally become a breakfast food for

7James Anderson and James Narus, “Business Marketing: Understand What Customers Value,” Harvard Business Rreview, November-December 1998. 8 Ben Shapiro, V. Kasturi Rangan and John J. Sviokla. “Staple Yourself to an Order,” Harvard Business Review 1992. 9 Thomas Bonoma, Major Sales: Who Really Does the Buying,” Harvard Business Review May-June 1982.

8

harried commuters.10 Similarly, some prescription drugs may be prescribed “off label” by physicians to cure diseases in ways that were once seen as “side effects.”11 That’s why it’s important to “get into the life” of customers and watch how they really use products. You may find clues to undiscovered needs, clues that could lead to new segments or enhanced products. Tip Two: Match Customer Needs to Observable Attributes You can’t look inside the hearts and minds of customers, so you’ve got to be able to link their needs, buying behavior, and usage patterns with explicit, observable traits. That means correlating easy-to-observe customer characteristics—like age or location—with more difficult to observe, internal characteristics, like the intensity of a particular customer’s need for your product or the amount of product that a customer might need to purchase. This will help you focus attention on the best customers. For example, you might be selling oversized bed and bedding. While you’re not psychic, you might observe that taller people seem to have a stronger need for long beds than shorter people. You might also observe that basketball players in high school, college, and professional leagues tend to be taller than average, and especially taller than those at gymnastic meets. This might lead you to find a basketball star as a spokesman and to advertise in the programs at basketball games.

FIGURE 4. HEIGHT OF ATTENDEES

Similarly, you might decide to track sales based on the zip codes of those who attend basketball games. While data based on athletic shoe sales may show strong revenues across zip codes, you may discover that only more affluent residents have the desire and the means to buy expensive, oversized beds. 10 Clay Christensen, “Discovering What Has Already Been Discovered: Why Did Your Customers Hate Your Product,” Harvard Business School, March 21, 2000. 11 For example, the active drug in the hair replacement product Rogaine at first was used to treat high blood pressure. Excessive hair growth originally was considered a negative side effect.

9

All of this makes it easier to focus on more powerful sales techniques like direct mail, telesales, and direct sales forces, instead of less powerful tools, like broadcast media, that may prove prohibitively expensive and ineffective. Tip Three: How Price, Location, and Messaging Affect Revenues per Segment Finding customers is one thing. Convincing them to buy enough products at a high enough price is another. As you segment customers, you’ll also want to observe how well the different tools you have at your disposal work with different segments of customers and, given prices per unit and unit volumes for each segment, how much revenue each segment can produce. As you categorize customers, ask yourself:

1. Do the customers in this segment tend to pay high prices or low prices? How much does a change in price per unit affect the number of customers who buy and the number of units bought?

2. Which product attributes have the biggest effect on buying behavior in a segment? Do

large numbers of customers want similar attributes or is there a large amount of customization required?

3. Where do customers buy? Do you need to make your product available in only one way,

like by mail order, or use multiple ways to deliver products, such as mass merchandisers, department stores, specialty stores, and the mail?

4. How do different messages affect the number of customers who will respond to a “call to

action?” For example, how many customers will respond to a “less filling” message versus “tastes great” message?

5. Which combination of products, price, location, and message work well together to

generate the highest revenues per segment? For example, it may be better to use a low price, “less filling” message for a new drink in a health clubs and a higher price, “tastes great” message in fine restaurants.

6. How can you sequence calls to action to create the right sales funnel for your customer segments?

Your goal is to group together as many customers as possible into segments where the behavior of attractive customers can be influenced as cheaply as possible. Tip Four: Identify the Most Profitable Customers (in the short run) Identifying and then motivating discrete groups of customers to pay a “high enough” price are only the first steps of targeting. What you really want to know is which customers are the most profitable.

10

Short-term profits per customer depend first on the volume of units sold and the price per unit. If you are selling MRI machines, a large hospital chain has the potential to buy more units than a small, rural hospital. However, a small, rural hospital with a local monopoly might be willing to pay a much higher price per machine. Once you know revenues per segment, you’ll need to estimate the cost of serving each segment —both the cost of selling to that segment and the cost of making and delivering products. Simply comparing the prices paid by different segments to the relative cost to serve those segments can be powerfully enlightening and show you where to focus.12

FIGURE 5. CUSTOMER ORDER / PROBABILITY INDEX

In most cases, however, you’ll also want to measure the average cost per item sold among different combinations of customers in order to see which groupings of segments provide the most profits at the lowest cost for the least investment. For example, plotting customers on the matrix like the one above would separate the best and worst customers and perhaps identify additional ways of segmenting.13 Sometimes you can economically deliver exactly what customers in particular segments want by increasing capacity on standard components early in a production process and then specializing tasks and components at the end of the production processes

FIGURE 6. SERVING MULTIPLE SEGMENTS WITH ONE PROCESS

12 Robert Dolan, “How Do You Know When the Price is Right?” Harvard Business Review, 1995. 13 Adapted from Benson Shapiro, “Close Encounters of the Four Kinds: Managing Customers in A Rapidly Changing Environment,” August 29, 1988.

11

For example, you might focus on stamping high volumes of metal triangles, standardizing tasks and adding capacity to satisfy a need common to several segments. Needs specific to individual segments—different colors, for example—can be added during the final steps of the production process. Tip Five: Identify the Most Profitable Customers (in the long run) While short-term profitability is important, maximizing long-term profitability is better. Identify customers who will not only be valuable in the short run, but who will also buy increasingly larger amounts of products for a long time (without growing to be so powerful as to be able to demand price concessions). Long-term profits from customers with repeat business depend not only on unit volume and margins, but on switching costs and other barriers to entry. A hospital chain, for example, might be large enough to have its own in-house maintenance department; the small rural hospital may be willing to sign a profitable long-term licensing agreement. Customer Lifetime Value You may find it helpful to calculate the “lifetime value” of the average customer for the more attractive segments. “Lifetime value” is the discounted, net present value of the contributions you expect a customer to make to you during all the years you serve them.

TABLE 2. CUSTOMER LIFETIME VALUE

As shown in table 2, the value of a repeat customer who (a) is easy to serve, (b) will pay high prices, and (c) will purchase large amounts year after year can be enormous. For example, using the “lifetime value” approach, customers in Segment C are worth over three hundred times the value of customers in Segment A. Quantifying customer lifetime values can change the way you think about your investments in customer acquisition.14

14 Elie Opek, “Customer Profitability and Lifetime Value,” Harvard Business Review, August 7, 2002.

12

Evangelizing Customers You may also want to identify delighted customers who will actively promote your product by word of mouth.

TABLE 3. THE EXPONENTIAL EFFECT OF EVANGELIZING CUSTOMERS (NUMBER OF CUSTOMERS)

As shown above, adding even ten evangelizing customers a year, each of whom will actively recruit ten more evangelizing customers (and so on), will yield over 100,000 customers by year five, as compared to fewer than 500 customers in a traditional sales effort. This assumes no customer attrition and that every new customer becoming an evangelist (unlikely), but there’s simply no substitute for the power of delighted customers who recommend your product or service to their friends. Finding any common attribute of evangelizing customers that will allow you to attract and energize these super-satisfied customers can cause sales to increase exponentially.15 Mapping Competitors and Substitutes Segmenting does not take place in a competitive vacuum. If you keep track of why prospects refuse to buy and why customers defect—and especially to which competitors and substitutes they defect—you may see some interesting patterns develop. As you are choosing which customer groups to serve, your competitors and new entrants are targeting customers as well. To identify the customers who are likely to belong to you for some time, it may be helpful to show which companies focus on which type of needs by using the intensity and volume of the two needs on the X and Y axis of a graph and then to map which segments are served by you, your competitors, or substitutes.16 Also note how competitors are honing skills and competencies that, over time, may threaten your company. 15 Roger Hallowell, “Word of Mouth Referral,” Harvard Business Review, April 24, 2002. 16 Richard Harrington and Anthony Tjan, “Transforming Strategy One customer at a Time,” Harvard Business Review, March 2008.

13

FIGURE 7. MAPPING DISRUPTION

The map above shows how mini-mills (which melted scrap to make steel) marched through the steel industry, segment by segment, to challenge the large integrated steel mills. The mini-mills were ignored by the integrated steel producers when, beginning in the 1960s, they entered the low-margin rebar markets. Then, by steadily improving quality and costs, the mini-mills moved up market a segment at a time, until by the late 1990s they threatened the very existence of the integrated mills.17 By mapping the progress of your firm and competitors over time, you can see how improvements in sales efforts and technology are stealing market share and profits. Finally, you may want to keep a lookout for customers who are rapidly growing as a share of your business, but who might be able to demand lower margins as they grow.

FIGURE 8. MAPPING FUTURE PROFITS

For example, you’d probably celebrate signing a large contract with Walmart, and commit much of your manufacturing capacity to a national rollout. The celebration would probably end, however, once you plot the profit margins and expected revenue growth (see above) and realize that, while you’ll be working harder to produce a higher volume of goods, you’ll be making far less money. 17 Christensen, Clayton. The Innovator’s Solution. 2003. Harvard Business School Press: Boston, MA.

14

Strategies for Targeting Customers: Whom Should You Serve First? Targeting is not merely displaying and analyzing customer data or making short-term competitive decisions. To the extent possible, you may want to devise a long-term strategy, while always keeping in mind that long-term strategies can be overrun by unexpected realities. Determine which segments seem the most attractive by taking into account the:

a. Intensity of needs and prices per unit b. Number of customers in the segment c. Long-term buying habits d. Ability of your company to defend against competitors

Then prioritize the segments to serve. There are a number of strategies you may choose from when assigning priority, including bootstrapping, first mover, adoption curves, and disruption. Strategy One: Bootstrapping If bootstrapping, you’ll want to first choose the segment with the most intense need (and highest price per unit) and then add additional segments with less intense needs. Decide to invest in standardized processes, greater capacity, and measures to lower the average cost per unit only after demand is proven.

FIGURE 9. BOOTSTRAPPING

By pricing high initially and keeping investments and fixed-period costs low, you can use the profits from the first segment to “bootstrap” into the next most attractive segment. Often, expansion can be financed from internal free cash flows. That way, you can retain all of the equity ownership in your firm. New segments can be added as long as the processes developed for early customers can be used to satisfy the primary need of the new customers, or as long as the later stages of the production process can be customized without reducing the efficiency of the main enterprise. Otherwise, the company is, in effect, starting a new business and will suffer from a loss of focus.

15

The biggest risk to bootstrapping comes if a well-financed competitor expands quickly and extensively, secures dramatically lower costs per unit, and captures customers who would experience high switching costs. Strategy Two: First Mover If there’s a great danger of having early competitors, high switching costs, and rapid cost reductions with increases in production volumes, you may choose to try and serve many segments at once, making up for a lack of customization by offering low prices. This means you may want to look for commonalities across segments, design and scale production processes accordingly, and price low to fill excess production capacity quickly. First-mover strategies can be dangerous if customer-switching costs are low and if customers, once educated, can easily be lured away by lower prices—or if a number of competitors, new entrants, and substitutes are all vying for the same customers. Strategy Three: Adoption Curves If you are in an industry with rapidly changing technologies, you may want to focus first on segments of customers who are the easiest to sell to and then use these early adopters (see figure 10) to help sell your products to other less adventuresome customer segments before the technology is obsolete.

FIGURE 10. ROGERS ADOPTION / INNOVATION CURVE

Staging segments according to an adoption curve can be dangerous if technologies have very short life spans and are subject to being leapfrogged by even more revolutionary products.

16

Strategy Four: Disruption Another strategy is to focus on customer segments that have been “over served” by competitors who charge for attributes that aren’t needed by lower value customers.

FIGURE 11. MAPPING DISRUPTION IN THE STEEL INDUSTRY By entering with substitute products that offer lower prices and simpler solutions, disruptors can pick off low-value segments as they pursue new production methods to add incrementally more and more value, over time picking off increasingly attractive segments until the incumbents are left with little market share. A disruption strategy is often easier to recognize in hindsight. It may backfire if an incumbent competitor reacts to the first attack or if the expected improvements in technology do not occur. The Cost of Data Collection The more customer, cost, and competitor data you have, the easier it is to make targeting decisions. Unfortunately, collecting, formatting, and analyzing such data can be expensive, especially if it is not easy to make it part of the normal sales or production process. To make matters worse, since many customers have a hard time stating rational reasons for purchases—and even lie—the best data comes as a result of watching what customers do, rather than asking them questions. This means data must be gathered step by step in the field, and often you will find that you have gathered the wrong data and must start over again with data collection. All of this means it is important to be thoughtful about targeting questions very early in the process, to make asking questions and observing customer behavior a part of the culture of your frontline employees, and to always ask what new questions or experiments can be launched and which old questions or experiments can be discontinued.

17

It is next to impossible to run every customer-targeting experiment you would like to, which is why segmentation is an art and not a science. But running no experiment at all is far worse than running the wrong segmentation experiment. Summary The ability to target the most attractive customers first, while efficiently expanding production capacity at the lowest risk possible, is one of the most important skills for any entrepreneur. There is little “science” to targeting. Rather, it is an art. You must observe and unearth needs, perform small experiments, and use these to correlate observable traits with unobservable internal needs, so that your business can focus on delivering exactly what your customers want, when they want it, and at a price and cost that allows you to make a healthy profit.