Diving Deeper Into Customer Segmentation: RFM and CLV

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As I explained in my last blog post, utilizing customer segmentation in your targeting helps you to take a step back from the traditional but less powerful mass marketing techniques and embrace personalization. Understanding that your customers are all different and need to be marketed based on their unique needs, preferences, and habits will help to make both your message and your sales pitch more effective, and a tried and true method for achieving this is RFM segmentation.  

What Are RFM and CLV and How Can They Help Me?

One of the most popular ways to segment your customers is by their purchasing behavior, namely recency, frequency, and monetary segmentation (RFM): how recent their last purchase was, how frequently they purchase from you, and the average price of their purchase. Perhaps most importantly, RFM segmentation can help you get the data needed to estimate a customer’s lifetime value (CLV), which is the monetary estimation of the value your business will derive from your relationship with any given customer.

A series of simple math equations can tell you the CLV of any given customer based on their purchase frequency and average order value. To calculate his or her average order value, divide your total annual revenue by the number of orders the customer has placed in the past year.

Determining his or her purchase frequency is as easy as dividing the number of orders they have placed in the past year by the number of unique customers you’ve had in the past year.

Once you have these two variables, multiply them to find a customer’s lifetime value.

Taking CLV into account through RFM segmentation is important as it can help you increase customer value and loyalty, which I’ll explain in detail later, but it’s important to understand how to interpret these numbers first.

How Do I Interpret the Data?

You now know how to calculate a customer’s lifetime value in the numerary sense, but what exactly do the numbers mean?

It’s easy to break down RFM segmentation. Recency describes how recent a customer’s last transaction was, so low numbers mean they were more recent; for example, a ranking of 1 means his or her most recent order was received within the last day. Frequency is the opposite: higher numbers translate to a higher frequency, meaning a ranking of 1 would be an infrequent, one-time customer while a ranking of 24 would mean they have purchased two dozen times. Monetary is the easiest to understand, as the ranking translates directly to the average amount of money spent.

Analyzing customer lifetime value can appear to be a little more complicated, but in reality, it isn’t so difficult to understand. Completing the equations in the previous section will give you a number, and this number stands for the net profit attributed to your relationship with the customer in question. For example, if the customer’s average order value was $20,000 and their purchase frequency came out to .07, their customer lifetime value would be $1,400. This is the amount you could expect to make from that customer throughout your relationship based on their past buying behavior.

 

Annual Revenue Customer’s Annual Orders Average Order Value
$100,000 5 200

 

Customer’s Annual Orders Unique Customers Purchase Frequency
5 70 7

 

Purchase Frequency Average Order Value CLV
7 200 $1,400

How Can RFM Segmentation Increase Customer Value and Loyalty?

Although the process can be painstaking, segmenting your customers based on buying behavior and purchasing habits and calculating customer lifetime value allows you to more easily increase customer value and loyalty. Dividing a large customer base into smaller groups based on their buying habits helps you to to identify your target audience and understand different kinds of customers’ wants, needs, and key motivators.

Additionally, segmenting customers into more manageable groups allows you to personalize content and marketing materials, which can improve your conversion and retention rates as well as customer loyalty. This is simply because generic, impersonal marketing materials are less appealing to customers than something personal and relevant to their behavior and preferences.  

Companies That Found Success with RFM and CLV

Don’t just take my word for it – RFM segmentation and calculation of CLV data has helped a number of major companies increase customer loyalty and revenue. Eastwood, L’Occitane, and Frederick’s of Hollywood have all used this type of segmentation and analysis to kickstart their brands and establish them as household names. Eastwood’s email marketing profits soared by over 20%, L’Occitane saw a 2,500% increase in revenue through email, and Frederick’s of Hollywood increased their conversion rates by nearly 10%.

Eastwood’s case in particular is interesting as their analysis revealed that nearly half of their engagement came from the 4% of its customers with the highest RFM rankings. Their findings led them to send daily emails to this small segment of loyal customers, and, amazingly, the frequency with which they were clicked through increased rapidly while the number of opt-outs and spam complaints dropped.

Can Customer Segmentation Ever Go Wrong?

Although RFM segmentation and the calculation of customer lifetime value can do wonders for a brand, the short answer is that, yes, customer segmentation can backfire if you overdo it. Over-segmentation is a real risk when trying to figure out how best to divide up your customer base as it could lead to the accidental exclusion of potential customers. Additionally, over-segmenting your customers can cost money and waste time. If you develop 12 buyer personas and later realize that half of these personas overlap and could have been consolidated, you’ll regret the hours you spent trying to define specific segments. To avoid this, stick to larger segments.

Another danger of over-segmentation is over-personalization. For example, say your company has a segment of customers that tend to spend the highest amounts of money per purchase out of any segment you’ve defined. You could send them personalized messages and notifications about your most expensive items or services to cater to their past buying behavior and purchase history, but you’d be neglecting to advertise other less expensive products that may appeal to these customers. In other words, if you fixate too much on what you know about consumers based on their past behavior, you may be creating echo chambers for members of your audience.

Despite these risks, RFM segmentation and CLV analysis can transform your business by reinvigorating your relationships with your customers. To learn more about how data can shape your strategy, make sure to check out my last blog post.

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