Customer segmentation is a practice widely used by companies to divide their customer base into sub-groups that share similar characteristics, and then deliver targeted, relevant messages to each group. Segmentation is done by looking at customer attributes such as demographic (e.g. age, gender, income, residential address) and / or their transactional patterns (e.g. RFM or recency, frequency, and monetary value of their transactions). One key challenge often encountered when doing this is how to measure the goodness of your segmentation?
Qualitative and mathematical objectives
A commonly agreed, qualitative objective for a good segmentation(or clustering, as referred to in machine learning) is that similar customers should be in a same group and different customers should be in separate groups. This criteria can be inspected visually if your data has low dimensions (typically less than 4), like in the below figure(image source: http://mines.humanoriented.com/classes/2010/fall/csci568/portfolio_exports/mvoget/cluster/kmeans_diagram.png). There we see two distinct colored clusters, each with a point at the centre called the cluster centroid. If each data point corresponds to a customer, the centroid can be thought of as the most representative member of a group.
If we know the representatives from each group then a natural segmentation mechanism is to find a representative most similar to a customer and assign him or her to the same group. This idea is utilised in the popular k-means clustering method, which has the objective of minimising the sum of total differences between customers in a group, across all groups. So one convenient way to evaluate the quality of a segmentation, for example when considering the number of segments to use (let’s call this k), is to compute the different objectives when varying k and choose the one with the smallest total difference. The disadvantage of this approach though is that this mathematical objective may not align with your business strategy, and the solution may look like a black-box to thus making the resulting segmentation not actionable.
Segmentation with a business objective
Instead of performing at customer segmentation purely from an optimisation perspective, it is important to tie it to your business objective and make sure that you have design a specific strategy for each of the final segments. For example, in one project we looked at customer behaviours in a short period after their acquisition and divide them into two segments: high-value and mass. The high-value segment contains only 15% of the new customers but accounts for 70% of the future life-time value. This allows the business to create two bespoke customer journeys and allocates more resources to retain the more valuable customers. In this case segmentation is determined by maximising the number of high-value customers that can be served, given the available budget for this segment. This indeed is still a constrained optimisation, but it is driven by a business objective and thus is better for execution with marketing campaigns.