The purpose of segmenting customers and products is to facilitate the adoption of strategic decisions and thus create better overall profitability. It’s about defining which products and customers should be targeted for growth, and which should be treated more opportunistically. Therefore, you rank the customers and products as being A, B or C level, whereby A represents the most profitable customers or products and C the least profitable ones.
Segmentation is a good solution to what we call the ‘complexity creep’ – the concept of adding more Stock Keeping Units (SKUs) each year without removing others, of promising shorter lead times, of offering more order flexibility while simultaneously facing stricter requirements in terms of quality and delivery times. All of the above increase the complexity in an almost imperceptible and unquestioned way. Organizations notice that their operational costs and inventory write-offs are increasing by 2 or 3% year after year, but they can’t get to the nub of the matter. Activity-Based Costing (ABC) and segmentation are both focused on the rationalization of the total cost of ownership to improve the EBIT and working capital.
Activity-Based Costing versus segmentation
So what’s the difference between these two rationalization tactics? Activity-Based Costing assigns overhead costs to the activities that create the overhead. Subsequently, the costs of those activities are only assigned to the products that actually place a demand on them. Therefore, the model converts more indirect costs into direct costs compared to conventional costing models that are usually used in ERP systems.
The downside of Activity-Based Costing is the fact that, although it gives you a better overview of your cost structure, it doesn’t necessary help you to make strategic decisions. It doesn’t answer questions such as: ‘What kind of products and services should we deliver to which customers?’. Activity-Based Costing is also a difficult and often underestimated process, because in theory you have to assign every activity to a specific product for a specific customer. Before you know it, you could be caught up in an impossible task.
To my mind, segmentation is a pioneering form of Activity-Based Costing. You define your 20% of customers and products that account for 80% of your profit. For the long tail of less profitable customers and products, you can make a distinction in service and lead times, among other things, without doing a detailed calculation.
An efficient partnership
To conclude, I would advise you to start by segmenting your customers and products. If you are in any doubt about some strategic choices, it can still be useful to then revert to Activity-Based Costing for more specific cost calculations. For example, when deciding to start charging C-level customers for a certain service, you first have to know the real cost of that service. In that sense, Activity-Based Costing is a suitable extension of segmentation.