Giridhar Ramachandran

BM Term V Session 3
What is Segmentation?

Segmenting, at its most basic,

Is the separation of a group of customers with different needs into subgroups of

customers with similar needs and preferences.

By doing this, a company can better tailor and target its products and services to
meet each segment’s needs.

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Why do we need Segmentation?

Segmentation is a critical enabler to achieve business objectives and realize

benefits

Segmentation is critical to identify white spaces for new products/offerings

Segmentation helps organizations to optimize their retention and acquisition

strategy

Segmentation is often used to optimize pricing across different products

Segmentation enables organizations to become more customer-centric

Market Dynamics make segmentation critical to business success

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What are the different ways of Segmentation?

Picture courtesy Prof. Theodoros Evgeniou 4

Different kinds of data used for Segmentation

Primary data (Qual Customer data Third party data

and Quant)

• Behavioral • Product/Service • Credit score

usage
• Satisfaction • Demographics
• Subscription
• Preferred comm • Behavioral
channels • Features usage

• Preferred • Social network

engagement level integration

• Attitudes • Acquisition
channel
• Some
demographics

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What makes for a good Segmentation?

Segmentation exercise is considered successful if the segments formed are

• Identifiable

• Substantial

• Accessible

• Stable

• Differentiable

• Actionable

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Cluster Analysis – Basic concept

Cluster analysis is an interdependence technique used to classify objects into

relatively homogeneous groups called clusters

Cluster analysis is a classification technique that falls under the umbrella of

unsupervised learning methods and so is different from classification methods
like Logistic Regression, Discriminant Analysis, CART, CHAID which are termed as
supervised learning methods.

Difference between cluster analysis and other methods mentioned above is that
clusters are discovered from the data and are not known apriori

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Cluster Analysis – Steps Involved

Step 1 – Problem formulation

Formulate the problem (Select variables that form the basis of clustering)

• Select variables describe the similarity between objects in terms that are
relevant to the marketing problem

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Cluster Analysis – Steps Involved

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Cluster Analysis – Steps Involved

Step 1 – Problem formulation

Formulate the problem (Select variables that form the basis of clustering)

• Select variables describe the similarity between objects in terms that are
relevant to the marketing problem
• Select variables based on past research, theory or consideration of hypotheses
to be tested
• Consult experts in the category
• Clustering variables Vs Profiling variables

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Cluster Analysis – Steps Involved

Step 2 – Select a distance or similarity measure

Measure similarity in terms of distance between objects

Similarity  1/distance

Measures of similarity:
Euclidean distance {∑(Vai – Vbi)2}1/2
City block or Manhattan distance
Chebychev distance Max {|Vai – Vbi|}

Euclidean distance is the most popular distance metric used

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Cluster Analysis – Steps Involved

Step 3 – Selecting a clustering procedure

Hierarchical (a procedure characterized by a tree-like structure)

Non-hierarchical (K-means clustering- a procedure that assigns a cluster center

and groups all objects within a specified threshold)

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Hierarchical Clustering Procedures
Cluster1 Cluster2

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Non-hierarchical clustering procedure

Choose the number of clusters, k.

Generate k random points as cluster centroids

Assign each point to the nearest centroid

Recompute the new cluster centroid

Repeat till convergence criteria is met (assignment to clusters is not changing

over multiple iterations)

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Cluster Analysis – Steps Involved

Step 3 – Selecting a clustering procedure

Question: What are the advantages, and disadvantages of non-hierarchical

clustering?

Answer:
Advantages: Faster, and has merit when the number of objects is large
Disadvantages: Number of clusters must be pre-specified
Selection of cluster centers is arbitrary
Clustering solution depends on order of objects

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Cluster Analysis – Steps Involved

Step 4 – Decide on the number of clusters

Theoretical, conceptual or practical considerations might suggest a number

In hierarchical clustering, distances at which clusters are combined can be used as

a criteria – get this info from agglomeration schedule or dendrogram

In non-hierarchical clustering, ratio of Within group variance to between group

variance can be plotted against the number of clusters – point at which an elbow
occurs indicates the number of clusters

Relative sizes of the clusters should be meaningful

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Exhibit 1 – Agglomeration schedule The Coefficients column indicates
the distance between the two
clusters (or cases) joined at
each stage.

Cluster combined Stage cluster first

appears
Stage Cluster1 Cluster2 Coefficients Cluster1 Cluster2 Next stage

1 2 7 1.922 0 0 2

2 2 3 6.452 1 0 10

3 4 11 10.580 0 0 5

4 1 12 13.700 0 0 6

5 4 9 62.775 3 0 7

6 1 10 101.530 4 0 9

7 4 8 316.408 5 0 11

8 5 6 489.957 0 0 9

9 1 5 1530.504 6 8 10

10 1 2 2271.371 9 2 11

11 1 4 11671.97 10 7 0
For a good cluster solution, you will see a
4 clusters remain sudden jump in the distance coefficient
after stage8 (or a sudden drop in the similarity
coefficient) as you read down the table.
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Exhibit 2 – Dendrogram
At each stage, one
case or cluster is
Stage joined with
another case or
1 2 7 cluster

2 2 When clusters or
3 cases are joined,
they are
3 4 11 subsequently
labeled with the
4 1 12 smaller of the two
cluster numbers.

5 4 9

10 2 1

11
1 4

1
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Cluster Analysis – Steps Involved

Step 5 – Interpret and profile the clusters

Examine the cluster centroids

Profile clusters based on variables that were not used for clustering

Identify variables that significantly differentiate between clusters using

Discriminant analysis or ANOVA

Significant differences across not only Clustering variables but also Descriptive
variables, indicates presence of Natural clusters

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Cluster Analysis – Steps Involved

Steps involved in Cluster analysis

Formulate the problem

Select a similarity measure

Select a clustering procedure

Decide on the number of clusters

Interpret, and profile the clusters

Assess Reliability, and Validity

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