​What is Cluster Analysis

Cluster analysis refers to a technique for identifying groups in which the elements of each group are similar. It is often used in marketing in order to understand differences among customers.
There are three types of analytics models – descriptive, predictive, and prescriptive. Cluster analysis is essentially a data mining tool which is considered predictive, but since it help managers make better decisions, it can also be considered prescriptive.
Cluster Analysis has several applications:
  • Market segmentation
The main idea of this application of cluster analysis is to create homogeneous market segments to target product offerings.
  • Product segmentation
In product segmentation, cluster analysis identifies groups of consumers who want different benefits or levels of functionality of a product category. The results are used to offer different versions of a product, in order to match consumers needs more precisely.
Example: Coffee producers offer regular and decaffeinated versions of the same brand.
  • Price segmentation
Here, the same product is offered at different prices to different groups. Higher prices are offered to customers in groups that are willing to pay for extras or pay for better quality packaging, or for additional customer services.
  • Human Resources
In human resources, clustering could identify characteristics of successful employees in order to improve recruiting and hiring practices.
  • Operations Management
Grouping customers by geographical areas is a typical application of cluster analysis in operations management.
 
Importance of market segmentation
The key idea in market segmentation is to divide a broad market into segments or clusters. The technique produces groups whose members have similar needs, interests, and priorities. And this helps companies design specific strategies. For example, an advertising campaign, or a set of promotions, to target each market segment.
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In the above graph, one can observe that it is not possible to find perfectly homogeneous groups. However, the groups resulting from cluster analysis are similar in some ways.
The important thing here is to identify and describe each cluster. In the above example, the orange cluster may be described as a group of multi-coloured round objects. The green cluster may be characterized as a group of square objects. And the blue cluster consists of triangular and diamond-shaped objects.

Use case for market segmentation
Product category: Natural and organic products.
Study details:
  • Conducted by Information Resources Inc. in the US markets    Surveyed 5,000 customers
  • Matched the participants answers with the actual purchasing behaviour
Basis of segmentation:
  • Lifestyle
  • History of purchasing organic and natural products
  • Attitudes towards organic and natural products
  • Demographics
Segments identified:
1.True Believers
  • passionate about staying fit and healthy
  • focused on trying new things
  • serving as a strong role models for their children
  • strong believers in the benefit of natural and organic products
  • median income is highest among all segments
  • average age is 40
  • have at least a college education

2.Enlightened Environmentalist
  • passionate about the environment and about making good choices to preserve it
  • committed to make healthier choices
  • go out of their way to shop at stores that carry natural and organic products
  • older than True Believers - averaging 63 years old
  • slightly lower median income than True Believers
3.Strapped Seekers
  • believe and seek natural products, when their budget allows it
  • realize the benefit of natural and organic products
  • have the potential of becoming True Believers as their income increases
4.Healthy Realists
  • passionate about being fit but find it difficult deciding whether to buy healthy or traditional products
5.Indifferent Traditionalists
  • lead a simple life with few passions
  • not likely to buy natural/organic products because they don't see the reason to change
6.Struggling Switchers
  • know that they should be eating healthier and exercising more but focus on staying within their budgets
7.Resistant Non-believers
  • very little desire to support all their options for things to buy
  • stay loyal to the products they know

Key segments: True Believers and Enlightened Environmentalists  represent 18% of the population  together, they drive nearly half of the total sales
Strong target: Strapped Seekers and Healthy Realist  representing 25% of the consumers  driving 24% of sales 
Segments not worth pursuing: Indifferent Traditionalists, Struggling Switchers and Resistant Non-believers