Welcome to the final
part of our four-part series on key
business metrics.
We’ve looked at
different aspects of business performance, from profitability to efficiency,
and we’re going to finish up with the people who generate all the financial
numbers we’ve been measuring—your customers.
Without customers, of
course, you have no business. In this tutorial, you’ll learn to track the
process by which you acquire customers, how much each customer is worth to you,
how often customers leave, and their overall satisfaction. You’ll get details
on calculating each metric, learn how to evaluate the results, and get tips on
improving them.
Whereas in the other
tutorials we’ve mostly used numbers from your financial statements, this
tutorial is focused on customers, so you’ll need access to your company’s sales
information and customer order history.
Let’s dive right in and
see how much it’s costing you to get customers through the door.
1. Cost of Customer Acquisition
Why It’s Important
No matter what kind of business you’re in, you
need to find people who want what you’re selling, and persuade them to buy it.
In other words, you need to acquire customers. Generally that costs money, and
it’s important to track how much. If you’re spending too much on sales and
marketing to attract new customers, you’ll struggle to make a profit.
How to Calculate It
The formula is very simple:
Cost of Customer Acquisition = Total Sales
& Marketing Cost / Number of New Customers Added
Let’s say you spent
$10,000 on an ad campaign, for example, and attracted 50 new customers. Your
cost of customer acquisition would be:
Cost of Customer Acquisition = $10,000 / 50 =
$200
What you include in “sales
and marketing cost” can vary depending on your business model. If your
customers need to deal with a salesperson in order to buy from you, then you’d
have to include that person’s salary in your costs. If you’re a web-based
business, you might need to take into account money you’re spending on jazzing
up the site. Use a free calculator for web-based businesses to estimate your costs.
Also keep in mind that
even if you use “free” marketing channels like social media, there’s still a
cost in terms of time. If you have a staff member assigned to blogging and
social media, you’ll need to include their salary (or a portion of it) in your sales
and marketing costs. The idea is to get a comprehensive picture of everything
you’re spending on attracting new customers.
How to Evaluate It
The cost of customer acquisition can vary
widely. According to Entrepreneur
magazine, travel company Priceline.com spends just $7 on acquiring a new
customer, whereas stockbroker TD Waterhouse spends $175.
It makes sense when
you think about it. When someone sets up a brokerage account, it’s likely that
they’ll use it for a long time (assuming they’re happy with the service), and
TD Waterhouse should be able to recoup that $175 over time. Booking a cheap
flight, on the other hand, is not a long-term commitment, so Priceline needs to
keep its customer acquisition cost lower. That way, even if the customer just
books a single flight, the company should still make a profit.
For your business,
evaluate the cost of customer acquisition by comparing it against how much you
expect each customer to spend. Don’t worry, we’ll have more detail on how to
work that out later on in this tutorial, in the “Lifetime Value of a Customer”
section.
How to Improve It
If your cost of customer acquisition is too
high, it means you’re not getting good enough value from your sales and marketing
efforts. So you either need to cut back, or try a different tactic.
If your company is
small, and the products you sell are quite low-value, cutting back may make
sense. Although it’s important to get the word out, over-spending on top-dollar
sales staff and expensive TV ads may be a step too far. Automating the sales
process can also cut costs.
On the other hand, it
may simply be about trying something different. Maybe you keep the same budget,
but try a new slogan, or a different venue, or a special offer to entice
people. If you’re advertising online, for example through Google AdWords, you
can analyze the data to see how many people are clicking on each ad, and tweak
the campaign to try to generate more sales.
2. Churn Rate
Why It’s Important
After you’ve spent all that money on acquiring
customers, you want them to stick around. The churn rate measures how quickly
your customers are leaving or becoming inactive, and a high churn rate can
indicate that your customers are unhappy. It also means you’ll have to spend a
lot of money chasing new customers to replace those who’ve left, so keeping the
churn rate low is important.
How to Calculate It
There are several slightly different formulas
for calculating customer churn. Here’s a simplified version:
Churn Rate = Number of Customers Who Left / Total
Number of Customers
If you run a gym, for
example, and 50 of your customers cancelled their contracts during the year,
leaving 500 customers at the end, your churn rate would be:
Churn Rate = 50 / 500 = 10%
You can also calculate
churn on a monthly or weekly basis, or any other time period that makes sense
for your business. If the gym lost 5 of its 500 customers in a month, for
example, it would have a 1% monthly churn rate.
A gym is an easy
example, because it’s clear when a customer cancels. But in other types of
business, it can be harder. A customer might still be on your books, but have
no intention of buying anything from you again.
In that case, you’ll need
to develop a set of criteria for deciding when a customer is lost to you.
Perhaps if they haven’t ordered anything for a year, for example, you could
count them as inactive and include them in the churn calculation. The exact
definition depends on your own business, and how often people typically order
from you.
How to Evaluate It
A lower number is desirable here, of course,
because it means fewer customers leaving, and more of them staying for repeat
purchases.
Comparative data can
be hard to find, because no company wants to advertise how many of its
customers are leaving. But this
table from 2006 shows annual churn rates for a number of companies in
different industries. Although the data is old, it at least gives some point of
comparison.
You can also track
your own churn rate over time, and make sure it’s heading in the right
direction. If the rate starts to increase, it’s time to take action.
How to Improve It
If you’re running a subscription-based
business, like our gym example, try to get as much information as you can from
the people who cancel. Find out why they’re leaving, so that you can fix any
problems that are causing a high churn rate. Good customer surveys of your
existing clients can also help—more on that later in this tutorial.
Some businesses face a
different problem. Maybe your customers are happy with your products or
services, but just don’t need to buy anything else from you. Examine your offerings,
and see if there’s a logical progression for your customers. After they’ve made
their first purchase, is there a follow-up offer you can send to them,
suggesting possible add-ons? If you’re running a service-based business, for
example training or education, do you have more advanced courses to offer
people after they’ve finished the basic training?
3. Lifetime Value of a Customer
Why It’s Important
We looked at how much it costs to acquire a
customer, and now it’s time to assess how much each customer is worth. This
metric is crucial if you want to know how much you can afford to invest in
acquiring and retaining each customer, and still make a profit.
How to Calculate It
This is another formula with several different
versions. Again, we’ll keep it fairly simple.
Lifetime Value = Average Order Total x Each
Customer’s Average Number of Purchases Per Year / Churn Rate
Going back to the gym
example, we already know the churn rate is 10%. If the membership fee is $50 a
month, then the order total is $50 and the number of purchases per year is 12
(12 months in a year), so the calculation would be:
Lifetime Value = $50 x 12 / 10% = $6,000
When you’re doing the
calculation, it’s important to remember that the churn rate is a percentage. So
in the above example, you input it as 0.1, not 10.
If you’re not sure of
your average order total, simply look at your purchase records over the past
year. Divide the total revenue by the number of orders, and that’ll give you
the average size of each order.
To figure out your
customers’ average number of purchases per year, take the total number of
orders and divide it by the number of customers. If you had 250 customers and
1,000 orders, for example, then each customer placed 4 orders on average.
The more complex
versions of the formula takes into account things like your business’s gross
margins, as well as the time
value of money. For examples of these formulas and how to calculate them
using Starbucks as a case study, take a look at this
infographic.
How to Evaluate It
You’ll want to compare this with your cost of
customer acquisition. Clearly, the Lifetime Value of a Customer needs to be significantly
higher than the cost of acquisition. You need to make sure you’re getting
enough value out of each customer to justify the cost of acquisition, as well
as to cover all your other costs and leave you with some profit.
This is a number you
want to calculate on a regular basis. Ideally, as your business grows and
begins to offer more products and improve customer service, the lifetime value
of a customer should increase. If it’s going in the other direction, then something’s wrong.
How to Improve It
If you can reduce the churn rate and retain
your customers for longer, then they’ll have a higher lifetime value. You could
also explore ways of improving each customer’s average number of purchases per
year, perhaps by offering special discounts and sales to existing customers, or
setting up a loyalty program to reward repeat orders. And finally, customer
satisfaction is key—happy customers buy more products, and are more valuable
to you. We’ll look at satisfaction in the next section.
4. Customer Satisfaction Rate
Why It’s Important
This one’s simple. Happy customers buy more.
Unhappy customers leave and go somewhere else. It’s probably the most important
of all the metrics we’re looking at in this series.
How to Calculate It
Just ask. A good customer satisfaction survey
will give you a clear picture of how happy your clients are. There’s no complex
formula for this one: it’s a simple percentage of happy versus unhappy.
Designing an effective
survey isn’t simple, though. You need to think very carefully about the
questions you ask, because you also want to find out why the person is satisfied or dissatisfied. Each question has to
be clear and simple, but designed to give you valuable information about your
business. And you may need to offer some kind of incentive to get people to
spend time giving answers.
It’s also important to
supplement formal satisfaction surveys with other information. Make sure you’re
regularly speaking with your customers on an informal basis, as well as paying
attention to feedback and complaints.
How to Evaluate It
Comparing your results with those of other
companies can be tricky, because each survey may be done in a slightly different
way, and the way the questions are asked can affect the results. It’s best to
set your own target, and track it over time—for example, if your customer
satisfaction is currently 75%, you might aim to improve it to 80%.
How to Improve It
While the headline number is important to
track, if you want to improve customer satisfaction, you’ll need to look beyond
it. That’s why it’s important to ask the right questions in your survey. If
you’ve done that, the data should help you pinpoint areas where you need to
improve.
Maybe you need to
train your customer service staff, for example, or give them better pay or
motivation, so that they start to exceed your customers’ expectations. Or maybe
the survey revealed that people are frustrated with technical glitches on your
website, and you’d be better off investing money in new technology.
The key is to ask your
customers good questions, listen very carefully to their answers, and take
action. Then run the same survey next year and see if your results improve.
The Big Picture
We’ve now looked at
key metrics to track in four different areas of your business. If you missed any
of the previous tutorials, you can access them all on our Key Metrics series page.
When you look at them
all together, you’ll get a clear, comprehensive picture of how you’re
performing. As you’ve seen in this tutorial, the different metrics fit together: the cost of customer acquisition and the churn rate shed light on lifetime
customer value, and the customer satisfaction rate is important for all three.
The different types of
metric also fit together in the same way. Strong numbers in your customer metrics will likely feed
through into better results in your profitability
and liquidity metrics, but only if
you keep your costs under control and have strong efficiency metrics.
Going all out for
success in one area while neglecting others is a recipe for disaster. It’s
pointless to have happy customers if you’re about to run out of cash. Strong
profit margins won’t last for long if you’re letting inefficiencies creep into
your business.
The most successful
businesses are well balanced, and score highly in all areas. So start tracking,
do it consistently, and remember what we said at the start of the series: You
are what you measure.
Resources
Graphic Credit: Line Graph designed by Scott Lewis from the Noun Project.