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Customer Retention Rate and Its Calculation

If you are a SaaS business, then you must read this article for the following reasons:

  • Understand what is Customer Retention Rate?
  • How to calculate Customer Retention Rate?
  • Why is it important for a SaaS business to focus on this metric?

Customer retention is a great challenge for many service companies in today’s highly competitive business environment. As per research, a service-based business must focus on predicting customer churn in order to address a part of the customer retention challenge. 

To resolve the customer retention challenge completely, a SaaS business will have to focus on other important aspects of managing retention. Otherwise, many managerial problems may remain unresolved.

There are a variety of metrics that a SaaS business must calculate to measure and monitor customer retention. In addition to calculating the customer retention metrics, a SaaS business must also distinguish between customers who are at risk and customers that need to be targeted.

Also, a SaaS business must identify trade-offs between reactive and proactive customer retention programs. It must also find a trade-off between short-term and long-term remedies, and between discrete campaigns and continuous processes for managing retention. 

The main purpose of managing customer relationships for a SaaS business is to focus on enhancing the overall customer value. This means that customer retention is critical to the success of a SaaS business. In fact, it is the most important component of the customer lifetime value (CLV) framework.

In this article, we are going to discuss what is the customer retention rate, why is it important for a SaaS business, and how a SaaS business can calculate its customer retention rate.

Customer Retention 

The term Customer Retention refers to the set of customers who continue to transact with the SaaS firm. It indicates the level of success of a SaaS business in maintaining a long-term relationship with its customers.

The term customer retention captures two concepts. The first concept is ‘continuity’ which means that the customer must continue to engage with the SaaS firm. And the second concept is customer retention. Customer retention is a form of customer behavior that SaaS firms need to manage.

Thus, the customer retention definition incorporates both contractual and non-contractual relationships. That is, one can categorize customer-firm relationships into contractual settings and non-contractual settings.

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Contractual settings refer to the scenarios in which SaaS firms directly observe when a customer terminates the relationship. For example, a newspaper subscription. On the other hand, non-contractual settings are the scenarios where a customer makes no formal declaration of the termination of such a relationship. For example, an online retailer. 

Note that in the case of contractual settings, the customer’s decision to renew a subscription defines retention. However, the focus on transactions goes beyond the renewal transaction. In fact, contractual settings include situations in which the customer ceases to transact and leaves the SaaS firm long before he actually informs the firm. Moreover, there are an increasing number of hybrid settings, in which customers can formally or informally cease their relationship with the SaaS firm. 

For instance, customers can either formally cancel their account or simply ignore the firm in case of many online services. Examples include daily deal sites, online retailers, etc. 

Then there are SaaS firms selling multiple products or services. In the case of such firms, ceasing to transact with one product or service does not mean that the customer stops transacting with the firm. For example, an online game player who got bored with game A and hence stopped playing game A. However, he continues to play game B that is offered by the same company.  This means that the customer has still retained his relationship with the firm. 

Thus, the therm customer retention signifies that retention is about continued transactions with the firm rather than solely with the product or service. Finally, churn complements the term retention. Thus, we would say that the customer has churned if he has decided to stop transacting with the firm. 

This means the cessation of the customers’ transactions with the firm defines the term churn. Thus, we can conclude that ‘customer retention’ focuses on the continuity of transactions with the firm. Further, this concept applies to a wider range of businesses, regardless of the existence of a customer-firm contract or the type of transactions. 

Measuring Customer Retention

It is important for a SaaS business to measure customer retention. This is because measuring customer retention helps a business to

  • Calculate lifetime value (CLTV) and customer equity (CE) 
  • Drive its profitability and value as a 1% increase in retention rate produces nearly a 5% increase in CE
  • Understand its health
  • Manage customer retention 

The following table has been taken from a Harvard publication that showcases the factors a SaaS business must consider when measuring customer retention.

Level of AggregationContractualNon-Contractual
Individual customer level0:1 indicator of whether the customer is still under contract at end of the periodLatent attrition, i.e., P(Alive) for the specific customer, inferred from a statistical model
0:1 indicator of whether customer transacted this period0:1 indicator of whether customer transacted this period
Recency − number of periods since the previous transactionRecency − number of periods since the previous transaction
Recency/inter-purchase-time ratioRecency/inter-purchase-time ratio
Aggregate levelRetention rate − Number of customers who renewed in a particular period divided by the total number of customers who were up for renewal in that same periodDistribution and summary statistics of latent attrition, i.e., of P(Alive) by cohort
Percentage of customers transacting during the periodPercentage of customers transacting during the period
Distribution and summary statistics of recency across customersDistribution and summary statistics of recency across customers
Distribution and summary statistics of recency/inter-purchase-time ratio across customersDistribution and summary statistics of recency/inter-purchase-time ratio across customers

Note that most of the retention metrics relevant for contractual firms are also relevant for non-contractual firms. For example, a simple 0:1 indicator of transaction and a measure of recency are relevant for both types of firms. However, recency on its own may not be a good indicator of customer retention. 

Suppose that customers A and B last purchased from the firm 6 months ago. On the one hand, customer A generally purchases once a year. That is, his inter-purchase time is 12 months. As a result, the firm cannot take recency of 6 months as an indication of churn. This is because it is well within the customer’s purchase cycle. 

On the other hand, customer B usually purchases every month. In this case, recency of 6 months is certainly worrisome for the firm. 

Thus, a SaaS business must calculate a recency/inter-purchase-time ratio to understand the customer retention problem. A ratio greater than 1 indicates that the SaaS firm is facing a customer retention problem. 

Suppose that customer A’s recency/inter-purchase-time is 6:12 = 0.5 whereas customer B’s ratio is 6:1 = 6. These numbers showcase that customer B is not a loyal customer.

However, using the recency/inter-purchase-time ratio as a measure of customer retention has some challenges. Firstly, this ratio requires a SaaS business to observe a reasonable number of transactions in order to reliably calculate the average inter-purchase time.

Secondly, the inter-purchase time measure may be biased even for those customers for whom the SaaS business observes a sufficient number of transactions. Such a bias may occur as the SaaS firm may ignore the time between the last purchase and the last when the firm observed such data.  

To overcome such a challenge, the SaaS business can use statistical models to determine whether the customer is no longer retained. That is, whether there has been latent attrition.

Also, a SaaS business can aggregate across customers any measure calculated at the individual level. The distribution and statistics of these aggregates are important and particularly useful when monitoring retention over time. 

Perhaps the most common measure of retention is the retention rate. At the individual level, this measure is quantified as a zero-one indicator. Whereas, at the aggregate level, it is quantified as a percentage of customers retained. 

Customer Retention Rate Meaning

Customer Retention Rate refers to the number of customers doing business with a firm at the end of a financial year expressed as a percentage of those who were active customers at the beginning of the year.

Some researchers define customer retention rate as the number of active customers in the cohort in time t who was active in time t-1 divided by the number of active customers in the cohort in time t-1. 

A cohort is a batch of customers acquired or active within a specified time period.

Retention Rate = Ct / Ct-1

where C is a specific batch of customers.

Customer Retention Rate Calculation

Customer Retention Rate (CRR) is a financial metric that demonstrates the proportion of customers that have stayed with the company only a while. It does not include new customers and can be calculated weekly, monthly, or annually.

Also, it is important for a SaaS business to calculate the CRR from the perspective of a longer period of time. This is because the nature of customer retention is such that it tends to last at a minimum length of a couple of months. 

Here is the Customer Retention Rate formula that a SaaS business may use to calculate its CRR:

Customer Retention Rate = ((CE-CN) / CS)) x 100 

Where

CE = Number of customers at the end of the period 

CN = Number of customers acquired during the period 

CS = Number of customers at the start of the period

Let’s consider an example to understand Customer Retention Rate calculation. Tomasz Tunguz, the renowned venture capitalist, uses the following details to calculate the customer retention rate.

MonthStarting RevenuePercent ChangeEnding Revenue
15812-20%4650
233420%3342
332212%361
454380%5438
5554914%6326
621616%251
7921716%10692
85383-6%5060
97660-8%7047
1021595%2267
119147-11%8141
12752-12%662
Total5499754235

The venture capitalist suggests that a SaaS business can calculate the Net Dollar Retention (NDR) in three ways. 

Firstly, it can either calculate NDR as the average of the Percent Change column. Accordingly, the average of each cohort will turn out to be 0.5%. 

The second way in which a SaaS business can calculate NDR is to determine the percent growth in total ending revenue compared to the total starting revenue. Accordingly, taking the annual data, NDR would be -1.4%.

The third way to calculate NDR is to aggregate the data by quarter and average that. Accordingly,  taking the average of each quarter, the NDR of the SaaS business would be -2.6%.

Note that all three methods give different averages for NDR. This happens because the overall average of a data set may be different than the averages of different groups. It is bound to happen as there’s no industry standard today.

But the question is which method to choose? The choice of method will depend upon the fact whether the NDR aligns with your billing cycles. In case the SaaS business has annual contracts, then it makes sense for the business to calculate the annual growth. However, if the business is utility-based, then it is better to determine the monthly or quarterly growth to smooth out revenue.

Then, the SaaS business must stick to the measure to maintain consistency in data. Also, it must benchmark its business to others who measure themselves in the same way.

Customer Retention Metrics

To monitor customer retention, a SaaS business can use the following financial metrics.

Customer Retention Rate Drivers

I. Churn

The churn of a SaaS business refers to the rate at which it loses customers or revenue during a defined period of time. This metric can have a significant impact on the growth of a SaaS firm.

Churn Rate may not be an important metric to track for a SaaS business in its launch phase. However, as the business grows, even a low rate of churn can impact the revenues and earnings of the SaaS business significantly.

II. Customer Churn

The second retention metric that a SaaS business must track is customer churn. Customer Churn refers to the number of customers that have discontinued their subscription during a given period of time.

A SaaS business must calculate and distinguish between revenue-based churn and customer-based churn in order to determine an accurate performance analysis.

Also, customer churn as a metric is determined in terms of the net increase in the number of subscribers and net subscriber churn. Further, it indicates the number of customers lost or those who did not renew their subscription against the total number of subscribers for a given period.

III. Net Revenue Churn

Another retention metric to monitor is the Net Revenue Churn. This SaaS metric measures the revenues lost during a given period as a result of loss of customers or run-rate due to reduced product features or users.

A SaaS business may experience revenue churn due to a loss of non-subscription-based or short-term products and services.

Note that customer churn of a SaaS business depends upon the size and the total number of customers for a given product or service. Thus, there is a difference between losing a customer as compared to losing a bottom customer as customers vary by size and value.

On the other hand, a SaaS business having varied product pricing must track dollar-based churn. This is because it is a more relevant metric of performance for such a business.

IV. Dollar-Based Net Expansion Rate

Another measure of customer retention is the Dollar-Based Net Expansion Rate (NDR). This measure compares the aggregate revenue for existing customers for the current year against the previous year.

Such a metric indicates the level of revenue sustainability of a SaaS business. Also, this metric indicates the quality of customer relationships over time.

V. Quick Ratio

Quick Ratio is a financial metric that provides a view of a SaaS business’ growth efficiency. This ratio combines two SaaS metrics. These include Revenue and Churn. Further, the investors and the internal management make use of this metric to benchmark the growth performance of a business.  

Why is Customer Retention Important?

One of the critical financial metrics that helps a SaaS business drive its profits is to maintain a high customer retention rate. This is because the cost of acquiring a customer is much higher than retaining a customer. Also, loyal customers generate more profit for a business.

As per research, even a 5% increase in the customer retention rate resulted in a 25% to 85% boost in profit among all industries studied. 

Thus, the following are the reasons why it’s important for a SaaS business to focus on customer retention.

I. Increased Purchases

Customers start trusting their suppliers as they come to know more about them over time. As a result of this growing trust, the risk, and uncertainty associated with each transaction reduce. This means that the customers tend to commit more of their spending to the known and proven supplier. Such a commitment is both in measures of order size and order frequency.

II. Lower Price Sensitivity

It is important to note that loyal or long-term customers tend to lose their vigilance towards the price. This is because they get more value from the established relationship than from a new one. Such customers understand the SaaS provider’s procedures and product lines much more than the competitive solutions. For such customers, the extra value lies in the convenience and purchase efficiency of the long-functioning process.

III. Lower Cost of Customer Management

As mentioned earlier, the cost of acquiring customers is quite high relative to the cost of managing existing customer relationships. This is especially the case in the B2B segment. That is, in the B2B segment, the cost of managing transactions and customer service can get very low as compared to the cost of acquiring the customer. 

IV. Customer Referrals

Long-term loyal customers who willingly spend their money with the preferred SaaS provider are more likely to deliver word-of-mouth. In other words, such customers influence the buying customs and beliefs of others in favor of the SaaS provider. As per research, the frequency of customer referrals and the corresponding profit grow as the relationship of the customer with the SaaS firm lengthens. 

Also, research showcases that customers who purchase more frequently also refer more frequently. 

Which Customers Should a SaaS Business Retain?

A SaaS business must retain those customers who signify the greatest strategic value to the company. It should first target its retention efforts towards such customers. Note that customers with a high strategic value for the SaaS business are either those with high lifetime value (LTV) or those who are strategically significant for the firm in other ways. 

There are five more groups of customers who are strategically significant for a SaaS business apart from high LTV customers. These include

I. High Volume Customers

These are the customers who subscribe to the SaaS product or service in high volumes. Say for instance an Accounting Consulting firm is in need of accounting software to cater to the accounting and tax requirements of its clients. 

The consultancy has a team of 50 CPAs who are consulting clients day in and day out. This means the accounting consultancy firm is in need of 50 accounting software licenses or user accounts for its CPAs to record and analyze accounting data. 

Now, the actual profit these customers generate may not be too large. But there might be a strategic value of having such customers. Such value is in terms of their absorption of fixed costs thus making it possible for the SaaS business to keep its unit cost low. 

II. Benchmark Customers

Some customers prefer selective SaaS providers over others. As a result, having them as customers may generate strategic value for SaaS providers. This is despite the fact that such a relationship may not generate much direct profit. The underlying reason for customer success in such a case is that if such customers are good for the competitive SaaS solution providers, they are good for the given SaaS business as well. 

III. Inspirational Customers

The inspirational customers include the customers who help a SaaS solution provider to learn and improve. Such customers may demand product improvements that are useful for other customers too. Furthermore, these customers may also help a SaaS business to identify ways to reduce its production cost or identify new segments where the end-user can utilize the SaaS product.

IV. Door Openers

A SaaS business must focus on retaining customers who are door openers. In simple words, a SaaS business must retain customers who open a door for it to new markets. 

This can be beneficial in further expansion and may be particularly important in case of crossing cultural boundaries.

V. Technology Partnerships 

Some customers act as technology partners for a SaaS business. These customers co-operate with the SaaS provider on a common goal of improving the product or the service’s technology. For doing so, the SaaS business usually offers some pre-agreed advantages to the customers. In fact, the SaaS business can also have place sharing of resources, such as people, money, or knowledge.

Customer Retention Strategies or Types of Customer Retention Methods

Customer Retention Rate Drivers and Growth Stages
Image Source: kpmg

I. Focus On Up-Sells and Cross-Sells

The first strategy that a SaaS business must focus on improving customer retention is to increase the revenue from a client. The SaaS business can do this by exploring additional opportunities once a relationship with the customer is established. In addition to this, a SaaS business can even think of ways of giving added value to the current offerings that the existing customers use.

II. Set Optimal Pricing For Usage-Based Billing

In case a SaaS business works on a usage-based billing model, it must charge or set optimal pricing for the services used by the end-user. It must incorporate different levels of price sensitivity based on the customer segments. In other words, a SaaS business must set the price for their usage-based business model depending upon the price that a customer segment is willing to pay.

III. Focus On New Customer Acquisitions

In addition to retaining the existing customers, a SaaS business must also focus on growing the overall customer and revenue base organically. This should be a consistent activity as it will help the business to minimize the impact of the customers that are lost in a given period of time.

IV. Enter Into Longer-Term Contracts

A SaaS business must prefer entering into long-term contracts with customers. This will help the business in reducing the turnover and risk of losing customers on a frequent basis. Note that longer-duration contracts with customers establish longer-term relationships with customers. Further, such relationships lead to guaranteed business for the firm.

V. Target Risk Segments

It is important for a SaaS business to employ or get onboard top talent to manage customer segments with low NPS scores. NPS score is another important SaaS metric that a business must determine as it provides insights into customer loyalty. Such a number ranges between -100 and +100 with positive scores considered good for the business. 

Thus, a SaaS business that focuses on managing customers with low NPS scores can increase its customer retention over a period of time.

VI. Undertake Product Segmentation

This is another customer retention strategy that a SaaS business may adopt. A SaaS business must segment customers accurately in order to assess the churn risks accurately. Once the business is aware of the churn risks, it can then highlight strategies to retain customers based on the churn risk insights determined.

VII. Engage Customers

A SaaS business must also engage and interact with customers to know their product expectations. Once they are aware of the customer expectations, they can certainly work on the strategies to retain such customers. 

Furthermore, a SaaS business must determine the parts of the product or the service that can go a long way in retaining the customers and hence reducing the churn.

VIII. Engage Customers

A SaaS business must constantly track the satisfaction levels of its customers. This activity will help the business in analyzing the reasons for contract cancellation and customer churn.

Besides this, a Saas company must also keep a track of user adoption rates. User Adoption is a key indicator of customer satisfaction levels.

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