This content originally appeared on Envato Tuts+ Tutorials and was authored by Andrew Blackman
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.
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 Ads, 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.
Editorial Note: This content was originally published in 2014. We're sharing it again because our editors have determined that this information is still accurate and relevant.
This content originally appeared on Envato Tuts+ Tutorials and was authored by Andrew Blackman
