Understanding and Calculating Customer Retention Rate

Updated On: August 21, 2019
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Customer retention is king for any subscription business.

Yes, charming visitors and turning trial users into paid subscribers are important—but building a SaaS business solely through brute-force acquisition doesn’t cut it anymore. Eventually, all you can do is add more customers to the top of the funnel in hopes that you’ll make up for all those leaking out the bottom.

That's why understanding your retention rate is so important. Your retention rate—and by retention rate I'm specifically referring to the percentage of customers retained over time—gives you a benchmark for consistently improving your product and business, provides early warning of potential problems, and simplifies revenue forecasting.

Here’s why retention rates should be top of mind for your SaaS business and why you should be calculating retention often.

What is retention rate?

Retention rate is the measurement of how many customers continue to be customers in the subsequent year (as a percentage). Retention rate is one of the most important metrics for subscription businesses because it shows how many of your customers are going to keep using your service.

Why is retention rate so important?

Time and again, I see SaaS companies addicted to growth, putting all their eggs in a single basket—customer acquisition—and spending almost no time retaining the customers they have. That’s a shame, since the data shows retention is a far more efficient growth driver than acquisition.

In a study of 1,432 SaaS companies, C-level executives and founders overwhelmingly placed more emphasis on “gaining more logos” (customer acquisition) than on keeping customers around longer (customer retention).

 Companies put far more effort into acquiring new customers than into customer retention.

Companies put far more effort into acquiring new customers than into customer retention.

These days, the battle for SaaS customers is raging, and the competition is fierce. Companies who focus solely on acquisition as their main growth lever are getting left behind. That’s why getting a handle on your retention rate is so important—without a higher retention rate, you’ll be losing money every day, no matter how many new customers you acquire.

But first, let’s unpack exactly what I mean when I talk about “retention,” since it can mean different things, depending on the context.

Retention rates come in different flavors

It bugs me when people talk only about “retention rates.” Everything I’ve written talks specifically about customer retention, or revenue retention, or user retention.

Only lazy people say “retention”—it just doesn’t give enough context, since retention could refer to a bunch of different subscription-related numbers:

  • User retention refers to the number of active users who stay with your product or service from week to week, month to month, etc.
  • Revenue retention includes the amount of recurring revenue at the end of the measurement period from customers who continue their subscription.
  • Customer retention measures how many customers maintain their subscription over time.

Each rate is independent of the others—for example, the loss of one large customer might only mean a small reduction in your customer retention rate, but it could be a significant loss in revenue retention.

In this post we’re specifically talking about customer retention rate—so it’s safe to assume when I mention retention, I’m talking about customers.

How to calculate retention rate

All the confusion around what retention is means most subscription companies tend to calculate retention incorrectly. The basic calculation for customer retention rate is pretty straightforward.

The Retention rate formula

Take the number of active customers who decide to continue their subscription at the end of the period—for most SaaS companies, this period will usually be either a month or a year.

Divide that by the total number of customers who were active at the beginning of that period.

Last but not least, multiply by 100 to convert that number to a percentage.

The formula for calculating customer retention rate.
Retention rate is the inverse of churn rate—retaining fewer customers means a corresponding increase in churn. As a quick example, a 7% monthly churn rate would equate to a 93% monthly retention rate.

What is a good retention rate?

Another reason customer retention confuses so many SaaS founders is that “good versus bad” retention can be so fuzzy.

Everyone wants to know the magic number they should target for their retention rate—but the reality is that the right number varies widely between industries, products, and customer segments. A stellar retention rate for a B2B SaaS company might look abysmal from an enterprise perspective.

The best-case scenario? You’re providing such a great service or product that 100% of your customers stay. This is the goal of any subscription business: Keep all the profitable customers as long as you possibly can.

Perfection, though, is an unattainable goal for most companies. Instead, the answer lies somewhere in the middle of the spectrum.

Bad retention: Churning customers faster than you gain them

Bad retention happens when you’re churning customers at the same rate (or faster) than you’re gaining new customers.

Let’s say you have an 85% retention rate; you might say, “That’s great, 85% of customers are staying.” Extend that 85% customer retention rate to five years, though, and you have only 44% of those original customers from year one.

This drives your customer acquisition costs through the roof, creating a stagnant effect that eventually just plateaus business growth. The number of new customers always matches the number of customers churning out, leading to the flatlined growth curve example you see below.
Bad customer retention can stagnate your SaaS growth and drive your acquisition costs through the roof. Bad customer retention can stagnate your SaaS growth and drive your acquisition costs through the roof. Image via Dan Wolchonok.

Good retention: Keeping more customers than you lose

A good retention rate looks vastly different. Instead of all going to zero, those cohorts layer on top of one another. This means that growth doesn't plateau like it does in our previous example. Instead, it accelerates over time, giving a growth chart that looks more like the one below.
Good customer retention leads to exponential customer growth over time. Good customer retention leads to exponential customer growth over time. Image via Dan Wolchonok.

The right retention rate is different for everyone

There’s no one-size-fits-all retention rate that works for every company. Instead, you need to work out the retention rate that’s best for your company.

The best benchmark for retention isn’t other companies—it’s your own company’s past performance. Your focus shouldn’t be on hitting some magical number but should instead be on doing better than last week, last month, or last year.

That means running retention experiments, aligning your internal incentives, segmenting your customer base, and—most importantly—using a tool like ProfitWell to track how your customer retention rate changes over time.

Why you need to calculate retention rate often

Churn can be cunning. Like we saw earlier, SaaS founders spend so much time focusing on acquisition, it’s easy to miss a company-killing drop in retention until it’s too late.

Calculating your customer retention rate frequently and monitoring for any fluctuations simplifies revenue estimation, gives you a great benchmark of your company’s performance, and lets you jump on minor issues before they turn into big problems.

Provides a benchmark for improvement

Is retention better this month than last month? Last year? How does it compare to your average lifetime customer retention? What targets do you need to aim for next year?

By tracking performance over time, you can quickly see if things are going uphill or down. Cause and effect become obvious—you can quickly see the results of any changes you make, along with the corresponding way that customers retain (or churn).

Gives you early insight into potential problems

Tracking how your customer retention rate changes over time helps you understand how your decisions directly affect your business.

If you notice your monthly retention rate is tipping downward, you may want to have a look at it as soon as you can, before it bleeds into years of losing customers.

Helps with revenue estimates

Especially for early-stage businesses without a lot of historical data to lean on, calculating how long a customer acquired today will remain a customer in the future can be difficult. Instead of relying on assumptions, knowing your customer retention rate makes calculating the average customer lifetime and revenue run rate easy.

Simply take 1 and divide by the customer churn rate (remember, that’s the inverse of the retention rate), and you’ll get the customer lifetime period. For example, if you have an annual retention rate of 60%, take 1 divided by 40% (the churn rate) to get a lifetime of 2.5 years.

This can help you plan ahead and see where your revenue will be down the road.

Don’t overlook your retention rates

Acquisition might be where we want to spend all our time—but myopically focusing on getting more customers instead of boosting retention with those we already have is no longer enough.

SaaS funnels are only becoming leakier over time—competition is getting tougher, once-valuable features aren’t the moats against competitors they used to be, and switching between products is easier than ever before.

Staying on top of your retention rate is your eject button from the hamster wheel. Measuring retention over time can boost your revenue and keep you off the slow SaaS ramp of death—as long as you use the data to drive your actions.

 

P.S. We created ProfitWell to help you track your customer retention rate and keep track of your growth. Get your free ProfitWell account today!

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