KPI Series Part 1: What is Churn, Why it is Important to Monitor and Common Ways to Calculate It
Updated: Nov 17, 2018
In Part 1 of the KPI Series, we will dive deep into churn (also commonly known as “attrition”), what it means for a business and a number of methods to calculate it. Churn is a metric that companies across the industry and size-spectrums should look to monitor accordingly, given it is an essential statistic that reveals the health of the customer base and performance of the business. Although there is no universal, agreed-upon methodology for calculating churn, I will provide a few prevalent calculations that can be applied to businesses of all kinds.
What is Churn?
Churn is the value of a business’ revenue attributable to users / customers who decide to “cancel” (i.e. the user / customer is no longer going to pay for and use a company’s product / service). It also represents the total count of users / customers that have cancelled over a selected period of time. Retention goes hand in hand with churn, as it represents the total amount of a company’s customer and revenue base that does not cancel and remains paying for the company’s product and service. Churn (and retention) can be stated over any given period of time (e.g. daily, weekly, monthly, quarterly, annually), depending on how a company’s user and customer model works, and how the company would like track it. Let’s compare how two companies operating with different business models in different industries may decide to track churn:
1) Company A is a meal kit delivery company who sells pre-made meal kits to customers on a weekly basis. Given that Company A’s products are sold on a weekly basis to customers, they monitor revenue and customer churn weekly as well. By aligning churn with its go-to-market approach, Company A can easily identify key performance trends in its sales and marketing strategy, and address these concerns in a timely manner.
2) Company B is a subscription media streaming service that charges a monthly fee for users to access its platform. In this case, the subscription media company tracks churn over a monthly period to align with its subscription sales model, while still having the ability to easily roll the metric up (as needed) for quarterly and annual calculations.
Why is Churn Important to Monitor?
Business owners and investors must view churn (if they do not already…) as a critical metric of a company’s health and going concern. By keeping a close eye on churn, companies will be informed on key elements of their strategy and performance, ensuring that they can implement or pivot on initiatives to improve their retention metric. Churn is not only important for monitoring historical performance, but also serves as an integral metric in forecasting and future budgeting decisions, as it can serve as a proxy for the probability of customers and revenue cancelling in the future. Using the same companies highlighted in the examples above, let us explore why tracking churn is essential for businesses:
1) Company A has conducted a detailed analysis on a constant cohort of its revenue base over the past three years, and have arrived at average weekly revenue churn rates of 0.1% in year 1 (5.2% annualized churn rate), 0.2% in year 2 (10.4% annualized churn rate) and 0.3% in year 3 (15.6% annualized churn rate). Although there are numerous variables that may have contributed to the uptick in churn from year 1 to year 3, Company A’s management team identifies that one of the main drivers of the increase was that the Company offered promotional discounts on its meal kits in year 1 to generate customer growth and retention, and did not continue to offer these in years 2 and 3. In order to move churn back to a sustainable level, Company A decides in year 4 to mirror its strategy from year 1, and at the end of year 4, sees average monthly churn decline to 0.15%.
2) Company B experienced an alarming increase in churn in years 1 and 2 on its user subscriptions, going from 1% average monthly churn (12% annualized) to 2% average monthly churn (24% annualized). After a contentious board call with its lead investors, Company B discovers that one of the primary reasons for the increase in churn was due to the rising average ticket response time on its customer support issues. In order to recalibrate its churn to normalized levels (and to keep its lead investors from losing confidence and patience…), Company B invests in increased customer support staff and software tools to improve issue response times. As a result of this investment, Company B reduces average monthly churn to 0.5% (6% annualized), its lowest rate over the three-year period.
Common Ways to Calculate Churn
The most intriguing and arguably the most contentious topic of discussion around churn is how to calculate it. As mentioned earlier, there is no universally accepted calculation or set of standards for churn, which tends to drive business owners and investors down a perpetual road of mental gymnastics trying to convince others that their way of calculating churn is superior. In order to avoid entering “churn calculation purgatory” (yes, I did just make that term up), I tend to use three rules of thumb to advise clients:
1) Keep it simple: adding complexities to a churn calculation will not only confuse your investors, but can also confuse people within your business, which can lead to incorrect and ineffective decisions (and will also lead to long, unreadable footnotes at the bottom of presentation pages);
2) Keep it consistent: whether we are talking about the consistency of presentation / calculation or merely the timeframe of churn presented, it is always important to maintain continuity to ensure proper comparability;
3) Keep it transparent: it is critical not to “hide the ball” when presenting churn to stakeholders, as maintaining transparency on how it is calculated will improve its understanding and belief in the historical and projected figures presented.
With these three best practices in mind, let’s introduce three simple and common churn calculation methods:
Method 1: Comparable Period Churn
When deriving comparable period churn, it is important to first determine which period will be assessed and what is the length of the comparable period chosen. As an example, if a company / investor decides to calculate quarterly churn using the comparable period approach, they will first select three months’ worth (i.e. one quarter) of performance, and compare it to the same three months (i.e. one quarter) from last year. No matter which length of time is chosen, this method requires a consistent comparison between the two periods. The below details the calculation and a simple depiction as a complement to this explanation:
Additionally, below are representative merits and considerations of the comparable period churn methodology:
Method 2: Consecutive Period Churn
Assessing churn over consecutive periods is another method that allows for quick and simple presentation of attrition. In this case, companies will select the number of customer cancellations or total revenue cancelled over one period as a starting framework, and compare it to the total base of customers / revenue in the prior sequential period. Under a quarterly convention, this is calculated by taking one quarter’s worth of cancelled revenue (e.g. Q1 2018) and dividing it by the total revenue in the prior quarter (e.g. Q4 2017). Here is accompanying graphic to consider, illustrating consecutive period churn:
Below are representative merits and considerations of the consecutive period churn methodology:
Method 3: Renewal-Based Churn
Of the three methods, renewal-based churn will produce arguably the most accurate and defensible presentation, particularly for companies that employ recurring, subscription business models. This is due to the fact that it compares cancellations only to the base of customers / revenue that are up for renewal over a selected period. Despite its increased precision, it is more difficult to track in a large and complex business environment, as it requires constant attentiveness to update details like contract, billing and/or revenue recognition dates over the lifetime of customers. This provides additional support to further understanding of renewal-based churn:
Below highlights representative merits and considerations of the renewal-based approach:
Concluding Thoughts: Never Turn a Blind Eye to Churn
Churn and retention are crucial metrics to monitor for every business owner and investor at every stage of a company’s growth cycle and maturity. Maintaining real-time calculations of this key performance indicator will inform the right strategic and operational decisions, and properly safeguard stakeholders from potential pitfalls and lagging financial performance. By aligning churn calculations to business models and processes (e.g. a company’s go-to-market approach), and ensuring that it can be interpreted in a straightforward manner, companies can also enhance reporting standards and credibility in presented historical and forecasted figures.