Last week, we looked at the typical formula used for measuring the retention rate. That formula is easy to use. But it’s not that accurate. The most commonly used retention rate formula is:
Formula #1: Retention Rate (RR) = (End – New) / Start
Some firms use a different formula. Instead of subtracting the new customers from the ending account total, they include new customers with the starting base.
Formula #2: RR = End / (Start + New)
Again, we’ll demonstrate the formula under the same scenario previously used: we start and end the year with 100 customers, and add 20 new customers during the intervening 12 months.
Example: RR = 100 / (100 + 20) = 100 / 120 = 83.3%
You end with 100 customers; you started with 100 customers, and added 20 along the way. Of the 120 total customers, you’ve “retained” 100 of them, for a retention rate of 100/120, or 83.3% – using Formula #2. One of the attributes of this approach, that management would appreciate, is that you end up with a higher figure. This formula, like #1, is also easy to calculate. But which of these, if either, is more appropriate?
The central challenge with any retention rate formula is how to treat new customers, or more precisely, how to treat when they are new. Let’s walk through a couple of examples, wearing an economist’s hat.
To help clarify a given problem, economists love to make assumptions. So let’s start by assuming that it’s the end of 2017, and we’re looking back and measuring the retention rate for 2017. Let’s further assume that all the new customers came in on the 2nd day of the year, January 2.
If all the new customers came in on the 2nd day of the year, then essentially, by the end of the year they have effectively had an entire year in which to leave, while the existing customers had the full year to leave. In this instance, it is quite reasonable and appropriate to treat the new customers as though they were existing; after all, they have had virtually the same amount of time in which to leave as the existing customers did. So the formula for measuring retention for 2017, under this scenario, is to take our ending customers and divide them by the starting plus new. Let’s call this the “NewYear” formula, since all the new customers arrive at the start of the new year.
NewYear Formula: RR = End / (Start + New)
Next, let’s run a different scenario where we assume that all the new customers arrive on the 2nd to last day of the year, December 30. Are we going to want to include them in our measurement of retention? Absolutely not; they haven’t had any time to leave yet. So here we’ll want to subtract our new customers from the count of ending customers, while our baseline will be our starting customers. Let’s call this the “YearEnd” formula, since all the new customers arrive at year end.
YearEnd Formula: RR = (End – New) / Start
Of course, our “YearEnd” and “NewYear” formulas are identical to the “Formula #1” and “Formula #2” that are commonly used. The primary formula, “Formula #1”, is identical to the YearEnd formula; it treats all new customers as though they came in at the very end of the year. Our second formula treats all new customers as though they come in at the start of the year. Clearly, neither of these formulas rest on a reasonable assumption.
Next week we’ll determine what the retention rate formula “should” be.