The Retention Rate Formula (Part 3)

Over the last two weeks, we’ve been looking at the formula used to calculate retention.  Unless an organization is able to separately track new and existing customers, the problem with the retention rate formula becomes one of determining how to treat new customers.  We found that the most commonly used formula effectively treats new customers as though they all arrive on the last day of the year.

YearEnd Formula:            Retention Rate (RR)  =  (End – New) / Start

Another formula some firms use effectively treats new customers as though they all arrive at the very beginning of the year.

NewYear Formula:          RR  =  End / (Start + New)

So what does a more accurate and “reasonable” formula look like?  Well, if you think about it, for most businesses, new customers will be coming in throughout the year.  Some will sign up on the equivalent of January 1, some will arrive December 31, and all the others will arrive all the various days in between.  On average, they’ll arrive around midyear.  So, to measure retention properly, we want a formula that treats new customers as though they arrive midyear.

A “MidYear” formula is quite easy to construct, if we just re-state our traditional formulas a little differently.  The “NewYear” formula can be revised to show that there are zero new customers being subtracted from the ending customers in the numerator, while the denominator re-states the new customers as “1 New”, meaning that it picks up all 100% of the new customers.

NewYear Formula Restated:      RR  =  (End – 0 New) / (Start + 1 New)

Similarly, the “YearEnd” formula can be restated to show all new customers subtracted from the ending in the numerator, while there are zero new customers added to the denominator.

YearEnd Formula Restated:        RR  =  (End – 1 New) / (Start + 0 New)

Well, a “midyear formula” should be the average of these two formulas, right?  In the numerator, we’ll subtract the average of 0 and 1, or ½, of the new customers.  And in the denominator, we’ll add the average of 0 and 1, or ½, of the new customers to the beginning customers.

MidYear Formula:             RR  =  (End – ½ New) / (Start + ½  New)

And voila, by treating new customers as arriving midyear, on average, we have a retention rate formula that remarkably well reflects the “true” retention rate.  Our example was for all of 2017, but it can be applied anytime during the year.  Though new customers will seldom come in on average at exactly midyear, they will probably usually come in very close to that.

We can now try out our new formula on the simple example we used previously.

MidYear Formula:            RR  =  (End – ½ New) / (Start + ½  New)

Example:                             RR = (100 – ½ x 20) / (100 + ½ x 20)

RR = (100 – 10) / (100 + 10)

RR = 90 / 110 = 81.8%

We subtract half the new customers, or 10, from the numerator, and add half of the new customers, or 10, to the denominator.  We arrive at a retention rate of 81.8%.  As one might expect, the result is roughly halfway between the 80% we got using the “YearEnd” formula, and the 83.3% obtained using the “NewYear” formula.  It’s a little more involved, but if you want to use the “right” formula for calculating the retention rate where the customer counts include new customers, the MidYear formula is the right one to use.