By Sudeep Vaidyanathan, Product Management Director, Oracle
When COVID-19 turned the world on its head, companies everywhere started looking at alternative business models. And even though many companies have since re-opened, customers are still looking for new ways to consume products and services: watching movies online, having take-out meals delivered, or working out at home instead of at the gym.
A subscription, or recurring revenue model, can offer a great solution, helping companies to bring in revenue and while giving customers the options they’re demanding. Even B2B companies are moving in this direction; for example, some airline manufacturers are moving from selling jet engines to leasing them as a service that includes maintenance and repairs.
A traditional business model, with a one-time sale or a perpetual license, may use metrics such as revenue growth, customer acquisition costs, manufacturing costs, and gross profit margins. But the subscription business model requires a different set of metrics to track and monitor the health of the business. Let’s review 6 key metrics to consider for a successful subscription business.
Monthly Recurring Revenue (MRR), represents the monthly revenue for a subscription. Recurring charges must be normalized to a monthly value (e.g., quarterly divided by 3). For example, if the business sells annual plans or half-yearly plans or quarterly plans, then the revenue amount is divided by 12, 6, and 4, respectively. To calculate, add up all the customer level MRR from all active subscriptions.
There are many nuances in the calculation of MRR:
Businesses can also track and monitor the MRR from new customer accounts, product upgrades, and product downgrades.
Once you sort out MRR, you can easily figure out your annual recurring revenue (ARR). This represents the yearly revenue of a subscription. This metric is helpful to see year-over-year trends and set growth goals.
You can also use ARR to look at other health indicators for the business. You can calculate an “average monthly recurring revenue per customer” number. This helps you see where you can adjust base subscription rates that would apply to the entire customer base. Companies such as Netflix look at these numbers to determine if a rate increase can be done without affecting their churn rate.
As a business, expect some churn: the number or percentage of customers that terminate a subscription in a given billing period. While you want a low churn rate, when you see large spikes, it can be a good indication that you need to make a change.
Companies can choose to compute the churn rate on a monthly, quarterly, or annual basis. A very common visual to explain churn is a leaky water bucket. A healthy subscription business should always be adding more customers than it churns. The metric is critical for businesses that have a very high initial customer acquisition cost, or a low lifetime value.
To calculate, compute the total number of customers that you lost in a period divided by the total number of customers at the beginning of that period.
It’s critical to analyze the key factors that contribute to churn. It’s always challenging to predict, as there could be several internal and external factors that can contribute to it. Depending on how customers terminate their subscription, you can try to gather data points on their reasons for leaving, which can be used for analysis and future customer retention actions.
Unlike subscriber churn, revenue churn expresses the percentage of lost revenue from existing subscribers in a given period. Compared to customer churn, it’s more critical to track and monitor revenue churn. This is the financial impact of customers terminating their subscriptions.
To figure this out, calculate the lost revenue due to both voluntary and involuntary terminations and downgrade in the period - upgrades in the period / revenue at the beginning of the period.
While mid-term churn is harder to predict, renewal rate is something your entire company can be a part of keeping on track.
Renewal rate is computed by determining the total number of subscriptions renewed in a given period, divided by the total number of subscriptions due for renewal in the same period.
In a healthy subscription business, your renewal rate needs to be high enough that you’re in a growth trajectory for the overall business, whether that’s total customers or revenue. You can also calculate the renewal rate on a revenue basis as the actual renewal value in a given period, divided by potential renewal value for the same period, times 100. Again, in a healthy subscription business, this metric should always be greater than 100%.
Renewal rate is a crucial metric to forecast future growth. Typically, subscription businesses should start the renewal process at least 30 days in advance—but the likelihood of renewal is based on all the experiences the customer has over the entire term of the subscription. Plan ahead, so you can run targeted customer engagements to keep the renewal rate healthy.
This gets us to where we start looking at the long-term relationship metrics that make a subscription business a success.
Customer lifetime value (CLV) is by far the most important metric for a subscription business. It indicates the total revenue potential from a customer. Of course, for a subscription business to be profitable, the CLV should always be higher than the customer acquisition cost.
The simplest model to calculate CLV is to divide the average monthly recurring revenue per customer by the monthly churn rate.
Now that you have an idea of what you should be tracking, you can focus your efforts to improve these numbers.
You may have noticed that these metrics focus on the customer, not on the business. This shift in view will help you make sure the customer experience is the top objective. If you do that, your new business model can be successful.