# 1 | What is Churn?
Churn is the current percentage of customers who terminate their contracts or subscriptions. It is a traditional KPI (Key Performance Indicator) for business performance and an important parameter in sales forecasts.
When used in the profit forecast, churn can be considered the probability rate at which customers are expected to terminate their contracts or subscriptions. In the simplest form, churn can be specified as the number of cancellations (Δ c) per time interval (Δ t) divided by the number of customers at the beginning of the interval (c).
|Δt x c|
In the above formula Δ is a common mathematical symbol, which means change or interval.
That would perhaps be the simplest answer to the question of what churn and churn rates are. In practice, churn is much harder to define and measure.
For example, it is very common to measure churn at the client level (customer churn), subscription level (product churn) and recurring revenue level (MRR or ARR weighted churn).
Moreover, it can be much more complicated if low churn rates, high churn rates, high growth rates , a variety of customer types, a variety of subscription and contract periods, and a variety of contract MRR values and changes are to be reflected in the churn rate over time .
In its most complex form of churn is the result of a Poisson process, something statisticians would calculate as “survival analysis” instead of the simplified formulas we use for marketing purposes.
If you feel a little confused while trying to put theory into practice don’t worry- you are not alone. Further down in the text, we’ll discuss some abbreviations for calculating accurate churn rates, while keeping the mathematics reduced to a minimum at the same time.
#2 | Why is the churn rate such an important KPI?
The reason why the churn rate is more important than all other metrics and measurements is that churn is in direct contradiction to growth – the primary goal of most businesses. As a limiting factor for growth, the churn rate has a very negative impact on both profitability and valuation. If in addition, the churn rate increases as the size of the customer base grows, an essentially negative spiral is underway, which is incredibly difficult to overcome.
In plain English: You spend a lot of money, time and energy on the acquisition of new customers and have to get back these investments over time. Obviously, you will want your newly acquired customers to stick around for as long as possible. The longer your customers stay, the stronger your business. Therefore, the value of your churn rate is used in the calculations for the average customer lifetime value.
# 3 | How do I calculate churn in my business?
Well, it depends! To calculate churn correctly, you should try to achieve the following ideal circumstances.
Consistent customer population: Calculate churn in a uniform population of customers. Uniform means all customers have the same probability of cancellation / termination of the contract during the measurement interval.
Coordinated customer population: The churn measured by the population of customers who actually do terminate or cancel the contract (Δ C) versus the original population of clients who could potentially could cancel (C).
Appropriate measurement time interval: Calculate Churn in a time interval (Bz), which is neither too short to not contain sufficient cancellations nor too long to contain too many cancellations. Otherwise it could not be statistically significant, biased and at worst random results could occur with the offered simplified calculation formulas.
MRR (Monthly Recurring Revenue) uncorrelated to the churn rate: If RR is confused with churn e.g. by frequent migration of larger customers vs. small customers, the churn rate may differ significantly from the expected revenue (!!), and in the end it is the revenue that counts!
Robust Business Processes: Most companies are constantly busy improving their business processes. A small start up may not yet have a stable business model or recurring income.
A simple measurement of the churn rate in the constantly (Caused by the very nature of start-ups) changing business processes yields poor results. Ideally, you should measure before and after important changes to your business in order to understand the churn as an impact on the interactions.
What does this mean practically? Most companies begin calculating the churn rate dividing the number of customers that are present at the end of the month by the number of customers that are present at the beginning of the month.
|Monthly Churn Rate Calculation||=||Cstart – Cend|
And, then multiply the monthly churn rate by twelve to get the annual churn rate.
Annual churn rate calculation = Monthly Churn Rate times 12
(Note: Cend is the number of customers who were present at the end of the month – thus being the original Cstart. It is not the total number of customers at the end of the month, which could include the ongoing customer acquisition. New customers should always be excluded from the calculation interval)
The following situations might cause a calculation problem:
- A too small number of customers ( measurement interval is too short)
- A very low monthly churn rate ( measurement interval is too short)
- A very high monthly churn rate ( measurement interval is too long)
- A high monthly growth rate ( population not matched)
- Contract extension periods longer than one month (population not matched)
- Mixed contract extension periods ( population not defined)
- Significantly different customer types and behavior (population not defined)
- High early dropout and subsequent long and loyal customers ( population not defined)
- A variety of MRR’s per contract ( population not defined)
- Upgrades or downgrades (MRR correlated churn )
- Change in contract renewal periods (MRR correlated churn )
These are just some of the possible scenarios! The attentive reader will notice that each of the above situations create problems by violating the respective ideal churn calculation bases (as assumptions in brackets indicate) .
Below are some churn calculation tips that will help you avoid many of the pitfalls in the churn calculations listed above without consulting a statistician or to have your churn calculations excessively difficult.
Tip # 1 | Select a measurement interval with churn <1% -10%
If the churn rate is low, many math relating things work better in terms of accuracy as well as in your business!
But even if your churn rate is high, you can improve the accuracy of your churn rate calculation by choosing a measurement interval, which has a churn rate that is relatively small (within the interval).
Consider a hypothetical company with a 25% monthly churn rate and 100 customers. At the end of months 1, 2 and 3 there are 75 = 100 * .75 * 56 = 75 .75 42 .75 * 56 = customers.
If you are using a measuring interval of a quarter, you will likely calculate a churn rate of 19% = (100-42) / 3 instead of 25%. If the contract cancellations in the measurement interval are too high, your churn calculations underestimate the true churn rate consistently.
Tip # 2 | With a measurement interval close to the average extension of the contract period
Your customers can only cancel if their contracts expire. If you are using annual contracts, only 1 of your 12 customers may terminate in a month (in theory).
On the other hand, for the 1 of the 12 who actually may cancel the contract, you theoretically would calculate the annual churn rate, because he was a regular customer for a year.
If your customer population is very large and uniform for some reason and you otherwise have zero growth, these two factors will cancel each other out.
Since this scenario is highly unlikely, it would be better to simply select a measurement interval close to your average contract extension period.
A frequent source of error in the churn calculation comes from the compatibility of Tip # 1, above the shorter churn measurement interval with Tip # 2, which brings a longer churn measurement interval in the rule. The solution to this problem requires a somewhat complex math hack described in tip # 7.
Tip # 3 | Respect only expiring contracts
If you find seemingly no middle ground between a low churn rate in the measurement interval (Tip # 1) and a measurement interval close to your average extension of the contract period (Tip # 2), then you should have your churn rate calculation only focused on contracts that are due for renewal .
The trick here is that since you selectively look only at contracts up for renewal, although these might have different renewal intervals.
The correct unit of measurement here is the average contract period of all contracts in the measurement interval.
|Monthly Churn Rate||=||ΔCCancellation per Month|
|ΔtAverage Contract Time x CM Contracts running out in months|
Tip # 4 | Segmenting customers into different churn categories
Too much adjustment to uneven customer populations can distort your churn rate calculation. The separation of different types of customer churn in separate categories and calculations can you help you to differentiate and identify different trends in different customer categories.
Churn in the various customer categories often varies depending on the contract type for example MRR, extension period, unstable customers versus loyalists, and a variety of customers with different attributes you already collected in your CRM system just waiting to be analyzed.
Tip # 5 | Measuring recurring revenue
The churn rate of recurrent revenue (RR Returning Revenue) is calculated by inserting monthly recurring revenue or annual recurring revenue (MRR or ARR) in the standard customer churn calculation. It is essentially a modified standard customer churn calculation version with emphasis on recurring revenue where large customers count more than smaller ones.
|Monthly MRR Churn Rate Calculation||=||MRRstart – MRRend|
The customer churn calculation can reveal significant financial problems, as well as downgrades or higher loss rates for larger customers.
Conversely, it could make things look worse than they really are from the perspective of financial profitability. Routinely measuring and comparing customer churn and churn rates MRR will help you to recognize nuances within your customer base that have a direct financial impact on your business.
Tip # 6 | Divide MRR churn in upgrades, downgrades and cancellations
Perhaps the most useful aspect of the MRR Churn is the insight into upgrades and downgrades it provides. There are two important financial indicators that cannot be calculated by the simple churn. The calculation is similar to the calculation of churn categories. There has to be an identification of subscriptions, which got services / products upgraded, have experienced a downgrade or may have been terminated during the measurement interval.
So each category can be separately calculated and evaluated.
# 7 Tip | Use of correct conversion formulas in high churn situations
So now it will be a bit more challenging with the math. If you work in a marketing department, you may be permitted to consults a statistician to help you out…
It turns out that the annual churn rate is only approximately equal to the 12 x monthly churn rate, and this approach is not suitable for larger churn scenarios. The true relationship between the annual churn rate and monthly churn rate is given by the following formula:
Annual churn rate = 1 – (1 – Monthly Churn Rate) ^ 12
Or, if you find that the monthly churn rate varies greatly from month to month one, you may also consider the following annual churn rate calculation:
Annual churn rate = 1 – (1 – m1) x (1 – m2) x … x (1 – m11) x (1 – m12)
mi is the monthly churn rate for the month i . The reason that this is the correct formula is that the number of customers that are present at the end of 12 months is calculated as follows:
Cend = Cstart x (1 – m1) x (1 – m2) x … x (1 – m11) x (1 – m12)
For example, say your monthly churn rate measurement is 10%. Multiplied by 12 it would be an annual churn rate of 120%, correct? Which is obviously not possible as a churn rate cannot exceed 100 % .
The correct answer is 72 % = 1 – (1-0.1) ^ 12
Monthly Churn rate = 1 – (1 – Annual Report Churn Rate) ^ (1 /12)
Remember Tip # 2 above; where a quarterly measurement interval caused us to falsely calculate the monthly churn rate at 19 % instead of 25 %. In this example, we had 100 customers at the beginning and only 42 at the end of each quarter. If we had the right formula for calculating the monthly churn we would have done the following:
Monthly Churn rate = 25 % = 1 – (42/ 100) ^ (1 /3)
If you like to do the math, you can define longer measurement intervals, even when churn is high and in absence of the need to follow Tip # 1 -2.