Customer Retention Cost Ratio and it’s sister metric - Customer Renewal Cost Ratio
This week’s SaaS Barometer Newsletter is brought to you by SaaS Metrics Palooza 2024. If you missed it, 40 of the SaaS industry’s top leaders shared the latest in SaaS metrics are trending, and how leading companies are using metrics and benchmarks to inform decisions, achieve efficient revenue growth and maximize enterprise value creation.
Customer Retention Cost Ratio
and it’s sister metric - Customer Renewal Cost Ratio
The recurring revenue model was a key reason why the Software as a Service (SaaS) business model became the primary way to develop, distribute, price and buy software over the past 20 years.? Key concepts of the SaaS model include: 1) Multi-tenant architecture; 2) Browser-based user access to the application via the public internet (the cloud); 3) subscription pricing invoiced on a monthly or annual basis and; 4) buyer’s decision to renew or not at the end of the subscription period.
?For investors the beauty of the subscription, recurring revenue business model was the increased predictability of future revenue. This predictability was based upon the average B2B SaaS company being able to retain ~ 86% of their existing customer subscription revenue annually - measured by the Gross Revenue Retention (GRR) metric. In addition, most SaaS companies were able to increase the annual recurring revenue of existing customers via upsells and cross-sells which was measured as Net Revenue Retention (NRR). B2B SaaS companies target a minimum of a 100%+ NRR, with a median benchmark of 105% in 2022 and 101% in 2023. A 100%+ NRR effectively says the revenue generated from existing customers is at least the same or more than in the previous year without including revenue from new customer acquisition.
SaaS Efficiency Metrics
A hallmark of the SaaS industry is measuring the efficiency of revenue growth processes across customer acquisition, retention and expansion. As an example, we use the CAC Ratio to understand how much Sales and Marketing expense is required to acquire one dollar of new ARR or expand one dollar of ARR at existing customers.? Another example is measuring how long it takes to payback Sales and Marketing expenses using the CAC Payback Period.
We measure how much Sales and Marketing expense is incurred as a percentage of total revenue to help develop budgets, and we target total Sales compensation costs to be approximately 20% of new bookings that are closed - thus a 5x Quota to OTE ratio.
We also measure how much it costs to deliver the revenue as measured by Cost of Goods Sold and the associated Gross Margin percentage.
The above are just a few sample metrics that a department leader and/or CFO would know off the top of their head.? HOWEVER, even though a primary positive attribute of the recurring revenue model is the predictability, including knowing that a median of 86% of existing customer recurring revenue will renew for next year using GRR as the metric, many SaaS companies cannot easily answer the below question:
?????????????“How much expense is incurred to retain and renew each dollar of ARR?”
Most SaaS companies will attempt to answer this question by identifying what employees, department(s) and/or programs are focused on customer retention. The initial process is to create a laundry list of functions and related expenses in Customer Success and Customer Support.??
The analysis will include questions about what part of Sales or Account Management expenses should be included in the calculation if they are partially responsible for customer renewal.??
Another question is should Professional Service expenses if they are responsible for customer on-boarding or training. I suggest that Professional Services should not be included in the Customer Retention Cost IF they are charged to the customer.? If the Professional Services are? not charged for, then I would suggest they should be included in the calculation.
What about product expenses if they are defining in-application functionally to further engage users or increase product adoption? This analysis could evolve? to discuss if part of the R&D expenses should be allocated to customer retention.? Another topic is what happens if you have a customer marking function or annual customer conference that is dedicated to building closer relationships with customers that lead to higher retention and ultimately more expansion revenue - should those expenses be included in customer retention costs?
All of the above questions highlight there is no COMMONLY defined metric to measure the cost to retain and/or renew a dollar of existing customer ARR.? As a result, there are no common benchmarks for how much SaaS companies spend to retain and/or renew a customer, or more specifically a dollar of existing customer ARR!?
The rest of today’s newsletter is dedicated to the why and how of measuring the expense associated with customer retention and renewal.
Customer Retention Cost
Below is how I define Customer Retention Cost:
“All costs incurred to service existing customers in pursuit of the primary goal to retain customer and the associated ARR”
Most companies that measure the expenses associated with retaining customers will take total expenses incurred to retain customers and divide that by the average number of customers during the period to calculate the Customer Retention Cost per the below formula:
The first decision companies have to make in using this metric is what expenses are allocated to retain customers. One common discussion that arises is how to allocate expenses of resources that are responsible for both retaining and expanding customer relationships.?
Before we discuss that, let’s identify the expenses that are incurred in the pursuit of customer retention:
Some of the above expenses are shared for resources that are responsible for both customer retention and customer expansion.? An example is what about how much time a Customer Success Manager allocates to daily customer management activities, such as quarterly business reviews, customer reporting, customer training and answering how-to questions versus the time they invest in creating customer interest in expanding the relationship by adding new users, departments or products - often referred to as up-sells and/or cross-sells.
Another example is how to allocate expenses for customer marketing programs or an annual customer conference. What percentage of those investments are targeted and those allocated to customer retention versus customer expansion and the related metrics???
When using shared resources, there are no perfect answers, but a quick survey asking those shared resources a basic question on “what percentage of your time do you spend on customer retention activities versus customer expansion activities?” is a great place to start..? There is no standard or best answer - but establishing a baseline on what percentage of time a resource spends on customer retention will allow you to effectively calculate the Customer Retention Costs.
Similar to understanding the Customer Acquisition Cost Ratio (CAC Ratio), the most relevant efficiency measurements compare how much expense is incurred retaining customers measured against total ARR. This measurement is the Customer Retention Cost Ratio!
Customer Retention Cost Ratio
The Customer Retention Cost Ratio is a customer retention efficiency measurement that compares the total expenses incurred to retain customers to the total ARR.? The basic formula is:
Below is a simple spreadsheet calculating the Customer Retention Cost Ratio:
A couple notes from the above calculation of the Customer Retention Cost Ratio.? First, this company allocated approximately 60% of their Customer Success expenses to retention and 40% to expansion. Marketing allocated approximately 15% of their total expenses to existing customer retention.? The point to the above is not to provide a prescriptive recommendation for how much time a Customer Success Manager or content marketing resource should allocate to customer retention - the concept is to capture the approximate percentage of time shared resources allocate to customer retention versus other activities such as customer expansion.
In the above example, this company invested 12% - 14% of total annual recurring revenue on activities, programs and resources to retain customers and then associated Annual Recurring Revenue. More specifically, the Customer Retention Cost Ratio highlights that this company incurred $.12 - $.14 of expenses to retain each dollar of ARR.
This metric becomes even more instructive when calculating the costs allocated to customer retention not just against the total ARR,? but to calculate it measured against the ARR renewed for the same period - introducing the Customer Renewal Cost Ratio!!
Customer Renewal Cost Ratio
The Customer Renewal Cost Ratio shares most aspects of the Customer Retention Cost Ratio, but uses a different number for the denominator.? Specifically, the denominator is the amount of ARR that is renewed during the same period as the expenses are recurred not including up-sells and cross-sells.? Effectively, this metric will use the same number as you use in calculating Gross Revenue Retention - which is best calculated using a cohort method.
There is one other slight nuance in the numerator of the Customer Renewal Cost Ratio.? If you are allocating Sales or Sales Development resources and/or expenses to customer renewals,? you will want to add those expenses into the numerator such as shown below:
Once you modify the denominator to only the ARR renewed and include expenses that are 100% allocated only to renewal such as Sale and Sales Development in this case - the resultant result is higher than the Customer Retention Cost Ratio. The $.17 Customer Renewal Cost Ratio in 2024 is equivalent to investing 17% of the value of the renewed ARR on customer retention + renewal expenses.? This stands in comparison to the $.12 Customer Retention Cost Ratio for 2024 which shows that $.12? of expense is being incurred measured against every dollar of total ARR? - but the probability of renewing 100% of total ARR is almost impossible in most B2B SaaS companies.
Summary
If a B2B SaaS company is investing more than 10% of their total revenue on expenses specific to customer retention and customer renewal, it is an area that should be measured and managed closely - especially in an era of “growth efficiency”.?
Would you be surprised to hear that less than 25% of companies measure the Customer Retention Cost Ratio or Customer Renewal Cost Ratio?
I was trained that it is very hard to manage something that is not measured, and even more difficult to improve performance when a resource consuming process is not measured and thus not managed closely.
What expenses you should include or exclude in your customer retention cost calculation initially is not the primary topic of this newsletter. The goal is to highlight the importance of defining how your company measures Customer Retention Cost, and then being able to understand how efficiently your company retains and renews existing customer ARR as measured by the Customer Retention Cost Ratio and the Customer Renewal Cost Ratio!
You can listen to Dave “CAC” Kellogg and I discuss this topic in more detail on the latest episode of SaaS Talk with the Metrics Brothers on your favorite podcasting app.
For the love of SaaS Metrics!!!
SaaS Talk with the Metrics Brothers features Dave “CAC” Kellogg, of @kellblog fame and Ray “Growth” Rike. Dave and Ray cover a wide range of SaaS Metrics topics and also cover the latest industry reports and benchmarks on a weekly basis.? You can catch an episode of their fast moving, banter and entertainment on your favorite podcasting app!!!