This is the sixth article in our 12-part subscription sales series, designed to help you understand and prepare for the evolving sales landscape. This article breaks down the components of profitability and provides the formulas required to measure customer acquisition costs, monthly recurring revenue, customer retention costs and time to profitability. Don’t forget to read the previous five articles in this series; a new sales strategy, customer segmentation, understanding your customer market, customer-centric sales approaches and understanding the customer journey.
The road to profitability
Let’s start with a story
One of our clients, let’s call them TechnoCo, had been successfully bootstrapping for nearly three years. To help scale their growth, they made the decision to raise a round of Series A funding. As part of this process, TechnoCo committed to triple their business over three years, which meant they would need to increase profits by 100% year-on-year. It was an audacious goal, but it was achievable.
TechnoCo sought our help to develop a sales strategy that would allow them to achieve their ambitious growth goals while ensuring their business was set up for success beyond those initial three years. Our strategy set up TechnoCo to maximise sales revenues without driving up their customer acquisition and maintenance costs to ensure their long-term profitability. The three key components underpinning this sales strategy were:
- how they would acquire customers
- how much they would charge customers
- how they would retain customers
The strategy specifically focused on these three components because they are the three drivers of profitability for subscription businesses.
Components of profitability
Subscription businesses make profit by creating a recurring revenue stream that consistently exceeds the cost of building and maintaining that revenue stream. This amounts to three categories:
- the cost of acquiring a customer: customer acquisition costs (CAC)
- the monthly revenues brought in by a customer: monthly recurring revenue (MRR)
- the ongoing costs to support and retain a customer: customer retention costs (CRC)
Businesses often only focus on the cost of acquiring customers to determine required revenue to break even. This means that many businesses overlook the ongoing costs to service and retain their customers and therefore miscalculate their profitability targets.
Businesses must understand, measure and track each of the three components of profitability to determine how long they need to retain a customer before they become profitable. This is known as time to profitability (TPP). The diagram below provides a representation of how the three profitability components can impact TTP throughout the customer journey.
- Use TechnoCo as the case study
- TechnoCo ran an outbound campaign to work with a group of hospitality venues. The customer had 1,000 staff
- The outbound campaign to win the customer cost TechnoCo $8,000
- Techno didn’t charge for onboarding, they instead started with the standard pricing from day 1 and absorbed the onboarding cost which amounted to $2,000
- TechnoCo charged $8 per user per month, this meant they were making $8,000 MRR
- The first month the customer required a high level of support, which cost the business $4,000
- After the first month, TechnoCo only provided standard servicing and retention support, costing $1,000
- In the end, the TTP for the client came to 56 days, or nearly 2 months]
1. Customer acquisition costs
Subscription businesses incur upfront sales and marketing costs to win customers. These costs include:
- People – employee salaries, sales commissions
- Pipeline – lead generation activities, content, digital marketing, outbound sales strategies
- Tools – CRMs, MASs, etc.
While CACs are usually a component of profitability that subscription businesses focus on, they are not always well understood. Subscription businesses looking to grow profits by increasing their customer base can easily exceed their predetermined CACs.
Increasing MRRs by increasing the customer base is an easy way to increase profitability. An obvious way to achieve this is to hire more sales staff. However, as a sales team grows, Sales Managers need to be hired. The sales team then begins to experience sales conflicts that they were not facing before. This means that the business must add to their lead pipeline. The cycle then repeats.
The most effective strategy to grow a customer base while minimising the impact to CACs, is to invest in technology instead of people. This does not mean that sales teams are not important; they are critical. It simply means that headcount costs do not scale well. However, technology delivers significant economies of scale as a business grows, and can also significantly improve the customer experience, which can support a business in committing to more deals.
The following formula calculates CACs:
Total sales and marketing costs during customer acquisition period
Total deals committed during customer acquisition period
To calculate CACs, you must first measure the time it takes for a customer to move from a sales qualified lead (SQL) to the ‘commit’ stage in the customer journey; this is the customer acquisition period. Once this the customer acquisition period is defined, calculate all sales and marketing costs incurred over this period. Lastly, determine the number of deals committed over the customer acquisition period.
If it takes a customer one month to go from qualified to committed, then all costs in that month should be divided by the total deals committed in that month. If it takes three months to commit a customer, that business should divide total costs incurred over 90 days by all deals committed over those 90 days.
2. Monthly recurring revenues
After a business converts a customer, they begin receiving monthly recurring revenues. MRR occurs when a business continuously delivers value to a customer who continues to buy that business’ offering.
Compounding MRR is one of the great benefits of the subscription business model. In other business models, customers make a payment each time they consume a product or service, such as buying groceries, going to the dry cleaner, or hiring a lawyer. These models require a business to ‘acquire’ the customer each time, which can drive up acquisition costs. There benefit of the subscription model is that after a customer commits, they continue to make payments without the business incurring further acquisition costs.
MRRs are by no means a static number. There are several strategies businesses can implement to increase MRR, thereby increasing profits and minimising TTP. The strategies to increase MRR include:
- Upselling – when a business sells more and new services to existing customers. There are three types of upselling:
- selling to more users within an existing customers’ business (in a B2B model)
- selling more functionality to existing users, such as upgrades to premium offerings
- selling increased consumption (i.e. more usage / SMS messages / active contacts etc.)
- Cross selling – where similar and new services are sold to different user groups within a customers’ business (in a B2B model). This strategy requires a specific skill set, investment in specialised tools, and pipeline management that is tailored to the specific customer.
- Increased pricing – there is benefit to customers subscribing on a month-to-month basis. This allow businesses to immediately benefit from price increases that are a result of delivering greater value to customers through improvements and updates. We recommend businesses avoid offering anything longer than annual contracts to allow businesses to immediately benefit from price increases that come with delivering increased value to customers. When customers are locked into multi-year contracts, businesses eliminate their option to use this strategy to increase revenues and improve profitability.
3. Customer retention costs
Customer retention costs are the expenses a business incurs when supporting, retaining and cultivating customers post onboarding. The components that contribute to CRC are:
- People – salaries of the customer success team, account management team etc., professional services and training costs.
- Pipeline – content, digital marketing costs and outbound pipeline development.
- Tools – CRMs, marketing automation, sales automation, engagement tools etc.
Many businesses overlook ongoing support costs when calculating profitability. The type of costs that should be factored into CRC include investments made for bug fixes, to address outages and for customer support.
CRCs should be the focus of the customer success team (CST). Counterintuitively, the CST should be given MRR targets, rather than CRC targets. This is because the only way the CST can increase revenues is by keeping customers happy. Happy customers will stay with the business longer, bring in higher MRR and increase the compounding benefits of MRR.
Time to profitability
As mentioned before, the TTP is the number of days it takes for a customer to start generating profits for a business.
The equation for TTP is:
(CAC + net customer onboarding costs + CRC)
___________________________________________________ * 30
Customer onboarding costs can significantly impact the TTP. In addition to the impact on satisfaction and retention, this is another reason that customer onboarding is a critical stage of the customer journey.
CACs are often the biggest factor impacting a business’ TTP. It generally costs six times more to acquire a customer than it does to retain a customer. This explains why businesses prone to customer churn will have higher TTP days as they need to continuously invest in customer acquisition. For this reason we spend significant time working with businesses to build solid customer retention strategies.
TTP must be calculated separately for each customer segment, and sometimes even separately for customer verticals. This is because different segments can have very different TTP outcomes. You might assume that SMB customers have a very low TTP because businesses can use inexpensive acquisition strategies for this segment. However, the support costs for SMB customers can be significant relative to their low MRRs. Conversely, Enterprise businesses, while expensive to acquire, often have a low TTP because their MRRs far exceed support costs.
A case study
One of our clients, we’ll call them FitzCo, engaged us to develop a sales strategy that would allow them to improve their profitability. The first step was to take a detailed look at the costs and revenues generated by their customers. In the five years that FitzCo had been operating, they had never taken a detailed look at the profitability of their different customers.
Our research found a cross section of 100 customers that were paying the lowest MRRs. We showed these customers to FitzCo who then identified these customers as their original customers that had joined when the business first began. FitzCo had never increased the costs of these subscriptions, despite significantly improving their offering and the value they were delivering to these customers.
FitzCo had not been correctly calculating their CRCs as they were not accounting for the cost of their employees’ time to provide customer support. After factoring in these costs, we discovered that these 100 original customers were actually costing FitzCo money. These customers had significant support requirements which is often true with early customers. They received high-touch support because the business was still working out its initial glitches, and continued to carry this mentality forward. However, new customers become accustomed to a low-touch relationship.
Our recommendation was for FitzCo to update their pricing so all customers were paying the same subscription rate. We knew this would probably result in FitzCo losing up to half of their original customers, but it didn’t matter. Even with 50 less customers, FitzCo would still be in a better position as it would lose those customers that were costing the business, and retain customers who drove up profitability.
Contact us for more information on measuring the components of profitability so you can improve your overall sales strategy.
The next article in this subscription sales series we detail online channels that simplify the customer journey.