It took me a long time before I got back to completing this series. I joined Akiban Technologies and that has gotten me very busy in the recent months.
In the previous post I presented the model for viral distribution of a free product.
Now I'll add the premium product and the variables that model the conversion from free to premium:
This is expressed as a percentage of the number of users of the free product in a particular time period. There is an important assumption in this – conversion numbers are driven by the inventory of free users, not by how long the users have been using the free product. It is a great simplification of the model, and in fact most often more accurate than models that try to predict the time involved to migrate from free to premium.
Customer Life Time Value
How much can you invest in programs to land a new paying customer? Surely not more than the total revenue that the new customer will bring over the time that he will be a customer. That amount is referred to as the Customer Life Time Value (Customer LTV). (In fact the calculation needs to be adjusted for timing issues: the cost generally precedes the revenue, so a company has to finance these upfront costs.)
Assume a scenario in which 1,000 customers are acquired who deliver $5,000 Average Revenue Per Year (ARPY). If the Annual Retention Rate (ARR) is 90%, the number of customers in year 2 will be 900. As you can see from the following spreadsheet this original group of 1,000 customers will dwindle to 6.36 after 50 years (delivering $31.813 in year 50). Adding the annual revenue from this dwindling group over 50 years and dividing it by the number of original customers gives you the 50 year value per customer at $49,714.
A workable formula to calculate the Customer LTV (without the 50-year constraint) is the following:
(Customer LTV) = (Customer ARPY) / (1 – (Customer ARR))
In my example this calculates to 5,000 / (1 – .9) = $50,000
If an airplane is about to take off and some chairs are empty, how much would it cost them extra to deliver the flight if they would allow an extra passenger to come on board? That extra coast will not include fuel and salaries, these costs would be made with or without the additional passenger. The extra costs include the food (s)he eats and the administration costs involved in processing the ticket. In economics terms, marginal cost is defined as the change in total cost that arises when the quantity produced changes by one unit. In the software industry, where distribution of product is generally done by sending bits across the internet, the marginal cost is mostly the cost of support, if the extra customer experiences problems.
Customer Acquisition Costs
The costs of acquiring a customer vary enormously from business to business. If you have to call your potential new customer, take him to lunch, meet his technical and finance teams, train his staff and install his acquired products, then obviously the cost of that acquired customer is higher that for the ecommerce commerce that relies exclusively on Google to be found and has no sales staff.
The easiest way to calculate this amount is by adding all sales and marketing costs, and dividing it by the number of new customers. More detailed models separate out the general branding programs and public relations, and attribute only the direct marketing and sales costs to this category.
The comprehensive model
Now that I have reviewed all the variables to are required to describe the revenue and profit modeling for a Freemium business, here is the spreadsheet model that brings it all together. It adds detail to the marketing costs and engineering costs, but that is all fairly self-evident. Take a look, and let me know if this is useful to your business. I will love to hear your comments and would be happy to answer any questions.