Eric Ries’ Four Engines of Growth Reduced to Two
In “The Lean Startup”, Eric Ries talks about four different “engines of growth”. The engines of growth are about how new customers are attracted in a sustainable way. They each dictate quite different marketing strategies, and so by knowing which engine your product is utilizing to grow, you can know what marketing strategy to pursue. According to this framework, there are four different ways that customer growth is made sustainable. Although they are certainly not mutually exclusive, products tend to have one main engine. They are:
- Word of mouth. Existing customers will encourage other customers to purchase. If the viral coefficient is greater than 1, then each customer you have will attract more customers, and you will grow. If it is less than one, then the situation is not sustainable, and you are shrinking.
- Side Effect of Product Usage. New customers are acquired by seeing others use the product.
- Funded Acquisitions of Customers. The cost of acquiring new customers is funded out of existing customers (though advertising or other means). This implies that the cost of acquisition (CAC) is less than the customer lifetime value (CLV)
- Customer Retention. Existing customers repurchase the product.
Looking at these four, I can’t help but notice that there are really only two fundamentally different types of growth being exploited. Viral, and Profitability.
The first two engines – Word of Mouth, and Product Usage – are viral. Just by having customers gets you customers in a virtuous spiral. The strength of the viral effect can be expressed by the “viral coefficient” which is the ratio of new customers attracted for every one customer you have. If this ratio is above 1, then exponential growth is the result. Less than one implies exponential decay, and the product will die. If you have viral-based growth, you do not need to worry about the profitability of the product in order to grow.
The second two engines – Funded Acquisition, and – Customer Retention, on the other hand critically depend on profitability. They depend on the the cost of acquiring or keeping the customer being lower than the profits from those customers. Both engines are therefore related to the familiar concept of the customer lifetime value (CLV).
Lifetime value is a simple concept and I present a simplified calculation here. It is the amount that each of your customers is worth. It is the revenue gained from the customer over the full lifetime that they are a customer (so includes repeat purchase), less the cost of providing the product/service (eg: operational overhead), and the cost of acquiring and retaining the customer (sales and marketing overhead). Let’s look at each of these in turn.
New Customer Profitability
When you sell to a customer the first time, how profitable are you? Taking the product revenue less product cost (COGS) give the net profit of the product per customer (PRODUCT PROFIT = PRICE – COGS). Deducting the cost of acquiring each customer gives the profitability of each new customer. New Customer Profit =(PROFIT – CAC).
Retained Customer Profitability
If the customer make a repeat purchase, then the actual profitability of this customer is higher. To calculate the customer lifetime value (CLV) we need to take into consideration the repurchase rate. Customer repurchases are interesting because the cost of securing a repeat customer (CRC) is typically much lower than the cost of acquiring a new customer. The cost of retention might be the investment in customer service, or specific advertising and promotions aimed at current customers. Repeat Customer Profit = (PROFIT – CRC)
The total value of retained a customer is also a function of the frequency of repurchases. Introducing the retention ratio allows us to calculate the total value of the repurchases over time. For example, if a product is renewed monthly, and my retention rate is 75%, then 75% of customers will repurchase in the first month, 56% in the second month, 42% in the third month and so on. This is simply exponential decay, where the decay constant (lambda) is one minus the retention ratio (1 – 0.75 = 0.25). Taking the reciprocal of the decay constant will handily give us the mean lifetime of our customers (in this case 1/0.25 = 4 months). The mean lifetime is useful because it is the average number of times that a customer will repurchase. In the example above, each customer will purchase our product, on average, 4 times.
Lifetime Value of the Customer
We can then calculate the Customer Lifetime Value as CLV = (PROFIT – CAC) + (PROFIT – CRC) / (1 – RETENTION)
Where PROFIT = PRICE – COST
The objective of a product employing either engine (3) or (4), is to increase the lifetime value of the customer. From the above equation we see that the success of a service or product is a simple function of the revenue from each customer (PRICE), the cost of providing the product (COST), the cost of acquiring new customers (CAC), the cost of retaining customers (CRC), and the repurchase rate. This is a slightly more formal treatment than Eric Ries gives it in “The Lean Startup”, but the elements are all the same.
If your engine of growth is (3) – Funded Acquisition – then you will look at ways to control the first half of this equation – product profitability and CAC. CAC must be below CLV in order for this growth model to be sustainable, and so price sensitivity of demand, the cost of the product/service, and the cost of new customer acquisition are all important factors. Obviously these are all interrelated with each other.
If your engine of growth is (4) – customer retention – then the second part of this equation linking CRC, and the retention ratio (the cost of retaining customers) is your concern.