Previously, we discussed three key questions you must ask to determine the suitability of the freemium model for your business.
Although affirmative answers to one or more of these key questions may lead you to choosing the freemium model for your enterprise, this is not the end of your due diligence. As I’m fond of saying, “You must inspect what you expect.” Measuring results is a critical element in managing any enterprise. When you change the way your business operates, you must measure the effects in a quantitative manner. This is no less true when you implement a freemium model in your enterprise. You can’t make the assumption that the freemium model is working “just fine”, as evidenced by examples in this post.
Acquiring the Data
Measuring anything requires data. If excellent record keeping isn’t an established practice in your enterprise, it will be exceedingly difficult, no—impossible for you to assess any aspect of business performance.
I don’t want to belabor this point, but you must think of your enterprise as a hypothesis. To prove any hypothesis, you need to conduct experiments and record data.
These are the six key pieces of information required to unlock the answers regarding the effectiveness of the premium model in your enterprise.
- Costs incurred in providing the free service expressed as CPFS
- This cost must never exceed the cost of providing premium service. Experience has demonstrated that the CPFS is typically less than or equal to the CPPS. If your analysis reveals this NOT to be the scenario in your freemium model…scrap it or fix it
- Costs associated with acquiring free users expressed as CAFU
- Total of all expenses incurred (marketing, market research, etc.) to acquire a free user
- Cost of providing paid user service expressed as CPPS
- This is determined by totaling all paid user revenues, less costs to acquire the paid user (see CAPU), less costs of providing the service, less CAFU. This equals net profit for all paid users. Dividing this number by the total number of paid users (TPU) results in profit per paid user (PPPU)
- Costs associated with acquiring paid users expressed as CAPU
- The concept of the freemium model pivots on a cost effective marketing strategy for premium users. Essentially, the bulk of marketing expenses would be incurred in the acquisition of free users. These free users, carried by the momentum of product or service value, will theoretically transition to a paid/premium version
- Total number of paid users expressed as TPU
- This will be the numerator in the fraction used to determine the conversion ratio (CR)
- Total number of free users expressed as TFU
- This will be the denominator in the fraction
The Conversion Ratio
The conversion ratio formula is rather straight forward:
For example, if you have 176,000 free users and 14,372 paid users, your conversion ratio is 14372÷176000=0.0816590909090909 or about an 8.2 percent conversion ratio.
What Does this Tell You?
The bulk of enterprises successfully employing the freemium model have conversion ratios that fall between 1 and 8 percent. In the above example, you have an excellent conversion ratio but—that isn’t the entire picture is it?
You also need to know if you are making sufficient profits from premium users to cover the costs and expenses associated with free users.
As previously discussed, the servicing costs for free and paid users are typically about equal. That said, from a mathematics standpoint, the CPFS and CPPS can be treated as equal.
This makes the formula for analyzing the comparative profitability of your freemium model a bit less complex. In short, the PPPU must be greater than (CAFU + CPPS).
Interpreting the Results
It is apparent to even the dimmest of us, that controlling the costs inherent in the acquisition free users is a critical element in the success of the freemium model.
Equally important, are conversion rates. Conversion rates are a key driver to the profitability of the freemium model. Obviously, if conversion rates are very low, premium user revenues cannot sustain the costs needed to support the free user segment. Simply raising the ante for the premium user is not the answer.
The freemium model is a balancing act and the successful enterprise must monitor all aspects of the equation, tweaking as necessary. In some instances, the freemium model is not going to prove out as the correct model for your enterprise. This was true in the case of Chargify LLC, and we discussed that in our previous post on this topic.
Your take away should be that cost per user (all users) is a crucial factor in determining the sustainability of any freemium model. When you have 8 or fewer users paying the freight for 92 to 99 free users, cost per user is important. Consider the parallels with Social Security where 2.9 workers support one retiree. How’s that working out for us?
In our next post, we will look at some of the methods companies using the freemium model have used to leverage free users into marketing their products, along with a few examples of well-run freemium enterprises. We will also examine key factors underpinning the successful outcomes.