Why Lean Startups Worship Cohort-based Reports

In The Lean Startup, Eric Ries calls cohort-based reports “the gold standard of learning metrics.”

Let’s explore why the creator of a system that has attracted thousands of adherents around the world places so much value on cohort analysis.

Removing Uncertainty

According to The Lean Startup, in the early stages there is little that founders can say they know for sure about their business. They have an idea for a new product that they think people will pay for. But they don’t know that people will value it, or which types of people will value it, which aspects of it they will value, or whether they’ll value it enough to pay for it. A startup’s early days are full of uncertainty and untested assumptions. And because every startup has a limited amount of time before it must either turn a profit or die trying, The Lean Startup philosophy believes that startups must be finely-tuned learning machines dedicated to testing those assumptions continuously.

In The Lean Startup world, the goal of every iteration of work should be to design and execute a test that confirms or rejects a hypothesis as quickly as possible. This is called the Build-Measure-Learn loop.

Building

Almost all startups are good at building things. Unfortunately, this can be their downfall. It’s easy for startups to fall into the trap of believing that if they just continue to iterate on the product, eventually paying customers will come flooding in. Some put all of their attention on the Build step, and don’t even consistently measure anything at all.

Measuring

Most startups avoid that mistake and are also good at collecting data and generating metrics. There are plenty of analytics tools that will generate a snippet of code that developers can plug into the product, and–Presto!–you’re measuring things. A dashboard of colorful charts and tables is produced every day providing a multitude of stats about the business.

All too often, however, this is where startups who don’t follow the Lean philosophy make a key mistake. They fall victim to tracking what The Lean Startup calls Vanity Metrics: aggregate numbers like total visits, page views, registrations, events, etc. that tend to increase over time and give the impression that the business is succeeding even if it really isn’t. With the numbers going up and to the right📈, it’s easy to justify each additional iteration of engineering and delude yourself into believing that success is just around the corner.

Tracking vanity metrics breaks the Learn portion of the Build-Measure-Learn loop. With a broken Learn step, startups never reject any of their assumptions. When they ship things customers don’t care about–wasting precious time and energy that could be used building something customers would care about–they don’t realize it. The aggregate metrics they’re tracking mask the impact of their work. If a dip in numbers does occur, it is easily attributed to something other than the startup’s hard work. (Or worse yet, internal groups will each blame each other.) The startup will go into the next Build iteration without any new knowledge or insight about how the product is working for customers.

Learning

In order to have a properly working Learn step, you must gather and analyze actionable and accessible metrics:

  1. Actionable metrics: show a clear cause-and-effect relationship between things the startup is doing and things customers are doing as a result.
  2. Accessible metrics: are simple enough to be understood by the entire organization.

Cohort-based reports check both of these boxes.

Actionable

Cohort-based reports measure the key actions that specific groups of customers perform over time. One of the most useful ways of grouping customers is by the week or month that they were acquired. This provides a natural way to track their key actions over time and compare them to other cohorts acquired earlier or later.

Here’s an example cohort analysis for a hypothetical startup whose key customer actions are signing up, saving a profile, and making a purchase:

Rather than showing aggregate values, this graph shows the rates at which new customers who signed up in each month completed the key actions. We can see that the rate at which new customers complete profiles is increasing at about 3% per month, but this increase is not translating to more purchases.

When combined with split-testing (aka A/B testing), which Lean startups also love, cohort-based reports can even compare how a group of people receiving a specific product enhancement within a cohort performs against those not receiving the change. This helps further isolate against other factors such as seasonality of the business or changes to sales or marketing campaigns.

Accessible

Today there are more analytics packages than ever before, and each one is racing every day to add more widgets, panels and dashboards. But just because you have more data does not mean you have more insight. It’s easy to get overwhelmed by the sheer number of reports, or to even not understand the meaning of the metrics being presented to you. The definitions around the things a report is tracking can be hard to keep straight.

Cohort-based reports are easy for everyone in the organization to understand because they report on a metric we can all identify with: people.

Each chart reflects the actions that a real person or group of real people took with your product. Everyone in the company should not only be able to identify with that, but tracking and improving the rate at which people move through your application should get them excited, because it directly translates to more engaged and successful customers.

Wrapping Up

Lean startups worship Cohort-based reports because they provide a highly effective way to test hypotheses about the business, learn what’s working and what’s not, and translate that learning into course corrections on the path to sustainable growth.

Ditch Cohort Retention Charts and Start Using Cohort LTV Graphs

When you first start digging into how cohort analysis can help you learn about the health of your business, you’ll typically encounter a lot of triangle-shaped retention charts that look like this:

Orienting yourself to these charts can take a minute, even if you’ve done it before. What do all these numbers mean? What’s with the colors? And why is it triangle-shaped?

These charts tabulate the percentage of customers who return each period after their first purchase and make a repeat purchase. Each row represents a cohort of customers acquired during a given period (usually a week or a month), which is listed in the first column. Cohorts are ordered from oldest to newest moving down. As you move to the right along a row, each column shows how many customers from that cohort returned or made a repeat purchase in each subsequent period. Older cohorts have more periods of possible retention than newer ones, which is why each row is shorter by one column than the row above it, producing the triangle shape. As for the colors, typically these charts will highlight cells above a given retention percentage in green, cells below a certain percentage in red, and those in between in yellow.

Once you’ve familiarized (or re-familiarized) yourself with the structure of these charts, you’re faced with another, more challenging question: how do you make sense of the data? Should you read it top down? Left to right? Diagonally? As humans, we have a natural tendency to see patterns in data, and your eye is probably drawn to multiple patterns in the above chart. Are those patterns significant, or are they just noise? What do they mean? How is my business actually doing?

Retention charts are confusing and overwhelming. There’s a better, more intuitive way to understand the health of your business.

Lifetime Value by Cohort

Customer lifetime value (LTV or CLV) is the single best metric for understanding the health of a business. If average order value goes up, lifetime value goes up. If margins improve, lifetime value improves. If customer retention improves, lifetime value improves. The opposite is also true. If order value, margin, or retention drop off, customer lifetime value is also going to suffer. LTV should be your go-to metric for the simple reason that it reflects the aggregate impact of many of the underlying drivers of profitability.

If we view LTV through the lens of cohorts grouped by acquisition date, we can open up another important dimension of understanding: how things are changing in the business over time.

Let’s see how this works by looking at an example LTV by Cohort graph exported from Everhort for a fictitious company:

Orienting yourself to this chart is easy. Each line shows the cumulative average lifetime value of a cohort over time. The longer (and darker) the line, the older the cohort. The Y-intercept, month 1 for all cohorts, shows the average value of their first order. From this chart we can see that first order value has been increasing steadily on average over the last 12 months, because the shorter, lighter lines have higher Y-intercept values than the longer, darker lines.

By comparing the shape and slope of each line, we can understand how much value each cohort contributes to the business over time. Lines that increase more sharply provide more value more quickly. In the chart above, we can see that recent cohorts have steeper slopes than older cohorts. This means the business is improving at recognizing more value in less time.

Here’s an example of a different fictitious company:

Like the previous company, this company is steadily increasing average first order value, as the Y-intercepts are rising for shorter, younger cohorts. Unlike the previous company, however, this company’s cohorts quickly flatten out after about 6 months. Flattening cohorts are a warning sign in these graphs. It means customers in the cohort have virtually stopped engaging and are no longer producing value.

LTV by Cohort charts help us quickly answer important questions like:

  • How long do newly acquired customers engage and generate value for our business ?
  • How does the rate of engagement of new customers compare to older ones?
  • Is the business improving the rate at which it generates profit from customers over time?

Answering these question can help confirm if tactics being worked on to improve underlying drivers of LTV are working or not, or what areas might need to be investigated further.