A conversion funnel shows the rate that users complete each step of a user journey to reach an overall goal. It is an important part of understanding how a website is performing and should be one of the core elements of measuring user interactions with your site. It is known as a funnel because it tends to start with a large number of users at the top, tapering to a smaller number at the bottom (though your aim is to get it to look less tapered).
It will show you over time whether users are doing what you want them to do. Namely, reach a goal that is important to your business, like sign up to a form, download some content, make a purchase etc. It will also show you where they are having difficulties on the way to reaching that goal. It may also tell you where users are going instead of your intended next step in the funnel.
Depending on the software you can set it up to measure how many users are going onto different pages/URLs or you can measure different events that have been triggered, such as button clicks/taps.
Before getting into the temptations of picking your tool, you should define the user journey you want to track. It can just be a case of sitting down with a pen and paper and working out the ideal user journey you want someone to go through to reach your business goal. This will form your funnel. If you are in the very early days of a project this might mean you are deciding the shape of your entire product at this stage.
To make sure you're not including unnecessary stages, it's a good idea to start at the goal itself and work backwards, defining the fewest steps required to reach it. This represents the ideal journey of a user, sometimes known as the happy path. You can have several of these per site/product for each different goal you want users to accomplish.
Then it's a case of picking your weapon in terms of software, which will be dependent on what you're looking to track (see below). Installing the tag for this in your site's code is a quick dev task. Once you've checked this is up and running properly you can then set up your funnel to collect your data.
In several pieces of software the funnel will only gather data from the day it is set up, so it's a good idea to get it up and running as soon as you know what you want to track. You'll want to gather data for a few weeks to get a sense of what is 'normal' on your site (or your baseline). You can then look at improving your product by starting with the steps that have the lowest conversion rate.
Almost all software tracks user journeys and funnels like this in a different way (some look at sessions, others at users, some at events and there are other variants besides). Thus it is quite common to have different funnels giving you different numbers for your conversion rate. Understand how different software tracks and what is most important to you and then stick to one.
For designers, conversion rates are better to follow than the absolute numbers completing your goal. This is because even if traffic goes up and down on your site, if the design is working it should still be converting at a consistent rate. However it is pretty common for different types of traffic to warp your conversion rates. If it suddenly drops, a good first port of call is to check with your marketing team if they have been buying in or gaining from social traffic that behaves differently (often this is less likely to convert).
Be aware of seasonality: pretty much all businesses are at the whims of it, in particular ecommerce ones. There are often key times of the year when people are just less likely to buy and it can be hard to know that if you are a startup who is just setting out. Once you've got a year's worth of data, it can be a good idea to quickly plot it to see if it shows any patterns you should keep an eye on in future.
As with all quantitative data it is just going to tell you what is happening on your website but it is never enough information to make design decisions. You're going to need to use other pieces of evidence to learn why users are behaving that way before you are in a position to make the right changes.
There are many pieces of software that offer conversion funnels. The classic Google Analytics (free & paid) is best for measuring URL visits at different steps and is often a good starting point for web projects. Mixpanel (free & from $150/mo) measures user events that you specify, like clicks and taps, making it better for apps and non-URL based funnels. Hotjar (free & from £29/mo) also offers funnel tracking functionality as well as the likes of Kissmetrics (from $120/mo) and many more.
Setting up your funnel should only be an hour's work—these tools will all have help pages/videos to guide you. After that I find checking the data on a weekly basis works well.
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Note: the examples in this guide are for website design, but most of the content is also applicable for native apps and software.