My first months at a startup were scary because I lacked the knowledge that I felt like everyone around me already had. I was bombarded with terms I had never heard of.
Two in particular — lifetime value (LTV) and customer acquisition cost (CAC) — kept coming up and now I wish I had understood them earlier on. These two metrics play a key role in determining the LTV:CAC ratio, which helps you gauge the health of your business.
Without an awareness of the LTV:CAC ratio, you miss many chances to adapt your business strategy and increase your overall profits.
In this guide, we’ll define what lifetime value and customer acquisition cost are, demonstrate how to calculate them, and explore their role in the LTV:CAC ratio. You’ll gain applicable insights to help direct your business strategy moving forward to maximize the value of your customers.
Table of contents
- What are lifetime value (LTV) and customer acquisition cost (CAC)?
- Importance of lifetime value and customer acquisition costs
- How to calculate LTV and CAC
- What is LTV:CAC ratio?
- Factors that affect LTV and CAC
- Strategies for improving LTC and reducing CAC
- Tracking and analyzing LTC and CAC data
- Strategies to increase customer lifetime value
What are lifetime value (LTV) and customer acquisition cost (CAC)?
LTV stands for customer lifetime value and represents the revenue a customer brings you throughout the entirety of your relationship. Consider Netflix where an average subscriber stays on board for 25 months. Netflix says the lifetime value of its customer averages $291.25 (see source).
CAC stands for customer acquisition. In general, it represents the average cost a company has to transform a lead into a customer.
Both LTV and CAC are fundamental to any business. Now let’s go further in depth.
Importance of lifetime value and customer acquisition costs
I will never forget the time when I was in a roadmap meeting where a marketing analyst bravely challenged top management. Bluntly, she said, “When are we going to talk about the elephant in the room? Our CAC is double our LTV. We’re bleeding out.”
The CEO tried explaining that they were more focused on growth than profitability because the business was still trying to prove its market fit. However, in their response, the CEO didn’t seem to know that our LTV:CAC ratio was not very good.
A poor understanding of LTV:CAC can put companies in complicated situations or lead to missed opportunities. Because of this, CEOs need to understand how the LTV:CAC ratio influences the health of their business.
As I alluded to above, the customer lifetime value represents the revenue you can collect from each customer, while the acquisition costs determine how much it costs to acquire the customer. The relation between the two defines how profitable your business is.
In startups, it’s natural to have high acquisition costs, but having a lifetime value lower than that is a sign of a mismatched market fit.
How to calculate LTV and CAC
Before you can utilize LTV and CAC for business decisions, you need to understand how these two metrics are calculated. Below are the most popular ways to calculate each:
Lifetime value
Calculating lifetime value can help you understand the nature of your business. There are various methods to do so, including:
1. Relationship time
Consider a monthly revenue of $100 and that your customers spend consistently throughout the year with you. This model is a simple and flexible one, and it tends to work well with online businesses and marketplaces.
The customer lifetime value would be:
LTV = average customer revenue * relationship time
LTV = $100 * 12
LTV = $1,200
2. Churn
The second method focuses on the frequency that you experience customers dropping from your product. This method works best with subscription models. Continuing the previous example, suppose your churn rate is 10 percent every month.
The formula for LTV would be:
LTV = average customer revenue / churn
LTV = $100 / 0.1
LTV = $1,000
You can find more methods to calculate the lifetime value, but the two mentioned above are the most common.
Customer acquisition
Now let’s clarify how you calculate the customer acquisition costs.
Suppose you’ve acquired 40 customers in a given month, and the total marketing costs were $10,000.
CAC = Marketing costs / customers acquired
CAC = $10,000 / 40
CAC = $250
What is LTV/CAC ratio?
The LTV:CAC ratio is a simple calculation of LTV/CAC. The ratio helps product managers make decisions on marketing investments, which type of features to create, and which opportunities to explore.
So, what makes a “good” LTV/CAC ratio?
Considering our previous example of LTV of 1,000 USD and CAC of 250 USD, the ratio would be 4:1. What does that tell you?
- Balanced ratio — A good ratio is generally 3:1, which means you’re collecting significant value from customers and acquiring them at a reasonable investment
- Unsustainable ratio — If you have a ratio of 2:1 or 1:1, you’re either paying too much to acquire customers or your product is unable to create enough revenue. You need to act to improve LTV or reduce CAC immediately when you face this case
- Missing potential — You may have a ratio of 5:1 or 10:1 and, probably, you’re happy about it, but you may be missing a growth opportunity. You could double down on your marketing costs and acquire more customers to accelerate your growth
Factors that affect LTV and CAC
Many factors will impact your customer’s lifetime value and acquisition cost. Product managers need to understand what keeps customers satisfied, how often they come back to you, and why they leave you. Knowing such metrics help you understand the health of your business.
Below are some of the main factors that impact LTV:
- Recurrence — How often does your customer do business with you?
- Churn — How many customers do you lose in a given time?
- Activation rate — How many customers can you activate?
- Business length — How long do customers sustain a business relationship with you?
Acquiring customers is more of an art than a process. Great product managers understand what drives costs up or down and also can double down on the winners and cut the losers. Not all channels will lead to sustainable conversions.
Alongside LTV, the following impact your CAC:
- Paid vs. organic cost — How’s your paid and organic customer acquisition rate? The more paid traffic you have, the more expensive it becomes to scale your business.
- Conversion rate — How many leads do you need to make a customer?
- Personnel — How big is your marketing team?
- Acquisition channels — How expensive are your customer acquisition channels?
Strategies for improving LTV and reducing CAC
Improving LTV and reducing CAC is essential for developing a sustainable business. It’s imperative to work on that continuously.
Let’s explore some opportunities for both:
How to improve LTV
- Increase retention — Work on retaining customers. Don’t let them go that easily. Figure out how to keep your customers satisfied
- Increase frequency — The best business models are the ones where customers frequently come to you. That’s why subscription models are so attractive
- Increase average order — Improving the basket size is valuable to improve the customer’s lifetime value. Cross sales can be a way to go
How to reduce CAC
- SEO — Work as hard as possible to organically drive customers to your product
- Recommendation — Empower customers to promote you in exchange for rewards. That’s generally a win-win situation. You win a new customer, and the customer and the new customer benefit from a reward
- Conversion rate — Understand your audience, double down on what works, and cut costs on what doesn’t. For example, you may successfully convert Apple users while failing with Windows. Focus on Apple, and reduce Windows investment, improving your conversion and reducing the CAC
Tracking and analyzing LTV and CAC data
Having dashboards with LTV, CAC, and LTV/CAC ratio are fundamental to empower you to make decisions faster.
The challenge now is creating a dashboard that gives you enough direction to make decisions. A dashboard can come down to personal taste.
I like having a dashboard that shows data from the previous year, the current year, and the forecast. This helps me understand if we’re improving or not, but sometimes that’s not enough.
You want to avoid the trap of generalization. Therefore, I recommend you explore different scenarios. Compare LTV, CAC, and LTV:CAC ratio changes over the period, as well as the following:
- Demographics — Understand the development of your data across different audience details, e.g., region, age, gender, and language. This will help you understand who brings more values and enable you to focus on them
- Behavior — Evaluate how your user behavior is developing over time. Strive to understand where you lose them and what keeps them with you
Strategies to increase customer lifetime value
You will find many alternatives to increase your customer LTV, and you may get confused about where to start.
Let me simplify it for you by giving five bulletproof strategies:
- Tailor onboarding emails — Don’t send standard emails to everyone. Send a well-designed and personalized welcome email to new customers. This will drive engagement and help activate customers
- Contact after purchase — Keep customers warm and collect feedback. As customers purchase something, contact them to understand how satisfied they are
- Cart abandon — Many customers go as far as the check-out, but bounce and never come back for some reason. On average you can reactivate, on average 30 percent of abandoned carts by contacting the customers
- Simplify the onboarding process — Confusing or extensive onboarding processes cause customers to disengage and potentially bounce, but when you craft a simple and intuitive onboarding process, you will have the customers on your side
- Loyalty program — What are the benefits of remaining in business with you? When you make it beneficial to sustain a long relationship with your company, customers will have more reasons to stay and will be discouraged from knocking on your competitors’ doors
Conclusion
Improving LTV and CAC is vital. You can only do that by monitoring how they evolve with time.
A bad LTV:CAC ratio will get in the way of business growth. That’s why you need to continuously evaluate what creates value and what doesn’t.
There is no one-size-fits-all strategy. The reality is that you need to adapt your strategy according to your learnings.
The post LTV:CAC ratio: Definition, strategies, and how to calculate appeared first on LogRocket Blog.
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