Would you like to better understand business profitability? I know no one likes business math…but it’s important. To really understand what’s going on in your business, we have to unpack a few terms and metrics: Lifetime Value (LTV) and Customer Acquisition Cost (CAC).
Understanding the relationship between LTV and CAC is crucial for businesses like yours. By unraveling these metrics, you can gain valuable insights into the success of your marketing efforts and make informed decisions to drive growth and profitability.
Defining Lifetime Value (LTV) and Customer Acquisition Cost (CAC)
Let’s Start with some quick definitions. LTV represents the total value a customer brings to your business over their entire relationship with you, while CAC quantifies the expense involved in acquiring new customers.
In a nutshell, these metrics shed light on the financial implications of acquiring and retaining customers—essential knowledge for any business striving for sustainable success.
Calculating Lifetime Value (LTV)
Calculating LTV is an empowering exercise that enables you to track the long-term revenue generated by each customer.
LTV = (average revenue per customer – cost to fulfill) * average duration of a customer relationship
Notice I subtracted the cost to fulfill from this metric. Many will hear Lifetime Value and think Lifetime Revenue. For example, my customer pays me $100/month and they usually stick around for 5 months.
That would be an LTV Calculation of $2,000/month * 5 months = $10,000
Right? Wrong.
That may be a useful metric to have but in this context, it’s not really helpful. We are trying to determine how much it costs to get a customer (CAC) and compare that to how much we make per customer (LTV). So what we really need is something more like Lifetime Gross Profit or LTGP. This takes into account the amount you spend to fulfill on the service.
*Note: when factoring in cost, we are looking at costs directly associated with fulfillment. There are hard costs associated with all businesses that stay constant and are independent of an individual sale. We are not using those here. Those should be covered by the profits of the business. All business profits either go back into the business to cover these things or go home with the owner as take home pay.
Let’s take the example from above. A client pays $100/month for my service. It costs me $50 to fulfill on that service (goods, materials, payroll, etc)
The real LTV math would be ($2000/month – $1000 cost) * 5 months = $5,000
This may be a good place to mention Churn.
Churn is how many customers you have leaving each month. This is another way of looking at the average 5 month timeline given above. If you know this number, you can also use it to calculate LTV.
Alternate LTV = Price – cost / churn
So we would have ($2,000 price – $1,000 cost) / 20% churn= $5,000
Is that number good? There is no way of knowing without knowing how much it costs to get that customer in the first place. This is where we come to Customer Acquisition.
Determining Customer Acquisition Cost (CAC)
Now, let’s turn our attention to CAC, the make-or-break metric of this calculation and thankfully, the simpler of the two.
CAC = How much you spend on marketing, ads, sales team, etc / the number of customers acquired.
For example:
In one month, I spend $10,000 on ads and 10,000 on payroll (sales & marketing) making my cost $20,000/month. In that month I get 20 customers.
$20,000 cost / 20 customers = $1,000 per customer
That’s my CAC. Simple enough right?
After you get this number, optimizing CAC is the name of the game. By implementing efficient marketing and sales tactics, you can lower customer acquisition costs, enhancing your profitability and long-term sustainability. We’ll share insights and strategies to help you unlock those cost-saving opportunities.
Analyzing Profitability
Now you have the pieces to understand the fundamental economic unit of your business. That is this: If I put $1 in here, I will get $X in return. The ratio of LTV to CAC gives you this unit. Let’s look at the example from earlier one last time.
Reminder
Our LTV was ($2000/month – $1000 cost) * 5 months = $5,000
Our CAC was $20,000 cost / 20 customers = $1,000 per customer
That means our LTV to CAC ratio is $5,000 / $1,000 or 5 to 1.
Congrats! This hypothetical business is profitable! I know from this math that, for every $1 I put into this business, I get $5 back. That is how you build a money printing machine.
Conclusion
We defined Lifetime Value (LTV) and Customer Acquisition Cost (CAC). We showed you how to calculate each and what to take into consideration for each. Finally we put those pieces together to get you the fundamental economic unit of any business: the LTV/CAC Ratio.
Now it’s just optimization. How can you increase that LTV? Is it upsells, longer retention rates, price increases? How can you decrease that CAC? Is it better ads, better sales script, organic content, a better lead magnet? All of this is up to you but now you have the tools to understand your business, your marketing, and your profitability.
Is your marketing spend not paying off?
We specialize in optimizing your marketing strategy and boosting customer value. Let’s discuss how we can lower your CAC and increase your LTV effectively. Book a free consultation today!
