“If you can’t measure it, you can’t improve it” – Peter Drucker
Companies periodically need to make informed economic decisions surrounding marketing budgets, resource allocation, profitability, and sales forecasting to increase their customer base and fuel growth. Understanding Customer Acquisition Costs (CAC) and Customer Lifetime Value (LTV) and their application will help companies in streamlining spending and marketing efforts to be more profitable. In this article, we explore the definition, why they are important, how they are interpreted along with some key insights.
At AND Business Consulting we have helped several companies not just to understand CAC and LTV, but monitor these metrics for investor diligence and internal KPI tracking with proven success.
Customer Acquisition Costs (CAC)
CAC are the sales and marketing costs incurred to acquire a new customer. It is calculated as the sales and marketing expenses divided by the number of new customers acquired in that corresponding period, as seen below.
A thorough understanding of CAC can help improve a company’s marketing return on investment – by determining the most cost-effective way to acquire new customers.
What is typically included in CAC:
- Sales costs
- Sales team salaries & overheads
- Marketing costs
- Digital marketing spend – Ads, SEO, Website, etc.
- Conventional marketing spend – Print, TV, Radio, Events, etc.
- Marketing team salaries & overheads
- Overheads attributable to Sales & Marketing functions
- General & Admin expenses – Professional fees, technology, admin, overheads, etc.
What is not included in CAC:
- Cost of Goods Sold / Cost of Services
- Direct or indirect cost of providing goods / services
- Customer Support
- Transaction / payment processing fees
- G&A costs not attributable to Sales & Marketing functions
Customer Lifetime Value (LTV)
LTV is the total predicted revenue earned from a single customer over the lifetime of their association with the company. For companies that employ a subscription-based model, LTV is calculated by multiplying the average value of the subscription, the average gross margin, and the average number of payment periods. But generally, LTV can be derived from the formula below.
LTV / CAC Ratio
Another key metric is the LTV / CAC ratio. Several companies and investors use it to analyze the spending efficiency of resources, thus enabling management to make strategic improvements to the business model.
Typically, a ratio of 3:1 is considered good, meaning the lifetime value of a customers is 3 times the cost of acquiring him/her. A lower ratio (say 1:1) means that the customers are not profitable. While a higher ratio (say 5:1) means that the company can grow faster by investing in sales & marketing. However, this benchmark can vary across industries based on other profitability metrics.
One of the major limitations of the LTV/CAC ratio lies in its interpretation, due to lack of uniformity in computing the metrics involved such as churn, ARPU, Gross Margins, etc. It is also important to note that the LTV/CAC ratio does not consider time value of money or cost of financing. Scott Stouffer in his article sheds some insights on the limitations of the LTV/CAC ratio and how it should be replaced with Customer NPV.
Understanding CAC and LTV – Key Takeaways
- It’s clear that the key to long-term profitability is by increasing the LTV. This can be achieved either by (i) decreasing the churn (increasing avg. lifetime) or (ii) increasing ARPU.
- It is prudent to have tailored strategies to achieve one or both of these LTV improvement methods
- Good communication, customer engagement, and activities that increase brand loyalty help reduce churn
- Value added services, features, upgrades and other upselling efforts are necessary to boost ARPU
- We have found from our extensive experience in interacting with investors that the LTV/CAC ratio is a quality indicator of a company’s health and something the investors look at closely. Importantly, it tells investors how fast, and how much, a company can expect to grow as a result of its sales & marketing efforts.
- It is essential to clearly define each element of LTV and CAC in order to arrive at accurate metrics. Lack of uniformity in standardizing the variables leads to in accurate metrics and poor business decisions.
Understanding CAC and LTV is key to improve profitability. Several companies fall in to the trap of customer acquisition at all costs without an eye on LTV. At AND Business Consulting, we help companies successfully navigate their growth journey by leveraging our vast experience and data-driven expertise. We are uniquely positioned to bring valuable insights from Investors and the industry to ensure robust and sustainable solutions.