The importance of LTV to CAC Ratio and why should it atleast be 3X?

Image result for cac and ltv

Measuring the LTV:CAC ratio is important because you don’t want the cost of acquiring a customer to be higher than the value of the customer. Even if it is 1:1, it is harder to be profitable. Even if it is just >1, it is difficult to be profitable because you have other costs involved in running the company. When calculating LTV, I would use a formula that incorporates gross margin for this ratio to be meaningful.

Customer acquisition cost and Customer lifetime value answer two key questions:

  • How much is an average customer worth? (CLV or LTV)
  • How much does an average customer cost? (CAC)

And, it indirectly helps to answer to what extent is a customer worth their cost? How many extra bucks can I spend to acquire the customer? Is it all worth it or not? Like, if you have to get 1,000 people to your site and 100 into your Free Trial to get one new customer, then that’s awful and you have to know that it is awful.

This ratio is particularly a useful metric for subscription based companies. This is largely a metric to understand the return on your marketing and sales expenditure. Like, how do you know if you’re spending the right amount? You need to know how long the average customer sticks with you before they cancel their service. Because of course the longer a customer sticks with you, the more valuable they are.

Start by looking at your churn rate – the number of people who cancel their subscription in any given month. If you have 40,000 customers and every month 2000 of them cancel, that works out to five per cent monthly churn. By simply inverting this value ( 1 / Monthly Churn ), you can calculate how many months on average your customers will stick around. At a 5% monthly churn, that works out to 20 months.

You will also need to know your Gross Margin % (the percentage of profit that remains after you have paid your costs for the product or service), and then how much money the average customer brings in each month.

Lifetime Value (CLV or LTV) = Gross Margin % X ( 1 / Monthly Churn ) X Avg. Monthly Subscription Revenue per Customer

So, for example, if you had a gross margin of 30% and monthly customer churn of 5%, and each customer spent an average of $30 with you every month, the calculation would look like this: 30% X ( 1 / 5% ) X $30 = $180 LTV

Why is the LTV:CAC ratio generally benchmarked at 3x?

The LTV:CAC ratio is usually benchmarked at 3x considering that the company has 30% R&D expenses, 30% Marketing expenses (built-in) and 30% COGS (built-in if the LTV formula used is margin based) and then atleast a 30% return is expected out of this all effort for the entrepreneurs or the investors. Subscription companies should recover the CAC, COGS cost, operations costs, overheads, delivery and service costs to reach the break-even. If the business cannot give that return, then probably investors would look at other startups or traditional instruments that give 14-18% return.

If keeping a healthy LTV:CAC ratio is difficult, one must need to first find if a high CAC is your problem or a low LTV is your problem. In the above example, the LTV is very low ($180) and it shows that this company will find it very difficult to scale up as the CAC will rise if the company tries to expand and then the LTV:CAC will further fall.

Pointers to improve your LTV

  • Build your Brand to be on top of the mind of your customer and to build retention
  • Drive more ARPU through other products and recruit category-heavy users
  • Reward Loyalty
  • Upsell. Upselling will increase the spend per customer
  • Have a large relevant selection of products for each of your customer segments and their customer journeys – this enables the customers to stick for long and to buy more.
  • Keep your customers highly engaged (this is very important in the given context). Keep sending them educational, promotional, re-engaging, feedback, marketing, and updates content regularly and measure all metrics of engagement.
  • Listen to your customers who are leaving and who are retaining, detect pain-points and delights and build solutions towards addressing the same.
  • Improve the Onboarding Process
  • Encourage customers to switch to an annual billing cycle

Optimize your CAC

Optimizing CAC is just about ‘paying less’ for a customer or reducing the cost of an AdWords click. By lowering CAC, you instantly reduce the time it takes to recover the cost of acquisition (what is also called as the CAC Payback Period) and the sooner you pay back CAC, the sooner you have a profitable customer. Optimizing CAC is about removing the waste and slack that your spending on current acquistion strategies. Some of the broad ways of optimizing your CAC are:

  • Optimize your conversion rates – focus on your product selection, catalog content, merchandizing, daily engagement metrics, testimonials, etc.
  • Use referral programs – start a rewarding customer referral program
  • Pragmatically cut spending on unprofitable channels: Some channels will bring you 20% of your customers for 80% of your spend. Find these channels and either try to optimize them or cut cost down.
  • Experiment with new channels in order to discover more things that work in the idea to bring more leads at an interesting CAC.

Here is a Shopify link on the key CAC metrics to measure to drive efficiency.

As the economy becomes increasingly customer-centric, delivering great customer experience has become central to retaining business and increasing profits. By understanding the different market segments within the customer base and their associated customer lifetime value, companies are able to strategically target the most valuable customers to increase retention, and improve their offering for similar high value targets.

Hope this is useful, thank you.