When it comes to business metrics, there are two that are far more important than all the rest. Two business metrics that all businesses should know and be actively monitoring to help guide decisions and make for a stronger business. So what are they?
The first one is the “Lifetime Value of a Customer” – or LTV. This tells you how valuable your customers are to your business in the long-term. It’s the total profitability of each customer over their lifetime with you.
The second metric is the average “Customer Acquisition Cost” – or CAC. This tells you how much it costs (in sales and marketing activities) to attract and win each customer.
These Business Metrics Guide Important Decisions
Having a good grip on your LVC and CAC numbers puts you in a far better position to make a whole lot of important business decisions. Things like;
- What kinds of marketing should you invest in / pull out of?
(The ones that have a low CAC but still attract the right types of clients to maintain LVC.)
- What kinds of sales activities should you invest in / pull out of?
(Optimise your sales process to minimise CAC.)
- Should you raise or lower your prices?
(What pricing gives you the best LVC?)
- What kinds of customers should you target?
(Which ones are most profitable and give you the best LVC?)
- What type and level of account management and customer service should you provide?
(How can you service your customers to maximise their value but minimise costs?)
- What kinds of customer retention strategies should you use?
(How valuable is each customer to you? What lengths should you go to to keep them?)
- What new product features should you add?
(Ones that make it easier to either attract new customers or keep existing ones.)
The Difference Between these Metrics Drives Profitability
The absolute values of these business metrics vary greatly between industries, but the balance between them is extremely important. Clearly, to have a profitable business, you need to run your business so that the Lifetime Value of the average Customer is greater than the average Customer Acquisition Cost (ie LTV > CAC). Many experts advise that the ratio should be at least 3:1 – ie LTV should be at least 3 times the value of CAC.
How to Calculate CAC and LTV
To work out your Customer Acquisition Cost (CAC), you simply total all of your sales and marketing costs over a given period. This includes the salaries and associated overheads of you and your team members that work on acquiring customers. Then you divide that number by the number of customers your business acquired in that period.
To calculate the Lifetime Value of a Customer (LTV), you would tally up the Gross Margin that you expect to make from each customer over the lifetime of your relationship. Another way of thinking about this is to total up the revenue per month that each customer spends and then multiply that by the average number of months a customer stays with your business. This gives you the total lifetime revenue of a customer. Then multiply that by your average gross margin percentage (which should take into account the product/service costs and costs of servicing the customer).
Taken together, all of your costs should be accounted for under these two measures. Open a spreadsheet now and start adding in some numbers.
Improving Your LTV and CAC Metrics
So how can you improve the ratio between your Customer Lifetime Value and Cost of Acquisition? Depending on your business these might give you some ideas…
|Customer Acquisition Cost (CAC) Drivers||Customer Lifetime Value (LTV) Drivers|
|Reduce CAC with:
Try to reduce / minimise the use of:
|Increase LTV by:
Try to reduce / minimise:
For more ideas and in-depth discussion, there is a great article here – particularly directed at SAAS businesses but the concepts apply to all businesses.
BUT Cash Flows are also Important
Having said all that, you also need to consider your cashflows. For example, if your LTV is high mainly because your customers stay with you for a very long time, you’d want to be careful about spending 1/3 of the LTV on CAC unless you have a lot of cash in reserve. It will take a long time to recover that investment. Therefore, it’s also recommended that most businesses should aim to recover the CAC within the customer’s first year.
An Imperfect Measure is Better than No Measure
I know that for small businesses, pulling together business metrics can seem complicated and is never as straight-forward as it seems in theory. How do you allocate your time when you spend half of it in sales and marketing and the other half putting out fires? Set up a spreadsheet, make some assumptions and make a rough start.
When you boil business down to it’s bare roots, it’s really about adding value to each customer, so let’s not overcomplicate things too much. Is it costing you more to acquire your customers than they’re worth? If so, then it’s time to change something.
Some businesses measure nothing and others measure too much – neither approach is right as it doesn’t give you the focus and direction you need. If you can figure out a rough approach to measuring your CAC and LTV, these two metrics alone can give you some incredible insights which just might change the course of your business.