Traditional business metrics (revenue, margin, etc.) fail to capture key factors that drive performance in companies that leverage a reoccurring revenue model. Additional SaaS metrics such as MRR, ARR, CMRR, CAC, Churn Rate and LTV in addition to creating actionable ratios can make a big difference in measuring the health of your company and future results. I’ll cover many of these in future posts, but today let’s focus on understand the relationship between customer acquisition cost (CAC) and lifetime value (LTV).
What is CAC and how to calculate?
In the most generic terms, CAC is the cost associated in convincing a customer to buy your product/service. To calculate the CAC, we need to take the sum of all our sales and marketing expenses over a given duration and divide it by the number of new customers acquired during the same period. Here is the simple formula. CAC = (Total Cost of Sales and Marketing) / (# of new customers).
Your goal should be to review and optimize your CAC constantly. You want to lower it as much as possible without compromising sales velocity or generating bad sales (yes, there is such a thing, and I’ll cover churn in a later post). In addition to traditional costs such as marketing expenses and employee salaries, time-based costs such as the number and level of touches required to close a deal can increase your CAC dramatically. There are many levers you can use to reduce CAC such as personnel costs, marketing program expense, sales team conversion rates, better qualifying of leads, etc. but adjust these carefully. Using a blunt instrument like simply finding cheaper sales people can wreak havoc on customer retention if they aren’t qualifying prospects well.
What is LTV and how is it calculated?
In simple terms, the lifetime value (LTV) of your customer is the total amount of net revenue you’re likely to generate over the life of that account. Let’s say you charge $100/month, it costs $25/month to service the customer (COGS), and they stay with you for 18 months. Their LTV would be (100-25) × 18 = $1,350. Another example might be if you sell a $20 product that costs you $3 to make and your customer purchases it four times a year for five years. The LTV would be (20-3) × 4 × 5 = $340.
The traditional way of calculating the “average lifetime” of a customer is N = 1/c, where c is your monthly cancellation rate. If 4% of your customer base cancels each month, N = 25 months. The importance of a low churn rate cannot be overstated. If your churn rate is high, then it is a clear sign of a problem with customer satisfaction.
The ratio matters…
The ratio between CAC and LTV is an important metric for any business. It informs decisions regarding what you can spend to acquire new customers, who are your best customers, and which type of customers should you be focusing on. If your customer acquisition cost (CAC) is $125 and that same customer has an LTV of $2400, you would spend every dollar possible on acquiring new customers. A good rule of thumb is the have a CAC to LTV ratio higher than 1:3.
It is critical that you accurately capture all the costs related to acquiring your customers and knowing how much it costs to service them. Too many entrepreneurs simply look at gross revenue or fail to account for time-based costs which grossly overstates their CAC to LTV ratio. In the end, those expenses kill profitability, and you experience a “death by a thousand cuts.” Get the numbers right and track this metric over time to make sure you are driving improvements.