My first months at a startup were scary because I lacked the knowledge that I felt like everyone around me already had. I was bombarded with terms I had never heard of.
Two in particular — lifetime value (LTV) and customer acquisition cost (CAC) — kept coming up and now I wish I had understood them earlier on. These two metrics play a key role in determining the LTV:CAC ratio, which helps you gauge the health of your business.
Without an awareness of the LTV:CAC ratio, you miss many chances to adapt your business strategy and increase your overall profits.
In this guide, we’ll define what lifetime value and customer acquisition cost are, demonstrate how to calculate them, and explore their role in the LTV:CAC ratio. You’ll gain applicable insights to help direct your business strategy moving forward to maximize the value of your customers.
LTV stands for customer lifetime value and represents the revenue a customer brings you throughout the entirety of your relationship. Consider Netflix where an average subscriber stays on board for 25 months. Netflix says the lifetime value of its customer averages $291.25 (see source).
CAC stands for customer acquisition. In general, it represents the average cost a company has to transform a lead into a customer.
Both LTV and CAC are fundamental to any business. Now let’s go further in depth.
I will never forget the time when I was in a roadmap meeting where a marketing analyst bravely challenged top management. Bluntly, she said, “When are we going to talk about the elephant in the room? Our CAC is double our LTV. We’re bleeding out.”
The CEO tried explaining that they were more focused on growth than profitability because the business was still trying to prove its market fit. However, in their response, the CEO didn’t seem to know that our LTV:CAC ratio was not very good.
A poor understanding of LTV:CAC can put companies in complicated situations or lead to missed opportunities. Because of this, CEOs need to understand how the LTV:CAC ratio influences the health of their business.
As I alluded to above, the customer lifetime value represents the revenue you can collect from each customer, while the acquisition costs determine how much it costs to acquire the customer. The relation between the two defines how profitable your business is.
In startups, it’s natural to have high acquisition costs, but having a lifetime value lower than that is a sign of a mismatched market fit.
Before you can utilize LTV and CAC for business decisions, you need to understand how these two metrics are calculated. Below are the most popular ways to calculate each:
Calculating lifetime value can help you understand the nature of your business. There are various methods to do so, including:
Consider a monthly revenue of $100 and that your customers spend consistently throughout the year with you. This model is a simple and flexible one, and it tends to work well with online businesses and marketplaces.
The customer lifetime value would be:
LTV = average customer revenue * relationship time
LTV = $100 * 12
LTV = $1,200
The second method focuses on the frequency that you experience customers dropping from your product. This method works best with subscription models. Continuing the previous example, suppose your churn rate is 10 percent every month.
The formula for LTV would be:
LTV = average customer revenue / churn
LTV = $100 / 0.1
LTV = $1,000
You can find more methods to calculate the lifetime value, but the two mentioned above are the most common.
Now let’s clarify how you calculate the customer acquisition costs.
Suppose you’ve acquired 40 customers in a given month, and the total marketing costs were $10,000.
CAC = Marketing costs / customers acquired
CAC = $10,000 / 40
CAC = $250
The LTV:CAC ratio is a simple calculation of LTV/CAC. The ratio helps product managers make decisions on marketing investments, which type of features to create, and which opportunities to explore.
So, what makes a “good” LTV/CAC ratio?
Considering our previous example of LTV of 1,000 USD and CAC of 250 USD, the ratio would be 4:1. What does that tell you?
Many factors will impact your customer’s lifetime value and acquisition cost. Product managers need to understand what keeps customers satisfied, how often they come back to you, and why they leave you. Knowing such metrics help you understand the health of your business.
Below are some of the main factors that impact LTV:
Acquiring customers is more of an art than a process. Great product managers understand what drives costs up or down and also can double down on the winners and cut the losers. Not all channels will lead to sustainable conversions.
Alongside LTV, the following impact your CAC:
Improving LTV and reducing CAC is essential for developing a sustainable business. It’s imperative to work on that continuously.
Let’s explore some opportunities for both:
Having dashboards with LTV, CAC, and LTV/CAC ratio are fundamental to empower you to make decisions faster.
The challenge now is creating a dashboard that gives you enough direction to make decisions. A dashboard can come down to personal taste.
I like having a dashboard that shows data from the previous year, the current year, and the forecast. This helps me understand if we’re improving or not, but sometimes that’s not enough.
You want to avoid the trap of generalization. Therefore, I recommend you explore different scenarios. Compare LTV, CAC, and LTV:CAC ratio changes over the period, as well as the following:
You will find many alternatives to increase your customer LTV, and you may get confused about where to start.
Let me simplify it for you by giving five bulletproof strategies:
Improving LTV and CAC is vital. You can only do that by monitoring how they evolve with time.
A bad LTV:CAC ratio will get in the way of business growth. That’s why you need to continuously evaluate what creates value and what doesn’t.
There is no one-size-fits-all strategy. The reality is that you need to adapt your strategy according to your learnings.
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