I think you'll agree with me when I say:
It's super important that you earn more from your customers than you spent to acquire them.
As it turns out, there's a super useful metric that measures exactly that.
Even better: this metric can (and should) inform your strategic initiatives going forward.
In this blog post, you're going to learn all about the LTV/CAC ratio and how to calculate it.
- The LTV/CAC ratio helps you measure your return on Sales and Marketing spend
- CAC stands for customer acquisition cost, which is the amount you spend (on average) to acquire new customers
- LTV stands for customer lifetime value, which is the amount of revenue you expect the average customer to generate for you over their time as a customer
- The ideal LTV/CAC ratio for early-stage (high-growth) companies is 3:1.
- What is Customer Acquisition Cost (CAC)?
- What is Customer Lifetime Value (LTV)?
- What is the LTV/CAC Ratio?
- How to Improve your LTV/CAC Ratio
- Limitations and Pitfalls of the LTV/CAC Ratio
What is Customer Acquisition Cost (CAC)?
CAC stands for customer acquisition cost.
It means exactly what it says: how much do we have to spend (in sales & marketing dollars) in order to acquire a customer?
To calculate this, take the total sales & marketing spend for a given period and divide it by new customers acquired in that same period.
CAC = (Sales & Marketing Spend) / # of New Customers Acquired
Now, at this point, you might be wondering:
- Aren't there different kinds of customers?
- Aren't some customers more expensive to acquire?
And you're not wrong—there are different kinds of customers. And some customers are more expensive to acquire.
This is when cohort analysis becomes handy, because you can get specific about metrics like CAC for a targeted subset of customers.
What is Customer Lifetime Value (LTV)?
LTV stands for Lifetime Value. It's the amount of revenue you expect the average customer to generate during their time as a customer.
There is no universally agreed way to calculate lifetime value. However, unless you have a specific reason for using a different formula, we like to keep it simple:
Your LTV is your Average Revenue Per User (ARPU) times your customer's lifetime (LT).
It looks like this:
LTV = ARPU * LT
...now, if you're thinking that looks suspiciously simple, it's because it is.
We have to calculate ARPU and Customer Lifetime first.
Let's get started on those.
Calculating Average Revenue Per User (ARPU)
Average Revenue Per User, like LTV, doesn't have an official calculation.
But it does have a generally accepted one, which is monthly recurring revenue divided by your number of users.
ARPU = MRR / # of Users
This should be a pretty easy calculation to make.
Customer Lifetime (LT)
Customer lifetime (LT) is the length of time you expect a customer to stay with you.
It makes sense that, in order to calculate lifetime value, you need to first know the length of the lifetime.
But this might feel like a strange calculation to make...especially if you're working with a newer company—how can you know your customer lifetime without years of historical data?
Fortunately, there's a simple approximation you can make if you know your churn rate.
Customer Lifetime = 1 / Monthly Churn Rate
(You can use monthly churn or annual churn; just make sure the rest of your calculations also use the time period you picked.)
For example, if you see 0.5% churn each month, then your LT = 1/0.005 = 200 months = 16 years and 8 months = 16.67 years.
In this post, since we're using monthly metrics like MRR and monthly churn rate, we want to keep Customer Lifetime in terms of months, too.
Now that you have your Average Revenue Per User (ARPU) and your Customer Lifetime (LT), you can calculate your Customer Lifetime Value (LTV, or CLTV).
To get your LTV, just multiply the two numbers together.
LTV = ARPU * LT
So if your average revenue per user is $100 (per month) and your expected customer lifetime is 200 months, then 100 * 200 = $20,000.
Again, it's important to keep your time segments consistent. Don't calculate LT in years and ARPU in months!
What is the LTV/CAC Ratio?
The LTV/CAC ratio is the ratio of the money you spend to acquire customers to the revenue you get from those customers.
In other words, it measures the ROI on your sales and marketing spend.
The ideal LTV/CAC Ratio for early-stage (high growth) companies is 3:1.
In other words, those companies want an LTV that's 3x their CAC.
Why is the LTV/CAC ratio important to track?
At a very high level, the LTV/CAC ratio tells you how sustainable your business model is.
When you analyze it a little more closely, it can tells you a few other things:
Who are your quality customers?
Especially when you calculate this ratio during cohort analysis, the LTV/CAC ratio tells you who your most profitable customers are. Once you know this, you can focus more of your marketing spend on acquiring them.
How much should you spend on acquiring customers?
The LTV/CAC ratio for your entire consumer base is a good indicator of your "average" customer. This means that, when you dig deeper into the data and look at individual cohorts, you have a benchmark to determine whether or not you're spending too much on acquiring certain types of customers.
If your LTV/CAC Ratio is above 3:1 (say, it's 5:1), then you're probably missing out on business. This means you have the funds to expand your sales & marketing team and also to go after some tougher-to-acquire customers.
If your LTV/CAC ratio is below 3:1 (say, it's 2:1 or 1:1), then you're spending too much on sales and marketing OR you need to increase the LTV of your existing customers.
LTV/CAC Ratio by Cohort
The real power of the LTV/CAC ratio is when you segment it by cohort.
In aggregate, this metric tells you how on-track you are as a company. It tells you about the "average customer."
Which is helpful information, but it's not specific enough unless all your customers are the same. (Which they probably aren't.)
If you're familiar with the Pareto principle, sometimes called the 80/20 rule, you know that a subset of your customers are responsible for the majority of your revenue.
Calculating your LTV/CAC ratio by cohort helps you identify exactly who those customers are.
In other words, this kind of individualized segmentation can uncover incredible insights about who your most profitable customers are.
...and about who you should reconsider marketing towards.
How to Improve your LTV/CAC Ratio
If your LTV/CAC ratio is low, it's either because your CAC is too high or your LTV is too low.
Here are some strategies to improve each:
How to Reduce Customer Acquisition Cost (CAC)
Focus on more efficient channels: Content marketing, ad retargeting, email marketing are all cheaper (and more efficient) marketing channels than going completely outbound or running ads to a cold audience.
Go after different customers: Not all customers cost the same to acquire. Study the market: is there any low-hanging fruit you haven't gone after? Could you be using better prospecting tools?
Increase your conversion rates: When your conversion rates are better, your CAC decreases because more customers will convert for the same amount of spend. Invest in user research and copywriting to improve your conversions.
Simplify your sales cycle: Longer sales cycles tend to be more expensive. How can you shorten or speed up your sales cycle?
How to increase Customer Lifetime Value (LTV)
Since churn directly affects LTV, anything you do to reduce your revenue churn will also positively affect your LTV.
Said differently, anything you can do to increase your customer lifetime (LT) will also increase your LTV.
Likewise, increasing your average revenue per user (ARPU) also increases LTV. So there's a lot to work with!
Experiment with pricing to increase ARPU: Raising your prices for new customers, assuming you don't also increase your churn rate, will lead to a higher LTV. This is worth experimenting with!
Improve your customer success experience to reduce churn: A large number of companies churn because of a frustrating customer success experience. When you invest in customer success, you're keeping customers around longer, thus increasing their LTV.
Offer expansions to increase ARPU: Up-sells, cross-sells, and expansions are all powerful ways to increase your ARPU, therefore increasing LTV.
Limitations and Pitfalls of the LTV/CAC Ratio
Like every metric, the LTV/CAC ratio is only a single piece of the story. Here are some of the things to keep in mind as you calculate and interpret your numbers:
Not accounting for all sales & marketing costs when calculating CAC
Paid advertisements are the most obvious costs when calculating CAC. But they're far from the only cost.
You also need to consider the costs of:
- Creative (design, copywriting, content marketing, and so on)
- Acquisition-related employee salaries
- Software (such as website hosting costs)
- Lead scoring and strategy
Among other costs.
Misrepresenting your CAC inflates your LTV/CAC ratio and paints a much rosier picture than reality.
The LTV/CAC ratio differs by cohort
We've said this many times, but it's worth repeating:
Since not all customers are created equal, their LTV/CAC ratios will differ.
Assuming their ratios are similar is a huge mistake.
For example, if a small subset of customers are wildly profitable but your largest customer base only has a LTV/CAC ratio is only 1:2, you'll invite slow growth that you could have avoided.
Now It's Your Turn
Now you know how to calculate and interpret the LTV/CAC ratio.
You also know how to use it to make aggressive, strategic recommendations to bolster your company's growth.
Now I want to turn it over to you: what are you going to focus on this year? Lowering your CAC? Or raising your LTV?
Share this on LinkedIn and tag Cube to keep the conversation going.