In order to keep the tipping point between expenditure and retaining profits in balance, for entrepreneurs and for marketing managers alike, is no mean feat. And that is why the LTV to CAC ratio proves useful as a significant indicator. Equating customers’ lifetime value (LTV) with cost of acquisition (CAC), businesses can calculate profitability for their customers.
Is determining the ratio just a numbers game, then? No, it is not. Knowing your LTV/CAC ratio offers valuable insight into whether your marketing is sustainable and working.
Lifetime Value
Lifetime Value (LTV) is every dollar one customer will generate in your business throughout the duration of their time with your business. It includes long-term purchases, repeat business, and loyalty that will be attracted over the long term. This is why it’s important for businesses to know.
How to Calculate LTV
The formula for LTV generally computes spends over a period of time and applies these three inputs:
- Average Purchase Value (total revenue / number of purchases)
- Purchase Frequency Rate (number of purchases / number of customers)
- Customer Lifespan (average length of time that customers are interacting with your business)
This is what the formula would look like:
LTV = (Average Purchase Value) x (Purchase Frequency Rate) x (Customer Lifespan).
So, for instance, if the average customer spends $50 per purchase, purchases from you five times a year, and is a customer for three years, their LTV would be:
$50 x 5 x 3 = $750.
That is their worth to your company during their lifetime.
Customer Acquisition Cost
Customer Acquisition Cost (CAC) is the price you pay to acquire a new customer. It’s a useful metric to see how effective your marketing is and how your acquisition is doing.
How to Calculate CAC
To calculate CAC, just divide your overall acquisition cost by the number of new customers acquired in that period.
CAC = Total Costs of Acquisition / New Customers Won.
For instance, imagine your business incurred $5,000 in marketing expenses for a quarter and acquired 100 new customers. Your CAC would be:
$5,000 ÷ 100 = $50.
That is, you cost $50 to bring on each new customer.
Why is the LTV/CAC Ratio Important?
The LTV/CAC ratio tells you whether your investment in customer acquisition is yielding sustainable returns. A good ratio is 3:1, with the revenue you obtain from a customer’s LTV being equal to three times that of acquiring them. The minute the ratio becomes less than 1, you are investing in acquiring customers that are worth less to your company, sacrificing profitability and growth. If this happens, contact a digital marketing agency to optimize your strategy.
Tracking this ratio indicates which areas to improve upon in your acquisition and retention processes. For example, if CAC is excessively high, it may suggest that your acquisition methods (such as advertisements or sales pipelines) need to be manipulated. Conversely, if LTV is stagnant, then maybe it is time to execute initiatives like reward programs in an attempt to increase lifespans of customers or increase purchase frequency.
Additionally, the LTV/CAC ratio is also significant in determining long-term scalability. Investors and stakeholders making decisions regarding the growth prospects of a company will generally consider this figure as a measure for long-term success.
Smart money planning and effective marketing is primarily the LTV/CAC ratio. From this, it will be fairly simple to determine how much value each customer is bringing to your business and at what expense in terms of getting them into business.
Tracking this measure on a regular basis provides entrepreneurs and marketing managers with a benchmark to apply in minimizing waste, maximizing strategy, and optimizing the greatest return on investment. Basically, companies that do not pay attention to their LTV/CAC ratio risk losing growth opportunities, while companies that make this metric a priority position themselves for success in highly competitive markets.
Knowing your LTV/CAC ratio keeps you in business; it gets your business growing profitably.
