These metrics are customer acquisition costs (CAC), and the customer’s lifetime value (LTV). Depending on the depth of your analysis, there are additional metrics available; however, these two metrics are an excellent starting point and can identify the best customer for your company.
Customer Acquisition Cost (CAC) is an essential metric in determining a business’s profitability. CAC is the cost of converting a lead to a client. CAC is an important metric because it measures the amount of money spent on acquiring the client against the value that client brings to the company. It is important to note that not all customers are created equal, and attracting the wrong customers in your marketing efforts can be costly because some customers do not add enough value to the company. Additionally, companies that can reduce their acquisition costs will see an increase in profitability as they decrease their spending on advertising.
The CAC formula is straightforward:
CAC = Cost of Sales & Marketing / the Number of New Customers Acquired
To determine the Cost of Sales & Marketing, identify all costs in that category over a period of time. It is not just your marketing budget. It also includes the salaries of all marketing and sales employees. These can also include time spent by managers or other department heads in meetings or related efforts that relate to sales and marketing. This cost is then divided by the number of customers acquired during that period.
For example, during February, your company spent $20,000 on sales and marketing, including salaries, meetings, and advertising. During that period, you acquired 100 new customers. This means that the CAC for customers in February is $20,000 / 100 = $200. This means that this company spends $200 to acquire a new client. Now we turn to the question of whether $200 per customer is good for the company.
To interpret whether the CAC value is helpful to the company, we need to compute the customer’s lifetime value (LTV). LTV is an estimation of the net profit attributed to the relationship with a customer. To calculate lifetime value, we must consider the total amount of revenue a customer brings to the company, minus all the costs required to service that customer, i.e., customer service, installation, or support.
Calculating LTV is more nuanced than CAC; LTV requires segmentation and a close analysis per customer. Several metrics are used to calculate LTV, which will be identified below. When starting the analysis, use averages based on time. After conducting an initial analysis, it may be possible to segment customers into groups by identifying demographics and other characteristics. This segmentation will improve conversion rates and decrease marketing costs by identifying the best customers for your business.
The metrics used to calculate LTV are:
- Average purchase value: This metric is calculated by dividing a firm's total revenue in a time period by the number of purchases over that period.
- Average customer lifespan: This metric is calculated by averaging the number of years a customer actively purchases from a company.
- Customer value: This metric is calculated by multiplying the average purchase value by the average purchase frequency.
- Average purchase frequency: This metric is calculated by dividing the number of purchases over a time period by the number of unique customers who made purchases that period.
Once these metrics have been collected, calculate LTV by multiplying the average customer lifespan by customer value. This calculation will help you to estimate the revenue for the average customer.
The ratio of LTV to CAC is a simple way to determine the value of each customer. Hubspot, a leader in CRM technology, suggests that LTV:CAC ratio should be three to one. This means that you should receive 3 times the value as compared to costs, i.e., if it costs $200 to acquire the client, then the client should bring $600 of value to the company.
To test the efficiency of your sales and marketing strategies, start with CAC and LTV. Too often, companies, especially early-stage companies, avoid the truths revealed in ratios, which can be caustic. Both of these metrics bring to mind the Stockdale Paradox, which will hopefully demonstrate the importance of honesty in evaluating your company’s performance.
“You must never confuse faith that you will prevail in the end—which you can never afford to lose—with the discipline to confront the most brutal facts of your current reality, whatever they might be”
This concept helped James Stockdale to survive as a prisoner of war in Vietnam, and hopefully, it helps you to gain perspective and bring success to your company.