Life Time Value helps you answer the early set of questions that every business faces.
You have started a new product line and getting on a marketing blitzkrieg. You have spent millions of dollars on the sales team, advertising budgets and building the brand. Now, answer some questions:
- How expensive is your lead generation?
- How do you measure the sustainability of the campaign?
- Are you getting more out of your customer than what you paid to get them?
- How do you know if the marketing campaign is going to boost the bottomline?
- Fundamentally, how do you know if you are on the right track with your campaign?
These are questions that will determine the future of the company. However, many startups and small businesses fumble on this. A lot of times they spend far too much to acquire a customer, because they don’t put a lot of thought into the two fundamental sales measures – Customer Acquisition Costs (CAC) and the Lifetime Value of a Customer (LTV). What you don’t measure, is what you don’t improve.
Customer Acquisition Costs (CAC)
Simply put, this is the average amount of sales & marketing dollars spent to get a new customer. The cost includes your PR campaign, sales headcount costs, infrastructure overheads, referral discounts, free trial period etc.
Lifetime Value of a Customer (LTV)
This is the total tangible and intangible value got out of a customer in his/her lifetime. You could calculate it as the NPV (Net Present Value) of cumulative gross profits from all the purchases he/she will make with you.
LTV vs. CAC
The fundamental equation any enterprise has to achieve for sustainability is:
CAC < LTV
That is, the value got out of a customer should be greater than what was paid to acquire them. If this equation goes the other way round, the company is on an unsustainable expansion. Healthy companies have a high multiple of CAC for their LTV. For instance, companies such as Salesforce have LTV > 5 x CAC. For startups and small enterprises, it is recommended that LTV > 3 x CAC.
Time to recover CAC
What if your CAC is 5 x LTV, but your business model requires the customers to stay on for 5 years or more? Most startups don’t have the cash cushion to have a longer period to recover CAC. Thus, it is recommended that startups & small enterprises plan for CAC recovery period under 1 year. If the recovery period is greater than 1 year, then it is time to either slowdown your expansion or work on improving the CAC/LTV ratio.
5 ways to improve LTV against CAC
Knowing the equations, now you can draw your updated business model that would push CAC way lower than LTV. But, how do you accomplish that?
- Shift focus from outbound marketing (advertisements, sales promotions) to inbound marketing (SEO, SEM and Social Media Marketing).
- Build strategic partnerships that will help you share customers thereby bringing down CAC.
- Reduce customer churn by improving customer satisfaction metrics (increases LTV and reduces CAC).
- Setup a good CRM system to avoid missing the hot leads (that have lower CAC).
- Looks for ways to up-sell/cross-sell to the customer to improve Life Time Value.