Do you know the lifetime value and cost of acquisition of your customers?
Read time: 4 minutes
There are many metrics entrepreneurs need to know when operating their business. Things like gross margin and cost of goods sold are essential information for managing your business.
A couple of other very important numbers sometimes get lost in the shuffle. They’re the lifetime value (LTV) and cost of acquisition (CAC) of a customer.
Simply put, you need to know how much value a customer brings to your business over the lifetime of your relationship. And you need to know how much money it took to get a customer’s business.
Why? Because when you know how much a customer is worth to you, you can start thinking about how much you need to spend to attract them and/or how efficient you need to be to stay ahead of the game. That can be a big deal and these calculations can help you to make the decisions/changes necessary to improve the performance of your business.
If you talk with your finance and accounting people these calculations can get very detailed and complicated very fast. For our purposes, let’s go a little higher level.
How to calculate lifetime value (LTV)
LTV represents the revenue/profit you will receive from a customer over your entire relationship—not just from a single sale, but from all revenue generating activities you engage in with that customer.
You can calculate it this way:The average value of a sale X average number of repeat transactions X average retention period for a customer (in years).
This calculation works for initial large one‑time sales transactions as well as for repeat transactions. You should also take into account any maintenance or after‑sale service you might do as part of overall revenue.
Let’s use the example of a company that specializes in heating, ventilation and air conditioning systems. It sells large commercial climate control systems that can cost anywhere from $15,000 to $100,000, depending on the customer, but average $25,000.
The value of an ongoing relationship
The business relationship usually doesn’t end there. Customers tend to use the company for their maintenance needs on the system for an average of 15‑years after the initial purchase.
So using our formula for this business, the initial sale calculation would be:
$25,000 average sale X 1 transaction (system purchase) X 1 (our retention rate is limited to this large one‑time purchase value) = $25,000
However, there is the ongoing maintenance that comes with owning these systems like the inspection of the duct work and motors, new filters, etc. The annual maintenance costs an owner $150 on average. So, this gets added into our calculation as well:
$150 average sale X 1 annual maintenance transaction per year X 15 years = $2,250
So, our overall LTV becomes $27,250.
How to calculate cost of acquisition (CAC)
Now that we know what a customer is worth to the business, we need to determine how much it costs to get a new customer to purchase a system. To do that, we need to know how much money we are spending on our sales and marketing efforts.
For calculating CAC, the formula would be:(Sales costs + marketing costs) / Number of new customers acquired through your activities
For our example company, they have one salesperson that earns $70,000 per year and has annual business costs of an additional $10,000 to do their job (e.g. office supplies, transportation, computers). The company spends another $100,000 annually on marketing (e.g. website, search engine marketing, trade shows, direct mail, print ads). As a result of those efforts, the company acquires four new customers per month on average. So, our CAC calculation becomes:
($80,000 in sales costs + $100,000 in marketing costs) / 48 new customers per year = $3,750 per customer
So what does it all mean?
For starters, these calculations can help you determine the long-term viability of your business. In this example, the LTV is greater than the CAC, which is good. It costs less to acquire a new customer than their overall value to the business. This puts the business in a favorable position as it grows.
But, what if the opposite were true? What if the CAC was greater than the LTV at our example company? What if they sold only one system every other month? Suddenly, you can see that the business is in jeopardy.
($80,000 in sales costs + $100,000 in marketing costs) / 6 new customers per year = $30,000
A rule of thumb for your business
Depending on the benchmark you look at, a very general guideline for business is that your LTV should be 2.5 to 3 times your CAC.
So, if a customer is worth $100 to you over their lifetime, it shouldn’t cost you more than $40 (at a 2.5 times ratio) to acquire them.
Do you use these numbers in your business? Has it helped your decision making process? We’d love a comment below.