For any company to be profitable, it must profit more from each customer (Customer Lifetime Value or LTV) than it spends on acquiring them (Customer Acquisition Cost or CAC).
So if your average Customer Lifetime Value is lower than your Cost Per Acquisition, that should be a big point of concern for your company because it means that you are losing money.
Being unable to maintain Costumer Acquisition Cost lower than Customer Lifetime Value is one of the main causes for business failure. This is why Compass shows and benchmarks your CAC/LTV, repurchase and churn rates in Compass’ dashboard.
How to calculate Customer Lifetime Value
Lifetime value is how your store profits from your clients during the time they remain customers.
For example, if your average client comes back to your store three times to buy something, spends on average $100 per purchase and your profit margin is 10% ($10), your Customer Lifetime Value is $30.
This is important because LTV is directly linked to profitability, since a company with high LTV will be able to spend more to attract customers and will have a higher margin.
To estimate LTV, you need to look into your historical data and:
- Forecast the average customer lifetime (or how long the customer continues to purchase your product or service);
- Forecast future revenues, based on estimations about future products purchased and prices paid.
- Estimate the costs of distributing those products.
- Calculate the net value of these future amounts.
If you don’t have historical data to do so (as is often the case), Compass calculates your LTV instantly, in your Revenue Report.
Famous best practices in Retention and Customer Lifetime Value
Companies that have high Retention (their customers keep coming back to shop more) are more successful because their Customer Lifetime Value gets higher. For example:
- Zappos won against their competition by keeping their customers coming back with an excellent customer service strategy. The more often they buy, the higher Zappos’ LTV gets.
- Amazon’s massive product offerings helps them in upselling or cross-selling to nearly everyone using an automated and personalized email marketing system. This means users spend more, which in turn improves Amazon’s LTV.
- Netflix’s recommendation system keeps viewers constantly engaged in new content. Netflix’s customers keep their subscriptions for a year or more, paying every month, which increases LTV.
- Facebook “habit loop” keeps their users coming back to the site on a daily basis (and often, multiple times a day). When users visit Facebook more often, they tend to click more on ads. Since Facebook profits from each ad click, this greatly improves their LTV.
Why the ratio between CAC and LTV is crucial for running your business
Customer Acquisition Cost (CAC) is calculated based on the amount of money you spend to acquire a customer. For example, if you pay $1 for each click that a person makes on your Facebook Ad and 1 in every 10 people who click on that ad ends up buying from you, your CAC is $10.
Considering the example above, of a company who’s Customer Lifetime Value is $30, if their CAC is $10, that means their profit is $20 per customer. A $20 profit is not so bad if your company has a high volume of sales.
However, if that company’s clients came back to shop at an average of 10 times, their LTV would be $100. If the LTV is $100 and the CAC is $10, then the final profit would be $90. Which is obviously much better.
If you’re currently running Facebook Ads or any other paid marketing channels, you’ll appreciate how difficult it is to keep Costs per Acquisition down. So it’s in your interest to keep Customer Lifetime Value as high as possible. And the secret for keeping LTV high is retention. See below:
How Retention Rates impacts Customer Lifetime Value
Next are two cases of Ecommerce businesses who are using Compass. We’ll use them to show how retention rates and CAC impact the lifetime value of their customers. The first example is of a company struggling to retain their customers. The second shows a business with high retention rates.
The graph below demonstrates the retention curve of a company with only 30% of their customers returning in the next month. You can see that they end up with almost zero customers from each cohort in less than 5 months:
- Low retention rates result in Customer Lifetime Value barely increasing over time.
- Companies with low Customer Lifetime Value can only really count on one purchase per customer to draw all of their profits.
- If a company has low Customer Lifetime Value, average CAC needs to be below average to profit from each customer.
That reflects very positively in their Customer Lifetime Value, as we can see in the graph below. Even though revenue from their first purchase is low, in the long run each customer becomes extremely valuable because of the high retention rate.
Whatever the case and the market you are in, a low LTV / CAC ratio is a problem that should be addressed as soon as possible. If that’s a problem you have, we strongly encourage you to your Retention after the first transaction. Read more about how to improve Retention Rates in this article.
For many young businesses, keeping a healthy CAC / LTV ratio is a challenge. If that’s your case, you need to identify whether your CAC is high or your LTV low (or both).
Benchmark your numbers against your competition to understand which of them is your biggest problem. Then divert all of your focus to getting it fixed. If the problem is retention, you have a few different options to test:
- Focus on customer satisfaction by providing an excellent experience with your product.
- Build a recommendations engine and an email automated system. Use them to personalize the offers to your customers based on their activity with your site or app.
- Work on developing a habit-forming loop to insert your product in the daily routine of your users.
- Or you can look at your own data and come up with your own strategy.
The important thing is to focus on your CAC / LTV ratio immediately. The lifetime value of your company depends on it.
At Compass we measure your average Customer Lifetime Value (LTV) and compare it with your Customer Acquisition Cost (CAC) for each channel. All you have to do is sign up and connect your Google Analytics account. Click on the button below to learn more: