LTV/CAC Ratio
The two terms are LTV which stands for “Lifetime Value” per customer, and the other is CAC which stands for “Customer Acquisition Cost.”
What is the LTV/CAC Ratio?
The LTV/CAC ratio is derived from two terms which are LTV which stands for “Lifetime Value” per customer, and the other is CAC which stands for “Customer Acquisition Cost.”
This ratio compares the value of a customer over their lifetime to the cost of acquiring them. It helps the business understand and determine how much it should spend on acquiring the customer.
A healthy LTV/CAC ratio is typically considered to be 3:1 or higher, indicating that a business generates three times the revenue from a customer over their lifetime compared to what it spent on acquiring them.
If the ratio is low, then it means that the business is burning more money in the long run for the acquisition of customers, and the expected returns on revenue of customers’ lifetime are relatively lower than the money spent on their acquisition and eventually leave the business with a lack of resources.
LTV/CAC ratio is not the only metric or ratio a business should consider while evaluating customer acquisition efforts and expenses.
Other factors should also be considered, such as customer churn rate, customer acquisition costs by channel, and customer engagement and satisfaction. The LTV/CAC ratio is a useful metric for businesses to monitor and optimize as they strive to acquire profitable customers and grow their revenue over the long term.
Key Takeaways
- The LTV/CAC ratio metric can help a business understand the relationship between a customer's Lifetime Value (LTV) and the Cost of Customer Acquisition (CAC).
- A high ratio shows that a business generates more revenue from a customer than the amount spent on acquiring them, making the business efficient and profitable in customer acquisition efforts.
- A healthy ratio is known to be 3:1 or higher than that, but the ideal ratio varies according to the industry and business model.
- The ratio is not the only metric that businesses should consider when evaluating customer acquisition efforts. Still, multiple other factors like customer churn rate, customer acquisition costs by channel, and customer engagement and satisfaction should also be considered.
- The ratio can inform decisions about customer acquisition, retention, and marketing strategies and help businesses determine how much they can spend on customer acquisition while maintaining profitability.
- Monitoring the ratio frequently can help businesses acquire profitable customers and grow their revenue over the long term.
LTV/CAC Ratio Formula
LTV and CAC are two completely different components of this ratio derived individually. So let’s break them into individual components.
1. Lifetime Value
It is a customer’s average revenue generated throughout their lifetime as a customer of the business.
While calculating LTV, a business considers a customer will generate the average revenue on every transaction, their frequency of purchase, and time duration of the customer with the business.
With the help of this, business estimates the total revenue a customer will be generating for them over the long term.
Formula,
Lifetime Value = ARPU / Churn Rate
Here,
- ARPU means Average Revenue Per User
- Churn Rate means a rate at which customers stop doing business with a company over a given period of time.
For example, if a customer remains a customer for 3 years while spending an average of $50 on every transaction and makes 5 transactions in a year, their Longterm Value (LTV) would be $750 ($50 x 5 x 3), which signifies the amount a customer spends on average.
The business can expect to generate $750 in revenue from that customer over its entire life as a customer.
Note
LTV is an important metric for businesses because it helps them understand the long-term profitability of their customer base and can inform decisions about customer acquisition, retention, and marketing strategies.
2. Customer Acquisition Cost
It is the total cost of acquiring the customer for the first time. This cost of acquisition is divided over a given period.
While calculating the CAC, a business considers all costs associated with acquiring new customers, including marketing and advertising expenses, sales commissions, and other costs related to the customer acquisition process.
Formula,
CAC = Cost Of Sales and Marketing / Number of New Customers Acquired
For example, if a business has $10,000 for marketing and advertising over a month which results in 100 new customers, the Customer Acquisition Cost (CAC) after calculations would be $100 ($10,000 / 100), which shows us that on average the business has spent $100 to acquire each new customer.
CAC is an important metric for businesses because it helps them understand the efficiency of their customer acquisition efforts and can inform decisions about marketing and advertising budgets, sales strategies, and pricing strategies.
By calculating CAC, businesses can determine how much they can spend on customer acquisition while maintaining profitability.
How to Calculate LTV/CAC Ratio?
For example, a software company spent $5,000 on marketing and sales in a given month, resulting in 100 new customers. The company expects every customer to generate an average of $500 in revenue per year and remain a customer for 3 years.
To calculate the LTV, we can use the following formula:
LTV = Average Annual Revenue per Customer x Customer Lifespan
LTV = $500 x 3 years = $1,500
Next, we can calculate the CAC as follows:
CAC = Total Marketing and Sales Expenses ÷ Number of New Customers Acquired
CAC = $5000 / 100 = $50
The last step is to calculate the LTV/CAC ratio:
Using the formula,
LTV/CAC Ratio = LTV / CAC
LTV/CAC = $1,500 / $50 = 30
In this example, the LTV/CAC ratio is 30, which indicates that the company is generating 30 times more revenue over a customer's lifetime than it is spending on customer acquisition.
This strong LTV/CAC ratio suggests that the company's customer acquisition efforts are efficient and profitable.
Challenges With the LTV/CAC Ratio
It is an important metric that helps businesses measure the effectiveness of their efforts for customer acquisitions. In this ratio, LTV tells about the customer's lifetime value, and CAC tells about the cost incurred on acquisition.
Calculating the LTV/CAC ratio can be challenging because it involves making several assumptions about future customer behavior and revenue streams. Here are some potential difficulties you may encounter:
1. Accurately calculating customer lifetime value
Determining the expected revenue from a customer over their lifetime can be tricky. You will be required to estimate how long customers will be with your business, how much they will be spending on average, and how frequently they will purchase.
2. Identifying and measuring customer acquisition costs
All the costs associated with acquiring new customers, like marketing and advertising expenses, sales commissions, and onboarding costs, should be identified and measured properly.
3. Accounting for churn
Customers will inevitably leave your business over time due to switching to a competitor or simply losing interest in your product or service. Therefore, you will need to factor in churn rates when calculating LTV.
4. Making accurate revenue projections
The LTV/CAC ratio requires estimating future revenue streams from each customer. Therefore, multiple factors, such as changing market conditions, shifts in consumer behavior, and the introduction of new competitors, can influence the projection of the ratio.
To overcome these challenges, using reliable data sources and making conservative assumptions when calculating LTV and CAC is important. You should also regularly review and update your calculations to account for changes in your business or market conditions.
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