Most businesses that have hired business consulting services firms believe that business consulting professionals’ focus on business metrics sometimes borders obsession. They may be right.
One such obsession at Proton Consulting Group is the ratio of the Customer Lifetime Value (CLTV) and Customer Acquisition Cost (CAC).
Although this ratio was initially used chiefly amongst Software-As-A-Service companies, many non-SaaS businesses now use it as well. Rightfully so.
We provide a summary description of the concept below so that readers have enough information to internalize the benefits of the ratio and adapt it to their business needs when pertinent.
Defining the CLTV CAC Ratio
This ratio compares the profit that a company estimates it will generate from a customer population, or cohort, over their lifetime relationships with the company, with the amount of money that the same company spent to attract that group of customers.
The CLTV is the net present value of total profits expected from a given customer, or customer cohort, during their relationship with the company.
Customer Lifetime Value Formula
Let’s first review the various elements of the definition.
The formula’s net present value (NPV) component reflects the value of money discounted over time. In other words, a specific amount of money today has more value than that same amount of money will have in 5 years and the NPV accounts for that.
To account for NPV, one would adjust the calculations with an agreed-upon yearly discount rate to be applied based upon the average number of years expected. A 5% yearly discount rate would see figures being multiplied by 0.95 (1-5%). To keep matters simpler, we will not be doing it here.
Some businesses use non-adjusted Gross Profit (GP) figures for this calculation. Others reduce GP by including consideration for pertinent Operating Expenses (OPEX). Of note, Compensation and Marketing spending, typically listed in OPEX, is included in the CAC calculation below. We will use regular, non-adjusted GP in our examples below.
For SaaS companies and businesses with customer contracts, the average length of the relationship between the company and its customers is derived from the churn amongst the measured customer cohort.
The churn is calculated by dividing the number of customers in a cohort leaving the company over the measured period by the total number of customers in that same cohort at the beginning of the period.
The formula could be:
Churn = Number of cohort customers who left the company during the period / Total number of cohort customers at the beginning of the period.
For example, in a cohort of 100 customers, 20 customers leaving the company over a period of one year would be 20/100 or a churn of 20%.
For these companies, the CLTV would then be calculated by dividing the yearly Gross Profit by the Churn rate. The formula could be:
CLTV = Annualized GP $ / Annualized Churn %
In our example, assuming cohort clients generate $1,000 in yearly GP, the CLTV would be $1,000 / 20% = $5,000. In other words, the average total estimated GP per customer over their lifetime relationships with the company would be $5,000.
What if one needs to calculate the CLTV for a business that cannot count on customer contracts? If the average length of the relationship is known, we could use a similar formula. For example, the formula could be:
CLTV = Yearly GP $ * Average length of the relationship.
Variations of this formula also exist for businesses that accept, and benefit from, renewal subscriptions from their customers. In those cases, we would need to account for the average percentage of customers renewing and the average number of times these customers renewed during the measured period.
Customer Acquisition Cost Formula
The CAC is the total amount spent to attract a new customer in the measured cohort.
CAC includes sales staff compensation (salary and commissions), marketing staff compensation (salary and commissions), and marketing demand generation costs.
The amounts used here are limited to the spending explicitly incurred acquiring the customer cohort measured.
A simple formula could be:
Total CAC = Total Sales Compensation + Total Marketing Compensation + Total Marketing Programs Cost.
The total CAC amount would then be divided by the number of customers acquired to arrive to the average CAC per customer:
CAC = Total CAC / New Customer Count
The CLTV to CAC Ratio
The ratio is then computed by dividing CLTV by CAC.
A positive result would indicate that the company’s marketing effort is profitable. Traditionally companies have targeted a 2:1 or even a 3:1 ratio.
A negative ratio would indicate that customer acquisition is a money-losing initiative for the company, a threatening signal to be sure.
The CLTV amount is then the highest amount that a company should spend on acquiring new customers to preserve that profitable ratio.
A CLTV:CAC ratio greater than two indicates that the marketing effort is efficient. Indeed, with a 2:1 ratio, a company generates two times the gross profit amount that it invests in new customer acquisition, which is a positive signal. Such metrics would indicate that the company can grow sales profitably.
Conversely, a smaller ratio could also indicate that improvements are needed in the new customer acquisition process.
But the significance of these ratios is not limited to efficiency measurements.
For example, CLTV-based market segmentations allow companies to develop enhanced retention programs for the most profitable customer groups or adjust their approach with the less profitable ones.
Similarly, learning from the metrics drawn from the best-analyzed cohorts, businesses can then focus on attracting new customer relationships that fit in those best cohorts. New customers would benefit from the enhanced targeted programs while the company generate more profitable partnerships. A win-win.
Proton Consulting Group partners with our clients to create innovative and customized solutions to improve their businesses. Our business consulting services team brings years of experience successfully advising and deploying profitable, data-based solutions that will benefit your organization.