With different strategies, every business calculates its customer acquisition. But startups have some parallels or metrics that are essential for their growth and progress. One of the metrics is LTV/CAC ratio, which determines how much your customer lifetime value is compared to your customer acquisition cost.
Customer acquisition cost (CAC) and customer lifetime value (LTV) go side by side in making a business model and evaluating its growth. Your business will have a positive return on investment (ROI) if your LTV is higher than your CAC.
Why is LTV/CAC important?
You already know what CAC and LTV are, but you may wonder why the need is to calculate these two ratios together. CAC and LTV are essential to understand your spending on new customers and what you will acquire within a given period.
LTV?CAC ratio calculation lets you determine whether your sales expenses and marketing spending are worth your marketing efforts. If not, how much value should you pay to market to the same customer? LTV/CAC ratio helps Saas companies to calculate and manage their marketing and sales expenses, future revenue, and underlying unit economics.
For instance, your company's gross margin is $1000 for all acquired customers. You spend the amount to market a single customer, but later, you know their average lifetime value is only $500. It means your customer acquisition won't get the required retention rate, and you lose money.
LTV/CAC ratio is also vital for individual investors or venture capitalists to understand your company's marketing costs, gross margin, and future revenue. You can attract more investors with a good ratio and average customer lifetime, but a low ratio needs improvement.
How do you calculate LTV to CAC?
Customer Acquisition Cost (CAC)
CAC is calculated by dividing the total cost of marketing and sales for the given period by the total number of acquiring customers for the same period. For instance, if your entire marketing cost is $1000 for acquiring 500 new customers, your cost to acquire customers is $2/customer.
For LTV, you need data on your customer churn rate and average revenue per user, also called ARPU. The churn rate is your company's customer retention rate, while APRU can be calculated by dividing the revenue for a specific time by the total number of marketing subscriptions.
After getting the required amounts, you need to divide the APRU by the Churn rate to get the lifetime value. With accurate data, the calculations are easy to make and get the required results.
Once you have calculated LTV and CAC, you can get the ratio with the LTV/CAC formula. You must divide the LTV (lifetime value) by the CAC (customer acquisition cost) to calculate the ratio. After the calculation, you'll know your company's average annual recurring revenue and spending on customers acquired.
What is a good LTV for CAC?
LTV and CAC are important metrics for determining and predicting a company's growth and underlying unit economics. With the LTV/CAC ratio, you can track and manage the acquired overhead costs of your customers. Therefore, the LTV/CAC ratio is a good initiative to know your company's worth.
Although a perfect LTV/CAC ratio never exists due to the difference in businesses, industries, and their lifecycle. The standard and ideal LTV to CAC ratio is 3:1, which indicates that the customer lifetime value is three times higher than the customer acquisition cost.
As the 3:1 ratio has great flexibility, your low or high performance can indicate the underlying issues of your business. If your LTV/CAC ratio is less, you are spending money on your customers' added than obtaining benefits. Less than a three ratio means your company will be burnt out soon. It highlights that you should try to decrease your marketing costs and expenses.
With accurate calculations of your LTV and CAC, you will get to know about your company's performance. Also, a regular track of your company's strengths and weaknesses will increase its value in the eyes of the investors.
What does a high LTV to CAC mean?
Besides a good LTV to CAC ratio, what about having a high LTV ratio? Suppose your typical customer lifetime value and customer acquisition cost has a great difference. For instance, LTV is five, and CAC is never above 1. It means your marketing costs are high, and you are not spending much on your CAC.
For startups and saas companies, annual revenue and customer growth are crucial to their development and progress. As they spend more on getting customers, their products and sales will reach more users.
LTV to CAC ratio is a picture of your company's health for investors. They will get to know how quickly and with how much value your company will grow. It also enables them to predict your annual revenues. They can get data on your profit and loss and improvements from your business model and decide whether you are a sound business for investment.
If your LTV ratio is higher than the CAC ratio, you are not getting the most out of your available opportunities. You need to manage the spending and increase the number of ideal customers. With balance, you can maintain your company's LTV to CAC ratio without a tremendous difference. The balance will keep your acquiring customers and marketing costs in managing state.
Ways to improve them
Companies with different purposes use different marketing strategies.
You can improve the average customer lifetime value with the following strategies without increasing customer acquisition costs.
- Search for an ideal customer base.
- Find out the ways your top customers use to reach you.
- Optimize your marketing campaigns.
- Determine the lifetime strategies of higher parties.
- Track the feedback regularly to reduce the annual churn.
- Search for ways to increase marketing spending.
- Attract and market customers with multiple subscriptions and membership plans.
- Improve and change ways for better customer engagement.