In our article Top 3 Reasons Why New Businesses Fail, we highlighted the importance of understanding Customer Acquisition Cost (CAC), and Customer Lifetime Value (CLV). Optimizing the CLV-CAC relationship is vital if you want to build a sustainable business model and make smarter investments by focusing on your most important customer segments.
Our goal here is to cover the fundamentals, using some common approaches as examples. We’ll discuss the key benefits to understanding your CLV-CAC metric, and how it can enable customer segmentation, increased wallet share, and product diversification.
For a quick summary of these concepts and approaches check out the infographic at the bottom of this article.
CLV is simply the present value of the future cash flows from a customer, over the course of their relationship with your business. We discount the future predicted cash flows using DCF (discounted cash flow) methodology in order to account for the time-value of money and future risk. We previously discussed this concept and the use of net present value in our article Buying vs. Leasing – use Net Present Value!. Basic versions of CLV do not always use DCF, which is typically considered an incomplete approach. As a starting point, however, it’s worth reviewing the more basic frameworks in order to understand the thinking behind CLV.
I. Simple CLV formula (without DCF):
CLV = Avg Annual Gross Profit / Avg Annual Churn Rate.
Gross profit (GP) = average gross profit from a customer = net sales – cost of goods sold (COGS);
Net sales = sales – returns & discounts;
COGS = fixed and variable costs directly tied to the production of the product or service (e.g., the labor and materials directly used to produce the good or service, and not the indirect costs for sales and distribution);
Churn rate (C) = 1 – retention rate (r);
Average Customer Lifespan = 1 / Churn Rate; and
Retention rate (r) = ((Customers at End of Period – Customers acquired during period)/Customers at Start of Period) x 100.
In some of our previous blog posts we used a coffee cart business as an example to illustrate concepts like cash flow and contribution margin. Let’s recycle that old example and change it up a bit for the purposes of this discussion.
Ex.: You own a coffee cart. Your average customer spends $4 per day, and buys from you 5 days per week, every week of the year (s/he REALLY likes coffee). You only sell coffee, and your average gross margin is 10%.
Based on this very simple example, the math would look something like this:
Average Annual GP = (Avg Rev Per Customer Per 52 wks) x (Average Gross Margin)
= ($4/day x 5 days/wk) x (52 wks) x (10%)
= ($1,040) x (10%)
= $104 per year, per customer, on average
r = ((Customers at End of Period – Customers acquired during period)/Customers at Start of Period) x 100
= ((90 – 20) / (100)) x 100%
= 70% retention
C = 1 – r = 1 – 70% = 1 – 0.7 = 0.3 = 30% churn
Avg Customer Lifespan = 1 / Churn = 1 / 0.3 = 3.33 years
Recalling our formula: CLV = Avg Customer Lifespan x Avg Annual GP
= Avg Annual GP / Churn
= 3.33 years x $104 per year = $346.67
-or- $104 per year / 0.3 = $346.67
II. Simple CLV formula (with DCF):
CLV = Avg Gross Margin x (retention rate / (1 + discount rate – retention rate)).
Using our data from above, and a suggested discount rate of 25%, we have:
CLV = (3.33 x $104) x (70% / (1 + 25% – 30%)) = 0.1 x (0.7 / (1 + 0.25 – 0.30))
= $346.67 x (0.7 / 0.55) = $346.67 x 1.27 = $441.22
Why is this useful to know? Well, if you can compare it to how much you spend to acquire and retain your customers, then you have a framework for evaluating how sustainable your business model really is. More specifically, the ratio of CLV:CAC can indicate whether you are investing optimally in growth. A ratio of at least 3:1 is considered a typical indication that a company is optimally balancing investment with growth, and will be able to cover these expenses and other non-customer contribution related expenses (e.g., opex, taxes, debt interest, etc.).
While the simple model above helps us to understand the general mechanics of CLV, it does not take into account retention costs, nor does it factor in varying discount rates for future cash flows. As well, if you have negative churn because you are actually adding customers faster than you are losing them, then the formula doesn’t really work. Additionally, it is very likely that your churn, growth, and discount rates will vary from one year to the next. Lastly, there is a distinct possibility that your retained customers may actually increase their spending with you in a manner that more than offsets the lost sales from the customers who leave you.
This is not meant to be an exhaustive analysis of CLV and CAC. The models can get complicated rather quickly when you start to factor in these other considerations, plus the underlying financial concepts such as weighted average cost of capital, and capital asset pricing models.
However, having said this, the approaches we’ve outlined in this article can certainly help guide you toward a better understanding of your Customer Lifetime Value. Continue reading below for Customer Acquisition Cost. We’ll tackle the more complex methods and related concepts in future posts, so stay tuned!
CAC: Customer Acquisition Cost
Typical CAC Approach:
CAC = Cost of Sales & Marketing Attributable to Period / Customers Acquired in Period
Sales & Marketing expenses would include all marketing costs, including related salaries and associated headcount expenses; technology purchases/software used in marketing & sales; and outside services for marketing & sales. Customers acquired would only include new customers, and not repeat customers.
Aside from the most obvious benefit of not overpaying to get new customers, there are several broader functions and extensions of CAC-CLV that are also important:
- Business Model Sustainability – getting a positive return on investment in a manner that also helps you to achieve the right time-shape cash flows to cover expenses and to fund other necessary growth investments
- Customer Segmentation – gaining an understanding of which customers are most valuable in order to focus sales, marketing, and other operations around that group in an effort to increase “wallet share” of the most desirable segment, resulting in maximization of ROI
- Portfolio Management – when applicable, to differentiate your products & services based on varying margins, market shares, and growth prospects in order to assemble a portfolio of businesses/products/services that intentionally compliment one another