Running a company these days comes with its own set of challenges. It’s the challenge of gaining the attention of customers. The world is dynamic enough, and people's attention is highly distracted, so entrepreneurs need a lot of focus on details that will allow them to properly assess whether their companies is gaining enough new business. At the same time, it is also important whether acquiring new customers, which often consumes a lot of time, is done with the right costs in mind. We need to remember the role of a business is to increase profitability while reducing costs as much as possible.
Often, entrepreneurs are absorbed by a huge number of tasks related to building their companies. They wonder if what they are doing is going in the right direction. Is there any way to keep your finger on the pulse and evaluate your business decisions more accurately? Yes, there are appropriate indicators, which, when well measured, will show you the full picture of your company's condition. In this article, we'll show you what you can do with two very important SaaS metrics that will help you better control your company and lower your costs.
CLTV and CAC
There are two essential business metrics that allow entrepreneurs to get a better overview of their business. One of them shows us how much turnover one customer generates for our business. The other shows how much it costs us to acquire that customer. The combination of the two allows us to determine how long it will take to recoup our investment in acquiring a new customer. Let’s go through them and see how they work.
1. Customer Acquisition Cost (CAC)
To properly measure all customer retention values, we should know how much it costs us to acquire one customer. CAC is an indicator that shows us what acquisition costs we have to incur to get one client in a given period.
How to calculate CAC?
In small companies, this ratio can be calculated in a fairly simple way. You divide all the expenses you have incurred on marketing by the number of customers acquired. So, if you use SEO and Facebook ads in your marketing, you just need to add up all these costs and then divide them by the number of new customers acquired in a particular period to calculate the average CAC for both channels. Of course, you can also calculate this ratio for each channel separately. But let's focus on our example of the CAC in 1 month.
So, let’s say you spent a total of $3000 on SEO and Facebook advertising in a given month. You acquired 10 new customers through this. So you divide $3000 by 10 and get the result: $300. That’s how much it costs you on average to get one client.
The important thing is that this example shows a slightly simplified version for a small company, where we have fewer costs than in a large organization. In a small company, we can use CAC to count the cost of activities, as well as the cost per advertising campaign. Larger businesses also include things like:
- expenses for marketing tools;
- marketing staff salaries;
- advertising agency salaries;
- costs of various promotional materials.
We can also use CAC to see which segments will be the most attractive in terms of resource consumption. It is also worth noting that knowing this parameter is very important for investors, as it allows them to assess the profitability and scalability of the company.
There’s also one thing you should keep in mind. Sometimes customer acquisition can take much longer. It may take a month or more. Then you may find that putting CAC and LTV together is not entirely meaningful, as customers may only convert at a later stage. In this case, it is worth considering a longer period to count the data.
2. Customer Lifetime Value (CLTV or LTV)
Businesses often look at customers in terms of how much a particular transaction amounts to. But it's worth looking a little wider and considering how much that customer is really worth to our business in the context of all the time they spend with us. Customer LTV, CLTV (or just LTV) is one of the primary metrics that allows businesses to measure how much turnover a single customer generates. No matter what product you have, this is worth measuring.
What can you read from LTV?
If it's increasing or staying the same, it means you're ok. If, on the other hand, LTV is going down, it could mean that either your customers are leaving faster than you assumed or your customers have low value to your business.
Why should you measure LTV in your business?
- Proper customer value management allows businesses to better understand the entire time a customer is with us. This, in turn, provides the opportunity to create a better customer experience and make customers happier.
- LTV also allows you to identify the customers who bring the most money into your business. This gives you a better idea of what is important to these individuals. So it also gives you the ability to determine which customers might be interested in using a wider range of your services.
- The more you know about how much customers typically invest in your solutions, the more you will be able to tailor your sales strategy, product value, and communications to meet the needs of your customers. This obviously translates into more prospects who will be able to equate the appropriate value of your product/service with its price.
- We've already mentioned that acquiring a new customer is usually more expensive than retaining a current one. Research indicates that the difference in cost can be quite large. Harvard Business Review indicated in their article that it can be 5 to 25 times more expensive to gain new business. This shows the importance of identifying customers who are firmly committed to using your product or service. The more you make sure you properly retain your current customers, the more you will reduce the cost of acquiring new business.
- Knowing CLTV will also allow you to look at the different segments in which you are acquiring customers and figure out which ones are most profitable for you long-term.
- Using CLTV also gives your company an opportunity to implement methods such as up-selling and cross-selling. Knowing that a customer spends a long business time with you, you can better sense at what moments such a person will be open to buying more products from us or expanding a current product with new features. As a result, you can simply increase sales in your company.
How to calculate LTV
LTV is also one of these metrics that can be calculated in a simplified or complex way, depending on what data you want to take into account, what market you are in, and how long you have been in the market. Calculating LTV allows you to see how much a customer is worth to your company over a specific time frame. That is, how much revenue they are able to generate for your business.
Let's say your customers on average pay $20 per month for your solution and they are with your company for an average of 3 months. The value of that customer to your business would be $60. So, you just multiply the average purchase value of a customer by their average lifespan. The simple formula you can use is:
LTV = Average purchase value x Average customer lifespan.
LTV : CAC ratio
What is LTV : CAC ratio
The LTV:CAC ratio allows us to compare the value of a customer to how much it costs us to acquire them. Knowing the ratio of customer value to spend, you can estimate how much the direction of your business makes economic sense. You see how much you spend on sales, marketing, and customer service activities, and then you are able to translate that into how much growth they generate. With this information, you have good foundations for structuring your sales and marketing processes accordingly to create an effective strategy tailored to your company.
How to calculate LTV : CAC ratio
Once you've calculated LTV and CAC, simply divide LTV by CAC. For example, if your LTV is $3,000 and your customer acquisition cost is $1,000, your RATIO is correct: 3:1. On the other hand, if you find that the customer value is $700, with you having to spend $1,500 to acquire the customer, it's clear at a glance that you're spending more than you're able to earn. Therefore, a simple math trick will give you a quick idea of the effectiveness of your business efforts.
Is there a perfect ratio?
What is an ideal LTV CAC ratio for a growing SaaS business? It is very often said that LTV : CAC Ratio should be 3:1. In other words, how much you spend to acquire one customer should be three times less than how much that customer can provide you with money. Then we can talk about healthy business growth, which means the earnings from a customer far exceed what we have to spend.
What to consider
Using the LTV:CAC Ratio, you can determine how much you should be spending on marketing and sales in your business to maintain the growth you expect. On the other hand, it's important to remember that everything in business changes over time. In practice, if new players enter the market and your customers' attention is drawn away, LTV can suddenly drop, which will have an impact on LTV:CAC Ratio. Therefore, it is important to remember that using these tools is good when you keep track of these parameters.