Are you a software company? Or at risk of becoming a professional services company?
When it comes to knowing your customers’ value and costs, there are two key SaaS metrics to consider: Customer Lifetime Value (LTV or CLV) and Customer Acquisition Cost (CAC). They will be your best buddies while making decisions and scoping your marketing and sales performance. We’ll be taking a deeper dive into them in the following sections.
Customer Lifetime Value
In marketing, Customer Lifetime Value or Lifetime Value is an estimate of the net profit contributed to the future relationship with a customer. In other words, it is the average revenue that a customer will generate throughout their lifespan as a customer. This metric is important because it represents an upper limit on spending to acquire new customers.
The purpose of the CLV is to assess the financial value of each customer. This metric differs from customer profitability in the latter measures the past, and CLV looks forward. CLV can be more useful in shaping your marketing leadership decisions but is much more difficult to quantify. While quantifying CP is carefully reporting and summarizing past activity results, quantifying CLV involves forecasting future activity.
There are many ways to calculate CLV. Depending on your business needs and conditions, the CLV formula can be as complex as you want it to be. Let’s take two examples: If we assume the yearly discount rate is 0% (more on this later), we can calculate a simple CLV model. If you charge on average $100/month per customer, and your churn rate, in the same period, is 2%, then your CLV formula is as follows:
In this case, your CLV is equal to $5,000 or 50 months.
Now, let’s see example number two. In this one, we assume a discount rate different than 0%; this is also known as the cost of capital, a variable present in all calculations of the time value of money. That being said, if we assume a yearly discount rate of 7% and we keep the rest as the last example, our formula would change to this new one:
First, we need to clarify the new variables: I is for revenue, r is for retention rate, and d is the discount rate. For the equation to make financial sense, we need to divide the yearly discount rate by twelve; that way, we get the monthly average we need to calculate the CLV in this particular example. Now the CLV is $3,793.55 or approximately 38 months.
There are different ways to take a reference as the yearly discount rate, it could be actual interest rates or the inflation rate, but it will depend on each case you work. We used a random number for the sake of this example.
Customer Acquisition Cost
Customer Acquisition Cost (CAC) is the marketing and sales cost associated with attracting a new customer to buy a product or service over a period of time. With CAC, companies can measure the money spent on acquiring new customers and help determine profitability. That’s why it is frequently combined with CLV.
To calculate your CAC, first, you need to establish the time period of study. This will help you gather the precise data you need. With this information, you can know all the other sales and marketing costs that would go into calculating the CAC. These can include salaries, bonuses, commissions, creative costs, production costs, Ad expenditure, technical costs, inventory upkeep, and overhead associated with attracting leads and converting them into new customers.
For example, suppose your company spends $100,000 on marketing, $200,000 on sales, and generates 1,000 customers over a year. In that case, you can calculate the value of your CAC following the next formula:
Companies are always looking to reduce their CAC not just to obtain higher profitability margins but because they want to optimize as much as possible their marketing, sales, and customer service efforts. Spending less money while generating the same or even more customers means you’re using your budget more efficiently, which translates into positive signs from your marketing and sales teams' performance. So if you’re looking to reduce your Customer Acquisition Cost, take a look at the variables you’re using and find ways to optimize them.
CLV to CAC ratio
As said in the section before, CAC tends to be studied in pairs with CLV. This is because you’re comparing how much you are spending to get a new customer against the revenue you’re getting from it. There’s a general consensus on the ideal CLV to CAC ratio, but we’re explaining all of them.
If you’re at a 1:1 ratio or close to it, you’re spending as much money to get new customers as they’re spending on your products or services. If you are lower than 1:1, it means you’re spending more money on converting new customers than you’re getting from them. Now, it is considered a good ratio to be 3:1, meaning your customers are worth three times more than the cost of acquiring them. But you don’t want to be much higher than the last ratio. If you’re closer to 5:1, you’re likely not spending enough on your marketing and sales efforts and therefore missing on potential opportunities to grow your customer base.
The importance of measuring LTV and CAC
To make well-informed business decisions on why, when, and how to allocate your resources, you need to carefully calculate the metrics explained before. Only then can you estimate your long-term business goals and how to adapt if you’re needed to.
Take your time now and research how your company’s CLV and CAC are doing!
To learn more about SaaS metrics, check out the following: