LTV/CAC Ratio: the Metric You Must Be Aware of in Digital Product Development

 Customer Acquisition Cost (CAC) Formula

Customer Acquisition Cost includes all expenses related to your brand’s marketing and sales activities for a given period (sales spending + marketing spending). This amount mustn’t include employee salaries as those aren’t directly related to CAC.

The easiest way to calculate the cost of customer acquisition is to divide the sum of your marketing costs and sales investments by the number of paying customers acquired. Correctly calculating acquisition costs is very important to ensure that the rest of your calculations are not biased.

Be careful not to confuse CAC with the cost of acquiring new customers in general (CAV = Cost of Acquiring Visits). Do not include costs related to CAV in your calculations.

Customer Churn Rate

The customer churn rate represents the percentage of customers who unsubscribe or cease to use your product or service. In general, the average product in a recurring subscription usually has a 3 to 5% monthly churn rate.

With this percentage, you’ll be able to calculate the lifetime value of a customer, i.e., the average income that a customer will generate throughout the entire duration of their subscription. This number is also a key indicator of customer turnover and loyalty.

How to Calculate Lifetime Value (LTV)

Lifetime Value (LTV) is the estimated total profit that a single customer will yield to the company throughout their entire relationship or subscription period. If you’re launching a new digital product, it is very important that you understand this formula.

You’ll need to take into account the churn rate. Here’s how to calculate LTV: divide the average revenue per subscriber by the churn percentage. Your subscription software should automatically calculate the latter. This formula will give you the approximate value of a paying customer.

Now that you understand LTV and that you know how to calculate CAC, you need to figure out how these two metrics relate. The ratio between these two numbers will determine whether or not a customer’s average Lifetime Value (LTV) is high enough when compared to cost of acquisition.

You should be aiming for a 3:1 LTV to CAC ratio. This means that a customer’s lifetime value should be at least three times greater than its acquisition cost.

Why is the LTV CAC Ratio Relevant for your company?

Being aware of your project’s LTV to CAC ratio will allow you to properly assess its sustainability as well as contribute to improving your marketing strategies. It will help you measure the efficiency of your marketing and sales campaigns. 

For example, having a 3:1 ratio is an indicator that your project is not generating enough revenue. Your project is therefore not feasible in the long run. You’ll need to take action to increase profit or reduce Customer Acquisition Costs if you want a healthy business. You could, for example, shorten your sales cycle.

On the other hand, if your ratio is higher than 5:1, then that’s an indicator of growth potential. You could afford to invest more money into project development. 

LTV to CAC ratio will tell you whether or not your business model is viable. It allows you to understand how effectively your company is utilizing its resources. This ratio can give you insight on various aspects of your business, including customer behaviour and overall performance.

An LTV to CAC ratio lower than 3:1 may indicate that:

• Customer Lifetime Value is too low
• Conversion rate is too low
• Retention rate is too low
• Customer Acquisition Strategy Cost is too high

To find out where the problem lies and to choose the best strategy for your business, you’ll need to analyze your Key Performance Indicators (KPIs).

Here’s a bit of food for thought:

• Analyze the CAC payback period: for how many months must a customer keep their subscription for the acquisition cost to be covered? Compare this number with the retention rate. For example, if you need customers to remain subscribed for 8 months ($800) to cover CAC, but you have a 5-month retention rate ($500), then your problem is a low retention rate. You must therefore discover why your customers are unsubscribing so quickly. In this particular example, the ideal retention rate would be 24 months, i.e., 3 times the cost of acquisition.
• Analyze the conversion rate of your acquisition channels: this will allow you to reduce the cost of acquiring paying customers. You must optimize the conversion steps that are key to a visitor becoming a paying customer. If your conversion rate is low, it may be wise to work on optimization levers or to go with a more efficient acquisition channel.
• Study your CAC: Is it too high? Could you lower customer acquisition costs by switching communication methods used to reach your target audience? Or simply by using a different acquisition channel?
• Look into your retention rate: is your churn rate superior to the average churn rate in your field? The number of subscriptions cancelled reduces Lifetime Value (LTV), which has a negative impact on your LTV to CAC ratio. If that’s the case, then the solution to your problem may lie in improving customer loyalty strategies.

Basically, you can improve your ratio by either improving customer value, reducing acquisition costs or improving customer retention.

It’s no secret that being able to track and analyze your company’s KPIs will allow you to make well-informed decisions that will help you achieve your growth goals.

As a business owner, there are several indicators that you can (should) keep track of. The LTV to CAC ratio is probably the most important one to keep an eye on if a digital product is what you’re launching. Listen to the Pivot podcast for more advice on how to reach the success level that lives up to your ambitions.

You’re an ambitious entrepreneur and you’ve got a digital product you’re looking to launch?

You might be interested in Pirate Metrics! We’re referring to the AARRR acronym:

• Acquisition (assess how people find you)
• Activation (are those that do find you taking the action you anticipated?)
• Retention (do the customers you’ve converted continue to be interested in your product or service?)
• Referral (find out if your customers are talking about your product).
• Revenue (find out if your ideal customer is willing to pay for your product).

Understanding and managing Customer Lifetime Value (CLV) and Customer Acquisition Cost (CAC) are essential for any business leader focused on long-term growth and profitability. By striking the right balance between these two critical metrics, companies can optimize their marketing strategies, enhance customer retention, and ensure that their investment in customer acquisition yields sustainable returns. In an increasingly competitive market, the ability to maximize CLV while controlling CAC is a powerful lever for driving business success.

As you continue to explore strategies for optimizing your business’s growth, it’s important to understand the role of Minimum Viable Product (MVP) in software development. An MVP allows businesses to validate their product ideas with minimal investment, reducing the risk and cost associated with customer acquisition. To learn more about how MVPs can complement your efforts in managing CLV and CAC, read our article: What is MVP in Software Development?

• Definition and Importance of CLV and CAC:
  • CLV represents the total revenue a business can expect from a customer over their entire relationship.
  • CAC is the cost associated with acquiring a new customer.
  • Balancing these metrics is crucial for profitable growth.
• Calculating CLV and CAC:
  • CLV can be calculated using average purchase value, purchase frequency, and customer lifespan.
  • CAC is calculated by dividing the total cost of acquiring customers by the number of new customers gained.
• Strategies to Optimize CLV:
  • Focus on customer retention through personalized marketing, loyalty programs, and excellent customer service.
  • Encourage repeat purchases and increase the average order value.
• Managing and Reducing CAC:
  • Improve targeting and segmentation in marketing campaigns to acquire high-value customers at a lower cost.
  • Utilize data analytics to refine customer acquisition strategies.
• Balancing CLV and CAC for Growth:
  • Regularly monitor and adjust strategies to ensure a favorable CLV to CAC ratio.
  • Invest in both customer acquisition and retention to create a sustainable growth model.