Customer Acquisition Cost (CAC)
Formula: CAC = Total Marketing and Sales Expenses/ Number of New Customers Acquire
Concept: Customer Acquisition Cost (CAC) represents the total cost of acquiring a new customer. This includes all the marketing and sales expenses incurred to attract and convert a potential lead into a paying customer. These expenses can include:
- Advertising costs
- Salaries of marketing and sales staff
- Software and tools used for marketing and sales
- Promotional and event costs
- Any other expenses directly related to acquiring customers
Example: If a company spends $10,000 on marketing and sales in a month and acquires 100 new customers, the CAC would be: $$100. So, the company spends $100 to acquire each new customer.
Customer Lifetime Value (LTV)
Formula: LTV=Average Revenue per Customer X Gross Margin X Customer Lifetime = Customer Lifetime Value (LTV)
Concept: Customer Lifetime Value (LTV) is a prediction of the net profit attributed to the entire future relationship with a customer. It considers the revenue a customer brings in, the gross margin (revenue minus the cost of goods sold), and the duration the customer remains active.
Example: If a customer spends $200 per year on a company’s services, the gross margin is 70%, and the average customer stays for 5 years, the LTV would be: LTV=200×0.70×5=$700. So, each customer is expected to generate $700 in profit over their lifetime.
LTV/CAC Ratio
Formula: LTV/CAC=Customer Lifetime Value / Customer Acquisition Cost
Concept: The LTV/CAC ratio measures the relationship between the value of a customer over their lifetime and the cost to acquire that customer. A higher LTV/CAC ratio indicates that the business is generating more value from its customers compared to the cost of acquiring them. This ratio helps businesses evaluate the efficiency and profitability of their customer acquisition efforts.
Ideal Ratio: An LTV/CAC ratio of 3:1 is generally considered healthy, meaning that the value generated by customers is three times the cost of acquiring them. Ratios lower than this may indicate that acquisition costs are too high, while much higher ratios might suggest that the business could invest more in acquiring customers to grow faster.
Example: Using the previous examples:
- LTV = $700
- CAC = $100
The LTV/CAC ratio would be: LTV/CAC=700 / 100 = 7
This indicates that for every dollar spent on acquiring a customer, the business expects to generate $7 in value from that customer over their lifetime.
Summary
- CAC helps you understand how much you are spending to acquire each new customer.
- LTV helps you understand the total value a customer brings to your business over their entire relationship with you.
- LTV/CAC ratio helps you assess the efficiency and profitability of your customer acquisition strategies.
By analyzing these metrics, businesses can make informed decisions about their marketing and sales strategies, optimize their spending, and ultimately improve profitability