We talked a bit about the importance of considering your customer lifetime value (CLV) to customer acquisition cost (CAC) ratio in “Top 8 Metrics to Monitor as You Bring Together Your 2023 Plan.” So why a whole additional post devoted to CLV-to-CAC ratio? Because when you compare the worth of your customer over the course of their entire relationship with you to your cost to acquire that customer, it’s a brilliant way to gauge the long-term success of your business at a fundamental level.
To review: Your CLV-to-CAC ratio tells you how much the value of your customer exceeds your cost to acquire that customer. Take all your customers, and determine what the dollar value of an average customer brings during their lifetime. Is that number more or less than the amount you spent to acquire them? If you’re spending more to acquire them than the value a customer is bringing to you, then that’s not sustainable.
For a CLV-to-CAC ratio, 3:1 is a good benchmark; the higher the number, the more valuable your business. Start by breaking apart the ratio to calculate the two metrics separately. When it comes to the insight, you’ll want to bring them together to have a meaningful ratio.
Customer lifetime value (CLV)
For CLV, which measures the worth of your customers over their entire relationship with you, there are different ways to calculate it, and some of them are complex. Technically, the CLV metric is not a real revenue metric, because it includes a future component: What’s the value over the entire relationship? You may not see it in a financial report, so people often shy away from it. But it’s a really important metric, so start somewhere, then refine your assumptions over time as you learn more. It can be a challenge, but you are missing a valuable insight into your business if you don’t do it.
The traditional CLV calculation is a good place to start, because it’s precise, but it’s also doable, and there’s nothing required that is not available in your existing financials or with a simple assumption, which can then be tweaked.
CLV = average gross margin per customer × retention rate ÷ (1 + discount rate – retention rate)
The result of this formula tells you how much contribution you are getting per customer. An example: If your average customer spends $1,000 dollars with you, and it costs you $200 to make that product and deliver it to them, then you’re keeping $800 from that customer, so that’s your average gross margin per customer. For the retention rate, you calculate that as 1 minus your churn rate. Say you are retaining 80% of your customers, you would then multiply the $800 by 80%, which gives you an average gross margin per customer of $640.
The higher your retention rate, the higher that total contribution you get from the customer over their lifetime. The sum of 1 plus discount rate minus retention rate gives you a mathematical view into perpetuity. The rate of discounts is a way of incorporating future risk into the calculation — it could be risk around interest rate or general uncertainty, and that percentage typically would be between 10% and 20%. For the example we began above, we’d take $640 and divide it by 0.3 (the sum of 1 + 10% – 80%) for a CLV of $2,133.
Customer acquisition cost (CAC)
Once you have the CLV, you then need to compare it against what it costs to get that customer. The CAC is a lot easier to calculate:
CAC = amount spent on sales and marketing to acquire new customers ÷ number of customers acquired
If you spent $1,000 in a certain month on your sales and marketing efforts for new customers — not for retaining old ones or expanding relationships with existing ones —and you gain three new clients, then $1,000 divided by 3, or $333, would be your CAC for that month.
Using the numbers from the previous example, the CLV-to-CAC ratio for this business would be $2,133 to $333, or 6.4:1.
Since 3:1 or higher is a good benchmark, this business is primed for long-term success.
If any of this seems confusing, or you need some assistance to ensure you calculate an accurate ratio, please reach out to me. I’m happy to help.