Calculating LTV and CAC ratios

The Art and Science of Calculating LTV and CAC for Firehawk Analytics Clients

Calculating Lifetime Value (LTV) and Customer Acquisition Cost (CAC) is essential for understanding the profitability and efficiency of your business's marketing efforts. However, this task can be particularly challenging for earlier-stage businesses with limited historical data. At Firehawk Analytics, we blend art and science to help our clients accurately calculate these metrics, enabling them to make informed decisions that drive sustainable growth.

Understanding LTV and CAC

Lifetime Value (LTV)

Definition: Lifetime Value (LTV) is the predicted net profit attributed to the entire future relationship with a customer, considering the gross margin rather than total revenue. It helps businesses understand how much a customer is worth over the duration of their relationship.

Formula: 

LTV=Average Purchase Value×Purchase Frequency×Customer Lifespan×Gross Margin Percentage

• Average Purchase Value: Total revenue divided by the number of purchases.
• Purchase Frequency: Number of purchases divided by the number of unique customers.
• Customer Lifespan: Average number of months or years a customer continues to purchase.
• Gross Margin Percentage: The percentage of revenue remaining after deducting the cost of goods sold (COGS).

Worked Example:

1. Average Purchase Value: If the total revenue for a year is $100,000 from 1,000 purchases, the average purchase value is: $100,000÷1,000=$100

2. Purchase Frequency: If you have 200 unique customers making those 1,000 purchases, the purchase frequency is: 1,000÷200=5

3. Customer Lifespan: If customers typically remain active for 3 years, the customer lifespan is: 3 years

4. Gross Margin Percentage: If the gross margin is 60%, then the gross margin as a decimal is: 0.60

5. LTV Calculation: LTV=$100×5×3×0.60=$900

This means each customer is worth $900 over their lifetime in terms of gross profit.

Customer Acquisition Cost (CAC)

Definition: Customer Acquisition Cost (CAC) is the total cost of acquiring a new customer. It includes all marketing expenses such as advertising, sales, and any other costs associated with bringing in new customers.

Formula:

CAC=Number of New Customers Acquired/Total Marketing and Sales Expenses​

Worked Example:

1. Total Marketing and Sales Expenses: If you spend $50,000 on marketing and sales in a year.

2. Number of New Customers Acquired: If you acquire 500 new customers during that year.

3. CAC Calculation: CAC=$50,000500=$100

This means it costs $100 to acquire each new customer.

The LTV to CAC Ratio

Definition: The LTV to CAC ratio is a key metric that indicates the relationship between the value of a customer over their lifetime and the cost of acquiring that customer. This ratio helps businesses assess the effectiveness and profitability of their customer acquisition efforts.

Formula:

LTV to CAC Ratio = LTV / CAC

Interpreting the Ratio:

• A ratio of 1:1 means you are breaking even; the cost to acquire a customer equals the gross profit they generate over their lifetime.
• A ratio less than 1:1 indicates a loss; it costs more to acquire a customer than the gross profit they bring in. This is a warning sign and that unless you can improve your LTV or reduce your acquition costs each new customer is costing you more than they are worth. Something that might be acceptable early on but is not sustainable.
• A ratio greater than 1:1 signifies profitability; the customer generates more gross profit than the cost to acquire them. Typically a ratio of more than 3x represents good value but this is not true for all industries.

What Constitutes a Good or Bad Ratio?

• SaaS and Subscription Businesses: Typically, a good LTV to CAC ratio is around 3:1. This means for every dollar spent on acquiring a customer, the customer generates three dollars in gross profit over their lifetime.
• E-commerce Businesses: A good ratio might be lower, around 2:1, due to higher competition and potentially lower margins.
• Highly Competitive Industries: In industries with high acquisition costs, even a ratio of 1.5:1 can be considered good.

Worked Example: Using the previous examples:

• LTV: $900
• CAC: $100

LTV to CAC Ratio=900 / 100 = 9x

This ratio of 9:1 indicates a highly profitable customer acquisition strategy.

The Challenges of Calculating LTV and CAC

For early-stage businesses, calculating LTV and CAC involves several challenges:

1. Accurate Marketing Spend Allocation: Distinguishing between brand marketing and acquisition costs can be difficult. Properly organising your chart of accounts can help separate these expenses and ensure accurate CAC calculations.

2. Estimating Churn: Without a long track record, predicting future churn rates can be speculative. Subscription businesses, in particular, may struggle to estimate how long customers will stay.

3. Tracking Repeat Customers in eCommerce: Identifying and tracking repeat customers can be challenging, making it hard to calculate LTV accurately.

4. Internal Resource Constraints: Many businesses lack the internal resources to dedicate the time required for thorough LTV and CAC analysis. Firehawk Analytics provides this analysis for our clients, freeing them to focus on their core operations.

The Benefits of Accurate LTV and CAC Calculations

Understanding LTV and CAC can transform your marketing strategy. By identifying customer cohorts with the highest LTV and marketing channels with the lowest CAC, you can optimise your marketing efforts for maximum return.

Practical Suggestions to Overcome Common Issues

1. Organise Your Chart of Accounts: Ensure your financial data is well-organised to separate brand marketing from acquisition costs. This clarity will improve the accuracy of your CAC calculations. You can read more about this by clicking here.

2. Leverage Early Data: For new businesses, use initial customer data to create early estimates. Monitor these metrics closely and adjust as more data becomes available.

3. Implement Robust Tracking Systems: Use advanced CRM and booking engines to track customer behavior. This data is crucial for accurate LTV calculations, especially in eCommerce businesses.

4. Utilise Firehawk Analytics’ Expertise: Our team assists clients in building LTV and CAC analysis into their Firehawk Analytics member portals, ensuring continuous monitoring and accurate calculations.

Firehawk Analytics’ Methodology

At Firehawk Analytics, we integrate data from multiple sources, combining financial information from your accounting platform with CRM and booking engine data. This comprehensive approach allows us to track individual and cohort customer behavior accurately.

Steps We Follow:

1. Data Collection: Gather financial and customer data from various platforms.
2. Data Preparation: Clean and organise the data to ensure accuracy.
3. Data Integration: Combine data from different sources to create a holistic view.
4. Analysis and Visualisation: Use advanced analytics and visualisation tools to calculate LTV and CAC and present the insights in an easily understandable format.

Real-World Impact

During onboarding, we discuss key performance metrics with our clients and assist them in building these into their Firehawk Analytics portals for constant analysis. This proactive approach ensures that businesses can continuously monitor and optimise their marketing strategies.

Conclusion

Accurately calculating LTV and CAC, and understanding the LTV to CAC ratio, is both an art and a science, especially for early-stage businesses. By leveraging Firehawk Analytics’ expertise and comprehensive data integration capabilities, businesses can overcome common challenges and make informed decisions that drive sustainable growth. Contact us today to learn how we can help you unlock the full potential of your business intelligence.