The concepts of customer acquisition cost vs lifetime value are fundamental to running a profitable and successful business. But what happens when customer acquisition costs begin to eclipse lifetime value? The mattress company Casper experienced this challenge as their rapid growth strategy came at a price.
In this post, you’ll learn the definitions of CAC and LTV, their differences, how to calculate each metric, and how to optimize customer acquisition cost vs lifetime value so you can set up your business for success. You’ll learn from the missteps of prominent companies, what factors affect these metrics, and discover strategies to build a customer base that continues to add to your bottom line long-term.
What Is Customer Acquisition Cost?
Customer acquisition cost (CAC) measures all direct and indirect expenses involved in turning a potential customer into a paying one. It considers things like advertising costs, content marketing efforts, marketing and sales team salaries, and free trials or freemium subscriptions you might offer to attract users.
Monitoring CAC over time will show you the efficiency of your marketing campaigns and the effectiveness of your overall growth strategy. It will also reveal customer segments where your money might be best spent. Tracking and measuring CAC can prevent costly business setbacks like those faced by Blue Apron, a prominent meal-kit company.
Why Tracking Customer Acquisition Costs Is Important
Despite offering a convenient and helpful service, Blue Apron’s aggressive marketing tactics to acquire new customers, primarily via paid advertising and partnerships, failed to consider the long-term financial sustainability of the business. They encountered the common challenge of acquiring customers but having a low customer lifetime value (LTV) that made achieving profit elusive.
Blue Apron reported their customer acquisition cost as approximately $94 per customer. However, experts say it is closer to somewhere between $150 to $400. As you’ll see as you learn about LTV:CAC ratios, a high CAC and low LTV is a recipe for financial struggle.
Another company that garnered media attention for having high customer acquisition costs and ultimately failing to turn a profit was Casper, the popular mattress company. The initial public offering (IPO) painted an optimistic picture, but in reality, the brand wasn’t recouping the costs associated with converting leads. Forbes even called it the “Latest Money-Losing IPO.” So, you’re probably wondering how customer lifetime value fits into all of this.
What Is Customer Lifetime Value?
Customer lifetime value (LTV or CLV) refers to the predicted total amount of revenue one paying customer will contribute to your business during your relationship. Essentially, it’s the average revenue from a customer based on how much and how often they buy from you. However, simply using a customer’s first purchase isn’t an accurate measurement of CLV, because many external factors can influence a customer’s decision to buy.
Andreessen Horowitz advises prioritizing contribution margin instead of gross margin. This ensures that variable expenses like radio advertising and overhead aren’t reflected in your CLV calculations. Using contribution margin allows for a more precise understanding of true profitability associated with your customer relationships.
A more complex breakdown of how to calculate LTV will include calculations for purchase frequency rate and average lifespan.
Why Calculating Lifetime Value Matters
A 2022 SimplicityDX study highlighted that CAC has skyrocketed by 222% over the past eight years. A number of things have contributed to this phenomenon, such as stricter regulations from laws like the General Data Protection Regulation (GDPR).
iOS updates, such as the introduction of iOS 14.5 and the fall of third-party cookies, also play a part. As online advertising becomes less effective and consumer privacy gets more complex, finding creative and reliable ways to reduce CAC is paramount. But although reducing customer acquisition cost is one path to higher profits, focusing on acquiring new customers while neglecting existing ones can significantly damage long-term financial stability.
Customer retention, rather than consistent new acquisition, helps drive profitable and sustainable growth. This is because these customers cost considerably less. These repeat customers cost six to seven times less and spend more (up to 67%) compared to first-time customers. Understanding LTV, rather than focusing on how much they spend with you once, illuminates the importance of retaining existing customers. This encourages brands to allocate more of their budget to retention tactics like email marketing and loyalty programs.
What’s the Connection Between Customer Acquisition Cost and Lifetime Value?
Evaluating the profitability of your marketing strategy and the sustainability of your business growth starts with understanding customer acquisition cost vs lifetime value. Most companies monitor and track CAC vs. LTV to ensure their acquisition costs aren’t overshadowing the long-term value their customers provide. Balancing growth and profitability starts with examining the relationship between customer acquisition cost vs lifetime value. To help quantify and evaluate this relationship, we’ll need to discuss the LTV:CAC ratio.
LTV:CAC Ratio
Simply put, an LTV:CAC ratio, or LTV to CAC ratio, provides a snapshot of how much your customers spend with you relative to what you spend acquiring them. The LTV/CAC ratio helps determine where to invest your money to maximize profitability and drive the best returns.
To calculate LTV/CAC, simply divide your business’s lifetime value for a particular period by the customer acquisition cost during the same timeframe. For example, if your LTV is $6,000, and your CAC is $2,000, your LTV:CAC would be 3:1 (6000 divided by 2000). In other words, for every $1 spent acquiring new customers, your business earns $3 in revenue.
Understanding What Constitutes a Good LTV:CAC
In general, merchants tend to focus on achieving an LTV:CAC ratio greater than three. But certain variables influence the most beneficial LTV to CAC ratio, such as whether you’re a rapidly growing startup or a well-established brand. Another important variable to factor in is your competitive landscape.
But when examining LTV:CAC ratios, businesses must understand that high ratios can indicate lost growth potential. While achieving a good ratio sounds optimal, spending too little on customer acquisition means your growth will likely be significantly stunted, especially as your brand gets established and gains traction.
Industry Benchmarks
This table showcases various LTV:CAC ratios from various industries:
| Industry | LTV | CAC | LTV:CAC Ratio |
|---|---|---|---|
| Business Consulting | $2,622 | $656 | $4:1 |
| eCommerce | $252 | $84 | 3:1 |
| Legal Services | $4,115 | $915 | 4.5:1 |
| Software-as-a-service (B2C) | $2,306 | $166 | 2.5:1 |
| Software-as-a-service (B2B) | $664 | $664 | 4:1 |
Source: First Page Sage
As this research demonstrates, a healthy LTV:CAC varies across industries and business models. This further underscores the importance of prioritizing metrics that align with your industry’s averages. Marketing metrics will differ from industry to industry, so be sure to follow the averages for yours.
Optimizing Customer Acquisition Cost vs Lifetime Value
Effectively managing your business’s customer acquisition cost vs lifetime value involves various marketing, pricing, and sales expenses. Strategies should be geared towards driving conversion rate optimization, retention tactics, and increasing customer loyalty. Here are a few methods you can use to improve customer lifetime value.
Free Shipping Threshold
Offering a free shipping threshold that unlocks free shipping is a great way to encourage customers to spend more. A real-world example of this tactic is from The Honest Company, which sells a diverse range of baby and personal care products. Rather than just advertising a minimum spend, they gamify the concept of reaching the $20 free shipping threshold.
They do this by presenting it as a fun challenge that will unlock free shipping. It creates a feeling of urgency to reach the threshold and discourages shopping cart abandonment, especially when the shipping threshold is achievable.
Gamification with a Loyalty Program
One of the easiest ways to inspire customers to keep spending with you is a rewards-based loyalty program, like Starbucks Rewards. You’ve probably used it at least once. Their framework is simple. Customers earn points (“Stars” in the case of Starbucks) with every purchase that can be redeemed later for rewards like discounts or free drinks. It incentivizes returning customers to spend and offers free advertising when these customers recommend your loyalty program to friends.
Introduce a Subscription Program
Although subscription programs are ubiquitous in the age of direct-to-consumer commerce, it still serves as an exceptional method to elevate customer lifetime value. Think Yankee Candle, for example. Their prepaid subscription plans provide consumers with substantial savings and simplify their purchasing process, meaning customers will buy candles automatically.
Compared to traditional bulk-buying approaches, subscriptions offer enhanced savings and alleviate the need for customers to physically pick up, transport, and store bulk quantities. Having an easy checkout process is important for customer retention.
Frequently Asked Questions about Customer Acquisition Cost vs Lifetime Value
Q. What is the relationship between lifetime value and customer acquisition cost?
A. Lifetime value and customer acquisition cost represent two critical metrics that directly impact the overall profitability and sustainable growth of any company. An ideal scenario involves keeping your customer acquisition costs lower than the value of the customers, signifying profitability.
Q. What is a good CAC to LTV ratio?
A. Generally speaking, a CAC:LTV ratio greater than 3 is considered favorable across various industries. A 3:1 ratio suggests that you generate $3 in revenue for each dollar you invest in acquiring a new customer. This indicates efficient allocation of marketing funds and signifies robust customer relationships.
However, it’s vital to remember that a ratio significantly higher than 3:1 may point towards underspending on acquisition efforts and a possible loss of valuable growth opportunities. Balancing LTV and CAC through consistent measurement and proactive adjustment of strategies, including acquisition, retention, pricing, and product enhancement is paramount.
Q. What is the difference between CLV and CAC?
A. CLV and CAC represent fundamental yet contrasting metrics for evaluating the economic success of your company. CLV refers to the expected monetary value of a customer during their association with your business, considering purchase behavior, product pricing, and churn rate. Contrarily, CAC specifically reflects the expenses you bear to secure a new paying customer, including social media campaigns, sales, and related expenses.
Q. What is the biggest difference between CPA and CLV analysis?
A. Cost per acquisition (CPA) and CLV analysis present different, yet complementary perspectives on customer engagement and business performance. CPA highlights immediate acquisition efficiency, evaluating marketing channels’ cost-effectiveness by measuring the cost of gaining a single customer. Meanwhile, CLV extends the analytical horizon, projecting a customer’s cumulative worth throughout their entire lifespan with the business.
By understanding and measuring each, you’ll be able to establish the proper balance to enhance financial sustainability and fuel sustainable business growth. If your CPA is high, it may be a result of ineffective advertisement design.
Final Thought
While diving into customer acquisition cost vs lifetime value can seem a little complicated, remember, you’re ultimately looking to make sure you aren’t overspending to attract new customers. Your efforts will be rewarded. You’ll create loyal customers that return for more and recommend you to others. If you use what you’ve learned in this article about optimizing your customer acquisition cost vs lifetime value and tracking these metrics carefully, you’ll be set to position your company for long-term success, ensuring sustainable and profitable business growth.
