If you’re looking to improve your LTV/CAC, then you need to know what is a good CAC to LTV ratio. Keep reading to find out!
I remember when I first started my business, I had no idea what this metric meant or how it could impact my bottom line. After doing some research, I realized that having a good CAC to LTV ratio was essential for ensuring the long-term success of my company. Since then, I’ve made it a point to track this metric closely and make sure that our ratios are in good shape. If you’re not sure what is a good CAC to LTV ratio, keep reading – we’ll cover everything you need to know.
What is a Good CAC to LTV Ratio
The Customer Lifetime Value (LTV) to Customer Acquisition Cost (CAC) ratio measures how the value of each customer stacks up against the cost of its acquisition.
For example, if your LTV to CAC ratio is 2:1, then the lifetime value is twice the amount you spent for acquiring the customer.
The LTV/CAC ratio is a simple way to understand how much profit each customer is generating for your business.
If you’re a software as a service (SaaS) company, then this metric is important to your bottom line.
The LTV-CAC metric tells you if the revenue your customers generate justifies the resources you put into acquiring them.
It can also be a good indicator of the health and growth potential of your business
This article will teach you how to calculate both the LTV and the CAC and how to combine them to help you make sound decisions.
What is LTV or Customer Lifetime Value?
The customer lifetime value is the total amount of revenue a customer generates for your business while they are your customer.
It costs five times more to acquire new customers than to retain existing ones. This makes the LTV a key metric to ensure that your business is getting value from keeping your customers.
How To Calculate LTV
The simple formula for determining LTV is to divide revenue by churn rate.
Lifetime Value (LTV) = Average Revenue Per Account (ARPA) / Customer Churn Rate
Although this basic calculation gives you a good estimation of your revenue, it ignores the volatility of monthly customer turnover.
A more conservative estimate of Lifetime Value (LTV) is found by adding a discount rate.
LTV = (ARPA / Customer Churn Rate) x 0.75
If you aren’t comfortable with adding a discount, you can alternatively calculate a customer’s worth by estimating their likely lifespan and dividing them into groups based on the likelihood of them leaving.
What Is CAC or Customer Acquisition Cost?
As a business owner, it’s important to be aware of your customer acquisition cost (CAC). This metric tells you how much it costs to acquire a new customer and can be a helpful guide in making decisions about marketing and sales campaigns. By understanding your CAC, you know where to allocate your resources for the best return on investment.
How To Calculate CAC
To figure out your CAC, add all of your marketing and sales expenses for a month or a year and divide that number by the total number of customers you gained during that same period.
So, CAC is:
CAC = (Total sales and marketing costs) / (number of new customers)
What Is The Formula for LTV/CAC Ratio?
Now that you’ve calculated your LTV and CAC, you can combine their values to find their ratio. To do this, simply divide LTV by CAC.
LTV:CAC Ratio = LTV / CAC
Here’s a quick example to show you how this formula works.
Let’s assume Company ABC spent $6,000 on social media marketing, $8,000 on Google AdWords, and $6,000 on other marketing activities. By doing so, it gained 1,200 customers.
The average revenue generated by each customer is $40 and the churn rate is 20%.
LTV:CAC ratio = [(40/0.2) x 0.75] / [(6000+8000+6000)/1200]
LTV:CAC ratio = 150/16.67
LTV:CAC ratio = 9:1
This means that every customer generated 9 times more value than what the company spent acquiring it.
What LTV/CAC Ratio Should You Aim For?
The most basic rule of the LTV/CAC ratio is that it should be greater than 1. If it’s greater, then that means that the value of a customer is greater than the cost of acquiring them.
An LTV/CAC ratio lower than 1 means that you are spending more to bring the customer in the door than you eventually recoup in revenue from their business. This is not a sustainable business model and will eventually lead to financial losses.
The question of how much more than 1 should be your LTV/CAC ratio may depend on the nature of your industry and your business plan.
In general, a 3:1 ratio of LTV to CAC is optimal. This means that the amount of money that a customer brings in is three times more than what it cost to acquire them.
But that formula doesn’t necessarily apply to all businesses. For example, if you have very predictable customer lifetime values, you can lower your ratio.
A 3:1 ratio is high enough to provide a cushion in case your margins go high or low. If you don’t need a buffer, you can succeed with a lower ratio.
In terms of business goals, if you’re anticipating a big exit or equity raise, then you should keep your LTV-CAC ratio high. This shows investors that your profit margins are healthy and that your revenue growth is rapid.
If you’re only looking to maintain your business and grow your customer base, the baseline ratio is enough.
3 Reasons Your LTV/CAC Might Be Low
If your LTV is lower than your CAC, it means you’re losing money. If your LTV to CAC ratio is within the 2:1 range, you still want to aim for 3:1 or higher.
Here are three reasons why your LTV to CAC ratio is low.
1. You’re Not Upselling Enough
It’s important to keep your customer success and sales teams in the loop. Upselling at appropriate times will help maintain good relationships with your customers and keep them happy.
2. Customers Churn Early
When companies fail to meet their customers’ expectations, they will leave. To prevent this, businesses need to ensure that their products or services are meeting their customer’s requirements.
The marketing and sales departments need to revisit the company’s ICPs to ensure product-market fit, build excitement, and keep clear communication open regarding new features or developments. These departments must work together closely to avoid any potential customer churn.
The product department may also need to work on developing the product more so that it meets the customer’s needs and wants.
3. C-Suite Involvement
Your CAC calculation should include the salaries of everyone involved in a sale. This ensures that your CAC is fully weighted and accurate. If executive leadership is part of the sales process, their salaries are included in your CAC calculation.
The founder-selling model can be beneficial early on, but it can also lengthen the payback period for your customer acquisition costs. It’s important to find the right time to build a dedicated sales team with an exclusive sales function.
How to Raise Your LTV/CAC Ratio
When finance collaborates with other departments and helps them understand the “why,” it’s able to become a more strategic business partner in growing the business.
Increasing your Lifetime Value and Customer Acquisition Cost are the two primary ways you can improve your overall profitability.
To improve your customer acquisition costs, it is important to have a good understanding of your target market and customers. Marketing strategies should be focused on efficient channels that have a high conversion rate, such as social media or content optimization. By collaborating with sales, you can get a better idea of what works and what doesn’t to further improve your CAC.
This keeps potential clients in the sales funnel, which makes it easier for your sales team to follow up with them.
The sales department can improve their LTV/CAC by looking at how to shorten and speed up the sales cycle. This will lessen the impact of their salaries and time on CAC.
If Lifetime Value (LTV) needs to be improved, one way to do so is to update your software-as-a-service (SaaS) pricing model.
You may need to change your model from subscription-based to more use- or pay-per-use. Or, you may just need to raise your rates.
In addition to selling the product, sales may upsell or cross-sell other products or services.
Customer lifetime value (LTV) is greatly affected by how well your marketing and sales teams are in sync. How well are your sales and marketing departments communicating?
Are you noticing an uptick in your product usage when new updates are released? Can you analyze your retention rates and renewal rates by customer service reps to better understand performance?
Finance has access to a wealth of data that can help answer important questions about reducing churn and improving LTV. By analyzing this data, finance can unlock insights that can help improve company performance.
If you’re looking to improve your LTV/CAC, then knowing what is a good CAC to LTV ratio is essential. Keep track of this metric closely and make sure that your ratios are in good shape to ensure the long-term success of your company!