• Customer Economics - Productivity

    LTV/CAC Ratio: What It Is & How to Calculate It

    March 11, 2022 - By 

    In today’s competitive business environment, understanding your customer economics is crucial for sustainable growth. One of the most powerful metrics to assess this is the LTV/CAC ratio — a key indicator that helps businesses understand the relationship between the value a customer brings and the cost it takes to acquire them.

    What Is the LTV/CAC Ratio?

    • LTV (Customer Lifetime Value) represents the total revenue or profit you expect to earn from a customer throughout their entire relationship with your business.
    • CAC (Customer Acquisition Cost) is the total cost incurred to acquire a new customer, including marketing, sales expenses, and onboarding.

    The LTV/CAC ratio compares these two numbers to determine whether acquiring customers is profitable. It tells you how much value you get back for every dollar spent on acquiring a customer.

    Why Is the LTV/CAC Ratio Important?

    This ratio provides insight into the efficiency and sustainability of your customer acquisition efforts. Here’s why it matters:

    • Profitability Check: A high LTV/CAC ratio indicates you’re making more from customers than you spend to get them.
    • Growth Potential: It guides your decisions on how much you can afford to invest in sales and marketing.
    • Investor Insight: Investors often look at this ratio to gauge the health of your business model.

    How to Calculate the LTV/CAC Ratio

    Step 1: Calculate Customer Lifetime Value (LTV)

    There are different ways to calculate LTV depending on your business model, but a common formula is:

    LTV = Average Purchase Value × Purchase Frequency × Customer Lifespan

    • Average Purchase Value: The average amount a customer spends per purchase.
    • Purchase Frequency: How often a customer buys from you in a given time period.
    • Customer Lifespan: The average duration a customer continues purchasing from your business.

    Alternatively, for subscription businesses, LTV can be calculated as:

    LTV = (Average Monthly Revenue per User × Gross Margin %) ÷ Churn Rate

    Step 2: Calculate Customer Acquisition Cost (CAC)

    Add up all sales and marketing costs during a period and divide by the number of customers acquired in that period:

    CAC = Total Sales & Marketing Expenses ÷ Number of New Customers Acquired

    Step 3: Calculate the LTV/CAC Ratio

    Simply divide LTV by CAC:

    LTV/CAC Ratio = Customer Lifetime Value ÷ Customer Acquisition Cost

    Interpreting the LTV/CAC Ratio

    • Ratio < 1: You’re spending more to acquire customers than they are worth — this is unsustainable.
    • Ratio = 1 to 3: This is generally considered healthy; for every dollar spent, you get $1 to $3 in return.
    • Ratio > 3: Indicates strong profitability and potential for growth, but could also mean you’re underinvesting in marketing.

    Tips to Improve Your LTV/CAC Ratio

    • Increase LTV: Enhance customer retention, upsell, cross-sell, and improve customer experience.
    • Lower CAC: Optimize your marketing channels, improve targeting, and increase sales efficiency.
    • Balance Growth and Profit: Avoid overspending on acquisition without increasing customer value.

    The LTV/CAC ratio is a critical metric that acts like a financial compass, guiding your marketing and growth strategies. By calculating and monitoring this ratio, businesses can make smarter decisions, allocate budgets wisely, and ensure long-term success.

    Do you know your LTV/CAC ratio? If not, now’s a perfect time to start measuring! It could change the way you grow your business.