Shopify Ecosystem

LTV To CAC Ratio: Why It’s Important & How To Calculate It

ltv-to-cac-ratio:-why-it’s-important-&-how-to-calculate-it

When running a business, there are lots of numbers vying for your attention. One metric that’s particularly worth watching is your LTV to CAC ratio.

So what exactly is this metric, and what makes it so important for business owners and managers? Let’s take a look at what it is, how to calculate it, and how to use it to supercharge your marketing efforts.

Key takeaways

  • Calculating your lifetime value (LTV), customer acquisition cost (CAC), and the ratio of your LTV to CAC can help reveal if your customer acquisition strategy is profitable.
  • There are several ways to help increase your LTV while reducing your CAC, thus improving your profits.

What do CAC, LTV, and LTV:CAC ratio mean?

Customer acquisition cost (CAC) refers to the average amount of money a business spends to attract a new customer. Lifetime value (LTV), otherwise known as customer lifetime value or CLV, measures the average amount of revenue that a single customer will generate for a business over the course of their entire relationship.

For example, if an ecommerce store spends $100 in marketing costs for each customer they acquire, and the average customer spends $500 in that store over their lifetime, then the LTV:CAC ratio is $500:$100 (or 5 to 1). This would be a very high CAC:LTV ratio.

Knowing your LTV:CAC ratio is essential to help determine whether or not your marketing strategies are working. 

Why is the LTV:CAC ratio important?

Marketing is usually one of the largest expense items in a company’s budget. According to a Statista report, 30% of ecommerce businesses studied spent  at least $20,000 a month on their website advertising spending alone.

A bar chart showing advertising spend of ecommerce businesses
Image Source: Statista

That’s why the cost effectiveness of a company’s marketing efforts is so important. The LTV:CAC ratio is a key performance indicator (KPI) that will tell you if your marketing spend is paying off. It will also tell you whether you can afford to incorporate additional services or offers into your strategy.

The LTV:CAC ratio is especially useful in subscription-based and ecommerce businesses. For those digital-native businesses, the additional cost to market to existing users can be very low. That’s because the business already has a database of user data and contact information, and can market to those users with low-cost channels like email and digital ads.

If a business doesn’t know their LTV:CAC ratio, they can easily find themselves losing money on each sale. That can give their competitors an opportunity to establish themselves as a dominant player.

LTV:CAC ratios can be used to identify the efficiency of different marketing channels. From there, companies can cut off underperforming channels and reallocate resources to higher-performing ones. Profits can then be constantly reinvested into the best-performing channels in a cycle that measurably powers the growth of a business. Note that it’s important to track these results over time to identify any trends or outliers in performance that require company action.

How to calculate the LTV to CAC ratio

Now that we know how important this metric is, let’s look at exactly how it’s calculated. First, we need to identify CAC and LTV.

A company’s CAC is calculated by dividing the total sales and marketing costs by the total number of new customers that were generated by that sales and marketing spend.

CAC = (total cost of sales + total cost of marketing) / new customers acquired

What should be included in those sales and marketing expenses? Certainly advertising and marketing campaigns, publishing expenses, and other marketing and production costs. Personnel costs are sometimes included as well. For example, the cost of freelance writers for an SEO campaign or designers who create banner ads should be included in the calculation. 

The costs of your entire marketing team, including marketing coordinators, managers, and executives, is usually not included, unless the company is evaluating whether or not its overall marketing efforts are profitable. 

LTV  is measured by multiplying a customer’s average purchase value by their average purchase frequency and average customer lifespan.

First, compute the average purchase value (APV) by dividing the total revenue earned in a given period by the total number of sales for the same period. 

Average purchase value = total revenue / total number of purchases

For example, if a business earned $10,000 in revenue for a particular month with 100 sales, the APV for the given period would be $10,000/100, or $100. 

Next, find the average purchase frequency (APF) by dividing the number of purchases by the number of unique buyers. 

Average purchase frequency = number of purchases / number of unique buyers

Note: Unique buyers means that customers, even if they have multiple transactions over a period, only count as one for the denominator of this formula. 

For example, if a business earned $5,000 monthly from 40 buyers who made 100 transactions, then the APF is 2.5. 

To find the average customer lifespan (ACL), divide the sum of customer lifespans by the total number of buyers.

Average customer lifespan = sum of customer lifespans / number of buyers

For new ecommerce sites, the average customer lifespan can be computed by calculating the churn rate.

Churn rate = (customers at the start of the period – customers at the end of the period) / customers at the start of the period

For example, if an ecommerce store has 100 customers at the start of the month and ends with only 90 customers, the churn rate is (100-90)/100, or 10%. The average customer lifespan will be 1/0.1, or 10 months. 

Now, compute the LTV by multiplying the average purchase value, average purchase frequency, and average customer lifespan. 

For example, if the average purchase value is $100, the average purchase frequency is 2.5, and the average customer lifespan is ten months, then:

LTV = $100 x 2.5 x 10 = $2,500

Finally, to get the LTV:CAC ratio, simply divide the LTV by the CAC. 

LTV:CAC ratio = lifetime value / customer acquisition cost

For example, if the LTV is $2,500 and the CACis $1,250, the LTV:CAC ratio is 2:1.

How to interpret various LTV:CAC ratios

LTV:CAC ratio of 0 to 1

The business is losing money to acquire customers. This is only sustainable for venture-backed technology companies competing in fast growing, emerging markets and other winner-take-all or winner-take-most scenarios—for example: large marketplaces, Uber, Airbnb, and social media in the 2010s. Successful marketing channels haven’t yet been determined. If the ratio remains at this level after some experimentation, then the business needs to decide if they want to keep exploring or abandon the channel.

LTV:CAC ratio of 1 to 2.5

This LTV:CAC ratio is good, but could benefit from some optimization and improvement. Many companies sit at this level.

LTV:CAC ratio of 2.5 to 3.5

This is an ideal LTV:CAC ratio.

LTV:CAC ratio of 3.5 and above

A ratio this high might sound incredible, but an LTV:CAC ratio higher than 3.5 might indicate under-investment in marketing efforts.

If a business’s LTV is lower than their CAC (the ratio is negative), it means the business is losing money on their customer acquisition efforts. This might be acceptable for large, venture-backed companies in winner-take-all industries.

In these spaces, businesses are trying to be the biggest and fastest under the assumption that their profits will come later. A classic example of this would be Uber, which used a negative LTV to CAC ratio to acquire customers early on. Even in this scenario, the ratio matters. A -10 ratio is worse than a -5 ratio because the former acquires half as many customers with the same spend as the latter. Or, put another way, a company with a -10 ratio would need to raise twice the amount of money from investors to get the same benefit of the better ratio.

For the majority of businesses, a negative LTV to CAC ratio is a disaster, and indicates that they should immediately halt the marketing campaigns associated with it.

Other LTV:CAC ratio considerations

A 1:1 ratio means the customer acquisition cost is equal to the lifetime value of the customer. Whether this is positive or negative depends on a variety of other business factors, including the energy, focus, and hassle of running a marketing campaign. There may also be other costs associated with marketing that aren’t properly accounted for by the LTV to CAC ratio alone.

1:1 may be a great ratio if, for example, each new user generated typically refers more users. In this case, there are other benefits impacting acquisition, like high brand awareness and customer loyalty, that could be used to generate customer testimonials. These aren’t captured by the LTV to CAC ratio formula, but they can be impactful for a business.

Of course, in the long run, unless the ratio improves, then the marketing campaign in question is not feasible for the business to sustain. After all, businesses exist to make profit, not just to break even.

A commonly-cited industry benchmark is that the ideal LTV:CAC ratio is at least 3:1.

A ratio of 5:1 or higher may not be ideal either, despite first appearances, and could mean that the business isn’t spending as much on marketing as they should be.

How to generate a favorable LTV to CAC ratio

Here are a few key strategies businesses typically use to improve their LTV:CAC ratios. 

Limit paid ad spend & invest in owned channels instead 

Paid marketing can work well, but it’s a channel that requires consistent spending to generate results. Efficiency can improve to a point, but CAC often grows higher over time as more competitors bid alongside you (these are auction systems). Contrast that with owned channels like organic social media or SEO, which boast compounding returns for decreasing incremental investment over time. 

Invest in customer retention

While it’s always ideal to attract new customers to a business, it’s much cheaper to retain the customers you already have, and to find new ways to encourage them to spend more. Happy customers are known to recommend the company or store to others in their network. Ultimately, this lowers customer acquisitions because referrals from existing customers cost very little to generate.

Know profitable customer segments

Different groups of customers behave in different ways. Depending on certain specific needs, behavioral patterns, or demographics, the CAC and LTV of different customer groups will vary. Therefore, it’s important to consider segmenting customers and calculating their respective LTV:CAC ratios to find opportunities to invest your marketing dollars in better ways.  

In summary, the LTV:CAC ratio should be one of the bedrock metrics of any marketing team. With it, you can invest your marketing dollars for maximum impact. You can then reinvest the profits to grow those channels, spend it elsewhere in your business, or pay higher dividends to shareholders. Without the benchmark of LTV:CAC ratios, you simply don’t know how well (or poorly)  your marketing is working, which will lead to wasted funds.

FAQs about LTV:CAC ratios 

1. What causes a low LTV:CAC ratio?

Low LTV:CAC ratios are primarily caused by poor sales and marketing strategy and campaigns. There are myriad root causes that could be at play, including insufficient understanding of user needs, a product that’s unappealing to the user, poor messaging in marketing campaigns, failure to optimize paid marketing spend, hiring ineffective agencies to help your business, and so on. 

Remember that the key to LTV:CAC ratios is balance. Your ratio shouldn’t be low, but it shouldn’t be too high either. The ideal ratio for many businesses is 3:1. For those who want to attract investors and establish their business growth, a 4:1 ratio is a worthy target. 

2. What does churn rate mean?

Churn rate is a customer acquisition metric that measures the efficiency with which the business retains its customers. It determines how many customers visited the store at a given period and how many of them remained customers at the end of that period. A higher churn rate means the business is having to acquire more new customers as opposed to marketing to existing ones, which drives down the LTV:CAC ratio. Monitoring monthly churn is critical for evaluating a business’s stability, since it helps identify loyal customers. 

3. What does low CAC mean for a business? 

A low CAC isn’t always a sign of marketing success—it might mean poor customer retention. For example, a company might market in a geography where it’s much cheaper to acquire users, but then attract users who can barely afford their products and who will churn at high rates. While this makes the CAC metric look impressive, the business hasn’t been made stronger or more profitable as a result. The ultimate goal is not to have the best ratio, but to generate the most profit for the business in the long run. To effectively assess this, all metrics in your marketing efforts should be evaluated.

Special thanks to our friends at ReCharge Payments for their insights on this topic.
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