Shopify Ecosystem

Understanding Customer Acquisition Cost And Customer Lifetime Value

understanding-customer-acquisition-cost-and-customer-lifetime-value

How can you determine your ideal marketing spend? More importantly, how can you determine your ideal business spend to attract and retain as many customers as possible while remaining profitable?

In eCommerce, customer acquisition cost (CAC) and customer lifetime value (CLV) are the two most important metrics to answer these questions. One matters slightly more than the other (we’ll get to that below), but both play a major role in helping you analyze and improve the success of your business.

In this guide, we’ll cover the basics of both CAC and CLV, and why they matter to online merchants. We’ll elaborate on the relationship between the two metrics and explain how merchants can succeed in competitive markets by optimizing their CLV to CAC ratio. Let’s dig in. 

What Is Customer Acquisition Cost?

As the name suggests, customer acquisition cost describes the total direct and indirect cost of converting a member of your target audience into a paying customer. 

For online merchants, these costs can vary widely. CAC includes not only the price of related marketing campaigns but also storing and shipping the actual product, as well as the cost of any marketing or sales professionals who have worked to procure the customer.

In other words, this is a business-level metric. A lower customer acquisition cost naturally leads to greater profitability potential, making this an important KPI across the entire business. 

Why Knowing Your CAC Matters

As a business-level metric, CAC tends to be an easy check for sustainable revenue and success in eCommerce.

Put simply, your average CAC needs to be below your average order value (AOV) to turn a profit. If that is not the case, lowering your CAC through more effective marketing or improving AOV through raising your product price, offering loyalty programs, and other tactics becomes essential.

CAC can also be an effective measure of the competitive environment. The reason CAC has increased by 60% in recent years is likely due to higher competition.

How to Calculate CAC

You can measure your CAC with this simple formula:

customer acquisition cost formula

Total sales and marketing costs can include:

  • The salary or contract cost of anyone involved in your marketing effort. If they work on marketing part-time, only calculate their salary in that same fraction.
  • Any overhead like equipment or office space spent on your marketing staff.
  • Any tools, from an online store or payment processing system to your email marketing software, that are needed to acquire new customers.
  • All direct advertising costs for channels like Google, social media, programmatic display, etc.
  • All costs that are required to get your product into the hands of your customers once you’ve converted them, including packing, shipping, and handling.

As an example, if a company spends $1000 in a year to acquire 20 customers, their CAC would be $50.

When using CAC to make business decisions, remember that consistency is key. Measuring CAC over time can only yield reliable insights if the same types of costs are included in the formula each time you benchmark your efforts.

What Is Customer Lifetime Value?

Customer lifetime value describes the total amount of revenue your average customer will deliver over their typical lifespan. 

For instance, imagine that the average customer stays with your company for about 2 years and makes five purchases from your website each worth an average of $50. Your CLV in this case would be $250. 

Why Knowing Your CLV Matters

CLV matters when selling goods online because it presents a holistic view of your customers’ revenue potential. Rather than focusing on first-buy metrics like AOV, you get a true idea of just how much each customer you acquire will be worth over their lifespan. 

As a result, you can use this metric not just to determine the success and efficiency of your marketing spend, but also to shift your emphasis from customer acquisition to customer loyalty. The AOV for the first conversion matters little if the major purchase comes once a customer has already tried out your products. 

We know, for instance, that it’s five to 25 times more expensive to acquire a new customer than it is to retain an existing one. We also know that existing customers are 50% more likely to try a new product and spend on average 31% more than new customers. A focus on CLV allows you to shift your marketing efforts to build a more loyal, profitable customer base.

How to Calculate CLV

There are many ways to calculate CLV, ranging from the simple to the complex. Here is a common formula:

Customer lifetime value formula

To calculate your AOV, divide revenue by the total number of orders in a given timeframe. Finally, your repeat purchase rate is the percentage of customers who purchase more than once from you in the same timeframe.

How CAC and CLV Work Together

One focuses on cost, while the other hits on the value side of the equation. That might give it away: CAC and CLV are at their best when closely intertwined to provide an overview of business success.

To accomplish that feat, eCommerce experts recommend focusing on a metric called CLV to CAC ratio. As the name suggests, this metric compares the full value of a customer to the cost of acquiring that customer.

If the ratio is less than 1, the company is losing revenue each time it acquires a new customer. A ratio above 1 suggests revenue gained, but not necessarily profitability; after all, other costs of running the business unrelated to acquiring a customer also need to be considered.

Generally speaking, most merchants focus on a ratio greater than 3, although that can change based on whether the merchant is in high-growth mode or maturing, the competitive environment, and other factors.

A ratio above 5 can suggest improvements, as well. It’s an important indicator that investing more in marketing would improve acquisition efforts and yield more online sales.

CAC and CLV: What Matters More for eCommerce Success?

Both CAC and CLV are vital pieces in measuring your business’ success. However, improving your CLV tends to be more crucial than lowering your CAC for a few reasons:

  • CAC is at least in part dictated by your audience and competitive environment and is more difficult to change. As a result, a focus on CLV can make a more tangible revenue impact.
  • A higher CLV means you can spend more to acquire each customer, allowing your investments in customer acquisition to spread further and become more effective. 
  • CAC can be a hot-button metric because of its focus on lowering costs. Non-marketing executives may be tempted to cut your marketing or advertising budgets to lower it, resulting in less effective marketing efforts.

4 Ways to Improve Your CLV to CAC Ratio

Any effort to improve your CLV to CAC ratio can focus on either end of the equation. The below tactics are just a few of the many examples through which you can minimize unnecessary costs while maximizing value. A focus on customer retention is key to achieving both.

1. Implement a subscription program

In a traditional eCommerce model, your CLV depends on customers making individual choices to buy your product every single time. A subscription model automates that process, increasing convenience for your customers and helping you build a more predictable and reliable revenue stream.

Learn more: Everything You Need to Know About Subscriptions

2. Implement a customer loyalty program

A loyalty program incentivizes your customers to stick with you for longer. It rewards them for initial and recurring purchases through points, discounts, or other perks. That, in turn, reduces the threshold of coming back for more, increasing your CLV without raising your CAC.

As a bonus, loyalty programs also tend to increase customer goodwill and, as their name suggests, brand loyalty. Tangible rewards for recurring customers, especially if they are unique, increase the likelihood of future purchases while decreasing the possibility your buyers will move to a competitor.

3. Encourage and incentivize customer referrals

Referrals can drastically lower your acquisition costs. A customer praising your product in front of their friends and family or professional network out of pure brand satisfaction is entirely free. Even incentivizing it with an active referral program carries lower costs than a comprehensive advertising strategy based on demographic markers.

Referrals, of course, only work if your customers love your product and brand experience. But when they do, a strategic approach to encouraging them can have a major impact on your CAC and improve your CLV/CAC ratio.

4. Use reorder capabilities to minimize friction

What if you could dynamically encourage your customers to reorder with you when their need is the greatest? For products that your customers use up over time, a simple text or email reminding them to reorder could go a long way.

In the process, you reduce friction. When the tool you use can identify the ideal points to reach out, spending on customer retention can be optimized. That improves your lifetime value while putting less focus on CAC.

Simply put, CLV and CAC are both vital markers to measure your eCommerce marketing and customer acquisition efforts. Both, but especially CLV and the CLV/CAC ratio, can lead to tangible insights with a straight line to improving your strategy and execution.

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