Why calculate the LTV/CAC ratio?
This ratio allows us to understand if the customer will bring us more money over their average lifespan than we spent to simply convert them.
How do you calculate the LTV:CAC ratio?
Calculate the CAC at full charge (including sales and marketing expenses) and then determine the Lifetime Value (LTV) taking into account the gross margin. Then, to get your final ratio, divide the LTV by the CAC.
The simple method of calculating the CAC:
The complete method for calculating the CAC:
For more details on calculating the CAC you can read this article where I generalized the formula above:”What is the CAC?“
Here is the LTV calculation formula that takes into account average monthly incomes/payments and monthly churn (the number of customers leaving your services).
For more details on how to calculate LTV, you can visit this article:”Understand everything about Customer Lifetime Value“
What is a good LTV:CAC ratio?
For growing businesses, the standard for this ratio is 3:1 (or higher). A higher a ratio means that your sales and marketing have a greater return on investment. However, being very high is not always the most favorable position. If the ratio is too high, you risk holding back your growth by limiting your expenses and giving your competitors an advantage.
A 1:1 ratio means that the more you sell, the more money you lose because what you earn barely compensates for your sales and marketing investments in converting customers.
In general, a ratio of 4:1 or higher indicates an excellent business model.
You invest a lot in your business - capital to start business, hours of work, lots of time to think. And every time you spend money to acquire a customer, you're investing again in the future success of the business. It is essential that each customer reimburses their acquisition cost and generates a significant profit for your business to be viable.
Many businesses operate on a subscription basis. This means that the full value of the customer's revenue will not be immediately returned to your business. The duration of this procedure depends on:
1. How much did you spend to acquire them and convert them into paying customers
Customers repay their CAC in periodic installments that are fixed over time.
The total cost of acquiring them has a direct impact on the time it takes for them to repay their CAC and start generating profits.
2. How to set your rates to be profitable
You want to make sure your customers are paying the right rate for the right value.
That's why it's important to focus on the key pillars of marketing, distribution, and pricing in your marketing strategy.
3. How long do your customers stay
The longer a customer stays and pays, the more opportunities you have to maximize their total value (LTV).
There will almost always be a lag, but your aim is to make this repayment period as short as possible.
LTV:CAC ratio examples (+ Meaning)
The reference LTV:CAC ratio is 3:1. This means that if you pay €3,000 to acquire each customer, your LTV ratio is €9,000: then each acquired customer is worth 3 times what you invested to convert them.
3 CAC:LTV examples (and what you can learn)
The chart below shows hypothetical data for three different businesses. The three companies involved show different average monthly payments. They all have the same gross margin percentage, the same CAC, and the same rate of churn.
Company A:
- Has an LTV of €21,000 and a CAC:LTV ratio of 5.
- Has a CAC repayment period of 4 months,
- This means that it can more quickly return the money spent on customer acquisition and reinvest it in other areas of the business.
Company B:
- Has an LTV of €12,000 and a CAC:LTV ratio of 3.
- Has a CAC repayment period of just under 7 months (6.7),
- This is a good reference for refunding the CAC, although a shorter repayment period would help this company grow more quickly.
Company C:
- Has an LTV of 4200€ and a CAC:LTV ratio of 1.
- Has a CAC repayment period of 20 months,
- This company is barely profitable and does not bode well for a long time. Indeed, it is fighting to cover the costs with difficulty the costs it has spent to acquire new customers.
It will therefore never be able to develop or pay all of the costs of its structure that were not involved in calculating the CAC.
These business examples show the importance of value for your company's repayment period and for the LTV:CAC ratio. Businesses that have a higher average monthly payment aren't necessarily just charging more — they just know how to bill each customer correctly so that customers pay the right price for the right value. Maybe that's the difference between paddling desperately and riding the wave.
LTV and CAC are closely linked to determine total customer value. Comparative evaluation of an LTV objective based on the LTV:CAC report will allow you to maximize each customer's net earnings. Working with an incorrect CAC completely skews your LTV goals and will leave you with compromised cash flow.
Don't ever put yourself in this awkward position. Together, we will look at 4 types of errors that are generally made that you should avoid in order to always be confident in your calculations.
Why care about the CAC
Profits generated by customers are the lifeblood of your business. They help your business grow and enable it to thrive.
But the customer acquisition costs (CAC) that come with each new customer reduce these critical revenues and hurt business profitability. It's the paradox of customer acquisition. You need them, but these costs drain your life force.
It is therefore essential that you precisely understand your CAC, so that you can set goals that will offset losses and generate profits. Your CLV should be higher than your CAC by a ratio of 3:1, but you can only compare this rate if you know your CAC.
Businesses often miscalculate their CAC and then make calculations with skewed numbers. This puts at risk the true economic potential of your customers, the growth plan, and how you make the most of your investment. You can't afford to go wrong.
Below, we review some of the common mistakes that are made in calculating CAC, and see how you can set yourself up for success, in the right way.
CAC Formula (+Common Mistakes)
When it comes to your CAC, being meticulous literally pays off.
You need to consider every detail and every possibility, both in terms of the total cost of acquisition and the customers actually acquired, to determine your true CAC.
While it's good for your cash flow to pay less to acquire each customer, the cheapest customers aren't necessarily the ones you want to acquire. They won't see the value of your product or service and may not stay customers for very long.
That's why it's important to know how you're going to monetize your customers once you've acquired them. You want customers who are going to stick around and pay — that's how you'll get an LTV that allows you to repay and make profits beyond your CAC.
Start with a good foundation. Calculate your CAC correctly and lay the foundations to master your SaaS measurements and build the success of your business.
General method for calculating the CAC
The general method for calculating the CAC is simple:
However, this framework leaves a great deal of room for error. What are the total expenses for acquiring customers? We will now review the four steps in calculating the CAC and show how mistakes made along the way can have important consequences.
Download this sample online sheet to find this example of the 4 common and critical errors in calculating the CAC
Mistake 1: You think paid advertising is your only acquisition expense
Your initial assessment of total spending to acquire customers may only include paid advertising. This includes ads on:
- Facebook, Twitter, Instagram and other social networks,
- Google AdWords,
- Advertising space on blogs and other relevant websites
Let's say you only include paid advertising in your CAC calculation. If you spent €1,000 on paid advertising in one month and acquired 50 new customers, you would calculate your CAC as follows:
Imagine that a customer's LTV is €1,500.
Based on these calculations, your LTV:CAC ratio equals 75.
A CAC this low compared to your LTV gives a very promising LTV/CAC ratio, well above your goal of 3.
But you should not rejoice yet... It's easy to only consider paid ads because they're obvious expenses. Unfortunately, you would miss a large part of your acquisition expenses if you stopped only at this stage.
Mistake 2: You don't include all marketing expenses
Remember that the visibility of the company and the construction of the brand that you do also serve to attract customers. You should include expenses for all tools, services, and software that you use:
- Content marketing
- SEO
- Lead scoring
- Data enrichment
- Content management systems
- Web site design
Now let's say you spend $10,000 on these items above per month to acquire those same 50 customers. When you include these costs, you determine that the CAC is as follows:
The CAC is increasing visibly compared to the LTV, whose value has not changed.
This increase in the CAC significantly lowers the LTV:CAC ratio compared to our previous result.
The LTV:CAC ratio increased from 75 to 6.8, which means that the additional expenses that increased your CAC strongly affected this ratio.
Although the LTV/CAC ratio is lower, it is still above the target of 3. It would be tempting to say that you are still able to be very profitable.
But at the end of the day, these advertising and marketing programs don't work by themselves.
Mistake #3: You don't include the salaries of all acquisition-related employees
Your sales and marketing teams are working hard to attract customers. Forgetting to include their salaries in your calculations would not only be inaccurate, but also careless. Remember to include these costs:
- Salary of sales managers and managers
- Base salaries for account managers
- Sales Salaries/SDR
- Marketing manager salary
- Remuneration for bonuses or overtime
Let's say that the combined salaries of sales and marketing teams are around €33,000. We are going to take into account the individual monthly salaries of a sales manager, a marketing manager, two sales people, and 2 SDRs.
Now here is the representation of your CAC:
The CAC is now over half of the LTV.
The LTV:CAC ratio fell to a worrying level of 1.7 with the increase in the CAC.
Your LTV:CAC ratio is now well below your ideal 3:1 ratio.
Simply because you miscalculated the numerator of the CAC equation - the total expenses to acquire customers. But if you haven't paid attention to your denominator, you may need to make an even greater adjustment.
Mistake #4: You count non-paying customers as “earned.”
While people interested in a free or trial plan use your service, you have no guarantee of the financial value they could bring you.
Including these users in the total number of acquired customers will skew your CAC.
Of the 50 customers who started using your services in the past month, only 30 may be on a paid plan.
You should not think of these free users as “acquired customers” when calculating the CAC. In this way “your recalculation” would show that your CAC is as follows:
With an LTV:CAC ratio of 1, LTV and CAC are nearly equal.
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You barely reach the breakeven point of your CAC during the customer's lifetime in your business.
These errors show that incorrect CAC calculations can cause its value to fluctuate up to 75 times using our example.
When calculating the CAC, the hardest part is in the details. In this example, a calculation error or an oversight along the way may cause you to calculate a CAC as low as 1/75 of your CAC at full load.
If you had realized that your full CAC was €1,467, you could have set a goal for the ideal customer's LTV to be at least €4,400.
On the other hand, on the other hand, you might have aimed too low unintentionally by thinking that your CAC was much lower.
In many companies, this type of error lays the foundation for future business decisions that are very misdirected, and perhaps even harmful.
What is the repayment period? (Payback period)
The repayment period in capital budgeting is the time it takes for your business to recover the cost of acquiring a customer.
Your company's CAC is a key factor in determining the repayment period and the future profitability of your business. This is how you can calculate the number of months needed to amortize the CAC:
To understand a little more clearly if this is not the case, here is an explanatory diagram of this repayment period as well as the moment of compensation for investments and the value generated by your customers.
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