If you’ve ever worked at an early-stage startup, built a new business line at an established company, or launched your own venture, you know how difficult it can be to measure your efforts’ success.
Entrepreneurs typically monitor key performance indicators, such as revenue, conversion, or adoption, to gauge effectiveness. But perhaps the most common metric for measuring a new venture’s success is what’s known as the LTV/CAC ratio.
To help you assess your company’s performance more effectively, here’s an overview of LTV/CAC, how to calculate it, and methods for improving it to achieve long-term profitability.
What Is LTV/CAC?
LTV/CAC is the ratio of a company’s customer lifetime value (LTV) to its customer acquisition cost (CAC). To break that down:
- Customer lifetime value (LTV) is the value a customer delivers to a company over the long term
- Customer acquisition cost (CAC) refers to the amount a company spends to acquire each new customer
LTV/CAC is a vital metric for startups. Many are initially unprofitable as they start obtaining initial customers. Yet, by comparing the long-term value those customers deliver to the cost of acquiring them, LTV/CAC can provide a measure of future profits, allowing founders and venture capitalists (VCs) to assess a business’s long-run health.
Below is a breakdown of each of the ratio’s components: LTV and CAC.
What Is LTV?
LTV, or lifetime value, is a metric that measures the value a customer contributes over the time they’re engaged with a company’s offering. It considers not only one-time or short-term sales but the profit contribution of each transaction a customer makes, giving a more accurate assessment of their contributions’ value.
To calculate your company’s LTV, you must know two things:
- Customer contribution margin (m): This refers to the revenue generated by an average customer minus the cost to offer the product or service to them for one year
- Customer lifetime (T): This is the average amount of time, in years, a customer stays with the company
Use those two metrics to calculate LTV:
Lifetime Value (LTV) = m * T
Let’s demonstrate this with a brief example. Imagine you’re a marketer at a small consumer software company operating on a subscription model. You determine that your annual customer contribution margin per customer is $115 and that, on average, your customers subscribe for three years.
Put those together to calculate LTV:
LTV = $115 * 3 = $345
In this example, the customer's lifetime value is $345. This represents the value the customer delivers to your software company over the time they remain in business with you.
What Is CAC?
CAC, or customer acquisition cost, refers to the cost it takes to acquire a new customer. Calculating CAC is straightforward: you need to know how much your business spent on marketing and how many new customers you acquired.
To calculate CAC, use the following formula:
Customer Acquisition Cost = Marketing Cost ($) / Number of Customers
Continuing with our software example, let’s say the company spent $2,000,000 on marketing, generating 16,000 new customers. Using the CAC formula, this would result in the following:
CAC = $2,000,000 / 16,000 = $125
This means the company spent $125 to acquire each customer.
How to Calculate LTV/CAC
Once you’ve determined your LTV and CAC, you can then calculate your LTV/CAC ratio.
Let’s continue with our example and calculate the LTV/CAC for your software company. Remember that LTV is $345, and CAC is $125. Using the formula, you get:
LTV/CAC = $345 / $125 = 2.76
This means that the value a customer delivers to the company is 2.76 times greater than the cost to acquire them.
What Is a Good LTV/CAC Ratio?
So, what's a good LTV/CAC ratio? In most industries, the benchmark for a healthy LTV/CAC ratio is generally considered at least three.
“A good rule of thumb is that an LTV-to-CAC ratio of three or higher is attractive and indicates a scalable business where you’ll be able to cover your marketing costs, overhead, and still make a profit,” says Harvard Business School Professor Christina Wallace in the online course Entrepreneurial Marketing.
If your LTV/CAC is less than one, it means you’re losing money because you’re spending more on acquiring customers than you’re receiving from them. If your ratio is in the one to two range, you’re breaking even or only doing slightly better, which may concern investors interested in greater profits.
How to Improve Your LTV/CAC
“A high ratio implies attractive economics because your essential profit formula is a success, while a low ratio implies you may need to adjust your business model—perhaps your customer value proposition, your go-to-market methods, or your pricing—and run more experiments to improve your profit formula,” Wallace says in Entrepreneurial Marketing.
Experiments to improve your LTV/CAC ratio should focus either on increasing your LTV, decreasing your CAC, or both. The key to increasing your LTV is to focus on improving two of your offering’s components:
- Customer profitability
- Customer satisfaction
Customer profitability is the value you derive from customers. You can improve this by charging higher prices or reducing the cost of delivering your product or service. However, you must balance this against customer satisfaction—the value you provide users. Maximizing both results in loyal customers who are satisfied with your offering and deliver long-term profits.
There are also several methods for decreasing your CAC. Because it consists of the costs and overhead to acquire customers, reducing those are key. Make sure you’ve chosen the most effective media channels that meet your customers where they are with a message that clearly communicates your value proposition.
Related: What Is a Brand Story? The Importance & 5 Compelling Examples
Leveraging LTV/CAC to Measure Your Company’s Success
Your brand’s LTV/CAC ratio is a key metric for measuring its success. Once you’ve determined it, you must decide what to do with the information and develop strategies for improving it.
To dive deeper into LTV/CAC, its nuances, and how to improve it using limited resources, consider taking an online course like Entrepreneurial Marketing. In it, you’ll immerse yourself in interactive exercises and real-world examples to develop a proven toolkit for identifying, influencing, and acquiring customers.
Are you interested in developing the entrepreneurial mindset and toolkit to create a viable, scalable business? Explore Entrepreneurial Marketing—one of our online marketing courses—download our free Marketing Terms Cheat Sheet for a quick reference to key marketing concepts.
