At Act! we always aim to provide our customers with the best business solutions, and especially in the all-important areas of customer acquisition and retention. That’s why we recently wrote two articles on the cost of customer acquisition (CAC) and calculating customer lifetime value (LTV).
These two useful metrics can help any business to get ahead of the game by providing a clear picture of probable customer behaviour and the costs involved in maintaining vital customer relationships. The LTV:CAC ratio is the third and final calculation that will help you get the most accurate measure of your business costs; at the same time it highlights the best steps you can take to reduce CAC and improve acquisition and retention.
In this article we offer insights into the LTV:CAC ratio; namely what it is, why it’s important and how you can calculate it.
A recap on CAC and LTV
In short, CAC (customer acquisition cost) equates to the total your business is spending on sales and marketing in order to acquire a new customer within a specified timeframe. It determines the true profitability of your business since it compares the amount of money you’re spending on customer acquisition to the number of customers that actually came on board.
The LTV (customer lifetime value) metric works in conjunction with the CAC metric to predict the revenue a customer will generate over the course of their interactions with your business. Those who spend the most with you over the longest time frame will have the highest LTVs.
What is an LTV:CAC ratio?
The LTV:CAC ratio is a metric that compares a customer’s lifetime value to the amount of money you spent on acquiring them. The ideal scenario would be as follows: what you are spending on acquiring a new customer (CAC) is approximately three times less than the lifetime value of that customer (LTV). In other words, you are aiming for an LTV:CAC ratio of 3:1.
If your calculations show that the ratio is more even than this (for example, 1:1), you are spending more than you should be. If your LTV is much higher than your CAC (for example, 4:1), the chances are you’re not spending enough. This inevitably means you’ll be losing business opportunities.
The rule of thumb is that if you always aim for an LTV:CAC ratio of 3:1, you should stay on the right track. However, you should note that it generally takes around a year to recoup what you’ve spent on acquiring a new customer.
Why is LTV to CAC ratio (LTV:CAC) important?
Since the LTV:CAC ratio can shine a light on business spends, it pinpoints just how much you’re splashing out on sales, marketing and customer service. Knowing exactly what your customers are worth to your business enables you to focus your efforts where they will be most appreciated, and therefore most lucrative.
It also helps you to fine-tune your processes and strategies so that you can lower the overall CAC, thus increasing profits. Blindly plowing money into marketing campaigns, or hit and miss approaches to sales targeting are a waste of resources all round and can seriously dent business turnover. By bringing your LTV:CAC ratio into balance, you can be sure you’re making the wisest investments in terms of both time and money.
How to calculate LTV:CAC ratio
Again, the trickier math is the initial calculations of CAC and LTV. If you haven’t done so yet, you can use our cost of customer acquisition calculator, which will also help you to calculate the customer lifetime value, and finally the LTV:CAC ratio.
Once you have calculated the first two numbers, you’re simply going to divide the LTV by the CAC. So for example, if you had a customer lifetime value of £3,000 but the cost of acquiring that customer was £1000, you have the ideal LTV:CAC ratio of 3:1. As we mentioned, your long-term goal is to reduce the CAC via more efficient spending habits, which inevitably will lead to higher profits. Once you integrate your findings in the form of updated strategies, you will be well on the way.