Summary: Getting your numbers right is critical for running and growing your business, especially if it’s just kicking off. Two important metrics are: Customer Lifetime Value (CLV) and Customer Acquisition Costs (CAC), yet those are often wrongly calculated. Common pitfalls include equating revenue with contribution margin and not considering a time dimension. Even though there are accurate ways to calculate CLV and CAC, calculating Payback-Time might be superior to CLV to CAC ratio when it comes to understanding Return On Investment (ROI).
Understanding Unit Economics, CLV & CAC
Often, when receiving pitch decks from founders, I see an incorrect calculation of unit economics, i.e. Customer Lifetime Value (CLV) and Customer Acquisition Cost (CAC).
Understanding what they mean is key to realizing why it’s detrimental to your business when they’re not properly calculated (and also to the impression you make on investors).
Customer Lifetime Value (CLV) is the accumulated profit contribution margin you can generate from customers over the entire lifetime of their account, discounted by an appropriate discount factor. In simple terms, it is the money you would earn from a customer before churning in today’s value. It is important to note that taking into account your customer’s lifetime will alter how much they are worth to your business.
Customer Acquisition Cost (CAC) measures how much an organization spends to acquire new customers. The standard way to calculate CAC is by dividing the total money spent in acquiring customers (marketing, trials, sales representative, advertisement, etc.), by the amount of customers acquired.
These metrics are important because they help businesses determine how much they can afford to spend on customer acquisition and retention, and whether their marketing efforts are yielding the desired effects or not.
There are two relations between CLV and CAC which are significant for understanding the actual value of your customers. The first is CLV:CAC ratio, and the second is CLV minus CAC, which indicates the net profit a customer signifies to you.
CLV:CAC ratio can tell you how much more your customers add to your company than what you are spending in acquiring them. For instance, a ratio of 3 indicates that for every dollar you put into customer acquisition, you end up making $3. This is considered a healthy ratio.
The difference between CAC and CLV indicates the net profit one customer brings to your business. It is an important indicator of how you are managing your business expenses. For instance, if you are spending $100 to acquire one customer, and your average CLV is $150, then you are only making $50 dollars per customer. Depending on the stage your business is at, this could indicate your business is on the right track, or that it is losing momentum, or that too much is spent on customer acquisition, etc.
CAC and CLV are metrics which provide information about a company’s operation best when they are analyzed together. This is because a high CAC or CLV in themselves do not provide insight. For instance, a high CAC is only pernicious if the CLV is comparably low (e.g., only 1.3x higher than CAC), and a high CLV is only beneficial if CAC is substantially lower. It is by contrasting both metrics that businesses can inform better long-term strategic and operational decisions.
The CLV:CAC ratio also constitutes a good benchmark to compare your performance with other companies in the industry.
Properly calculating CLV and CAC can help answer these questions:
7 Common Pitfalls when Analyzing CLV & CAC
1. Equating revenue with value: The lazy (and often employed) way to calculate CLV is by simply multiplying the amount of money spent on average per purchase, the average frequency with which a purchase is made, and the average lifespan of a customer’s activity. This assumes that your profit margins are 100% (no variable costs and costs of servicing of 0), an assumption that would rarely be feasible in reality, as there are usually costs of production, shipping or software expenses involved. Therefore, CLV is overestimated, unit economics look healthier than they are and founders may over-invest in marketing.
2. Not discounting future revenues / factoring in the time value of money (hence there is big importance of payback time): When you discount future revenues, you’re taking into account the time value of money (i.e., the fact that a dollar received today is worth more than a dollar received in the future), risk factors, and potential changes in customer behavior. If you don’t, you could overestimate CLV. When analyzing CLV:CAC, it’s helpful to factor in the payback period (the time it takes to recover the cost of acquiring a customer) and the Internal Rate of Return of CAC (IRR, which measures the profitability of a marketing investment). The sooner an investment can pay back its initial cost, the sooner it can be reinvested into more growth to create compound effects.
3. Overestimating customer lifetime value: Entrepreneurs often make the mistake of assuming that customers will stay loyal to their brand for longer periods than is realistic. This can lead to inflated CLV calculations, causing businesses to over-invest in customer acquisition and retention efforts.
4. Underestimating customer acquisition cost: Entrepreneurs may not account for all costs associated with acquiring new customers, such as marketing, advertising, sales efforts, and onboarding. This can result in an underestimation of CAC, which may cause businesses to underestimate the return on investment (ROI) from their marketing and sales strategies.
5. Failing to consider customer segmentation: Not all customers are created equal. Some may generate more revenue and stay loyal for longer periods, while others may churn quickly. Entrepreneurs should segment their customers and calculate CLV and CAC for each segment, ensuring they allocate resources effectively to maximize ROI. If you can determine the profile of high-value customers, you can tailor your marketing efforts to that profile. Moreover, by segmenting your acquisition channels, you can evaluate which are actually effective.
6. Ignoring cohort analysis: Entrepreneurs should track cohorts of customers acquired at different times and through different channels, as this can provide valuable insights into the effectiveness of acquisition strategies and the changes in customer behavior over time. Failing to perform cohort analysis may lead to incorrect conclusions about the overall CLV and CAC.
7. Relying on static metrics: CLV and CAC are not static figures; they should be constantly updated as new data becomes available. Entrepreneurs should regularly recalculate these metrics to ensure they are making data-driven decisions about customer acquisition and retention strategies, based on the most recent and accurate information.
How To Calculate Real CLV
When the seven pitfalls listed above are considered, your CLV will look different and more accurate. This will better guide your decision-making.
To factor in the cost of the Costs Of Goods Sold (COGS) and other variable costs when calculating CLV, businesses need to subtract these costs from the average money spent on a purchase. To discount future revenues, you’ll take into account the Discount Rate, which is the rate at which future revenues are discounted back to their present values).
The results will be the present value of all future profits from a customer.
Taking into account how much was spent in production and shipping will yield not a CLV that refers to the total revenue generated by a customer over their lifetime, but the total profit that this customer meant. Taking into account the discount factor and the time value of money will yield the real value from a customer rather than an inflated value.
However, it’s important to note that discounting will vary year on year. This is not because the discount factor changes. The discount factor will remain constant, but later years get discounted multiple times (e.g., (1+d)² for 2 years in the future).
This approach, known as a time-varying or dynamic discount rate, takes into account the changing value of money over time. Here is the final formula:
If that looks complicated, it is because calculating CLV accurately is not straightforward. Here APV is average purchase value, APF is average purchase frequency, CM is contribution margin, d is discount rate, and ACL is average customer lifespan.
Remember, the discount rate is expressed as per-period. For instance, if you’re measuring everything in years and your discount rate is 30% per year, you would use 0.30 as the discount rate in the equation.
Startups exist in an inherently high-risk environment. They’re expected to grow rapidly and provide substantial returns to their investors, particularly venture capitalists (VCs). VCs typically look for high-risk, high-return investments and often seek a return rate of 30% or more on their investments.
The 30% discount rate reflects the high level of risk and the high return expectations associated with these startup investments. When calculating the CLV, startups might use this high discount rate as a benchmark to align with investor expectations. As startups often depend on VC funding, using a discount rate that matches VC return expectations can help align the startup’s strategic and financial planning with those of their potential investors.
Your contribution margin is the revenue remaining from sales of the product after all variable costs before marketing (i.e., costs that change in direct proportion to volume of production), including COGS, have been subtracted. Note that contribution margin is the same as gross margin minus other variable costs.
Contribution margin typically includes marketing expenses, customer care, payment processing cost, fraud losses, and shipping costs (if these are not already included in gross margin).
For instance, if you sell a product for $100 and your variable costs before marketing are $60, you would have a contribution margin of $40.
Suppose you have an e-commerce business that sells handmade crafts. You have the following data:
- Average Purchase Value (APV): $100. This is the average amount a customer spends per purchase.
- Average Purchase Frequency (APF): 4 purchases per year. This is how often a customer makes a purchase in a given period (a year, in this case).
- Average Customer Lifespan (ACL): 5 years. This is how long we expect a customer to keep making purchases.
- Contribution Margin (CM): $40. (So, 40% of $100, so we’d use 0.4) This is the revenue remaining from selling a product after all variable costs incurred have been subtracted.
- Discount Rate (d): 30% per year. This is the interest rate you would earn if you invested your money elsewhere. It’s used to calculate the present value of future cash flows. If your discount rate is 30% per year, you would use 0.30.
Plug these values into our CLV formula:
CLV = [$100 * 4 * 0.4 / (1 + 0.3)] + [$100 * 4 * 0.4 / (1 + 0.3)²] + [$100 * 4 * 0.4 / (1 + 0.3)³] + [$100 * 4 * 0.4 / (1 + 0.3)⁴] + [$100 * 4 * 0.4 / (1 + 0.3)⁵]
CLV = [$160 / 1.3] + [$160 / 1.3²] + [$160 / 1.3³] + [$160 / 1.3⁴] + [$160 / 1.3⁵]
CLV = $123.08 + $94.68 + $72.82 + $56.01 + $43.08
CLV = $389.67
So, based on these assumptions and using this formula, the present value of all future profits from a typical customer is $389.67.
The importance of right discounting cannot be overstated. Many people don’t consider a dynamic discount rate. Especially in the startup context of high volatility, wrong discounting can overestimate CLV and lead to wrong business decisions. Check out the graph to compare the impact of (i) calculating CLV without discounting, and (ii) calculating CLV by using revenue instead of gross profits as your value.
(i) CLV without discounting
(ii) CLV using revenue
In traditional corporate finance settings, discount rates are usually around 10%. However, in the world of startups, particularly in the tech sector, the risk associated with future cash flows is significantly higher, and appropriate discount rates in this context range between 30–50%. This range better reflects the high volatility and uncertainty that startups often face, including rapid technological changes, evolving customer behavior, and intense competition.
This adjustment bridges two worlds: corporate finance, with its rigorous risk analysis, and performance marketing, with its emphasis on data-driven, agile decision-making. This is a crucial step towards a more robust, pragmatic approach to understanding unit economics in the startup environment, an invaluable insight in today’s uncertain business landscape.
Next, you’ll need to incorporate segmentation in your calculation of CLV, in order to understand the actual value that different types of customers have for your business.
The key is to determine the profile of those high-value customers, in order to cater your product/service and marketing to that audience. Note this will also inform your customer acquisition strategy.
To create segments, you must break down either of the three variables involved in calculating CLV. So, either sort customers by how frequently they purchase, how much they purchase (e.g., the subscription tier they have), or by how long they remain active customers. You can also create a complex segmentation involving all variables which would look something like this:
The table above only segments into three types of customers. A more thorough analysis could segment into many more, as customers can have a high average purchase value, but with low frequency, and a long lifetime, or combine the three metrics in any other way.
In the example above, your Tier 1, or high-value customers (i.e., those who stay the longest and purchase the most), can then be analyzed in order to understand them and their needs. Marketing campaigns can be targeted to people sharing interests and needs with your high-value customers.
Furthermore, different marketing strategies can be designed for each type of customer. Segments allow you to send relevant content to your customers depending on their purchasing habits, for instance, you can send targeted campaigns or build a VIP welcome flow depending on the predicted CLV of each customer segment.
Additionally, you could segment your Tier 1, 2, and 3 customers according to the following, to obtain extra depth on your analysis of CLV:
Channels: Run a CLV formula on customers who were acquired from different channels. This allows you to see which channel is giving you the most value. You can then allocate more marketing budget or time to these more profitable channels.
Location: A CLV analysis on customer location can reveal areas that are more profitable to your store. Say you discover that shoppers from Canada have a much higher CLV. You can then adjust your marketing to target more of these customers.
Actions: Take a look to see how certain customer actions are impacting CLV. Are customers who are registered for your loyalty program generating more value? How much more is a registered account worth over its life? These are questions you can answer when you segment by actions.
This will allow you to get a personal profile of each Tier and relate variables such as the most popular location of your high-value customers (Tier 3).
How To Measure Real CAC
In light of the problem with standard CLV, I showed how to calculate CLV in a way that will become much more effective and informative for your customer strategy. Similarly, CAC can be calculated by taking into account all of the problems pointed out above.
As I mentioned, customer acquisition needs to be segmented to analyze which marketing channels are proving most effective.
Some of the acquisition channels may involve the ones shown in the infographic, which is a breakdown of how much each channel is used on average by businesses.
Other segments may include ads, trials, and specific marketing campaigns. Within CACs you could also include the design for marketing materials (ad designs, landing pages), sales and marketing employee salaries, and sales and marketing tools. However, these are not channels and their ‘acquisition effectiveness’ would be harder to measure.
Measuring the effectiveness of these channels is not straightforward. This is because some of the channels may lead to multiple ‘clicks’, yet no purchases thereafter. They can attract but not acquire customers.
However, measuring the effectiveness of each channel is becoming increasingly easier as tracking metrics tell how many of those clicks actually end up in purchases.
An effective way to measure how successful each marketing channel is would be by asking your customers how they’ve heard about your brand once they’ve finalized a purchase. This would also help you pinpoint how many clients reached your brand through organic marketing, by adding an option ‘Heard from a friend’.
To factor in the impact of organically generated customer acquisition when calculating CAC, businesses can separate these customers from those acquired through paid channels, and calculate their value and cost separately. This can provide a more accurate picture of the profitability and sustainability of a business.
Calculating CAC in organic marketing may seem contradictory, as organic marketing is defined as being non-paid. What are the costs involved in calculating CAC specifically geared towards facilitating organic marketing?
This could involve the money put into creating referrals. For instance, if a customer refers the service to a friend, both can get a discount. Other costs could involve money spent for creating engaging content directed to existing customers, like newsletters, which contain information that would appeal to people with similar interest to your customers. And how best to reach them than through your very customers, who are more likely to share interest with your potential clients? Moreover, there are many rewards programs offered to your current customers if they bring new customers, or if they follow and share your content on social media. Other costs may involve marketing managers that engage and collaborate with existing customers to spread content. For millennial and generation-z shoppers in particular, user-generated content fosters a sense of trust and ownership which is likely to grow peer-to-peer marketing.
A company which has shown the effectiveness of CAC geared towards facilitating peer-to-peer marketing is Uber. A strategy that has definitely fueled Uber’s success is its referral program, which continues to drive growth every year. Uber offers a free ride to both a referrer and a new driver upon a successful referral. Offering a free ride mitigates the initial doubts users have towards new services. This low-stakes trial is perfect to draw people in who wouldn’t otherwise try the service right away. Then, given the success of users’ Uber experience, they tend to join the brand as regular customers.
Uber maximizes CLV by making smart CAC investments. The latter make full use of the power of peer-to-peer marketing. Moreover, Uber shows its customers how great its service is, rather than telling them. The success of their service itself is the bait that ends up generating frequent, long-term, customers.
The importance of organic marketing should not be underestimated. Not only is it a way of lowering total CAC, as it usually involves less costs of acquisition than other channels, but also word of mouth marketing is a form of marketing that 92% of customers trust.
Why Payback-Time could be superior to simple CLV/CAC
Although customer lifetime value divided by customer acquisition cost (i.e., ratio) is a widely used metric for evaluating marketing investments, considering payback time may provide a more relevant insight into the effectiveness of a marketing budget.
Payback time is a financial metric that calculates the time period (in months) required for an investment to generate returns equal to the initial outlay, thereby measuring the efficiency and viability of that investment. In the context of marketing budgets, payback time refers to the duration it takes for the revenue generated by a customer to cover the costs associated with acquiring them.
One of the primary reasons to consider payback time is that it accounts for the time value of money. As businesses have ongoing expenses, such as salaries and office space, the sooner they can recoup their marketing investment, the better their cash flow will be. By focusing on payback time, companies can optimize their marketing strategies to ensure faster returns, enabling them to allocate resources more effectively and maintain a healthy financial position.
Considering the payback time of marketing investments is particularly advantageous when taking into account the high internal rate of return (IRR) associated with fast payback times. IRR is a metric used to estimate the profitability of potential investments, and a higher IRR indicates a more attractive investment opportunity. By achieving a quick payback time, businesses not only recover their initial marketing investment faster, but they also experience a higher IRR. This higher IRR implies that the marketing budget generates a greater return on investment over a shorter period, thus making it a more profitable and efficient use of resources.
The best businesses in the world have very fast payback times and strong CLV:CAC, which enables them to achieve hypergrowth reinvesting the profits generated from their marketing efforts quickly. Payback on the first order typically implies an infinite IRR, which is rare and means that you likely have a business that can print money for you.
Moreover, payback time offers a better understanding of the speed at which money can be reinvested to create compound effects. A shorter payback period implies that the company can recover its investment quicker, reinvesting sooner in business growth tactics. In contrast, a longer payback period implies greater uncertainty,exposure to market fluctuations, and an inability to reinvest in rapid business growth. By taking into account the payback time, businesses can make more informed decisions about their marketing investments and minimize potential risks.
Additionally, payback time is a more straightforward metric that is easier to communicate to stakeholders. While CLV and CAC involve complex calculations and assumptions about customer behavior, payback time provides a simpler, more tangible way to assess the effectiveness of marketing strategies. By focusing on the time it takes to recover the investment, managers and investors can make quicker and more accurate decisions regarding the allocation of marketing resources.
The formula for CAC payback period is as follows:
CAC Payback Period = CAC / (Contribution Margin per Month)
This formula divides the Customer Acquisition Cost (CAC) by the Contribution Margin per month, which is calculated as the average revenue per user (ARPU) per month multiplied by the contribution margin ratio. This will give you the time (usually in months) it takes to recoup the marketing investment used to acquire new customers, considering the amount you earn from them each month and how much of this is actual profit after variable costs.
Using the Contribution Margin instead of Gross Margin in this context is more accurate because the Contribution Margin considers the specific variable costs associated with the product or service, thus providing a more precise insight into how much each customer is truly contributing to your profit.
So, the formula considers not just the value of a customer over their lifetime (like the traditional CLV/CAC ratio does), but also the speed at which the investment in acquiring a customer is recouped.
Remember, the lower the payback time, the faster the company recoups its investment. Therefore, a lower payback time is generally preferred as it indicates a more efficient use of resources and improves the company’s cash flow situation.
In conclusion, payback time offers a more comprehensive and practical way to evaluate marketing investments than solely relying on the CLV/CAC ratio. By incorporating the time value of money, accounting for risks, and providing a more straightforward metric, payback time enables businesses to make better-informed decisions about their marketing budgets.
The way you have been calculating CLV and CAC might be all wrong. Companies often fail to see the complexities in these metrics, and end up giving inaccurate and inflated estimations. To properly understand the actual value a customer has to your business, and to be able to plan your marketing strategy accordingly, I suggest you follow this article’s advice and carry out an in-depth analysis of your marketing metrics.
By considering the variable costs before marketing (including COGS), businesses can get a more accurate picture of the profitability of their products or services. This is particularly important for businesses that sell physical products, where the cost of production and shipping can be a significant portion of the total cost of a sale. By factoring in these costs, businesses can make more informed decisions about pricing and product or service offerings.
By considering the nuances when calculating CLV and CAC, instead of sticking to the standard method, businesses can make more informed decisions about their pricing, product or service offerings, and marketing strategies, and ultimately improve their profitability and sustainability.
Furthermore, it’s worth considering Payback-Time as a potentially superior metric to the standard CLV/CAC ratio. This measure takes into account the time value of money, emphasizing the speed at which the investment in acquiring a customer is recouped. It is also more accurate and easier to communicate. This focus on cash flow efficiency can help companies reinvest their profit quicker and speed up business growth, optimize their marketing strategies, better allocate resources, and maintain a healthy financial position.
As we close, it’s important to stress the unique integration this analysis has achieved, bridging the gap between two critical business spheres — corporate finance and performance marketing. Traditionally seen as separate domains, this exploration has unveiled how a transdisciplinary approach can lead to a significantly enhanced understanding of crucial business metrics. By delving into the complex mechanics of Customer Lifetime Value, Customer Acquisition Cost, and Payback Time, we’ve effectively employed corporate finance principles to augment the depth and accuracy of performance marketing metrics.