We don't need to tell you this, but running an online business isn’t without challenges. There are sales and marketing, numerous time-consuming operational tasks, management, and an endless list of other duties. All those responsibilities can make it hard to find the time - and motivation - to consistently report on your performance.
But there are some metrics that are crucial to understanding the success of your company. One of those is your customer lifetime value (LTV) to customer acquisition cost (CAC) ratio. Understand this metric, and you'll have an idea of whether your marketing costs to acquire new customers are paying off - a pretty critical piece of your store's success.
LTV/CAC compares the expected lifetime value of a new customer to the cost that it took to acquire that customer. In other words, it allows you to determine whether the profit you will make from a customer over their lifetime is worth the expense you incurred to obtain that customer.
To understand this metric, it’s important to dig into the two individual data points that make it up. Let’s take a closer look at customer lifetime value and customer acquisition cost.
Customer lifetime value is the estimated revenue that a business will gain from its customers, over their entire lifetime. It takes into account your average order value, your purchase frequency and your customer relationship length. It offers insights about how your business is performing when it comes to customer satisfaction, loyalty, and trust and measures your efforts in nurturing customer relationships. It also allows for more accurate forecasting and focuses on a long-term approach to customer value. Learn more about calculating customer LTV.
Customer acquisition cost, on the other hand, tells you how much it costs to acquire your new customers. To get to an accurate acquisition cost, you should to include expenses related to marketing, any commissions that are paid to sales team members for their successful conversions, and any other expenses related to acquiring new customers. It provides insights about sales and marketing efficiency.
You can see how LTV and CAC are related – their values go hand-in-hand. A lower LTV isn’t necessarily bad, as long as the CAC is much lower. A higher CAC isn’t bad when you have a higher level of revenue coming in. The ratio of LTV/CAC provides you with a complete picture of your marketing team’s efforts and performance.
What that means is that the higher your LTV/CAC ratio, the more efficient and effective your sales and marketing are. That said, you may be wondering what the “magic number” that indicates success is when you calculate your ratio. While there aren’t any hard and fast rules regarding what your ratio should be, and a good ratio may be different for different types of businesses, a ratio of 3:1 is generally accepted as a favorable indication of a company’s performance. It shows that you are doing well with acquiring new customers and retaining existing ones.
When your LTV/CAC ratio is lower than it should be, it means that you need to work on retaining customers and building loyalty. Conversely, when your ratio is higher than it should be, it means that you should be looking for new customers.
If this metric sounds pretty straightforward, that’s because it is. You don’t have to do any mental gymnastics to understand what your ratio means. However, it is important that you track your ratio to better understand your business and which direction you should take your marketing strategies.
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