Step 1: Determine contribution per customer. Variable contribution equals revenue earned less all variable costs incurred in serving a customer in a given year, excluding marketing costs related to customer acquisition. A back-of-the-envelope approach for calculating the average contribution per customer—usually sufficient for providing a rough “reality check” on a business model—simply subtracts a company’s total variable cost from its revenue for the most recent period, then divides the remainder by the average number of customers served during that period.
A more sophisticated approach recognizes that 1) contribution per customer may vary substantially for different customer segments, and 2) the annual contribution per customer is likely to change over the life of a customer relationship. With respect to the latter point, a company may be able to increase its prices over time. Also, the company should be able to collect information about the customer’s preferences and may be able to use that information to cross-sell related products. Finally, over time, variable costs incurred in serving a customer tend to decline as a percentage of revenues for two reasons. First, experienced customers tend to generate fewer customer service inquiries because they “know the ropes.” Second, as a company grows, it typically can improve its operational efficiency and realize volume discounts in procurement.
Step 2: Determine customer life. To calculate the average length of a customer relationship, one can employ the formula 1/x, where “x” is the annual customer churn rate, that is, the percentage of customers that terminate their relationship with a company from year to year. So, if a company retains 70% of its customers each year, then the average customer life is 1/0.3 = 3.33 years. Of course, the average length of a customer relationship may vary widely for different customer segments.
Step 3: Calculate LTV. The annual cash flows per customer calculated in Step 1 are discounted to their present value, using the number of years for the duration of a customer relationship calculated in Step 2.
Step 4: Calculate CAC. A back-of-the-envelope approach for calculating the average cost of acquiring a new customer takes total sales and marketing expense incurred during a period, then 1) subtracts any costs related to retention and usage stimulation efforts targeted at existing customers (e.g., time spent by sales reps calling on existing accounts, rather than prospecting for new customers); and 2) divides by the total number of new customers acquired during the period.
As with the other inputs described above, average customer acquisition costs will vary considerably by customer segment. Likewise, different acquisition methods may have very different costs. Each method will be subject to decreasing returns during a given period as available prospects in the most attractive segments are converted into purchasers and the company is then forced to target prospects for whom the product is less compelling. For this reason, companies employ cohort analysis: they measure the productivity of their marketing efforts—and optimize their efforts accordingly—by tracking, over time, the LTV and CAC of “vintages” of new customers acquired during a given period through different marketing methods.
Step 5: Compare LTV and CAC. In theory, for any given new customer, a company can afford to increase CAC up to the point that CAC = LTV for that customer. Of course, if CAC = LTV for every new customer that a company acquired, it would not generate enough contribution to cover its fixed costs. For this reason, many companies employ a target LTV/CAC ratio. For many software-as-a-service businesses, for example, the target ratio is 3:1.
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