Calculating and Evaluating LTV:CAC for eCommerce Businesses
Choosing which KPIs to monitor can be difficult for an eCommerce business. There are so many formulas to consider--COGS, average order values, CAC--it can quickly become overwhelming. Not all benchmarks are created equal, so picking the best options for your company that will provide valuable insight is crucial. One important metric in evaluating your eCommerce company is your LTV:CAC ratio.
What is the LTV:CAC ratio?
The LTV:CAC ratio comprises two separate metrics, customer lifetime value (LTV) and customer acquisition costs (CAC). By examining this number, you can understand how your gross profit per customer compares to how much you spent to acquire them. These analytics help you judge many areas of your company, such as your marketing spending and your product pricing. Ideally, your LTV should be significantly higher than your CAC to indicate that the money you are putting in to get your customer base is paying off.
LTV:CAC = Customer Lifetime Value (LTV) / Customer Acquisition Cost (CAC)
What is customer lifetime value (LTV)?
Your lifetime value of a customer (LTV) is the gross profit that a specific customer is expected to create during their time interacting with your company. When calculating your LTV, you not only look at the gains that a customer has brought in but your customer retention rates. The longer you can keep customers buying your products and producing revenue for you, the higher your LTV will be.
What is customer acquisition cost (CAC)?
Your customer acquisition cost (CAC) considers all expenses for gaining one customer across your platforms. For example, you must consider your costs across all marketing channels, such as social media ads like Facebook or Instagram, Google SEO targeting, marketing team salaries, cost of goods, and other content marketing costs.
How to calculate LTV:CAC in eCommerce
To calculate LTV:CAC, we'll first examine how to calculate the separate metrics.
How to calculate LTV
To calculate your LTV, you can use a few different equations.
LTV = (Average Revenue Per Customer x Gross Profit Margin) / Customer Churn Rate
LTV = (Revenue Per Customer - Direct Expenses Per Customer) / (1 - Customer Retention Rate)
Subscription eCommerce businesses may use Average Annual Recurring Revenue (ARR) as a proxy to revenue per customer and then use their annual churn rate rather than their individual customer churn rate as an alternative method.
How to calculate CAC
For CAC calculation, use the below:
CAC = Total Sales and Marketing Expenses / Number of New Customers
The key to effectively tracking CAC is that you include all costs associated with sales and marketing. This number should include advertising, technology and people costs within the time period you are examining.
An example of LTV:CAC
A Shopify merchant spends $20,000 to acquire 500 new customers. The cost is fully loaded with advertising, technology and personnel costs for that period. The average revenue per customer is $75 and the gross margin per customer is 66.6%. The company retains 80% of its customers per year.
LTV = ($75 Average Revenue Per Customer x 66.6% gross profit margin) / (1 - 80%) = $250
CAC = $20,000 in Total Sales and Marketing Expenses / 500 New Customers = $40
LTV:CAC Ratio = $250 / $40 = 6.25x
What is considered a good LTV:CAC in eCommerce?
Generally, a 3:1 ratio is considered good, but this assumption can vary significantly across different categories and products. Any LTV:CAC ratio less than 1 means the eCommerce business is destroying value by spending too much in acquisition. In the example above, the Shopify merchant should have high confidence that money they put into the business will result in strong profits.
By using LTV:CAC analytics specific to your company category and measuring it over time, you can gain greater awareness of your strengths and weaknesses and your performance against industry benchmarks. When your ratios are lower than desired, it's time to evaluate how to improve margins, churn, marketing effectiveness or all of the above. When your ratios are high, double down on what's working.
Conclusion
LTV:CAC is a valuable metric you can use to understand your profits per customer better. Building up your brand and increasing customer loyalty can help dramatically improve your LTV. By examining this ratio, you can better identify key pain points in your process, from customer churn to marketing costs.
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