Most often B2B startup and small business owners are given the advice to measure CAC and LTV, some even wonder what do these stand for. There are loads of TLA (Three Letter Acronyms) in the business world.
CAC stands for Customer Acquisition Cost – The cost of acquiring a customer
LTV stands for Life Time Value – The total revenue generated from a customer over their relationship with your company
In our interactions, We have observed that most B2B startup and small business owners don’t quite understand these financial metrics and most importantly the ones that are important. Their energies are channelized towards building a product, marketing them and selling them. At the same time they also desperately want to be cash flow positive and attract the attention of investors.
Most importantly your company needs to be gross margin positive, even though companies like Amazon, Flipkart, Uber are running on loss, they make money on each transaction and in the long term that’s what makes them cash flow positive, their focus is growth over profitability. However what matters most is the access to capital to fund that growth and stay afloat during the waiting period in the trenches.
While on the other hand, the scarcity of capital is also a good thing as it helps companies focus their attention and innovate. Raising a large amount has proven to be disastrous when one doesn’t know where to invest it that’s ROI positive.
Getting back to the CAC and LTV, these are terms that are so loosely used at quick introductions, pitches, meetups, associations and so on.
In principle the lower your CAC the higher your margins and higher your LTV the better are your margins. Entrepreneurs have been sold to the idea of LTV/CAC should be > 1 ensuring that their ventures are going great. However, in practical operating environments, there are some aspects that entrepreneurs need to keep a watch over.
Customer Acquisition Cost:
The customer acquisition cost is the cost/expense you pay to acquire a new customer. In its simplest form, it can be worked out by:
Dividing the total costs associated with the acquisition by total new customers, within a specific time period.
Total Marketing costs/Total number of new customers
CAC is a metric that’s often measured wrong by the marketing and sales teams. This happens often because marketing costs are spread across channels and buyer journey pathways are complex. Moreover, there is a carryover aspect (last year advertisements producing results this year because of some triggers). Empirical relationships are always a challenge to calculate. Contrary to the above CAC is thought to be a straightforward calculation.
Calculation by responses:
We have observed that companies spend money on ads, and they calculate CAC by the number of responses. Let’s say they spend about $500, and they got 5 clients, they assume that the CAC is $100, what they missed here is the overall marketing spend that covered PR, marketing tech, staff and other aspects that run the whole marketing function.
Secondly, they fail to recognize the attribution of the pathways, and they just want to know what channels are working best in that direction.
Channel offered CAC:
Thirdly with channels selling cost of per unit conversion, entrepreneurs assume that to be CAC, let’s say Facebook shows you cost per lead is $50, it’s assumed to be the CAC
Increased Ad spends:
Fourthly, with the emergence of “marketing gurus”, whose advice mostly is to spend money in certain channels where the returns are higher for certain industries, entrepreneurs take this advice very seriously and invest in high ad spends rather than on focussing on conversion rate optimization across the funnel. Most do not have a funnel in the first place. What could optimization do let’s say your company spend $500 on an ad campaign on LinkedIn and you got 5 leads, the overall marketing budget for the month is $5000 then your CAC is $1000/lead, let’s say you created an exclusive landing page for the target audience of the Ad and A/B tested it, and now after the optimization you get 12 leads the CAC drops to $417 that’s a huge drop by over 50%?
When we have discussions on growth with entrepreneurs what they most often share is a free flow idea of growth especially a visionary expansion but growth is tangible and in business growth translates into an increase of shareholder value. CAC needs to also be seen in that light and what we are emphasizing here is to get the metrics right.
This is going to be an ongoing series on Metrics that Matter. Next post will be on Life Time Value.