As an ecommerce entrepreneur, one of the most critical metrics you need to keep an eye on is the ratio of Customer Lifetime Value (CLV) to Customer Acquisition Cost (CAC). In simple terms, CLV is the total gross margin revenue generated by a customer during their entire relationship with your business, and CAC is the cost of acquiring that customer. By measuring this ratio, you can make informed decisions about your marketing efforts and optimize your overall business strategy. In this article, we’ll dive into the importance of CLV to CAC ratio and how to calculate it for your ecommerce business.
Why is the CLV to CAC Ratio Important?
Understanding the CLV to CAC ratio helps you determine the efficiency and effectiveness of your marketing and customer acquisition efforts. It allows you to evaluate whether you are spending too much or too little on acquiring customers and informs you about the sustainability of your business model.
A high CLV to CAC ratio indicates that your customers are generating more revenue than it costs to acquire them, which is a positive sign for your business. On the other hand, a low ratio means you might be spending too much on customer acquisition or not maximizing the lifetime value of your customers.
Calculating Customer Lifetime Value (CLV)
To calculate CLV, you need to consider three key factors: average order value (AOV), purchase frequency, average customer lifespan, and gross margin. The formula for CLV is:
CLV = (AOV x Purchase Frequency) x Average Customer Lifespan x Contribution Margin Percentage
Let’s break down each component:
- Average Order Value (AOV): The average amount spent by customers per transaction. You can calculate AOV by dividing the total revenue in a given period by the number of orders placed during that period.
- Purchase Frequency: The average number of times a customer makes a purchase within a specific timeframe. Calculate this by dividing the total number of orders by the total number of unique customers.
- Average Customer Lifespan: The average length of time a customer continues to make purchases from your business. This can be challenging to calculate, especially for new businesses, but you can estimate it using historical data or industry benchmarks.
- Cointribution Margin Percentage: Take the total revenue and subtract the variable cost of fulfilling those orders (Variable costs are expenses that vary directly with the quantity of products sold, such as the cost of goods sold (COGS), shipping costs, payment processing fees, etc.) Once you have your contribution margin dollars, divide that number by total revenue to get your contribution margin percentage.
Calculating Customer Acquisition Cost (CAC)
CAC is calculated by dividing the total marketing and sales expenses by the number of customers acquired during a specific period. This includes costs such as advertising, promotions, and staff salaries related to marketing and sales efforts.
CAC = Total Marketing and Sales Expenses / Number of Customers Acquired
Measuring the CLV to CAC Ratio
Now that you have calculated your CLV and CAC, simply divide your CLV by your CAC to find the ratio:
CLV to CAC Ratio = CLV / CAC
Determining a Profitable CLV to CAC Ratio
Software businesses, with their incredibly high gross profit margins shoot for a CLV to CAC ratio of greater than 3:1; meaning the lifetime value of a customer is at least three times the cost of acquiring them.
Monitoring the CLV to CAC ratio is crucial for ecommerce businesses looking to optimize their marketing strategies and improve overall profitability. By regularly calculating this metric, you can identify areas for improvement, adjust your marketing spend, and focus on strategies that maximize customer lifetime value while minimizing acquisition costs.