In today’s competitive business landscape with shifting consumer behavior, customer acquisition is a top priority for companies across all industries. To evaluate how effective sales and marketing efforts are, businesses rely on key metrics to measure their return on investment (ROI). One of those key metrics is the LTV to CAC ratio. Here’s how to make sense of the LTV to CAC ratio, how to calculate it, and why it matters.
Understanding LTV and CAC
Let’s break down the individual components of the LTV to CAC ratio:
Customer Lifetime Value (LTV) represents the predicted gross profit a business can expect to generate from a customer over time. Factors that influence LTV include the average order value, purchase frequency, the product gross margin and customer retention rate. LTV helps businesses quantify the long-term financial worth of their customers. Building repeat business from loyal customers is the key to increasing LTV.
Customer Acquisition Cost (CAC) refers to the total cost incurred by a business to acquire a new customer. This includes expenses related to marketing campaigns, advertising, sales salaries, and any other costs associated with attracting and converting a new customer.
Calculating LTV to CAC ratio
First, calculate LTV & CAC
LTV = Average order value X Average purchase frequency X Customer lifespan X Gross Margin
- Average order value: The average dollar amount a customer spends per transaction.
- Average purchase frequency: The average number of purchases a customer makes in a given period.
- Customer lifespan: The average duration of a customer’s relationship with the company, typically in years. Depending on the business, it may make sense to measure annually, or longer.
- Gross Margin: Gross profit (Revenues minus Costs of Goods Sold, or COGS) / Revenue
For an instant calculation, you can plug your numbers directly into our LTV Calculator here.
CAC = Total sales and marketing expenses / Number of customers acquired
- Total sales and marketing expenses: Total costs you incur to convert prospects into customers, including marketing, advertising, sales, and other related expenses.
Once you have the LTV and CAC values, you can calculate the ratio by dividing LTV by CAC.
LTV to CAC ratio = LTV / CAC
An example company
To explain these concepts, let’s assume that Julie is the founder of Sunrise Organics, a direct-to-consumer (DTC) business that sells organic skincare products online. The company buys inventory from several dozen suppliers and invests heavily in sales and marketing to generate revenue.
Julie is working on a plan to add more product offerings in order to grow the brand’s market share. Expansion will require a bigger investment in inventory, sales, marketing, and customer support. Management needs metrics to determine if the expansion will be profitable over the long-term, and decides to first take a look at the LTV to CAC ratio.
The company determines that the average order value is $100, and that four orders are placed per year, and the gross margin is 50%. Research indicates that the average customer lifespan is three years. Now let’s plug those numbers into the formula.
1) LTV = Average order value X Number of purchases per year X Customer lifespan X Gross Margin
- Average order value: $100
- Number of purchases per year: 4
- Customer lifespan: 3 years
- Gross margin: 50%
LTV = ($100 x 4 x 3 x 50%) = $600
So, the LTV for Sunrise Organics is $600. Now, Julie needs to determine the costs required to find customers.
2) CAC = Total sales and marketing expenses / Number of customers acquired
- Total sales and marketing expenses: $50,000
- Number of customers acquired: 500
CAC = ($50,000 / 500) = $100
Now that she has both LTV and CAC, Julie can easily calculate the LTV to CAC ratio.
3) LTV to CAC ratio = (LTV / CAC)
LTV to CAC ratio = $600 / $100 = 6
So, the LTV to CAC ratio for this organic skincare brand is 6.
When Sunrise Organics spends $100 to acquire a new customer, that average customer will generate $600 in revenue over time. If the company can continue to spend $100 and generate $600 in revenue, adding more product offerings to grow their market share makes financial sense.
Interpreting the LTV to CAC ratio
In the example above, the LTV to CAC ratio of 6 indicates that, on average, the revenue generated from customers is six times higher than the cost of acquiring them. This suggests a favorable situation for the company, as the revenue generated from customers is significantly greater than the investment made to acquire a new customer. It implies that the company’s marketing and sales efforts are efficient and that there is potential for profitability and growth.
A lower ratio could indicate a need to reevaluate your sales and marketing spend, while a higher ratio could indicate there’s an opportunity to invest more in sales and marketing.
|Impact on LTV
|Impact on LTV/CAC
|Average order value ⬆
|Number of purchases per year ⬆
|Customer lifespan ⬆
|Gross Margin ⬆
|Impact on CAC
|Sales/marketing spend effectiveness ⬆
|# of new customers ⬆
Additional factors that can increase LTV are high customer retention rate, repeat purchases, cross-selling and upselling, increased average order value (AOV), customer loyalty programs, referral programs, personalized customer service, and positive customer reviews.
On the other hand, factors that can decrease LTV include low customer retention rate, infrequent or no additional purchases, decreased AOV, lack of customer engagement, negative customer experience and reviews, lack of personalization, and poor product quality.
The benefits of repeat business
When consumers find a business that provides a quality product or service at a reasonable price, the customer is likely more inclined to purchase again. A reputable business can spend less on marketing and sales and maintain a relationship with the repeat customer when they have built trust around their brand.
Motivating repeat customers
When customers stay longer, they generate more total revenue, which increases LTV. An increase in LTV improves the LTV to CAC ratio. There are several approaches a company can use to drive repeat business.
- Provide great service: You may do business with a company that has some flaws but goes above and beyond to offer great service. When customers have a good experience, they’re more likely to come back to your brand over a competitor that may offer lower prices.
- Discounts: Offering discounts to existing customers is much cheaper than spending dollars to find a new customer. Although businesses need to price items accordingly to turn a profit, a 15% discount resulting in an additional sale is still something to consider.
Reducing acquisition costs
Another effective strategy to improve the LTV to CAC ratio is to lower CAC. Analyze your entire process to move someone from a prospect to a customer. How many emails, sales calls, or webinars does it require, on average? Are there sales and marketing efforts that are more effective than others? If so, focus your spending on activities that produce the best results, and reduce costs in other areas.
|LTV to CAC Components
|Impact on LTV to CAC Ratio
|Higher average order value (AOV)
|More purchases per year
|Longer customer lifespan
|Lower average order value (AOV)
|Less purchases per year
|Shorter customer lifespan
These components have a direct impact on the LTV to CAC ratio. By focusing on increasing LTV and decreasing CAC, businesses can achieve a higher LTV to CAC ratio, which indicates more favorable financial performance and potential for growth.
Successful companies continually look for ways to improve results. Increasing your LTV to CAC ratio can generate higher profits and improve cash inflows over the long-term. If you find that your ratio is going up or down over time then you can be certain key business drivers that are behind these shifts, so it is worth your while to monitor your ratio, and the individual components, and make any adjustments early to correct deviations that may weaken the LTV to CAC ratio in order to keep your business operating in strong condition.
By tracking the LTV to CAC ratio over time and comparing it with industry benchmarks, management is better positioned to assess the effectiveness of its marketing campaigns, make informed decisions about allocating resources, and identify areas for improvement to ensure the long-term profitability of the business. Use the LTV to CAC ratio to make informed decisions, and to outperform the competition.