The Dangers in Making and Using CLV and CAC Calculations

, ,

This Strategy Lab turns our attention to incredibly important and incredibly misleading statistics used by just about every company, every investor, and every analyst:

The Cost of Acquiring Customer (CAC),  and;

The Customer Lifetime Value (CLV; sometimes called LTV, for Lifetime Value).

Let’s dig in.

Conceptually, subscription businesses — and most businesses end up being subscription businesses at some level — need to understand the value of a customer and the cost of acquiring that customer. This analysis drives decisions on sales cycles, pricing, marketing channels and just about every other activity related to sales and customer retention.

Customer Lifetime Value (CLV)

Customer Lifetime Value (CLV) is an estimate of the value of the customer. The best way to estimate this is to take:

  • An educated average of a customer’s likely time with the company and multiply that by
  • An estimated incremental contribution by period for that time.

In example form:

  • Over the past 4 years, the company sees its customers terminate the relationship after 36 months. The range is between 12 months, and not-at-all-yet, but those that did leave lasted on average about 36 months.
  • The company’s weighted average revenue per client per month is $1,000 (the subscription value), and the company estimates its gross margin at 70 percent, and its incremental sales expense at 5 percent. So, a starting estimate for the contribution would be revenue x 65 percent = $650 per month.
  • CLV could be estimated at 36 months x $650 per month, or $23,400.

So many choices, so many pitfalls

Like most analyses, the most dangerous outcome is the simplest: I know with absolute certainty that the $23,400 CLV is wrong. Decisions that use this will be equally, and perhaps tremendously more so, wrong.

The most common shortcut, and it is most commonly used by advertisers and customer channel providers in their pitches to a company, is to substitute customer revenue for gross profit. In the example above, that would change the contribution from $650 per month to $1,000 per month.
Most companies suffer from a dramatically different, variable cost structure. Check the marketer’s math, and substitute a realistic contribution value for the shortcut.

The second most common shortcut or error is the exclusion of identifiable marginal costs. In our example above, the sales channel is paid a marginal 5% commission on revenue , or $50 per month. That’s easily included. There may be others that are generally true: Is there an incremental support expense for an ‘average’ customer? Look for something that is outsourced, for example.

Finally, people collectively and frequently overestimate customer life times —> they underestimate churn. The reason for this one is really simple: It’s hard to fess up to customer losses. Everyone wants to believe that they create customers for life. It’s honestly healthier to place a more conservative, or shorter, estimate on customer decision cycles. That mentality will usually force a more candid perspective on investments and payoffs associated with customer retention.

Which leads into the second part of the equation:

The Cost of Acquiring Customers (CAC).

This should be sub-titled: The Lengths People Will Go In Efforts to Reclassify Selling Costs.

There is growing investor interest in lead or demand generation. Oversimplifying to some degree: This is the web 2.0 version of “build it and they will come.’ We think of it as a ‘network effect’ benefit. If a company builds buzz, and the interest in the offering exceeds sales resources, demand generation becomes a powerful growth tool.

Most hyper-growth companies utilize some demand generation management approach. That does not mean that demand generation created hyper-growth companies. In our experience, few companies actually get to this point. For the rest of us, sales is an honorable necessity.

As a result, CAC should include the selling and marketing expenses, broadly defined, and divided by the normalized number of customers acquired in the measured period.

To continue our simplified example:

  • The company employs 2 marketing people, 2 sales people (on a combination of commission and base salary and expenses), and several outsourced resources supporting channel efforts. The company also participates in several conferences, regular advertising and software to manage leads and opportunities. The total burdened departmental costs are $2 million annually, or $500,000 per quarter.
  • In the last quarter, the company signed 100 new customers.
  • The resulting CAC is $5,000 ($500,000 / 100).
  • The resulting CLV : CAC = 4.68 (23,400 / 5,000).

Beyond testing for general reasonableness, there is not much good that comes from this figure alone. It is equally dangerous to drive comparisons to peer groups or industry expectations (search for ‘what is a good CAC ratio’ for examples of what not to do).

There are some great things that come from the doing the analysis. Here are a few:

  1. Because the numbers can be worked so easily, we now know to review them skeptically. Purchase cautiously from any vendor or channel partner that leads with some ridiculous CLV : CAC expectation or ROI calculation. You are so warned. A lot of work done in automotive retailing relies on claims of 25: 1 ROI multiples, and even some that are higher. They all rely on retail revenue, in an industry with gross margins of 2 or 3 percent.
  2. There is real insight to be gained in thinking through the efficacy of channels, and CAC via a specific channel is a good analytic tool. Channel investments and tradeoffs are a great use of CAC –> an internal check and review.
  3. CAC will fluctuate wildly, based on the calculation of acquired customers. Rarely are sales numbers and trends linear, or even necessarily predictive. We guide clients through a deeper understanding of sales cycles and timing and cost to gain real insight into a ‘normalized’ number or expectation.
  4. Use the analysis to consider trends, and test the reasonableness of assumptions around the elasticity of the ROI. At some point, even for the greatest situations, diminishing returns show themselves.
  5. Customer churn, or more positively retention, is a more interesting and productive dialogue. A penny saved is indeed a penny earned. If CLV is declining, spend some time considering the tenure and potential of longer retention.

If you are still committed or required to use these figures and ratios on their own, we encourage conditional ranges and scenarios. And, be very cautious in assuming, especially early in the growth curve, any network effect or magical demand generation. Yes, it can happen, and yes, it is totally magical, and yes, many hyper-growth companies see this happen. It just doesn’t happen as frequently as many would believe. There is strong history and experience to encourage proper suspicion and skepticism of plans or vendors that promise or depend on this occurrence.

Instead, use the opportunity or question around CAC to think and talk about the customer acquisition model, and which variables and assumptions need to be tested, can be extrapolated, or are of real value. CAC and CLV are valuable starting points to a conversation, just not great punch lines on their own.

14 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published.