Lifetime value and customer acquisition cost
Many direct marketers focus on response and conversion rates to determine the success of a direct mail program. Based on those analyses they often develop a CAC (Customer Acquisition Cost), sometimes also referred to as a CPA (Cost Per Customer Acquisition).
This analysis is only providing partial information since it’s limited only to analyzing the cost of adding a customer without knowledge of the value of that customer. The customer value metric most marketers use is the Lifetime Value (LTV) of a customer. (It’s also referred to as a Customer Lifetime Value, CLV or CLTV, just to add a couple more acronyms to the list.)
Using Lifetime Value to Calculate Program Profitability
Simply put, if your customer Lifetime Value (LTV) is greater than your Customer Acquisition Cost (CAC) then your direct mail program will be profitable. That makes it essential that your LTV calculations are well thought out using appropriate methodology and assumptions.
If you are charged with acquisition marketing, make it your responsibility to understand your LTV and how it’s determined—or calculate the LTV yourself if need be. Your best bet is to collaborate with your colleagues in finance and gain alignment around LTV and your CAC targets for marketing.
Calculating Customer Lifetime Value
Search online and you’ll find many ways to calculate customer LTV. Some are very complicated and appropriate for sophisticated financial analysis. Below is a more simplified approach for making initial assessments of customer segments and targeting. It accounts for three key factors:
Let’s use a simple example of selling specialty coffee to show how this works.
Annual Margin Calculation (m): Let’s assume that our average sale is $25, and that the average customer will make eight purchases per year, for an average annual revenue of $200. Let’s also assume that the cost of the coffee itself and order fulfillment is $10 per order. The calculation for the Annual Margin for a customer ($25-$10)*8 = $120.
Retention Rate (r): Since our coffee and service are great, our annual Retention Rate is 85%.
Finally, the Rate of Discount (i): We’ll peg our Rate of Discount at 10%.
Drum roll please! Based on our assumptions our LTV is $408. If we acquire new customers for less than $408, our marketing program is profitable. If it costs more, we are losing money.
Other LTV Considerations
We’ve provided a simple example of an LTV calculation. There are a number of other factors for consideration. For example:
- LTVs often differ by segment: Start by calculating an overall LTV, but evolve to the best practice of segmenting LTV calculations based on customer types (especially B-to-B), geography or other measurable segments.
- LTVs differ by channel: Our discussion here is about direct mail, but LTV by acquisition channel can vary significantly. For example, the LTV of customers acquired via the web may be very different from those acquired from various offline channels.
- Year-Over-Year Metrics: The simplified formula assumes that Annual Margin, Retention Rate and Discount Rate are the same year-over-year in perpetuity. However, some businesses may have metrics that change significantly over time. For example, maybe Annual Margin increases as customer relationships deepen – or perhaps Retention Rate rapidly deteriorates as new competitive products hit the market. Calculating LTV using these scenarios requires a more sophisticated approach that is beyond the scope of this article.
- Customer Referrals: In some industries, customer referrals can be a significant source of new business. One client in the high school tutoring space acquired over 35% of its new customers through referrals. If customer referrals are a key driver of your business, include them in your LTV equation (and we recommend more research for options on how to do this).
- Make it a dynamic process: Challenge your LTV calculations as the company gains knowledge about customer behavior and the costs related to LTV calculations change over time.
Once you’ve calculated your Lifetime Value, you will have the power to set your target Customer Acquisition Cost to optimize your overall marketing spend knowing both the value and the cost of every new customer.