What is LTV:CAC Ratio and Why is it important?

Knowing your KPIs well is a crucial part of the ecommerce business. For store owners running their business as a one-man army, it can get even more difficult. If you are struggling with KPIs, here’s something to note down – The LTV:CAC ratio is one of the most important ecommerce growth KPIs. 

So what is it  & why should you care about it? Let’s break it down.

The LTV : CAC Ratio

The LTV:CAC ratio, also known as the customer lifetime value to customer acquisition cost ratio, is a measure of the efficiency of a company’s sales and marketing efforts. It is calculated by dividing the customer lifetime value (LTV) by the customer acquisition cost (CAC).

To understand this KPI, it’s necessary first to understand what LTV and CAC are.

Customer Lifetime Value (LTV)

LTV (or LTVC) stands for ‘lifetime value’ and is used to calculate how much money a customer spends over their lifetime with a company. In ecommerce, LTV is calculated using the following formula:

LTV Sales / Average Order Value

The average order value is simply the total amount spent divided by the number of orders placed. So if someone buys $100 worth of products each month for 6 months, then they have an average order value of $600. However, if they spend $1000 at the end of the year, then their LTV would be $500.

In terms of calculating the LTV of a product, we need to know what the average order value of a product is and what sales volume it achieves. If a product sells for $10 per unit, then its average order value is $100. If it sells 100 units in a month, then its LTV would be $10,000.

Customer Acquisition Cost (CAC)

It can be described as the total cost of acquiring customers divided by the total number of customers acquired over a given period.  This cost includes all expenses related to marketing and sales efforts, such as advertising, lead generation, and sales salaries. It is an important metric for businesses to track, as it can help to determine the efficiency of their sales and marketing efforts and the return on investment for those efforts. 

So what does it tell you?

A high LTV: CAC ratio indicates that a company is effectively acquiring and retaining customers, while a low ratio may indicate that the company is spending too much to acquire new customers or is not effectively retaining them. Optimizing this ratio is important for businesses, as it can help to ensure that they are generating a positive return on investment for their marketing and sales efforts.

In short, it lets you know how much you should spend to acquire a customer. It is an indicator that lets you identify whether you are spending too much per customer or losing opportunities because of low spending. 

An ideal LTV:CAC ratio is 3:1, which means that you are generating 3x revenue than what you spend on acquisition.  If your LTV/CAC ratio is less than 1.0, you’re in danger. If the ratio is 1:1, you lose the more you sell. 

The Cons

Even though the LTV:CAC ratio is an important metric, there are a few drawbacks that you need to keep in mind. 

• It does not take into account the time value of money, i.e, it does not account for the fact that money received in the future is worth less than money received today. This means that the ratio may overstate the efficiency of a company’s sales and marketing efforts if the CAC is paid upfront while the LTV is received over a longer period of time.
• It does not consider the profitability of individual customers: The LTV:CAC ratio treats all customers as equally valuable, regardless of their profitability. This means that a company with a high LTV:CAC ratio may still be losing money on some of its customers.
• It does not account for changes over time as it is based on historical data and does not consider changes in market conditions or the company’s own operations that may affect future LTV or CAC.

The Take-Away

In conclusion, it measures the efficiency of a company’s sales and marketing efforts by comparing the customer lifetime value to the customer acquisition cost. A high LTV:CAC ratio indicates that a company is effectively acquiring and retaining customers, while a low ratio may indicate that the company is spending too much to acquire new customers or is not effectively retaining them. 

NOTE: While the LTV/CAC ratio is a great indicator of your growth, the predictions can change with several factors.  For example, your LTV depends on churn rates and can change according to seasons, market conditions, etc. 

Therefore, it is advisable to track other KPIs like customer churn, monthly revenue growth etc., along with the LTV/CAC ratio.

Thanks For Reading !