Why LTV to CAC Isn’t the Best Measurement to Use

May 8, 2023 by Christine

Like any business owner, you understand the importance of measuring your business’s performance. And to do that, you probably calculate your LTV to CAC. But what you may not realize is that this metric isn’t totally reliable. Although it’s long been considered the standard for calculating profitability, it doesn’t necessarily give you a clear, accurate view.

If you want to determine how your business is really doing, you need to look beyond LTV to CAC. To help you out, we’re going to explain why this metric isn’t the best measurement and what to look at instead.   

What Is LTV to CAC?

LTV to CAC stands for lifetime value to customer acquisition cost. It’s a metric that compares the lifetime value of a customer to the cost of acquiring that customer.  

The lifetime value (LTV) of a customer is the total amount of revenue a customer is expected to generate over the entire course of their relationship with your business. This includes the initial purchase, along with any subsequent purchases, referrals, and other forms of engagement.

The customer acquisition cost (CAC) is the cost of acquiring a new customer. This can include marketing and advertising expenses, sales team salaries, and other costs associated with acquiring new customers.

These metrics can and should be looked at individually. However, comparing them can (in theory) provide insights into your business’s long-term profitability.  

How?

• A high ratio indicates your business is generating more revenue from each customer than it is spending to acquire them. This suggests that your business has a sustainable model and can continue to invest in customer acquisition.
• A low ratio, on the other hand, it may mean your business is spending more to acquire customers than it is generating revenue from them. This can be a warning sign that your business may not be sustainable in the long run and may need to adjust pricing, marketing, or other strategies.

How to Calculate LTV to CAC

To calculate your LTV to CAC, you need to use the following formula: Lifetime Value of a Customer / Customer Acquisition Cost

That is, you need to divide the customer lifetime value by your customer acquisition cost.

For example…

• If your LTV is $2,000 and your CAC is $500, your ratio would be 4:1 (i.e., for every $1 you spend on acquisition, you bring in $4).
• If your LTV is $1,200 and your CAC is $600, your ratio would be 2:1 (i.e., for every $1 you spend on acquisition, you bring in $2). 

So, what’s considered a good LTV to CAC? 

The truth is that it varies by factors like industry and business age. But in general, 3:1 is considered the benchmark for a good ratio. 

Where LTV to CAC Falls Short

Overall, LTV to CAC is a useful metric for businesses to track, as it provides valuable insights into customer profitability and the effectiveness of marketing and sales efforts. However, it’s not always the most accurate or comprehensive way to measure a business’s health. Often it can be misleading or fall short of providing an adequate view of performance. 

Why?

• LTV can be difficult to calculate accurately. 

Calculating LTV requires predicting how much revenue a customer will generate over their lifetime. This can be challenging and may require significant assumptions, including how long they’ll do business with you before leaving. Also, LTV can be affected by factors outside of the business’s control, such as changes in the market or competitive landscape.

•  CAC doesn’t account for the quality of customers.

CAC only measures the cost of acquiring a customer; it doesn’t take into account the quality of the customer. You may be able to acquire customers at a low cost, but if those customers are not profitable or are unlikely to be loyal, the business may not be sustainable over the long term.

•  Sales efficiency can provide more comprehensive insights. 

Sales efficiency measures how much revenue a business generates per dollar of sales and marketing spend. By tracking this metric, you can determine which sales and marketing channels are most effective at driving revenue and adjust your strategy accordingly.

•  Customer success is a key driver of sustainable growth.

Customer success metrics, such as customer retention rate, customer satisfaction, and Net Promoter Score (NPS), can provide more useful insights into whether a business is creating value for customers and building long-term relationships. This is an important factor in your business’s success and one that LTV to CAC doesn’t consider. Improving customer success can lead to increased customer loyalty, positive word of mouth, and sustained revenue growth.

• LTV to CAC isn’t suitable when pricing varies dramatically.

Another issue with using LTV to CAC is that it’s dependent on averages—something critics of this metric often point out. This isn’t practical if you offer products or services with different price points and spend the same amount on customer acquisition. The ratio you end up with may be high for top-paying customers and low for others. So, you won’t have a true understanding of how well your business is performing.

What Are Better Measures of Performance?

As you can see, LTV to CAC can be a misleading metric. That’s why it’s important to consider other sales and marketing metrics to gain a more comprehensive understanding of business performance. 

Here are some other metrics to track for a more in-depth view:

• Customer retention rate: This metric measures the percentage of customers who continue doing business with you over a given period of time. A high retention rate indicates that your customers are happy with your product or service and are likely to continue using it in the future. Focusing on improving customer retention can often be more cost-effective than acquiring new customers.
• Customer churn rate: Churn rate is the percentage of customers who stop using your product or service over a given period of time. High churn rates can indicate that customers are dissatisfied with your product or service or that there are competitive pressures or other external factors impacting your business. Reducing churn can help improve long-term profitability and growth.
• Gross margins: Gross margin is the percentage of revenue remaining after deducting the cost of goods sold (COGS). High gross margins indicate that your business is profitable and that you have a healthy level of pricing power. Maintaining strong gross margins can help fund future growth and investments.
• Customer satisfaction and Net Promoter Score: Measuring customer satisfaction can provide valuable insights into what customers like and dislike about your product or service. Net Promoter Score (NPS) is a widely used measure of customer satisfaction that asks customers how likely they are to recommend your product or service to others. Improving customer satisfaction can lead to increased retention, referrals, and, ultimately, higher revenue growth.
• Marketing ROI: Marketing return on investment (ROI) measures the effectiveness of your marketing spend in generating revenue or other key business outcomes. Tracking marketing ROI can help you optimize your marketing spend and prioritize investments that are driving the most impact.

Takeaway

Although LTV to CAC can be useful in certain contexts, it’s important to consider a range of other metrics to gain a more comprehensive understanding of your business’s performance. By tracking metrics such as customer retention, churn rate, gross margins, customer satisfaction, and marketing ROI, you can make more informed decisions and drive sustainable growth over the long term. Change the way you view success for greater accuracy. 

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Filed Under: Business Tips Tagged With: Customer Acquisition, customer lifetime value, Improving Performance, small business tips