Updated: May 18
One of the most popular business models today are subscription based. From Dollar Shave Club to Netflix, and even accounting firms! Accountants used to charge clients on an hourly basis but find that they can add value with a monthly fee - this is because predictability in pricing benefits both parties.
Business leaders have been shifting their focus from enticing customers to purchase more of the product, and instead are building long-term relationships with them. The effectiveness can be measured by Lifetime Value or LTV - how much revenue do you expect over your lifetime?
List of inputs that drive LTV:
Average Revenue per User (ARPU): The average annual revenue per account in the initial year of a cohort.
Gross Margin: The margin based on the revenue left over after accounting for the cost of serving customers—for example, the cost of operations, support, or customer success programs.
Churn Rate: The rate of lost customers during a period represented by number of lost customers divided by beginning number of customers.
Retention Rate: The rate of customers retained at the end of a period or 1 – churn rate.
Expansion: Any additional annual revenue earned from the current customer base through volume growth, cross-selling, or upselling.
Customer Acquisition Cost
To measure the costs of acquiring new customers, it's important to know how many you've acquired in total and how much did it cost. To measure the costs to acquire a customer is straight forward, use a ratio of the total marketing and sales expense and the number of new customers acquired.
The typical rule of LTV/CAC is that it should be a multiple between 3 and 7. If your cost to acquire customers isn't high enough, then there are many ways you can improve the ratio by using leverage tools which will help bring down spending on marketing campaigns while increasing revenue in relation with each customer acquisition effort.
How to increase the Ratio:
Increase your retention rate: when you increase your retention then the lifetime value of the customer will also increase. This is where it would be in your best interest to build strong relationships with your customers.
Increase Price: Increasing prices will increase your ARPU and possibly LTV, but it may also increase your churn which could decrease your LTV. This one may be a double-edged sword, depending on the price sensitivity of your product and the number of existing substitutes in the market.
Upsell: Adding a new tier of service and moving your current customer base onto the newer price point can be a good way to increase price while increasing the customer value proposition.
Cross-sell: When you sell your existing customers additional complementary service, such as maintenance or support can help increase your revenue stream per customer.
Lower your customer acquisition cost: This will require adjusting your marketing strategy to effectively reach your intended customers in a cost efficient manner.
The LTV/CAC ratio is a powerful tool for subscription-based businesses. It provides a clear view of financial health, marketing effectiveness and value creation. If your business needs guidance on LTV/CAC as you start your SAAS or subscription business, we at GFT have the expertise that can help. Feel free to contact us for a free consultation.