Updated: May 19, 2020
One of the most popular business model today are subscription based businesses. From Dollar Shave Club to Netflix, and even the accounting world. Accountants used to charge clients on an hourly basis, at GFT we find that the subscription business model adds value to both the firm and the customers. As clients find a service that they consume daily or monthly at various levels of consumption, predictable pricing is to their advantage.
Business leaders shift from enticing customers to purchase more of the product to building and protecting long term relationships with its customers. Longer relationships mean a longer revenue stream. The effectiveness of this relationship can be measured as Lifetime Value or LTV.
Below explains how to get to your 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.
The cost of acquiring these customers is needed to measure your profitability. To measure the costs to acquire a customer is straight forward, it is a ratio based off of the total marketing and sales expense and the number of new customers acquired.
If it costs too much for you to acquire your customers in relationship to the revenues you will earn, then you need to look at what leverages you can use to improve the ratio. The typical rule is that your LTV/CAC must be at least a multiple of 3 – the lifetime value of your customer must be 3 times higher than the cost to acquire them.
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 amount 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.
In short, 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 someone to track LTV/CAC and guide you through decisions 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.