Have you found yourself asking, How much money can I spend on marketing to acquire a customer and still be profitable? That’s a pretty common challenge ecommerce businesses face while planning their marketing budget. The answer is rooted in your Customer Lifetime Value (CLV) and Customer Acquisition Cost (CAC).
In this post, we’re diving into each equation so you can understand how much it takes to attract a customer. And, what it means for your business if they stick around.
Defining Customer Lifetime Value (CLV or LTV)
CLV is the estimated amount of profit (after operational expenses like COGS, shipping, and fulfillment but before marketing expenses) that each of your customer brings to your store. Marketing expenses are highly variable and may change after you calculate and analyze your CLV. That’s why you leave those out of this calculation.
The calculation methods for CLV vary greatly and get complex. The model below is a simple place to start. Note: there is no one way to calculate CLV!
First we want to calculate the Customer Value (CV). This tells us, on average, how much a customer is worth over a certain time period. Here we calculate all metrics across a one year time period.
Customer Value (CV) = Avg. Order Profit * Purchase Frequency over a given time period.
Note: Avg. Order profit should not include marketing expenses but should include COGS, transaction fees, refunds, taxes and shipping costs.
Average. Order Revenue = [Revenue / # of orders] in a given time period
Avg. Net Profit Margin = [(Revenue – all expenses, except marketing) / Revenue] in a given time period
Purchase Frequency = [Total # of Orders / Total # Customers] in a given time period
Customer Lifetime Value (CLV) = CV * Average Customer Lifespan
Average Customer Lifespan: That’s the amount of time you expect to retain customers, typically measured in years. The average customer lifespan varies depending on store type, customer satisfaction, products, and how often your customers view or remember your brand.
On average, three years is a good rough number for a new healthy ecommerce store. If you’re dropshipping or have a hard time re-engaging customers with your store, use one year. Subscription businesses should use a different calculation (see contractual vs. non-contractual CLV methods).
Defining Customer Acquisition Cost (CAC)
The customer acquisition cost is the total marketing expenses to acquire a customer.
- Ad Spend of all campaigns (Facebook Ads, Google Ads, print, etc)
- Payroll of marketing employees
- Costs related to the design of the ads
- Marketing Software </ul>
Using CLV and CAC Together
If CLV tells us how much the average lifetime of our customers are worth after non-marketing related expenses and the CAC tells us how much it costs us to acquire a customer, then we can use the combination of these metrics to see what we can spend on marketing to acquire a customer and remain profitable.
A useful metric is your CLV:CAC ratio.
Payback period = CAC / ((annual revenue per customer) * (Gross margin in %)) Common misuses of LTV
A common mistake is for a CLV prediction to calculate the total revenue or even gross margin associated with a customer. It can cause CLV to be multiples of their actual value, and instead need to be calculated as the full net profit expected from the customer.
Check out our profitability guide for more ecommerce tools, tips, and resources.