Why you shouldn’t use CLTV/CAC

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Long-Term Business Sustainability Depends on the Right Measures

A metric commonly used to measure the performance of high-growth businesses is Customer Lifetime Value over Customer Acquisition Cost, or more simply CLTV/CAC. It is a much better metric to provide an objective to marketing teams than many others we have seen in the past, but it has also some tremendous flaws associated with it, and if not used correctly and in the right context, it can jeopardize the business using it.

Let’s first start with a historical perspective

Ten to fifteen years ago, it was common for businesses give to their marketing teams and agencies goals based on traffic or cost per visit. (You may not believe it, but I was on the Google Sales team managing a portfolio of ~50 clients per quarter – trust me, it was a thing!) This approach may be unthinkable now, but remember that at the time the advertising industry was mostly made of TV and print advertising. Measuring visits, rather than reach, was a big step forward.

TV advertising has not evolved in a long time – Photo by Peter ᴳᴱᴼ Kent

    Then tracking technologies became more advanced, and businesses started setting their objectives based on cost per sale (or cost per action – CPA). Measuring your teams or partners based on actual results was a big step forward, and that’s where the big divide between brand marketing and performance (or DR) marketing really started shaping the industry.

This metric soon showed its limits when businesses had to deal with a variable basket size and the average order size wasn’t truly representative of the consumer population. This is around the time “big data” became the thing every company wanted to use, and while it brought a lot of nonsense, it also brought a higher degree of sophistication when segmenting and clustering the customer base and target audience. In this context, return on investment (ROI) or return on ad spend (ROAS) was providing a much more granular view, but it set apart the businesses that were able to track their activity at a transaction-level. It also became obvious which businesses did not prioritize the infrastructure and engineering resources to make the “big data dream” a reality.

Right at this point (3 to 5 years ago depending on the country and industry), after multiple years of economic growth, the deep pockets of venture capital groups, and the mainstream idolization of startups and entrepreneurs, everyone with an idea was getting funded, and disruptive businesses started taking off. Investors had to manage their portfolios discerning the companies that had a path to profitability and the ones that did not.

Blue Apron subscription box

The best business model for investors to fund was one based on subscription: you can more easily forecast the revenue stream and the growth pattern than any other “on-demand” business. Here you see great startup companies like Dollar Shave Club, Birchbox, Blue Apron and Stitch Fix really taking off. At the same time, large players like Adobe stopped sales of their Photoshop, Lightroom, and Illustrator programs and instead bundled them in a subscription service called Creative Cloud.

In the context of a subscription service, monitoring cost per sale or acquisition alone doesn’t make sense anymore. It’s all about the customer lifetime value (CLTV – or the profits they are going to bring over time) over the cost of acquiring new customers (CAC). As more and more companies were being funded and financed, CLTV/CAC started to become more and more popular.

What metric should I use then?

To some degree, all businesses should look at customers rather than sales in order to build loyalty, but there is a fundamental difference in the way we look at retention in a subscription business versus an on-demand business. In a subscription business, a key metric to monitor is churn (i.e. what makes your customers cancel their subscription once you have acquired them), while in an on-demand service, every sale from a repeat customer may be driven from a re-acquisition of some sort. Not being locked into a plan means that every time they want to make a purchase for the good or service the company provides, they can choose between all the available options. Retention becomes a much more meaningful term because it’s the customer deciding to come back to your business for another transaction. To remind them to choose you over someone else, you are likely going to have to spend a combination of money or resources (advertising, promotion, communication, content).

All businesses should look at customers rather than sales in order to build loyalty, but there is a fundamental difference in the way we look at retention in a subscription business versus an on-demand business

For this reason, a much better metric for a non-subscription business is customer lifetime value (CLTV) over customer acquisition and retention cost (CARC) or CLTV / CARC. The lower is the amount of resources spent retaining your customer base, the higher are the margin opportunities of the business. Customer acquisition cost is not a meaningful metric and neither is the retention component of lifetime value if we don’t also look at the cost of driving this retention.

Why I have never heard of this metric?

I understand I cannot just make up a metric and hope it becomes a thing, but it’s important to understand why CLTV/CAC became so popular.

Early stage investors focus more on growth than long-term sustainability

 

The boom of startups in recent years was possible only thanks to the financing made available from angel investors and venture capital groups. These investors are not in a company for the long-term, and they are likely to re-sell the stake after a period of high growth. This means that they are far more concerned with the growth rate (of customers, sales, revenue) than the long-term sustainability of the business. Also, when favoring subscription business models, the risk of burning through the addressable audience (i.e. customers making one purchase and never coming back) is much less of a concern. With so many more people being involved with early businesses, there has been a democratization of the CLTV / CAC metric that is very insightful but tailored to a specific context: the one of subscription services and early-stage investors.

With so many more people being involved with early businesses, there has been a democratization of the CLTV / CAC metric that is very insightful but tailored to a specific context: the one of subscription services and early-stage investors.

I predict that the attention to the cost of retention, and therefore a shift to CLTV/CARC, is going to become much more meaningful in the next few years. Nowadays everyone has a subscription service for clothing, toothbrushes, makeup, food, and entertainment, but this also creates incredible competitive pressure for the players in the market. When I canceled my subscription to Hulu, Netflix, or the New York Times, I received multiple emails with incredibly discounted offers, and I kept seeing “please come back” ads online. Accepting any of the tempting offers means a cost or a margin loss for the company that is not captured in the CLTV/CAC metric. (For the record, I re-subscribed to Netflix and the NYT).

Re-acquisition offers are not considered in CAC – Photo by Artem Bali

If you are focused on long-term sustainability of the business you should start looking at CLTV/CARC rather than CLTV/CAC. You may have minimal retention costs if you are running a subscription service or concerns to monitor it if you are bankrolled by VC money, but when the competitive pressure in the subscription space is going to mount and the economic growth is going to slow down, having a good routine on monitoring your sustainability may be the thing that will help you thrive for many more years.


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Author: Paolo

Economist by education, digital marketer by profession, coffee roaster by hobby.