(103) On Unit Economics, CAC, LTV et al

Starting this post, I am looking to write a series of articles on commercial aspects of products — pricing and packaging, profitability, business cases etc.

Most often when people talk about growth, they often write about:

1. Acquisition
2. Retention and
3. Monetization

In that order.

Acquisition often acquires the lion’s share of attention when it comes to growth. PriceIntelligently, a pricing consultant firm conducted a survey of over 500 SaaS companies and found that monetization has the biggest impact on the bottom line.

Let’s understand the fundamentals of SaaS pricing.

Working on your Unit Economics is the foundation for product profitability

Pricing can drastically improve the foundational numbers of your unit economics.

A primer on Unit Economics

Unit economics describes a specific business model’s revenues and costs in relation to an individual unit. A unit refers to any basic, quantifiable item that creates value for a business. Thus, unit economics demonstrates how much value each item — or “unit” — generates for the business.

For an airline, a unit might be single seat sold, whereas a rideshare app like Uber would define a unit as one ride in their vehicle.

These units are then analyzed to determine how much profit or loss they individually produce.

In one of my previous organizations, the unit economics was number of gross orders (GO) from customers. These orders could mean any product. That factored in the budget and future business planning.

Reasons Unit Economics Is Important

The data produced through unit economics analysis is integral to the short-term and long-term financial planning of a company.

1. Unit economics can help you forecast profits. Understanding unit economics can help you project how profitable your business is (or when it is expected to achieve profitability), since it produces a simple, granular picture of your company’s profitability on a per-unit basis.
2. Unit economics can help you optimize your product. An understanding of unit economics is also helpful in determining the overall soundness of a product, providing evidence to suggest whether it’s overpriced or undervalued. Such information can help a company identify favorable strategies for product optimization, as well as determining whether marketing expenses are worth the cost.
3. Unit economics can help you assess market sustainability. Unit economics is also particularly adept at analyzing a product’s future potential. For this reason, many startup founders and co-founders rely heavily on unit economics in the early stages of business development to measure their overall market sustainability.

How to Calculate and Analyze Unit Economics

There are two ways to approach calculating unit economics, depending on how you choose to define a unit.

Method 1: Define Unit as “One Item Sold”

If a unit is defined as “one item sold,” then you can determine unit economics by calculating the contribution margin, which is a gauge of the revenue amount from one sale minus the variable costs associated with that sale. The equation is expressed as:

Contribution margin = price per unit — variable costs per sale.

Method 2: Define Unit as “One Customer”

If you choose to define a unit as “one customer,” then the unit economics is determined by a ratio of two different metrics:

• Customer lifetime value (LTV): how much money a business receives from a given customer before the customer “churns” or stops doing business with the company
• Customer acquisition cost (CAC): the cost of attracting a client

Therefore, the equation that produces your unit economics is: customer lifetime value divided by customer acquisition cost (UE = LTV/CAC)

To succeed in business, LTV > CAC

• Increasing your customer lifetime value (LTV) and decreasing your customer acquisition cost (CAC) are fundamental to achieving high growth as a business. And the ratio LTV/CAC is the ratio that your entire business is based on.
• CAC is the cost of your sales and marketing efforts to acquire a new customer.

CAC = (Total cost of sales & marketing)/ (Number of customers acquired)

How to Model Customer Lifetime Value?

There are two ways to model customer lifetime value: predictive LTV and flexible LTV.

Method 1: Predictive LTV

Predictive LTV helps you forecast the average customer is likely to act in the future. The formula for measuring predictive LTV is:

Predictive LTV = (T x AOV x AGM x ALT) / number of customers for a given period

• T (average number of transactions): The number of total transactions divided by a given time span, thus determining the average number of transactions in that period.
• AOV (average value of an order): AOV is determined by dividing the total revenue by the number of orders, resulting in an average monetary value of each order.
• AGM (average gross margin): AGM is calculated by deducting the cost of sales (CS) from the total revenue (TR) in order to determine actual profit. The equation to determine gross margin is: GM = ((TR-CS) / TR) x 100.
• ALT (average lifetime of a customer). ALT is equal to the churn rate figure divided by 1. The churn rate is determined by taking the number of customers at the beginning of a given period (CB) and measuring it against the customers left at the end of the period (CE). That equation is expressed as: Churn rate = ((CB-CE)/CB) x 100.

Method 2: Flexible LTV

Flexible lifetime value helps you account for potential changes in revenue. This is particularly useful for new businesses and startups, which are likely to undergo changes as they grow and develop. The formula for measuring flexible LTV is:

Flexible LTV = GML x (R/(1 + D — R))

• GML (average gross margin per customer lifespan): The amount of profit generated by your business from a given customer in an average lifespan. This is measured by the equation: Gross Margin x (Total Revenue / Number of Customers During the Period).
• D (discount rate): Discount rate measures the rate of return on investment.
• R (retention rate): Retention rate is determined by measuring the number of customers who repeatedly made purchases (Cb and Ce) against the number of new customers acquired (Cn), expressed in the equation: ((Ce — Cn) / Cb) x 100.

Why CAC is important and how to measure it?

The CAC metric is important to two parties: companies and investors. The first party includes outside, early-stage investors who use it to analyze the scalability of new Internet technology companies. They can determine a company’s profitability by looking at the difference between how much money can be extracted from customers and the costs of extracting it.

The other party interested in the metric is an internal operations or marketing specialist. They use it to optimize the return on their advertising investments. In other words, if the costs to extract money from customers can be reduced, the company’s profit margin improves and it makes a larger profit.

Then, investors are more interested in providing the company with the resources it needs, partners are more committed to growth, and the company can use the improved profit margins to pass the value to its customers for a greater market position.

How to measure CAC?

Basically, the CAC can be calculated by simply dividing all the costs spent on acquiring more customers (marketing expenses) by the number of customers acquired in the period the money was spent. For example, if a company spent $100 on marketing in a year and acquired 100 customers in the same year, their CAC is $1.00.

There are caveats about using this metric that you should be aware of when applying it. For instance, a company may have made investments on marketing in a new region or early stage SEO that it does not expect to see results from until a later period. While these instances are rare, it may cloud the relationship when calculating the CAC.

It is suggested that you perform multiple variations to account for these situations. However, we will provide some examples of calculating the CAC metric in its most pragmatic and simple form with two examples. The first company (Example 1) has a poor metric. The second (Example 2) has a great one.

Example 1: An ecommerce company

In this example, we take a fictitious ecommerce company that sells organic food products. The company spent $100,000 on advertising last month, and its marketing team says 10,000 new orders were placed. This suggests a CAC of $10, a figure that has no meaning in itself.

If a Mercedes-Benz dealer has a CAC of $10, the management team will be delighted when looking at the year’s financial statements.

However, in the case of this company, the average order placed by customers is $25.00, and it has a markup of 100% on all products. This means that on average, the company makes $12.50 per sale and generates $2.50 from each customer to pay for salaries, web hosting, office space, and other general expenses.

While this is the quick and dirty calculation, what happens if customers make more than one purchase over their lifetime? What if they completely stop shopping at brick and mortar grocery stores and buy from only this company?

The purpose of customer lifetime value (CLV) is specifically designed to resolve this. You can find a CLV calculator by simply searching in your favorite search engine. In general, this metric helps you form a more accurate understanding of what the customer acquisition cost means to your company.

A $10.00 customer acquisition cost may be quite low if customers make a $25.00 purchase every week for 20 years! However, in this ecommerce company, they are struggling to keep customers and most of the customers make only one purchase.

Example 2: An online CRM (SaaS) software company

The company in this example provides an online system for managing sales contacts for customer relationship management. The cost of distributing the software is low since it is cloud-based, and customers need little support. Moreover, it is able to easily retain customers because of the pain customers would experience uploading all the contacts, tasks, and events they are tracking onto a new CRM software.

The company has worked its way up the search engines and has an expert sales support team working for minimum wage, based out of their call centers in a rural Midwestern town. The company also has many strategic partnerships that provide a steady supply of customers. In fact, they spend only $2.00 acquiring a new customer with a lifetime value of $2,000. Here is the calculation:

1. Total cost of new customer sales support call centers: $1,000,000/year
2. Total cost paid to strategic alliance partners per customer: $1.00
3. Total monthly spending on search engine optimization: $20,000/year

Total new customers generated in the year: 1,020,000

Customer acquisition cost: ($1,020,000 / 1,020,000 customers) + $1.00 per customer = $2.00

As in our previous example, the amount is worth only the money extracted from customers. This company has used a customer retention calculation to determine that its customer lifetime value (CLV) is $2,000. That means this particular company is able to turn a $2.00 investment into $2,000 of revenue! This is both attractive to investors and a signal to the marketing team that an effective system is in place.

What About CAC Per Marketing Channel?

Knowing the CAC for each of your marketing channels is what most marketers want to know. If you know which channels have the lowest CAC, you know where to double down on your marketing spend. The more you can allocate your marketing budget into lower CAC channels, the more customers you can obtain for a fixed budget amount.

If you know which channels have the lowest CAC, you know where to double down on your marketing spend.

The simple approach is to break out your spreadsheet and gather all your marketing receipts for the year, quarter or month (however you want to do it) — and add up those amounts by channel. For example, how much did you spend on Google Adwords and Facebook advertising? In this case, you might put this in a column called “PPC” or “Pay-Per-Click”. How much did you spend on SEO and blogging? This might go into a column called “Inbound Marketing Costs”.

Now that you know how much you spent on each channel, you can apply a simplistic formula and assume each channel “worked” to get the same amount of customers as the next channel. This would be an averaging method. The only issue is that it can be difficult to know what channel is responsible for which customers.

You can easily see where this approach becomes futile. Say you only ran one Pay-Per-Click advertisement on one day — just as a test. You spent $10 total and that’s all. When you look at your spreadsheet, it will appear Pay-Per-Click would be the best marketing channel because of its extremely low CAC. It would be unwise to double down on Pay-Per-Click because you know you really didn’t utilize it all for that period of time.

For ecommerce companies that sell physical products, it’s easy to know what Pay-Per-Click advertisements lead to direct sales because of the conversion tracking the advertising platform provides. In this case, you can determine that value and note this in your spreadsheet. This will give you a better idea of how your Pay-Per-Click campaigns are doing relative to the rest of your marketing spend.

Also, with tools like customer analytics, you can trace paying customers back to their “last touch” attribution source. This means you can see the last channel the customer visited before doing their first sales with your online business.

For example, if a customer came from an organic search result, you would know that SEO would be responsible for that customer acquisition.

Now, this is where marketing gets philosophical :).

One school of thought is that each marketing channel supports the next channel — it’s a combined effort. Your blog posts reinforce your Pay-Per-Click ads, and all channels work together to bring in customers. This is a common notion in outdoor advertising. Billboards reinforce T.V. campaigns, which reinforce radio spots and so on. Ultimately it comes down to your own company’s philosophy on how to attribute customer acquisition.

If you feel that last touch is “good enough,” you can use that model for your CAC calculations.

However, you may have wildly popular viral videos (think Dollar Shave Club) or a blog that drives a lot of word-of-mouth referrals. These obviously support your overall marketing efforts and tend to be more difficult to track and attribute to customer acquisition.

How You Can Improve CAC

Let’s face it, we all wish that our company was like Example 2. The reality is that our advertising campaigns can always be more effective, customer loyalty can always be improved, and more value can always be extracted from consumers. There are several methods your business can improve its CAC in its industry:

• Improve on-site conversion metrics: One may set up goals on Google Analytics and perform A/B split testing with new checkout systems in order to reduce shopping cart abandonment rate and improve the landing page, site speed, mobile optimization, and other factors to enhance overall site performance.
• Enhance user value: By the highly conceptual notion of “user value,” we mean the ability to generate something pleasing to the users. This may be additional feature enhancements/qualities that consumers have expressed interest in. It may be implementing something to improve the existing product for greater positioning, or developing new ways to make money from existing customers. For instance, you may realize that customer satisfaction ratings have a positive correlation with retention rate.
• Implement customer relationship management (CRM): Nearly all successful companies that have repeat buyers implement some form of CRM. This may be a complex sales team using a cloud-based sales tracking system, automated email lists, blogs, loyalty programs, and/or other techniques that capture customer loyalty.

An optimized pricing strategy leads to an optimized funnel. If you position, package, and price effectively, then a significant part of your sales and marketing job is already done. Without this pricing strategy, its more expensive to acquire customers as you will be attracting the wrong prospects that don’t fit with your value.

If you position, package, and price effectively, then a significant part of your sales and marketing job is already done. Without this pricing strategy, its more expensive to acquire customers as you will be attracting the wrong prospects that don’t fit with your value.

Based on the experiences of successful SaaS companies, you need an LTV/CAC ratio of atleast 3:1 to run a successful business. With continous price optimization, you can push that ratio to 11:1 and beyond.

Pricing is the foundation of your unit economics. LTV/CAC is the most important ratio your business is based upon.