You should already be familiar with the definition and concept of ROI: as the name Return On Investment suggests, it will tell you whether you are making money off your investments.
However, measuring ROI on your digital marketing campaigns can be complicated. Not all digital marketing aspects will tie directly to revenue or conversion, and so don’t have any tangible value on paper. Yet, we know that activities that contribute to metrics like traffic, awareness, impressions, and other intangible metrics do contribute to our revenue and profit. We often call these metrics as ‘soft metrics’, and they will be a huge part of this discussion.
So, how can we effectively measure ROI for digital marketing campaigns? Although the answer to this question can be very broad, there are two key metrics that can help you: the Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV).
In this guide, we have an in-depth discussion for the two metrics, and how you can use them not only in calculating ROI, but also to make future predictions. Let us begin.
Customer Acquisition Cost (CAC)
CAC, as the name suggests, is how much money you will need to spend before a lead finally purchases your product or service, or in short, converts into an actual customer.
In the past, tracking this cost is fairly difficult, and in some cases, impossible. Yet, in this digital era with all the trackable campaigns and web-based advertising, CAC has grown to be one of the most important digital marketing metrics.
How CAC Will Affect Your Business
CAC is a very useful metric to determine the profitability of your company, and so is often used by early-stage investors and incubators to analyze the scalability of a new company.
For internal operations, and especially marketers, CAC is mainly used to optimize the ROI of advertising campaigns. When CAC can be reduced, it will translate into a bigger profit margin.
Determining CAC is actually really simple:divide your total marketing expenses during a certain period with the number of customers acquired.
So, for example, if your company spent $1,000 on advertising expenses in a year, and you acquire 500 customers that year, your CAC is $2.
But, how about marketing expenses that are more long-term in nature, and won’t directly contribute to customer acquisition? You’re right, in these situations, for example if we have an early investment of SEO, the CAC calculation will be a little clouded. On the other hand, what if a certain customer bought your product or service more than once during that one year period? This will also disturb the ‘accuracy’ of your CAC.
Well, digital marketing is indeed a complicated thing, and these situations are just a few examples of countless others. Thankfully, there are other metrics, that in conjunction with CAC will resolve these situations, and as we move forward in this guide, we will learn how.
How To Use CAC
In general, our aim is to know the CAC for each of your marketing channels. This way, we will know which channels are effective in acquiring customers, and which are not. The main idea is: the more money you put on lower CAC channels, the more ‘effective’ your marketing progress is.
There is no easy way to achieve this, as you will need to track all of your marketing bills in different channels.
There are many different approaches in calculating CAC for individual marketing channels, but generally they will boil down to just three groups:
- The Average Approach: Here, you assume all channels contribute equally in acquiring customers. This thought roots on the belief that each channel supports the next: your ads support your blog posts, organic search support ads, etc.
- The Ideal Approach: Ideally, we should calculate CAC based on the channel’s direct contribution. This can be really difficult, but the latest technologies have helped us achieve this better. For example, conversion tracking pixels in PPC ads will let us know exactly how many customers we acquired.
Ultimately, this step will depend on your company’s own views and philosophy on how you acquire customers.
Lifetime Value (LTV)
Above, we have discussed how repeat purchases may cloud CAC calculations. On the other hand, what if a certain customer keep purchasing from your competitors after they bought from you?
Lifetime Value (LTV) or Customer Lifetime Value (CLV) is a metric that is specifically designed to resolve this type of situations, and it is also one of the most popular and effective marketing metrics to analyze marketing costs and customer acquisition strategy.
So what is LTV? As the name suggests, it is the projected valve generated in revenue by a certain customer during the lifetime of their relationships with your company.
Why LTV Is Important
The focus of CAC is generally how we can acquire a lot of customers, and how cost-efficient we can do so. However, we can’t always make everything cheaper, and so the LTV shifts our focus on how to maximize our acquisition spending instead of minimizing cost.
In an ideal world, we will strive to get both, but the truth is, it is always more costly to acquire new customers (see CAC above) than retaining existing ones. And so, the primary focus of our businesses should be increasing LTV, either by maximizing revenue during that lifetime, or extending the lifetime period.
By focusing on LTV, we shift our paradigm on our customers: their value is not short-term, but rather long-term with repetitive purchases.
Realizing the true value of our customers will help us focus on the right channels: those that bring us the most profitable long-term customers. Also, by having a proper LTV calculation, it will also improve our CAC calculation: we now have more budget to acquire customers, because we are not limited by the value of a single customer purchase, but their repetitive purchase over the relationship with our brand.
There are many different approaches in calculating LTV. In fact, a lot of big companies adopt several different methods to calculate their LTV. So, ultimately your LTV calculation will be based on your company’s philosophy on customer retention.
Here, we will share several of the most common calculation methods, which can act as a great building block for your future calculation.
Historic LTV Method
This is the most basic LTV calculation. Yet, although the concept is pretty simple, the execution can be really complicated.
Here, you calculate the actual value of LTV with the gross profit sum of all historic purchases of a customer. So:
Historic LTV= (Transaction 1+Transaction 2 ….+Transaction N) x Average Gross Margin
You might have seen that the issue with this method is that it will be extremely difficult to calculate on an individual and up to date basis. However, there are many marketing tools and software that can assist you with this, such as Ometria or KissMetrics.
Simple Predictive LTV Method
Predictive LTV calculation attempts to predict the total revenue a customer will generate throughout their entire lifetime.
The keys in a successful predictive LTV calculation is your average customer lifespan (ACL) and average gross margin (AGM). For both, you will need to collect enough data to make them accurate.
The simple predictive LTV calculation is:
LTV=(average monthly transactions x average revenue x AGM)x ACL in months
Detailed Predictive LTV Method
Here, you put monthly retention rate and monthly discount rate into the equation.
Calculating retention rate is fairly simple:
Retention Rate= Number of Customers who made a purchase within the last 2 years who made another purchase within the last 6 months/Total number of customers who made a purchase within the last 2 years
This number will change every month (if not, you are doing an excellent job!), and so we call it monthly retention rate.
Depending on your policy, your discount rate might also change every month, and so the detailed LTV calculation is like this:
Detailed LTV= Simple LTV (monthly retention rate/(1+monthly discount rate-monthly retention rate)
LTV to CAC Ratio
LTV/CAC=LTV to CAC Ratio
Calculating the ratio between LTV and CAC is a great way to predict future growth. If your LTV:CAC Ratio is above 1, you are making an investment of the future, and the bigger the number is, the better you are.If the ratio is too high, you can also decide to invest more on marketing and/or sales.
The benchmark varies by industry, but generally you want to aim for a 3:1 or better. If your ratio is 5:1 or higher, it is likely that you are under-investing in marketing, and you might want to adjust to achieve better short-term gains.
Remember, however, that LTV is a volatile metrics. It can drop easily if a new competitor enters the scene, or can increase dramatically if you update your product/service.
CAC and LTV are useful metrics, especially to understand the true value of your customers. By measuring your CAC and LTV, you can have a better understanding on how much you will need to spend on marketing, and whether your campaigns are making or losing money in a long-term basis.
As mentioned, measuring the ratio between LTV and CAC is a great way to predict future growth, and hence you can adjust your strategy depending on the result.