Understand where your business is heading with the right metrics
Most financial managers spend a huge amount of time getting the accounting right, the funding optimized and the cash flows in order (i.e. chasing customers for payment). Yet, very little time is spent on measuring the fundamental health of the business.
Traditional managerial accounting practices reflect very poorly on how well a business is doing. For instance, contribution margin measures the incremental margin (aka operational margin) that every individual sale is contributing to the fixed costs. Yet, in many businesses, and increasingly in our hyper-competitive societies, the contribution margin can be very high but the costs of getting a new customer are also high.
In addtion, the only way you can be successful is through high loyalty - where the costs of subsequent sales is close to zero and the margin stays high.
What are CAC and CLV?
The software industry, and more precisely the 'SaaS' (Software as a Service) industry popularized two concepts, which I believe can be applied to many industries and help to better assess the health of a business:
The CAC, or Customer Acquisition Cost, represents the average spend necessary to acquire a new customer in a given business unit or for certain products.
The CLV, or Customer Lifetime Value, represents the present value of all incremental cash flows brought by this customer after they has been 'acquired' (i.e. their first purchase).
There are multiple ways to calculate them. So rather than pretend to make a guide, we'll show you how we calculate them at Odoo and their value for our Direct Sales team in Europe (selling subscriptions to Odoo online, as opposed to our Indirect team, which manages sales made through our partner network). We use an inbound model with inside sales: customers contact us through our website, and our sales people usually close the sale on the phone.
For the CAC, we simply took our monthly average sales and marketing costs, divided by the monthly new customers (which we averaged for the last 12 months) resulting in average CAC of €2,990. Given that the marketing team works for both direct & indirect sales, we allocated marketing costs based on revenues. It's worth noting, some companies only take the variable marketing costs (e.g. the advertising spend) to reflect the incremental costs - we do very little paid marketing so we assume the entire marketing cost is variable.
The CLV in our case is a bit more complex. Most customers subscribe to our 'Business Pack' (now replaced by 'Customized apps' and implementation services), which means that we offer them a proactive, dedicated consultant to set up Odoo for their company and provide further support at anytime. The value is great, but the costs aren't negligible. The largest chunk of costs occur in Year 1, then decrease as time goes on. As of Year 2, we discounted the cash flows to their present value, at the weighted average cost of funding.
Other key figures (or assumptions for your plan) are the churn rates, i.e. what's the percentage of clients leaving (or not repeating business) at the end of every period (the average 'repeat' payment, or renewal period: a month, year, etc.).
You have two churn rates: the $ amount churn (the $ value of customers leaving vs the total $ of customers due to renew) and the 'logo churn' (the number of clients leaving among your total base under renewal). The main number to use for your CLV is the $ churn. If your customers pay monthly, a monthly churn should be measured, and a yearly churn for yearly payments. It is important to have the 'true churn': among all the customers than can leave, how many are actually leaving? For example, do not simply take the new customers from last month if they all signed a yearly contract.
Lastly, you can take an upsell factor, which is the average amount of extra money the customers that stay will spend after every period. Customers that love your products or services will be willing to spend more as you nurture your relationship with them. At Odoo, the upsell almost entirely compensates for the churn which is great, but to be conservative we make the assumption that the net churn is about 10%.
Having the churn, the future cash flows and discounts for your total customer base, you can calculate an average CLV for your customers.
So we mapped out the cash flows post-acquisition and discounted them. I've created a simple spreadsheet which gives you the key numbers for Odoo as an example (P=1 Year). For Odoo, our CLV nets to €7,300, or 2.4 times the CAC. Feel free to use the spreadsheet as a template.
For companies not working with subscriptions, the CLV is simply based on frequency of purchases and the average basket size. The churn is customers that simply stopped buying after a certain period. For companies selling mostly indirect (e.g. fast moving consumer goods), the CAC & CLV can be typically measured through retail data or consumer research, but I would think that those numbers are equally important to assess the vitality of the products or category and define actions to improve them (lower churn, more repeat purchases, etc.) - yet I don't think they are actually measured by most companies in those industries.
How to interpret CAC and CLV?
For instance, the CAC and CLV, and their ratio (CLV/CAC) are extremely useful for working out how sustainable your business is and defining required actions:
If CAC > CLV or the ratio <1, this means your business is sub-scale or unsustainable. Your churn may be too high, or CAC too high, or the average purchase of your hard-earned customers too low. By identifying and playing with the underlying data and assumptions moving forward, you can identify your biggest improvement levers or pivot to another business model.
If the CAC < CLV or the ratio > 1, then you're ok. However, if the ratio is close to 1, it means you hardly break even on cost of sales. If, in addition, you have very good churn (less than 10%), it probably means that you heavily rely on the cash flow brought by customers as of Year 2. Which means that your cash flow is going to suffer a lot, since the CAC needs to be paid immediately (usually in advance).
How can I learn more?
On the second point, it is equally useful to calculate your 'months to breakeven on CAC', which works out how long customer should stay in order to recoup the sales & marketing costs incurred to acquire that customer.
If you mapped out your cash flow post acquisition, it's fairly easy to cumulate it and check when it 'crosses the line': the accumulated cash flow from a customer gets higher than what it took to acquire him/her. A few indications:
Customers pay yearly and their break even point is less than a year - well done, your growth can be funded by your own customers. This scenario is very rare, but it does exist, mostly with companies that are perceived as market leaders during a significant market disruption.
Customers pay monthly (or repeat purchase monthly or less) and their break even is less than a year - great, but be ready to fund those months of customer acquisition in advance. I know only of a few SaaS companies with this type of record.
Break even is more than a year (but less than 2). In many cases (except if you have multi-year contracts paid upfront, which is rare), you will need to get substantial funding to grow your business. Yet, if your churn is ok, it will still be a sustainable business. Many SaaS startups I talked to are in this category.
If the breakeven is more than 2 years, the business is probably unsustainable. Unless of course you're in long term capital goods like real estate where it's normal. But in low capital businesses or high risks businesses like startups, and given the market uncertainties, the underlying assumptions (i.e. very low churn) are hard to justify and sustain.
Are you measuring CAC & CLV? If you are, what have you learnt? Let me know in the comments.
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