Business is a very human activity. Despite the existence of high frequency trading, supply chain optimization and manufacturing automation all business boils down to one person selling something to another person. A product is worth what someone else is willing to pay for it, and business is the act of making that transaction happen. So, you would assume that you cannot describe business using mathematics.
But you can, and the formula that does is as follows:
LTV – CAC > 0
This equation describes the viability of your business. LTV (Lifetime Value) is the total amount of money you can expect to make from a customer over the entire period of time they are your customer. CAC (Customer Acquisition Cost) is how much it costs to acquire the customers that will then make you money. If the lifetime value of your customers is higher than your customer acquisition cost, then you have a profitable business because you make more from customers than it costs you to find them. If not, then it costs more to operate your company than it makes, and the business will fail.
This equation maps into every kind of business precisely because all business is the act of one party selling something to another party. Below are some examples of how this equation applies to various types of business:
1. Physical Product
When you build and sell a physical product, both your LTV and CAC have many factors. Your LTV is not just the sale price of the product, as you have to remove the cost of producing the product in the first place. The CAC is a combination of both your marketing spend, as well as the sales commissions you pay to either your salespeople or the retail stores that sell your product. Hence, your equation looks like the following:
(Sales price – Cost of good) – (Marketing Spend + Sales Commissions) / Units sold > 0
As you can see, you calculate the net profit for the sale of a given item (Sales price – Cost of producing it) and remove the amount of marketing and sales commission that went into that item. In some cases, simply dividing the overall marketing and sales commissions by the unit price is misleading since different distribution channels have different costs. In those cases, you would measure the viability of each channel independently and use the actual per item marketing and sales commission numbers.
2. Software as a Service
Most software as a service businesses are based on monthly subscriptions. Here, the LTV is the amount of the monthly subscription (often called the Monthly Recurring Revenue or MRR) times the average number of months a customer is active (paying for your service). The CAC depends a lot on your user acquisition strategy but is typically either sales commission based or performance marketing.
(MRR * Avg Months Active) – (Marketing + Sales) / Number of customers > 0
The most challenging factor here is estimating the average active months for a customer, especially for new services which might not have a long history of data to use. Because of that difficulty, it is often easier to measure monthly churn rates which are simply the percentage of customers you lose every month. You can then use the MRR and monthly churn to estimate the LTV and use the following equation:
(MRR / Monthly Churn Rate) – (Marketing + Sales) / Number of customers > 0
By dividing the MRR by the monthly churn rate, you are calculating retained revenue (the value of customers that stuck around). By subtracting out the cost of marketing and sales, you are measuring how much it costs you to retain that revenue. You can see that if your churn rate is high (and hence your average active months per customer is low) then your business is not viable unless your marketing and sales costs are extremely low.
If you measure your MRR in aggregate instead of per customer, you do not need to divide the cost by the number of customers as you are calculating everything in aggregate.
3. Consulting
In consulting, both your revenue and costs are measured in time. Every hour you spend working for a customer is revenue, and every hour you spend recruiting new customers is the cost of acquiring those users. Assuming your hourly rate is fairly consistent, then you can measure your viability the following way:
Average # hours per contract – Average # hours recruiting contract > 0
The great thing here is that you don’t need to estimate your CAC cost per unit since you are measuring your business in a universal unit of time (instead of money). This works even for large consulting firms who have many employees, assuming a fairly even hourly billing rate. If it is difficult to track the recruiting hours specific to each contract, you can generalize this and just use the total billable hours and the total recruiting hours across all contracts.
Note that this requires you to track your business development time in the same way you track your customer billable time, which I always recommend anyway. It is common for consultants to consider only the time that they bill in determining their cost structure, which is a mistake.
Viability vs. Profitability
Most companies have a goal of being profitable, not just being viable. In those cases, the fact that your LTV is greater than your CAC is not as important as how much greater. One rule of thumb for high growth companies is for your LTV to be 3 times your CAC because that gives you room to make mistakes and still be profitable. Keep in mind that the cost of your operations is likely not zero, so your ratio needs to cover that cost as well. The best person to judge the right ratio for your business will always be you.
If you don’t already watch this viability equation as one of the key metrics of your business, you should start. It will provide a simple way to understand the fundamentals of your business.
This article was originally published at Sean on Startups, a blog about starting and growing companies.
Image Credit: CC by Alan Cleaver
