This article discusses how to use 4 key metrics in direct marketing for a consumer product business. Those metrics are breakeven (BE), customer acquisition cost (CAC), customer lifetime value (CLTV) and media efficiency ratio (MER). The latter is an industry term most commonly used in direct response TV and radio media, but I find it helpful for any form of direct marketing and like to refer to it also as “marketing efficiency ratio”.
Calculating these metrics is fairly straightforward in principal, certainly more difficult in action. BE can be reported in many different ways, from breakeven marketing spend to breakeven net income and more I will use BE as a ratio of revenue divided by costs, which is also MER. CAC is operating costs of the business divided by the number of customers. CAC may also be called cost per order (CPO). This metric should be calculated weekly for TV, radio or other forms of recurring media spends and by event for specific marketing activities, such as purchasing an email list. It is your total costs divided by total customers. CLTV is average revenue per customer over the lifetime that that individual will remain a customer. MER is your revenue divided by your costs. It is represented as a whole number to the 10th or 100th decimal place. For example, if your marketing spend in a week is $50 K, and your revenue is $110 K, your MER is 2.2. Breakeven MER means that your costs at a given marketing spend (marketing spend is included in costs) are equal to your revenue. I will leave the details about using the proper assumptions to calculate these metrics for another article.
CLTV can be used a couple of ways. Its useful for determining your product’s ability to please a customer such that they return to buy more. If you sell an ingestible product and your CLTV is equal to or close to the average revenue per first purchase, then customers are generally only buying once and not returning. If the average time period in your industry to retain a customer is 6 months and you sell them a 3 month’s supply, then you may have a problem because customers are not returning to purchase more. You might fix this by either getting your customers to buy a 6 month supply on first order, so at least you extract the maximum value out of them as possible, or you might go back to product development to work on the features and benefits of your product to increase its appeal and utility to customers. The former is a short-term fix, while the latter is a fix that could bode well for the long-term sustainability of your business.
Second, the CLTV helps you understand the profitability in your business and where you have margin to spend. For example, you breakeven at a $60 CAC spend week in and week out; that is, you can spend $60 each week to acquire each customer and breakeven on the P&L of your business. Your CLTV is $100, which means that you acquire an additional $40 over time from that customer; so, the customer spends $60 on first purchase and over time, comes back and spends an additional $40 for a total CLTV of $100. You could use some of those profits at times to boost marketing expenditures to acquire future revenues. Lets say you boost your CAC to $80. Your are now unprofitable by $20, but you will make it up with an additional $20 over time from that customer. Your short-term P&L suffers, but profitability in the future is increased.
The problem with CLTV is that you cannot get an accurate figure of your CLTV because it requires sufficiently reliable operating history and is constantly changing. You could limit the time period for calculating your CLTV. For example, 12 months may be a rule-of-thumb baseline period for including the revenue you receive from a customer, with day 1 of the 12 month period beginning when you first acquire them. You need to adjust it to better match your industry and product category. CLTV is best used as a guide and not something on which to place significant reliance.
The argument I have read is that you should always spend so that CAC = CLTV. Thus, your short-term P&L will be negative, but will catch up in the future if you reduce your CAC or find some additional leverage in your business to add sales. I could agree with that in certain circumstances. For example, your strategy for direct marketing is to acquire customers and create brand awareness so that you can develop a path to retail, where you will make up for the current deficit-producing expenditures from the multiple you get in sales on retail shelves. Also, you have cash and risk capital in an industry where you have to get big fast. Or, maybe your shareholders want to see you get big as quickly as possible. Equity investors like the CAC = CLTV argument because they want to give you more cash (and take more of your equity) with the chance that you will be the 1 in 10 in their portfolio that hits it big.
Recall that BE is a ratio of revenue divided by costs, which is also MER and expressed as a whole number to the 10th or 100th decimal place. Your BE is a ratio that can be compared to the norm for your industry. If its higher, then your operating costs may be out of sync, your customer pricing too low, your order cancelations, declines and returns too high, a combination there of, or a host of other metrics are off. Your BE will also tell you your minimum marketing spend required and tell you how well it must perform to achieve BE. A higher BE can limit your selection of marketing channels that can reliably perform at the BE.
Your MER is always looked at relative to BE MER and how much better it is over the latter. If you want to employ the strategy previously mentioned for fast growth now at the expense of cash flow for future increased return, then a general rule of thumb is to spend the maximum amount on media such that your MER and BE are equal. If your MER is 1.7 and you are currently hitting at 2.2, then you will want to spend more until you reach 1.7 (greater media spend yields diminishing returns). This helps keep you out of debt or sacrifice equity for investment.
In summary, CLTV and CAC are good metrics that help you understand the health of your business as it relates to selling products to customers. CLTV in particular gets more at the long-term viability of your product and company. It’s a quantitative number that can say a lot from a qualitative perspective. It can also be useful if you are looking to spend now with available cash for future expected payoffs, but needs to be treated with care due to inherent accuracy issues. BE and MER, on the other hand, are accurate metrics that really get at the heart of the current financial health of your business and are more useful for maximizing media spend and staying profit neutral.
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