Gram Marketing Chapter 1: CLV to CAC
How effective is my ad spend? (CLV:CAC)
Advertising today has become a massive industry due to the growing number of products and services being offered in the world. As a result of this market expansion, the competition faced by companies has increased, leading to a higher inclination for marketers to spend more resources on advertising their products and services to reach more customers.
Advertising can be achieved through different mediums such as newspapers, social media ads, product placement, emails, and even video ads. Creative digital agencies like Gram exist to help businesses convey even the most complex of topics into simplified visuals and animations as a form of video advertising.
In this day and age where advertisements can be seen everywhere, it is the marketer’s responsibility to ensure that they are able to adapt to the ever-changing advertising landscape. Needless to say, it is an increasingly tough job to grab the attention of customers. With marketers all jumping on the bandwagon of advertising, here’s the next question – how do we know if an advertisement is effective and how can we justify the money spent on each ad campaign?
The CLV:CAC ratio
To do this, we will look at our Customer Lifetime Value to Customer Acquisition Cost ratio (CLV:CAC). The CLV (Customer Lifetime Value) calculation answers the question of: “How much is one customer worth to your business?” The CLV is calculated by finding the average purchase value and multiplying it by the average purchase frequency rate of the customer to find the customer value. Thereafter, by multiplying the customer value with the customer lifespan, we are able to derive at the customer lifetime value.
Whereas, the CAC (Customer Acquisition Cost) calculation determines the cost of one customer to your business. The CAC can be calculated by dividing all costs spent on acquiring more customers by the number of customers acquired in the period where the money was spent. To give an example, if a company spends $500 on its marketing expenses in a year and acquired 50 customers in the same year, its CAC is $10 ($500/50).
Therefore, the two calculations work together to give us the true value of each customer to our business, and provides marketers with greater insights to the effectiveness of every ad dollar spent.
Determining the perfect CLV:CAC ratio
There is no fixed perfect CLV to CAC ratio per se; the ratio varies from business to business depending on the type of products or services offered. However, there are a few things we can look out for when analysing a healthy ratio.
- Your CLV:CAC ratio should not be too low
A low ratio indicates that you are spending too much money to acquire customers that are not worth the spending. For example, a ratio of 1:1 means that a customer is paying back exactly the amount that you spent on acquiring them. In other words, you are not profiting from the customer at all.
- Your CLV:CAC ratio should not be too high either!
Although a higher ratio indicates higher sales and marketing ROI, there is a limit to how high the ratio should go. If your CLV:CAC ratio is as high as 5:1, it could symbolise that you are restraining your growth by under-investing in marketing. Therefore, higher is not always better.
- Assess your payback period and customer churn rate
The payback period reflects how long it takes for a business to recover its acquisition costs from a customer. A shorter payback period would be more advantageous to a company because the longer it takes for a customer to churn from the business, the more likely it is that the customer would make it past the payback period – meaning that any future contributions made by the customer would provide value to the business. Therefore, a company should look out for a faster payback period and a lower churn rate when pursuing an ideal CLV:CAC ratio.
How can we achieve a good ratio?
Since we know that a good CLV:CAC ratio should comprise of a higher CLV compared to CAC, let’s look at ways to achieve a better CLV.
- Provide quality customer service
According to statistics provided by Bain & Company, companies that excel at customer experience drive revenues that are 4-8% above their market. It is important to focus on customer service because delivering a good one is more likely to make your existing customers become loyal long-term customers.
- Foster good customer relationships
Building relationships with customers is key to the success of your business; it is important to understand your audience and learn about their thoughts and feelings. Customers like to feel appreciated by the company they are giving business to.
- Expand your revenue – upsell and cross-sell
If your business sells numerous products and services with different pricing tiers, upselling is one of the easiest ways to raise your CLV. Upselling is essentially selling a more expensive version of your product or service, to increase the revenue earned by your existing customers.
Cross-selling, on the other hand, is selling a similar and complementary product or service to your existing customers. It is useful because it delivers increased sales revenue and develops more leads for your business.
Understanding the importance of these metrics (CLV:CAC)
In order to determine how effective your ad spend is, CLV and CAC are two important metrics to look at. Using the two metrics in tandem will provide a more holistic understanding of your customers, and most importantly, show the true value of each customer to your business. The CLV:CAC ratio will paint a clear picture on your returns on marketing investments, enabling you to better evaluate future prospects for your business. Therefore, to get the answer on how effective your ad spend is, start by calculating this ratio!
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