Wednesday, February 15, 2017

Unit Economics: Lifetime Value and Customer Acquisition Cost

Another common way to think of Unit Economics (i.e. instead of the method I've described in my prior posts) is to use Customer Lifetime Value (i.e. the Gross Profit of all purchases made by an average customer over the lifetime of the customer's relationship with your company) instead of Price, and to use Customer Acquisition Cost (i.e. how much you spend in marketing and sales efforts to acquire one customer) instead of Variable Costs. This method is often used for subscription services such as Netflix and tech start-ups, partly because software does not have any variable cost except Customer Acquisition Cost (CAC).

This method can be useful because it allows a manager or entrepreneur to quickly identify how much he or she can safely spend to acquire a customer. For example, if the Lifetime Value (LTV) is $1000, then, theoretically, you could spend up to $999 in CAC and still be profitable. Realistically, if your CAC is too much more than 1/4 of your LTV, then your margins will be too tight for comfort, and you'll need to either find ways to market and sell more efficiently or increase gross margin by raising prices or lowering other variable costs. 

However, this CAC/LTV method confuses calculations somewhat, as all non-CAC variable costs are accounted for in the LTV instead of in Variable Costs. The full revenues are not used as a starting point in the calculation, and overhead can be completely ignored by people using this method. A better approach is to simply use Total Lifetime Revenue from an average customer as the LTV, and use this in place of the Price or Revenues starting point for the Unit Economics calculations. Similarly, include CAC in the list of Variable Costs. This way, all the basic Unit Economics formulas stay exactly the same. Break Even, Pre-tax Cash Flows, and Payout can all be easily derived.

Although the CAC/LTV method can be useful for certain business models or industries, make sure that if someone starts throwing around the terms Unit Economics, Break Even, or Payout, you know specifically what they're referring to and how they're calculating it. They may not even know themselves, so, if nothing else, clarifying this can serve as a quick litmus test of whether they're full of crap or actually know what they're talking about.

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