WHAT ARE UNIT ECONOMICS, AND WHY SHOULD WE CARE?

Who are our most profitable customers? How are our Google pay-per-click advertising campaigns performing? How much does it cost to acquire a new customer? These are the exact types of questions that unit economics can help answer.

In this article, we break down how executives, product managers, and marketers can use the principles of unit economics to better understand and operate their companies. Specifically, we discuss what customer acquisition cost (CAC) and customer lifetime value (CLV) are, why they are relevant, and how to correctly calculate each.

WHAT IS CAC?

CAC stands for “customer acquisition cost.” It measures the total amount of money spent by a business to acquire a single new customer.

The formula for CAC is:

If a company spends $1,000 on sales and marketing to acquire a new customer and acquires 10 new customers, then its CAC is $100.

WHY IS CAC IMPORTANT?

CAC tells us how much a company spent on average to generate a new customer. Through deduction, it then also tells us how much a company needs to make on average from each new customer to earn a profit. Sticking with the previous example, if it costs a company $100 to acquire one new customer, then that company must make at least $101 from that customer to be profitable. Reviewing CAC can answer important questions about why a company’s advertising spend is increasing or decreasing in aggregate and help inform a company’s advertising choices.

HOW TO LOOK AT CAC?

Two of the most common ways to analyze CAC are over time and by segment.

CAC Over Time

Looking at how CAC is trending over time can indicate whether it is getting cheaper or more expensive to acquire new customers. Positive or negative trends can signal important information about changes to the underlying health of a company, its customers, and its product offering. It can also offer information about the competitive landscape and advertising environment. Comparing CAC relative to total marketing spend over time can also provide clues as to how well CAC scales (or doesn’t) as more money is invested in sales and advertising.

CAC by Segment

Looking at CAC for the entire company provides useful information about the average CAC. But as the great investor Howard Marks reminds us, “Never forget about the 6-foot tall man who drowned crossing the stream that was 5-feet deep on average.” Segmenting CAC can help identify low cost, high ROI, subsegments of customers and advertising channels, and thus where and how advertising dollars are best spent. Segmenting CAC can also reveal underperforming advertising spend.

Typical segments include:

Advertising channel – Social media, email, paid search, and direct mail
Advertising campaign – Messaging, creative, featured product or service
Geography – Country, state, zip code
Access platform – Mobile, desktop, tablet
Customer demographics – Age, household income, sex

HOW TO CALCULATE CAC?

As straightforward as CAC seems, many businesses still don’t measure it correctly - partially because it is difficult to do so. A brief overview of how to calculate CAC follows.

Sales and Marketing Expenses

The numerator of CAC should include the total amount of sales and marketing spent on acquiring new customers. Not including all relevant expenses will understate the numerator and make CAC appear artificially low. When calculating CAC, be sure to consider the following:

Media spend – All amounts spent on media, including digital, TV, podcast, print, and radio; Trade shows; And marketing displays
Creative spend – All amounts spent on creating the media mentioned above
Labor – All amounts spent employees, consultants, and agencies involved in sales and marketing
Travel and entertainment – All amounts spent by sales and marketing people on travel and entertainment
Overhead – All amounts spent on indirect costs such as office space, phones, computers, and supplies for sales and marketing people

# of New Customers Acquired

New customers represent customers that are doing business with the company for the first time and have never purchased something in the past. The number of new customers is different from the total transactions in a period, which can include returning customers as well. Delineating between new customers and existing customers is usually straightforward. However, not doing so will overstate the denominator and thus make CAC look artificially low.

Other Considerations

Sales and marketing expenses and the timing of new customers are not always perfectly correlated. As Brian Balfour, founder and CEO of Reforge and former VP of Growth at HubSpot, points out, in instances where a business has a long sales cycle or free trial period, there can be a considerable lag between when spend occurs and when a customer makes its first purchase. In other instances, the purchase happens more immediately, and there is no material difference in timing. To calculate CAC correctly, it’s essential to match the amount spent on acquiring a new customer with when the new customer made a purchase.

WHAT IS CLV?

CLV stands for “customer lifetime value.” It measures how much profit a company earns on a single customer over the duration of that customer’s relationship with a company.[1]

The formula for CLV is:[2]

To illustrate how to calculate CLV in practice, it’s useful to review a simple example.

Let’s suppose a wine of the month club company offers a monthly subscription to receive a case of wine at the beginning of each month for $100 per month, and that the company generates a 50% profit margin on each monthly shipment of wine. Let’s further assume that the company pays $100 to acquire a new customer and that each new customer is expected to receive three shipments before subsequently canceling their wine subscription. Using the CLV formula above, we can then determine that this customer has a CLV of $50 as follows:

CLV = [Variable Profit1 + Variable Profit2 + Variable Profit3] - CAC

CLV = [($100 x 50%) + ($100 x 50%) + ($100 x 50%)] – $100

CLV = [$50 + $50 + $50] – $100

CLV = $50

Importantly, CLV represents the value of a customer over its entire lifetime. For existing customers, CLV includes both past and future expected purchases. When calculating CLV, it is important to distinguish between how much value has occurred in the past (known as historical value) versus how much value is expected in the future (known as residual lifetime value). Calculating historical values only requires analyzing known transaction data, while calculating residual lifetime value requires making predictions about future transactions.

WHY IS CLV IMPORTANT?

CLV provides a useful tool for quantifying how much a company has profited, or can expect to profit, on average from each new customer it acquires over that customer’s lifetime. CLV breaks down into several variables, including: average order value (AOV), average order profit margin (Margin), average order frequency (Frequency), and customer acquisition costs (CAC). Analyzing CLV’s counterparts can help explain why aggregate sales and profitability are trending a certain way and uncover what levers a company has available to pull to influence sales and profitability. CLV also has other applications, for example, advertisers can use CLV to create lookalike audiences to targeted with their digital ads.

HOW TO LOOK AT CLV?

A few of the most common ways of analyzing CLV are presented below.

CLV by Customer

Breaking down CLV by individual customer, as opposed to merely looking at the average CLV of all customers, can help identify high-value and low-value customers. Often, the Pareto principle applies to customer heterogeneity, and companies find that ~20% of customers account for ~80% of the value. Identifying these high CLV customers can allow a company to be more customer-centric and focus on catering to the needs of its most valuable customers. Further, companies can combine what they know about a customer’s CLV with other known customer attributes (e.g., source of acquisition, product purchased, geography, age)(known as “data appending”). Using this appended data, companies can then develop improved customer prospecting strategies focused on identifying and acquiring “look-alike” customers – i.e., prospective customers with similar attributes to the company’s high-value CLV customers.

CLV by Component

Breaking down CLV into its components (e.g., AOV, Margin, Frequency, and CAC) in aggregate and by customer can reveal how customers are currently behaving and what levers a business can pull to impact value. For example, an analysis of AOV can help a company better understand what products and services customers currently buy, and thus generate ideas on how to potentially increase the number of items a customer buys on average through bundling or cross-selling. Similarly, an analysis of Frequency can illuminate when and how frequently a customer transacts with the company. Companies can leverage this information to explore various customer retention strategies, such as what sort of incentives could be offered to a customer and at what point in the customer journey those incentives should be offered.

CLV by Cohort

Breaking down CLV by cohort entails grouping each customer by date acquired. Looking at CLV by cohort can be a great way to visualize how business decisions have impacted revenue and profitability at the customer level over time. It can also be useful to review the components of CLV by cohort. A typical cohort analysis includes looking at total revenue or total number of transactions by month or year (sometimes called the C3 chart or customer cohort chart). The C3 can bring to light how much of the company’s business in a particular period is being derived from new customers versus existing customers. This can inform executives as to how “sticky” customers, when customers are most likely to churn, and how many new customers need to be generated each period to continue growing.

HOW TO CALCULATE CLV?

Calculating CLV involves making a determination as to the past and future expected AOV, Margin, Frequency, and CAC for each customer. This article will focus on how to calculate each input historically which only requires historical transaction data, as opposed to how to forecast each input which requires complex predictive models that are beyond the scope of this article.

AOV

AOV stands for “average order value.”

The formula for AOV is:

If a company generates $300 in revenue via three transactions in a period, then its AOV is $100.

When calculating AOV it is important to use net revenue (as opposed to gross revenue). Net revenue takes into account discounts, returns, and allowances.

Margin

Margin refers to the average variable profit generated on each order.

The formula for Margin is:

A company with an AOV of $100 and total variable costs per order of $50, has a Margin of 50%.

Most people use gross profit as a proxy for Margin. This is a decent proxy, but not entirely accurate. Gross profit, as measured by GAAP, does not always capture all relevant variable costs. When identifying variable costs, be sure to consider including: cost of goods sold, fulfillment costs (labor, in-bound and out-bound shipping costs, and supplies), merchant processing fees, sales commissions, and any other variable costs that can be directly tied back to the sale of a product or service.

Frequency

Frequency refers to the average number of transactions a customer makes with the company over their lifetime.

The formula for Frequency is:

If a company generated three transactions in a period to one customer, then the average purchase frequency per customer is 3.0x.

CLV

Putting the above together, we can then re-write the formula for CLV as:

Returning to our wine club example, if the average customer pays $100 per month to receive a shipment of wine and cancels their subscription after the third shipment, and if the company pays $100 to acquire the customer and earns a 50% variable profit margin on each monthly shipment, then using the CLV formula above, we can then determine this customer has a CLV of $50 as follows:

CLV = [AOV x Margin x Frequency] - CAC

CLV = [$100 x 50% x 3] – $100

CLV = [$150] – $100

CLV = $50

SUMMARY

Unit economics help us understand the core drivers of a company’s performance. CAC and CLV specifically provide valuable information about revenues and costs at the product and customer level and can help answer fundamental questions like which customers are most profitable, how much it costs acquire a new customer, and how a digital advertising campaign is performing. The answers to these questions can uncover valuable business and marketing insights that can be leveraged by executives, product managers, and marketers to grow and increase profitability.

SabinoDB is an e-commerce and marketing solutions company committed to helping companies use big data, real-time analytics, AI, and machine learning to better understand their customers and grow their business. If you are interested in learning about how SabinoDB can help your company, please reach out directly to Ryan Hammon. Email - ryan.hammon@sabinodb.com Phone - (415) 847-8103.

Notes:

[1] Technically CLV is concerned with measuring profits derived from customers on a net present value basis. Net present value is finance jargon for the fact that profits received today are worth more than profits received in the future, and thus should be adjusted by a discount factor that accounts for the time value of money and the firm’s cost of capital. To simplify our discussion, we will ignore discounting.

[2] Adjusting for the time value of money, the formula for CLV becomes:

Sources:

Chen, Andrew. “How to (actually) calculate CAC.” Retrieved https://andrewchen.co/how-to-actually-calculate-cac/

McCarthy, Daniel. “A general framework for customer lifetime value.” Retrieved https://www.dropbox.com/s/xjak7pezn6i9m06/CLV%20framework.pptx?dl=0

McCarthy, Daniel. “A detailed look at Blue Apron’s challenging unit economics.” Retrieved https://www.linkedin.com/pulse/detailed-look-blue-aprons-challenging-unit-economics-daniel-mccarthy/

Chartio. “What is customer acquisition cost and when to use it?” Retrieved https://chartio.com/learn/product-analytics/what-is-customer-acquisition-cost-cac/

Exponea. “The importance of customer lifetime value (CLV) in marketing 2020".” https://exponea.com/blog/customer-lifetime-value-guide/

Theta Equity Partners. “C3: The emerging “gold standard” of customer disclosures that investors should demand. Retrieved https://www.thetaequity.com/c3

Chantiles, Aaron. “How to perform cohort analysis and calculate customer lifetime value in Exel.” Retrieved https://blog.usejournal.com/how-to-perform-cohort-analysis-calculate-customer-ltv-in-excel-80bfed785ec4

Why unit economics like CAC and CLV matter.