Why optimize eCommerce KPIs with MMM? Part 4: Scalability
September 13, 2023 | Juha Nuutinen, Paul Arpikari, Carmen Bozga
Welcome to the fourth part of our series on eCommerce KPIs. As we delve deeper, our lens sharpens on crucial metrics that underpin every successful eCommerce venture's decision-making: Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV). In this part, we’ll deep dive into these essential metrics in order to show how they and MMM guide the trajectory of eCommerce brands aiming for sustained growth and profitability.
CAC and LTV as Metrics
In eCommerce, while immediate sales metrics might give you a glimpse of current performance, the true testament to sustained success lies in a brand's ability to minimize the cost of acquiring new customers and maximize the lifetime value of the relationship. Let’s look at these metrics first separately.
Customer Acquisition Cost (CAC)
Customer Acquisition Cost, or CAC, serves as a financial beacon for businesses in their initial stages or those venturing into new territories. It efficiently measures the resources committed—both monetary and otherwise—to attract a fresh set of eyes to your offerings. While securing new customers is a commendable feat, it becomes paramount to place this cost within the broader context of the customer's anticipated contribution to the business. Thus, alongside CAC, predicting accurate Lifetime Value (LTV) and understanding product or service margins is indispensable. This holistic perspective empowers businesses to discern if they're merely adding numbers or genuinely fostering valuable, long-term relationships.
Lifetime Value (LTV)
Often, the allure of a product or service doesn't end at the first purchase. Businesses, especially those operating in sectors with a high propensity for repeat purchases, find themselves in the unique position of capitalizing on this extended relationship with the customer. Enter LTV. This metric crystallizes the estimated net profit that a customer will bring during their entire relationship with a business. It's not just about acknowledging repeat purchases; it's about appreciating the sustained customer engagements. By channeling efforts to keep these long-standing customers engaged, brands can enjoy the perks of a loyal customer base while continuously enhancing their offerings to suit evolving customer preferences.
These two metrics not only hold immense individual significance but their interrelation provides businesses with a profound understanding of profitability and sustainable growth. Let’s delve deep into the intricate relationship between these metrics and understand how to leverage them effectively.
Pathway to Scalability: LTV:CAC Ratio
The LTV to CAC ratio stands out as a definitive marker of a company's health and sustainability. It presents a clear picture of how the value derived from customers compares to the costs incurred in acquiring them. But what's a commendable LTV to CAC ratio, and how is it accurately calculated? Let's delve in.
Optimal LTV to CAC Ratios: The Benchmarks
The LTV to CAC ratio acts as a financial compass, guiding businesses about their returns on customer acquisition strategies. A standard thumb rule is:
- 3:1 Ratio: This is generally viewed as a good benchmark. If your LTV is three times your CAC, you're on solid ground.
- 4:1 Ratio: Crossing this threshold indicates an exceptional business model, reflecting both efficient customer acquisition and high customer value.
- 5:1 Ratio and Beyond: Here's where introspection is crucial. Such a high ratio might indicate under-investment in marketing. While the returns are substantial, the potential for faster growth could be untapped.
eCommerce LTV Calculation
In the context of eCommerce, deriving the LTV involves a multiplicative approach:
- Average Order Value (AOV) is the mean revenue earned from each transaction.
- Repeat Sales represents the average number of times a customer transacts over a given period.
- Average Retention Time gauges the typical duration (in months) a customer continues to transact with the business.
- Lifetime Value (LTV) can be calculated using the above method for eCommerce, or by adjusting the average monthly or annual revenue per customer based on churn and gross margin.
- Customer Acquisition Cost (CAC) is derived by summing all sales and marketing expenses (inclusive of salaries, overheads, etc.) over a specific period and dividing this by the number of customers acquired during that period.
The LTV and CAC play pivotal roles in determining a business's scalability. A high LTV relative to CAC indicates that customers deliver significant value over their lifespan compared to the initial cost to acquire them. This dynamic means that businesses can confidently invest more in acquisition strategies, knowing that the return will be worth the expense. Conversely, a low LTV compared to CAC may signal constraints in scaling, as the business might spend more than it recovers from customers over time. Thus, a healthy LTV to CAC ratio not only ensures sustained profitability but also provides the financial leeway for a business to expand and scale effectively.
A low CAC is a gold standard for businesses, and here's why:
- Optimal Budget Utilization: A reduced CAC ensures that the company can rope in more customers without ramping up the budget. It means the company is effectively utilizing its resources, leading to potential rapid growth.
- Increased Marketing Effectiveness: A declining CAC often suggests that marketing endeavors are resonating with the audience, which, in turn, can lead to quicker brand recognition and a further decline in acquisition costs.
A high LTV relative to CAC is a signpost for business success:
- Sustainability and Scalability: If a customer’s lifetime value significantly outweighs the initial acquisition cost, it's a testament to the business's viability. It's an indicator that the revenue derived from a customer will surpass the initial investment made to acquire them, offering the business a healthy profit margin.
- Refined Customer Retention: A high LTV is often a reflection of robust customer loyalty and retention strategies. It's an affirmation that the company isn't just acquiring customers but also nurturing and retaining them, ensuring steady revenue streams.
MMM’s value to CAC:LTV Metrics
As Media Mix Modeling (MMM) is a measurement methodology that tries to estimate how much certain media activities are driving business and what is the optimal investment levels, it can be used to find an optimal CAC: LTV ratio.
Maximizing LTV is out of scope from MMM’s perspective, but finding an incremental, or marginal, CAC is at the core of MMM.
Incremental Customer Acquisition Cost (Incremental CAC) refers to the additional cost associated with acquiring each subsequent customer beyond the initial one. In many cases, the initial customers are the low-hanging fruit – they are the ones most receptive to a product or service and can be acquired with relatively minimal marketing effort and cost. However, as a business tries to expand its customer base further, it may encounter diminishing returns. This means that reaching and converting each new batch of customers can require more intensive marketing efforts and, consequently, higher costs.
More on diminishing return here
In practice, incremental CAC means you are trying to estimate the impact of increasing media investment. For example, if you aqcuire 2 000 customers at a cost of $4 million, the simple CAC is that it costs $2 000 to add each customer. This does not necessarily mean that if you add $1 million to your media investments, the delta would be 500 customers. The next customer will most likely cost you more to acquire.
In essence, Incremental CAC can be seen as the change in total CAC when one additional customer is acquired so that you can maximize the growth without sacrificing important LTV:CAC ratio.
MMM can define your desired point of incremental CAC by visualizing the saturation point of media investments (with Response curves) where the last acquired customer has been f.e. $500.
For businesses aspiring to scale, monitoring the ratio of LTV to CAC becomes paramount. This ratio encapsulates the essence of scalability. If the balance tilts favorably towards a higher LTV, it's indicative of a scalable and sustainable business model. Inversely, if CAC starts outweighing LTV, it's a clear call for revisiting and refining business strategies.
Scaling isn't just about rapid expansion; it's about sustainable and profitable growth. And in this journey, the dual metrics of CAC and LTV serve as the north star, guiding businesses towards a scalable horizon.
Conclusion: The Holistic View of eCommerce Metrics
Across this four-part series, we have journeyed through the intricate landscape of eCommerce KPIs, from understanding immediate returns on marketing investments to delving deep into customer behavior and profitability. Each segment of this series underscored a fundamental tenet: success in eCommerce isn’t derived from isolated metrics but a harmonious interplay of various KPIs
The realm of eCommerce is vast, and its dynamism is unparalleled. To navigate its complexities, brands must have a multi-dimensional approach, with a keen eye on both the micro and macro metrics. Whether it's optimizing ad spends, enhancing customer engagement, reducing acquisition costs, or maximizing lifetime value, each metric has its role in sculpting the eCommerce narrative.
In the end, the key takeaway for eCommerce brands is clear: Stay informed, stay agile, and continuously adapt. The numbers don’t just represent data; they echo the voices of customers, the effectiveness of strategies, and the pulse of the market. By holistically embracing these metrics, businesses are not only positioned for growth but also for sustained success in the ever-evolving eCommerce arena.
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