Growing an ecommerce business can feel like juggling knives whilst riding a unicycle on a tightrope. Owners and managers have so much data available and so many key performance indicators, it can be difficult to know where to focus attention or investment.
While there are many possible metrics or KPIs, businesses aimed at long-term, stable ecommerce growth would do well to focus on two: customer lifetime value (CLV) and customer acquisition cost (CAC).
The two metrics can even be combined into a single KPI: the CLV-to-CAC ratio (CLV:CAC). It tracks the relationship between what a company pays to get a first-time buyer and how much that customer is likely to spend over time.
A CLV:CAC of one to one (i.e., 1:1) tells you that your company is failing. With this ratio, ecommerce growth can only be achieved with significant investment, and you should not expect to earn much profit.
On the other hand, a CLV:CAC ratio of three-to-one or higher indicates that your company is building value. Investing in your business should lead to profitable growth.
There are limits, too. If the CLV:CAC ratio is too high, say 25:1, you are investing too little and may be vulnerable to competition.
Let’s review how you can calculate both CLV and CAC.
There are a few ways to calculate customer lifetime value. You could try to predict CLV, but for purposes of this article, I will calculate CLV based on a company’s historical sales data.
CLV = Average Order Value x Purchase Frequency x Margin
First, find your ecommerce company’s average order value (AOV) for the past year. AOV is the total sales for a given period divided by the number of orders for that same period. (Some ecommerce platforms include AOV in their default reports.)
AOV = Total Sales ÷ Order Count
Next, multiply your company’s AOV by the average number of times a given customer made a purchase in the past 12 months. If your company had 10,000 orders and 8,250 customers in the past year, your purchase frequency would be 1.2.
Purchase Frequency = Total Orders ÷ Customer Count
Finally, multiply your result by your margin, which is what’s left after all expenses. So it would be your average order value less cost of goods sold and less average overhead.
Margin = AOV - Cost of Goods Sold - Average Overhead
The CAC for a given period is the total of all promotional costs divided by the number of new customers acquired. I addressed it earlier this year, at “How to Measure Customer Acquisition Cost.”
CAC = Total Promotional Costs ÷ Number of New Customers
Your company’s promotional cost includes the cost of an ad, labor to make the ad, and similar. The key is to include everything needed to get the new customer.
Look at your company’s CLV:CAC ratio in two ways. Both options should help monitor ecommerce growth and give you an indication of how to invest your resources. But each has a slightly different perspective.
12-month view. Consider calculating your 12-month CLV:CAC ratio each month. Put another way, each month look at your business’s CLV:CAC ratio for the prior 12 months. Thus, look at the AOV for the past 12 months, purchase frequency for the past 12 months, and margin for the past 12 months.
The monthly CLV:CAC ratio should be a good indicator of your company’s health and general growth opportunity. Also, as you look at this figure each month, you can see trends in your company’s performance.
Three-month view. Separately, look at your ecommerce company’s CLV:CAC ratio for the prior three months. Again, run the report every month, but rather than looking at the ratio for the past year, consider only the past three months.
This ratio will help you spot immediate trends, identify peaks or valleys, and perhaps see problems before they get too large. This relatively shorter view also helps to identify seasonal trends such as how the Christmas holiday could be impacting your business.
If your company’s goal is to grow, to increase sales, profit, or both, CAC and CLV can indicate if you are succeeding and where to focus your efforts.
Ultimately, how well your company acquires and retains customers will determine sustainable success.
A CAC that is too high, for example, will tell you to focus on improving how your company attracts shoppers or improving how well it converts them. While a CLV that is similar to your CAC, for example, shows that you should pay attention to customer loyalty.
In my experience, there is no perfect KPI. You’ll likely need to juggle several of them. But an understanding of CLV and CAC can help most any ecommerce business.