Are you calculating your LTV with Gross Margin?
Your customers are priceless. They act as ambassadors, help you improve your service, and ultimately allow you to complete the mission of your business.
That being said, it is important to understand their monetary value to your business. If you haven’t yet, take a quick peep at our Lifetime Value (LTV) Deep Dive. There, you’ll see exactly how to calculate, analyze, and improve this metric. In short, LTV is the revenue a customer is projected/expected to generate for your company throughout its lifetime (however long they are doing business with you.)
How to calculate LTV with Gross Margin
While your LTV is critical to understanding your price points, and can ultimately help you create forecasts and evaluate the health of your teams. As mentioned, however, LTV measures revenue, not profit. Sure, you’re receiving a set amount--but how much money did you spend to generate that revenue?
Enter Gross Margin, the percentage of your revenue left after factoring in the Cost of Goods Sold. Let’s say your COGS is $20k and your total revenue is $100k. Congrats, your Gross Margin is the benchmark 80% for SaaS companies. $80k of your total revenue is available for you to put back into your business. The other 20% is spent delivering the service to your customer. In other words, in order to earn the $100k in revenue, you had to pay $20k.
Gross Margin gives your LTV important context
What does this mean for your LTV metric? Your LTV really only shows what the customer is bringing in—calculating with your Gross Margin factors in the amount required to deliver the service to them, leaving you with your profit.
If your customer’s LTV is $10k, and your Gross Margin is 80%, you’ll spend the remaining 20% delivering the service throughout their lifetime ($2k). Really then, after considering the cost, your customer is actually valued at $8k. In other words, you had to spend $2k to deliver your service to earn the $10k, leaving you with the $8k.
What happens if you don’t consider Gross Margin?
Neglecting to use LTV with your Gross Margin can also get you into a bit of trouble, especially once you start considering your LTV to CAC ratio. Let’s say your Gross Margin is 60% (not ideal). If your Customer Acquisition Cost is $2k, and your LTV alone is $10k, you might think your LTV:CAC ratio is at 5x and feel great about it! However, when you take into account the Gross Margin, you realize that your customer is really valued at $6k, since you spent $4k delivering the service. All of the sudden, your LTV:CAC ratio dips down to 3. Knowing this, you are better positioned to realize you must improve your Gross Margin or find lower cost methods of customer acquisition.
Make your metrics work for you
As always, LTV, like all metrics, is just a piece of the puzzle to tell the story of your business. Clearly, factoring in other metrics (COGS and Gross Margin) gives more context to your metrics, making them more useful for you in the long run.
If you’re looking to up your finance strategy and start incorporating richer context into your metrics, shoot us a note. We’re happy to help!